CA Final SFM. - CA Mayank Kothari. May 2017 Exam ICAI Material (2016) Reference for Imp. Questions. Page No.

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1 CA Final SFM - CA Mayank Kothari May 2017 Exam ICAI Material (2016) Reference for Imp. Questions No. Book Question No. Page No. No. Book Question No. 1 Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Example Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module I Practice Manual Module II Practice Manual Old RTP 84 Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Page No.

2 No. Book Question No. Page No. No. Book Question No. 32 Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Practice Manual Supplementary 2 A Practice Manual Supplementary 5 A Practice Manual Supplementary 1 A Practice Manual Supplementary 6 A Practice Manual Supplementary 7 A Practice Manual Supplementary 6 A Practice Manual Supplementary 1 A22 47 Practice Manual Supplementary 5 A Practice Manual Supplementary 3 A Practice Manual Supplementary 3 A Practice Manual Supplementary 8 A Practice Manual Supplementary 2 A Practice Manual Supplementary 2 C.6 53 Practice Manual Supplementary 3 C.8 54 Practice Manual Supplementary 4 C.9 55 Practice Manual Supplementary 5 C.9 56 Practice Manual Supplementary 6 C Practice Manual Supplementary 3 A Practice Manual Supplementary 5 A Practice Manual Supplementary 1 A Practice Manual Supplementary 8 A Practice Manual Supplementary 5 A Practice Manual Supplementary 6 A Practice Manual Supplementary 7 A Practice Manual Supplementary 9 A Practice Manual Supplementary 2 A Supplementary 1 A Supplementary 8 A Supplementary 4 A.26 Page No. a

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4 CA FINAL STRATEGIC FINANCIAL MANAGEMENT Fast Track Book CA Mayank Kothari BBA, ACA

5 Strategic Financial Management Fast Track Book Date: January 05, 2017 Mayank M. Kothari, BBA, ACA Author This edition is printed with license from the author CA Mayank M. Kothari All rights reserved. No part of this work covered by the copyright herein, may be reproduced, transmitted, stored or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, web distribution, information networks or information storage and retrieval systems without the prior written permission of the publisher or the author. CA Mayank Kothari 2698, SaiSagar, Behind Jindal School Dattawadi, Nagpur Tel: Facebook: Conferenza.in Tel: Facebook: Disclaimer: While every effort is taken to avoid errors or omissions in this publication, any mistake or omission that may have crept in, is not intentional. It may be taken note of that neither the publisher, nor the author, will be responsible for any damage or loss of any kind arising to any one in any manner on account of such errors or omissions. The discussion in the present text is academic and does not tantamount to expertise/professional service to the readers on the related subject matter. Further comments and suggestions for improving quality of the book are welcome and will be gratefully acknowledged. My Inspiration - CA Mayank Kothari

6 Think Different When you grow up you tend to get told the world is the way it is, and your life is just to live it inside the world, try not to bash into the walls too much, try to have a nice family have fun... save a little money. That s a very limited life. Life can be much broader once you discover one simple fact: Everything around you that you call life was made up by people that were no smarter than you and you can change it, you can influence it, and you can build your own things that other people can use. Once you learn that, you ll never be the same again. - Steve Jobs

7 Words of Acknowledgment When a dream turns into a reality, it s my duty to acknowledge those who have been the real strength behind my work. Thanks To- - Senior CA Kamal Mulchandani, Prof. Sudhir Sachdeva, CA Farooq Haque, for believing in me and giving me an opportunity to stand ahead of all. - My friend, CA Arjun Phatak for his extensive support in helping us to reach the maximum number of students. - My friend, CA Garvita Agrawal, her suggestions has made all the complex decisions very simple and effective. - My Friend, Sanskriti Khanna, her support and suggestions helped me not to give up on my goals. - Finally and the most important, Thank you Mom & Dad Your everyday support means a lot to me. - CA Mayank Kothari

8 Practical Questions (84 Marks) No. Subjects No. of Questions Page No. 1 Capital Budgeting Leasing Decisions Dividend Decisions Portfolio Management Derivatives Mutual Funds Bond Valuation Foreign Exchange and Risk Management Mergers, Acquisitions & Restructuring Business Valuation Financial Services Miscellaneous Topics Total 159 Theory Questions (16 Marks) No. Topic No. of Questions Page No. 1 Indian Capital Market Derivatives Portfolio Management Dividend Decisions Foreign Exchange & Risk Management Project Planning Capital Budgeting Leasing Decisions Financial Services Bond Valuation Mutual Funds Money Market Operations Mergers, Acquisitions & Restructuring Security Analysis Total 176

9 Words to the wise CA Exams Getting practical with the bookish knowledge is very important. I had to keep that thing in my mind all the time during exam preparation that only 5-6 People are going to pass out of 100. Writing the correct answer and expecting to get the marks would have been the biggest mistake I could have done. Because I cannot underestimate other participant in the contest, that s why I assumed that everybody is going to put their efforts for the same exam, and among 100 it s obvious that atleast people can give the right answer for any particular question but not all the are going to Pass the Exam. Clear enough. So, writing the correct answer and expecting a spot in top 5 represents that I am still the poor guy who didn't understand the game yet. And there's absolutely no place for the weak people in exams like CA, hence there's no choice but to be Strong. Knowing all these things I was bound to put extra efforts, something which majority of the students might not be doing in their preparation. I researched, I surfed, I asked and then found few things. I did it and frankly it was a blind game because I didn't know whether it s going to work or not. But taking the risk again is only option which may give you return. And on the other side I was happy somewhere because the moment I decided to do something extra was the moment I separated myself from rest of the world. In my eyes I was no more a person picked up from the crowd. First you only have to feel that you are special and then the world will participate in your belief. It s a game, not an exam Your fight is against the rest of the participants not with ICAI or its question paper. You not only have to prepare for what s in there your course, but also you have to prepare more than what the best person sitting in the exam will be. Be a Smart, not a Dolt If you have an option, why not to think big. Have some special reason of your own to get that degree, only then you will put extra efforts. Push your own limits and get out of the comfort zone. Every day break your own records else the world out there will break you to your knees. Perseverance is what all required. Keep Going, Keep Trying, Keep Improving... One day everything will be yours. -CA Mayank Kothari

10 Capital Budgeting Capital Budgeting 1. DEF Ltd has been regularly paying a dividend of `19,20,000 per annum for several years and it is expected that same dividend would continue at this level in near future. There are 12,00,000 equity shares of `10 each and the share is traded at par. The company has an opportunity to invest `8,00,000 in one year's time as well as further `8,00,000 in two year's time in a project as it is estimated that the project will generate cash inflow of `3,60,000 per annum in three year's time which will continue for ever. This investment is possible if dividend is reduced for next two years. Whether the company should accept the project? Also analyze the effect on the market price of the share, if the company decides to accept the project. 2. X Ltd. is a taxi operator. Each taxi cost to company `4,00,000 and has a useful life of 3 years. The taxi s operating cost for each of 3 years and salvage value at the end of year is as follows: Year 1 Year 2 Year 3 Operating Cost 1,80,000 2,10,000 2,38,000 Resale Value 2,80,000 2,30,000 1,68,000 You are required to determine the optimal replacement period of taxi if cost of capital of X Ltd. is 10%. [SM_2.55_16] 1 Page

11 CA Final SFM CA Mayank Kothari 3. A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A & Co. currently pays no taxes. The replacement machine costs `90,000 now and requires maintenance of `10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of `20,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls each year as follows: Year Maintenance Salvage Present 0 `40,000 1 `10,000 `25,000 2 `20,000 `15,000 3 `30,000 `10,000 4 `40,000 0 The opportunity cost of capital is 15% and you are required to find out when the company should replace the machine. 4. A machine used on a production line must be replaced at least every four years. Cost incurred to run the machine according to its age are: Age of the Machine (years) Figures in (`) Purchase Price 60,000 Maintenance 16,000 18,000 20,000 20,000 Repair 0 4,000 8,000 16,000 Scrap Value 32,000 24,000 16,000 8,000 Future replacement will be with identical machine with same cost. Revenue is unaffected by the age of the machine. Ignoring inflation and tax, determine the optimum replacement cycle. PV factors of the cost of capital of 15% for the respective four years are , , and [May 2012, 10 Marks] Page

12 Capital Budgeting 5. Determine NPV of the project with the following information: Initial Outlay of project `40000 Annual revenues (Without inflation) `30000 Annual costs excluding depreciation (Without inflation) `10000 Useful life 4 years Salvage value Nil Tax Rate 50% Cost of Capital (Including inflation premium of 10%) 12% 6. XYZ Ltd. requires `8,00,000 for a unit. The useful life of a project is 4 years. Salvage value Nil. Depreciation charge `2,00,000 p.a. Expected revenues and costs (excluding depreciation) ignoring inflation are: Year Revenues `6,00,000 `7,00,000 `8,00,000 `8,00,000 Cost `3,00,000 `4,00,000 `4,00,000 `4,00,000 Tax rate 60%, Cost of capital 10%. Calculate NPV of the project if inflation rates for revenues & costs are: Year Revenues Costs 1 10% 12% 2 9% 10% 3 8% 9% 4 7% 8% 7. Determine the risk adjusted net present value of the following projects X Y Z Net Cash outlays Project life 5 years 5 years 5 years Annual cash inflow Coefficient of variation The company selects the risk adjusted discount factor on the basis of the coefficient of variation as follows: 3 Page

13 CA Final SFM CA Mayank Kothari Coefficient of variation RADR Present value factor of 1-5 RADR % % % % % % More than 2 25% [Nov 2005, 6 Marks] [May 1999, 6 Marks] New projects Ltd. is evaluating 3 projects P-I, P-II, P-III. Following information is available in respect of these projects. P-I P-II P-III Cost `15,00,000 `11,00,000 `19,00,000 Inflows Year 1 6,00,000 6,00,000 4,00,000 Year 2 6,00,000 4,00,000 6,00,000 Year 3 6,00,000 5,00,000 8,00,000 Year 4 6,00,000 2,00,000 12,00,000 Risk Index Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free interest rate is 10%. Required 1. Find out the risk adjusted discounted rate (RADR) for these projects. 2. Which project is best? [Nov 2009, 10 Marks] Page

14 Capital Budgeting 9. The globe manufacturing Company Ltd. is considering an investment in one of the two mutually exclusive proposals Project X and Project Y, which require cash outlays of `3,40,000 and `3,30,000 respectively. The certainty-equivalent approach is used in incorporating risk in capital budgeting decisions. The current yield on government bond is 8% and this is to be used as the riskless rate. The expected net cash flows and their certainty equivalents are as follows: Year Project X Project Y Cash flow C.E. Cash flow C.E. 1 1,80, ,80, ,00, ,80, ,00, ,00, Required: 1. Find out the risk adjusted discounted rate (RADR) for these projects. 2. Which project should be accepted? 10. The following information applies to a new project: Initial investment `125,000 Selling price per unit `100 Variable cost per unit `30 Fixed cost for the period `1,00,000 Sales Volume 2,000 Life 5 years Discount rate 10% Required: Projects NPV and show how sensitive the results are to various factors. 5 Page

15 CA Final SFM CA Mayank Kothari 11. The Easygoing Company Limited is considering a new project with initial investment, for a product Survival. It is estimated that IRR of the project is 16% having an estimated life of 5 years. Financial Manager has studied that project with sensitivity analysis and informed that annual fixed cost sensitivity is %, whereas cost of capital (discount rate) sensitivity is 60%. Other information available are: Profit Volume Ratio (P/V) is 70%, Variable cost `60/- per unit Annual Cash Flow `57,500/- Ignore Depreciation on initial investment and impact of taxation. Calculate (i) Initial Investment of the Project (ii) Net Present Value of the Project (iii) Annual Fixed Cost (iv) Estimated annual unit of sales (v) Break Even Units Cumulative Discounting Factor for 5 years 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% Page

16 Capital Budgeting 12. Following are the estimates of the net cash flows and probabilities of a project of M/s X ltd. Year P=0.3 P=0.5 P=0.2 Initial investment 0 4,00,000 4,00,000 4,00,000 Estimated net after tax cash flows 1 to 5 1,00,000 1,10,000 1,20,000 per year Estimated after tax salvage value 5 20,000 50,000 60,000 Required rate of return for the project is 10% Find: i) The expected NPV of the project ii) iii) The best case and worst case NPVs The probability of occurrence of the worst case, if the cash flows are i) Perfectly dependent over time ii) Independent overtime iv) Standard deviation and coefficient of variation assuming that there are only three streams of cash flow, which are represented by each column of the table with the given probabilities. v) Coefficient of variation of X Ltd. on its average project which is in the range of 0.95 to 1.0. If the coefficient of variation of the project is found to be less risky than average, 100 basis points are deducted from the company s cost of capital. Note: For Standard Deviation and Coefficient of Variation concept Go through PORTFOLIO MANAGEMENT chapter [Nov 2006, 16 Marks] Page

17 CA Final SFM CA Mayank Kothari 13. L & R Limited wishes to develop new virus-cleaner software. The cost of the pilot project would be `2,40,000. Presently, the chances of the product being successfully launched on a commercial scale are 50%. L&R can invest the sum of `20 lacs to market the product. Such an effort can generate perpetually, an annual net after tax cash income of `4 lacs. Even if the commercial launch fails, they can make an investment of smaller amount of `12 lacs with the hope of gaining perpetually a sum of `1 lac. Evaluate the proposal, adopting the decision tree approach. The discount rate is 10%. 14. Skylark Airways is planning to acquire a light commercial aircraft for flying class clients at an investment of `50,00,000. The expected cash flow after tax for the next 3 years is as follows: CFAT Probability CFAT Probability CFAT Probability Year 1 Year 2 Year 3 14,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, The company wishes to take into consideration all possible risk factors relating to airline operations. The company wants to know: i) The expected NPV of this venture assuming independent probability distribution with 6% risk free of interest. ii) The possible deviation in the expected value. iii) How would standard deviation of the present value distribution help in capital budgeting decisions? [Nov 2002, 14 Marks] Page

18 Leasing Decisions Leasi ng Deci si ons 1. Leasing Company expects a minimum lease of 10% on its investment in the leasing business. It proposes to lease a machine costing `5,00,000 for ten years. Calculate the lease rentals if the lease payments are to be received in a. Advance b. At the end of the year 2. Assuming lease amortised in 5 years, calculate alternate rental structure from the following: Investment Outlay 100 Lakhs Pre Tax Rate 20% Scrap Value Nil Schemes a. Equal Annual Plan b. Stepped up plan (15% increase each year) c. Balloon Plan (he pays Rs in the fourth year) d. Deferred payment plan (deferment of 2 years) Calculate lease rentals 3. Alfa Ltd. desires to acquire a diesel generating set costing `20 lakh which will be used for a period of 5 years. It is considering two alternatives (i) taking the generating set on lease or (ii) purchasing the asset outright by raising a loan. The company has been offered a lease contract with a lease payment of `5.2 lakh per annum for five years payable in advance. Company's banker requires the loan to be 12% p.a. in 5 equal annual instalments, each instalment being due at the beginning of the each year. Tax relevant depreciation of the generator is 20% as per WDV method. At the end of 5 th year the generator can be sold at `2,00,000. Marginal Tax rate of Alfa Ltd. is 30% and its post tax cost of capital is 10%. Determine: 9 Page

19 CA Final SFM CA Mayank Kothari (a) The Net Advantage of Leasing to Alfa Ltd. and recommend whether leasing is financially viable. (b) Break Even Lease Rental [May 2010, 12 Marks] With the following data available, compute the BELR that ABC Ltd. should charge from lessee. Cost of Machine `150 Lakhs Salvage Value of Machine at the end of 5 years `10 Lakhs Expected useful life 5 years Rate of depreciation (WDV) 25% K 0 14% Applicable tax rate 35% Machine will constitute a separate block for depreciation purpose. 5. Fair finance, a leasing company, has been approached by a prospective customer intending to acquire a machine whose Cash Down price is `3 crores. The customer, in order to leverage his tax position, has requested a quote for a three year lease with rentals payable at the end of each year but in a diminishing manner such that they are in the ratio of 3 : 2 : 1. Depreciation can be assumed to be on straight line basis and Fair Finance s marginal tax rate is 35%. The target rate of return for Fair Finance on the transaction is 10%. Required: Calculate the lease rents to be quoted for the lease for three years [Nov 2004, 08 Marks] [Nov 2012, 8 Marks] Page

20 Leasi ng Deci si ons 6. Khalid Tour Operator Ltd. is considering buying a new car for its fleet for local touring purpose. Purchase Manager has identified Renault Duster model car for acquisition. Company can acquire it either by borrowing the fund from bank at 12% p.a. or go for leasing option involving yearly payment (in the end) of `2,70,000 for 5 years. The new car shall cost `10,00,000 and would be depreciable at 25% as per WDV method for its owner. The residual value of car is expected to be `67,000 at the end of 5 years. The corporate tax rate is 33%. You are required to: (a) Calculate which of the two options borrowings or leasing shall be financially more advantageous for the Company. (b) Measure the sensitivity of Leasing/ Borrowing Decision in relation to each of the following parameters: (i) Rate of Borrowing (ii) Residual Value (iii) Initial Outlay Among above which factor is more sensitive [Nov 2015, RTP] The following are the details of a lease by RST Ltd. a. Cost of machine is `1,00,000 financed 80% through debt and balance through equity. Cost of debt before tax amount to 20% and equity 16%. b. The lessor is in 35% tax bracket. The rate of depreciation for machinery is 20% WDV. c. The scrap value of machine is `10,000 at the end of 5 th year. d. Estimated cost for maintenance is `1,000 per annum. e. The lessee agrees to pay the following: (i) Annual rent of `36,000 for 5 years payable at the end of each year. (ii) The security deposit of `3,000 which is refundable at the end of lease period. (iii) Training fees payable at the beginning of lease period is `2,500. Decide whether the lessor should lease the asset (based on IRR). 11 Page

21 CA Final SFM CA Mayank Kothari 12 Page

22 Dividend Decisions Dividend Decisions 1. XYZ Co. which earns `10 per share is capitalized at 10% and has a return on investment of 12%. Determine the optimum dividend payout ratio and price of the share at the payout using Walter s dividend policy model. 2. The following information pertains to M/s XY Ltd. Earnings of the company Dividend payout ratio 60% `5,00,000 No. of shares outstanding 1,00,000 Equity capitalization rate 12% Return on investment 15% a. What would be the market value per share as per Walter model? b. What is the optimum dividend payout ratio according to Walter s model and the market value of the Company s share at that payout ratio? [May 2006, 8 Marks] [Nov 2010, 8 Marks] X ltd. has an internal rate of 20%. It has declared 18% on its equity shares, having face value of `10 each. The payout ratio is 36% and Price Earnings Ratio is Find the cost of equity according to Walter s Model and hence determine the limiting value of its shares in case the payout ratio is varied as per the said model. 4. Starlite Limited is having its share quoted in major stock exchanges. The company is having a paid up capital of`10 lakh (`10 each share). Dividend is distributed at the rate of 20% per annum. Annual growth rate in dividend is expected at 2%. The expected rate of return on its equity capital is 15%. Calculate the value of the share of Starlite Limited based on Gordon s model. 13 Page

23 CA Mayank Kothar i CA Fi nal SFM 5. Calculate the implied Growth Rate and Return on Equity Current stock price = `65 Next year s dividend =`4 Capitalization rate =12% Earnings retention ratio =50% 6. Two companies A Ltd. and B Ltd. paid a dividend of `3.50 per share. Both are anticipating that dividend shall 8%. The beta of A Ltd. and B Ltd. are 0.95 and 1.42 respectively. The yield on GOI Bond is 7% and it is expected that stock market index shall increase at an annual rate of 13%. You are required to determine: (a) Value of share of both companies. (b) Why there is a difference in the value of shares of two companies. (c) If current market price of share of A Ltd. and B Ltd. are `74 and `55 respectively. As an investor what course of action should be followed? [Nov 2015, RTP] P.L. Engineering Ltd. belongs to a risk class for which the capitalisation rate is 10%. It currently has outstanding shares selling at `100 each. The firm is contemplating the declaration of dividend of`5 per share at the end of the current financial year. It expects to have a net income of `1,00,000 and has a proposal for making new investments of `2,00,000. Show how under M-M hypothesis, the payment of dividend does not affect the value of the firm. 14 Page

24 Dividend Decisions 8. X Limited, just declared a dividend of `14.00 per share. Mr. B is planning to purchase the share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three years. He also expects the market price of this share to be `360 after three years. You are required to determine: (i) The maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per annum. (ii) The maximum price Mr. B will be willing to pay for share, if he is of the opinion that the 9% growth can be maintained indefinitely and require 13% rate of return per annum. (iii) The price of share at the end of three years, if 9% growth rate is achieved and assuming other conditions remaining same as in (ii) above. Calculate the rupee amount up to two decimal points. 9. Zumo & Co. is a watch manufacturing company and is all equity financed and has paid up capital `10,00,000 (`10 per shares) The other data related to the company is as follows: Year EPS Net dividend per share Share price Zumo & Co. has hired one management consultant, Vidal Consultants to analyze the future earnings and other related item for the forthcoming years. As a Vidal Consultant s report (1) The earnings and dividend will grow at 25% for the next two years. (2) Earnings are likely at rate of 10% from 3 rd year and onwards (3) Further if there is reduction in earnings growth occurs dividend payout ratio will increase to 50% Assuming the tax rate as 33% (not expected to change in the foreseeable future) calculate the estimated share price and P/E Ratio which analysts now expect for Zumo& Co. using the dividend valuation model. You may further assume the post tax cost of capital is 18%. 15 Page

25 CA Mayank Kothar i CA Fi nal SFM 10. Truly Plc presently pay a dividend of 2.00 per share and has a share price of (i) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm s expected or required return on equity using a dividend-discount model approach? (ii) Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the firm s expected, or required, return on equity? 16 Page

26 Portfolio Management Portfolio Management 1. Investor has assigned the probability of occurrence of the possible alternative returns. Find out the expected return. Possible returns Probability 20% % % % % Calculate the variance and standard deviation considering the data given below Possible returns Probability 20% % % % % Ashok Rai has a portfolio of five securities whose expected return and amount invested are as follows I II III IV V Amount (in Lakhs) Expected Return 12% 9% 15% 18% 14% Find out the % expected return of the portfolio. 4. Consider the following data A B r 20% 25% σ 50% 30% r ab Now suppose the portfolio is constructed with 40% of the funds invested in A and balance 60% in B 17 Page

27 CA Mayank Kothar i CA Fi nal SFM You are required to calculate: a. Expected Return of the portfolio b. Variance of the portfolio c. Standard deviation of the portfolio d. State whether diversification has resulted in reduction of risk? 5. Calculate the risk of the following multiple asset portfolio Security X i σ i Correlation coefficient X X and Y = 0.7 Y X and Z = 0.3 Z Y and Z = 0.4 It may be noted that the correlation coefficient between X and X, Y and Y, Z and Z is The historical rates of return of two securities over the past ten years are given. Calculate the Covariance and the Correlation coefficient of the two securities: Years: Security 1: (Return per cent) Security 2: (Return per cent) [May 2007, 10 Marks] The distribution of return of security F and the market portfolio P is given below: Probability Return % F P You are required to calculate the expected return of security F and the market portfolio P, the covariance between the market portfolio and security and beta for the security [May 2006, 8 Marks] Page

28 Portfolio Management 8. An investor has decided to invest to invest `1,00,000 in the shares of two companies, namely, ABC and XYZ. The projections of returns from the shares of the two companies along with their probabilities are as follows: Probability ABC(%) XYZ(%) You are required to 1. Comment on return and risk of investment in individual shares. 2. Compare the risk and return of these two shares with a Portfolio of these shares in equal proportions. 3. Find out the proportion of each of the above shares to formulate a minimum risk portfolio. 9. The returns and beta of 3 stocks are given below Stock A B C Return (%) Beta Factor If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the above stocks are over, under, or correctly valued in the market? What shall be the strategy? 19 Page

29 CA Mayank Kothar i CA Fi nal SFM 10. A Portfolio Manager (PM) has the following four stocks in his portfolio: Security No. Of Market Price per β Shares share (`) VSL 10, CSL 5, SML 8, APL 2, Compute the following: (i) Portfolio Beta (ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring in? (iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he bring in? [Nov 2011, 8 Marks] An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend be ing paid by the company is `2 per share and the share is being sold at `25 per share in the market. However, several factors are likely to change during the course of the year as indicated below: Existing Revised Risk free rate 12% 10% Market risk premium 6% 4% Beta value Expected growth rate 5% 9% In view of the above factors whether the investor should buy, hold or sell the shares? And why? [May 2003, 8 Marks] Page

30 Portfolio Management 12. The following information is available in respect of Security X Equilibrium Return 15% Market Return 15% 7% Treasury Bonds trading at $140 Covariance of Market return and security Return 225% Coefficient of Correlation 0.75 You are required to determine the Standard Deviation of Market Return and Security Return. 13. Mr. Nirmal Kumar has categorized all the available stock in the market into the following types: (i) Small cap growth stocks (ii) Small cap value stocks (iii)large cap growth stocks (iv) Large cap value stocks Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market index. Further, more the sensitivity of returns on these categories of stocks to the three important factor are estimated to be: Category of the stock Weight in the market index Factor I (Beta) Factor II (book price) Factor III (Inflation ) Small cap growth 25% Small cap value 10% Large cap growth 50% Large cap value 15% Risk Premium 6.85% -3.5% 0.65% The rate of return on treasury bonds is 4.5% 21 Page

31 CA Mayank Kothar i CA Fi nal SFM Required: a) Using Arbitrage Pricing Theory, determine the expected return on the market index. b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the market index. c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the small cap value and large cap growth stocks. If the target beta for the desired portfolio is 1, determine the composition of his portfolio. 14. A has portfolio having following features: Security β Random Error σ ei Weight L M N K You are required to find out the risk of the portfolio if the standard deviation of the market index σ m is 18% [May 2012, 8 Marks] Following are the details of a portfolio consisting of three shares: Share Portfolio Weight Beta Expected Return % Total Variance A B C Standard Deviation of Market Portfolio Returns = 10% You are given the following additional data: Covariance (A, B) Covariance (A, C) Covariance (B, C) Page

32 Portfolio Management Calculate the following: (i) The Portfolio Beta (ii) Residual variance of each of the three shares (iii) Portfolio variance using Single Index Model (iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz) 16. An Indian investor invests in bonds in America. If the price of the bond in the beginning of the period is $100 and it is $105 at the end of the period. The coupon interest during the period is $7. The US dollar appreciates during this period by 3% find the return on investment in terms of the home country currency. 17. A study by a Mutual fund has revealed the following data in respect of three securities: Security σ(%) correlation with Index, Pm A B C The standard deviation of market portfolio (BSE Sensex) is observed to be 15%. (i) (ii) (iii) (iv) (v) What is the sensitivity of returns of each stock with respect to the market? What are the covariance s among the various stocks? What would be the risk of portfolio consisting of all the three stocks equally? What is the beta of the portfolio consisting of equal investment in each stock? What is the total, systematic and unsystematic risk of the portfolio in (iv)? [Nov 2009, 8 Marks] Page

33 CA Mayank Kothar i CA Fi nal SFM 18. Five portfolios experienced the following results during a 7 year period Portfolio Average Annual Return (Rp) Standard Deviation (Sp) Correlation with the market returns (r) A B C D E Market risk (Sm) Market Rate of Return (Rm) Risk Free Rate (Rf) Rank the portfolios using (a) Sharp s Method, (b) Treynor s Method and (c) Jensen s Alpha 19. Ramesh wants to invest in stock market. He has got the following information about individual securities: Security Expected Return Beta σ 2 ci A B C D E F Market index variance is 10 percent and the risk free rate of return is 7%. What should be the optimum portfolio assuming no short sales? [May 2010, 10 Marks] Page

34 Portfolio Management 20. Indira has a fund of `3 lacs which she wants to invest in share market with rebalancing target after every 10 days to start with for a period of one month from now. The present NIFTY is The minimum NIFTY within a month can at most be She wants to know as to how she should rebalance her portfolio under the following situations, according to the theory of Constant Proportion Portfolio Insurance Policy, using 2 as the multiplier: (1) Immediately to start with. (2) 10 days later being the 1 st day of rebalancing if NIFTY falls to (3) 10 days further from the above date if the NIFTY touches For the sake of simplicity, assume that the value of her equity component will change in tandem with that of the NIFTY and the risk free securities in which she is going to invest will have no Beta [May 2012, 8 Marks] Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the portfolio management techniques and wants to test one of the techniques on an equity fund she has constructed and compare the gains and losses from the technique with those from a passive buy and hold strategy. The fund consists of equities only and the ending NAVs of the fund he constructed for the last 10 months are given below: Month Ending NAV Month Ending NAV Dec May Jan Jun Feb Jul Mar Aug Apr Sep Assume Sunidhi had invested a notional amount of `2 lakhs equally in the equity fund and a conservative portfolio (of bonds) in the beginning of December 2008 and the total portfolio was being rebalanced each time the NAV of the fund increased or decreased by 15%. You are required to determine the value of the portfolio for each level of NAV following the Constant Ratio Plan. 25 Page

35 CA Mayank Kothar i CA Fi nal SFM 22. The returns on stock A and market portfolio for a period of 6 years are as follows: Year Return on A (%) Return on market portfolio(%) You are required to determine: (i) Characteristic line for stock A (ii) Also find out the Securities Characteristics Line and Securities Market Line and Capital Market line, given that the risk free rate of interest is 6% (iii) The systematic and unsystematic risk of stock A [Jun 2009, 8 Marks] ABC Ltd. manufactures Car Air Conditioners (ACs), Window ACs and Split ACs constituting 60%, 25% and 15% of total market value. The stand-alone Standard Deviation (SD) and Coefficient of Correlation with market return of Car AC and Window AC is as follows: Standard Deviation Coefficient of Correlation Car AC Window AC No data for stand-alone SD and Coefficient of Correlation of Split AC is available. However, a company who derives its half value from Split AC and half from Window AC has a SD of 0.50 and Coefficient of correlation with market return is Market Index has a return of 10% and SD of Further, the risk free rate of return is 4%. You are required to determine: (i) Beta of ABC Ltd. (ii) Cost of Equity of ABC Ltd. (iii)assuming that ABC Ltd. wants to raise debt of an amount equal to half of its Market Value then determine equity beta, if yield of debt is 5%. 26 Page

36 Derivatives Derivatives 1. The price of equity shares of Onida Picture Ltd. (a non dividend paying) company is ` 30. The risk free rate is 12% p.a. with continuous compounding. An investor wants to enter into a 6 months forward contract. Find out the forward price. 2. Consider a 3 month maturity forward contract on a non-dividend paying stock. The stock is available for `200. With compounded continuously risk-free rate of interest (CCRRI) of 10 % per annum, what is the price of the future contract? 3. Calculate the price of 90-day futures contract on a stock that pays `1.50 dividend on 50th day. The current stock price is `100. The yield on risk-free assets is 10% pa on simple interest rate basis (or 9.53% p.a. continuous compounding basis). The inputs are thus: S = 50; r = ; T = year (or 90 days); t = year (50 days). 4. BSE 5000 Value of portfolio `10,10,000 Risk free interest rate 9% p.a. Dividend yield on Index 6% p.a. Beta of portfolio 1.5 We assume that a future contract on the BSE index with four months maturity is used to hedge the value of portfolio over next three months. One future contract is for delivery of 50 times the index. Based on the above information Calculate: (i) Price of future contract. (ii) The gain on short futures position if index turns out to be 4,500 in three months [Nov 2007, 8 Marks] Page

37 CA Mayank Kothar i CA Fi nal SFM 5. Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company. He expects to purchase a portfolio of shares in 90 days. However he is worried about the expected price increase in shares in coming day and to hedge against this potential price increase he decides to take a position on a 90-day forward contract on the Index. The index is currently trading at Assuming that the continuously compounded dividend yield is 1.75% and risk free rate of interest is 4.16%, you are required to determine: (c) Calculate the justified forward price on this contract. (d) Suppose after 28 days of the purchase of the contract the index value stands at 2450 then determine gain/ loss on the above long position. (e) If at expiration of 90 days the Index Value is 2470 then what will be gain on long position. Note: Take 365 days in a year and value of e = , e = A trader is having in its portfolio shares worth `85 lakhs at current price and cash`15 lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares dropped by 3.2%. Determine: (i) Current portfolio beta (ii) Portfolio beta after 3 months if the trader on current date goes for long position on `100 lakhs Nifty futures. 7. The following data relates to Anand Ltd s share prices: Current price per share Price per share in the forward market `1800 `1950 It is possible to borrow money in the market for securities transactions at the rate of 12% per annum. Required: i) Calculate the theoretical minimum price of a 6 month forward contract ii) Explain if any arbitraging opportunities exist [May 2004, 6 Marks] Page

38 Derivatives 8. On January 1, 2013 an investor has a portfolio of 5 shares as given below: Security Price No. of Shares Beta A B C D E The cost of capital to the investor is 10.5% per annum. You are required to calculate: (i) The beta of the portfolio (ii) The theoretical value of the NIFTY futures for February (iii) The number of contracts of NIFTY the investor needs to sell to get a full hedge until February for his portfolio if the current value of NIFTY is 5900 and NIFTY futures have a minimum trade lot requirement of 200 units. Assume that the futures are trading at their fair value. (iv) The number of future contracts the investor should trade if he desires to reduce the beta of his portfolios to 0.6. No of days in a year be treated as 365. Given: In(1.105)= e ( ) = A company is long on 10 MT of `474 per kg (spot) and intends to remain so for the ensuing quarter. The standard deviation of changes of its spot and future prices are 4% and 6% respectively, having correlation of What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect hedge? [May 2012, 5 Marks] Page

39 CA Mayank Kothar i CA Fi nal SFM 10. Sensex futures are traded at a multiple of 50. Consider the following quotations of 30 Page Sensex futures in the 10 trading days during February, 2009: Abhishek bought one Sensex futures contract on February, 04. The 0 average daily absolute change in the value of contract is `10,000 and standard deviation of these changes is `2,000. The maintenance margin is 75% of initial margin. You are required to determine the daily balances in the margin account and payment on margin calls, if any [Nov 2010, 8 Marks] XYZ established the following spread on the Delta Corporation's stock: (i) Purchased one 3-month call option for 100 Nos. with a premium of `30 and an exercise price of `550. (ii) Purchased one 3-month put option for 100 Nos. with a premium of `5 and an exercise price of `450. The current price of Delta Corporation's stock is `500. Determine XYZ profit or loss if the price of Delta Corporation: (i) Stays at`500 after 3 months. (ii) Falls to `350 after 3 months. (iii) Rises to `600. Assume the size option is 100 shares of Delta Corporation. --[May 2010, 4 Marks]--[Nov 2008,6 Marks]--[Nov 2010, 6 Marks]--[May 2011, 8 Marks]- Day High Low Closin

40 Derivatives 12. The equity shares of Ramacast Ltd. are being sold at `210. A 3-month call option is available for a premium of `6 per share and a 3 months put option is available for a premium of `5 per share. Find out the net pay off of the option holder of the call option and put option given that (i) The strike price in both the cases is `220 and (ii) The share price on the exercise day is `200 or `210 or `220 or `230 or ` You as an investor had purchased a 4 month call option on the equity shares of X Ltd. of `10, of which the current market price is `132 and the exercise price of `150. you expect the price to range between `120 and `190. The expected share price of X Ltd. and relate probability is given below: Expected Price (`) Probability Compute the following: (1) Expected share price at the end of 4 months. (2) Value of Call option at the end of 4 months, if the exercise price prevails. (3) In case the option is held to its maturity, what will be the expected value of the call option? [Nov 2012, 8 Marks] Explain the reason why the investors are not required to pay margin in case of buying the option (call or put), but are required to pay margin (mark to market) in case they write (sell) options. 31 Page

41 CA Mayank Kothar i CA Fi nal SFM 15. Shares of Infar Machines Ltd. are selling at `3000. Following options are available for one month s duration Call Options Put Options Strike Price Premium Strike Price Premium `2900 `120 `3100 `125 `3000 `35 `3000 `40 `3100 `5 `2900 `10 Find out the Intrinsic Value and Time Value of the Call and Put Options 16. The current market price of an asset is `80(S). In one year s time from now, the price may be `100(S1) or `70(S2). A call option at the strike price of `80 is available for `20. The risk free rate of interest for the one period till expiration of call option is 10%. Find out the fair value of the call option as per BM. 17. Following is the two period tree for share of stock in CAB Ltd.: Now S1 One period Using the binomial model, calculate the current fair value of the regular call option on CAB stock with the following characteristics: X = `28, risk free rate = 5% (per sub period). 18. The current market price of a share is `19 and call option and put option at a strike price of `20 are available for `3 for a period of 3 months. If the risk free rate is 10%, identify the arbitrage opportunities. Apply Put-Call Parity theory 32 Page

42 Derivatives 19. The shares of TIC Ltd. are currently priced at `415 and call option exercisable in three months time has an exercise rate of `400. Risk free rate of interest is 5% p.a. and standard deviation (volatility) of share price is 22%. i) Based on the assumption that TIC Ltd. is not going to declare any dividend over the next three months, is the option worth buying for `25? ii) Calculate value of the call option based on Black Scholes valuation model if the current price is considered as `380. iii) What would be the worth of put option if the current price is considered `380? iv) If TIC share price is taken as `408 and a dividend of `10 is expected to be paid in the two months time, then calculate value of the call option. 20. From the following data for certain stock, find the value of a call option: Price of the stock now `80 Exercise Price Standard Deviation of (Continuously Compounded Rate of Return) Maturity period ` months Annual Interest rate 12% Given Number of S.D. from Mean, (z) Area of the left or right (one tail) e 0.12x0.05 =1.062 In = [Nov 2006, 8 Marks] Page

43 CA Mayank Kothar i CA Fi nal SFM 21. Derivative bank entered into a plain vanilla swap through on OIS(Overnight Index Swap) on a principal of `10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on the principal. The swap was entered into on Monday, 2 nd August, 2010 and was to commence on 3 rd August, 2010 and run for a period of 7 days. Respective MIBOR rates for Tuesday to Monday were: 7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.15% If derivative bank received `317 net on settlement, calculate fixed rate and interest under both legs. Notes: i) Sunday is Holiday. ii) Work in rounded rupees and avoid decimal working [Nov 2010, 8 Marks] ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + 1/4% for `200 million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month LIBOR treating six months as exactly half a year. (a) What will be the "all in cost" funds to ABC Bank? (b) Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for first three years and LIBOR ¼% for remaining two years. Given a three year swap rate of 8%, suggest the method by which the bank should achieve fixed rate funding [May 2010, 10 Marks] Page

44 Derivatives 23. M/s Parker & Co. is contemplating to borrow an amount of `60 crores for a period of 3 months in the coming 6 months time from now. The current rate of interest is 9% p.a. but it may go up in 6 months time. The company wants to hedge itself against the likely increase in interest rate. The Company s Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a. What will be the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest after 6 months happens to be (i) 9.60% p.a. and (ii) 8.80% p.a.? [May 2013, 8 Marks] Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate Agreement). They want to borrow a sum of `100 crores after 2 years for a period of 1 year. Bank has calculated Yield Curve of both companies as follows: Year XYZ Ltd ABC Ltd *The difference in yield curve is due to the lower credit rating of ABC Ltd. compared to XYZ Ltd. (ii) You are required to calculate the rate of interest DEF Bank would quote under 2V3 FRA, using the company s yield information as quoted above. (iii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of the amount of loan, you are required to calculate the interest payable by XYZ Ltd. if interest in 2 years turns out to be (a) 4.50% (b) 5.50% 35 Page

45 CA Mayank Kothar i CA Fi nal SFM 25. Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature. In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6 months firm cash crunch, leading to borrowing of money to cover up its exposures for running the business. It is expected that firm shall borrow a sum of 50 million for the entire period of slack season in about 3 months. A Bank has given the following quotations: Spot 5.50% % 3 x 6 FRA 5.59% % 3 x 9 FRA 5.64% % 3 month 50,000 future contract maturing in a period of 3 months is quoted at (5.85%). You are required to determine: (a) How a FRA, shall be useful if the actual interest rate after 3 months turnout to be: (i) 4.5% (ii) 6.5% (b) How 3 months Future contract shall be useful for company if interest rate turns out as mentioned in part (a) above. 26. XYZ Limited borrows 15 million of six months LIBOR % for a period of 24 months. The company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its bankers at the strike rate of 8.00%. The lump sum premium is 1.00% for the entire reset periods and the fixed rate of interest is 7.00% per annum. The actual position of LIBOR during the forthcoming reset period is as under: Reset Period LIBOR % % % You are required to show how far interest rate risk is hedged through Cap Option. For calculation, work out figures at each stage up to four decimal points and amount nearest to. It should be part of working notes [May 2013, 5 Marks] Page

46 Derivatives 27. ABC Ltd. is raising a loan at a floating rate of LIBOR +20 basis points. It anticipates a rise in interest rates, and is considering to hedge against the interest rate risk. The loan is to be raised on 1.1.Y1 and the expected LIBOR for next two years with a break of 6 months are 1.1.Y1 5.5% 1.7.Y1 7.0% 1.1.Y2 5.5% 1.7.Y2 3.5% Following hedging strategies have been suggested: (i) A two year 5.5% cap against LIBOR at a premium of 0.5% (ii) A two year zero cost collar LIBOR with a cap of 6.5% and floor of 4.5% Find out the overall cost to the company for each six month period for the years Y1 and Y2 under the following situations (a) If no hedge is taken up (b) If cap is purchased or (c) If collar is created 37 Page

47 CA Mayank Kothar i CA Fi nal SFM Mutual Funds 1. An investor purchased 300 units of Mutual Fund at rate of `12.25 per unit on 31 st December As on 31 st December 2010 he has received `1.25 as dividend and had received a capital gains distribution of `1.00 per unit. You are required to find out: a) Holding period return, assuming that this no load fund has a NAV of `13.00 as on 31 st December b) Holding period return, assuming all the dividends and capital gains distributions are reinvested into additional units as at average price of `12.50 per unit [May 2011, 8 Marks] A mutual fund s opening NAV is `20 and its closing NAV is`24. If the expense per unit is `0.50, what is the expense ratio? 3. TUV Ltd. has invested in three Mutual Fund schemes as per the details given below: Scheme X Scheme Y Scheme Z Date of investment Amount of investment `15,00,000 `7,50,000 `2,50,000 Net Asset Value (NAV) at entry `12.50 `36.25 `27.75 Dividend received `45000 `12,500 Nil NAV as at `12.25 `36.45 `27.55 Required: What is the effective yield on per annum basis in respect of each of the three schemes upto ? [Nov 2004, 6 Marks]-----[May 2013, 10 Marks]-----[May 2015, 4 Marks] Page

48 Mutual Funds 4. Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open -ended equity oriented scheme Chanakya Opportunity Fund. There were three plans viz. A Dividend rupee investment Plan, B Bonus Plan & C Growth Plan. At the time of Initial Public Offer on , Mr. Anand, Mr. Bacchan & Mrs. Charu, three investors invested `1,00,000 each & chosen B, C & A Plan respectively. The History of the Fund is as follows: Dividend % Bonus Ratio Net Asset Value per Unit (F.V. `10) Plan A Plan B Plan C : : : On 31st July all three investors redeemed all the balance units. Calculate annual rate of return to each of the investors. Consider: 1. Long-term Capital Gain is exempt from Income tax. 2. Short-term Capital Gain is subject to 10% Income tax. 3. Security Transaction Tax 0.2 per cent only on sale/redemption of units. Ignore Education Cess [Nov 2005, 12 Marks] On ABC Mutual Fund issued 20 lakh units at `10 per unit. Relevant initial expenses involved were `12 lakhs. It invested the fund so raised in capital market instruments to build a portfolio of `185 lakhs. During the month of April 2012 it disposed off some of the instruments costing `60 lakhs for `63 lakhs and used the proceeds in purchasing securities for `56 lakhs. Fund management expenses for the month of April 2012 was `8 lakhs of which 10% was in arrears. In April 2012 the fund earned dividends amounting to `2 lakhs and it distributed 80% of the realized earnings. On the market value of the portfolio was `198 lakhs. 39 Page

49 CA Mayank Kothar i CA Fi nal SFM Mr. Akash, an investor, subscribed to 100 units on and disposed off the same at closing NAV on What was his annual rate of earning? 6. Mr. X on , during the initial offer of some Mutual Fund invested in 10,000 units having face value of `10 for each unit. On the dividend operated by the M.F. was 10% and Mr. X found that his annualized yield was %. On , 20% dividend was given. On Mr. X redeemed all his balance of 11, units when his annualized yield was 73.52%. What are the NAVs as on , and ? [Nov 2006, 6 Marks] Based on the following data determine NAV of the regular income scheme ` (in lakhs) Listed shares at cost (ex-dividend) Cash in hand 2.76 Bonds and debentures at cost 8.96 Of these, bonds not listed and quoted 2.50 Other fixed interest securities at cost 9.75 Dividend accrued 1.95 Amount payable on shares Expenditure accrued 1.76 Current realizable value of fixed income securities of face value of `100 is ` Number of Units (`10 face value each): All the listed equity shares were purchased at a time when market portfolio index was 12,500. On NAV date, the market portfolio index is at 19,975. There has been a diminution of 15% in unlisted bonds and debentures valuation. Listed bonds and debentures carry a market value of `7.5 lakhs, on NAV date. Operating expenses paid during the year amounted to `2.24 lakhs 40 Page

50 Mutual Funds 8. Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is considering a recently announced equity based mutual fund scheme in which initial expenses are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much should the mutual fund earn to provide Mr. A return of 16 per cent? [Nov 2003, 4 Marks] There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund Ltd. Each having close ended equity schemes. NAV as on of equity schemes of D Mutual Fund Ltd. is `70.71 (consisting 99% equity and remaining cash balance) and that of K Mutual Fund Ltd. is `62.50 (consisting 96% equity and balance in cash). Following is the other information: Particulars Equity Schemes D Mutual Fund Ltd. K Mutual Fund Ltd. Sharpe Ratio Treynor Ratio Standard Deviation There is no change in portfolios during the next month and annual average cost is `3 per unit for the schemes of both the Mutual Funds. If Share Market goes down by 5% within a month, calculate expected NAV after a month for the schemes of both the Mutual Funds. For calculation, consider 12 months in a year and ignore number of days for particular month [May 2015, 8 Marks] Page

51 CA Mayank Kothar i CA Fi nal SFM Bond Valuation 1. Following information is available in respect of a bond Face value `1000 Coupon Rate 8% Time to Maturity 10 years Market Price `1140 Callable in 6 years `1100 Find out the YTM and YTC of the bond? 2. The following data are available for a bond Face value `1,000 Coupon Rate 16% Years to Maturity 6 Redemption value `1,000 Yield to maturity 17% What are the current market price, duration and volatility of this bond? Calculate the expected market price, if increase in required yield is by 75 basis points [Nov 2005, 8 Marks] A 5% bond with face value of `1000 is being traded in the market at`1000. It is redeemable at par after 10 years. Find out the duration of the bond if the required rate of return or YTM of the investor is 5%. Also find out the duration by short-cut method? 4. Find the current market price of a bond having face value `1,00,000 redeemable after 6 year maturity with YTM at 16% payable annually and duration years. Given: = [May 2007, 6 Marks] Page

52 Bond Valuation 5. Calculate Market Price of: a) 10% Government of India security currently quoted at `110, but interest rate is expected to go up by 1% b) A bond with 7.5% coupon interest, Face value of `10,000 & term to maturity of 2 years, presently yielding 6%. Interest payable half yearly [Nov 2010, 5 Marks] On 31st March, 2013, the following information about Bonds is available: Name of the security Face Value Maturity Date Coupon Rate Zero Coupon st March 2023 NA NA T-Bill th June 2013 NA NA Coupon Date 10.71% GOI st March % 31 st March 10% GOI st March % 31 st March and 31 st October Calculate: 1. If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would fetch on 31st March, 2013? 2. What will be the annualized yield if the T-Bill is 98500? 3. If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2013 (after coupon payment on 31st March)? 4. If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch onapril 1, 2013 (after coupon payment on 31st March)? 43 Page

53 CA Mayank Kothar i CA Fi nal SFM 7. Pet feed plc has outstanding, a high yield Bond with following features: Face Value 10,000 Coupon 10% Maturity Period 6 Years Special Feature Company can extend the life of Bond to 12 years. Presently the interest rate on equivalent Bond is 8%. a. If an investor expects that interest will be 8%, six years from now then how much he should pay for this bond now. b. Now suppose, on the basis of that expectation, he invests in the Bond, but interest rate turns out to be 12%, six years from now, then what will be his potential loss/ gain. 8. XL Ispat Ltd. has made an issue of 14% non-convertible debentures on January 1, These debentures have a face value of `100 and is currently traded in the market at a price of `90 Interest on these NCDs will be paid through post dated cheques dated Jun 30 and December 31. Interest payments for the first 3 years will be paid in advance through post dated cheques while for the last 2 years post dated cheques will be issued at the third year. The bond is redeemable at par on December 31, 2011 at the end of 5 years. You are required to i) Estimate the current yield and the YTM of the bond ii) Calculate the duration of the NCD iii) Assuming that intermediate coupon payments are not available for reinvestment calculate the realised yield on the NCD [Nov 2008, 6 Marks] Page

54 Bond Valuation 9. The following is the Yield structure of AAA rated debenture: Period Yield 3 months 8.5% 6 months 9.25% 1 year 10.50% 2 years 11.25% 3 years and above 12.00% i) Based on the expectation theory calculate the implicit one year forward rates in year 2 and year 3. ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of the bond having maturity of 5 years? Assume that the bond is fairly priced at the moment at `1, [Nov 2008, 4 Marks] From the following data for Government securities, calculate the forward rates: Face value (`) Interest Rate Maturity (Years) Current Price (`) [May 2010, 8 Marks] ABC Ltd. issued 9%, 5 year bonds of `1,000/- each having a maturity of 3 years. The present rate of interest is 12% for one year tenure. It is expected that Forward rate of interest for one year tenure is going to fall by 75 basis points and further by 50 basis points for every next year in further for the same tenure. This bond has a beta value of 1.02 and is more popular in the market due to less credit risk. Calculate (i) 100,000 0% 1 91, ,000 10% 2 99, , % 3 99, , % 4 99,900 Intrinsic value of bond (ii) Expected price of bond in the market 45 Page

55 CA Mayank Kothar i CA Fi nal SFM 12. The following data is related to 8.5% Fully Convertible (into Equity shares) Debentures issued by JAC Ltd. at `1000. Market Price of Debenture `900 Conversion Ratio 30 Straight Value of Debenture `700 Market Price of Equity share on the date of Conversion 25 Expected Dividend Per Share `1 You are required to calculate: (a) Conversion Value of Debenture (b) Market Conversion Price (c) Conversion Premium per share (d) Ratio of Conversion Premium (e) Premium over Straight Value of Debenture (f) Favourable income differential per share (g) Premium pay back period 46 Page

56 Foreign Exchange& Risk Management 1. The following spot rates are observed in the foreign currency market Currency Foreign currency per US $ Britain Pound Netherlands Guilder 1.90 Sweden Kroner 6.40 Switzerland Franc 1.50 Italy Lira Japan Yen On the basis of this information, compute to the nearest second decimal the number of: a. British pound that can be acquired for $100. b. Dollars that 50 Dutch guilders will buy. c. Swedish Krona that can be acquired for $40. d. Dollars that 200 Swiss Franc can buy. e. Italian Lira that can be acquired for $10. f. Dollars that 1000 Japanese yen will buy. 2. You, a foreign exchange dealer of your bank, are informed that your bank has sold TT on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = Rs You are required to cover the transaction either in London or New York Market. The rates on that date are as under Mumbai-London Rs Rs Mumbai-New York Rs Rs London-Copenhagen DKK DKK New York- Copenhagen DKK DKK In which market will you cover the transaction, London or New York, and what will be the exchange profit or loss on the transaction? Ignore Brokerages. 47 Page

57 CA Fi nal SFM CA Mayank Kothar i 3. Followings are the spot exchange rates quoted at three different forex markets : USD/INR in Mumbai GBP/INR in London GBP/USD in New York The arbitrageur has USD1,00,00,000. Assuming that there are no transaction costs, explain whether there is any arbitrage gain possible from the quoted spot exchange rates [Nov 2008, 6 Marks] On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could make the remittance only on February 4, The interbank market rates were as follows: January, 28 February 4 Bombay US$1 = `45.85/ /45.97 London Pound 1 =US$ / / Pound 1 =SGD3.1575/ / The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of.0001) [Nov 2011, 5 Marks] [May 2005, 8 Marks] On April 3, 2016 a bank quotes the following Spot exchange rate (US$1) INR INR months swap points months swap points In a spot transaction delivery is made after two days. Assume spot date as April 5, 2016 Assume 1 swap point = You are required to: (a) ascertain swap points for 2 months and 15 days (For June 20, 2016) (b) determine foreign exchange rate for June 20, 2016 (c) compute the annual rate of premium/discount of US$ on INR on an average rate. 48 Page

58 Foreign Exchange and Risk Management 6. Spot rate 1 US $ = ` days Forward rate for 1 US $ =` Annualised interest rate for 6 months Rupee = 12% Annualised interest rate for 6 months US $ = 8% Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is willing to borrow `40,00,000 or US $83, [Nov 2006, 5 Marks] The rate of inflation in India is 8% per annum and in the US it is 4%. The current spot for USD in India is `46. What will be the expected rate after 1 year and 4 years applying the purchasing power parity theory. 8. Ms. Omega electronics Ltd. exports air conditioners to Germany by importing all the components from Singapore. The company is exporting 2400 units at a price of Euro 500 per unit. The cost of imported components is S$ 800 per unit. The fixed cost and other variables cost per unit are `1,000 and `1,500 respectively. The cash flows in foreign currencies are due in six months. The current exchange rates are as follows: `/ 51.50/55 `/S$ 27.20/25 After 6 months the exchange rates turn out as follows: `/ 52.00/05 `/S$ 27.70/75 1) You are required to calculate loss/gain due to transaction exposure. 2) Based on the following additional information calculate the loss/gain due to transaction and operating exposure if the contracted price of air conditioners is ` 25,000: The current exchange rate changes to `/ 51.75/80 `/S$ 27.10/15 Price elasticity of demand is estimated to be 1.5 Payments and receipts are to be settled at the end of six months [Nov 2009, 12 Marks] Page

59 CA Fi nal SFM CA Mayank Kothar i 9. XYZ Ltd. a US firm will need 300,000 in 180 days. In this connection, the following information is available: Spot rate 1 = $ days forward rate of as of today = $1.96 Interest rates are as follows: U.K. US 180 days deposit rate 4.5% 5% 180 days borrowing rate 5% 5.5% A call option on that expires in 180 days has an exercise price of $1.97 and a premium of $0.04. XYZ Ltd. has forecasted the spot rates 180 days hence as below: Future rate Probability 50 Page $ % $ % $ % Which of the following strategies would be most preferable to XYZ Ltd.? (a) a forward contract (b) a money market hedge (c) an option contract (d) no hedging Show calculations in each case [May 2007, 16 Marks] Columbus Surgicals Inc. is based in US, has recently imported surgical raw materials from the UK and has been invoiced for 480,000, payable in 3 months. It has also exported surgical goods to India and France. The Indian customer has been invoiced for 138,000, payable in 3 months, and the French customer has been invoiced for 590,000, payable in 4 months. Current spot and forward rates are as follows: / US$ Spot: Three months forward: US$ / Spot: Four months forward:

60 Foreign Exchange and Risk Management Current money market rates are as follows: UK: 10.0% 12.0% p.a. France: 14.0% 16.0% p.a. USA: 11.5% 13.0% p.a. You as Treasury Manager are required to show how the company can hedge its foreign exchange exposure using Forward markets and Money markets hedge and suggest which the best hedging technique is. 11. EFD Ltd. is an export business house. The company prepares invoice in customers' currency. Its debtors of US$. 10,000,000 is due on April 1, Market information as at January 1, 2015 is: Exchange Rates Contract size: `24,816,975 US $/` Currency Futures Spot January Month Forward April Months Forward Initial Margin Interest Rates in India 1 Month `17, % 3 Months `22, % On April 1, 2005 the spot rate US $/` is and currency future rate is Comment which of the following methods would be most advantageous for EFD Ltd.: (a) Using forward contract (b) Using currency futures (c) Not hedging currency risks [Nov 2006, 10 Marks] [May 2015, 6 Marks] Page

61 CA Fi nal SFM CA Mayank Kothar i 12. An American firm is under obligation to pay interest of CAN$ and CAN$ on 31 st July and 30 th September respectively. The firm is risk averse and its policy is to hedge the risks involved in all foreign currency transactions. The finance manager of the firm is thinking of hedging the risk considering two methods i.e fixed forward or option contracts. It is now June 30. Following quotations regarding rates of exchange US$ per Can$, from the firms bank were obtained. Spot 1 Month Forward 3 Months Forward Price for Can$/US$ option on a US stock exchange (cents per Can$, payable on purchase of the option, contract size Can$50000) are as follows. Strike Price Calls Puts US$/Can$ July September July September NA NA NA According to the suggestion of finance manager if options are to be used, one month option should be bought at a strike price of 94 cents and three month option at a strike price of 95 cents and for the remainder uncovered by the options the firm would bear the risk itself. For this, it would use forward rate as the best estimated of spot. Transactions costs are ignored. Recommend which of the above two methods would be appropriate for the American firm to hedge its foreign exchange risk on the two interest payments. 13. A Inc. and B Inc. intend to borrow $ 200,000 and $ 200,000 in respectively for a time horizon of one year. The prevalent interest rates are as follows: Company Loan $ Loan A Inc. 5% 9% B Inc 8% 10% The prevalent exchange rate is $1= Page

62 Foreign Exchange and Risk Management They entered in a currency swap under which it is agreed that B Inc. will pay A 1% over the loan interest rate which the later will have to pay as a result of the agreed currency swap whereas A Inc. will reimburse interest to B Inc. only to the extent of 9%. Keeping the exchange rate invariant, quantify the opportunity gain or loss component of the ultimate outcome, resulting from the designed currency swap [May 2011, 8 Marks] NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three months. The company has also exported goods for US $ 4,50,000 and this amount is receivable in two months. For receivable amount a forward contract is already taken at ` The market rates for ` and Dollar are as under: Spot Two Months Three Months `48.50/70 25/30 points 40/45 points The company wants to cover the risk and it has two options as under: (A) To cover the payables in the forward market and (B) To lag the receivables by one month and cover the risk only for the net amount. No interest for delaying the receivables is earned. Evaluate both the options if the cost of Rupee Funds is 12%. Which option is preferable? [May 2012, 8 Marks] ABC Ltd. is considering a project in US, which will involve an initial investment of US $11,000,000. The project will have 5 years of life. Current spot exchange rate is `48 per US $. The risk free rate in US is 8% and the same in India is 12% Cash inflow from the project are as follows: Year Cash Inflow 1 $ 2,000,000 2 $ 2,500,000 3 $ 3,000,000 4 $ 4,000,000 5 $ 5,000,000 Calculate NPV of the project using foreign currency approach. Required rate of return on this project is 14% [Nov 2006, 5 Marks] Page

63 CA Fi nal SFM CA Mayank Kothar i 16. XY Limited is engaged in retail business in India. It is contemplating for expansion into a country of Africa by acquiring a group of stores having the same line of operation as that of India. The exchange rate for the currency of the proposed African country is extremely volatile. Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year. Management of XY Limited expects these rates likely to continue for the foreseeable future. Estimated projected cash flows in real terms, in India as well as African Country for the first three years of the project are as follows: Year Cash flows in Indian `(000) -50,000-1,500-2,000-2,500 Cash flows in African Rands (000) -2,00, , , ,000 XY Ltd. Assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It evaluates all investments using nominal cash flows and a nominal discounting rate. The present exchange rate is African Rand 6 to `1 You are required to calculate the net present value of the proposed investment considering the following: (i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate. (ii) All cash flows for these projects will be discounted at a rate of 20% to reflect its high risk. (iii) Ignore Taxation. Year % [May 2013, 10 Marks] Page

64 Foreign Exchange and Risk Management 17. On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$ 1,00,000 on 31 December 2015 at `65.40/$. However, due to the request of the importer, Mr. X received amount on 28 November Mr. X requested the bank the take delivery of the remittance on 30 November 2015 i.e. before due date. The interbanking rates on 28 November 2015 was as follows: Spot `65.22/65.27 One Month Premium 10/15 If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the prevailing prime lending rate is 18%. 18. A customer with whom the bank had entered into 3 months forward purchase contract for Swiss Francs 10,000 at the rate of `27.25 comes to the bank after 2 months and request cancellation of the contract. On this date, the rates prevailing are: Spot CHF 1= ` One month forward CHF 1= ` What is the loss/gain to the customer on cancellation? 19. On 15th January 2015 you as a banker booked a forward contract for US$ for your import customer deliverable on 15th March 2015 at ` On due date customer request you to cancel the contract. On this date quotation for US$ in the interbank market is as follows: Spot ` /2975 per US$ Spot/ April 3000/ 3100 Spot/ May 6000/ 6100 Assuming that the flat charges for the cancellation is `100 and exchange margin is 0.10%, then determine the cancellation charges payable by the customer. 55 Page

65 CA Fi nal SFM CA Mayank Kothar i 20. You as a banker has entered into a 3 month s forward contract with your customer to purchase AUD 1,00,000 at the rate of ` However after 2 months your customer comes to you and requests cancellation of the contract. On this date quotation for AUD in the market is as follows: Spot ` /3500 per AUD 1 month forward ` /5200 per AUD Determine the cancellation charges payable by the customer. 21. Suppose you are a banker and one of your export customer has booked a US$ 1,00,000 forward sale contract for 2 months with you at the rate of ` and simultaneously you covered yourself in the interbank market at ` However on due date, after 2 months your customer comes to you and requests for cancellation of the contract and also requests for extension of the contract by one month. On this date quotation for US$ in the market was as follows: Spot ` / month forward ` / Determine the extension charges payable by the customer assuming exchange margin of 0.10% on buying as well as selling. 22. Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5th March with an export customer for 3 months at the rate of ` On the same day you also covered yourself in the market at ` However on 5th May your customer comes to you and requests extension of the contract to 5thJuly. On this date (5th May) quotation for US$ in the market is as follows: Spot ` /1400 per US$ Spot/ 5th June ` /2425 per US$ Spot/ 5thJuly ` /6425 per US$ Assuming a margin 0.10% on buying and selling, determine the extension charges payable by the customer and the new rate quoted to the customer. 56 Page

66 Foreign Exchange and Risk Management 23. An importer requests his bank to extend the forward contract for US$ 20,000 which is due for maturity on 30 th October, 2010, for a further period of 3 months. He agrees to pay the required margin money for such extension of the contract. Contracted Rate US$ 1= `42.32 The US Dollar quoted on :- Spot - ` / months Premium % /0.93% Margin money for buying and selling rate is 0.075% and 0.20% respectively. Compute: (i) The cost to the importer in respect of the extension of the forward contract, and (ii) The rate of new forward contract [Nov 2010, 4 Marks] An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th ` The bank covered its position in the market at ` The exchange rates for dollar in the interbank market on 10th June and 20th June were: 10 th June 20 th June Spot USD 1 = Rs /8200 Rs /7200 Spot June / /8500 July / /9900 August / /2500 September / /5600 Exchange Margin 0.10% and interest on outlay of 12%. The importer requested on 20th June for extension of contract with due date on 10th August. Rates rounded to 4 decimal in multiples of On 10th June, Bank Swaps by selling spot and buying one month forward. Calculate: (i) Cancellation rate (ii) Amount payable on $2,00,000 (iii) Swap loss 57 Page

67 CA Fi nal SFM CA Mayank Kothar i (iv) Interest on outlay of funds, if any (v) New contract rate (vi) Total Cost 25. XYZ Bank, Amsterdam, wants to purchase Rs. 25 million against for funding their Nostro account and they have credited LORO account with Bank of London, London Calculate the amount of s credited. Ongoing inter-bank rates as per $, ` /3700& per, $1.5260/ Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas subsidiaries, one based in Amsterdam and one in Switzerland. The Dutch subsidiary has surplus Euros in the amount of 725,000 which it does not need for the next three months but which will be needed at the end of that period (91 days). The Swiss subsidiary has a surplus of Swiss Francs in the amount of 998,077 that, again, it will need on day 91. The XYZ plc in UK has a net balance of 75,000 that is not needed for the foreseeable future. Given the rates below, what is the advantage of swapping Euros and Swiss Francs into Sterling? Spot Rate ( ) day Pts Spot Rate( ) CHF day Pts Interest rates for the Deposits Amount of Currency 91 days interest rate % p.a CHF 0-100,000 1 ¼ 0 100, , ½ ¼ 500,001-1,000, ½ Over 1,000, Page

68 Mergers, Acquisitions & Restructuring Mergers, Acquisitions & Restructuring 1. Firm A is studying the possible acquisition of Firm B by way of merger. The following data are available: Firm After tax No. of equity shares Market price per share earnings A `10,00,000 2,00,000 `75 B `3,00,000 50,000 `60 a. If the merger goes through by exchange of equity shares and the exchange ratio is set according to the current market prices, what is the new earning per share of the Firm A? b. Firm B wants to be sure that its earnings per share is not diminished by the merger. What exchange ratio is relevant to achieve the objective? 2. ABC Company is considering acquisition of XYZ ltd. which has 1.5 crores shares outstanding and issued. The market price per share is `400 at present. ABC s average cost of capital is 12%. Available information from XYZ indicates its expected cash accruals for the next 3 years as follows. Year ` in Crores Calculate the range of valuation that ABC has to consider. 59 Page

69 CA Fi nal SFM CA Mayank Kothar i 3. The following information is provided related to the acquiring Firm Mark Limited and the target Firm Mask Limited:: Mark Ltd. Mask Ltd. Earnings after tax(`) 2000 Lacs 400 Lacs Number of shares outstanding 200 Lacs 100 Lacs PE Ratio (times) 10 5 Required: (i) What is the Swap Ratio based on current market prices? (ii) What is the EPS of Mark Limited after acquisition? (iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio of Mark Limited remains unchanged? (iv) Determine the market value of the merged firm. (v) Calculate gain/loss for shareholders of the two independent companies after acquisition. 4. Elrond Limited plans to acquire Doom Limited. The relevant financial details of the two firms prior to the merger announcement are: Elrond Limited Doom Limited Market Price Per Share `50 `25 No. of shares outstanding 20 lakhs 10 lakhs The merger is expected to generate gains, which have a present value of `200 lakhs. The exchange ratio agreed to is 0.5. What is the true cost of the merger from the point of view of Elrond Limited? 60 Page

70 Mergers, Acquisitions & Restructuring 5. BA Ltd. and DA Ltd. both the companies operate in the same industry. The Financial statements of both the companies for the current financial year are as follows: Balance Sheet BA Ltd. (`) DA Ltd. (`) Current Assets 14,00,000 10,00,000 Fixed Assets (Net) 10,00,000 5,00,000 Total 24,00,000 15,00,000 Equity capital (`10 each) 10,00,000 8,00,000 Retained earnings 2,00, % long-term debt 5,00,000 3,00,000 Current liabilities 7,00,000 4,00,000 Total 24,00,000 15,00,000 Income Statement BA Ltd. (`) DA Ltd. (`) Net Sales 34,50,000 17,00,000 Cost of Goods sold 27,60,000 13,60,000 Gross profit 6,90,000 3,40,000 Operating expenses 2,00,000 1,00,000 Interest 70,000 42,000 Earning before taxes 4,20,000 1,98,00 50% 2,10,000 99,000 Earning after taxes (EAT) 2,10,000 99,000 Additional Information: No. of Equity shares 1,00,000 80,000 Dividend payment ratio (D/P) 40% 60% Market price per share `40 `15 Assume that both companies are in the process of negotiating a merger through an exchange of equity shares. You have been asked to assist in establishing equitable exchange terms and are required to: (i) Decompose the share price of both the companies into EPS and P/E components; and also segregate their EPS figures into Return on Equity (ROE) and book value/intrinsic value per share components. (ii) Estimate future EPS growth rates for each company. 61 Page

71 CA Fi nal SFM CA Mayank Kothar i (iii) Based on expected operating synergies BA Ltd. estimates that the intrinsic value of DA s equity share would be `20 per share on its acquisition. You are required to develop a range of justifiable equity share exchange ratios that can be offered by BA Ltd. to the shareholders of DA Ltd. Based on your analysis in part (i) and (ii), would you expect the negotiated terms to be closer to the upper, or the lower exchange ratio limits and why? (iv) Calculate the post-merger EPS based on an exchange ratio of 0.4:1 being offered by BA Ltd. Indicate the immediate EPS accretion or dilution, if any, that will occur for each group of shareholders. (v) Based on a 0.4:1 exchange ratio and assuming that BA Ltd. s pre-merger P/E ratio will continue after the merger, estimate the post-merger market price. Also show the resulting accretion or dilution in pre-merger market prices [Nov 2008, 20 Marks] The following information relating to the acquiring Company Abhiman Ltd. and the target Company Abhishek Ltd. are available. Both the Companies are promoted by Multinational Company, Trident Ltd. The promoter s holding is 50% and 60% respectively in Abhiman Ltd. and Abhishek Ltd.: Abhiman Ltd. Abhishek Ltd. 62 Page Share Capital (`) 200 lacs 100 lacs Free reserves and surplus(`) 800 lacs 500 lacs Paid up value per share (`) Free float market capitalization (`) 400 lacs 128 lacs PE Ratio (times) 10 4 Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the swap ratio weights are assigned to different parameters by the Board of Directors as follows: Book Value 25% EPS 50% Market Price 25% a) What is the swap ratio based on above weights? b) What is the book value, EPS and expected market price of Abhiman Ltd. after acquisition of Abhishek Ltd. (assuming PE ratio of Abhiman Ltd. remains unchanged and all assets and liabilities of Abhishek Ltd. are taken over at book value)?

72 Mergers, Acquisitions & Restructuring c) Calculate: (i) Promoter s revised holding in the Abhiman Ltd. (ii) Free float market capitalization. (iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.), if after acquisition of Abhishek Ltd., Abhiman Ltd. decided to: (a) Issue Bonus shares in the ratio of 1:2; and (b) Split the stock (share) as `5 each fully paid [Jun 2009, 20 Marks] [May 2011, 8 Marks] Two companies Bull Ltd. and Bear Ltd. recently have been merged. The merger initiative has been taken by Bull Ltd. to achieve a lower risk profile for the combined firm in spite of fact that both companies belong to different industries and disclose a little co- movement in their profit earning streams. Though there is likely to synergy benefits to the tune of `7 crore from proposed merger. Further both companies are equity financed and other details are as follows: Market Cap Beta Bull Ltd Crores 1.50 Bear Ltd. 500 Crores 0.60 Expected Market Return and Risk Free Rate of Return are 13% and 8% respectively. Shares of merged entity have been distributed in the ratio of 2:1 i.e. market capitalization just before merger. You are required to: (a) Calculate return on shares of both companies before merger and after merger. (b) Calculate the impact of merger onmr. X, a shareholder holding 4% shares in Bull Ltd. and 2% share of Bear Ltd. 63 Page

73 CA Fi nal SFM CA Mayank Kothar i 8. M/s Tiger Ltd. wants to acquire M/s Leopard Ltd. The balance sheet of Leopard as on 31 st March,2012 is as follows Liabilities ` Assets ` Equity Capital (70,000 7,00,000 Cash 50,000 shares) Retained Earnings 3,00,000 Debtors 70,000 12% Debentures 3,00,000 Inventories 2,00,000 Creditors and other liabilities 3,20,000 Plans and 13,00,000 Equipment 16,20,000 16,20,000 Additional Information a. Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every two shares. External liabilities are expected to be settled at `5,00,000. Shares of Tiger Ltd. would be issued at its current price of `15 per share. Debenture holders will get 13% convertible debentures in the purchasing company for the same amount. Debtors and inventories are expected to realize `2,00,000. b. Tiger Ltd. has decided to operate the business of Leopard Ltd. as a separate division. The division is likely to give cash flows (after tax) to the extent of `5,00,000 per year for 6 years. Tiger Ltd. has planned that, after 6 years, this division would be demerged and disposed of for `2,00,000 c. The company s cost of capital is 16%. d. Make a report to the board of the company adivising them about the financial feasibility of this acquisition [Nov 2013, 10 Marks] Page

74 Mergers, Acquisitions & Restructuring 9. The Nishan Ltd. has 35,000 shares of equity stock outstanding with a book value of `20 per share. It owes debt `15,00,000 at an interest rate of 12%. Selected financial results are as follows. Income & Cash Flow EBIT 80,000 Interest 1,80,000 EBT (1,00,000) Tax 0 EAT (1,00,000) Depreciation 50,000 Principal (75,000) Repayment Cash Flow (1,25,000) Capital Debt 15,00,000 Equity 7,00,000 Restructure the financial line items shown assuming a composition in which creditors agree to convert two thirds of their debt into equity at book value. Assume Nishan will pay tax at a rate of 15% on income after the restructuring, and that principal repayments are reduced proportionately with debt. Who will control the company and by how big a margin after the restructuring? 10. The equity shares of XYZ Ltd. are currently being traded at `24 per share in the market. XYZ Ltd. has total 10,00,000 equity shares outstanding in number, and promoters equity holding in the company is 40%. PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The estimated present value of these synergies is `80,00,000. Further PQR feels that management of XYZ ltd. has been over paid. With better motivation, lower salaries and fewer perks for the top management, will lead to savings of `4,00,000 p.a. Top management with their families are promoters of XYZ Ltd. present value of these savings would add `30,00,000 in values to the acquisition. Following additional information is available regarding PQR Ltd. Earnings Per share `4 Total number of equity shares outstanding 15,00,000 Market price of equity share `40 65 Page

75 CA Fi nal SFM CA Mayank Kothar i Required 1. What is the maximum price per equity share which PQR Ltd. can offer to pay for XYZ Ltd.? 2. What is the minimum price per equity share at which the management of XYZ Ltd. will be willing to offer their controlling interest? [May 2014, 6 Marks] Bank 'R' was established in 2005 and doing banking in India. The bank is facing DO OR DIE situation. There are problems of Gross NPA (Non Performing Assets) at 40% & CAR/CRAR (Capital Adequacy Ratio/ Capital Risk Weight Asset Ratio) at 4%. The net worth of the bank is not good. Shares are not traded regularly. Last week, it was `8 per share. RBI Audit suggested that bank has either to liquidate or to merge with other bank. Bank 'P' is professionally managed bank with low gross NPA of 5%.It has Net NPA as 0% and CAR at 16%. Its share is quoted in the `128 per share. The board of directors of bank 'P' has submitted a proposal to RBI for take over of bank 'R' on the basis of share exchange ratio. The Balance Sheet details of both the banks are as follows: Rs. In Lacs Bank R Bank P Paid up share capital Reserves and Surplus Deposits ,000 Other Liabilities 890 2,500 Total Liabilities Cash in Hand with RBI Balance with other Banks Investments Advances Other Assets Total Assets Page

76 Mergers, Acquisitions & Restructuring It was decided to issue shares at Book Value of Bank 'P' to the shareholders of Bank 'R'. All assets and liabilities are to be taken over at Book Value. For the swap ratio, weights assigned to different parameters are as follows: Gross NPA 30% CAR 20% Market Price 40% Book Value 10% (a) What is the swap ratio based on above weights? (b) How many shares are to be issued? (c) Prepare Balance Sheet after merger. (d) Calculate CAR & Gross NPA % of Bank 'P' after merger. 12. Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are given below: (` In lakhs) Year Yes Ltd Merged Entity Earnings would have witnessed 5% constant growth rate without merger and 6% with merger on account of economies of operations after 5 years in each case. The cost of capital is 15%. The number of shares outstanding in both the companies before the merger is the same and the companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd. PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, respectively. 13. ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large business entity XYZ has expressed its interest in making a bid for KLM. XYZ expects that after acquisition the annual earning of KLM will increase by 10%. Following information, ignoring any potential synergistic benefits arising out of possible acquisitions, are available: (i) Profit after tax for KLM for the financial year which has just ended is estimated to be `10 crore. (ii) KLM's after tax profit has an increasing trend of 7% each year and the same is expected to continue. (iii) Estimated post tax market return is 10% and risk free rate is 4%. These rates are expected to continue. 67 Page

77 CA Fi nal SFM CA Mayank Kothar i (iv) Corporate tax rate is 30%. XYZ ABC Proxy entity for KLM in the same line of business No. Of Shares 100 lakhs 80 Lakhs - Current Share Price `287 `375 - Divided Pay Out 40% 50% 50% Debt: Equity at 1:2 1:3 1:4 market values P/E Ratio Equity Beta Assume gearing level of KLM to be the same as for ABC and a debt beta of zero. You are required to calculate: (i) Appropriate cost of equity for KLM based on the data available for the proxy entity. (ii) A range of values for KLM both before and after any potential synergistic benefits to XYZ of the acquisition. 14. Personal computer division of Distress ltd. a computer hardware manufacturing company has started facing financial difficulties for the last 2 to 3 years. The management of the division headed by Mr. Smith is interested in a buyout on 1 April However, to make this buyout successful there is an urgent need to attract substantial funds from venture capitalists. Ven Cap, a European venture capitalist firm has shown its interest to finance the proposed buy-out. Distress Ltd. is interested to sell the division for `180 crores and Mr. Smith is of opinion that an additional amount of `85 crores shall be required to make this division viable. The expected financing pattern shall be as follows: Source Mode Amount (`Crores) Management Equity shares of `10 each Vencap VC Equity shares of `10 each % debentures with attached warrant of `100 each 8% Loan 160 Total Page

78 Mergers, Acquisitions & Restructuring The warrants can be exercised any time after 4 years from now for 10 equity per share. The loan is repayable in one go at the end of 8th year. The debentures are repayable in equal installment consisting of both principal and interest amount over a period of 6 years. Mr. Smith is of view that the proposed dividend shall not be kept more than 12.5% of distributable profit for the first 4 years. The forecasted EBIT after the proposed buyout is as follows: Year EBIT (` in cores) Applicable tax rate is 35% and it is expected that it shall remain unchanged at least for 5-6 years. In order to attract VenCap. Mr. Smith stated that book value of equity shall increase by 20% during above 4 years. Although, Vencap has shown their interest in investment but are doubtful about the projections of growth in the value as per projections of Mr.Smith. Further VenCap also demanded that warrants should be convertible in 18 shares instead of 10 as proposed by Mr. Smith. You are required to determine whether or not the book value of equity is expected to grow by 20% per year. Further if you have been appointed by Mr. Smith as advisor then whether you would suggest to accept the demand of VenCap of 18 shares instead of 10 or not. [Supplementary Module A.75] 69 Page

79 CA Fi nal SFM CA Mayank Kothar i Business Valuation 1. A valuation done of an established company by a well-known analyst has estimated a value of `500 lakhs, based on the expected free cash flow for next year of `20 lakhs and an expected growth rate of 5%. While going through the valuation procedure, you found that the analyst has made the mistake of using the book values of debt and equity in his calculation. While you do not know the book value weights he used, you have been provided with the following information: (i) Company has a cost of equity of 12%, (ii) After tax cost of debt is 6%, (iii)the market value of equity is three times the book value of equity, while the market value of debt is equal to the book value of debt. You are required to estimate the correct value of the company. 2. Following information is given in respect of WXY Ltd., which is expected to grow at a rate of 20% p.a. for the next three years, after which the growth rate will stabilize at 8% p.a. normal level, in perpetuity. For the year ended March 31, 2014 Revenues `7,500 Crores Cost of Goods Sold (COGS) `3,000 Crores Operating Expenses `2,250 Crores Capital Expenditure `750 Crores Depreciation (included in COGS & Operating `600 Crores Expenses) During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at 20% p.a. and capital expenditure net of depreciation will grow at 15% p.a. From year 4 onwards, i.e. normal growth period revenues and EBIT will grow at 8% p.a. and incremental capital expenditure will be offset by the depreciation. During both high growth & normal growth period, net working capital requirement will be 25% of revenues. The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%. Corporate Income Tax rate will be 30%. 70 Page

80 Business Valuation 3. Following information are available in respect of XYZ Ltd. which is expected to grow at a higher rate for 4 years after which growth rate will stabilize at a lower level: Base year information: Revenue - `2,000 crores EBIT - `300 crores Capital expenditure - `280 crores Depreciation - `200 crores Information for high growth and stable growth period are as follows: High Growth Stable Growth Growth in revenue & EBIT 20% 10% Growth in capital expenditure and depreciation 20% Capital expenditure are offset by depreciation Risk free rate 10% 9% Equity Beta Market Risk Premium 6% 5% Pre Tax Cost of Debt 13% 12.86% Debt Equity Ratio 1:1 2:3 For all time, working capital is 25% of revenue and corporate tax rate is 30%. What is the value of the firm? 4. BRS Inc deals in computer and IT hardwares and peripherals. The expected revenue for the next 8 years is as follows: Year Sales Revenue ($ Million) Summarized financial position as on 31 March 2012 was as follows: Liabilities Amount Assets Amount Equity Stocks 12 Fixed Assets (Net) 17 12% Bonds 8 Current Assets Page

81 CA Fi nal SFM CA Mayank Kothar i Additional Information: a. Its variable expenses is 40% of sales revenue and fixed operating expenses (cash) are estimated to be as follows: Period Amount ($ Million) 1-4 Years Years 2 b. An additional advertisement and sales promotion campaign shall be launched requiring expenditure as per following details: Period Amount ($ Million) 1 Year Years Years Years 1.00 c. Fixed assets are subject to depreciation at 15% as per WDV method. d. The company has planned additional capital expenditures (in the beginning of each year) for the coming 8 years as follows: Year Sales Revenue ($ Million) e. Investment in Working Capital is estimated to be 20% of Revenue. f. Applicable tax rate for the company is 30%. g. Cost of Equity is estimated to be 16%. h. The Free Cash Flow of the firm is expected to grow at 5% per annuam after 8 years. With above information you are require to determine the: (i) Value of Firm (ii) Value of Equity 72 Page

82 Business Valuation 5. 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 `66 per share Outstanding debt 1934 Lakhs Number of outstanding shares 75 Lakhs Net income (PAT) 17.2 Lakhs EBIT 245 Lakhs Interest expenses Lakhs Capital expenditure Lakhs Depreciation Lakhs Working capital 44 Lakhs Growth rate 8% (from 2010 to 2014) Growth rate 6% (beyond 2014) Free cash flow (Year 2014 onwards) Lakhs The capital expenditure is expected to be equally offset by depreciation in future and the debt is expected to decline by 30% in Required: 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 Page

83 CA Fi nal SFM CA Mayank Kothar i 74 Page

84 Financial Services Financial Services 1. A Ltd. has a total sales of `3.2 crores and its average collection period is 90 days. The past experience indicates that bad-debt losses are 1.5% on Sales. The expenditure incurred by the firm in administering its receivable collection efforts are `5,00,000. A factor is prepared to buy the firm s receivables by charging 2% Commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as reserve. Calculate the effective cost of factoring to the Firm. 2. The credit sales and receivables of DEF Ltd. at the end of year are estimated at `561 lakhs and `69 lakhs respectively. The average variable overdraft interest rate is 5% p.a. DEF Ltd. is considering a factoring proposal for its receivables on a non-recourse basis at an annual fee of 1.25% of credit sales. As a result, DEF Ltd. will save `1.5 lakhs p.a. in administrative cost and `5.25 lakhs p.a. as bad debts. The factor will maintain a receivables collection period of 30 days and will provide 80% of receivables as advance at an interest rate of 7% p.a. You may take 365 days in a year for the purpose of calculation of receivables. Required: Evaluate the viability of factoring proposal. 3. A Ltd. has an export sale of `50 crore of which 20% is paid by importers in advance of dispatch and for balance the average collection period is 60 days. However, it has been observed that these payments have been running late by 18 days. The past experience indicates that bad debt losses are 0.6% on Sales. The expenditure incurred for efforts in receivable collection are `60,00,000 p.a. So far A Ltd. had no specific arrangements to deal with export receivables, following two proposals are under consideration: A non-recourse export factoring agency is ready to buy A Ltd. s receivables to the firm at an interest rate of MIBOR % after withholding 20% as reserve. Insu Ltd. an insurance company has offered a comprehensive insurance policy at a premium of 0.45% of the sum insured covering 85% of risk of non-payment. A Ltd. can 75 Page

85 CA Fi nal SFM CA Mayank Kothar i assign its right to a bank in return of an advance of 75% of the value insured at MIBOR+1.50%. Assuming that MIBOR is 6% and A Ltd. can borrow from its bank at MIBOR+2% by using existing overdraft facility determine the which of the two proposal should be accepted by A Ltd. (1 Year = 360 days). 4. PQR Ltd. has credit sales of `165 crores during the financial year and its average collection period is 65 days. The past experience suggests that bad debt losses are 4.28% of credit sales. Administration cost incurred in collection of its receivables is `12,35,000 p.a. A factor is prepared to buy the company's receivables by charging 1.95% commission. The factor will pay advance on receivables to the company at an interest rate of 16% p.a. after withholding 15% as reserve. Estimate the effective cost of factoring to the company assuming 360 days in a year. Extracts from the forecasted financial statements of ABC Ltd. are given below. Turnover Cost of sales Gross Profit 4900 Non-current assets 3000 Current assets Inventory 4500 Trade receivables Total Assets Trade payables 3000 Overdraft Equity Shares 1000 Reserves Debentures 3000 Total Liabilities XYZ Fincorp, a factor has offered to manage the trade receivables of ABC Ltd. under a servicing and factor-financing agreement. XYZ expects to reduce the average trade receivables period of ABC from its current level to 35 days; to reduce 76 Page

86 Financial Services bad debts from 0.9% of turnover to 0.6% of turnover; and to save of ABC `40,000 per year on account of administration costs. The XYZ would also make an advance to ABC of 80% of the revised book value of trade receivables. The interest rate on the advance would be 2% higher than the ABC currently pays on its overdraft i.e. 7%. The XYZ would charge a fee of 0.75% of turnover on a with-recourse basis, or a fee of 1.25% of turnover on a non-recourse basis. Assuming 365 days in a year and all sales and purchases are on credit, you are required to evaluate the proposal of XYZ Fincorp. 5. Beans talk Ltd. manages its accounts receivable internally by its sales and credit department. The cost of sales ledger administration stands at `10 crores annually. The company has accredit policy of 2/10, net 30. Past experience of the company has been that on an average 40 percent of the customers avail of the discount by paying within10 days while the balance of the receivables are collected on average 90 days after the invoice date. Bad debts of the company are currently 1.5 percent of total sales. The projected sales for the next year are `1,000 crores. Beans talk Ltd. finances its investment in debtors through a mix of bank credit and own long term funds in the ratio of 70:30. The current cost of bank credit and long term funds are 13 percent and 15 percent respectively. With escalating cost associated with the in house management of debtors coupled with the need to unburden the management with the task so as to focus on sales promotion, the Company is examining the possibility of outsourcing its factoring service for managing its receivable and has two proposals on hand with a guaranteed payment within 30 days. The main elements of the Proposal from Fine bank Factors Ltd. are: Advance 88 percent and 84 percent for the re course and non re course arrangements. Discount charge in advance, 21 percent for with re course and 22 percent without recourse. 77 Page

87 CA Fi nal SFM CA Mayank Kothar i Commission, 4.5 percent without recourse and 2.5 percent with recourse. The main elements of the Proposal from Rough bank Factors Ltd. are: Advance, 84 percent with recourse and 80 percent without recourse respectively. Discount charge upfront without recourse 21 percent and with recourse 20 percent. Commission upfront, without recourse 3.6 percent and with recourse 1.8 percent. The opinion of the Chief Marketing Manager is that in the context of the fact or in arrangement, his staff would be able exclusively focus on sales promotion which would result in additional sales of 10% of projected sales. Kindly advice as a financial consultant on the alternative proposals. What advice would you give? Why 78 Page

88 Miscellaneous Topics Miscellaneous Topics 1. Calculate the value of share from the following information Profit of the company `290 crores Equity capital of the company `1,300 crores Par value of share `40 each Debt Ratio of company 27 Long Run growth rate of the company 8% Beta 0.1 Risk free interest rate 8.7% Market returns 10.3% Capital Expenditure per share `47 Depreciation per share `39 Change in working capital `3.45 per share 2. Trupti Co. Ltd. promoted by a Multinational group INTERNATIONAL INC is listed on stock exchange holding 84% i.e. 63 lakhs shares. Profit after Tax is `4.80 crores. Free Float Market Capitalisation is `19.20 crores. As per the SEBI guidelines promoters have to restrict their holding to 75% to avoid delisting from the stock exchange. Board of Directors has decided not to delist the share but to comply with the SEBI guidelines by issuing Bonus shares to minority shareholders while maintaining the same P/E ratio. Calculate (i) P/E Ratio (ii) Bonus Ratio (iii) Market price of share before and after the issue of bonus shares (iv) Free Float Market capitalization of the company after the bonus shares. 79 Page

89 CA Fi nal SFM CA Mayank Kothar i 3. Following Financial data are available for PQR Ltd. for the year 2008: (` in lakh) 8% debentures % bonds (2007) 50 Equity shares (`10 each) 100 Reserves and Surplus 300 Total Assets 600 Assets Turnovers ratio 1.1 Effective interest rate 8% Effective tax rate 40% Operating margin 10% Dividend payout ratio 16.67% Current market Price of Share `14 Required rate of return of investors 15% You are required to: (i) Draw income statement for the year (ii) Calculate its sustainable growth rate (iii) Calculate the fair price of the Company's share using dividend discount model, and (iv) What is your opinion on investment in the company's share at current price? 4. 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% Bonds 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 make a $15m placement of shares which will be at the price of 185 per share. 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. 80 Page

90 Miscellaneous Topics As on date the capital structure of Denter Inc is as follows: $ 000 Ordinary Shares (25Ȼ per share) 8,000 Share Premium 11,200 Free Reserves 23,100 42,300 15% term bonds 5,000 11% debenture ,000 56,300 The entity s current share price is 190, and debenture price $102. 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. Cost of capital of Denter Inc is 10%. 5. Pragya Limited has issued 75,000 equity shares of `10 each. The current market price per share is `24. The company has a plan to make a rights issue of one new equity share at a price of `16 for every four share held. You are required to : (i) Calculated the theoretical post right price per share (ii) Calculate the theoretical value of the right alone. (iii) Show the effects of the right issue on the wealth of the shareholder who has 1000 shares assuming he sells entire right. (iv) Show the effect if the shareholder does not take any action 81 Page

91 CA Fi nal SFM CA Mayank Kothar i 6. RST Ltd. s current financial year's income statement reported its net income as `25,00,000. The applicable corporate income tax rate is 30%. Following is the capital structure of RST Ltd. at the end of current financial year: ` Debt (Coupon rate = 11%) 40 lakhs Equity (Share Capital + Reserves & Surplus) 125 lakhs Invested Capital 165 lakhs Following data is given to estimate cost of equity capital: Beta of RST Ltd Risk free rate i.e. current yield on Govt. bonds 8.5% Average market risk premium (i.e. Excess of return on market portfolio 9% over risk-free rate) Required: (i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and (ii) Estimate Economic Value Added (EVA) of RST Ltd. 82 Page

92 Miscellaneous Topics 7. The following data pertains to XYZ Inc. engaged in software consultancy business as on 31 December 2010 ($ Million) Income from Consultancy 935 EBIT 180 Less: Interest on Loan 18 EBT % Balance Sheet Liabilities Amount Assets Amount Equity Stock (10 Million Shares at $10 each) 100 Land and Building 200 Reserves and Surplus 325 Computers and Software 295 Loans 180 Current Assets Current Liabilities 180 Debtors 150 Bank 100 Cash With the above information and following assumption you are required to compute (a) Economic Value Added (b) Market Value Added. Assuming that: (i) WACC is 12%. (ii) The share of company currently quoted at $ 50 each 83 Page

93 Area under the Standard Normal Probability Curve (Z Table) Where, z = X μ σ 84 Page

94 Natural Logarithm [ln (x), log e (x) or log(x)] The natural logarithm ln(x) is the logarithm having base e, where e= Apart from logarithms to base 10which is being normally calculated, we can also have logarithms to base e. These are called natural logarithms How To Use: You need to find the natural logarithm of 2.85 Find the row with N = 2.8 Find the column 5, the number inside the cell is The result is Now suppose you need to find natural log of We can calculate the same using Interpolation formula ln(1.07) ln(1.06) ln(1.0667) = ln(1.06) + x ln(1.0667) = x ln(1.0667) = ln(1.0667) = Calculating Natural Log on Calculator (Say ln1.3) Press times M times MRC - = N N Page

95 N N N N N Page

96 N N The natural logarithm table (Equal to or less than 1.0) n logen n logen n logen n logen Page

97 CA FINAL STRATEGIC FINANCIAL MANAGEMENT SFM Theory CA Mayank Kothari BBA, ACA No. Topic No. of Questions Page No. 1 Indian Capital Market Derivatives Portfolio Management Dividend Decisions Foreign Exchange & Risk Management Project Planning Capital Budgeting Leasing Decisions Financial Services Bond Valuation Mutual Funds Money Market Operations Mergers, Acquisitions & Restructuring Security Analysis Total Page

98 Strategic Financial Management SFM Theory Mayank M. Kothari, BBA, ACA Print: January 2017 Author This edition is printed with license from the author CA Mayank M. Kothari All rights reserved. No part of this work covered by the copyright herein, may be reproduced, transmitted, stored or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, web distribution, information networks or information storage and retrieval systems without the prior written permission of the publisher or the author. CA Mayank Kothari 2698, SaiSagar, Behind Jindal School Dattawadi, Nagpur Tel: Facebook: Conferenza.in Tel: Facebook: Disclaimer: While every effort is taken to avoid errors or omissions in this publication, any mistake or omission that may have crept in, is not intentional. It may be taken note of that neither the publisher, nor the author, will be responsible for any damage or loss of any kind arising to any one in any manner on account of such errors or omissions. The discussion in the present text is academic and does not tantamount to expertise/professional service to the readers on the related subject matter. Further comments and suggestions for improving quality of the book are welcome and will be gratefully acknowledged. 89 Page - CA Mayank Kothari

99 90 Page Transforming Education

100 My Inspiration Words of Acknowledgment When a dream turns into a reality, it s my duty to acknowledge those who have been the real strength behind my work. Thanks To- - Senior CA Kamal Mulchandani, Prof. Sudhir Sachdeva, CA Farooq Haque, for believing in me and giving me an opportunity to stand ahead of all. - My friend, CA Arjun Phatak for his extensive support in helping us to reach the maximum number of students. - My friend, CA Garvita Agrawal, her suggestions has made all the complex decisions very simple and effective. - My Friend, Sanskriti Khanna, her support and suggestions helped me not to give up on my goals. - Finally and the most important, Thank you Mom & Dad Your everyday support means a lot to me. - CA Mayank Kothari 91 Page

101 92 Page

102 Importance of SFM Theory [Analysis of theory questions asked in past 18 exams] Indian Capital Market No Exam Project Planning and Capital Budgeting Indian Capital Market Financial Services Leasing Decisions Dividend Decisions Derivatives Bond Valuat ion Portf olio Mana geme nt Mutua l Funds Money Market Operation s Foreign Exchange Risk Manageme nt Merger, Acquisition and Restructuring May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov Average Rank IV III I IV IV II IV V IV IV III IV Total *Cover Small Things, Big Score on page 83 before you start reading. Matter of discussion: SFM Theory Notes For CA Final- Strategic Financial Management Print: Jan 2017, Contact author at: , The discussion in the present text is academic and does not tantamount to expertise/professional service to the readers on the related subject matter. Further comments and suggestions for improving quality of the book are welcome and will be gratefully acknowledged. - CA Mayank Kothari 93 P age

103 CA Fi nal SFM CA Mayank Kothar i Questions Index No. Chapter Q No. Question Page No. 1 Indian Capital Market 1 What is Financial Market and its two major components? Indian Capital Market 2 What is Capital Market? Indian Capital Market 3 What is Money Market? Indian Capital Market 4 What is the difference between Capital Market and Money Market? 1 Indian Capital Market 5 What constitutes Capital Market? Indian Capital Market 6 What is meant by Primary Market and Secondary market? 1 Indian Capital Market 7 Distinguish between Primary Market and Secondary Market. 1 Indian Capital Market 8 Name the Leading Stock Exchanges in India and Abroad. 1 Indian Capital Market 9 What are the functions of Stock Exchanges? Indian Capital Market 10 What is Stock Market Index? Indian Capital Market 11 What do the fluctuations of Index Say? Indian Capital Market 12 How is the Index calculated? Indian Capital Market 13 Write short note on Settlement Cycle and Trading Hours. 1 Indian Capital Market 14 What is Clearing Houses? Indian Capital Market 15 What is the role of clearing house? Indian Capital Market 16 Write short note on Trading Mechanism Indian Capital Market 17 What are the major capital market instruments? 1 Indian Capital Market 18 Write short notes on American Depository Receipts (ADRs). 1 Indian Capital Market 19 Write short notes on Global Depository Receipts (GDRs). 1 Indian Capital Market 20 Explain Moving Averages Indian Capital Market 21 Write short notes on Stock Lending Scheme. 1 Indian Capital Market 22 Explain the functions of Merchant Bankers? Indian Capital Market 23 Write short notes on Book Building Indian Capital Market 24 Explain the term Buy Back of Securities Indian Capital Market 25 Write short notes on Green Shoe Option Indian Capital Market 26 Write short notes on Euro Convertible Bonds. 1 Indian Capital Market 27 Explain the term Short Selling P age

104 No. Chapter Q No. Question Page No. 1 Indian Capital Market 28 Explain the term Offer for Sale. Write short notes on Bought Out Deals Indian Capital Market 29 Explain the term Placement Method Indian Capital Market 30 Explain briefly the advantages of holding securities in demat' form than in physical 1 Indian Capital Market 31 Explain briefly the terms ESOS and ESPS with reference to the SEBI guidelines 1 Indian Capital Market 32 Write short notes on Real Estate Investment Trust [REIT] 1 Indian Capital Market 33 Write short notes on Infrastructure Investment Trusts 2 Derivatives 1 What are derivatives? Who are the users of derivatives? What is the purpope of use? 2 Derivatives 2 What is the difference between Forward Contract and Futures Contract? 2 Derivatives 3 Write short note on Embedded Derivatives Derivatives 4 What do you know about the Swaptions and their uses? 2 Derivatives 5 Write short note on Caps, Floors and Collars [CFC]. 2 Derivatives 6 What are the features of futures contract? Derivatives 7 What is insider trading practice? Derivatives 8 Write short notes on the Marking to Market. 2 Derivatives 9 Explain the term Intrinsic Value and Time Value of the option. 2 Derivatives 10 Write short notes on Interest Swaps Derivatives 11 What is the significance of underlying in relation to derivative instrument? 2 Derivatives 12 What is the difference between options and futures 2 Derivatives 13 Explain Initial Margin & Maintenance Margin. 2 Derivatives 14 Write Short Notes on Put Call Parity Theory Derivatives 15 Write Short Notes FRA s Derivatives 16 What is the difference between Cash and Derivative Market 2 Derivatives 17 Write Short Notes on Options Derivatives 18 How are stock futures settled? Or Write short note on Settlement Mechanism of Futures P age

105 CA Fi nal SFM CA Mayank Kothar i No. Chapter Q No. Question Page No. 2 Derivatives 19 What are the reasons for stock index futures becoming more popular financial derivatives over stock futures segment in India? Derivatives 20 What are the assumptions under Black- Scholes Model Answer 2 Derivatives 21 Explain various types of Swaps Portfolio Management 1 What are the objectives of portfolio management? 3 Portfolio Management 2 What are the steps in Portfolio Management? 3 Portfolio Management 3 Write short note on Factors affecting investment decisions in portfolio management 3 Portfolio Management 4 Distinguish between Systematic Risk and Unsystematic Risk? 3 Portfolio Management 5 What is Diversification? Portfolio Management 6 What do you mean by Risk Reduction? Portfolio Management 7 Write short notes on Capital Asset Pricing Model. 3 Portfolio Management 8 What sort of investor normally views the variance (or Standard Deviation) of an individual security's return as the security's proper measure of risk? 3 Portfolio Management 9 What sort of investor rationally views the beta of a security as the security's proper measure of risk? In answering the question, explain the concept of beta. 3 Portfolio Management 10 Discuss the Random Walk Theory Portfolio Management 11 Discuss how the risk associated with securities is effected by Government Policy 3 Portfolio Management 12 Write short notes on assumptions of the Markowitz Model of Risk Return Optimization 4 Dividend Decisions 1 Write Short notes on Dividend Policy Dividend Decisions 2 What are the factors determining dividend policy of the company? Or What are the determinants of dividend policy? 4 Dividend Decisions 3 Write short notes on Optimum Dividend Payout P age

106 No. Chapter Q No. Question Page No. 4 Dividend Decisions 4 Explain the concept of Homemade Dividends Dividend Decisions 5 Explain various dividend policies Dividend Decisions 6 Explain various forms of dividends Dividend Decisions 7 List down the assumptions under Gordon Growth Model 4 Dividend Decisions 8 List down the assumptions under Modigliani Miller Hypothesis 4 Dividend Decisions 9 What is Radical Approach under Dividend Policy 4 Dividend Decisions 10 According to the position taken by Miller and Modigliani, dividend decision does not influence value. Please state briefly any two reasons, why companies should declae dividend and not ignore it Dividend Decisions 11 Write short note on effect of a Government imposed freeze on dividends on stock prices and the volume of capital investment in the background of Miller - Modigliani (MM) theory on dividend policy. 4 Dividend Decisions 12 Write a short note on Traditional & Walter Approach to Dividend Policy Forex 1 Operations in foreign exchange market are exposed to a number of risks. Explain 5 Forex 2 Write short notes on: Forex 3 Write short notes on Nostro, Vostro and Loro accounts. 5 Forex 4 What is Exposure Netting? What are the advantages of Netting? 5 Forex 5 What is Leading and Lagging? Forex 6 Write short notes on Arbitrage Operations Forex 7 Explain the significance of LIBOR in international financial transactions Project Planning 1 Explain the concept of Zero date of project in project management. 6 Project Planning 2 What is Project Cost Accounting? Project Planning 3 What are the advantages of post completion audit? P age

107 CA Fi nal SFM CA Mayank Kothar i No. Chapter Q No. Question Page No. 6 Project Planning 4 Write a brief note on project appraisal under inflationary conditions Project Planning 5 What are the contents of the Project Report? 7 Capital Budgeting 1 What are the issues that need to be considered by an Indian Investor and incorporated within the Net Present Value (NPV) Model for the evaluation of Foreign Investment Proposals? 7 Capital Budgeting 2 Distinguish between Net Present Value and Internal Rate of Return. 7 Capital Budgeting 3 Write short note on Certainty Equivalent Approach. 7 Capital Budgeting 4 What is Sensitivity Analysis in Capital Budgeting? 7 Capital Budgeting 5 What is Capital Rationing? Capital Budgeting 6 Write short note on Risk Adjusted Discount Rate. 7 Capital Budgeting 7 Distinguish between Risk Adjusted Discounted Rate (RADR) and Certainty Equivalent 7 Capital Budgeting 8 What is hard and soft capital rationing? Capital Budgeting 9 What are the Steps in Simulation Analysis? Capital Budgeting 10 Many companies calculate the internal rate of return of the incremental after tax cash flows from financial leases. What problems do you think this may give rise to? To what rate should the internal return be compared? Discuss. 7 Capital Budgeting 11 How would standard deviation of the present value distribution help in capital budgeting decisions? 7 Capital Budgeting 12 Write short notes on Real Options in Capital Budgeting. 7 Capital Budgeting 13 Write short notes on Techniques of Social Cost Benefit Analysis 7 Capital Budgeting 14 Distinguish between Financial Options and Real Options 7 Capital Budgeting 15 Write Short Notes on Financial Engineering Leasing Decisions 1 Write short note on Cross Border Leasing P age

108 No. Chapter Q No. Question Page No. 8 Leasing Decisions 2 Distinguish between Financial and Operating lease Leasing Decisions 3 What is Sales and Lease back leasing? Leasing Decisions 4 What is Sales Aid Lease? Leasing Decisions 5 What are the advantages and disadvantages of leasing? 8 Leasing Decisions 6 Write short notes on Internal Rate of Return Analysis of lease evaluation 8 Leasing Decisions 7 Write short notes on Bower-Herringer- Williamson method of lease evaluation 9 Financial Services 1 What are the functions of Investment Banks Financial Services 2 Distinguish between Investment Banks and Commercial Banks. 9 Financial Services 3 What is Credit Rating? What is the benefit of credit rating? 9 Financial Services 4 What are the different Credit Rating Agencies in India 9 Financial Services 5 Explain the Credit Rating Process/ How credit rating is being issued? 9 Financial Services 6 What are the uses of Credit Rating? Financial Services 7 What is Scripless Trading System? Financial Services 8 What is the difference between Debit Card and Credit Card? 9 Financial Services 9 Explain CAMEL model in Credit Rating Financial Services 10 Explain the Credit Rating Process/ How credit rating is being issued? 9 Financial Services 11 What is Depository? What are the major players of the Depository System? What are the advantages to the clearing member offered by depository system? 9 Financial Services 12 What is the difference between Physical and Dematerialized Share Trading? 9 Financial Services 13 What are the benefits of Credit Cards over Debit Cards? 9 Financial Services 14 What is meant by Online Share Trading? Financial Services 15 What are the advantages and disadvantages of depository system? 9 Financial Services 16 What are the advantages of Online Stock Trading? P age

109 CA Fi nal SFM CA Mayank Kothar i No. Chapter Q No. Question Page No. 9 Financial Services 17 What are the disadvantages of Online Stock Trading? Financial Services 18 Write short notes on Debt Securitisation Financial Services 19 Write short notes on Depository Participant. 9 Financial Services 20 Write short notes on Asset Securitisation Bond Valuation 1 Why should the duration of a coupon carrying bond always be less than the time to its maturity? 10 Bond Valuation 2 Write short notes on Zero Coupon Bonds Mutual Funds 1 Explain Briefly the NAV of a Mutual Fund scheme. 11 Mutual Funds 2 What are the advantages and drawbacks of investing in a Mutual Fund? 11 Mutual Funds 3 Explain Briefly what is Exchange Traded Funds. 11 Mutual Funds 4 Distinguish Between Open Ended and Close Ended Funds. 11 Mutual Funds 5 What are the signals that indicate that is time for an investor to exit a mutual fund scheme? 12 Money Market Operations 1 What is Call Money/Notice Money in the context of financial market? 12 Money Market Operations 2 What is the distinction between Money Market and Capital Market? 12 Money Market Operations 3 Explain briefly what is Money Market Mutual Funds. 12 Money Market Operations 4 Write a short note on Inter Bank Participation Certificate. 12 Money Market Operations 5 Write short note on Commercial Bill Money Market Operations 6 What are the advantages of developed bill market? 12 Money Market Operations 7 Write short note on Certificate of Deposits Money Market Operations 8 Write short note on Commercial Paper Money Market Operations 9 What is Repo Rates? Money Market Operations 10 What is Reverse Repo Rates? Money Market Operations 11 What is Cash Reserve Ratio (CRR)? Money Market Operations 12 What is Statutory Liquidity Ratio (SLR)? Money Market Operations 13 Write short not on Treasury Bills P age

110 No. Chapter Q No. Question Page No. 12 Money Market Operations 14 What is interest rate risk, reinvestment risk & default risk & what are the types of risk involved in investments in G Sec? Mergers & Acquisitions 1 What are the different types of Merger? Mergers & Acquisitions 2 Write short notes on Friendly and Hostile takeover. 13 Mergers & Acquisitions 3 What are the various antitakeover strategies? Or what do you mean by defending against takeover bid? 13 Mergers & Acquisitions 4 What do you mean by Takeover by reverse bid or Reverse Bid or Reverse Merger? 13 Mergers & Acquisitions 5 Write short note on Chop Shop Method Mergers & Acquisitions 6 Write short note on Leverage Buy Out (LBO) Mergers & Acquisitions 7 Write short note on Management Buy Out (MBO). 13 Mergers & Acquisitions 8 Write short note on Financial Restructuring Mergers & Acquisitions 9 Write short note on Demerger Mergers & Acquisitions 10 Write short note on Economic Value Added. 13 Mergers & Acquisitions 11 Explain synergy in the context of Mergers and Acquisitions Security Analysis 1 Explain the Efficient Market Theory and what are major misconceptions about this theory? 14 Security Analysis 2 Explain the different challenges to Efficient Market Theory. 14 Security Analysis 3 Explain the Empirical Evidence of Weak form Efficient Market Theory 14 Security Analysis 4 Explain in detail the Dow Jones Theory? Security Analysis 5 Explain Elliot Wave Theory of Technical Analysis? 14 Security Analysis 6 Mention the various types of techniques used in economic analysis. 14 Security Analysis 7 Mention the factors affecting Economic Analysis 14 Security Analysis 8 Mention the factors affecting Industry Analysis 14 Security Analysis 9 Mention the various types of techniques used in company analysis. 14 Security Analysis 10 Explain Various types of Charts P age

111 CA Fi nal SFM CA Mayank Kothar i No. Chapter Q No. Question Page No. 14 Security Analysis 11 What is Odd Lot Theory Security Analysis 12 Discuss the Buy and Sell Signals provided by the moving averages Total P age

112 Indian Capital Market Q1 What is Financial Market and its two major components? A financial market is a market that brings buyers and sellers together to trade in financial assets such as stocks, bonds, commodities, derivatives and currencies. The purpose of a financial market is to set prices for global trade, raise capital and transfer liquidity and risk. Although there are many components to a financial market, two of the most commonly used are: a. Capital Market b. Money Market Q2 What is Capital Market? It is the part of a financial system concerned with raising capital by dealing in shares, bonds, and other long-term investments. Q3 What is Money Market? It is the trade in short-term loans between banks and other financial institutions. Q4 What is the difference between Capital Market and Money Market? Money markets are used for a short-term basis, usually for assets up to one year. Conversely, capital markets are used for long-term assets, which are any asset with maturity greater than one year. Capital markets include the equity (stock) market and debt (bond) market. Together the money and capital markets comprise a large portion of the financial market and are often used together to manage liquidity and risks for companies, governments and individuals. Q5 What constitutes Capital Market? The main components of capital market are: 1. Primary Market 2. Secondary Market! Q6 What is meant by Primary Market and Secondary market? Primary Market This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM). In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. The primary market performs the crucial function of facilitating capital formation in the economy. You can t start the next chapter of your life, if you keep re-reading the last one. 103 P age

113 CA Fi nal SFM CA Mayank Kothar i The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as "going public." Methods of floatation Secondary Market The secondary market, also called the aftermarket, it is a market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. In the secondary market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the secondary market be highly liquid. As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the centralization of that marketplace, the more liquid the market. Q7 Distinguish between Primary Market and Secondary Market. No. Basis Primary Market Secondary Market 104 P age 1 Nature of Securities 2 Nature of Financing 3 Organisational Difference The primary market deals with new securities i.e. securities which are traded for the first time. It provides additional funds to the issuing company directly. The primary market is not rooted in any particular area and has no geographical existence. The secondary market deals with the old securities. Whereas secondary market does not provide additional funds to the concerned company.(there is indirect supply of capital) The stock exchanges have physical existence and are located in a particular geographical area. 4 Another Name New Issue Market (NIM) After Market 5 Type of Direct Indirect purchasing 6 How many Only Once Multiple Times times a security can be sold? 7 Buying and Company and Investors Investors Selling between 8 Intermediary Underwriters Brokers 9 Price Fixed Price Fluctuates, based on the demand and supply Q8 Name the Leading Stock Exchanges in India and Abroad. Stock Exchanges in India a) Bombay Stock Exchange (BSE) b) National Stock Exchange (NSE) Stock Exchanges Abroad a) New York Stock Exchange (NYSE) b) Nasdaq (National Association of Securities Dealers Automated Quotations.) c) London Stock Exchange If I have the belief that I can do it, I shall surely acquire the capacity to do it even if I may not have it at the beginning.

114 Q9 What are the functions of Stock Exchanges? (a) Liquidity and Marketability of Securities: Stock exchange provides a ready and continuous market for purchase and sale of securities. Investors can at any time sell one and purchase another security, thus giving them marketability. (b) Fair Price Determination: Due to nearly perfect information, active bidding takes place from both sides. This ensures fair price to be determined by demand and supply forces. (c) Sources of Long Term Funds: Corporate, Government and public bodies raise funds from equity markets. (d) Helps in Capital Formation: Stock exchange accelerates the process of capital formation. It creates the habit of saving, investing and risk taking among the investing class and converts their savings into profitable investment. It acts as an instrument of capital formation. In addition, it also acts as a channel for right (safe and profitable) investment. (e) Reflects the General State of the Economy: Stock exchange indicates the state of health of companies and the national economy. It acts as a barometer of the economic situation / conditions. (f) Regulates Company Management: Listed companies have to comply with rules and regulations of concerned stock exchange and work under the vigilance (i.e. supervision) of stock exchange authorities. (g) Provides Clearing House Facility: Stock exchange provides a clearing house facility to members. It settles the transactions among the members quickly and with ease. The members have to pay or receive only the net dues (balance amount) because of the clearing house facility. Q10 What is Stock Market Index? A stock index or a stock market index is a list of figures and stocks that are used to indicate the combined value of its constituents. The stock index is applied as a device for representing the essential features of its constituent stocks. Stock indices function as an indicator of the general economic scenario of a country. If the stock market indexes are on the high, it reflects that the overall financial condition of the different companies in the country and the general economy of the country are stable. If, however, there is a plunge noticed in the stock market index, it is indicative of poor economic condition of the companies and therefore, the general economy. Stock Market Index answers to the question how is the market doing? A base year is set along with a basket of base shares. Each stock exchange has a flagship index like in India Sensex of BSE and Nifty of NSE and outside India is Dow Jones, FTSE, Nasdaq etc. Q11 What do the fluctuations of Index Say? a. Stocks are valued by discounting future earnings of the company; therefore stock indices reflect expectation about future performance of the companies listed in the stock market. b. When the Index goes up, the market thinks that the future returns will be higher than they are at present and when it goes down, the market thinks that the future returns will be lower than they are at present. Sometime the right path is not the easiest one. 105 P age

115 CA Fi nal SFM CA Mayank Kothar i The concept behind the Index Stock price are sensitive to the following news: Company specific news Country specific news (budget, elections, government policies, wars etc.) On any one day there is some good news and bad news related to specific companies, which offset with each other. This news does not affect the index. However, the country specific news, which is common to all stocks, affects the index. Q12 How is the Index calculated? Step 1: Calculate market capitalization (or market cap) of each individual company comprising the index. [Market price per share x Total no. of outstanding shares] Step 2: Calculate total market capitalization by adding the individual market capitalization of all companies in the Index. Step3: Computing index of the next day requires the index value and the total market capitalization of the previous day and is computed as follows: Index value = Index on previous day x total market capitalization for current day total capitalisation of previous day Note: Indices may also be calculated by price weighted method. Here the share price of constituent companies forms the weights. However almost all equity indices world-wide are calculated using market capitalization weighted method (the one used above). Q13 Write short note on Settlement Cycle and Trading Hours. Equity spot markets follow a T+2 rolling settlement. This means that any trade taking place on Monday gets settled by Wednesday. All trading on stock exchanges takes place between 9:15 am and 3:30 pm, Indian Standard Time, Monday through Friday. Delivery of shares must be made in dematerialized form, and each exchange has its own clearing house, which assumes all settlement risk, by serving as a central counterparty. T+2 Q14 What is Clearing Houses? Clearing house is an exchange associated body charged with the function of ensuring the financial integrity of each trade. Orders are cleared by means of clearinghouse acting as a seller to all the buyers and buyer to all the sellers. It provides range of services related to the guarantee of contracts, clearing and settlement of trades and management of risk for their members and associated exchanges. 106 P age I don t believe in luck. I believe in being harbingers of our fate, taking action and creating our own path and destiny in life. Your life is yours to create Don t let others do it for you.

116 Q15 What is the role of clearing house? Ensuring adherence to the system and procedures for smooth trading. Minimising credit risk by being a counter party to all trades. Daily accounting of gains and losses. Ensuring delivery of payment for assets on maturity dates for all outstanding contracts. Monitors the maintenance of speculation margins. Q16 Write short note on Trading Mechanism. Trading at both the exchanges takes place through an open electronic limit order book, in which order matching is done by the trading computer. There are no market makers or specialists and the entire process is order-driven, which means that market orders placed by investors are automatically matched with the best limit orders. As a result, buyers and sellers remain anonymous. The advantage of an order driven market is that it brings more transparency, by displaying all buy and sell orders in the trading system. However, in the absence of market makers, there is no guarantee that orders will be executed. All orders in the trading system need to be placed through brokers, many of which provide online trading facility to retail customers. Q17 What are the major capital market instruments? a) Debt Instruments b) Equities (Common stock) c) Preference Shares d) Derivatives Q18 Write short notes on American Depository Receipts (ADRs). Introduced to the financial markets in 1927, an American Depository Receipt (ADR) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on U.S. stock markets just like regular stocks and are issued/sponsored in the U.S. by a bank or brokerage. ADRs were introduced in response to the difficulty of buying shares from other countries which trade at different prices and currency values. U.S. banks simply purchase a large lot of shares from a foreign company, bundle the shares into groups and reissue them on either the NYSE, AMEX or Nasdaq. The depository bank sets the ratio of U.S. ADRs per home country share. This ratio can be anything less than or greater than 1. For example, a ratio of 4:1 means that one ADR share represents four shares in the foreign company. success all depends on the second letter. 107 P age

117 CA Fi nal SFM CA Mayank Kothar i Advantages of Investing in ADR ADRs allow US Investor to invest in companies outside North America with greater ease. By investing in different countries, you have the potential to capitalize on emerging economies. Disadvantages of Investing in ADR ADRs come with more risks, involving political factors, exchange rates and so on. Language barriers and a lack of standards regarding financial disclosure can make it difficult to research foreign companies. Q19 Write short notes on Global Depository Receipts (GDRs). A global depositary receipt (GDR) is similar to an ADR, but is a depositary receipt sold outside of the United States and outside of the home country of the issuing company. Most GDRs are, regardless of the geographic market, denominated in United States dollars, although some trade in Euros or British sterling. It is not a different financial instrument, as it may sound, from that of ADR. In fact if the Indian Company which has issued ADRs in the American market wishes to further extend it to other developed and advanced countries such as Europe, then they can sell these ADRs to the public of Europe and the same would be named as GDR. GDR can be particularly helpful to those persons who are not resident of a country in which they want to invest. Because through GDR those persons can invest in the shares of the company without any problem and hence it is a great alternative of investment for them Prices of GDR are often close to values of related shares, but they are traded and settled separately than the underlying share. Advantages of GDR to issuing company Accessibility to foreign capital markets Rise in the capital because of foreign investors Advantages of GDR to investor Helps in diversification, hence reducing risk More transparency since competitor s securities can be compared 108 P age "Would you like me to give you a formula for success? It's quite simple, really. Double your rate of failure. You are thinking of failure as the enemy of success. But it isn't at all. You can be discouraged by failure or you can learn from it. So go ahead and make mistakes. Make all you can. Because remember that s where you will find success."

118 Q20 Explain Moving Averages. Moving averages are frequently plotted with prices to make buy and sell decisions. The two types of moving averages used by chartists are: 1. Arithmetic Moving Average(AMA) 2. Exponential Moving Average(EMA) 1. Arithmetic Moving Average (AMA): An n period AMA at period t is nothing but the simple average of the last n period prices. AMA n,t = 1/n[P t + P t P t (n 1) 2. Exponential Moving Average (EMA): Unlike AMA, which assigns equal weight of 1/n to each of the n prices used for computing the average, the Exponential Moving Average (EMA) assigns decreasing weights, with the highest weight being assigned to the latest price. The weights decrease exponentially, according to a scheme specified by exponential smoothing constant, also known as the exponent, EMA=[CP x e]+ [Previous EMA x (1-e)] CP= Current Closing Price, e=exponent in decimals Q21 Write short notes on Stock Lending Scheme. In stock lending, the legal title of a security is temporarily transferred from a lender to a borrower. The lender retains all the benefits of ownership, other than the voting rights. The borrower is entitled to utilize the securities as required but is liable to the lender for all benefits. A securities lending programme is used by the lenders to maximize yields on their portfolio. Borrowers use the securities lending programme to avoid settlement failures. Securities lending provide income opportunities for security holders and creates liquidity to facilitate trading strategies for borrowers. It is particularly attractive for large institutional shareholders as it is an easy way of generating income to offset custody fees and requires little involvement of time. Q22 Explain the functions of Merchant Bankers? The basic function of merchant bankers is marketing of corporate and other securities. In this process, he performs a number of services concerning various aspects of marketing viz. origination, underwriting, and distribution of securities. Other activities or services performed by merchant bankers in India include: Project promotion services Project Finance Management and marketing of new issues Underwriting of new issues Syndication of new issues Syndication of credit Leasing services Corporate advisory services Providing venture capital Operating mutual funds and off shore funds Investment management or portfolio management services Bought out deals So long as there is breath in me, that long I will persist. For now I know one of the greatest principles on success; if I persist long enough I will win. 109 P age

119 CA Fi nal SFM CA Mayank Kothar i Providing assistance for technical and financial collaborations and joint ventures Management of and dealing in commercial paper Investment services for non-resident Indians Q23 Write short notes on Book Building. Book building is a technique used for marketing a public offer of equity shares of a company. It is a way of raising more funds from the market. After accepting the free pricing mechanism by the SEBI, the book building process has acquired too much significance and has opened a new lead in development of capital market. A company can use the process of book building to fine tune its price of issue. When a company employs book building mechanism, it does not pre-determine the issue price (in case of equity shares) or interest rate (in case of debentures) and invite subscription to the issue. Instead it starts with an indicative price band (or interest band) which is determined through consultative process with its merchant banker and asks its merchant banker to invite bids from prospective investors at different prices (or different rates). Those who bid are required to pay the full amount. Based on the response received from investors the final price is selected. The merchant banker (called in this case Book Runner) has to manage the entire book building process. Investors who have bid a price equal to or more than the final price selected are given allotment at the final price selected. Those who have bid for a lower price will get their money refunded. In India, there are two options for book building process. One, 25 per cent of the issue has to be sold at fixed price and 75 per cent is through book building. The other option is to split 25 per cent of offer to the public (small investors) into a fixed price portion of 10 per cent and a reservation in the book built portion amounting to 15 per cent of the issue size. The rest of the book built portion is open to any investor. The greatest advantage of the book building process is that this allows for price and demand discovery. Secondly, the cost of issue is much less than the other traditional methods of raising capital. In book building, the demand for shares is known before the issue closes. In fact, if there is not much demand the issue may be deferred and can be rescheduled after having realised the temper of the market. Q24 Explain the term Buy Back of Securities. Companies are allowed to buy back equity shares or any other security specified by the Union Government. In India Companies are required to extinguish shares bought back within seven days. In USA Companies are allowed to hold bought back shares as treasury stock, which may be reissued. A company buying back shares makes an offer to purchase shares at a specified price. Shareholders accept the offer and surrender their shares. The following are the management objectives of buying back securities: (i) To return excess cash to shareholders, in absence of appropriate investment opportunities. (ii) To give a signal to the market that shares are undervalued. (iii) To increase promoters holding, as a percentage of total outstanding shares, without additional investment. Thus, buy back is often used as a defence mechanism against potential takeover. (iv) To change the capital structure. 110 P age I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times. - Bruce Lee

120 Q25 Write short notes on Green Shoe Option. The green shoe option allows companies to intervene in the market to stabilise share prices during the 30-day stabilisation period immediately after listing. This involves purchase of equity shares from the market by the company-appointed agent in case the shares fall below issue price. Guidelines for exercising green shoe option The guidelines require the promoter to lend his shares (not more than 15% of issue size) which is to be used for price stabilisation to be carried out by a stabilising agent (normally merchant banker or book runner) on behalf of the company. The stabilisation period can be up to 30 days from the date of allotment of shares to bring stability in post listing pricing of shares. After making the decision to go public, the company appoints underwriters to find the buyers for their issue. Sometimes, these underwriters also help the corporate in determining the issue price and the kind of equity dilution i.e. how many shares will be made available for the public. But with the turbulent times prevailing in the market place, it is however quite possible that the IPO undersubscribed and trades below its issue price. This is where these underwriters invoke the green shoe option to stabilise the issue. How green shoe option works - As said earlier, the entire process of a greenshoe option works on over-allotment of shares. For instance, a company plans to issue 1 lakh shares, but to use the greenshoe option; it actually issues 1.15 lakh shares, in which case the over-allotment would be 15,000 shares. Please note, the company does not issue any new shares for the over-allotment. - The 15,000 shares used for the over-allotment are actually borrowed from the promoters with whom the stabilising agent signs a separate agreement. For the subscribers of a public issue, it makes no difference whether the company is allotting shares out of the freshly issued 1 lakh shares or from the 15,000 shares borrowed from the promoters. - Once allotted, a share is just a share for an investor. For the company, however, the situation is totally different. The money received from the over-allotment is required to be kept in a separate bank account (i.e. escrow account) Role of the stabilising agent 1. The stabilizing agent start its process only after trading in the share starts at the stock exchanges. 2. In case the shares are trading at a price lower than the offer price, the stabilizing agent starts buying the shares by using the money lying in the separate bank account. In this manner, by buying the shares when others are selling, the stabilizing agent tries to put the brakes on falling prices. The shares so bought from the market are handed over to the promoters from whom they were borrowed. 3. In case the newly listed shares start trading at a price higher than the offer price, the stabilizing agent does not buy any shares. Ninety-nine percent of failures come from people who have the habit of making excuses. George W. Carver 111 P age

121 CA Fi nal SFM CA Mayank Kothar i Green Shoe Option Stabilising Agent(SA) Borrow shares from the promoters (Max.15% of IPO). and then he keep watch on the market price of the share on stock exchange. If the price goes up If the price goes down No activity by SA SA starts buying shares from the market from the money kept in separate account. and by this way he tries to put the brakes on falling prices after that shares so bought from the market are handed over to promoters by SA Q26 Write short notes on Euro Convertible Bonds. Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted into depository receipts or local shares. ECBs offer the investor an option to convert the bond into equity at a fixed price after the minimum lock in period. The price of equity shares at the time of conversion will have a premium element. The bonds carry a fixed rate of interest. These are bearer securities and generally the issue of such bonds may carry two options viz., call option and put option. A call option allows the company toforce conversion if the market 112 P age Have the courage & faith in yourself to follow your dreams- be the 1% who live a life the other 99% dream of.

122 price of the shares exceeds a particular percentage of the conversion price. A put option allows the investors to get his money back before maturity. In the case of ECBs, the payment of interest and the redemption of the bonds will be made by the issuer company in US dollars. ECBs issues are listed at London or Luxemburg stock exchanges. Indian companies which have opted ECBs issue are Jindal Strips, Reliance, Essar Gujarat, Sterlite etc. Indian companies are increasingly looking at Euro-Convertible bond in place of Global Depository Receipts because GDRs are falling into disfavour among international fund managers. An issuing company desirous of raising the ECBs is required to obtain prior permission of the Department of Economic Affairs, Ministry of Finance, and Government of India. The proceeds of ECBs would be permitted only for following purposes: (i) Import of capital goods. (ii) Retiring foreign currency debts. (iii) (iv) Capitalising Indian joint venture abroad. 25% of total proceedings can be used for working capital and general corporate restructuring. Q27 Explain the term Short Selling In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most commonly used. They serve as an intermediary between the investor and the seller and often charge a fee for their services. In finance short selling (also known as shorting or going short) is the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them ("covering"). The short seller borrows shares and immediately sells them. The short seller then expects the price to decrease, when the seller can profit by purchasing the shares to return to the lender. The procedure: Here's the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security. Nothing great has ever been achieved except by those who dared to believe that something inside them was superior to circumstances. - Bruce Barton 113 P age

123 CA Fi nal SFM CA Mayank Kothar i Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price. Q28 Explain the term Offer for Sale. Write short notes on Bought Out Deals. Offer for sale is also known as bought out deal (BOD). It is a new method of offering equity shares, debentures etc., to the public. In this method, instead of dealing directly with the public, a company offers the shares/debentures through a sponsor. The sponsor may be a commercial bank, merchant banker, an institution or an individual. It is a type of wholesale of equities by a company. A company allots shares to a sponsor at an agreed price between the company and sponsor. The sponsor then passes the consideration money to the company and in turn gets the shares duly transferred to him. After a specified period as agreed between the company and sponsor, the shares are issued to the public by the sponsor with a premium. After the public offering, the sponsor gets the shares listed in one or more stock exchanges. The holding cost of such shares by the sponsor may be reimbursed by the company or the sponsor may get the profit by issue of shares to the public at premium. Thus, it enables the company to raise the funds easily and immediately. As per SEBI guidelines, no listed company can go for BOD. A privately held company or an unlisted company can only go for BOD. A small or medium size company which needs money urgently chooses to BOD. It is a low cost method of raising funds. The cost of public issue is around 8% in India. But this method lacks transparency. There will be scope for misuse also. Besides this, it is expensive like the public issue method. One of the most serious short coming of this method is that the securities are sold to the investing public usually at a premium. The margin thus between the amount received by the company and the price paid by the public does not become additional funds of the company, but it is pocketed by the issuing houses or the existing shareholders. Q29 Explain the term Placement Method 1. Yet another method to float new issues of capital is the placing method defined by London Stock Exchange as sale by an issue house or broker to their own clients of securities which have been previously purchased or subscribed. Under this method, securities are acquired by the issuing houses, as in offer for sale method, but instead of being subsequently offered to the public, they are placed with the clients of the issuing houses, both individual and institutional investors. Each issuing house has a list of large private and institutional investors who are always prepared to subscribe to any securities which are issued in this manner. Its procedure is the same with the only difference of ultimate investors. 2. In this method, no formal underwriting of the issue is required as the placement itself amounts to underwriting since the issuing houses agree to place the issue with their clients. 3. The main advantage of placing, as a method of issuing new securities, is its relative cheapness. 4. There is a cost cutting on account of underwriting commission, expense relating to applications, allotment of shares and the stock exchange requirements relating to contents of the prospectus and its advertisement. This method is generally adopted by small companies with unsatisfactory financial performances. 5. Its weakness arises from the point of view of distribution of securities. As the securities are offered only to a select group of investors, it may lead to the concentration of shares into a few hands who may create artificial scarcity of scrips in times of hectic dealings in such shares in the market. 114 P age When I hear somebody sigh, Life is hard, I am always tempted to ask, Compared to what?

124 Q30 Explain briefly the advantages of holding securities in demat form rather than in physical form. From an individual investor point of view, the following are important advantages of holding securities in demat form: It is speedier and avoids delay in transfers. It avoids lot of paper work. It saves on stamp duty. From the issuer-company point of view also, there are significant advantages due to dematting, some of which are: Savings in printing certificates, postage expenses. Stamp duty waiver. Easy monitoring of buying/selling patterns in securities, increasing ability to spot takeover attempts and attempts at price rigging. Q31 Explain briefly the terms ESOS and ESPS with reference to the SEBI guidelines Basis ESOS ESPS 1. Meaning Employee Stock Option Scheme means a scheme under which the company grants option to employees. 2. Auditors Certificate Auditors certificate to be placed at each AGM stating that the scheme has been implemented as per the guidelines and in accordance with the special resolution passed. Employee Stock Purchase Scheme means a scheme under which the company offers shares to employees as a part of public issue. No such certificate is required. 3. Transferability It is not transferable. It is transferable after lock in period. 4. Consequences The amount payable may be Not Applicable in this case of Failure forfeited. If the option is not vested due to non-fulfillment of condition relating to vesting of option then the amount may be refunded to the employees 5. Lock in Period Minimum period of 1 year shall be there between the grant and vesting of options. Company is free to specify the lock in period for the shares issued pursuant to exercise of option. One year from the date of allotment. If the ESPS is part of public issue and the shares are issued to employees at the same price as in the public issue, the shares issued to employees pursuant to ESPS shall not be subject to any lock in. People who achieve the most are selective as well as determined. - Richard Koch 115 P age

125 CA Fi nal SFM CA Mayank Kothar i Q32 Write short notes on Real Estate Investment Trust [REIT] A Real Estate Investment Trust (REIT) is a trust that pools resources by offering units to the investors. Such funds are used to acquire and manage income producing properties and income generated from such properties is distributed to investors. REITs receive special tax considerations and are characterized by lower transaction costs. REIT typically offer the following benefits:- For the Investors:- REITs as an investment class provide the common man an opportunity to invest in fixed income securities which also provide long term capital appreciation and a natural inflation hedge. It also opens to small investors an arena (i.e rent generating real estate assets) which was hitherto the monopoly of large investors. For the Industry:- REITs assist in streamlining the real estate sector by creating a new and transparent source of raising finance in the real estate sector. Further, REITs can provide developers with institutional capital to sell their assets and use funds to repay banks and/or utilize the funds for more development. Key features of SEBI(Real Estate Investment Trusts) Regulations, 2014 a. REITs shall be set up as a trust and registered with SEBI. It shall have parties such as Trustee, Sponsor(s) and Manager. b. The trustee of a REIT shall be a SEBI registered debenture trustee who is not an associate of the Sponsor/manager. c. REIT shall invest in commercial real estate assets, either directly or through SPVs. In such SPVs a REIT shall hold or proposes to hold controlling interest and not less than 50% of the equity share capital or interest. Further, such SPVs shall hold not less than 80% of its assets directly in properties and shall not invest in other SPVs. d. Once registered, the REIT shall raise funds through an initial offer. Subsequent raising of funds may be through follow-on offer, rights issue, qualified institutional placement, etc. The minimum subscription size for units of REIT shall be `2 lakhs. The units offered to the public in initial offer shall not be less than 25% of the number of units of the REIT on post-issue basis. e. Units of REITs shall be mandatorily listed on a recognized Stock Exchange and REIT shall make continuous disclosures in terms of the listing agreement. Trading lot for such units shall be `1Lakh. f. For coming out with an initial offer, the value of the assets owned/proposed to be owned by REIT shall be of value not less than `500 crore. Further, minimum issue size for initial offer shall be `250 crore. g. The Trustee shall generally have an overseeing role in the activity of the REIT. The manager shall assume operational responsibilities pertaining to the REIT. Responsibilities of the parties involved are enumerated in the Regulations. h. A REIT may have multiple sponsors, not more than 3, subject to each holding at least 5% of the units of the REIT. Such sponsors shall collectively hold not less than 25% of the units of the REIT for a period of not less than 3 years from the date of listing. After 3 years, the sponsors, collectively, shall hold minimum 15% of the units of REIT, throughout the life of the REIT. 116 P age Suffer the pain of discipline or suffer the pain of regret.

126 i. Not less than 80% of the value of the REIT assets shall be in completed and revenue generating properties. j. Not more than 20% of the value of REIT assets shall be invested in following : developmental properties, mortgage backed securities, listed/ unlisted debt of companies/body corporate in real estate sector, equity shares of companies listed on a recognized stock exchange in India which derive not less than 75% of their operating income from Real Estate activity, government securities, money market instruments or Cash equivalents. However investments in developmental properties shall be restricted to 10% of the value of the REIT assets k) A REIT shall invest in at least 2 projects with not more than 60% of value of assets invested in one project. Detailed investment conditions are provided in the Regulations. l) REIT shall distribute not less than 90% of the net distributable cash flows, subject to applicable laws, to its investors, atleast on a half yearly basis. m) REIT, through a valuer, shall undertake full valuation on a yearly basis and updation of the same on a half yearly basis and declare NAV within 15 days from the date of such valuation/updation. n) The borrowings and deferred payments of the REIT at a consolidated level shall not exceed 49% of the value of the REIT assets. In case such borrowings/ deferred payments exceed 25%, approval from unit holders and credit rating shall be required. o) Detailed provisions regarding related party transactions. valuation of assets, disclosure requirements, rights of unit holders, etc. are provided in the Regulations. However, for any issue requiring unit holders approval, voting by a person who is a related party in such transaction as well as its associates shall not be considered. Q33 Write short notes on Infrastructure Investment Trusts INVITS or Infrastructure Investments Trusts are similar to REITs with the difference that INVITs invest in income generating infrastructure projects as compared to REITs wherein investments are made in income generating real estate assets. SEBI notified SEBI (Infrastructure Investment Trusts) Regulations, 2014 on September 26, The salient features of the regulations are as under:- 1) Infrastructure is as defined by Ministry of Finance vide its notification dated October 07, 2013 and shall include any amendments/additions made thereof. 2) INVITs shall be set up as a trust and registered with SEBI. It shall have parties such as Trustee, Sponsor(s), Investment Manager and Project Manager The trustee of an INVIT shall be a SEBI registered debenture trustee who is not an associate of the Sponsor/Manager. 3) INVITs shall invest in infrastructure projects, either directly or through SPV. In case of PPP projects, such investments shall only be through SPV. 4) An INVIT shall hold or propose to hold controlling interest and more than 50% of the equity share capital or interest in the underlying SPV, except where the same is not possible because of a regulatory requirement/ requirement emanating from the concession agreement. In such cases sponsor shall enter into an agreement with the INVIT, to ensure that no decision taken by the sponsor, including voting decisions with respect to the SPV, are against the interest of the INVIT its unit holders. The only way to succeed is not to worry about what others are doing 117 P age

127 CA Fi nal SFM CA Mayank Kothar i 5) Sponsor(s) of an INVIT shall, collectively, hold not less than 25% of the total units of the INVIT on post issue basis for a period of at least 3 years, except for the cases where a regulatory requirement/concession agreement requires the sponsor to hold a certain minimum percent in the underlying SPV. In such cases the consolidated value of such sponsor holding in the underlying SPV and in the INVIT shall not be less than the value of 25% of the value of units of INVIT on post-issue basis. 6) The proposed holding of an INVIT in the underlying assets shall be not less than `500 crore and the offer size of the INVIT shall not be less then `250 crore at the time of initial offer of units. 7) The aggregate consolidated borrowing of the INVIT and the underlying SPVs shall never exceed 49% of the value of INVIT assets. Further, for any borrowing exceeding 25% of the value of INVIT assets, credit rating and unit holders' approval is required. 8) An INVIT which proposes to invest at least 80% of the value of the assets in the completed and revenue generating Infrastructure assets, shall : raise funds only through public issue of units. have a minimum 25% public float and at least 20 investors. have minimum subscription size and trading lot of ten ` lakhs and ` five lakhs respectively. distribute not less than 90% of the net distributable cash flows, subject to applicable laws, to the investors, at least on a half yearly basis. through a valuer, undertake a full valuation on a yearly basis and updation of the same on half yearly basis and declare NAV within 15 days from the date of such valuation/updation. 9) A publicly offered INVIT may invest the remaining 20% in under construction infrastructure projects and other permissible investments, as defined in the regulations. However, the investments in under construction infrastructure projects shall not be more than 10% of the value of the assets. 10) An INVIT which proposes to invest more than 10% of the value of their assets in under construction infrastructure projects shall : raise funds only through private placement from Qualified Institutional Buyers and body corporates. have minimum investment and trading lot of `1 crore. have minimum of 5 investors with each holding not more than 25% of the unit distribute not less than 90% of the net distributable cash flows, subject to applicable laws, to the investors, at least on a yearly basis undertake full valuation on yearly basis and declare NAV within 15 days from the date of such valuation. Conditions for INVITs investing in under construction projects i. For PPP project(s):- has achieved completion of at least 50% of the construction of the infrastructure project as certified by an - independent engineer; or has expended not less than 50% of the total capital cost set forth in the financial package of the relevant project agreement. ii. For Non-PPP project(s), the Infrastructure Project has received all the requisite approvals and certifications for commencing construction of the project; 118 P age You only live once, but you do it right once is enough

128 11) Listing shall be mandatory for both publicly offered and privately placed INVITs and INVIT shall make continuous disclosures in terms of the listing agreement. 12) Detailed provisions for related party transactions. valuation of assets, disclosure requirements, rights of unit holders, etc. are provided in the Regulations. However, for any issue requiring unit holders approval, the voting by any person who is a related party in such transaction as well as its associates shall not be considered. Nothing is particularly hard if you divide it in small jobs. 119 P age

129 CA Fi nal SFM CA Mayank Kothar i Derivatives Q1 What are derivatives? Who are the users of derivatives? What is the purpose of use? Enumerate the difference between Cash and Derivative Market. A Derivative is an agreement between buyer and seller for an underlying asset which is to be bought/sold on certain future date. Derivative does not have any value of its own but its value, in turn, depends on the value of the other physical assets which are called underlying assets. Users of derivative market and purpose of use 1. Hedgers: Use derivatives to reduce risk of unfavourable price movement in the market to provide offsetting compensation against the underlying asset (kind of insurance). 2. Speculators: These are traders who use derivatives in the expectation of making a profit through market fluctuations. 3. Arbitrageurs: Arbitrageurs simply sell the asset in the overpriced market and simultaneously buy it in the cheaper market in order to gain from the different price of underlying in two different markets. Difference between cash and derivative market 1. In cash market tangible assets are traded whereas in derivative market contracts based on tangible or intangibles assets like index or rates are traded. 2. In cash market, we can purchase even one share whereas in futures and options minimum lots are fixed. 3. Cash market is more risky than futures and options segment. 4. Cash assets may be meant for consumption or investment. Derivative contracts are for hedging, arbitrage or speculation. 5. Buying securities in cash market involves putting up all the money upfront whereas buying futures simply involves putting up the margin money. 6. With the purchase of shares of the company in cash market the shareholder becomes part owner of the company. While in futures it does not happen. Q2 What is the difference between Forward Contract and Futures Contract? Basis Forward Contract Futures Contract Trading Traded in Over-the Traded on an Exchange. Counter(OTC) market. Default Risk Traded privately and hence bears the risk of default. Are exchange traded who provides the protection and hence no default risk. Margin requirement Involves no margin payment. Initial margin is required to be paid as a good faith money. Uses Used for hedging purposes. Used for both hedging and speculating purposes. Transparency Not transparent as the contract is private in nature. Transparency is maintained and is reported by the exchange. Delivery Settled by physical delivery. Settled by net cash payment only 120 P age Success doesn t happen overnight. Keep your eye on the prize and don t look back

130 Derivatives and very few by actual delivery. Size of contract No standardised size. Standard in terms of quantity or amount as the case may be. Maturity Any valid business date agreed to by the two parties. Standard Date. Usually one delivery date such as the second Thursday of every month. Currencies Traded All currencies Major Currencies Cash Flow None until maturity date. Initial margin plus ongoing variation margin because of mark to market and final payment on maturity date. Q3 Write short note on Embedded Derivatives. An embedded derivative is a derivative instrument that is embedded in another contract- the host contract. The host contract might be an equity or debt instrument, a lease, an insurance contract or a sale or purchase contract. When a derivative feature is combined in a non-derivative contract, the derivative is referred to as embedded derivative and such non-derivative contract is called host contract. The combined contract is called hybrid contract. Suppose entity XYZ enters into a contract to issue a bond, and the payment of interest and principal of the bond is indexed with the price of gold. Here, the payment will increase or decrease according to the movement in the price of gold; and the debt instrument is host contract with an embedded derivative. Examples of Embedded Derivative Company X issues `100 million variable-rate debt with a maturity of 5 years. The variable rate is LIBOR, (which is currently 5%) plus 75 basis points. The debt has an embedded derivative that caps the variable rate at 10%. Company X leases property with a lease term of ten years. Embedded in the lease is a provision that requires the lease payment to be adjusted every two years for the changes in the Rupee consumer price index. The functional currency of Company X is the Rupee. Lease payments are also to be made in Rupee. Why Host contract Debt Embedded derivative Interest Rate Cap The cap is indexed to interest rates, which is closely related to debt. The cap is above the current market rate when the instrument is issued (i.e. it is out of the money on the date of issuance) and contains no leverage feature Host contract lease Embedded derivative forward contract to adjust rent payments by the rate of inflation (indexed to the consumer price index) Rentals for the use of leased assets and adjustments for inflation are considered to If something is important enough, even if the odds are against you, you should still do it. 121 P age -Elon Musk

131 CA Fi nal SFM CA Mayank Kothar i Examples of Embedded Derivative Why be closely related. Z Ltd, a company with a sterling functional currency, enters into a contract to buy widgets from Y Ltd, to be delivered in 6 months time. Payment is to be made on delivery, but the contract gives Z Ltd the option of paying either 1 million or Japanese Yen (JPY) million for the widgets. (The figures reflect the GBP/JPY exchange rate at the start of the contract.) Widgets are not usually traded in Yen. The currency feature in the purchase contract is a derivative, allowing Z Ltd to profit from favourable currency movements. When payment falls to be made, JPY million is worth 980,000, so the company chooses to pay in Yen. Q4 What do you know about the Swaptions and their uses? Interest rate swaption is an option on an interest rate swap whereby holder gets the right but not the obligation to enter into an interest rate swap at the specific fixed rate on an agreed future date. Uses of swaptions (a) Swaptions can be used as an effective tool to swap into or out of fixed rate or floating rate interest obligations, according to a treasurer s expectation on interest rates. Swaptions can also be used for protection if a particular view on the future direction of interest rates turned out to be incorrect. (b) Swaptions can be applied in a variety of ways for both active traders as well as for corporate treasurers. Swap traders can use them for speculation purposes or to hedge a portion of their swap books. It is a valuable tool when a borrower has decided to do a swap but is not sure of the timing. (c) Swaptions are useful for borrowers targeting an acceptable borrowing rate. By paying an upfront premium, a holder of a payersswaption can guarantee to pay a maximum fixed rate on a swap, thereby hedging his floating rate borrowings. (d) Swaptions have become useful tools for hedging embedded option which is common in the natural course of many businesses. Q5 Write short note on Caps, Floors and Collars [CFC]. Answer Caps: A cap provides a guarantee that the coupon rate each period will not be higher than agreed limit. It will be capped at certain ceiling. It s a derivative instrument where the buyer of the cap receives payment at the end of each period where the rate of interest exceeds the agreed strike price. Floors: A floor provides a guarantee that the coupon rate each period will not be lower than agreed limit. It will be floored at certain ceiling. It s a derivative instrument where the buyer of the floor receives payment at the end of each period where the rate of interest goes below the agreed strike price. 122 P age It s supposed to be hard. If it wasn t hard everyone would be doing it. The hard is what makes it great.

132 Derivatives Collars: Collar provides a guarantee that the coupon rate each period will not fall below lower limit and will not go beyond upper limit. It will be capped at upper limit and floored at lower limit. It s a combination of caps and floors. It s a derivative instrument where the buyer of the collar receives payment at the end of each period where the rate of interest goes below the lower limit or goes beyond the upper limit. Q6 What are the features of futures contract? These are traded on organised exchanges. Standardised contract terms like the underlying assets, the time of maturity and the manner of maturity etc. Associated with clearing house to ensure smooth functioning of the market. Margin requirements and daily settlement to act as further safeguard i.e. marked to market. Existence of regulatory authority. Every day the transactions are marked to market till they are re-wound or matured. Q7 What is insider trading practice? The insider is any person who accesses the price sensitive information of a company before it is published to the general public. Insider includes corporate officers, directors, and owners of firm etc. who have substantial interest in the company. Even persons who have access to non public information due to their relationship with the company are an insider. Insider trading practice is the act of buying or selling or dealing in securities by as a person having unpublished inside information with the intention of making abnormal profit s and avoiding losses. This inside information includes dividend declaration, issue or buy back of securities, amalgamation, mergers, takeover or major expansion plans. Insider trading practices are lawfully prohibited. The regulatory bodies in general are imposing different fines and penalties for those who indulge in such practices. SEBI has framed various regulations implemented the same to prevent the insider trading practices. Q8 Write short notes on the Marking to Market. Futures contracts follow a practice known as mark-to-market. At the end of each trading day, the exchange sets a settlement price based on the day s closing price range for each contract. Each trading account is credited or debited based on that day s profits or losses and checked to ensure that the trading account maintains the appropriate margin for all open positions. While the margin accounts of each party get adjusted at the end of each day, on the same time the old futures contract gets replaced with the new one at the new price. Thus each future contract is rolled over to the next day at new price. I had to make my own living and my own opportunity! And I made it! Don t sit down and wait for the opportunities to come. Get up and make them! - C.J. Walker 123 P age

133 CA Fi nal SFM CA Mayank Kothar i Q9 Explain the term Intrinsic Value and Time Value of the option. Intrinsic value of an option and time value of an option are primary determinants of an option s price. Intrinsic value is the value that any given option would have if it is to be exercised immediately. This is defined as the difference between the options strike price and the stock s actual current price. An option s intrinsic value can never be negative. 1. Say you bought a call option with strike price of `500 for `20 and two months later its market price is `515 Here the intrinsic value of the option is = Spot (Market) Price Strike Price = = Say you bought a put option with strike price of `500 for `20 and two months later its market price is `490 Here the intrinsic value of the option is = Strike price Spot Price = = 10 Time value (extrinsic value) is the difference between options premium and its intrinsic value. Considering the same example of call option we can compute the time value of the option Time Value = Options Premium Intrinsic Value = = 5 Q10 Write short notes on Interest Swaps A swap is a contractual agreement between two parties to exchange or swap future payment streams based on differences in the returns to different securities or changes in the price of some underlying item. In an Interest rate swap, the parties to the agreement, termed as swap counterparties, agree to exchange payments indexed to two different interest swaps. Financial intermediaries, such as banks, pension funds, and insurance companies as well as non financial firms use interest rate swaps to effectively change the maturity of outstanding debt or that of an interest bearing asset. Currency swaps grew out of parallel loan agreements in which firms exchange loans denominated in different currencies. Q11 What is the significance of underlying in relation to derivative instrument? The underlying may be a share, commodity or any other asset which has a marketable value which is subject to market risks. The importance of underlying in derivative instruments is as follows: All derivative instruments are dependent on an underlying to have value. The change in value in a derivative contract is broadly equal to the change in value in the underlying. In the absence of a valuable underlying asset the derivative instrument will have no value. On maturity, the position of profit/loss is determined by the price of underlying instruments. If the price of the underlying is higher than the contract price the buyer makes a profit. If the price is lower, the buyer suffers a loss. 124 P age Success consists of doing the common things of life uncommonly well.

134 Derivatives Q12 What is the difference between options and futures Basis Futures Options Obligation to perform Both parties are obliged to perform. Only the seller (Writer) is obliged to perform. Premium No premium is paid by any party. Potential of gain/loss There is potential/risk for unlimited gain/loss for the futures buyer. Exercise A futures contract has to be honoured by both the parties only on the date specified. Premium is paid by the buyer to the seller at the inception of the contract. Loss is restricted while there us unlimited gain potential for the option buyer. An American option contract can be exercised any time during its period by the buyer. Q13 Explain Initial Margin & Maintenance Margin. Initial Margin Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. Upon opening the futures position, an amount equal to the initial margin requirement will be deducted from the trader's margin account and transferred to the exchange's clearing firm. This money is held by the exchange clearinghouse as long as the futures position remains open. Maintenance Margin The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin. If the balance in the futures trader's margin account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement. Example: Let's assume we have a speculator who has `10000 in his trading account. He decides to buy August Crude Oil at `40 per barrel. Each Crude Oil futures contract represents 1000 barrels and requires an initial margin of `9000 and has a maintenance margin level set at `6500. Since his account is `10000, which is more than the initial margin requirement, he can therefore open up one August Crude Oil futures position. One day later, the price of August Crude Oil drops to `38 a barrel. Our speculator has suffered an open position loss of `2000 (`2 x 1000 barrels) and thus his account balance drops to `8000. Although his balance is now lower than the initial margin requirement, he did not get the margin call as it is still above the maintenance level of `6500. Unfortunately, on the very next day, the price of August Crude Oil crashed further to `35, leading to an additional `3000 loss on his open Crude Oil position. With only `5000 left in his trading account, which is below the maintenance level of `6500, he received a call from his broker asking him to top up his trading account back to the initial level of `9000 in order to maintain his open Crude Oil position. This means that if the speculator wishes to stay in the position, he will need to deposit an additional `4000 into his trading account. Otherwise, if he decides to quit the position, the remaining `5000 in his account will be available to use for trading once again. One day you will wake up and there won t be any more time to do the things you ve always wanted. Do it now. - Paulo Coelho 125 P age

135 CA Fi nal SFM CA Mayank Kothar i Q14 Write Short Notes on Put Call Parity Theory This theory was developed to explain the relationship between the prices of the options and their underlying stock. Put-call parity is the relationship that must exist between the prices of European put and call options that both have the same underlier, strike price and expiration date. (Put-call parity does not apply to American options because they can be exercised prior to expiry.) According to Put Call parity theory The total of current price of the underlying stock and the price of the put option is exactly equal to the total of the price of the call option and present value of the exercise price of the underlying stock. We can represent the above theory in following formula S + P = C + PV of Exercise price of the stock Where, S = Current price of the underlying asset P= Price (Premium) of the put option C= Price (Premium) of the call option Q15 Write Short Notes FRA s Forward Rate Agreement(future)is an agreement between two parties to fix the future interest rate. Interest rate is based on agreed notional principal for a specified period. On the agreed date if the market rate differs from the agreed FRA rate. A difference amount is paid by either of the party as settlement. The principal amount is not exchanged here and no party is obliged to borrow or lend money. Users Those who wish to hedge against future interest rate risk by fixing the future interest rate today itself. Those who want to make profit based on their expectation on the future development of interest rate. Those who try to take advantage of different prices of FRAs and other financial instruments. Characteristics It is an off balance sheet agreement as there is no exchange of principal amount. There is no need to pay initial margins or variation margins The existing FRA agreement can be closed any time by entering into new and opposite FRA at a new price. FRAs are customised to meet the specific requirements of the customer. FRAs offers highest liquidity and hence termed as money market instrument 126 P age Study while others are sleeping; work while others are loafing; prepare while others are playing; and dream while others are wishing. -William Arthur Ward

136 Derivatives Q16 What is the difference between Cash and Derivative Market Basis Cash Market Derivative Market Assets traded Quantity Traded In cash market tangible assets are traded In cash market, we can purchase even one share In derivative market contracts based on tangible or intangibles assets like index or rates are traded. In Futures and Options minimum lots are fixed. Risk Cash market is more risky Futures and Options segment are less risky as compared to the cash market Purpose Cash assets may be meant for consumption or investment. Derivative contracts are for hedging, arbitrage or speculation. Amount Required Ownership Buying securities in cash market involves putting up all the money upfront With the purchase of shares of the company in cash market, the holder becomes part owner of the company. Buying futures simply involves putting up the margin money. While in future it does not happen. Q17 Write Short Notes on Options Option Contract is a type of derivatives contract traded on the exchanges which gives the buyer of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at the end of a specified period. The buyer / holder of the option purchase the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. Under Securities Contracts (Regulations) Act, 1956 options on securities has been defined as "option in securities" meaning a contract for the purchase or sale of a right to buy or sell, securities in future, and includes a teji, a mandi, a tejimandi, a galli, a put, a call or a put and call in securities. Further, an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on the expiry date, is called European option. Therefore, in the case of American options the buyer has the right to exercise the option at any time on or before the expiry date.this request for exercise is submitted to the exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame. The price at which the option is to be exercised is called Strike price or Exercise price. In a Covered Option, the seller of the option already owns the asset. In a Naked Option, Don't be afraid to give your best to what seemingly are small jobs. Every time you conquer one it makes you that much stronger. If you do the little jobs well, the big ones will tend to take care of themselves. 127 P age

137 CA Fi nal SFM CA Mayank Kothar i 128 P age the seller does not own the asset. Margin amount is required to be paid in case of Short Position in Options, means instead of buying call and put if you are selling options then the traded is required to deposit the margin amount to the exchange. There are two basic types of Option: 1) A Call option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price. 2) A Put option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price. Q18 How are stock futures settled? Or Write short note on Settlement Mechanism of Futures The positions in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day's settlement price, as the case may be, and the current day's settlement price. The Client Members who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Q19 What are the reasons for stock index futures becoming more popular financial derivatives over stock futures segment in India? Stock index futures is most popular financial derivatives over stock futures due to following reasons: It adds flexibility to one s investment portfolio. Institutional investors and other large equity holders prefer the most this instrument in terms of portfolio hedging purpose. The stock systems do not provide this flexibility and hedging. It creates the possibility of speculative gains using leverage. Because a relatively small amount of margin money controls a large amount of capital represented in a stock index contract, a small change in the index level might produce a profitable return on one s investment if one is right about the direction of the market. Speculative gains in stock futures are limited but liabilities are greater. Stock index futures are the most cost efficient hedging device whereas hedging through individual stock futures is costlier. Stock index futures cannot be easily manipulated whereas individual stock price can be exploited more easily. Since, stock index futures consists of many securities, so being an average stock, is much less volatile than individual stock price. Further, it implies much lower capital adequacy and margin requirements in comparison of individual stock futures. Risk diversification is possible under stock index future than in stock futures. One can sell contracts as readily as one buys them and the amount of margin required is the same. If somebody is continuously trying to stop you from going forward, step backward, think again, plan again, this time with more hard work, with more dedication, with more passion and then attack once more. I am sure you will succeed in not only moving forward but also breaking them for coming in your way.

138 Derivatives In case of individual stocks the outstanding positions are settled normally against physical delivery of shares. In case of stock index futures they are settled in cash all over the world on the premise that index value is safely accepted as the settlement price. It is also seen that regulatory complexity is much less in the case of stock index futures in comparison to stock futures. It provides hedging or insurance protection for a stock portfolio in a falling market. Q20 What are the assumptions under Black-Scholes Model 1. Options considered are European options means the options which are redeemed only on the expiry date. 2. The underlying security does not pay a dividend. 3. There is no arbitrage opportunity. 4. It is possible to borrow and lend cash at known risk free interest rate. 5. It is possible to buy and sell even the fraction of the share. 6. The above transaction does not incur any fees or cost. i.e. no transaction cost 7. Stock price movement follow random walk. 8. Stock returns are normally distributed over a period of time. 9. The variance of the return is constant over the life of the option. Q21 Explain various types of Swaps 1. Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of `20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of `20 million. 2. Basis Rate Swap A basis swap is a floating-floating interest rate swap. A simple example is a swap of 1- month Libor for 6-month Libor. Basis rate swap is a type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates. The real winners in life are the people who look at every situation with an expectation that they can make it work or make it better 129 P age

139 CA Fi nal SFM CA Mayank Kothar i For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk. 3. Asset Rate Swap Similar in structure to a plain vanilla swap, the key difference is the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating investments are being exchanged. In a plain vanilla swap, a fixed libor is swapped for a floating libor. In an asset swap, a fixed investment such as a bond with guaranteed coupon payments is being swapped for a floating investment such as an index. 4. Amortising Rate Swap An exchange of cash flows, one of which pays a fixed rate of interest and one of which pays a floating rate of interest, and both of which are based on a notional principal amount that decreases. In an amortizing swap, the notional principal decreases periodically because it is tied to an underlying financial instrument with a declining (amortizing) principal balance, such as a mortgage. The notional principal in an amortizing swap may decline at the same rate as the underlying or at a different rate which is based on the market interest rate of a benchmark like mortgage interest rates or the London Interbank Offered Rate. The opposite of an amortizing swap is an accreting principal swap - its notional principal increases over the life of the swap. In most swaps, the amount of notional principal remains the same over the life of the swap. 130 P age Good things come to those who wait, Better things comes to those who don t give up and the best thing comes who believe.

140 Derivatives 131 P age

141 CA Fi nal SFM CA Mayank Kothar i Portfolio Management Q1 What are the objectives of portfolio management? 1. Security of the Principal Investment Portfolio management not only involves keeping the investment intact but also contributes towards the growth of its purchasing power over the period. The motive of a financial portfolio management is to ensure that the investment is absolutely safe. 2. Consistency of returns Portfolio management also ensures to provide the stability of returns by reinvesting the same earned returns in profitable and good portfolios. 3. Risk reduction Portfolio management is purposely designed to reduce the risk of loss of capital and/or income by investing in different types of securities available in a wide range of industries. The investors shall be aware of the fact that there is no such thing as a zero risk investment. 4. Capital growth 1. Security of the principle amount 2. Consistency of returns 3. Risk Reduction 4. Capital Growth 5. Liquidity 6. Marketability 7. Favourable tax treatment Objectives of Portfolio Management Portfolio management guarantees the growth of capital by reinvesting in growth securities or by the purchase of growth securities. 5. Liquidity Portfolio management is planned in such a way that it facilitates to take maximum advantage of various good opportunities upcoming in the market. The portfolio should always ensure that there are enough funds available at short notice to take care of the investor s liquidity requirements. 6. Marketability Portfolio management ensures the flexibility to the investment portfolio. A portfolio consists of such investment, which can be marketed and traded. 7. Favourable tax treatment Portfolio management is planned in such a way to increase the effective yield an investor gets from his surplus invested funds. By minimizing the tax burden, yield can be effectively improved. 132 P age The people who are crazy enough to think they can change the world are the ones who do. Steve Jobs

142 Portfolio Management Q2 What are the steps in Portfolio Management? Steps in Portfolio Management 1. Analysis of the underlying security 1.Analysis 2. Forming Portfolio 2. Forming a feasible portfolio of the selected securities 3. Selecting the optimal portfolio 3. Selection 4. Monitoring 4. Constantly monitoring and revising the selected portfolio 5. Assessing the performance of the portfolio 5. Assessment Q3 Write short note on Factors affecting investment decisions in portfolio management. (ii) Objectives of investment portfolio: There can be many objectives of making an investment. The manager of a provident fund portfolio has to look for security (low risk) and may be satisfied with none too higher return. An aggressive investment company may, however, be willing to take a high risk in order to have high capital appreciation. (ii) Selection of investment (a) What types of securities to buy or invest in? There is a wide variety of investments opportunities available i.e. debentures, convertible bonds, preference shares, equity shares, government securities and bonds, income units, capital units etc. (b) What should be the proportion of investment in fixed interest/dividend securities and variable interest/dividend bearing securities? (c) In case investments are to be made in the shares or debentures of companies, which particular industries show potential of growth? (d) Once industries with high growth potential have been identified, the next step is to select the particular companies, in whose shares or securities investments are to be made. (iii) Timing of purchase: At what price the share is acquired for the portfolio depends entirely on the timing decision. It is obvious if a person wishes to make any gains, he should buy cheap and sell dear i.e. buy when the shares are selling at a low price and sell when they are at a high price. Being the richest man in the cemetery doesn't matter to me. Going to bed at night saying we've done something wonderful... that's what matters to me. Steve Jobs 133 P age

143 CA Fi nal SFM CA Mayank Kothar i Q4 Distinguish between Systematic Risk and Unsystematic Risk? Particulars Systematic Risk Unsystematic Risk Meaning Risk inherent to the entire market or entire market segment. Risk inherent to the specific company or industry. Control Uncontrollable by an organisation Controllable by an organisation Nature Macro in nature Micro in nature Types Interest rate risk, market risk, purchasing power / inflationary risk Business/Liquidity risk, financial/credit risk Also known as Market risk, Non diversifiable risk Diversifiable risk Example Recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. Q5 What is Diversification? Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio. Diversification lowers the risk of your portfolio. Academics have complex formulas to demonstrate how this works, but we can explain it clearly with an example: Suppose that you live on an island where the entire economy consists of only two companies: one sells umbrellas while the other sells sunscreen. If you invest your entire portfolio in the company that sells umbrellas, you'll have strong performance during the rainy season, but poor performance when it's sunny outside. The reverse occurs with the sunscreen company, the alternative investment; your portfolio will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you'd rather have constant, steady returns. The solution is to invest 50% in one company and 50% in the other. Because you have diversified your portfolio, you will get decent performance year round instead of having either excellent or terrible performance depending on the season. There are three main practices that can help you ensure the best diversification: 1. Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds and perhaps even some real estate. 2. Vary the risk in your securities. You're not restricted to choosing only blue chip stocks. In fact, it would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas. 3. Vary your securities by industry. This will minimize the impact of industry-specific risks. Diversification is the most important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some risk. Another question that frequently baffles investors is how many stocks should be bought in order to reach optimal diversification. According to portfolio theorists, adding about 20 securities to your portfolio reduces almost all of the individual security risk involved. This assumes that you buy stocks of different sizes from various industries. 134 P age My favorite things in life don't cost any money. It's really clear that the most precious resource we all have is time Steve Jobs

144 Portfolio Management Q6 What do you mean by Risk Reduction? Risk reduction means actual risk (σ) of the portfolio is less than the weighted average risk of the securities that constitutes the portfolio. This is the point where one can say that diversification has resulted into risk reduction. Q7 Write short notes on Capital Asset Pricing Model. The Capital Asset Pricing Model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already diversified portfolio, given that assets non-diversifiable risk. R j =Defined as the minimum expected return needed so that investor will purchase and hold asset. SML is the graphical representation of the results of the CAPM. Advantages of CAPM 1. Considers only systematic risk. 2. Better method to calculate cost of equity. 3. Can be used as risk adjusted discounted rate (RADR) Limitations of CAPM 1. Unreliable Beta. 2. Hard to get the market information. Return of security under CAPM R j = R f + β(r m R f ) Where, R j = Return on Security R f = Risk free rate of return R m = Market return β = beta of the security Q8 What sort of investor normally views the variance (or Standard Deviation) of an individual security s return as the security s proper measure of risk? A rational risk-averse investor views the variance (or standard deviation) of her portfolio s return as the proper risk of her portfolio. If for some reason or another the investor can hold only one security, the variance of that security s return becomes the variance of the portfolio s return. Hence, the variance of the security s return is the security s proper measure of risk. While risk is broken into diversifiable and non-diversifiable segments, the market generally does not reward for diversifiable risk since the investor himself is expected to diversify the risk himself. However, if the investor does not diversify, he cannot be considered to be an efficient investor. The market, therefore, rewards an investor only for the non-diversifiable risk. Hence, the investor needs to know how much non- diversifiable risk he is taking. This is measured in terms of beta. An investor therefore, views the beta of a security as a proper measure of risk, in evaluating how much the market reward him for the non-diversifiable risk that he is assuming in relation to a security. An investor who is evaluating the non -diversifiable element of risk, that is, extent of deviation of returns viz -a-viz the market therefore consider beta as a proper measure of risk. Q9 What sort of investor rationally views the beta of a security as the security s proper measure of risk? In answering the question, explain the concept of beta. If an individual holds a diversified portfolio, she still views the variance (or standard deviation) of her portfolios return as the measure of the risk of her portfolio. However, she is no longer interested in the variance of each individual security s return. Rather she is interested in the contribution of each individual security to the variance of the portfolio. Under the assumption of homogeneous expectations, all individuals hold the market portfolio. Thus, we measure risk as the contribution of an individual security to the variance of the market portfolio. It s better to be a pirate than to join the navy. 135 P age -Steve Jobs

145 CA Fi nal SFM CA Mayank Kothar i The contribution when standardized properly is the beta of the security. While a very few investors hold the market portfolio exactly, many hold reasonably diversified portfolio. These portfolios are close enough to the market portfolio so that the beta of a security is likely to be a reasonable measure of its risk. In other words, beta of a stock measures the sensitivity of the stock with reference to a broad based market index like BSE Sensex. For example, a beta of 1.3 for a stock would indicate that this stock is 30 per cent riskier than the Sensex. Similarly, a beta of a 0.8 would indicate that the stock is 20 per cent (100 80) less risky than the Sensex. However, a beta of one would indicate that the stock is as risky as the stock market index. Q10 Discuss the Random Walk Theory Many investment managers and stock market analysts believe that stock market prices can never be predicted because they are not a result of any underlying factors but are mere statistical ups and downs. This hypothesis is known as Random Walk hypothesis which states that the behaviour of stock market prices is unpredictable and that there is no relationship between the present prices of the shares and their future prices. Proponents of this hypothesis argue that stock market prices are independent. A British statistician, M. G. Kendell, found that changes in security prices behave nearly as if they are generated by a suitably designed roulette wheel for which each outcome is statistically independent of the past history. In other words, the fact that there are peaks and troughs in stock exchange prices is a mere statistical happening successive peaks and troughs are unconnected. In the layman's language it may be said that prices on the stock exchange behave exactly the way a drunk would behave while walking in a blind lane, i.e., up and down, with an unsteady way going in any direction he likes, bending on the side once and on the other side the second time. The supporters of this theory put out a simple argument. It follows that: Prices of shares in stock market can never be predicted. The reason is that the price trends are not the result of any underlying factors, but that they represent a statistical expression of past data. There may be periodical ups or downs in share prices, but no connection can be established between two successive peaks (high price of stocks) and troughs (low price of stocks). Q11 Discuss how the risk associated with securities is effected by Government Policy The risk from Government policy to securities can be impacted by any of the following factors. (i) Licensing Policy (ii) Restrictions on commodity and stock trading in exchanges (iii) Changes in FDI and FII rules. (iv) Export and import restrictions (v) Restrictions on shareholding in different industry sectors (vi) Changes in tax laws and corporate and Securities laws. 136 P age We don t get a chance to do that many things, and every one should be really excellent. Because this is our life. Life is brief, and then you die, you know? And we ve all chosen to do this with our lives. So it better be damn good. It better be worth it.

146 Portfolio Management Q12 Write short notes on assumptions of the Markowitz Model of Risk Return Optimization The return on an investment adequately summarises the outcome of the investment. The investors can visualise a probability distribution of rates of return. The investors' risk estimates are proportional to the variance of return they perceive for a security or portfolio. Investors base their investment decisions on two criteria i.e. expected return and variance of return. All investors are risk averse. For a given expected return he prefers to take minimum risk, for a given level of risk the investor prefers to get maximum expected return. Investors are assumed to be rational in so far as they would prefer greater returns to lesser ones given equal or smaller risk and are risk averse. Risk aversion in this context means merely that, as between two investments with equal expected returns, the investment with the smaller risk would be preferred. Return could be any suitable measure of monetary inflows like NPV but yield has been the most commonly used measure of return, so that where the standard deviation of returns is referred to it is meant the standard deviation of yield about its expected value. You take your life in your own hands, and what happens? A terrible thing, no one to blame. 137 P age

147 CA Fi nal SFM CA Mayank Kothar i Dividend Decisions Q1 Write Short notes on Dividend Policy Firm s dividend policy divides net earnings into retained earnings and dividends. Retained earnings provide necessary funds to finance long term growth while dividends are paid in cash generally. Dividend policy of the firm is governed by: (i) (ii) Long Term Financing Decision: a. When dividend decision is treated as a financing decision, net earnings are viewed as a source of long term financing. b. When the firm does not have profitable investment opportunities, dividend will be paid. The firm grows at a faster rate when it accepts highly profitable opportunities. c. External equity is raised to finance investments. But retained earnings are preferable because they do not involve floatation costs. d. Payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance. e. Thus earnings may be retained as part of long term financing decision while dividends paid are distribution of earnings that cannot be profitably re-invested. Wealth Maximisation Decision: a. Because of market imperfections and uncertainty, shareholders give higher value to near dividends than future dividends and capital gains. b. Payment of dividends influences the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches. c. When the firm increases retained earnings, shareholders' dividends decrease and consequently market price is affected. Use of retained earnings to finance profitable investments increases future earnings per share. On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of funds and thereby decrease the future earnings per share. d. Thus, management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders. e. Such policy will be influenced by investment opportunities available to the firm and value of dividends as against capital gains to shareholders. Q2 What are the factors determining dividend policy of the company? Or What are the determinants of dividend policy? The factors that affect the dividend policy of the company are: 1. Liquidity: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends. 2. Repayment of debt: If debt is scheduled for payment then it may be difficult for the company to pay dividend. 3. Stability of profits: A company which has stable earnings can afford to have a higher dividend payout ratio. 4. Financial needs of the company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 138 P age "You should learn from your competitor, but never copy. Copy and you die." - Jack Ma, Alibaba Group

148 Dividend Decisions 5. Legal considerations: Legal stipulations do not require a dividend declaration but they specify the requirements under which dividends must be paid. 6. Shareholders preference: The dividend policy of a firm is likely to be affected by the owner s considerations of (i) the tax status of the shareholders, (ii) their opportunities of investments and (iii) dilution of ownership. 7. State of Capital Market: a. Favourable Market: Liberal dividend policy. b. Unfavourable market: Conservative dividend policy. 8. Inflation: Inflation should also be considered in dividend policy. Q3 Write short notes on Optimum Dividend Payout Investors put their money in the shares of a company in order to earn income on the investment by way of dividend and capital appreciation. But what if you have the option to earn more than what the company will pay you via dividend and capital appreciation. It s obvious that you will choose that option and are not going to put the money in shares. Shareholders expect some returns from the company. It s termed as cost of equity for the company (K e ) and the return that the company will earn on its investment is (r) Considering this as the basis we come across three different situations: A. When the company is earning more than what the investor would have earned Means: 1. Investors expectation(k e ) are less than what the company earns(r) 2. K e < r 3. Means the company is growth company. 4. Investors will be willing to let the company retain the profits and do not declare dividends in anticipation of the more returns in the future. 5. Hence the optimum payout ratio will be 0% B. When the company is earning exactly same as the investor would have earned Means: 1. Investors expectation(k e ) are equal to what the company earns(r) 2. K e = r 3. Means the company is normal company. 4. Investors will be indifferent at this point as it does not matter whether company retain or distribute the profit as dividend 5. Hence the optimum payout ratio does not matter here. C. When the company is earning less than what the investor would have earned Means: 1. Investors expectation (K e ) are more than what the company earns(r) 2. K e > r 3. Means the company is declining company. 4. Investors will be willing to let the company distribute all its profits by way of dividends 5. Hence the optimum payout ratio will be 100% There is no royal road to anything. One thing at a time, all things in succession. That which grows fast, withers as rapidly. That which grows slowly, endures. Josiah Gilbert Holland 139 P age

149 CA Fi nal SFM CA Mayank Kothar i Q4 Explain the concept of Homemade Dividends A form of investment income that comes from the sale of a portion of shares held by a shareholder. This differs from dividends that shareholders receive from a company according to the number of shares the shareholder has. The existence of homemade dividends is the reason some financial analysts believe that looking at a company s dividend policy is not important. If investors desires an income stream they will either sell their shares when they want the income or they will invest in other income-generating assets. Let s take an example ABC Ltd. is quoted at `50 and Sundar is holding 100 shares of this company. Now if the company declare a dividend of `2/share then you would expect the market prices ex-dividend to go down to Rs.48 after the record date. 1. The total wealth of the Sundar is 100 x 50 = Once the dividend has been paid it will become 100 x = If Sundar was expecting more than Rs.2/dividend then he can add money to his pocket by selling 2 shares Market value + Dividend + Sale Proceeds (100 2)x x2 + 48x2 = 5000 Thus in all the above cases wealth of the shareholders was same and dividend policy of the company is irrelevant. Q5 Explain various dividend policies 1. Constant Dividend per Share Some companies may follow the policy of paying constant dividend per share every year irrespective of the earnings of that year. This is because companies would like to retain some amount for the payment of dividend in the bad years as well. When the company thinks it has reached a certain satisfied level of earnings then it can increase the annual dividend per share. This type of policy is preferred by the investors who are dependent on dividend income for their expenses as the policy ensures regular amount of dividend. e.g. Rs 20 per share will be paid every year. 2. Constant percentage of earnings Some companies may like to follow the policy of paying constant % of earnings every year. This ratio which is based on the earnings of the company is known as the dividend payout ratio. By this the amount of dividend every year will be in direct proportion to the earnings of the company. This policy will ensure that the shareholders will get more returns in the year of high profits and they will get no returns in case company incurs losses. e.g. 20% will be paid as dividend out of the profits of every year 3. Small Constant Dividend per Share plus Extra Dividend Companies can adopt the policy to pay dividend which consist of two amount. First part will be certain fixed amount of dividend and other is variable dividend means extra. Fixed amount of dividend will be paid every year irrespective of the performance of the company. Variable amount will depend each year on the performance of the company. If the 140 P age The real opportunity for success lies within the person and not in the job. Zig Ziglar

150 Dividend Decisions company earns high profits it can payout some extra dividend treating as variable amount and if the company earns normal profits only then company can either pay small amount as variable or else can even skip paying variable amount. This way company can ensure that investors are satisfied with regular income and also with variables on the occasions. Even when the company fails to pay extra dividend it will not have any depressing effect on investors. e.g`20 per share plus 5% of the profits of every year. Q6 Explain various forms of dividends (i) Cash dividend: a. The company should have sufficient cash in bank account when cash dividends are declared. If it does not have enough bank balance, it should borrow funds. b. For stable dividend policy a cash budget may be prepared for coming period to indicate necessary funds to meet regular dividend payments. c. The cash account and reserve account of the company will be reduced when cash dividend is paid. d. Both total assets and net worth of the company are reduced when cash dividend is distributed. According to Hastings, market price of share drops by the amount of cash dividend distributed. (ii) Stock Dividend (Bonus shares): a. It is distribution of shares in lieu of cash dividend to existing shareholders. b. Such shares are distributed proportionately thereby retaining proportionate ownership of the company. c. If a shareholder owns 100 shares at a time, when 10% dividend is declared he will have 10 additional shares thereby increasing the equity share capital and reducing reserves and surplus (retained earnings). d. The total net worth is not affected by bonus issue. Q7 List down the assumptions under Gordon Growth Model This model explicitly relates the market value of the firm to dividend policy. In this model, the current ex-dividend at the amount which shareholders expected date of return exceeds the constant growth rate of dividends. It is based on the following assumptions: The firm is an all equity firm, and it has no debt. No external financing is used and investment programmes are financed exclusively by retained earnings. The internal rate of return, r, of the firm is constant. The appropriate discount rate, ke, for the firm remains constant. The firm has perpetual life. The retention ratio, b, once decided upon, is constant. Thus, the growth rate, g = br, is also constant. The discount rate is greater than the growth rate, ke> br. Don t worry about failures, worry about the chances you miss when you don t even try. Jack Canfield 141 P age

151 CA Fi nal SFM CA Mayank Kothar i Q8 List down the assumptions under Modigliani Miller Hypothesis Modigliani and Miller Hypothesis is in support of the irrelevance of dividends. Modigliani and Miller argue that firm s dividend policy has no effect on its value of assets and is, therefore of no consequence i.e. dividends are irrelevant to shareholders wealth. According to them, Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm's investment policy, its dividend policy may have no influence on the market price of shares. The hypothesis is based on the following assumptions: The firm operates in perfect capital markets in which all investors are rational and information is freely available to all. There are no taxes. Alternatively, there are no differences in the tax rates applicable to capital gains and dividends. The firm has a fixed investment policy. There are no floatation or transaction costs. Risk of uncertainty does not exist. Investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r = k = k t for all t. Q9 What is Radical Approach under Dividend Policy This approach takes into consideration the tax aspects on dividend i.e. the corporate tax and the personal tax. Also it considers the fact that tax on dividend and capital gains are taxed as different rate. The approach is based on one premise that if tax on dividend is higher than tax on capital gains, the share of the company will be attractive if the company is offering capital gain. Similarly, if tax on dividend is less than the tax on capital gains, i.e. company offering dividend rather than capital gains, will be priced better. Q10 According to the position taken by Miller and Modigliani, dividend decision does not influence value. Please state briefly any two reasons, why companies should declare dividend and not ignore it. The position taken by M & M regarding dividend does not take into account certain practical realities is the market place. Companies are compelled to declare annual cash dividends for reasons cited below:- (i) Shareholders expect annual reward for their investment as they require cash for meeting needs of personal consumption. (ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free receipt, whereas some part of capital gains may be taxable. (iii) Other forms of investment such as bank deposits, bonds etc, fetch cash returns periodically, investors will shun companies which do not pay appropriate dividend. (iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on undistributed profits of certain companies. 142 P age Keep away from people who try to belittle your ambitions. Small people always do that, but the really great makes you feel that you, too, can become great. Mark Twain

152 Dividend Decisions Q11 Write short note on effect of a Government imposed freeze on dividends on stock prices and the volume of capital investment in the background of Miller-Modigliani (MM) theory on dividend policy. According to MM theory, under a perfect market situation, the dividend of a firm is irrelevant as it does not affect the value of firm. Thus under MM s theory the government imposed freeze on dividend should make no difference on stock prices. Firms if do not pay dividends will have higher retained earnings and will either reduce the volume of new stock issues, repurchase more stock from market or simply invest extra cash in marketable securities. In all the above cases, the loss by investors of cash dividends will be made up in the form of capital gains. Whether the Government imposed freeze on dividends have effect on volume of capital investment in the background of MM theory on dividend policy have two arguments. One argument is that if the firms keep their investment decision separate from their dividend and financing decision then the freeze on dividend by the Government will have no effect on volume of capital investment. If the freeze restricts dividends the firm can repurchase shares or invest excess cash in marketable securities e.g. in shares of other companies. Other argument is that the firms do not separate their investment decision from dividend and financing decisions. They prefer to make investment from internal funds. In this case, the freeze of dividend by government could lead to increased real investment. Q12 Write a short note on Traditional & Walter Approach to Dividend Policy Answer According to the traditional position expounded by Graham and Dodd, the stock market places considerably more weight on dividends than on retained earnings. For them, the stock market is overwhelmingly in favour of liberal dividends as against niggardly dividends. Their view is expressed quantitatively in the following valuation model: P = m (D + E/3) Where, P = Market Price per share D = Dividend per share E = Earnings per share m = a Multiplier. As per this model, in the valuation of shares the weight attached to dividends is equal to four times the weight attached to retained earnings. In the model prescribed, E is replaced by (D+R) so that P = m {D + (D+R)/3} = m (4D/3) + m (R/3) The weights provided by Graham and Dodd are based on their subjective judgments and not derived from objective empirical analysis. Notwithstanding the subjectivity of these weights, 143 P age

153 CA Fi nal SFM CA Mayank Kothar i the major contention of the traditional position is that a liberal payout policy has a favourable impact on stock prices. The formula given by Prof. James E. Walter shows how dividend can be used to maximise the wealth position of equity holders. He argues that in the long run, share prices reflect only the present value of expected dividends. Retentions influence stock prices only through their effect on further dividends. It can envisage different possible market prices in different situations and considers internal rate of return, market capitalisation rate and dividend payout ratio in the determination of market value of shares. Walter Model focuses on two factors which influences Market Price (i) Dividend Per Share. (ii) Relationship between Internal Rate of Return (IRR) on retained earnings and market expectations (cost of capital). If IRR > Cost of Capital, Share price can be even higher in spite of low dividend. The relationship between dividend and share price on the basis of Walter s formula is shown below: DPS + Market price per share = P = Rate of Return on Investment Cost of Equity Capital Cost of Equity Capital D + r K e (E D) K e (EPS DPS) 144 P age Its hard to wait around for something you know might never happen; but its harder to give up when you know its everything you want.

154 Foreign Exchange & Risk Management Foreign Exchange & Risk Management Q1 Operations in foreign exchange market are exposed to a number of risks. Explain Firm dealing with foreign exchange may be exposed to foreign currency exposures. Following are the three types of exposure that a firm may face: FX Exposures 1. Transaction Exposure A firm has transaction exposure whenever it has contractual cash flows (sales/purchases) whose values are subject to unanticipated changes in exchange rate due to contract being denominated in a foreign currency. Ex. Change in the value of Receivables on export on exchange rate fluctuation. 2. Economic/Operating Exposure A firm has economic exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Ex. Shift in exchange rate will affect demand of the product. This is economic exposure 3. Translation Exposure A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements Ex. Revaluation of debtors and creditors at balance sheet date for the exchange rate fluctuations. Q2 Write short notes on: a. Interest Rate Parity Theory b. Purchasing Power Parity Theory a. Interest Rate Parity Theory Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. IRP theoretical formula 1 + r d = F 1 + r f S Where, r d= Rate of interest in domestic market r f= Rate of interest in foreign market F = Forward rate of the foreign currency S = Spot rate of the foreign currency When Interest rate parity exist then high interest in one country will be offset by the depreciation in the currency of that country. IRP theory states that the size of the forward premium (discount) should be equal to the interest rate differential between the two countries in consideration. One of the most important keys to Success is having the discipline to do what you know you should do, even when you dont feel like doing it. 145 P age

155 CA Fi nal SFM CA Mayank Kothar i b. Purchasing Power Parity Theory Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power. PPP theoretical formula F = S x 1 + i d 1 + i f Where, i d= Inflation rate in domestic market i f= Inflation rate in foreign market F = Forward rate for foreign currency S =Spot rate for foreign currency Two forms of Purchasing Power Parity theory 1. The Absolute form: The purchasing power parity theory is based on the common sense idea. If a basket of goods cost `1000 in India and the same goods cost $25 in United States then the purchasing power parity between the two currencies is `40 / US Dollar. This form of exchange rate is called absolute PPP. The Absolute form which is also known as Law of One price states that prices of similar product of two different countries should be equal when measured in a common currency 2. The Relative form: The relative purchasing power parity explains the relationship between the inflation rates and exchange rates of the two countries. It means that if the inflation rate in one country is higher than that in another country then the effect of this high inflation is offset by the depreciation in the currency of that country. Q3 Write short notes on Nostro, Vostro and Loro accounts. Suppose there are Two Banks ICICI bank in India and Bank of America(BOA) in US. Now the ICICI bank has 1 account of its own in BOA. From ICICI banks point of view- It s My Account in Your Bank, - Nostro Account From BOA s point of view- It s Your Account in My Bank, - Vostro Account Now suppose if the Bank of London has to make some payment to ICICI bank but instead of direct payment to ICICI bank it has deposited the money in ICICI Bank s account in Bank of America. So this account is LORO Account for Bank of London. So here, the same account is Nostro For ICICI Bank Vostro For Bank of America Loro For Bank of London i) Nostro Account: (Italian, English, 'ours'): It is the overseas account which is held by the domestic bank in the foreign bank or with the own foreign branch of the bank. For example the account held by ICICI bank with bank of America in New York is a Nostro account of the ICICI bank. ii) Vostro Account (Italian, English, 'yours'): a bank account held by a foreign bank with a domestic bank, is Vostro Account. Thus, if the account of Bank of America in ICICI bank is Vostro account for ICICI 146 P age Go where you are celebrated not tolerated. If they can t see the real value of you, it s time for a new start.

156 Foreign Exchange & Risk Management iii) Loro Account (Italian, English, 'theirs'): it is used when referring to third party accounts. Ex: If ICICI, Mumbai has an account with Bank of America, New York denominated in US Dollars then when Bank of London has to refer to this account while corresponding with Bank of America, it would refer to it as LORO Account, meaning their account with you Q4 What is Exposure Netting? What are the advantages of Netting? Answer Exposure Netting refers to offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure. The objective of the exercise is to offset the likely loss in one exposure by likely gain in another. This is a manner of hedging forex exposures though different from forward and option contracts. This method is similar to portfolio approach in handling systematic risk. Advantages of Netting Reduces the number of cross border transactions between subsidiaries thereby decreasing the overall administrative costs of such cash transfers. Reduces the need for foreign exchange conversion and hence decreases transaction costs associated with foreign exchange conversion. Improves cash flow forecasting since net cash transfers are made at the end of each period. Gives an accurate report and settles accounts through co-ordinate efforts among all subsidiaries. Q5 What is Leading and Lagging? Leading: Leading refers to prepaying import payments or receiving early payment for exports; If the importer expects the foreign currency to appreciate beyond the cost of home currency funds then he will be willing to make an early payment by borrowing the amount. On the other hand if the exporter expects that the foreign currency to depreciate more than the cost of investment then he will be willing to receive early payments for the sales made by him. Lagging: Lagging relates to delaying import payments or receiving late payment on exports. If the importer expects the foreign currency to depreciate more than the interest charged by the vendor for delaying the payments then he will be willing to make delayed payment. On the other hand if the exporter expects that the foreign currency to appreciate more than the cost of investment then he will be willing to receive late payments for the sales made by him. Forget all the reasons it won t work and believe the one reason that it will. 147 P age

157 CA Fi nal SFM CA Mayank Kothar i Q6 Write short notes on Arbitrage Operations. Arbitrage is the buying and selling of the same commodity in different markets. A number of pricing relationships exists in the foreign exchange market, whose variation would imply the existence of arbitrage opportunities the opportunity to make a profit without risk or investment. These transactions refer to advantage derived between two currencies at two different centers at the same time or of difference between cross rates and actual rates. For example, a customer can gain from arbitrage operation by purchase of dollars in the local market at cheaper price prevailing at a point of time and sell the same for sterling in the London market. The sterling will then be used for meeting his commitment to pay the import obligation from London. Q7 Explain the significance of LIBOR in international financial transactions. LIBOR stands for London Inter Bank Offered Rate. It is the base rate of exchange with respect to which most international financial transactions are priced. It is used as the base rate for a large number of financial products such as options and swaps. Banks also use the LIBOR as the base rate when setting the interest rate on loans savings and mortgages. It is monitored by a large number of professionals and private individuals worldwide. 148 Page Give me a stock clerk with a goal, and I will give you a man who will make history. Give me a man without a goal, and I will give you a stock clerk.

158 Project Planning Q1 Explain the concept of Zero date of project in project management. Project Planning Zero date of project means a date is fixed from which implementation of the project begins. It is a starting point of incurring cost. The project completion period is counted from the zero date. Pre Project activities should be completed before zero date. These activities are: i) Identification of project ii) Determination of plant capacity iii) Selection of technical help iv) Selection of site v) Selection of survey of soil/plot etc. vi) Manpower planning and recruiting key personnel vii) Cost and finance scheduling Q2 What is Project Cost Accounting? Project cost accounting is essentially a service that supports Project Management. It is the process of recognizing, measuring, recording and reporting the project cost data (MIS) to its stakeholders about the project milestones and costs. One of the most important requirements of Project Cost Accounting is estimating the Cost to Completion and therefore, differs from financial and corporate accounting significantly. Project costing starts with a Budget, a benchmark, with which the current performance is continuously measured. Note that What cannot be measured cannot be managed/ controlled (Peter Drucker). Reporting on cost overruns, physical overruns, time overruns is the essential part of the Project Costing. Finally, timeliness in reporting on project costs and milestone overruns is much more important than precision in reporting. Q3What are the advantages of post completion audit? Post completion audit evaluates actual performance with projected performance. It verifies both revenues and costs. The advantages of completing post completion audit are: The experience gained is highly valuable for future decision making since it can highlight mistakes that can be avoided and areas of improvements brought about. Identify individuals with superior abilities in planning and forecasting. It helps in discovering biases in judgment. It induces healthy caution among the sponsors of projects as project sponsors make overoptimistic projections for their proposals. It helps in exerting discipline in the investment planning and control process. Self confidence is the most attractive quality a person can have. How can anyone see how awesome you are if you can t see it yourself? 149 P age

159 CA Fi nal SFM CA Mayank Kothar i Q4 Write a brief note on project appraisal under inflationary conditions Project Appraisal under Inflationary Conditions: Project Appraisal normally involves feasibility evaluation from technical, commercial, economic and financial aspects. It is generally an exercise in measurement and analysis of cash flows expected to occur over the life of the project. The project cash outflows usually occur initially and inflows come in the future. During inflationary conditions, the project cost increases on all heads viz. labour, raw material, fixed assets such as equipments, plant and machinery, building material, remuneration of technicians and managerial personnel etc. Beside this, inflationary conditions erode purchasing power of consumers and affect the demand pattern. Thus, not only cost of production but also the projected statement of profitability and cash flows are affected by the change in demand pattern. Even financial institutions and banks may revise their lending rates resulting in escalation in financing cost during inflationary conditions. Under such circumstances, project appraisal has to bedone generally keeping in view the following guidelines which are usually followed by government agencies, banks and financial institutions. (i) It is always advisable to make provisions for cost escalation on all heads of cost, keeping in view the rate of inflation during likely period of delay in project implementation. (ii) The various sources of finance should be carefully scrutinized with reference to probable revision in the rate of interest by the lenders and the revision which could be effected in the interest bearing securities to be issued. All these factors will push up the cost of funds for the organization. (iii) Adjustments should be made in profitability and cash flow projections to take care of the inflationary pressures affecting future projections. (iv) It is also advisable to examine the financial viability of the project at the revised rates and assess the same with reference to economic justification of the project. The appropriate measure for this aspect is the economic rate of return for the project which will equate the present value of capital expenditures to net cash flows over the life of the projects. The rate of return should be acceptable which also accommodates the rate of inflation per annum. (v) In an inflationary situation, projects having early payback periods should be preferred because projects with long payback period are more risky. Under conditions of inflation, the project cost estimates that are relevant for a future date will suffer escalation. Inflationary conditions will tend to initiate the measurement of future cash flows. Either of the following two approaches may be used while appraising projects under such conditions: (i) Adjust each year's cash flows to an inflation index, recognising selling price increases and cost increases annually; or (ii) Adjust the 'Acceptance Rate' (cut-off) suitably retaining cash flow projections at current price levels. An example of approach (ii) above can be as follows: Normal Acceptance Rate : 15.0% Expected Annual Inflation : 5.0% Adjusted Discount Rate : or 15.75% It must be noted that measurement of inflation has no standard approach nor is easy. This makes the job of appraisal a difficult one under such conditions. 150 P age Though no one can go back and make a brand new start, anyone can start from now and make a brand new ending.

160 Project Planning Q5 What are the contents of the Project Report? The following aspects need to be taken into account for a Project Report - 1. Promoters: Their experience, past records of performance form the key to their selection for the project under study. 2. Industry Analysis: The environment outside and within the country is vital for determining the type of project one should opt for. 3. Economic Analysis: The demand and supply position of a particular type of product under consideration, competitor s share of the market along with their marketing strategies, export potential of the product, consumer preferences are matters requiring proper attention in such type of analysis. 4. Cost of Project: Cost of land, site development, buildings, plant and machinery, utilities e.g. power, fuel, water, vehicles, technical knowhow together with working capital margins, preliminary/pre-operative expenses, provision for contingencies determine the total value of the project. 5. Inputs: Availability of raw materials within and outside the home country, reliability of suppliers cost escalations, transportation charges, manpower requirements together with effluent disposal mechanisms are points to be noted. 6. Technical Analysis: Technical know-how, plant layout, production process, installed and operating capacity of plant and machinery form the core of such analysis. 7. Financial Analysis: Estimates of production costs, revenue, tax liabilities profitability and sensitivity of profits to different elements of costs and revenue, financial position and cash flows, working capital requirements, return on investment, promoters contribution together with debt and equity financing are items which need to be looked into for financial viability. 8. Social Cost Benefit Analysis: Ecological matters, value additions, technology absorptions, level of import substitution form the basis of such analysis. 9. SWOT Analysis: Liquidity/Fund constraints in capital market, limit of resources available with promoters, business/financial risks, micro/macro economic considerations subject to government restrictions, role of Banks/Financial Institutions in project assistance, cost of equity and debt capital in the financial plan for the project are factors which require careful examinations while carrying out SWOT analysis. 10. Project Implementation Schedule: Date of commencement, duration of the project, trial runs, cushion for cost and time over runs and date of completion of the project through Network Analysis have all to be properly adhered to in order to make the project feasible. When the past calls, let it go to voic , believe me, it has nothing new to say. 151 P age

161 CA Fi nal SFM CA Mayank Kothar i Capital Budgeting Q1 What are the issues that need to be considered by an Indian Investor and incorporated within the Net Present Value (NPV) Model for the evaluation of Foreign Investment Proposals? Following are the issues that need to be considered in NPV Model for evaluation of foreign investment proposals: 1) Taxes on Income associated with foreign projects a. Heavy Indirect Taxes b. Difference in definition of taxable income from country to country c. Tax treaties entered into with different countries 2) Political Risks: a. Risk of seizure of property b. Risk of nationalization of industry without paying full compensation c. Restrictions on employment of foreign managerial personnel d. Restrictions on imports of raw material 3) Economic Risk: a. Fluctuation in Exchange Rates b. Inflation Q2 Distinguish between Net Present Value and Internal Rate of Return. Basis Net present value (NPV) Internal rate of return (IRR) Expressed in Value in units of a currency Percentage terms Cash flows are assumed to be Additional wealth Reinvested at the cost of capital NPV takes into account additional wealth Reinvested at an internal rate of return IRR does not consider additional wealth Cash Flows Users NPV can be used even if the cash flows are changing For general public NPV is better method to grasp. IRR method cannot be used if the cash flows are changing Business managers are more comfortable with the IRR method. Q3 Write short note on Certainty Equivalent Approach. CE is an approach for dealing with risk in capital budgeting to reduce the forecasts of cash flows to some conservative level. One of the ways of incorporating risk is Certainty Equivalent Method, wherein the expected cash flows are adjusted to reflect the project risk. The cash flows are brought down because higher the risk less is the probability of those cash flows being certain. The certainty equivalent approach adjusts future cash flows rather than discount rate. Certainty equivalent coefficient lies between 0 and 1. CE coefficient of 1 indicates that the cash flow is certain or there is no risk. 152 P age Love what you have. Need what you want. Accept what you receive. Give what you can. Always remember, what goes around, comes around

162 Capi tal Budgeti ng Q4 What is Sensitivity Analysis in Capital Budgeting? Sensitivity analysis is used in Capital Budgeting for measuring the risk. It helps in assessing information as to how sensitive are the estimated parameters of the project such as cash flows, discount rate, and the projects life to the estimation errors. It answers questions like: i) What happens to the present value if cash flows are, say Rs than the expected Rs. 80,000? ii) And what will happen to NPV if economic life of the project is only 3 years rather than expected 5 years? Sensitivity analysis involves three steps: i) Identification of all those variables having an influence on the projects NPV or IRR. ii) Definition of the underlying quantitative relationship among the variables. iii) Analysis of the impact of the changes in each of the variables on the NPV of the project. In Sensitivity Analysis, decision maker always asks himself the question What IF? systems. Q5 What is Capital Rationing? Capital Rationing means the utilization of existing funds in most profitable manner by selecting the acceptable projects in the descending order or ranking with limited available funds. The firm must be able to maximise the profits by combining the most profitable proposals. Capital rationing may arise due to external factors(hard capital rationing) such as high borrowing rate and internal factors(soft capital rationing) such as limits imposed by management on spending of funds. Either the internal rate of return method or the net present value method may be used in ranking investments. Where there is a multi period capital rationing linear programming techniques should be used to maximise NPV. Just remember there is someone out there that is more than happy with less than what you have. 153 P age

163 CA Fi nal SFM CA Mayank Kothar i Q6 Write short note on Risk Adjusted Discount Rate. RADR, where the various project risks are dealt with by changing the discount rate. The project having i) average risk is discounted at the organization's cost of capital, ii) higher risk is discounted at the rate higher than the cost of capital, iii) low risk is discounted at the rate lower than the cost of capital. Here discount rate is adjusted to incorporate the risk of the project RADR when underlying consideration is Risk Premium r k = i f + n + d k Where, i f = risk free rate of interest, n = adjustment for firms normal risk, d k = risk premium RADR when underlying consideration is Risk Factor r k = i f + (K e i f )xrisk Factor Where,K e = Cost of equity of the firm Q7 Distinguish between Risk Adjusted Discounted Rate (RADR) and Certainty Equivalent Approach (CEA). Comparison between RADR and CEA Certainty equivalent Sr. No. Particulars Risk adjusted discount rate 1 Method of incorporating risk by adjusting the Discount Rate approach by adjusting Cash Flows 2 NPV Formula deals with the denominator of the NPV formula 3 Variation in the risk in RADR there is an implied assumption that, the risk of the proposal increases at a constant rate over the life of the project deals with the numerator of the NPV formula Whereas, the CE approach incorporates different risk for different years. Q8 What is hard and soft capital rationing? Hard Capital Rationing: When the external environment imposes a condition as to availability of financial resources for a firm to deploy on its capital projects, the resulting paucity of capital forces rationing of the resources to deserving projects. This situation is called hard capital rationing. External capital rationing is nothing but the hard capital rationing. Soft Capital Rationing: Sometimes restrictions are imposed by the executive board of the company, even though funding is available from the external environment. Such situation is called as the soft capital rationing. Internal capital rationing is nothing but soft capital rationing. 154 P age No one is going to hand me success. I must go out & get it myself. That s why I m here. To dominate. To conquer. Both the world, and myself.

164 Capi tal Budgeti ng Q9 What are the Steps in Simulation Analysis? 1. Modeling the project: The model shows the relationship of NPV with parameters and exogenous variables. 2. Specify values of parameters and probability distributions of exogenous variables. 3. Select a value at random from probability distribution of each of the exogenous variables. 4. Determine NPV corresponding to the randomly generated value of exogenous variables and pre specified parameter variables. 5. Repeat steps (3) & (4) a large number of times to get a large number of simulated NPVs. 6. Plot frequency distribution of NPV. Q10 Many companies calculate the internal rate of return of the incremental after -tax cash-flows from financial leases. What problems do you think this may give rise to? To what rate should the internal rate of return be compared? Discuss. Main problems faced in using Internal Rate of Return can be enumerated as under: (1) The IRR method cannot be used to choose between alternative lease bases with different lives or payment patterns. (2) If the firms do not pay tax or pay at constant rate, then IRR should be calculated from the lease cash-flows and compared to after-tax rate of interest. However, if the firm is in a temporary non-tax paying status, its cost of capital changes over time, and there is no simple standard of comparison. (3) Another problem is that risk is not constant. For the lessee, the payments are fairly riskless and interest rate should reflect this. The salvage value for the asset, however, is probably much riskier. As such two discount rates are needed. IRR gives only one rate, and thus, each cash-flow is not implicitly discounted to reflect its risk. (4) Multiple roots rarely occur in capital budgeting since the expected cash flow usually changes sign once. With leasing, this is not the case often. A lessee will have an immediate cash inflow, a series of outflows for a number of years, and then an inflow during the terminal year. With two changes of sign, there may be, in practice frequently two solutions for the IRR. Q11 How would standard deviation of the present value distribution help in Capital Budgeting decisions? Standard deviation is a statistical measure of dispersion; it measures the deviation from a central number i.e. the mean. In the context of capital budgeting decisions especially where we take up two or more projects giving somewhat similar mean cash flows, by calculating standard deviation in such cases, we can measure in each case the extent of variation. It can then be used to identify which project is least riskier in terms of variability of cash flows. A project, which has a lower coefficient of variation will be preferred if sizes are heterogeneous. Besides this, if we assume that probability distribution is approximately normal we are able to calculate the probability of a capital budgeting project generating a net present value less than or more than a specified amount. You don t drown by falling into water. You only drown if you stay there. 155 P age

165 CA Fi nal SFM CA Mayank Kothar i Q12 Write short notes on Real Options in Capital Budgeting. Real options are the options companies have when making capital investment decisions. A company has the option to invest in such a project but can delay the decision. It can also put an existing operation on hold; it can expand an investment or reduce it. The traditional analytical methods of project evaluation (IRR,NPV etc.) assume managements passive commitment to a certain operating strategy, viz. initiate the project immediately and operate it continuously at a set scale until the end of its pre specified expected useful life. These methods typically ignore the synergistic effects that an investment project can create. Sometimes the performance of one project will allow you to perform a second project that would not have been possible without the first (e.g. many research and development projects). Similarly, there could be significant value in waiting for additional information that could make an impact on the success of a project. Therefore the existing analytical methods usually underestimate investment opportunities because they ignore management s flexibility to alter decisions as new information becomes available. The real option methodology is an approach to capital budgeting that relies on option pricing theory to evaluate projects. Insights from option based analysis can improve estimates of project value and therefore has potential in many instances to significantly enhance project management. However Real Options approach is intended to supplement, and not replace, capital budgeting analysis based on standard DCF methodologies. Q13 Write short notes on Techniques of Social Cost Benefit Analysis Goods & Services: social gain/losses from outputs and inputs of a project are measured by the willingness of the consumers to pay for the goods. Labour: Social cost of labour is lower than market wage because of massive un/under employment along with traditions, changes in life style etc. Removal of labour from farms should not cause reduction in agricultural output as other members work harder to offset the loss. Employing labour on nonfarm activities is costless. Shadow wage is zero. Foreign Exchange: Existence of extensive trade controls leads to official undervaluation of foreign exchange. Official exchange rate understates the benefit of exports and costs of imports in terms of domestic resources. An upward adjustment is necessary. Social Rate of Discount: Market rate of interest does not reflect society s preference for current consumption over future consumption. Choice of social discount rate is based on value judgment about weights to be attached to the welfare of future generations compared to that of present generations. Shadow Price of Investment: Society as a whole gives importance to future generations than that accorded by private decision makers. Imperfections of capital markets lead to less than optimal total investment. 156 P age Don t watch the clock. Do what it does. Keep Going

166 Capi tal Budgeti ng Q14 Distinguish between Financial Options and Real Options Basis Financial Options Real Options Trading Payoffs Exercise Period Pricing/ Valuation Financial options have an underlying asset that is traded - usually a security like a stock. The payoffs for financial options are specified in the contract. Real options are found or created inside of projects. Their payoffs can be varied. Financial Options have short exercise period. E.g. 3 months And finally, financial options are priced. A real option has an underlying asset that is not a security - for example a project or a growth opportunity, and it isn t traded. Real Options have long exercise period E.g. 15 years (Life of the project) And real options are valued Q15. Write Short Notes on Financial Engineering Financial Engineering involves the design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions and problems in finance. Financial engineering lies in innovation and creativity to promote market efficiency. In involves construction of innovative asset liability structures using a combination of basic instruments so as to obtain hybrid instruments which may either provide a risk-return configuration otherwise unviable or result in gain by heading efficiently, possibly by creating an arbitrage opportunity. It is of great help in corporate finance, investment management, trading activities and risk management. Over the years, Financial managers have been coping up with the challenges of changing situations. Different new techniques of financial analysis and new financial instruments have been developed. The process that seeks to adopt existing financial instruments and develop new ones so as to enable financial market participants to cope more effectively with changing conditions is known as financial engineering. In recent years, the rapidity with which corporate finance and investment finance have changed in practice has given birth to new area of study known as financial engineering. It involves use of complex mathematical modelling and high speed computer solutions. Financial engineering includes all this. It also involves any moral twist to an existing idea and is not limited to corporate finance. It has been practiced by commercial banks in offering new and tailor made products to different types of customers. Financial engineering has been used in schemes of merger and acquisitions. The term financial engineering is often used to refer to risk management. When it is obvious that goals cannot be reached don t adjust the goals, adjust the action steps. 157 P age

167 CA Fi nal SFM CA Mayank Kothar i Leasing Decisions Q1 Write short note on Cross Border Leasing. Cross-border leasing is a leasing arrangement where lessor and lessee are situated in different countries. This presents significant additional issues related to tax avoidance and tax shelters. A major objective of the cross border leasing is to reduce the overall cost of financing through utilization by the lessor of tax depreciation allowances to reduce its taxable income. The tax savings are passed through to the lessee as a lower cost of finance. The basic prerequisites are relatively high tax rates in the lessor s country, liberal depreciation rules and either very flexible or very formalistic rules governing tax ownership. Other important objectives of the cross border leasing include the following: 1. The lessor is often able to utilize nonrecourse debt to finance a substantial portion of the equipment cost. The debt is secured by among other things, a mortgage on the equipment and by an assignment of the right to receive payments under the lease. 2. Also depending on the structure, in some countries the lessor can utilize very favourable leveraged lease financial accounting treatment for the overall transaction. 3. In some countries it is easier for a lessor to repossess the leased equipment following a lessee default because the lessor is an owner and not a mere secured lender. 4. Leasing provides the lessee with 100% financing. Q2 Distinguish between Financial and Operating lease. Or What are the salient features of Financial and Operating lease? Basis Financial Lease Operating Lease Lease term Cancellation Amortization Risk of obsolescence Costs of maintenance, taxes, insurance etc. Covers the economic life of the equipment. Financial lease cannot be cancelled during the primary lease period. The lease rentals are more or less fully amortized during the primary lease period. The lessee is required to take the risk of obsolescence. Incurred by the lessee unless the contract provides otherwise. Covers significantly less than the economic life of the equipment. Operating lease can be cancelled by the lessee prior to its expiration. The lease rentals are not sufficient enough to amortize the cost of the asset. The lessee is protected against the risk of obsolescence. Incurred by the lessor. Q3 What is Sales and Lease back leasing? Leaseback, short for 'sale-and-leaseback,' is a financial transaction, where one sells an asset and leases it back for the long-term; therefore, one continues to be able to use the asset but no longer owns it. After purchasing an asset, the owner enters a long-term agreement by which the property is leased back to the seller, at an agreed rate. One reason for a leaseback is for the seller to raise money by 158 P age A great pleasure in life is doing what people say you cannot do.

168 Leasi ng Deci si ons offloading a valuable asset to a buyer who is presumably interested in making a long-term secured investment. Q4 What is Sales Aid Lease? Sale aid lease: When the leasing company (lessor) enters into an agreement with the manufacturer of the equipment, to market the latter s product through its own leasing operations, it is called sales-aid-lease. Leasing company gets a commission from the manufacturer on such sales. Q5 What are the advantages and disadvantages of leasing? Advantages 100% Financing Protection against obsolescence Off-balance-sheet financing Tax advantages Leasing Increases Lessee's Capacity To Borrow Absence Of Restrictive Convenience Flexible requirements according to user needs Disadvantages Cash outflow soon after the acquisition of asset Seller s warranty may not be there Hypothecation by bank High cost of financing Q6 Write short notes on Internal Rate of Return Analysis of lease evaluation Under this method there is no need to assume any rate of discount. To this extent, this is different from the former method [Present Value Analysis] where the after-tax cost of borrowed capital was used as the rate of discount. The result of this analysis is the after tax cost of capital explicit in the lease which can be compared with that of the other available sources of finance such as a fresh issue of equity capital, retained earnings or debt. Simply stated, this method seeks to establish the rate at which the lease rentals, net of tax shield on depreciation are equal to the cost of leasing. In Internal rate of return analysis Leasing is compared with buying an asset from retained earnings. Q7 Write short notes on Bower-Herringer-Williamson method of lease evaluation This method segregates the financial and tax aspects of lease financing. If the operating advantage of a lease is more than its financial disadvantage or vice-versa lease will be preferred. The procedure of evaluation is briefly as follows: 1. Compare the present value of debt with the discounted value of lease payments (gross), the rate of discount being the gross cost of debt capital. The net present value is the financial advantage (or disadvantage). 2. Work out the comparative tax benefit during the period and discount it at an appropriate cost of capital. The present value is the operating advantage (or disadvantage) of leasing. 3. If the net result is an advantage, select leasing. The secret of getting ahead is getting started. The secret of getting started is breaking your complex, overwhelming tasks into smaller manageable tasks, and then starting on the first one. 159 P age

169 CA Fi nal SFM CA Mayank Kothar i Financial Services Q1 What are the functions of Investment Banks. The following are, briefly, a summary of investment banking functions: Underwriting: The underwriting function within corporate finance involves shepherding the process of raising capital for a company. In the investment banking world, capital can be raised by selling either stocks or bonds to the investors. Managing an IPO (Initial Public Offering): This includes hiring managers to the issue, due diligence and marketing the issue. Issue of debt: When a company requires capital, it sometimes chooses to issue public debt instead of equity. Follow-on hiring of stock: A company that is already publicly traded will sometimes sell stock to the public again. This type of offering is called a follow-on offering, or a secondary offering. Mergers and Acquisitions: Acting as intermediary between Acquirer and target company Sales and Trading: This includes calling high net worth individuals and institutions to suggest trading ideas (on a caveat emptor basis), taking orders and facilitating the buying and selling of stock, bonds or other securities such as currencies. Research Analysis: Research analysts study stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. Private Placement: A private placement differs little from a public offering aside from the fact that a private placement involves a firm selling stock or equity to private investors rather than to public investors. Financial Restructuring: When a company cannot pay its cash obligations - it goes bankrupt. In this situation, a company can, of course, choose to simply shut down operations and walk away or, it can also restructure and remain in business. Q2 Distinguish between Investment Banks and Commercial Banks. Basis Investment Bank Commercial Bank 1. Function Investment banks help their clients by acting as an intermediary between the buyers and the sellers of securities (stocks or bonds). 2. Acceptance of deposits 3. Ownership for the product selling to the customers Investment banks do not take deposits from customers. Investment banks do not own the securities and only act as an intermediary for smooth transaction of buying and selling securities. 4. Source of Income Investment banks earn underwriting commission. Commercial banks are engaged in the business of accepting deposits from customers and lending money to individuals and corporate. Commercial banks can legally take deposits from customers. Commercial banks own the loans granted to their customers. Commercial banks earn interest on loans granted to their customers. 160 P age Winning isn t everything, but it beats anything in second place.

170 Financial Services Q3 What is Credit Rating? What is the benefit of credit rating? An expression of opinion of rating agency, The opinion is in regard to a debt instrument, The opinion is as on a specific date, The opinion is dependent on risk evaluation, The opinion depends on the probability of interest and principal obligations being met timely. Benefits from credit rations Provide superior information to the investors at a low cost; Provide a sound basis for proper risk-return structure; Subject borrowers to a healthy discipline and Assist in the framing of public policy guidelines on institutional investment. Q4 What are the different Credit Rating Agencies in India CRISIL Credit Rating Information Services of India Limited FITCH Fitch Rating India Private Limited ICRA Investment Information and Credit Rating Agency of India Limited CARE Credit Analysis and Research Limited Brickworks Brickwork Ratings India Private Limited SMERA Small and Medium Enterprises Rating Agencies Q5 Explain the Credit Rating Process/ How credit rating is being issued? 1) Request from issuer and analysis A company approaches a rating agency for rating a specific security. A team of analysts interact with the company s management and gathers necessary information. 2) Rating Committee On the basis of information obtained and assessment made, team of analysts present a report to the Rating committee. The issuer is not allowed to participate in this process as it is an internal evaluation of the rating agency. The nature of credit evaluation depends on the type of information provided by the issuer. 3) Communication to management and appeal The rating decision is communicated to the issuer and then the rating is shared with the issuer. If the issuer disagrees, an opportunity of being heard is given to him. Issuer appealing against a rating decision is asked to submit relevant material information. The Rating Committee reviews the decision although such a review may not alter the rating. The issuer may reject a rating and rating score need not be disclosed to the public. 4) Pronouncement of the rating If the rating decision is accepted by the issuer, the rating agency makes a public announcement of it. Tough times never lasts, but tough people do. 161 P age

171 CA Fi nal SFM CA Mayank Kothar i 5) Monitoring of the assigned rating The rating agencies monitor the on-going performance of the issuer and the economic environment in which it operates. 6) Rating watch Based on the constant scrutiny carried out by the agency it may place a rated instrument on Rating Watch. The rating may change for the better or for the worse. Rating watch is followed by a full scale review for confirming or changing the original rating. Q6 What are the uses of Credit Rating? For Users - Aids in investment decisions. - Helps in fulfilling regulatory obligations. - Provides analysts in Mutual Funds to use credit ratings as one of the valuable inputs to their independent evaluation system. For Issuers - Requirement of meeting regulatory obligations as per SEBI guidelines. - Recognition given by prospective investors providing value to the ratings which helps them to raise debt/equity capital. Q7 What is Scripless Trading System? The depository holds electronic custody of securities and also arranges for transfer of ownership of securities on the settlement dates. This system is known as scripless trading system. Q8 What is the difference between Debit Card and Credit Card? The basic difference between the two is the fact that a credit card takes the form of a personal loan from the issuing bank to the consumer while a debit card is more like a cheque, money is directly deducted from a person s bank account to pay for transaction. Q9 Explain CAMEL model in Credit Rating. CAMEL stands for Capital, Asset, Management, Earnings and Liquidity. The CAMEL model adopted by the rating agencies deserves special attention; it focuses on the following aspects: a) Capital: Composition of retained earnings and external funds; Fixed dividend component for preference shares and fluctuating component for equity shares and adequacy of long term funds adjusted to gearing levels; ability of issuer to raise further borrowings. b) Assets: Revenue generating capacity of existing/ proposed assets, fair values, technological/ physical obsolescence, linkage of asset values to turnover, consistency, appropriation of methods of depreciation and adequacy of charge to revenues. Size, ageing and recoverability of monetary assets. c) Management: Extent of involvement of management personnel, team work, authority, timeliness, effectiveness and appropriateness of decision making along with directing management to achieve corporate goals. d) Earnings: Absolute levels, trends, stability, adaptability to cyclical fluctuations ability of the entity to service existing and additional debts proposed. e) Liquidity: Effectiveness of working capital management, corporate policies for stock and creditors, management and the ability of the corporate to meet their commitment in the short run. 162 P age If you don t give up, you still have a chance.

172 Financial Services Q10 Explain the Credit Rating Process/ How credit rating is being issued? Credit rating is a very important indicator for prudence but it suffers from certain limitations. Some of the limitations are: Conflict of Interest The rating agency collects fees from the entity it rates leading to a conflict of interest. Since the rating market is very competitive, there is a distant possibility of such conflict entering into the rating system. Industry Specific rather than Company Specific Downgrades are linked to industry rather than company performance. Agencies give importance to macro aspects and not to micro ones; overreact to existing conditions which come from optimistic / pessimistic views arising out of up / down turns. At times, value judgments are not ruled out. Rating Changes Ratings given to instruments can change over a period of time. They have to be kept under constant watch. Downgrading of an instrument may not be timely enough to keep investors educated over such matters. Corporate Governance Issues Special attention is paid to: o o o Rating agencies getting more of their revenues from a single service or group. Rating agencies enjoying a dominant market position. They may engage in aggressive competitive practices by refusing to rate a collateralized / securitized instrument or compel an issuer to pay for services rendered. Greater transparency in the rating process viz. in the disclosure of assumptions leading to a specific public rating. Basis of Rating Ratings are based on point of time concept rather than on period of time concept and thus do not provide a dynamic assessment. Investors relying on the credit rating of a debt instrument may not be aware that the rating pertaining to that instrument might be outdated and obsolete. Cost Benefit Analysis Since rating is mandatory, it becomes essential for entities to get themselves rated without carrying out cost benefit analysis.. Rating should be left optional and the corporate should be free to decide that in the event of self rating, nothing has been left out. Q11 What is Depository? What are the major players of the Depository System? What are the advantages to the clearing member offered by depository system? Depository means one who receives a deposit of money, securities, instruments or other property, a person to whom something is entrusted, a trustee, a person or group entrusted with the preservation or safe keeping of something. The depository is an organization where the securities of a shareholder are held in the form of electronic accounts, in the same way as a bank holds money. There are two security depositories 1) NSDL- National Securities Depository Limited (1996) 2)CDSL- Central Depository Services Limited (1999) Players of the depository system i. Depository ii. Issuers or Company iii. Depository participants iv. Clearing Members v. Corporation vi. Stock Brokers vii. Clearing Corporation viii. Investors ix. Banks Your body will argue that there is no justifiable reason to continue. Your only recourse is to call on your spirit, which fortunately functions independently of logic. 163 P age

173 CA Fi nal SFM CA Mayank Kothar i Advantages to the clearing member Enhanced liquidity, safety and turnover on stock market. Opportunity for development of retail brokerage business. Ability to arrange pledges without movement of physical scrip and further increase of trading activity, liquidity and profits. Improved protection of shareholder s rights resulting from more timely communications from the issuer. Reduced transaction costs. Elimination of forgery and counterfeit instruments with attendant reduction in settlement risk from bad deliveries. Provide automation to post-trading processing. Standardization of procedures. Q12 What is the difference between Physical and Dematerialized Share Trading? Physical Share Trading Dematerialized Share Trading 1) For buy transaction, delivery is to be sent to 1) No need to send the document to the company for registration. company for registration. 2) Open delivery can be kept 2) Not possible to keep delivery open. 3) Processing time is long 3) Processing time is less 4) Stamp 0.5% are levied for 4) No stamp charges are required for transfer transfer 5) For sales transaction, no charges other than 5) Sales transactions are also charged. brokerage are levied. 6) Actual delivery of share is to be exchanged 6) No actual delivery of share is needed. Q13 What are the benefits of Credit Cards over Debit Cards? a. With a flexible spending limit, a cardholder can take advantage of the easy loan facility of a credit card, and can use it to purchase items or spend money that he expects in the near future, not just money that he presently has in his account. b. Most of the major features of a debit card such as withdrawal of cash from ATMs are available on credit cards as well. c. A credit card has greater security measures. d. A credit card can be used as a convenient way to check and record your spending. e. Since there is a fixed credit limit, a cardholder cannot overstretch his purchases. Q14 What is meant by Online Share Trading? Online stock trading is an internet based stock trading facility where investor can trade shares through a website without any manual intervention from the broker. It also provides investors with rich, interactive information in real time including market updates, investment research and robust analysis. 164 P age In running, it doesn t matter whether you come in first, in the middle of the pack, or last. You can say, I have finished. There is a lot of satisfaction in that.

174 Financial Services Q15 What are the advantages and disadvantages of depository system? Advantages: Transaction costs are reduced. Immediate Transfer: Transfer of securities is effected immediately. Paper work is minimized. Safe: Securities are held in a safe and convenient manner. No stamp duty: Stamp duty for transfer is eliminated. Bad deliveries, fake securities and delays in transfers are eliminated. Routine changes viz. change in address of one person owning securities issued by different companies can be taken care of simultaneously for all securities with little delay. Disadvantages: Human Fraud: Unlawful transfers by individuals against whom insolvency proceedings are pending or transfer by attorney holders with specific or limited powers are possible. Additional record keeping: In built remote provisions for rematerialization exist to take care of the needs of individuals who wish to hold securities in physical form. Companies will invariably need to maintain records on a continuous basis for securities held in physical form. Periodical reconciliation between demat segment and physical segment is very much necessary. Cost of Depository Participant (DP) Onetime fee is levied by the depository participant which small investors consider to be an avoidable cost. Systematic Failure: Unforeseen failures, intentional or otherwise, on the part of the individuals entrusted with protecting data integrity, could lead to chaos. Q16 What are the advantages of Online Stock Trading? Standardized Procedure One stop Shop Flexibility Time Informed Research Customer can easily expect the time when cash or shares to be credited to his account. Bank statements and transaction statements can be viewed at the click of a button. Customers can modify the placed orders according to the market movements. Customers can trade online in a real time basis as buying and selling of shares happen with a press of button. Customers can directly see the stock analysis provided by the broker. To achieve great things two things are needed. 1) A Plan and 2) Not quite enough time. 165 P age

175 CA Fi nal SFM CA Mayank Kothar i Q17 What are the disadvantages of Online Stock Trading? Time required Internet Connectivity Limited Knowledge Customers have to spend lots of time seating in front of terminal to monitor stock prices. It s not suitable for busy professionals. Online trading requires high speed internet connectivity. But many rural and urban areas don t have this facility today. Sometimes customers don t have knowledge regarding how to use the online trading portal. And also lack the financial awareness about stock market. Q18 Write short notes on Debt Securitisation. Debt securitisation is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the lending volumes. Assets generating steady cash flows are packaged together and against this assets pool market securities can be issued. The process can be classified in the following three functions. 1. The origination function: A borrower seeks a loan from finance company, bank or housing company. On the basis of credit worthiness repayment schedule is structured over the life of the loan. 2. The pooling function: Similar loans or receivables are clubbed together to create an underlying pool of assets. This pool is transferred in favour of a SPV (Special Purpose Vehicle), which acts as a trustee for the investor. Once, the assets are transferred they are held in the organizers portfolios. 3. The securitisation function: It is the SPV s job to structure and issue the securities on the basis of asset pool. The securities carry coupon and an expected maturity, which can be asset based or mortgage based. These are generally sold to investors through merchant bankers. The investors in this type of securities are generally institutional investors like mutual fund, insurance companies etc. The originator usually keeps the spread. Generally, the process of securitisation is without recourse i.e. the investor bears the credit risk of default and the issuer is under an obligation to pay to investors only if the cash flows are received by issuer from the collateral. Q19 Write short notes on Depository Participant. Under this system, the securities (shares, debentures, bonds, Government securities, MF units etc) are held in electronic form just like cash in a bank account. To speed up the transfer mechanism of securities from sale, purchase, transmission, SEBI introduced Depository Services also known as Dematerialization of listed securities. It is the process by which certificates held by investors in physical form are converted to an equivalent number of securities in electronic form. The securities are credited to the investor s account maintained through an intermediary called Depository Participant (DP). Shares/Securities once dematerialized lose their independent identities. Separate numbers are allotted for such dematerialized securities. Organization holding securities of investors in electronic form and which renders services related to transactions in securities is called Depository. 166 P age You have to learn the rules of the game. And then you have to play better than anyone else.

176 Mutual Funds Q20 Write short notes on Asset Securitisation. Securitisation is a process of transformation of illiquid asset into security which may be traded later in the open market. It is the process of transformation of the assets of a lending institution into negotiable instruments. The term securitisation refers to both switching away from bank intermediation to direct financing via capital market and/or money market, and the transformation of a previously illiquid asset like automobile loans, mortgage loans, trade receivables, etc. into marketable instruments. This is a method of recycling of funds. It is beneficial to financial intermediaries, as it helps in enhancing lending funds. Future receivables, EMIs and annuities are pooled together and transferred to a special purpose vehicle (SPV). These receivables of the future are shifted to mutual funds and bigger financial institutions. This process is similar to that of commercial banks seeking refinance with NABARD, IDBI, etc. Bond Valuation Q1 Why should the duration of a coupon carrying bond always be less than the time to its maturity? Duration is nothing but the average time taken by an investor to collect investment. If an investor receives a part of his/her investment over the time on specific intervals before maturity, the investment will offer him the duration which would be lesser than the maturity of the instrument. Higher the coupon rate lesser would be the duration. Q2 Write short notes on Zero Coupon Bonds. As the name indicates these bonds do not pay interest during the life of the bonds. Instead, zero coupon bonds are issued at discounted price to their face value, which is the amount a bond will be worth when it matures or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus interest that has been accrued on the investment made. The maturity dates on zero coupon bonds are usually long term. These maturity dates allow an investor for a long range planning. Zero coupon bonds are issued by banks, government and private sector companies. However, bonds issued by corporate sector carry a potentially higher degree of risk, depending on the financial strength of the issuer and longer maturity period, but they also provide an opportunity to achieve a higher return. Perseverance is failing 19 times and succeeding the 20th. 167 P age

177 CA Fi nal SFM CA Mayank Kothar i Mutual Funds Q1 Explain Briefly the NAV of a Mutual Fund scheme. NAV is the value of the fund s assets minus its liabilities. SEBI rules require funds to calculate the NAV daily. To calculate the NAV per share, simply subtract the fund s liabilities from its assets and then divide the result by the number of shares outstanding. If the market value of a fund s portfolio increases, after deduction of expenses and liabilities, then the value (NAV) of the fund and its shares increases. The higher NAV reflects the higher value of your investment. NAV of a Mutual Fund are published on a daily basis in the newspapers and electronic media and play an important role in investor s decision to enter or to exit. Analyst use the NAV to determine the yield on the schemes. Net asset value = Net assets of the scheme Number of units outstanding Where Net Assets of the scheme Particulars Amount Market value of the Investment XXXX + Receivables XXX +Other Accrued Income XXX + Other Assets XXX - Accrued Expenses (XXX) -Other Payables (XXX) -Other Liabilities (XXX) Net assets of the scheme XXXX Q2 What are the advantages and drawbacks of investing in a Mutual Fund? Advantages 1. Professional management 2. Diversification 3. Affordability 4. Convenience 5. Return Potential 6. Low Cost 7. Liquidity 8. Transparency 9. Well Regulated 10. Flexibility 11. Tax Benefits Drawbacks 1. No Guaranteed Return 2. Fees and Expenses 3. Management Risk 4. Unethical Practices 168 P age If you don t build your dream, someone else will hire you to help them build theirs.

178 Mutual Funds Q3 Explain Briefly what is Exchange Traded Funds. An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. ETFs are the most popular type of exchange-traded product. ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Advantages of ETFs are the following: Buy and sell just like shares Buy and sell at real time prices One can put limit orders Delivery in your demat account Minimum trading lot is just one unit Q4 Distinguish Between Open Ended and Close Ended Funds. PARAMETER OPEN ENDED FUNDS CLOSE ENDED FUNDS Fund Size Flexible Fixed Liquidity provider Fund itself Stock market Sale Price At NAV plus load, if any Significant premium/discount to NAV Availability Fund itself Through exchange where listed Intra-Day Trading Not possible Expensive NAV Daily Daily Portfolio Disclosure Monthly Monthly Q5 What are the signals that indicate that is time for an investor to exit a mutual fund scheme? (1) When the mutual fund consistently under performs the broad based index, it is high time that it should get out of the scheme. (2) When the mutual fund consistently under performs its peer group instead of it being at the top. In such a case, it would have to pay to get out of the scheme and then invest in the winning schemes. (3) When the mutual fund changes its objectives e.g. instead of providing a regular income to the investor, the composition of the portfolio has changed to a growth fund mode which is not in tune with the investor s risk preferences. (4) When the investor changes his objective of investing in a mutual fund which no longer is beneficial to him. (5) When the fund manager, handling the mutual fund schemes, has been replaced by a new entrant whose image is not known. The first step toward success is taken when you refuse to be a captive of the environment in which you first find yourself. 169 P age

179 CA Fi nal SFM CA Mayank Kothar i Money Market Operations Q1 What is Call Money/Notice Money in the context of financial market? Call money is a part of the money market where day to day surplus funds, mostly of banks are traded. Moreover, the call money market is most liquid of all short term money market instruments. The maturity period of call loans vary from 1 to 14 days. The money that is lend for one day in call money market is also known as overnight money. Current and expected interest rates on call money are the basic rates to which other money markets and to some extent the Government securities market are anchored. In India, call money is lent mainly to even out the short term mismatches of assets and liabilities and to meet CRR requirements of banks that they should maintain with RBI every fortnight and is computed as a percentage of Net Demand and Time Liabilities (NDTL). Q2 What is the distinction between Money Market and Capital Market? Basis Money Market Capital Market Classification There is no distinction between Capital market is classified into primary primary and secondary market. and secondary market. Purpose It deals for funds of short term requirement. It deals with funds of long term requirement. Instruments Money market instruments include interbank call money, notice money, short term deposits upto 3 months, commercial paper, 91 days treasury bills Capital market instruments are shares and debt instrument. Participants Money Market participants are banks, financial institutions, RBI and Government. Capital Market participants include retail investors, institutional investors like mutual funds, financial institutions, corporate and banks Q3 Explain briefly what is Money Market Mutual Funds. A money market fund is a mutual fund that invests solely in money market instruments. Money market instruments are forms of debt like Commercial Papers (CPs), Certificate of Deposits (CDs) and Treasury Bills (TBs) that mature in less than one year and are very liquid. Treasury bills make up the bulk of the money market instruments. Securities in the money market are relatively risk-free. Money market mutual funds are one of the safest instruments of investment for the retail low income investor. The assets in a money market fund are invested in safe and stable instruments of investment issued by governments, banks and corporations etc. Generally, money market instruments require huge amount of investments and it is beyond the capacity of an ordinary retail investor to invest such large sums. Money market mutual funds allow retail investors the opportunity of investing in money market instrument and benefit from the price advantage. The goal of a money-market fund is to preserve principal while yielding a modest return. Money-market mutual fund is akin to a high-yield bank account but is not entirely risk free. 170 P age. Whenever you find yourself on the side of the majority, it is time to pause and reflect.

180 Money Market Operations Q4 Write a short note on Inter Bank Participation Certificate. Inter-Bank Participation Certificates are instruments issued by scheduled commercial banks only to raise funds or to deploy short term surplus. There will be two types of Participations: I. Inter-Bank Participations with Risk Sharing II. Inter-Bank Participations without Risk Sharing The IBP with risk sharing can be issued for a period between 91days to 180 days. The IBP without risk sharing is a money market instrument with a tenure not exceeding 90 days and the interest rate on such IBPs is left to be determined by the two concerned banks without any ceiling on interest rate. Q5 Write short note on Commercial Bill. A commercial bill is one which arises out of a genuine trade transaction i.e. credit transaction. As soon as goods are sold on credit, the seller draws a bill on the buyer for the amount due. The buyer accepts it immediately agreeing to pay amount mentioned therein after a certain specified date. Thus, a bill of exchange contains a written order from the creditor to the debtor, to a pay a certain sum, to a certain person, after a certain period. A bill of exchange is a self-liquidating paper and negotiable; it is drawn always for a short period ranging between 3 months and 6 months. Q6 What are the advantages of developed bill market? A developed bill market is useful to borrowers, creditors and to financial and monetary system as a whole. The bill market scheme will go a long way to develop the bill market in the country. The following are various advantages of developed bill market i) Bill finance is better than cash credit. Bills are self-liquidating and the date of repayment of banks loan through discounting or rediscounting is certain. ii) Bills provide greater liquidity to their holders because they can be shifted to others in the market in case of need for cash. iii) A developed bill market is also useful to the banks in case of emergency. In the absence of such market the banks in need of cash have to depend either on call money market or the Reserve Bank s loan window. iv) The commercial bill rate is much higher than the Treasury bill rate. Thus, the commercial banks and other financial institutions with short term surplus funds find in bills an attractive source of both liquidity as well as profit. v) A developed bill market will also makes the monetary system of the country more elastic. Q7 Write short note on Certificate of Deposits. A certificate of deposit (CD) is a fixed-deposit investment option offered by banks and lending institutions. It offers higher interest rates than conventional savings accounts because it requires investors to deposit funds for a specified term ranging from one month to more than five years. However, like savings accounts, CDs are a secure form of investment, as they are insured by government agencies. A person can buy a certificate of deposit (CD) by depositing the minimum requisite amount. In general, the higher the deposited amount, the better will be the interest rate offered on it. The buyer of a CD receives a written declaration or certificate where the applicable interest rate, term of deposit and date of maturity are stated. If you don t value your time, neither will others. Stop giving away your time and talents. Value what you know & start charging for it. 171 P age

181 CA Fi nal SFM CA Mayank Kothar i CDs can be issued by (i) scheduled commercial banks {excluding Regional Rural Banks and Local Area Banks}; and (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh thereafter. The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue. The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue. [Master Circular dated July 01, 2013: Guidelines for Issue of Certificate of Deposit, RBI/ /104, IDMD.PCD.05/14.01/03/ ] Q8Write short note on Commercial Paper. What is it? Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. Corporate, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to issue CP. It is generally issued at a discount freely determined by the market to major institutional investors and corporations either directly by issuing corporation or through a dealer bank. Commercial paper represents a form of financing that allows the issuer of the paper to borrow money at relatively low interest rates. The availability of funding through the commercial paper market means the firm can negotiate to get bank loans, another source of financing, on better terms. From the issuer s point of view, the inability to retire debt before the end of its term without paying a penalty is a disadvantage. The firm may want to retire the debt early and save money on interest payments. Q9 What is Repo Rates? Repo rate is the rate at which RBI lends to commercial banks generally against government securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate. Increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Q10 What is Reverse Repo Rates? Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation. Increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy. As of August 2013, the repo rate is 7.25 % and reverse repo rate is 6.25% 172 P age Really it comes down to your philosophy. Do you want to play it safe and be good or do you want to take a chance and be great?

182 Money Market Operations Q11 What is Cash Reserve Ratio (CRR)? Definition: Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country. Description: The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy. CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking. Q12 What is Statutory Liquidity Ratio (SLR)? Statutory liquidity ratio refers to the amount that the commercial banks require to maintain in the form of gold or govt. approved securities before providing credit to the customers. Here by approved securities we mean, bond and shares of different companies. Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of India in order to control the expansion of bank credit. It is determined as percentage of total demand and time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers after a certain period mutually agreed upon and demand liabilities are such deposits of the customers which are payable on demand. Example of time liability is a fixed deposits for 6 months, which is not payable on demand but after six months. Example of demand liability is deposit maintained in saving account or current account, which are payable on demand through a withdrawal form of a cheque. SLR is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved liabilities (deposits). It regulates the credit growth in India. Q13 Write short not on Treasury Bills Treasury Bills: Treasury bills are short-term debt instruments of the Central Government, maturing in a period of less than one year. Treasury bills are issued by RBI on behalf of the Government of India for periods ranging from 14 days to 364 days through regular auctions. They are highly liquid instruments and issued to tide over short-term liquidity shortfalls. Treasury bills are sold through an auction process according to a fixed auction calendar announced by the RBI. Banks and primary dealers are the major bidders in the competitive auction process. Provident Funds and other investors can make non-competitive bids. RBI makes allocation to non-competitive bidders at a weighted average yield arrived at on the basis of the yields quoted by accepted competitive bids. These days the treasury bills are becoming very popular on account of falling interest rates. Treasury bills are issued at a discount and redeemed at par. Hence, the implicit yield on a treasury bill is a function of the size of the discount and the period of maturity. Now, these bills are becoming part of debt market. Take up one idea. Make that one idea your life think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body, be full of that idea, and just leave every other idea alone. This is the way to success. 173 P age

183 CA Fi nal SFM CA Mayank Kothar i In India, the largest holders of the treasury bills are commercial banks, trust, mutual funds and provident funds. Although the degree of liquidity of treasury bills are greater than trade bills, they are not self liquidating as the genuine trade bills are. T-bills are claim against the government and do not require any grading or further endorsement or acceptance. Q14 What is interest rate risk, reinvestment risk & default risk & what are the types of risk involved in investments in G-Sec.? (i) Interest Rate Risk: Interest Rate Risk, market risk or price risk are essentially one and the same. These are typical of any fixed coupon security with a fixed period to maturity. This is on account of inverse relation of price and interest. As the interest rate rises the price of a security will fall. However, this risk can be completely eliminated in case an investor s investment horizon identically matches the term of security. (ii) Re-investment Risk: This risk is again akin to all those securities, which generate intermittent cash flows in the form of periodic coupons. The most prevalent tool deployed to measure returns over a period of time is the yield-to-maturity (YTM) method. The YTM calculation assumes that the cash flows generated during the life of a security is reinvested at the rate of YTM. The risk here is that the rate at which the interim cash flows are reinvested may fall thereby affecting the returns. Thus, reinvestment risk is the risk that future coupons from a bond will not be reinvested at the prevailing interest rate when the bond was initially purchased. (iii) Default Risk: The event in which companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk. The higher the risk, the higher the required return, and vice versa. This type of risk in the context of a Government security is always zero. However, these securities suffer from a small variant of default risk i.e. maturity risk. Maturity risk is the risk associated with the likelihood of government issuing a new security in place of redeeming the existing security. In case of Corporate Securities it is referred to as credit risk. 174 P age If you don t design your own life plan, chances are you ll fall into someone else s plan. And guess what they have planned for you? Not much.

184 Mergers, Acquisitions & Restructuring Merger Acquisition & Restructuring Q1 What are the different types of Merger? - A Horizontal Merger is usually between two companies in the same business sector. The example of horizontal merger would be if a health care system buys another health care system. This means that synergy can be obtained through many forms including such as; increased market share, cost savings and exploring new market opportunities. - A Vertical Merger represents the buying of supplier of a business. In the same example as above if a health care system buys the ambulance services from their service suppliers is an example of vertical buying. The vertical buying is aimed at reducing overhead cost of operations and economy of scale. - Conglomerate Merger is the third form of M&A process which deals the merger between two irrelevant companies. The example of conglomerate M&A with relevance to above scenario would be if the health care system buys a restaurant chain. The objective may be diversification of capital investment. - Congeneric Merger is a merger where the acquirer and the related companies are related through basic technologies, production processes or markets. The acquired company represents an extension of product line, market participants or technologies of the acquirer. These mergers represent an outward movement by the acquirer from its current business scenario to other related business activities. Q2 Write short notes on Friendly and Hostile takeover. Friendly takeover The acquisition of one firm by another where the owners of both firms agree to the terms of the takeover transaction is known as friendly takeover. Hostile takeover A hostile takeover of a corporation results from a takeover that is opposed by the target corporation's directors. In a tender offer, an acquiring entity offers the target corporation's shareholders cash in exchange for their shares. If the acquiring corporation obtains enough shares, it can approve a merger resolution or, alternatively, simply operate the corporation as its subsidiary by replacing its directors and officers with its own appointees and direct corporate affairs in this manner. Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees and shareholders. Q3 What are the various antitakeover strategies? or What do you mean by Defending against takeover bid? Takeover defenses include actions by managers to resist having their firms acquired by other companies. There are several methods to defend a takeover. 1. Crown Jewel Defense: The target company has the right to sell off the entire or some of the company s most valuable assets when facing a hostile bid in the hope to make the company less attractive in the eyes of the acquiring company and to force a drawback of the bid. The question isn t who is going to let me; it s who is going to stop me. 175 P age

185 CA Fi nal SFM CA Mayank Kothar i 2. Poison Pill: The logic behind the pill is to dilute the targeting company s stock in the company so much that bidder never manages to achieve an important part of the company without the consensus of the board. 3. Poison Put: Here the company issue bonds which will encourage the holder of the bonds to cash in at higher prices which will result in Target Company being less attractive. 4. Greenmail: Greenmail involves repurchasing a block of shares which is held by a single shareholder or other shareholders at a premium over the stock price in return for an agreement called as standstill agreement. In this agreement it is stated that bidder will no longer be able to buy more shares for a period of time often longer than five years. 5. White Knight: The target company seeks for a friendly company which can acquire majority stake in the company and is therefore called a white knight. The intention of the white knight is to ensure that the company does not lose its management. In the hostile takeover there are lots of chances that the company acquired changes the management. 6. White squire: A different variation of white knight is white squire. Instead of acquiring the majority stake in the target company white squire acquires a smaller portion, but enough to hinder the hostile bidder from acquiring majority stake. 7. Golden Parachutes: A golden parachute is an agreement between a company and an employee (usually upper executive) specifying that the employee will receive certain significant benefits if employment is terminated. This will discourage the bidders and hostile takeover can be avoided. 8. Pac-man defense: The target company itself makes a counter bid for the Acquirer Company and let the Acquirer Company defence itself which will call off the proposal of takeover. Q4 What do you mean by Takeover by reverse bid or Reverse Bid or Reverse Merger? "Acquisition" usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger occurs when a privately held company (often one that has strong prospects and is eager to raise financing) buys a publicly listed shell company, usually one with no business and limited assets. Three test requirement for takeover by reverse bid 1. The assets of the transferor company are greater than the transferee company. 2. Equity capital to be issued by the transferee company for acquisition should exceed its original share capital. 3. There should be a change of control in transferee company by way of introduction of a minority holder or group of holders Q5 Write short note on Chop Shop Method. Chop shop methods seeks to identify the companies having different segments of operations which if separated can fetch more value. It s simple 1. Find out the different business segments of the target company. 2. Calculate the value of the each of the basis (sales, assets etc.). It is the sum total of the (basis x applicable capitalization ratio). 3. Average of the all the basis will be the average theoretical value of the target company. 176 P age Don t let the fear of losing be greater than the excitement of winning.

186 Mergers, Acquisitions & Restructuring Q6 Write short note on Leverage Buy Out (LBO). A leveraged buyout (LBO) is an acquisition (usually of a company, but can also be single assets such as a real estate property) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. In other words, the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Since the debt always has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explains the origin of the term LBO. LBOs can have many different forms such as Management Buy-out (MBO), Management Buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations and insolvencies. Q7 Write short note on Management Buy Out (MBO). A management buyout (MBO) is a form of acquisition where a company's existing manager acquires a large part or all of the company from either the parent company or from the private owners. Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company, An MBO can occur for a number of reasons 1. The owners of the business want to retire and want to sell the company to the management team they trust (and with whom they have worked for years). 2. The owners of the business have lost faith in the business and are willing to sell it to the management (who believes in the future of the business) in order to get some value for the business. 3. The managers see a value in the business that the current owners do not see and do not want to pursue. Q8 Write short note on Financial Restructuring. Financial restructuring, is carried out internally in the firm with the consent of its various stakeholders. Financial restructuring is a suitable mode of restructuring of corporate firms that have incurred accumulated sizable losses for/over a number of years. As a sequel, the share capital of such firms, in many cases, gets substantially eroded/lost; in fact in some cases, accumulated losses over the years may be more than share capital, causing negative net worth. Given such a dismal state of financial affairs, a vast majority of such firms are likely to have a dubious potential for liquidation. Can some of these firms be revived? Financial restructuring is one such a measure for the revival of only those firms that hold promise/prospects for better financial performance in the years to come. To achieve the desired objective, such firms warrant/merit a restart with a fresh balance sheet, which does not contain past accumulated losses and fictitious assets and shows share capital at its real/true worth. It isn t about how hard you hit, It s about how hard you get hit and keep moving. 177 P age

187 CA Fi nal SFM CA Mayank Kothar i Q9 Write short note on Demerger. Demerger: The word demerger is defined under the Income-tax Act, It refers to a situation where pursuant to a scheme for reconstruction/restructuring, an undertaking is transferred or sold to another purchasing company or entity. The important point is that even after demerger, the transferring company would continue to exist and may do business. Demerger is used as a suitable scheme in the following cases: Restructuring of an existing business Division of family-managed business Management buy-out. While under the Income tax Act there is recognition of demerger only for restructuring as provided for under sections of the Companies Act, in a larger context, demerger can happen in other situations also. Q10 Write short note on Economic Value Added. Economic Value Added method (EVA): It is defined in terms of returns earned by the company in excess of the minimum expected return of the shareholders. EVA is calculated as follows: EVA = EBIT Taxes Cost of funds employed = Net operating profit after taxes Cost of Capital employed. Where, net operating profit after taxes = Profit available to provide a return to lenders and the shareholders. Cost of Capital employed = Weighted average cost of capital x Capital employed. EVA is a residual income which a company earns after capital costs are deducted. It measures the profitability of a company after having taken into account the cost of all capital including equity. Therefore, EVA represents the value added to the shareholders by generating operating profits in excess of the cost of capital employed in the business. EVA increases if: (i) Operating profits grow without employing additional capital. (ii) Additional capital is invested in projects that give higher returns than the cost of incurring new capital and (iii) Unproductive capital is liquidated i.e. curtailing the unproductive uses of capital. In India, EVA has emerged as a popular measure to understand and evaluate financial performance of a company. Several Companies have started showing EVA during a year as a part of the Annual Report. Infosys Technologies Ltd. and BPL Ltd. are a few of them. Q11 Explain synergy in the context of Mergers and Acquisitions Synergy May be defined as follows: V (AB) >V(A) + V (B). In other words the combined value of two firms or companies shall be more than their individual value. This may be result of complimentary services economics of scale or both. A good example of complimentary activities can a company may have a good networking of branches and other company may have efficient production system. Thus the merged companies will be more efficient than individual companies. On Similar lines, economics of large scale is also one of the reasons for synergy benefits. The main reason is that, the large scale production results in lower average cost of production e.g. reduction in overhead costs on account of sharing of central services such as accounting and finances, Office executives, top level management, legal, sales promotion and advertisement etc. These economics can be real arising out of reduction in factor input per unit of output, whereas pecuniary economics are realized from paying lower prices for factor inputs to bulk transactions. 178 P age If not for you, do it for the people who want you to see Fail

188 Security Analysis Security Analysis Q1 Explain the Efficient Market Theory in and what are major misconceptions about this theory? The EMH theory is concerned with speed with which information effects the prices of securities. As per the study carried out technical analyst it was observed that information is slowly incorporated in the price and it provides an opportunity to earn excess profit. However, once the information is incorporated then investor can not earn this excess profit. Level of Market Efficiency: That price reflects all available information, the highest order of market efficiency. According to FAMA, there exist three levels of market efficiency:- Weak form efficiency Price reflect all information found in the record of past prices and volumes. Semi Strong efficiency Price reflect not only all information found in the record of past prices and volumes but also all other publicly available information. Strong form efficiency Price reflect all available information public as well as private. Q2 Explain the different challenges to Efficient Market Theory. Information inadequacy Information is neither freely available nor rapidly transmitted to all participants in the stock market. There is a calculated attempt by many companies to circulate misinformation. Other challenges are as follows: (a) Limited information processing capabilities Human information processing capabilities are sharply limited. According to Herbert Simon every human organism lives in an environment which generates millions of new bits of information every second but the bottle necks of the perceptual apparatus does not admit more than thousand bits per seconds and possibly much less. David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting information grid, the market can become a giant. (b) Irrational Behaviour It is generally believed that investors rationality will ensure a close correspondence between market prices and intrinsic values. But in practice this is not true. J. M. Keynes argued that all sorts of consideration enter into the market valuation which is in no way relevant to the prospective yield. This was confirmed by L. C. Gupta who found that the market evaluation processes work haphazardly almost like a blind man firing a gun. The market seems to function largely on hit or miss tactics rather than on the basis of informed beliefs about the long term prospects of individual enterprises. (c) Monopolistic Influence A market is regarded as highly competitive. No single buyer or seller is supposed to have undue influence over prices. In practice, powerful institutions and big operators wield great influence over the market. The monopolistic power enjoyed by them diminishes the competitiveness of the market. Forget all the reason why it won t work, and believe the one reason why it will. 179 P age

189 CA Fi nal SFM CA Mayank Kothar i Q3 Explain the Empirical Evidence of Weak form Efficient Market Theory: Three types of tests have been employed to empirically verify the weak form of Efficient Market Theory- Serial Correlation Test, Run Test and Filter Rule Test. (a)serial Correlation Test: To test for randomness in stock price changes, one has to look at serial correlation. For this purpose, price change in one period has to be correlated with price change in some other period. Price changes are considered to be serially independent. Serial correlation studies employing different stocks, different time lags and different time period have been conducted to detect serial correlation but no significant serial correlation could be discovered. These studies were carried on short term trends viz. daily, weekly, fortnightly and monthly and not in long term trends in stock prices as in such cases. Stock prices tend to move upwards. (b) Run Test: Given a series of stock price changes each price change is designated + if it represents an increase and if it represents a decrease. The resulting series may be -,+, -, -, -, +, +. A run occurs when there is no difference between the sign of two changes. When the sign of change differs, the run ends and new run begins. To test a series of price change for independence, the number of runs in that series is compared with a number of runs in a purely random series of the size and in the process determines whether it is statistically different. By and large, the result of these studies strongly supports the Random Walk Model. (c) Filter Rules Test: If the price of stock increases by at least N% buy and hold it until its price decreases by at least N% from a subsequent high. When the price decreases at least N% or more, sell it. If the behaviour of stock price changes is random, filter rules should not apply in such a buy and hold strategy. By and large, studies suggest that filter rules do not out perform a single buy and hold strategy particular after considering commission on transaction. Q4 Explain in detail the Dow Jones Theory? Dow Jones Theory is the Bible for traders, who want to trade in stock market. Dow Jones Theory has been established by Charles Dow. This most popular theory is regarding the behaviour of stock market prices according to Charles Dow The market is always considered as having three movements, all going at the same time. 1) Daily Fluctuations This is the narrow movement from day to day. 2) Secondary movement This is the short swing running from two weeks to a month or more and 3) Primary movement This is the main movement, covering at least 4 years in its duration. 1. Primary Movements: They reflect the trend of the stock market from last one year to four years or sometimes even more. On study of the long range behaviour of market prices, it has been empirically observed that share prices go though definite phases, Where the prices are either consistently rising or falling. These phases are popularly known as bull and bear phases. So long as each successive rally or price advance reaches a higher level than the one before it, and each secondary reaction, or price decline, stops at a higher level than the previous one, primary trend is up. This is called a Bull Market. When each intermediate decline carries prices to successively lower levels and each intervening rally fails to bring them back up to the top level of the preceding 180 P age What we think, or what we know, or what we believe is, in the end, of little consequence. The only consequence is what we do.

190 Security Analysis rally, the trend is down. This is called a Bear Market. Popularly Bull market is known by formation of Higher Tops and Higher Bottoms, and Bear Market is known by formation of Lower Tops and Lower Bottoms. 2. Secondary Movements: The secondary trends are intermediates declines or corrective phase, which occur in bull market and intermediate rallies which occur in bear markets. Normally they last from 4 weeks to 13 weeks. Generally it retraces 33.33% or 66.66% of primary movements. It is imperative to note here that secondary movements are always in opposite direction of the primary movements. 3. Daily Movements: They are irregular fluctuations, which occur every day in the market. These fluctuations are without any definite trend. Thus if the daily share market price index for a few months is plotted on the graph it will show both upward and downward fluctuations. These fluctuations are on account of speculative factors. The theory advocates behaviour of stock price is 90% psychological and 10% logical. The behaviour is contingent upon the mood of the investors at large and this behaviour can fairly estimated by analyzing various price movements and volume of transactions. Q5 Explain Elliot Wave Theory of Technical Analysis? The Elliott Wave Theory is named after Ralph Nelson Elliott. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. In fact, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves. Simplifying Elliott Wave Analysis Elliott Wave analysis is a collection of complex techniques. Approximately 60 percent of these techniques are clear and easy to use. The other 40 are difficult to identify, especially for the beginner. The practical and conservative approach is to use the 60 percent that are clear. When the analysis is not clear, why not find another market conforming to an Elliott Wave pattern that is easier to identify? From years of fighting this battle, we have come up with the following practical approach to using Elliott Wave principles in trading. The whole theory of Elliott Wave can be classified into two parts: Impulse patterns Corrective patterns We are what we repeatedly do; excellence, then, is not an act but a habit. 181 P age

191 CA Fi nal SFM CA Mayank Kothar i Q6 Mention the various types of techniques used in economic analysis. Some of the techniques used for economic analysis are: 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. 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: o 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. o Roughly Coincidental Indicators: They reach their peaks and troughs at approximately the same in the economy. o 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. o All these approaches suggest direction of change in the aggregate economic activity but nothing about its magnitude. 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. Q7 Mention the factors affecting Economic Analysis Some of the economy wide factors are as under: (a) Growth Rates of National Income and Related Measures (b) Growth Rates of Industrial Sector (c) Inflation (d) Monsoon Q8 Mention the factors affecting Industry Analysis (a) Product Life-Cycle; (b) Demand Supply Gap; (c) Barriers to Entry; (d) Government Attitude; (e) State of Competition in the Industry; (f) Cost Conditions and Profitability and (g) Technology and Research. 182 P age Defeat is a state of mind; No one is ever defeated until defeat has been accepted as a reality.

192 Security Analysis Q9 Mention the various types of techniques used in company analysis. a. Correlation & Regression Analysis: Simple regression is used when inter relationship covers two variables. For more than two variables, multiple regression analysis is followed. b. Trend Analysis: The relationship of one variable is tested over time using regression analysis. It gives an insight to the historical behavior of the variable. c. Decision Tree Analysis: In decision tree analysis, the decision is taken sequentially with probabilities attached to each sequence. To obtain the probability of final outcome, various sequential decisions are given along with probabilities, then probabilities of each sequence is to be multiplied and then summed up. Q10 Explain Various types of Charts Solution: (i) Bar Chart : In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short horizontal line protruding from the bar representing the closing price for the period. (ii) Line Chart: In a line chart, lines are used to connect successive day s prices. The closing price for each period is plotted as a point. These points are joined by a line to form the chart. The period may be a day, a week or a month. (iii) Point and Figure Chart: Point and Figure charts are more complex than line or bar charts. They are used to detect reversals in a trend. Q11 What is Odd Lot Theory Solution: This theory is a contrary - opinion theory. It assumes that the average person is usually wrong and that a wise course of action is to pursue strategies contrary to popular opinion. The odd-lot theory is used primarily to predict tops in bull markets, but also to predict reversals in individual securities. Q12 Discuss the Buy and Sell Signals provided by the moving averages Solution: 1. Buy Signal (i) Stock price line rise through the moving average line when graph of the moving average line is flattering out. (ii) Stock price line falls below moving average line which is rising. (iii) Stock price line which is above moving average line falls but begins to rise again before reaching the moving average line At the end of the day your feet should be dirty, your hair messy and your eyes sparkling. 183 P age

193 CA Fi nal SFM CA Mayank Kothar i 2. Sell Signal (i) Stock price line falls through moving average line when graph of the moving average line is flattering out. (ii) Stock price line rises above moving average line which is falling. (iii) Stock price line which is slow moving average line rises but begins to fall again before reaching the moving average line. Important Websites i) Securities and Exchange Board of India- ii) National Stock Exchange- iii) Bombay Stock Exchange- iv) Multi Commodity Exchange of India Ltd. - v) Reserve Bank of India P age You can t connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future. You have to trust in something your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all the difference in my life.

194 Security Analysis Small Things, Big Score 1. The first step to score big is the belief that You can do it. Self confidence is must, put no place for fear in your mind. Be strong enough to face every obstacle. 2. While practicing questions make sure you practice your writing speed also. You have exactly 1.8 minutes for 1 mark. 3. Make sure you present the paper as if you are presenting it to the Chairman of your company you are finance manager in. It should be the best presentation ever. If you really want different result, make sure your paper is different than rest of the candidates. Writing the correct answer only is no more the criteria for passing, your level of language matters a lot. 4. Try to incorporate maximum number of working notes in your paper for every question and drawings wherever possible are an added advantage. Main answer should be on the top and working notes should follow it. 5. Before three months of the exam make sure you are following a time table strictly. With 5-6% results in CA Final, you really need to do something different from more than 1 lakh students preparing with you for the same exam. 6. Atleast 12 hours of studies on an average is required per day throughout the 3 months before exam. Motivation is the best medicine that will keep you survive throughout three months before the exams. Keep yourself motivated by talking to your mentors, reading to ranker s interviews on internet, watching inspirational movies, and listening to motivational songs. 7. At exam hall there will be only one thing with you, it s your brain. Keep it safe and fresh by proper sleep and food. These are indirectly related to your success. 185 P age

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