MGT201….
Midterm Subjective
Suppose ABC Company is given Rs. 3 as dividend which is
expected to grow at constant rate of 9% per year from now on. What would be the
stock price of company if the required rate return is 17%? (3 Marks :)
EXPECTED RATE OF RETURN mark 5
Probability

Return

25%

12%

25%

11.50

25%

10

25%

9.50

Answer .1075 or 10.75
Slandered Deviation?
Correlation

1.8

Return on asset z

20%

Slandered deviation of z ?


Answer 63 % (
=sqrt
Rs 63 , Rs 36 ,
36 %
10 Year bond with 12% coupon rate is selling at Rs. 1650
face value of bond is Rs. 1000. Required rate of return is 14%. SEMI ANUALLY.
=FV/(1+ror%/M)^20
=1435
Differentiate the Floating rate bond and junk bound
Floating
Rate Bond:
It is
defined as a type of bond bearing a yield that may rise and fall within a
specified range
according
to fluctuations in the market. The bond has been used in the housing bond
market
Eurobonds: it issued from a foreign country
Junk
Bonds & High Yield Bonds: Corporations that are small in size,
or lack an established operating
track
record are also likely to be considered speculative grade. Junk bonds are most
commonly
associated with corporate issuers. They are highrisk debt
with rating below BB by S&P
H Corporation’s stock currently sells for Rs.20 a share.
The stock just paid a dividend of Rs.2 a share (Do = Rs.2). The dividend is
expected to grow at a constant rate of 11% a year. What stock price is expected
1 year from now?
Stock
Price= div+price/(1g)
Briefly explain what call provision is and in which case
companies use this option. (3 marks)
The right (or option) of the Issuer to call back (redeem) or
retire the bond by payingoff the Bondholders before the Maturity Date. When
market interest rates drop, Issuers (or Borrowers) often call back the old
bonds and issue new ones at lower interest rates
Suppose you approach a bank for getting loan. And the
bank offers to lend you Rs.1, 000,000 and you sign a bond paper. The bank asks
you to issue a bond in their favor on the following terms required by the bank:
Par Value = Rs 1, 000,000, Maturity = 3 years
Coupon Rate = 15% p.a, Security = Machinery
You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option. (5 marks)
Coupon Rate = 15% p.a, Security = Machinery
You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option. (5 marks)
Data:
Par Value = Rs 1, 000,000
Maturity = 3 years
Coupon Rate = 15% p.a,
Security = Machinery
Solution:
CF = Cash Flow = Coupon Value =
Coupon Rate x Par Value
CF = 15% x 1,000,000
CF = 150000/12
Monthly CF = 12500
Assume that rD = 10%
PV = CF1/(1+rD/12)12+CFn/(1+rD/12)2x12 +..+CFn/ (1+rD/12) n
+PAR/ (1+rD) n
PV = 12500/ (1 + 0.10/12)12 + 12500/ (1 + 0.10/12)2x12 +
12500/ (1 + 0.10/12)3x12 + 1000000/(1 + 0.10/12)3x12
PV = 12500/ (1.00833)12 + 12500/ (1.00833)24 + 12500/
(1.00833)36 + 1000000/(1.00833)36
PV = 11315.60425 + 10243.43196 + 9272.849775 + 741828
PV = 772660
FV = CCF (1 + rD/m )nxm  1/rD/m
FV = 12500 (1 + 10%/12)3x12  1 / 10%/12
FV = 12500 (41.779)
FV = 522237.5
PV (Coupons Annuity) = FV / (1 + rD/m) nxm
PV = 522237.5/(1 + 10%/12) 3x12
PV = 522237.5/1.348021407
PV = 387410
PV (Par) = 1,000,000 / (1.00833)36
PV (Par) = 741828
PV = PV (Coupons Annuity) + PV (Par)
PV = 387410 + 741828
PV = 1129238
A security analyst has estimated the following returns on
the stocks of 4 large companies:
Weight age Expected Returns
Company A 25%
12%
Company B 25% 11.5%
Company C 25% 10%
Company D 25% 9.5%
Company B 25% 11.5%
Company C 25% 10%
Company D 25% 9.5%
You are required to calculate the expected return on this
portfolio. (5 marks)
rP * = rA xA + rB xB + rC xB + rD xD
= 12% (25/100) +
11.5 %( 25/100) + 10%(/25/100) + 9.5%(25/100)
= 3% + 2.8757% + 2.5 + 2.375
= 10.75%
5 Marks: Suppose Govt. pay coupon on its bond quarterly; calculate the intrinsic value of bond under following circumstances: 10 Year bond with 10% coupon rate is selling at Rs. 1050 face value of bond is Rs. 1000. Required rate of return is 12%.
1.
Suppose there are 2 stocks in
your investment portfolio,

Value of
investment

Expected IRR

A

40

30

B

60

20

Total

100


Calculate
the expected portfolio return
Solution:
Expected
Portfolio return calculation:
rP = rA x
A + rB x B
rP = 30% x
(40 / 100) + 20% x (60 / 100)
rP = 0.12
+ 0.12
rP = 0.24
or 24%
Why the companies prefer to raise money through debt not
through equity? (3 Marks)
Debt financing refers to any borrowed money which the entrepreneur must pay back to the lending institution. An interest rate and other terms apply. Company which are well established and profitable growth often rely on debt financing.
Equity
financing is money lent in exchange for ownership in a company. New businesses
can use equity financing for their startups or when they need to raise
additional equity capital to offset existing debt. REASON
The debt finance company is not
interested in becoming a partner in your endeavor, instead they are in business
to make money from their money, letting you use it for periods of time. When
seeking outside capital, whether equity or debt, remember that certain sources
are familiar and like to work with particular industries. Take the time to look
around and be sure that the source you are considering is wellaquatinted with
your type of business.
What is the relationship between standard deviation &
Risk (3 Marks)
The standard deviation is a direct measure of risk involved
in the purchase of the share. The more the standard deviation, the more the
stock is considered to be risky. Standard deviation is commonly used as a
measure to compare two or more set of data. The price of two stocks can have
same mean, but they will have different standard deviation. The stock with
larger standard deviation is considered to be more risky than the stock having
smaller standard deviation, because it has more variability in its mean price.
However, we should also calculate the range of data for the
two stocks to make our conclusion more stronger. The range is calculated as
Range = Highest value  Lowest value.
The stock having
small range is considered to be less risky than the stock with larger range.
Risk means the chance of actual outcome differing from
expected outcome. Higher risk tends to result in a lower share price as
shareholders demand more compensation for the greater risk in the form of
higher expected returns. In nutshell, the stock having small standard deviation
and range is considered as less risky than the stocks having larger standard
deviation and range.
Suppose you approach a bank for getting loan. And the
bank offers to lend you Rs.1, 000,000 and you sign a bond paper. The bank asks
you to issue a bond in their favor on the following terms required by the bank:
Par Value = Rs 1, 000,000, Maturity = 3 years
1 Company ABC wants to issue
more common stock face value Rs.10. Next year the Dividend is expected to be
Rs.2 per share assuming a Dividend growth rate of 10%pa. The lawyers’ fee and
stock broker commission will cost Rs.1 per share. Investors are confident about
company ABC so the common share is floated at market price of Rs.16 (i.e.
Premium of Rs.6). If the capital structure of company ABC is entering common
equity then what is the company WACC? Use Retained Earning Approach to
calculate the result. (Marks=5)
Calculate Required ROR for Common
Stock using Gordon’s Formula
r = (DIV1/Po) +
g
Po = market
price = 16
Div1 = Next
Dividend = 2
G = growth rate
= 10%
r = (2/16)+10% =
22.50%
Now If company wanted to issue
the stock via new float then it has to pay the lawyer fee and broker commission
which 1 Rs.
Net proceed = 16
– 1 = 15
r = (2/15)+10% =
22.50% = 23.33%
Find the Beta on a stock given that its expected Return
is 16% the Risk free rate is 4% and the Expected return on the Market portfolio
is 12% (Marks 5)
r = rRF + Beta (rM  rRF).
r=16%
Rf=4%
rM=12%
B=?
16% = 4% + Beta (12%  4%).
16%4%=Beta*8%
12%/8%=Beta
1.5=Beta
Risk free Rate is 15% and expected Market Return is 20%.
FM Corporation has a bet of 1.9 and Gold Corporation has beta of 1.5. Find
Expected Return on FM Corporation and Gold Corporation.
r = rRF + Beta (rM  rRF).
B=1.9
rM=20%
rRF=15%
r=15%+1.9(5%)
Gold Company:
B=1.5
rM=20%
rRF=15%
r = rRF + Beta (rM  rRF).
r=15%+1.5(5%)
EBIT
of a firm is Rs. 200 and corporate tax rate, Tc is 30 %. If the firm is 100%
Equity and rE is 20%. Then calculate WACC.
WACC = rD XD. + rP XP + rE XE .
WACC=0+0+20%(100)
WACC=20%
Explain the equation of EBIT
when it is equal to Break Even Point. MARKS5
An indicator of a company's
profitability, calculated as revenue minus expenses, excluding tax and
interest. EBIT is also referred to as "operating earnings",
"operating profit" and "operating income", as you can
rearrange the formula to be calculated as follows:
EBIT = Revenue  Operating Expenses
Also known as Profit before
Interest & Taxes (PBIT), and equals Net Income with interest and taxes
added back to it.
Breakeven Point: Quantity of Sales at which EBIT = 0
EBIT = Op Revenue
 Op Costs = Op Revenue  Variable Costs – Fixed Costs
=
PQ  VQ  F. Where P= Product Price (Rs), Q= Quantity
or
#Units Sold, V=
Variable Cost (Rs), F= Fixed Cost (Rs). So IF EBIT = 0
then PQVQF = 0 so Breakeven Q = F
/ (P  V)
Calculate the market value of equity for a 100% equity
firm using the following information extracted from its financial statements: EBIT
= Rs. 50, 000, return on equity is 12%, amount of equity is Rs. 100, 000. tax
rate is 35%.
First all all we net to calculate Net income
Net income = EBIT – Interest – tax
Net income = 50,000 – 0 – (.35*
50,000) = 32,500
Now to calculate the market value of firm
Net income/ return on equity
= 32500/.12 = 270833.3
Market value of unleveraged firm
(100% equity firm) equity + debit
= 270833.3 + 0
= 270833
Earnings before interest and
taxes (EBIT) of Firm is Rs.1000 and Corporate Tax Rate, Tc is 30%
If the Firm is 100% Equity (or
UnLevered) and rE = 30% then what is the WACCU of Unlevered Firm?
1) Net income =
EBIT  I  Tax
= 1000  0 
30% (0.3)
= 700
2) Equity (UnL)
= NI/Re
= 700/30% (0.3)
= 2334
3) WACC(UnL) =
Equity + Debt
= 2334 + 0 So
= 2334 Here is
note that wacc is equal to equity
= 30% Jitna
equity k rate hoga otahi WACC ho of Unlevered firm.....
If the Firm takes Rs.1000 Debt
at 10% Interest or Markup then what is the WACCL of Levered Firm? (There is no
change in return in equity)
1)Net income =
EBIT  I  Tax
=
1000  .1(1000)  30% (900)
2) Equity (UnL)
= NI/Re
= 630/30% (0.3)
= 2100
3)WACC (L) =
Equity + Debt
= 2100 + 1000
= 3100
Formula:...
WACC = Rd*(1 
tc)Xd + Re*Xe
= .1*(1 
0.3)*(1000/3100) + 0.3*(2100/3100)
= 0.225806
= 22.5806%
100% Equity (un – levered)
firm as total Assets of Rs. 50000 weighted average cost of capital for an un –
levered firm (WACCU) is 35% and cost of debt for un – levered firm (r d u ) of
20% it then adds Rs. 20000 of debt financial Risk increases cost of debts (r d
L) of leverd Firm to 18% (Marks 5)
Required
What is levered firms Cost of
equity (r e L)?
What will be the WACC L of
levered Firm
Assuming Pure MM View  Ideal
Markets: Total Market Value of Assets of Firm (V) is
UNCHANGED. Value of un levered
firm = Value of levered firm. Also, WACC remains
UNCHANGED by Capital Structure
and Debt.
• WACCU = WACCL
= 35%
Re = cost of
equity
Rd = 18 % cost of
debt
E = market value
of the firm's equity
D = market value
of the firm's debt =
V = E + D
E/V = percentage
of financing that is equity
D/V = percentage of financing that
is debt
T = corporate tax rate
Re = ?
WACCu = 35%
rE,L =WACC + Debt/Equity (WACCL 
rD,L)
Re = 35% + 2000/48000(35%18%)
35.70%
WACC = E/V *Re + D/V * Rd * (1 T)
Now by plugging values
V= E+D = 48000+2000 = 50000
35% = (48000/50000) * Re +
(2000/50000)* 18%
By rearranging equation
35% = 9.6 Re + .0072
.96Re = 35%  .0072
Re = (35%.0072) / .96 = 35.70%
Cost of Equity for Levered Firm
= rE,L = Risk Free Interest Rate +
Business Risk Premium + Financial Risk Premium.
Question
No: 29 ( Marks: 3 )
Briefly
explain what call provision is and in which case companies use this option.
The right (or option) of the Issuer to call back (redeem)
or retire the bond by payingoff the Bondholders before the Maturity Date. When
market interest rates drop, Issuers (or Borrowers) often call back the old
bonds and issue new ones at lower interest rates
Question
No: 30 ( Marks: 3 )
Lakson Corporation is a stagnant market and analysts
foresee a long period of zero growth of the firm. It is paying a yearly
dividend of Rs.5 for some time which is expected to continue indefinitely. The
yield on the stock of similar firm is 8%. What should lakson’s stock sell for?
Data:
P0 = ?
D1V1 = 5
RCE = 8%
Solution:
P0 = D1V1/RCE
P0 = 5/8%
P0 = 5/0.08
P0 = 62.5
Question No: 31 ( Marks: 5 )
What
are different types of bonds? (Give any five types)
Types
of Bonds:
·
Mortgage Bonds: backed & secured by real
assets
·
Subordinated Debt and General Credit: lower rank
and claim than Mortgage Bonds.
·
Debentures: These are not secured by real
property, risky
·
Floating Rate Bond: It is defined as a type of
bond bearing a yield that may rise and fall within a specified range according
to fluctuations in the market. The bond has been used in the housing bond
market
·
Eurobonds: it issued from a foreign country
·
Zero Bonds & Low Coupon Bonds: no regular
interest payments (+ for lender), not callable (+ for investor)
Question
No: 32 ( Marks: 5 )
H
Corporation’s stock currently sells for Rs.20 a share. The stock just paid a dividend
of Rs.2 a share (Do = Rs.2). the dividend is expected to grow at a constant rate
of 11% a year.
What stock price
is expected 1 year from now?
What would be the
required rate of return on company’s stock?
Data:
P0 = rs 20
D0 = 2.
g = 11%
P1 = ?
ROR = ?
Solution
Part A:
P1 = P0(1 + g)
P1= 20(1.11)
P1= 22.2
Solution
part B:
ROR = D1 / P0 + g
ROR = (2 * 1.11/20) + 0.11
ROR = (2.22/20) + 0.11
ROR = 0.111 + 0.11
ROR = 0.221*100
ROR = 22.1%
Question No: 29 ( Marks: 3 )
Define interest rate risk and investment risk.
Interest
rate risk
Interest
rate risk is the risk (variability in value) borne by an interestbearing
asset, such as a loan or a bond, due to variability of interest rates. In
general, as rates rise, the price of a fixed rate bond will fall, and vice
versa. Interest rate risk is commonly measured by the bond's duration.
Investment
Risk
The
uncertainties attached while making an investment that the investment may not
yield the expected returns.
OR
Possibility
of a reduction in value of an insurance instrument resulting from a decrease in
the value of the assets incorporated in the investment portfolio underlying the
insurance instrument. This reduction can also be effected by a change in the
interest rate.
Question
No: 30 ( Marks: 3 )
A
stock is expected to pay a dividend of Rs.0.75 at the end of the year. The
required rate of return is ks = 10.5%, and the expected constant growth rate is
g = 6.4%. What is the stock's current price?
Data:
P0
=?
D1
= 0.75
g
= 6.4%
ROR
= 10.5%
Solution:
P0 = D1 / (ror – g)
P0 = 0.75 / (0.105 0.064)
Po = 0.75/0.041
P0 = 18.29
Question
No: 31 ( Marks: 5 )
There
are some risks (Unique Risk) that we can diversify but some of the risks
(Market risks) are not diversifiable. Explain both types of risk.
Unique
Risk
Allocation
of proportional risk to all parties to a contract, usually through a risk
premium. Also called risk allocation.
In
finance and economics, systematic risk (sometimes called aggregate risk, market
risk, or undiversifiable risk) is vulnerability to events which affect
aggregate outcomes such as broad market returns, total economywide resource
holdings, or aggregate income. In many contexts, events like earthquakes and
major weather catastrophes pose aggregate risks—they affect not only the
distribution but also the total amount of resources. If every possible outcome
of a stochastic economic process is characterized by the same aggregate result
(but potentially different distributional outcomes), then the process has no
aggregate risk.
Question
No: 32 ( Marks: 5 )
Hammad
Inc. is considering two alternative, mutually exclusive projects. Both projects
require an initial investment of Rs. 10,000 and are typical, averagerisk
projects for the firm. Project A has an expected life of 2 years with aftertax
cash inflow of Rs. 6,000 and Rs. 8,000 at the end of year 1 and 2,
respectively. Project B has an expected life of 4 years with aftertax cash
inflow of Rs. 4,000 at the end of each of next 4 years. The firm’s cost of
capital is 10 percent.
If
the projects cannot be repeated, which project will be selected, and what is
the net present value?
Net
Present Value:
Project A: Initial investment, I0 = Rs 10,000
Cash flow in yr 1, CF1 = Rs 6000
Cash flow in yr 2, CF2 = Rs 8000
Discount rate, I = 10 %
No. of yrs, n = 4
NPV =  I0 + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i)
n
= 10,000 + 6000/(1.10) + 8000/(1.12)2
= 10,000 + 5454.54 + 6611.57
=  10,000 +12066.11
= 2066.11
Project B: Initial investment, I0 = Rs 10,000
Cash flow in yr 1, CF1 = Rs 4000
Cash flow in yr 2, CF2 = Rs 4000
Cash flow in yr 3, CF3 = Rs 4000
Cash flow in yr 4, CF4 = Rs 4000
Discount rate, I = 10 %
No. of yrs, n = 4
NPV =  I0 + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i)
n
= 10,000 + 4000/(1.10) + 4000/(1.10)2+ 4000/(1.10)3+
4000/(1.10)4
= 10,000 + 3636.36 + 3305.8 + 3005.25 + 2732.053
= 10,000 + 12679.463
= 2679.463
Question
No: 30 ( Marks: 3 )
There
are two stocks in the portfolio of Mr. N, Stock A and Stock B. the information
of this portfolio is as follows:
Common stock
Expected rate of return Standard
deviation
Stock A 15% 10%
Stock B 20% 15%
Calculate
the expected rate of return on this portfolio assuming that Stock A consists of
75% of the total funds invested in the stocks and the remainder in Stock B.
Solution:
Formula
on page 93 of handouts.
(XA2 Ïƒ A 2 +XB2 Ïƒ B 2 + 2 (XA XB Ïƒ A Ïƒ B AB) x (0.5)
={(75/100)2(10/100)2+(25/100)2(15/100)2+2((75/100)(25/100)(10/100)(15/100)(.6)}(.5)
=
{(0.5625)(0.01)+(.0625)(0.0225)+2((.75)(.25)(.1)(.15)(.6))}(.5)
=(0.010406)*.5
=0.005203*100
=0.520313%
Question
No: 31 ( Marks: 5 )
(a) What is correlation of coefficient?
Correlation Coefficient ( AB or “Ro”):
Risk of a Portfolio of only 2 Stocks A & B depends on
the Correlation between those 2 stocks.
The value of Ro is between 1.0 and +1.0
If Ro = 0 then Investments are Uncorrelated & Risk
Formula simplifies to Weighted Average Formula. If Ro = + 1.0 then Investments
are Perfectly Positively Correlated and this means that
Diversification does not reduce Risk.
If Ro =  1.0, it means that Investments are Perfectly
Negatively Correlated and the Returns (or Prices or Values) of the 2
Investments move in Exactly Opposite directions.
In this Ideal Case, All Risk can be diversified away. For
example, if the price of one stock increases by 50% then the price of another
stock goes down by 50%.
In Reality, Overall Ro for most Stock Markets is about Ro
= + 0.6.it is very rough rule of thumb. It means that correlations are not
completely perfect and you should remember that if the correlation coefficient is
+1.0 then it is not possible to reduce the diversifiable risk.
This means that increasing the number of Investments in
the Portfolio can reduce some amount of risk but not all risk
(b) What are efficient portfolios?
Efficient Portfolios are those whose Risk & Return
values match the ones computed using Theoretical Probability Formulas. The
Incremental Risk Contribution of a New Stock to a Fully
Diversified Portfolio of 40 UnCorrelated Stocks will be
the Market Risk Component of the New Stock only. The Diversifiable Risk of the
New Stock would be entirely offset by random movements in the other 40 stocks.
Adding a New Stock to the existing Portfolio will create more Efficient
Portfolio Curves. The New Stock will contribute its own Incremental Risk and Return
to the Portfolio.
Question
No: 32 ( Marks: 5 )
Suppose
you approach a bank for getting loan. And the bank offers to lend you Rs.1,
000,000 and you sign a bond paper. The bank asks you to issue a bond in their
favor on the following terms required by the bank: Par Value = Rs 1, 000,000,
Maturity
= 3 years
Coupon
Rate = 15% p.a, Security = Machinery
You
are required to calculate the cash flow of the bank which you will pay every
month as well as the present value of this option.
Data:
Par
Value = Rs 1, 000,000
Maturity
= 3 years
Coupon
Rate = 15% p.a,
Security
= Machinery
Solution:
CF = Cash Flow = Coupon Value = Coupon Rate x Par Value
CF = 15% x 1,000,000
CF = 150000/12
Monthly CF = 12500
Assume
that rD = 10%
PV = CF1/(1+rD/12)12+CFn/(1+rD/12)2x12 +..+CFn/ (1+rD/12)
n +PAR/ (1+rD) n
= 12500/ (1 + 0.10/12)12 + 12500/ (1 + 0.10/12)2x12 +
12500/ (1 + 0.10/12)3x12 +1000000/(1 + 0.10/12)3x12
PV = 12500/ (1.00833)12 + 12500/ (1.00833)24 + 12500/
(1.00833)36 +1000000/(1.00833)36
PV = 11315.60425 + 10243.43196 + 9272.849775 + 741828
PV = 772660
FV = CCF (1 + rD/m )nxm  1/rD/m
FV = 12500 (1 + 10%/12)3x12  1 / 10%/12
FV = 12500 (41.779)
FV = 522237.5
PV (Coupons Annuity) = FV / (1 + rD/m) nxm
PV = 522237.5/(1 + 10%/12) 3x12
PV = 522237.5/1.348021407
PV = 387410
PV (Par) = 1,000,000 / (1.00833)36
PV (Par) = 741828
PV = PV (Coupons Annuity) + PV (Par)
PV = 387410 + 741828
PV = 1129238
Question
No: 29 ( Marks: 3 )
Differentiate
the real assets and securities.
Real
assets are physical property such as Land, Machinery, equipments and Building
etc.
Where
as securities basically, are legal contractual piece of paper.
Kinds
of securities:
We
have discussed about two types of securities.
Direct claim securities:
Stocks (Shares):
It is
defined as equity paper representing ownership, shareholding. Appears on
Liabilities side of Balance Sheet
Bonds:
It is a debt paper representing loan or borrowing. These are long term
debt instruments.
A
security analyst has estimated the following returns on the stocks of 4 large
companies:
Weightage Expected
Returns
Company A
25% 12%
Company B 25% 11.5%
Company C 25% 10.%
Company D 25% 9.5%
You are required to calculate the expected return on
this portfolio.
Expected Portfolio Return Calculation:
rP * = rA xA + rB xB + rC xB + rD xD
= 12% (25/100) + 11.5 %( 25/100) + 10%(/25/100) +
9.5%(25/100)
= 3% + 2.8757% + 2.5 + 2.375
= 10.75%
Question
No: 31 ( Marks: 5 )
Why a person should invest in shares? Give reasons.
Capital
growth
Over
the longer term, shares can produce significant capital gains through increases
in share prices. Some companies also issue free or bonus shares to their
shareholders as another way of passing on company profits or increases in their
net worth.
Diversifying
your investments
in
order to diversify your investment portfolio, you will probably have part of
your money in the share market. You may buy shares directly or through managed
funds or your superannuation.
Easy
buying and selling
Compared
to other investments like property, shares are very portable. They can be
bought and sold quickly, and the brokerage on the transactions is lower than for
a property transaction. Unlike selling a property, you can sell part of your
share parcels.
Question
No: 29 ( Marks: 3 )
By
applying Common Life Approach calculate the NPV of the following projects:
Projects
Initial outflow Inflow Yr 1 Inflow Yr 2
A 100 200 
B 200 200 200
Project A
NPV=100+(200100)/1.1)+200/(1.1)2 = 156
Project B
NPV =200+200/1.1+200/(1.1)2 = 147
Question
No: 31 ( Marks: 5 )
What are Strike Price and Option Price?
Option Price and Strike Price are the part or terminology
of Option Contract.
Option Price: Option price is the price which the option
buyer pays to the option seller. It is also know as Option Premium.
Strike Price: The price specified in the option contract
is known as the strike price or the exercise price.
What does the meaning of standard deviation in finance?
(2.5)
Some analysts use
standard deviation to predict how a particular investment or portfolio will
perform. They calculate the range of the investment's possible future
performances based on a history of past performance, and then estimate the
probability of meeting each performance level within that range.
Question
No: 30 ( Marks: 3 )
What
is risk averse assumption?
When
we talk in terms of risk averse, we know that most investors are
psychologically risk averse. In case of two investments offer with the same
prospective return most investor would choose the one with the lower risk or
standard deviation or spread or votality. In other words most of the investors
are not major gamblers. Gamblers would choose that project which appeals to
investors greed by offering upsite return of 30% plus 10% = 40%. The
consequences on the share price, the higher the risk of share the higher its
rate of return and the lower its market price, so any investor will choose
surely with the low risk and he will take care of very closely risk averse
assumption while finalizing any project.
Question
No: 31 ( Marks: 5 )
How
negatively correlated investments behave in a market?
If Ro
=  1.0, it means that Investments are Perfectly Negatively Correlated and the
Returns (or Prices or Values) of the 2 Investments move in Exactly Opposite
directions. In this Ideal Case, All Risk can be diversified away. For example,
if the price of one stock increases by 50% then the price of another stock goes
down by 50%.
Question
No: 32 ( Marks: 5 )
What
types of shares are available in the market?
The
following are the shares available normally in the market;
1.
Preferred Stock: These stocks have regular Constant / Fixed Future
Dividends Certain for the Preferred Shareholders. Use old Perpetuity Cash Flow
Pattern and formulas to estimate theoretical Fair Stock Price.
2.
Common Stock: Theses stocks have variable future dividends expected by
the common shareholders. Use
Zero
& Constant Growth Models to simplify future Dividend forecasts in estimated
Theoretical Stock Price (or PV) equation. There dividend depend upon the income
earned by the company and also upon the management decision regarding the
dividend declaration.
Question
No: 41 ( Marks: 5 )
Explain
why financial planning is important to today’s chief executives?
It
is important to plan finances in order to reap long term benefits through the assets
in hand. The investments that one makes are structured properly and managed by
professionals through financial planning. Every decision regarding our finances
can be monitored if a proper plan is devised in advance. The following points
explain why financial planning is important.
Cash
Flow: Financial planning helps in increasing cash flow as well as monitoring
the spending pattern. The cash flow is increased by undertaking measures such
as tax planning, prudent spending and careful budgeting.
Capital:
A strong capital base can be built with the help of efficient financial
planning. Thus, one can think about investments and thereby improve his
financial position.
Income:
It is possible to manage income effectively through planning. Managing income
helps in segregating it into tax payments, other monthly expenditures and
savings.
Family
Security: Financial planning is necessary from the point of view of family
security. The various policies available in the market serve the purpose of
financially securing the family.
Investment:
A proper financial plan that considers the income and expenditure of a person,
helps in choosing the right investment policy. It enables the person to reach
the set goals.
Standard
of Living: The savings created by through planning, come to the rescue in
difficult times. Death of the bread winner in a family, affects the standard of
living to a great extent. A proper financial plan acts as a guard in such
situations and enables the family to survive hard times.
Financial
Understanding: The financial planning process helps gain an understanding about
the current financial position. Adjustments in an investment plan or evaluating
a retirement scheme becomes easy for an individual with financial
understanding.
Assets:
A nice 'cushion' in the form of assets is what many of us desire for. But many
assets come with liabilities attached. Thus, it becomes important to determine
the true value of an asset. The knowledge of settling or canceling the
liabilities, comes with the understanding of our finances. The overall process
helps us build assets that don't become a burden in the future.
Savings:
It is good to have investments with high liquidity. These investments, owing to
their liquidity, can be utilized in times of emergency and for educational
purposes.
The
argument made by people from low income groups is that they don't need to plan
their finances due to the less money they possess. However, no matter how much
one earns, better planning of income always helps in the long run.
Question
No: 42 ( Marks: 5 )
How risk and expected return is compared in two
distributions?
The future is uncertain. Investors do not know with
certainty whether the economy will be growing rapidly or be in recession. As
such, they do not know what rate of return their investments will yield.
Therefore, they base their decisions on their expectations concerning the
future.
Question
No: 41 ( Marks: 5 )
Suppose
Ali Inc. issues tenyear bonds (par Rs. 1,000) with an annual coupon of 8.6%.
Similar tenyear bonds are paying 8.0% interest. What is the value of one Ali's
new bonds that is, what should be its price?
Bond Price = PV(all inflows) +
PV(face value)
So in this case
Bond Price = PV(of all coupon
payments) +PV(1000)
As bond will pay same amount for the next 10 year assume it
annuity so we use annuity formula if some done get this formula he/she can try
manually PV for every year for ten years.
8.6% of one
thousand = 1000*.086 = 86
Which he gets every year as coupon payment
PV = Amt * PVIF = [1  (1+i)^n
]/i
i = 8%
Price = 86* [( 1 – (1.08)^10)
]/.08 + (1000/1.08)^10
Price = 577.0670003 + 463.1934881
= 1040.260488
= 1040.26
Question
No: 42 ( Marks: 5 )
Draw
a three year time line which illustrates the following situation:
i. An outflow of Rs. 10,000 occurs at time 0
ii. Inflows of Rs. 5,000 occur at the end of year 1, 2
and 3.
iii. The interest rate during
the three year is 10%.
Question No: 16 ( Marks: 3 )
Assume that one year from now; you will deposit Rs. 1,000
into a saving account that pays 8% interest. If the bank compounds interest semiannually,
how much will you have in your account four years from now?
FV = PV(1+i/m)^mn
FV = 1000 (1.04)^6 ( m*n = 2*3 as we are depositing after
one year so total years will be 3)
FV = 1265
Question No: 17 ( Marks: 3 )
How much should you pay for the preferred stock of the
PST Corporation, if it has $ 50 par value, pays $20 a share in annual
dividends, and your required rate of return is 15%.
=20/.15 = 133.33
Question No: 19 ( Marks: 3 )
What do you mean by yield to maturity (YTM) of a bond?
Explain briefly.
The most useful measure of the return on holding a bond is
called the yield to maturity (YTM).
This is the yield bondholders receive if they hold the bond
to its maturity when the final principal payment is made. It can be calculated
from the present value formula.
The value of i that solves this equation is the yield to
maturity
If the price of the bond is $100, then the yield to maturity
equals the coupon rate.
Since the price rises as the yield falls, when the price is
above $100, the yield to maturity must be below the coupon rate.
Question No: 20 ( Marks: 3 )
Explain briefly the Constant Growth Dividends Model of
common stocks valuation.
In this, we need only to forecast
the next year dividend and assume constant dividends Growth at Inflationary
Growth Rate “g” which equals 5  10% pa (depending on country). DIVt+1 = DIVt x
(1 + g) t. t = time in years i.e. If g = 10% Dividends Cash Flow Stream grows
according to the Discrete Compound Growth Formula
DIVt+1 = DIVt x (1 + g) t.
t = time in years.
So if you have estimated the
present Dividend (DIVo) or the next year’s Dividend (DIV1) then you can
estimate all future dividends using this formula. In this, the trick is how to
pick the right growth rate. Generally, we pick the rate of growth of inflation.
As common stock holders we assume that the dividends are continue to grow at
constant rate which is equal to rate of growth of inflation.
Question No: 41
( Marks: 10 )
You are a financial analyst for the Hittle Company. The
director of capital budgeting has asked you to analyze two proposed capital
investments Project X and Project Y. Each project has a cost of Rs. 10,000 and
the cost of capital for both projects is 12%. The projects’ expected cash flows
are as follows:
Year

Expected net
cash flows


Project X

Project Y


0

(10,000)

(10,000)

1

6,500

3,500

2

3,000

3,500

3

3,000

3,500

4

1,000

3,500

i.
Calculate each project’s payback, net present value
(NPV), internal rate of return (IRR), and profitability index (PI).
ii. Which
project or projects should be accepted if they are independent?
iii. Which
project should be accepted if they are mutually exclusive?
ANSWER:
1.
Payback:
PROJECT X:
Cost of
project = Rs. 10,000
Payback period is the time required
by the project to recover its costs.
Year 1 the project will recover Rs.
6,500
Year 2 the project will recover Rs
3000
Year 3 project will recover the remaining Rs. 500 in 1^{st}
month of 3^{rd} yr. So payback period for Project X is 2 yrs and 1
month.
PROJECT Y: Cost of project= Rs 10,000
Year 1 project will recover Rs 3,500
Year 2 project will recover Rs
3,500
Year 3 project will recover
remaining Rs 3000 in approximately 11 months of 3^{rd} yr.
So payback period of project Y is 2 yrs and 11 months.
2. Net Present
Value:
Project X: Initial investment, I_{0} = Rs
10,000
Cash flow in yr 1, CF_{1}
= Rs 6500
Cash flow in yr 2, CF_{2 }=
Rs 3000
Cash flow in yr 3, CF_{3}
= Rs 3000
Cash flow in yr 4, CF_{4}
= Rs 1000
Discount rate, I = 12 %
No. of yrs, n = 4
NPV =  I_{0 }+ CF_{1}/(1+i)^{n} + CF_{2}/(1+i)^{n}
+ CF_{3}/(1+i)_{ }^{n }+ CF_{4}/(1+i) ^{n}
^{ }= 10,000 + 6500/(1.12) + 3000/(1.12)^{2}+
3000/(1.12)^{3}+ 1000/(1.12)^{4}
=
Rs 966
Project Y: Initial investment, I_{0} = Rs
10,000
Cash flow in yr 1, CF_{1}
= Rs 3500
Cash flow in yr 2, CF_{2 }=
Rs 3500
Cash flow in yr 3, CF_{3}
= Rs 3500
Cash flow in yr 4, CF_{4}
= Rs 3500
Discount rate, I = 12 %
No. of yrs, n = 4
NPV =  I_{0 }+ CF_{1}/(1+i)^{n}
+ CF_{2}/(1+i)^{n} + CF_{3}/(1+i)_{ }^{n }+
CF_{4}/(1+i) ^{n}
^{ }= 10,000 + 3500/(1.12) + 3500/(1.12)^{2}+
3500/(1.12)^{3}+ 3500/(1.12)^{4}
= Rs 631
 IRR:
Project X: Put NPV = 0
NPV =  10000_{ }+
6500/(1+i) + 3000(1+i)^{2}+ 3000(1+i)_{ }^{3}+
1000/(1+i) ^{4}
 Profitability Index:
Project X: PI= Sum(CF_{t}/(1+i)^{t})/I_{o}
=
10,966/10000 = 1.096
Project Y : PI= Sum(CF_{t}/(1+i)^{t})/I_{o}
=
10631/10000 = 1.0631
Result: Since NPV and PI of project X are higher than that of project Y
so Project X will be accepted..
Question No: 41
( Marks: 10 )
ICO Company must
decide between two mutually exclusive projects. The following information
describes the cash flows of each project.
Year Project "A" Project "B"
0 Rs. (20,000) Rs. 24,000
1 10,000 10,000
2 8,000 10,000
3 6,000 10,000
a. Assume
that 15% is the appropriate required rate of return. What decision should the
firm make about these two projects?
b. If
the firm reevaluated these projects at 10%, what decision should the firm make
about these two projects?
A) We have 2
project A , B
Project A, Io=  Rs20000, Yr 1 = +Rs10000, Yr2= Rs8000,
Yr3= Rs6000
Project B, Io= Rs24000, Yr1= +Rs10000, Yr2=Rs10000,
yr3=Rs10000
In simple NPV=
Project A=
20000+10000+8000+6000/(1.15)^3
Rs= 2630.19
Project B=
24000+10000+10000+10000/(1.15)^3
Rs= 3945.29
The firm will decide to take the 2^{nd}
project B. becz its NPV is greater tha project A.
B)
Project A=
20000+10000+8000+6000/(1.10)^3
Rs= 3005.25
Project B=
24000+10000+10000+10000/(1.10)^3
Rs= 4507.88
Again on 10%, project B is better
than project A.
What are the types of bond?
(Any five) 5 Marks.
Types of Bonds:
 Mortgage Bonds:
 Backed & secured by real assets
 Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds. Debentures:
 These are not secured by real property, risky
 Floating Rate Bond:
It is defined as
a type of bond bearing a yield that may rise and fall within a specified range
according to fluctuations in the market. The bond has been used in the housing
bond market
 Eurobonds: it issued from a foreign country
 Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for investor) Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established operating track record are also likely to be considered speculative grade. Junk bonds are most commonly associated with corporate issuers. They are highrisk debt with rating below BB by S&P
 Convertible Bonds:
A convertible
bond is a bond which can be converted into the company's common stock. You can
exercise the convertible bond and exchange the bond into a predetermined amount
of shares in the company. The conversion ratio can vary from bond to bond. You
can find the terms of the convertible, such as the exact number of shares or
the method of determining how many shares the bond is converted into, in the
indenture. For example a conversion ratio of 40:1 means that for every bond
(with Rs.1,000 par value) you hold you can exchange for 40 shares of stock.
Occasionally, the indenture might have a provision that states the conversion
ratio will change through the years, but this is rare. Convertibles typically
offer a lower yield than a regular bond because there is the option to convert
the shares into stock and collect the capital gain. But, should the company go
bankrupt, convertibles are ranked the same as regular bonds so you have a
better chance of getting some of your money back
Define the Diversifiable Risk
and Market Risk and Causes of Risk. 5 Marks
In case of portfolio risk we can
further made distinction between Diversifiable Risk and Market risk
Diversifiable Risk: random risk specific to one company, can be virtually
eliminated. Market Risk: It is defined as uncertainty caused by broad movement
in market or economy.
Diversifiable Risk:
random risk specific to one company, can be virtually eliminated.
Market Risk: It is
defined as uncertainty caused by broad movement in market or economy.
Causes of Risk:
These
can be CompanySpecific or General. It may be because of Cash Losses from
operations or poor financial management of the company. This is one possibility
but the real question is that why these losses occurred. One of the reasons for
the losses might be the company’s Debt, Inflation, Economy, Politics, War or
Fate. Final analysis of risk is that it is a game of fate or chance
Why should you invest in
shares? Give reasons 5 marks
Invest in share is better than any other form of investment
due to following reasons.
Easy to sale
Easy to purchase
Limited liability
No risk
Why company prefer debt on
equity to raise funds 3 marks
There are numerous ways to
acquire funds, i.e., finances can be raised in the form of debt or equity. The
proportion of debt and equity constitutes the capital structure of the firm.
Financial experts attempt to find a combination of debt and equity that could
increase the overall value of the company, i.e., they try to find the optimal
capital structure. The following concepts would be used to understand how an
optimal capital structure could be attained.
o Cost of Capital
o Leverage
o Dividend
Policy
o Debt
Instruments
Two approaches for life span
of different life span of two different projects. Discuss any one. (5 marks)
Practical view:
Companies and individuals running
different types of businesses have to make the choice of the asset according to
the life span of the project. For instance, a tailor shop owner would have to
decide whether to invest in a sewing machine that has a useful life of ten
years or to invest in another machine with a useful life of three years. These
decisions are important since they involve major cash outflows of the business.
There are advantages & disadvantages associated with different life span.
Different Lives &
Budget Constraint:
Companies and individuals running
different types of businesses have to make the choice of the asset according to
the life span of the project. Advantages of asset with a long life:
The advantage of a longer asset
life is that the cash flows from the project become more predictable, since
there are lesser cash outflows occurring during the life of the project.
Common life approach
In order to make the two
investment opportunities we equate the life of the two projects. We would
repeat the cash flow pattern of each project over a horizon that matches the
least common multiple of the lives of the two projects. For instance, if there
are two projects, and the life of first project is one year and that of the
second is two years, the least common multiple would be two and the cash flow
pattern of the project would be repeated for the next year, in order to make
the two projects comparable. Similarly, if first project has a life of two
years and second project has a life of three years, the least common multiple
would be six. In that case, the cash flows of the first project would be
repeated thrice and that of the second project would be repeated twice. Having
equated the lives of the project the net present value of both the projects can
be calculated and compared.
1) In Efficient Markets where
investors have almost equal information, Fair Value will basically match Market
Price. But, temporarily they can differ. Then what happens?
Usually, you think that whether
the price of the thing purchased by you have that much price or not. Similar
question will be asked in share trading
If Market Price < Fair Value:
then Stock is under valued by the Market. It is a bargain and investors will
rush to buy it. Therefore, Share’s Demand will rise and Market Price will rise
to match the Fair Value.
Dynamic Equilibrium
If Market Price > Fair Value
then Stock is Over Valued Share Price Valuation Perpetual Investment in Common
Stock: Perpetual Investment in Common Stock
Explain the impact of interest
rate on long term and short term bonds?
Interest Rate Risk for Long Term
Bonds (i.e. 10 year bonds) is more than the Interest Rate Risk for Short Term
Bonds (i.e. 1 year bonds) provided the coupon rate for the bonds is similar.
When investor buy a long term bond he is locked in investment for long term
period there are more chances of fluctuation in interest rate and the inflation
rate.
So, the impact of interest rate changes on
Long Term bonds is greater. Long Term
Bond Prices fluctuate more because their Coupon Rates are fixed (or locked) for
a long time even though Market Interest Rates are fluctuating daily; therefore
the price of Long Bonds has to constantly keep adjusting.
Price of the long term bond
fluctuates more as compared to the short term bond. Because, you have a long
term bond with fix coupon rate but the market interest rate is fluctuating in
between the years
Why does diversification reduce risk?
It states that don’t put all your
eggs in one basket. Diversification can reduce risk. By spreading your money
across many different Investments, Markets, Industries, Countries you can avoid
the weakness of each. Make sure that they are Uncorrelated so that they don’t
suffer from the same bad news. Due to certain change in the interest rates some
of the investments in your portfolio may go up and the others go downward.
Diversification
is a technique that reduces risk by investing among various financial
instruments, industries and other categories. It aims to increase return by
investing in different areas. Make sure that they are uncorrelated so that they
don’t suffer from the same bad news.
Diversification states “Don’t put all your eggs in one basket”
What are the effects of changes in macro interest rates on the portfolios of the bonds?
Macro Interest Rates have 2 Major
Impacts on the Portfolio (collection of bond investments) of the Bondholder:
(1) Interest Rate Risk: In this,
the value of Bond Portfolio Drops if interest rates Rise) and (2) Reinvestment
Risk: In this, the overall Rate of Return (or Yield) on the Bond Portfolio
Rises when interest rates rise the opportunity cost for the bond holder has
changed. For example, somebody may have bought a short term bond with coupon
rate of 15 % for one year. At maturity there is a risk that bondholder may not
find another investment that can yield as much as 15%. When old bonds mature,
bondholders are forced to invest in bonds at lower coupon rates). It is higher
for short term bonds.
Different types of investments
time horizons. 3 marks
There are two types of Investment
Time Horizons
 Finite Investment: In this duration of our investment is limited. Cash inflow from Forecasted Selling Price must be taken into account in price estimate.
 Perpetual Investment:
It is very long term horizon for
long term investment. It is Perpetual so Forecasted Selling Price not
significant and can be eliminated. If you are planning to buy and hold the
share for 20 or 30 years then you can consider it as a long term assets.
Similarly, an investment in the share for the period of one or two years
Value of a Share (which is a
Direct Claim Security) can be estimated based on the Cash Flows that is
generates. A Share generates Cash
Dividends just like a Real Asset Project generates Cash Income.
How to calculate NPV for different lives of projects? Any
one approach. 5
marks
marks
NPV is also the most important
criteria in capital budgeting. It is very difficult to calculate because
different inputs used in Net present value equation are based upon a forecast,
which may or may not be accurate e.g. future cash flows and sales. Similarly,
when we talk about the life of the project, again we are estimating the
duration of the project. We also have to choose subjectively the discount rates
to be used, including cost of capital, opportunity cost & required rate of
return in the calculation of Net present value. We will discuss how to choose
the interest rate when we would talk about risk. In NPV the idea is to bring
back each cash flow to the present and then to add or subtract them on present
time. The project or investment, which is offering the highest NPV, gets the
highest rank. Formula: NPV = Io + CFt / (1+i)t = Io + CF1/(1+i) + CF2/(1+i) 2
+ CF` /(1+i) 3 +..
Suppose there are 2 stocks in your investment portfolio,

Value of
investment

Expected IRR

A

40

30

B

60

20

Total

100


Calculate the expected portfolio return
Expected Portfolio return calculation:
rP = rA x A + rB x B
rP = 30% x (40 / 100) + 20% x (60 /
100)
rP = 0.12 + 0.12
rP = 0.24 or 24%
You want to start your business so you approach a bank.
The bank offers you to lend you Rs. 100000 and you sign a bond paper. The bank
asks you to issue a bond in their favor on the following requirement by bank.
Par value = Rs, 100000
Maturity = 2 years
Coupon rate = 12% Mark up paid at the end of each year
For the bank
What is the value of investing in a bond with that bank
has opportunity cost of 10%.
Cash flow = coupon value = par value x coupon rate
= 100,000 x 12%
= 12000
So,
PV = 12000 / 1.1 + 12000 / (1.1)2 +100000
/(1.1)2
PV = 103471
Perpetual investment for
preferred stock. (Marks 5)
Preferred
share holders get a preference over common shareholders in recovering their
money if the company goes bankrupt. Although preferred shareholders are owners
they may not get voting rights. It is also known as hybrid equity. As it is mix
of bonds and share. Preferred shareholders receive a fixed regular dividend.
Perpetual investmentmeans you are considering buying this stock and keeping
it forever.
PV =
DIV1/rPE
Where r
PE = Minimum Required Rate of Return on Preferred Stock Equity for the
individual investor
PV =
Present Market Value (or Estimated Present Price) which depends on
DIV
1 = Forecasted Future Dividend in the next period
Question No: 18 ( Marks: 3 )
What is a portfolio? Why an investor should invest
his/her funds in a portfolio rather than in the stocks of a single corporation.
YE QUESTION POST PAY A ANSWER MAY
B A JAY
Question
No: 42 ( Marks: 5 )
Draw
a three year time line which illustrates the following situation:
i. An outflow of Rs. 10,000 occurs at time 0
ii. Inflows of Rs. 5,000 occur at the end of year 1, 2
and 3.
iii. The interest rate during
the three year is 10%.
How
risk affects the share price? (2.5)
Coupon Rate = 15% p.a, Security = Machinery
You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option.(5 Marks)
You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option.(5 Marks)
3 Marks: Suppose ABC Company preferred stock is
sold for Rs. 30 with dividend of Rs. 5. What would be price of the preferred
stock of infinite life if required rate of return is 14%?
5 Marks: AB Company common stock was as under:

value

Exp return

Stock A

15

10

Stock B

20

15

You are required to compute the following:
A Expected value of Return
B Standard Deviation of Return