Contents About the Author I-5 Acknowledgement I-7 Preface to the Ninth Edition I-9 Chapter-heads I-11 Solved Paper CA Final May 2016 I-25 1 FINANCIAL POLICY AND CORPORATE STRATEGY 1.1 Financial Management 1.1 1.2 Corporate Strategy 1.2 1.2-1 Corporate Level Managers 1.2 1.2-2 Business Level 1.2 1.2-3 Functional Level 1.2 1.3 Strategic Financial Management 1.2 1.3-1 Features of SFM 1.3 1.3-2 Basic Premises of Strategic Financial Management 1.4 1.4 Interface of Financial Policy with Corporate Strategic Management 1.4 1.4-1 Corporate Strategic Management 1.4 1.4-2 Financial Policy 1.5 1.4-3 Interface 1.5 1.5 Strategic Decision Making Framework 1.5 1.5-1 Strategic Decisions 1.5 1.5-2 Framework 1.6 1.6 Financial Goals vis-à-vis Sustainable Growth 1.8 1.6-1 Sustainable Growth 1.8 1.6-2 Financial Goals 1.8 1.6-3 Balancing the Financial Goals vis-à-vis Sustainable Growth 1.9 THEORETICAL QUESTIONS 1.9 2 FOREIGN EXCHANGE RISK MANAGEMENT 2.1 Foreign Exchange Arithmetic 2.2 2.1-1 Three Types of Quotes 2.2 2.1-2 Spot and Forward Rates 2.10 I-13
CONTENTS I-14 2.1-3 Forward Margin (Premium or Discount) 2.10 2.1-4 Cross Currency Rates 2.15 2.2 Risk in Foreign Exchange 2.18 2.2-1 Forward Exchange Contracts 2.19 2.2-2 Futures Contracts 2.32 2.2-3 Options 2.39 2.2-4 Currency Swaps 2.47 2.2-5 Money Market Operations 2.51 2.3 Some Related Topics 2.58 2.3-1 Purchasing Power Parity Theory 2.58 2.3-2 The Fisher Effect 2.59 2.3-3 Interest Rate Parity Theory (IRPT) 2.59 2.3-4 Nostro Account and Exchange Position 2.62 2.3-5 Arbitrage Opportunities 2.65 2.3-6 Leading and Lagging 2.70 2.3-7 Foreign Exchange Risk Exposure 2.71 2.3-8 International Working Capital Management 2.74 2.3-9 General Problems on FERM 2.78 2.4 Practice 2.80 THEORETICAL QUESTIONS 2.88 3 DERIVATIVES 3.1 Derivatives 3.2 3.1-1 Users of Derivative Markets 3.2 3.1-2 Cash Market v/s Derivatives Market 3.3 3.1-3 Stock Market Derivatives in India 3.3 3.1-4 Other Derivatives in India 3.4 3.2 Options 3.4 3.2-1 Intrinsic Value v/s Time Value of Option 3.5 3.2-2 Trading Strategies 3.9 3.2-3 General Problems on Options 3.17 3.2-4 Option Valuation 3.19 3.2-5 Put-Call Parity Theory (PCPT) 3.34 3.2-6 Factors affecting the Option Premium under BS Model 3.37 3.2-7 The Greeks 3.38 3.2-8 Perfectly Hedged Situation 3.40 3.2-9 Choice of Option Valuation Method 3.41
I-15 CONTENTS 3.3 Futures 3.42 3.3-1 Share Index Futures 3.43 3.3-2 Settlement of Stock Futures 3.43 3.3-3 Mark to the Market 3.43 3.3-4 Pricing the Futures Contracts 3.44 3.3-5 Convergence Principal 3.44 3.4 OTC Derivatives 3.47 3.4-1 Cap, Floor and Collar 3.47 3.4-2 Forward Rate Agreements 3.48 3.4-3 Interest Swaps 3.52 3.4-4 Swaptions (Swap options) 3.62 3.5 Stock Market Derivatives in India 3.63 3.6 Arbitrage Opportunities 3.65 3.6-1 Arbitrage Opportunities : Options 3.65 3.6-2 Arbitrage Opportunities : Futures 3.70 3.6-3 Arbitrage with Options and Futures 3.73 3.7 Commodities Derivatives 3.74 3.8 Interest Rate Derivatives 3.82 3.9 Practice 3.82 THEORETICAL QUESTIONS 3.83 APPENDIX A : SHARE PRICES INDEX NUMBERS (SHARE INDICES) 3.86 APPENDIX B : CALCULATION OF VALUE OF NATURAL LOG 3.89 APPENDIX C : FINDING THE VALUES OF N(D 1 ) AND N(D 2 ) 3.92 4 RISK AND RETURN 4.1 Risk and Return 4.2 4.1-1 Systematic and Unsystematic Risk 4.7 4.1-2 Beta 4.8 4.1-3 Standard Deviation v/s Beta 4.9 4.1-4 Total Risk of an Investment 4.10 4.2 Capital Asset Pricing Model 4.11 4.2-1 The Principle of Higher the Return, Higher will be the Risk 4.12 4.3 Overall Beta 4.14 4.4 Portfolio Theory 4.19 4.4-1 Fundamental Objective of Portfolio Management 4.25 4.4-2 Portfolio Beta 4.27 4.4-3 Minimum Risk Portfolio 4.28
CONTENTS I-16 4.4-4 Reducing the Risk of a Portfolio 4.36 4.4-5 Enhancing the Risk of a Portfolio 4.38 4.4-6 Hedging the Portfolio 4.42 4.5 Modern Portfolio Theory (Markowitz) 4.45 4.6 Some More Aspects of Risk and Return 4.54 4.6-1 Efficient Market Hypothesis 4.54 4.6-2 Alpha 4.61 4.6-3 Characteristic Line 4.62 4.6-4 Security Market Line (SML) 4.65 4.6-5 Capital Market Line (CML) 4.66 4.6-6 Market Model 4.67 4.6-7 Matrix Approach in Investment Decisions 4.67 4.6-8 Portfolio Management 4.68 4.7 General Problems 4.72 4.8 International Investing 4.80 4.9 Arbitrage Pricing Theory (APT) 4.88 4.9-1 Arbitrage 4.90 4.10 Sharpe Index Model 4.101 4.10-1 Sharpe s Optimal Portfolio 4.109 4.11 Practice 4.112 THEORETICAL QUESTIONS 4.114 APPENDIX A : SD AND VARIANCE 4.116 APPENDIX B : DERIVATION FOR MINIMUM VARIANCE FORMULA 4.118 5 MUTUAL FUNDS 5.1 Introduction 5.1 5.1-1 Mutual Fund Schemes 5.2 5.1-2 Regulation of Mutual Funds in India 5.2 5.1-3 Establishment a Mutual Fund 5.3 5.1-4 Asset Management Company 5.3 5.1-5 Role of Mutual Funds in the Financial Markets 5.4 5.1-6 Rights of a Mutual Fund Investor 5.5 5.1-7 Advantages of Investing in a Mutual Fund 5.5 5.1-8 Disadvantages of Investing in Mutual Funds 5.5 5.1-9 Fund of Funds 5.6 5.1-10 NAV 5.6
I-17 CONTENTS 5.2 Criteria for Evaluation of Mutual Funds/Portfolio Performance 5.19 5.2-1 Sharpe ratio 5.19 5.2-2 Treynor ratio 5.19 5.2-3 Jenson s Alpha 5.20 5.3 Practice 5.21 THEORETICAL QUESTIONS 5.22 6 BOND VALUATION 6.1 Yield 6.1 6.1-1 Current Yield 6.1 6.1-2 Yield to Maturity 6.2 6.1-3 Yield to Call 6.4 6.2 Value of Bond 6.5 6.3 Bond Risk 6.8 6.4 Duration 6.9 6.5 Yield Curve 6.13 6.6 Forward Rates 6.14 6.7 Convexity 6.18 6.8 Convertible Bonds 6.22 6.9 Interest Immunization 6.24 6.10 Practice 6.29 THEORETICAL QUESTION 6.32 7 PROJECT PLANNING & CAPITAL BUDGETING (CAPITAL EXPENDITURE DECISIONS) 7.1 Project 7.2 7.1-1 Project Planning 7.2 7.1-2 Project Report 7.3 7.1-3 Feasibility Study of the Project 7.3 7.1-4 Project Financing 7.4 7.1-5 Social Cost Benefit Analysis 7.4 7.1-6 Appraisal under Inflationary Conditions 7.5 7.2 Capital Expenditure Decisions 7.6 7.2-1 Method based on Accounting Profit 7.7 7.2-2 Methods based on Cash Flows 7.8 7.2-3 Borrowed Funds and Capital Budgeting 7.33
CONTENTS I-18 7.2-4 Capital Rationing 7.39 7.2-5 Inflation 7.44 7.2-6 Capital Recovery Factor (CRF) 7.49 7.2-7 Projects with Unequal Lives 7.53 7.2-8 Foreign Exchange and Capital Budgeting 7.63 7.2-9 Risk and Uncertainty 7.71 7.2-10 Accounting Rate of Return 7.96 7.2-11 CPM, PERT and Simulation Model 7.98 7.2-12 Mutual Exclusive Projects 7.106 7.2-13 IRR Complications 7.107 7.2-14 Terminal Value Method 7.108 7.2-15 Adjusted Present Value (APV) 7.109 7.2-16 General Problems 7.111 7.3 Practice 7.120 THEORETICAL QUESTIONS 7.125 APPENDIX A : SOME ASSUMPTIONS IN CAPITAL BUDGETING 7.127 8 REAL OPTIONS 8.1 Introduction 8.1 8.2 Types of Real Options 8.2 8.2-1 Abandonment (NPV Method) 8.2 8.2-2 Follow on Investment/Expansion Option (NPV Method) 8.5 8.2-3 Follow on Investment/Expansion Option (Risk Neutral Method) 8.6 8.2-4 Follow on Investment/Expansion Option (Black-Scholes Model) 8.7 8.2-5 Investment Timing Option (NPV Method) 8.8 8.2-6 Investment Timing Option (Black-Scholes Model) 8.9 8.2-7 Some More Problems on Real Options (Risk Neutral Method and BS Model) 8.9 9 LEASE DECISIONS 9.1 Introduction 9.1 9.1-1 Advantages of Lease Financing 9.2 9.2 Methods of Lease Decisions 9.2 9.2-1 NPV 9.2 9.2-2 Cost of lease by IRR method 9.2 9.2-3 Williamson Method (B.S.W. Method) 9.3 9.3 Calculation of lease rent - Four situations 9.6
I-19 CONTENTS 9.4 Lease vs. Hire Purchase 9.17 9.5 Monthly lease instalments 9.19 9.6 Calculation of cost of the machine 9.22 9.7 Cross-Border lease 9.23 9.8 Practice 9.28 THEORETICAL QUESTIONS 9.35 10 DIVIDEND POLICY 10.1 Determinants of Dividend Policy 10.2 10.2 Tax Considerations of Dividend decisions 10.2 10.3 Pay-out Ratio v/s Shareholders Wealth 10.3 10.3-1 Irrelevance Theory 10.3 10.3-2 Relevance Theory 10.5 10.4 Residual Theory of Dividend 10.9 10.5 Linter s Model of Dividend 10.12 10.6 Buy Back 10.13 10.7 General Problems Relating to Dividend 10.14 10.8 Practice 10.21 THEORETICAL QUESTIONS 10.26 11 FUNDAMENTAL ANALYSIS 11.1 The Concept of Fundamental Analysis 11.1 11.2 Three Types of Analysis 11.1 11.2-1 Economic Analysis 11.2 11.2-2 Industry Analysis 11.2 11.2-3 Company Analysis 11.2 11.3 Valuation of Goodwill 11.2 11.4 Valuation of Shares 11.5 11.4-1 PE Ratio (also known as PE multiple) 11.9 11.5 Accounting Ratios 11.15 11.5-1 Solvency Ratios 11.15 11.5-2 Profitability Ratios 11.17 11.5-3 Activity Ratios 11.18 11.5-4 Financial Leverage Ratios 11.19 11.5-5 Share Valuation Ratios 11.20
CONTENTS I-20 11.6 Dupont chart 11.20 11.7 Practice 11.20 THEORETICAL QUESTIONS 11.27 APPENDIX A : NUMBER OF YEARS OF PURCHASE 11.28 12 TECHNICAL ANALYSIS 12.1 Technical analysis 12.1 12.1-1 The Fundamental Principles of Technical Analysis 12.2 12.2 Charts 12.2 12.2-1 Line Chart 12.3 12.2-2 Bar Chart 12.3 12.2-3 Japanese Candlestick Chart 12.4 12.3 Trend 12.5 12.3-1 Reversal of Trend 12.7 12.3-2 Flat Trend 12.8 12.4 Chart Patterns/Price Patterns 12.9 12.4-1 Reversal Pattern 12.9 12.4-2 Continuation Patterns 12.11 12.5 Moving Average 12.12 12.5-1 Simple Moving Average 12.12 12.5-2 Exponential Moving Average 12.13 12.6 Momentum Analysis/Relative Strength Index (RSI) 12.17 12.7 Bollinger Bands 12.19 13 VALUATION OF BUSINESS AND MERGER & ACQUISITION 13.1 Valuation of business 13.1 13.1-1 Adjusted Book Value Method 13.2 13.1-2 Value of Shares & Debt Method 13.2 13.1-3 Comparison Method 13.3 13.1-4 Discounted Cash Flow Method 13.4 13.1-5 Practice 13.9 13.2 Merger & Acquisition 13.16 13.2-1 Merger 13.16 13.2-2 Acquisitions and Takeovers 13.18 13.3 Some related concepts 13.22 13.3-1 Divesture 13.22 13.3-2 Financial Restructuring 13.23 13.4 Some related terms 13.23
I-21 CONTENTS 13.4-1 Due Diligence 13.23 13.4-2 Co-insurance Effect 13.24 13.4-3 Dual Listing 13.24 13.5 Exchange Ratios 13.25 13.5-1 Maximum Exchange Ratio 13.26 13.5-2 Minimum Exchange Ratio 13.27 13.5-3 Two Important Exchange Ratios 13.29 13.6 General problems 13.33 13.7 Practice 13.43 THEORETICAL QUESTIONS 13.52 14 GENERAL PROBLEMS 14.1 Financing 14.1 14.2 Rights Issue 14.14 14.3 Interest Coverage Ratio 14.15 14.4 Money Market 14.17 14.5 EVA 14.25 14.6 Sustainable Growth 14.29 14.7 Bonus Shares 14.30 14.8 Consumer Finance 14.32 14.9 NBFC 14.34 14.10 Miscellaneous 14.36 14.11 Practice 14.40 15 CAPITAL MARKET 15.1 Introduction 15.1 15.1-1 Money Market v/s Capital Market 15.2 15.1-2 Capital Market Regulator 15.2 15.2 Capital Market Participants and Service Providers 15.2 15.2-1 Stock Exchanges 15.2 15.2-2 Merchant Bankers 15.10 15.2-3 Depositories 15.12 15.2-4 Credit Rating Agencies 15.14 15.2-5 Venture Capital 15.15 15.2-6 Restrictive Covenants Placed by a Lender on a Borrower 15.15 15.3 Public Offerings 15.16 15.3-1 Application Supported by Blocked Amount (ASBA) 15.16 15.3-2 Book-Building 15.16
CONTENTS I-22 15.3-3 Greenshoe Option 15.17 15.3-4 Offer for Sale 15.18 15.4 General Topics 15.19 15.4-1 ESOP and ESPP 15.19 15.4-2 Random Walk Theory 15.20 15.4-3 Buy-back of Shares by Companies 15.20 15.4-4 Call Option and Put Option with Reference to Debentures 15.21 15.4-5 Zero Coupon Bonds 15.21 15.4-6 Debt Securitization 15.21 15.4-7 Refinancing 15.22 THEORETICAL QUESTIONS 15.22 16 INTERNATIONAL CAPITAL MARKET 16.1 Global Depository Receipts 16.1 16.1-1 Double Taxation Agreements on GDRs 16.2 16.1-2 Impact of GDRs on Indian Capital Markets 16.3 16.2 American Depository Receipts 16.3 16.3 External Commercial Borrowings 16.4 16.4 Debt Route for Foreign Currency Funds 16.5 16.5 Indian Depository Receipts 16.6 THEORETICAL QUESTIONS 16.7 17 FOREIGN INVESTMENTS 17.1 India s Investments Abroad 17.1 17.2 Foreign Collaborations 17.2 17.2-1 Tax Issues in Foreign Collaborations 17.2 17.3 FII Investments/Portfolio Investments 17.2 17.3-1 Participatory Notes (P-Notes) 17.3 17.4 Foreign Direct Investment in India 17.4 THEORETICAL QUESTIONS 17.5 18 MONEY MARKET 18.1 Raising Funds against Receivables 18.1 18.1-1 Factoring 18.2 18.1-2 Forfaiting 18.2 18.1-3 Factoring v/s Forfaiting 18.2 18.1-4 Discounting of Bills 18.3
I-23 CONTENTS 18.1-5 Discounting of Bills v/s Factoring 18.4 18.2 Temporary Funds for Implementation of the Project 18.4 18.3 Raising Funds for Regular Working Capital Requirements by the Corporate 18.5 18.4 Raising Short-term Funds by the Banks 18.5 18.5 Raising Short-term Funds by the Government 18.6 18.6 RBI Regulations 18.6 18.6-1 CRR 18.6 18.6-2 Statutory Liquidity Ratio 18.6 18.6-3 Primary Dealers System 18.6 18.6-4 Call/Notice Money 18.7 18.6-5 Repo and Reverse Repo 18.7 18.6-6 Inter-Bank Participation Certificate 18.8 18.7 Financing of International Trade 18.8 18.7-1 Letter of Credit 18.8 18.7-2 Packing Credit 18.9 18.7-3 Post-Shipment Credit 18.9 THEORETICAL QUESTIONS 18.10 19 INFLATION AND FINANCIAL MANAGEMENT 19.1 Inflation and Financial Management 19.1 19.2 Inventory Management under Inflationary Conditions 19.2 19.3 Impact of Inflation on Working Capital Management 19.3 THEORETICAL QUESTIONS 19.4 20 GENERAL TOPICS 20.1 Consumer Finance 20.2 20.2 Credit Cards 20.2 20.3 Inter-Relationship between Investment, Financing and Dividend Decision 20.3 20.4 Impact of Taxation on Corporate Financing 20.4 20.5 Asset Securitization 20.5 20.6 Exchange Traded Funds 20.6 20.7 Economic Value Added Method 20.7 20.8 Carbon Trading 20.8 20.9 Self Insurance 20.9 20.10 Special Economic Zones 20.9 20.11 Private Equity 20.9 20.12 Hedge Funds 20.10
CONTENTS I-24 20.13 Embedded Options/Embedded Derivatives 20.11 20.14 Curvilinear Break-even Analysis 20.12 20.15 Financial Intermediation 20.12 20.16 Shareholder Value Analysis 20.12 20.17 Financial Engineering 20.13 20.18 Non-Banking Finance Companies 20.13 20.19 Big-ticket Lease 20.14 20.20 Dow Jones Theory 20.14 20.21 Corporate Governance 20.15 20.22 Corporate Social Responsibility 20.17 20.23 Information Technology 20.17 20.24 Investment Banking 20.18 20.25 Retail Banking 20.19 THEORETICAL QUESTIONS 20.20 APPENDICES APPENDIX A : MATHEMATICS OF FINANCE APPENDIX B : LEVERAGE APPENDIX C : COST OF CAPITAL TABLES A3 A7 A11 TABLE I : NORMAL PROBABILITY DISTRIBUTION TABLE (ONE TAIL) A21 TABLE II : CUMULATIVE DISTRIBUTION FUNCTION FOR THE STANDARD NORMAL RANDOM VARIABLE N (D) + A22 TABLE III : CUMULATIVE DISTRIBUTION FUNCTION FOR THE STANDARD NORMAL RANDOM VARIABLE N (D) A23 TABLE IV : AREAS UNDER THE NORMAL CURVE AREAS UNDER THE STANDARD NORMAL DISTRIBUTION A24 TABLE V : NATURAL LOGS, e x AND e -x VALUES A25 TABLE VI : PRESENT VALUE OF RE. 1 TO BE RECEIVED/PAID AFTER N PERIOD(S) A28 TABLE VII : PRESENT VALUE OF RE. 1 TO BE RECEIVED/PAID PERIODICALLY FOR N PERIOD(S) A31 TABLE VIII : LOGARITHMS A34 TABLE IX : ANTILOGARITHMS A38