Pen & Paper Final Group I SFM April 10 Test 1 Answer

8/6/2019 Pen & Paper Final Group I SFM April 10 Test 1 Answer

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Pen & Paper : Examination

April 2010

CA FINAL-1 :STRATEGIC FINANCIAL MANAGEMENT

SOLUTION

Time Allowed: 3 Hours Max. Marks: 100

Answer 1Incremental CFAT and NPV (Rs. in lakhs)

Particulars 1 2 3 4 5Sales 300 300 300 300 300

Add: Cost Savings:

Maintenance(note2)

15 15 30 30 30

Costofutilities

2.5 2.5 2.5 2.5 2.5

LabourCosts (note3)

17.16 18.87 20.76 22.84 25.12

Less: Incremental Cost

Rawmaterials(note4)

142.5 142.5 142.5 142.5 142.5

Depreciation(note5)

25.2 25.2 54 54 54

Insurance(note6)

4.12 3.71 3.34 3 2.71

Earningbefore Tax

163.04 165.16 153.42 155.84 158.76

Less: Taxes(0.35)

57.064 57.806 53.607 54.544 55.426

Earningafter Taxes

105.976 107.354 99.723 101.296 102.934


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CFAT(EAT +Depreciation)

130.976 132.354 153.723 155.296 156.934

Salvage value 30

Release of working capital 50(x) PVfactor at .20

0.833 0.694 0.579 0.482 0.402

PV 109.10 91.85 89.01 74.85 95.25

Total present Value (t =1-5) 460.06

Less: cash outflow 276.55

NPV 183.51

Comments: Since the NPV is positive, replacement of the exiting machines is financially viable.

FINANCIAL ANALYSIS WHETHER TO REPLACE THE EXISTION MACHINES (USING NPVMETHOD)

Incremental cash outflows:Cost of 3 new machines (Rs.100 lakh 3) 300,00,000Additional working capital 50,00,000Less: Sale proceeds of existing machines 96,00,000Add: Removal cost of existing machines 4,80,000Tax on profit on sale of machine (working note1) 11,76,000Cost of laying off 34 workers (Rs.921000 tax advantage @ .35 i.e. to Rs.3,22,350) 5,98,650Incremental cash outflows 2,76,54,650

Working Notes1. Tax on profit on sale of existing machine:

Sale proceeds of existing machine: 96,00,000(8 12,00,000)

Less: Book value (Rs.18 lakh 8 Original Costaccumulated depreciation 28.80 3) 57,60,000

Gross profit 38,40,000Less: Removal Cost (60,000 8) 4,80,000

Net Profit 33,60,000Tax rate 0.35

Taxes payable on profit 11,76,000

2. Saving in Maintenance cost: (Rs. in lakhs)

Year 1 2 3 4 5OldMachine

22.5 22.5 67.5 67.5 67.5

NewMachine

7.5 7.5 37.5 37.5 37.5

Saving incost

15 15 30 30 30


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3. Savings in Labour cost:Existing labour cost:Unskilled (18 Rs.3,500 12 months) 7,56,000Skilled (18 Rs.5,500 12 months) 11,88,000Supervisor (3 Rs.6,500 12 months) 2,34,000

Maintenance (2 Rs.5,000 12 months) 1,20,00022,98,000Proposed labor cost:Skilled (6 Rs.7,000 12 months) 5,04,000Maintenance (1 Rs.6,500 12 months) 78,000

Cost savings 17,16,000

Savings in subsequent years will increase by 10%

4. Incremental cost of raw material:Raw material required for old machine:

(3000000 Rs.15 per unit 0.60) 2,70,00,000Raw material required for new machine(5000000 Rs.15 per unit 0.55) 4,12,50,000

Additional raw material Cost 1,42,50,000

5. Incremental Depreciation: (Rs. in Lakhs)Years 1 2 3 5Depreciation (with new machine) 54.00 54.00(Rs.100 lakh 3 10 3) / 5 yearsDepreciation (with old machine) 28.80 -(Rs.18 lakh 8/5 years)Incremental Depreciation 25.20 54.00

6. Insurance: (Rs. in lakhs)

Years 1 2 3 4 5

NewMachine

6.00 5.40 4.86 4.37 3.94

OldMachine

1.88 1.69 1.52 1.37 1.23

IncrementalInsurance

4.12 3.71 3.34 3.00 2.71


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Answer 2(a) If the yield of the bond falls the price will always increase. This can be shown by following calculation.IF YIELD FALLS TO 6%Price of 5yr. bondRs.80 (PVIFA 6%, 5yrs.) + Rs.1000 (PVIF 6%, 5yrs.)Rs. 80 (4.212) + Rs. 1000 (0.747)

Rs. 336.96 + Rs. 747 = Rs. 1,083.96.

Increase in 5 years bond price = Rs. 83.96

Current price of 20 year bondRs. 80 (PVIFA 6%, 20) + Rs. 1,000 (PVIF 6%, 20)Rs. 80 (11.47) + Rs. 1,000 (0.312)Rs. 917.60 + Rs. 312.00 = Rs. 1229.60So increase in bond price is Rs. 229.60

PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL5 yrs. Bond

Rs. 1,000 (PVIF 6%, 5) Rs. 1,000 (PVIF 8%, 5)Rs. 1,000 (0.747) Rs. 1,000 (0.681)Rs. 747.00 Rs. 681.00 = Rs. 66.00& change in price due to change in PV of Principal(Rs. 66/ Rs. 83.96) x 100 = 78.6%

20 yrs. BondRs. 1,000 (PVIF 6%, 20) Rs. 1,000 (PVIF 8%, 20)Rs. 1,000 (0.312) Rs. 1,000 (0.214)Rs. 312.00 Rs. 214.00 = Rs. 98.00& change in price due to change in PV of Principal(Rs. 98/ Rs. 229.60) x 100 = 42.68%

PRICE CHANGE DUE TO CHANGE IN PV OF INTEREST5 yrs. BondRs. 80 (PVIFA 6%, 5) Rs. 80 (PVIFA 8%, 5)Rs. 80 (4.212) Rs. 80 (3.993)Rs. 336.96 Rs. 319.44 = Rs. 17.52% change in price(Rs.17.52/ Rs.83.96) x 100 = 20.86%

20 yrs. BondRs. 80 (PVIFA 6%, 20) Rs. 80 (PVIFA 8%,20)

Rs. 80 (11.47) Rs. 80 (9.82)Rs. 917.60 Rs. 785.60 = Rs. 132& change in price = (Rs.132/ Rs.229.60 x 100) = 57.49%


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(b) Duration in the average time taken to recollect back the investment

Years(A)

Coupon Payments(Rs.)

Redemption(Rs.)

Total (B)(Rs.)

PVIF @ 7%(C) (Rs.)

(A )x(B)x (C)

1 70 - 70 0.935 65.45

2 70 - 70 0.873 122.223 70 - 70 0.816 171.36

4 70 - 70 0.763 213.64

5 70 - 70 0.713 249.556 70 1000 1070 0.666 4,275.72

ABC 5,097.94

years098.51000.Rs

94.5097.Rs

icePrPurchase

ABCDuration ==

=

(c) If YTM goes up to 10% , current price of the bond will decrease toRs. 70 x PVIFA (10%,6) + Rs. 1000 PVIF (10%,6)Rs. 304.85 + Rs. 564.00 = Rs. 868.85

Year (A) Inflow (Rs.) (B) PVIF @ 10% (C) (A )x(B)x (C) (Rs.)

1 70 0.909 63.63

2 70 0.826 115.64

3 70 0.751 157.71

4 70 0.683 191.24

5 70 0.621 217.356 1070 0.564 3,620.88

ABC 4,366.45

New Duration Rs. 4,366.45/ Rs. 868.85 = 5.025 yearsThe duration of bond decreases, reason being the receipt of slightly higher portion of ones investment onthe same intervals.

(d) Duration is nothing but the average time taken by an investor to collect his/her investment. If aninvestor 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. Higherthe coupon rate, lesser would be the duration.


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Answer 3(a) (i) According to Purchasing Power Parity forward rate is

t

r

r

F1

H1rateSpot

+

+

So spot rate after one year

1

03.01

065.0140.43

+

+

= 43.4 (1.03399)= 44.8751After 3 years

3

03.01

065.0140.43

+

+

= 43.40 (1.03398)

= 43.40 (1.10544)= Rs.47.9762

(ii) As per interest rate parity

S1 = S0

+

+

Bin1

Ain1

S1=0.7570

+

+

123)035.0(1

123)075.0(1

= 0.7570 1.0099 = 0.7645

S1 = UK 0.7645 / US$

(b) Earning per share for company K. Ltd. after Merger :Exchange Ratio 160 : 200 = 4: 5That is 4 shares of K. Ltd. for every 5 shares of N. Ltd.

Therefore, total number of shares to be issued =

5

4 2,50,000 = 2,00,000 shares

Therefore, total number of shares of K. Ltd. and N .Ltd.= 10,00,000 K. Ltd.+ 2,00,000 N. Ltd12,00,000

Total profit after Tax = Rs. 50,00,000 K. Ltd.Rs. 15,00,000 N Ltd.Rs. 65,00,000

Therefore, E.P.S. (Earning per share) of K. Ltd. after Merger= 65,00,000/ Rs.12,00,000= Rs.5.42 Per Share


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(ii) To find the Exchange Ratio so that shareholders of N. Ltd. would not be at a Loss:Present Earnings per share for company K. Ltd.= Rs.50,00,000/ Rs.10,00,000 = Rs.5.00

Present Earnings Per share for company N. Ltd.

= Rs.15,00,000/ Rs.2,50,000 = Rs.6.00

Therefore, exchange Ratio should be 6 shares of K. Ltd. for every 5 shares of N Ltd.Therefore, shares to be issued to N. Ltd.= (2,50,0006)/5 = 3,00,000 Shares

Therefore, total No. of Shares of K.Ltd. and N. Ltd.= 10,00,000 K. Ltd.+ 3,00,000 N. Ltd13,00,000

Therefore, E.P.S. After Merger= 65,00,000/13,00,000 = Rs.5.00 Per Share

Total Earnings Available to Shareholders of N. Ltd. after Merger= Rs.3,00,000 Rs.5.00 = Rs.15,00,000This is equal to Earnings prior Merger for N. Ltd.

Therefore, exchange ratio on the Basis of Earnings per Share is recommended.

Answer 4a)

1006.1

318.0

2586.008455.0

318.0

3)0162.007.0()0882.1(l

318.0

3)2

18.0

07.0()170185(l

t

t)2r()ES

(ld n

2

n

2

n

1

=

+=

++=

++=

++=

d2 = d1- t =1.1006-0.31177 = 0.7888

N(d1) = 0.8770 (from table)N(d2) = 0.7848

Value of option = 7848.02336.1

170245.162)7848.0(

e

170)8770.0(185)d(N

e

E)d(NV

21.02rt1s== =

= 162.245 108.151 = Rs.54.094.

(b) Total premium paid on purchasing a call and put option= (Rs.30 per share 100) + (Rs.5 per share 100).= Rs.3,000 + Rs. 500 = Rs.3,500(i) In this case, X exercises neither the call option nor the put option


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As both will result in a loss for him.Ending value = - Rs.3,500 + zero gain= - Rs.3,500i.e Net loss = Rs.3,500(ii) Since the price of the stock is below the exercise price of the call, the call will not be

exercised. Only put is valuable and is exercised.Total premium paid = Rs.3,500Ending value = Rs.3,500 + Rs.[(450 350) 100]= Rs.3,500 + Rs.10,000 = Rs.6,500Net gain = Rs.6,500(iii) In this situation, the put is worthless, since the price of the stock exceeds the putsexercise price. Only call option is valuable and is exercised.Total premium paid = Rs.3,500Ending value = -3,500 +[(600 550) 100]Net Gain = -3,500 + 5,000 = Rs.1,500

(c)(i)

PV of cash outflows under leasing alternative

Year After Tax LeasePayment

PVAF (14%, 4) Total PV

1 4 Rs.5,00,000 2.913 Rs.14,56,500

Calculation of instalment payable under Buying optionPresent Value Annuity Factor at 16% for 4 years. 2.798Value of Instalment = Rs.50,00,000/ 2.798 = Rs.17,86,990

Calculation of Interest component in Installments and tax benefit on interestcomponent.

(Amount in Rs.)

Period Loan inBeginning

Loaninstallment

Interest @16%

PrincipalRepayment

Principaloutstanding

1 50,00,000 17,86,990 8,00,000 9,86,990 40,13,010

2 40,13,010 17,86,990 6,42,082 11,44,908 28,68,102

3 28,68,102 17,86,990 4,58,896 13,28,094 15,40,008

4 15,40,008 17,86,990 2,46,982 15,40,008 Nil

(Balancing Figure)Calculation of Tax benefits on interest and Depreciation.

Period Interest Depreciation Total Tax Benefit1 8,00,000 7,50,000 15,50,000 7,75,000

2 6,42,082 7,50,000 13,92,082 6,96,041

3 4,58,896 7,50,000 12,08,896 6,04,448

4 2,46,982 7,50,000 9,96,982 4,98,491


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Present value of Cash Outflow under buying alternatives

Year Loaninstalment

Tax Savingson Interestand

Depreciation

Netoutflow

SalvageValue

PVF(14%)

Presentvalue

1 17,86,990 7,75,000 10,11,990 - 0.877 8,87,515

2 17,86,990 6,96,041 10,90,949 - 0.769 8,38,940

3 17,86,990 6,04,448 11,82,542 - 0.675 7,98,216

4 17,86,990 4,98,491 12,88,499 - 0.592 7,62,791

4 - - (20,00,000) 0.592 (11,84,000)

21,03,462Recommendation: The lease option is financially better.

(ii)Determination of Cash Flow after tax

Rs.Lease Rent receivable 10,00,000Less: Depreciation 7,50,000EBIT 2,50,000Less: Tax @ 50% 1,25,000EAT 1,25,000Add: Depreciation 7,50,000

8,75,000Determination of NPV

Particulars Year Cash Flows PVF @ 14 Present Value

Purchase of

Computer

0 (50,00,000) 1.00 (50,00,000)

Annual CashInflow

1-4 8,75,000 2.914 25,49,750

Salvage Value 4 20,00,000 0.592 11,84,000

(12,66,250)Recommendation: The proposal is not financially viable.

(iii) Let desired CFAT to earn a return of 16% is X, then

Rs.50,00,000 = = +

++

4

1t4)16.01(

000,00,20.Rs

)16.01(

X

Rs.50,00,000 = X (2.798) + Rs.20,00,000 (0.552)Rs.50,00,000 = 2.798 X +11,04,582Rs.38,95,418 = 2.798 XX = Rs.13,92,215Thus, lease rent for IRR of 16% should be Rs.13,92,423.


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Answer 5

(a) Investment AEconomic

Climate

Probability (P) Returns %

(RA)

P RA RA - AR P(RA - AR )2

DullStable

Growth

0.20.50.3

101420

276

%15

-5-15

5.00.57.5

00.13

So, the variance of return of A is 13 and the standard deviation A = 00.13 =3.6%.

Investment B

EconomicClimate

Probability (P) Returns %(RB)

P RB RB - BR P(RB - BR )2

DullStable

Growth

0.20.50.3

61511

1.27.53.3

%12

-63-1

7.24.50.3

00.12

Variance of Investment B is 12 and the standard deviation is B = 00.12 =3.46%.

In case, one half of the total amount is invested in Investment A and done half in Investment B,the risk of the portfolio can be calculated as follows:

EconomicClimate

Probability(P)

Returns % (RA) P R R- R P(R- R )2

Dull

StableGrowth

0.2

0.50.3

(10+6)/2=8.0

(14+15)/2=14.5(20+11)/2=15.5

1.60

7.254.65

R =13.50%

-5.5

1.02.0

6.05

0.501.20

75.7

The variance of the portfolio is 7.75 and the standard deviation is

(A+B)= 75.7 = 2.78%

Hence, the expected return from the portfolio is 13.50% and the standard deviation of theportfolio is 2.78%.Covariance (A,B) of the portfolio can be found as follows:

Economic

Climate

Probability (P) RA - AR RB - BR P(RA - AR ) (RB - BR )

DullStable

Growth

0.20.50.3

-5-15

-63-1

6.0-1.5-1.5

So, the covariance (A, B) is 3.Now, the correlation between A, B may be found as follows:Correlation, PAB= covariance (A, B)/AB = 3.0/(3.63.46) = 0.24


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(b)Expected rate of return of shares of ABC Ltd:= %142

1711

n

R=

+=

Expected rate of return of shares of PQR Ltd:= %142

820=

+

Expected rate of portfolio (50% of ABC Ltd. and 50% of PQR Ltd.) = (0.514%)+(0.514%)=14%

Expected rate of portfolio (60% of ABC Ltd. and 40% of PQR Ltd.) = (0.614%)+(0.414%)=14%

Standard deviation of ABC Ltd. shares= A = 32

)1417()1411( 22=

+

Standard deviation of PQR Ltd. shares= P = 62

)148()1420( 22=

+

Covariance between ABC Ltd. and PQR Ltd.:

Cov = )RR)(RR(N1

n

1i

PPAA= = )148)(1417()1420)(1411(

21 + = -18

Coefficient of Correlation= Covariance of ABC & PQR = -18 =AP 63

Portfolio risk in case ABC Ltd. and PQR Ltd. are invested in the ratio of 2:1:21

PAAPPA2P

2P

2A

2A ))r(2( ++= =

0)631(3

1

3

2236

3

19

3

22

122

=

+

+

Portfolio risk in case ABC Ltd. and PQR Ltd. are invested in the ratio of 1:1= =

5.1)631(2

1

2

1236

2

19

2

1 21

22

=

+

+

(c) Calculation of Present Value of Dividend Income(Figures in Rs.)

Date Div. @ 10% Div. after tax PV factor PV

31.3.2003 100 80 0.91 72.80

31.3.2004 100 80 0.83 66.40

31.3.2005 100 80 0.75 60.00

31.3.2006 100 80 0.68 52.40

31.3.2007 140 112 0.62 69.44Total PresentValue

Rs. 321.04


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Calculation of present value of sale proceeds:

Selling price of 140 shares @ Rs.50 on 31.3.2006 Rs.7000

Less : Total Cost of shares (100 Rs. 30) Rs.3000

Capital gain Rs.4000

Capital gain tax @ 15% Rs.600

Net gain Rs.3400Total cash inflow (3400+3000) Rs.6400

(This amount is receivable on 31.3.2008 i.e after 6 years from the date ofpurchase).

PV Factor @ 10% for 6 years 0.56

Present value of Rs.6400 64000.56=Rs.3584

Total present value of inflows (3584 + 321.04) Rs.3905.04

Less : cash outflow (cost of purchases) Rs.3000.00

Net present value (gain) Rs.905.04

Since, the net present value (gain) of the investment in shares of A Ltd. is positive @ 10%, therefore,

investor X is getting a return on his investment at a rate more than 10%.

Answer 6

a) Credit DerivativesCredit derivative is an instrument designed to segregate market risk from credit risk to allow theseparate trading of credit risk. Credit derivatives allow a more efficient allocation and pricing ofcredit risk. Credit derivatives are privately negotiated bilateral contracts that allow users tomanage their exposure to credit risk. For example, a bank concerned that one of its customersmay not be able to repay a loan can protect itself against loss by transferring the credit risk toanother party while keeping the loan on its books. This mechanism can be used for any debtinstrument or a basket of instruments for which an objective default price can be determined.

Credit derivatives are traded over- the counter (OTC) in developed markets. OTC trades arecontracts negotiated between counter parties that take place outside the regulated exchanges. Thispermits maximum flexibility in structuring a contract that meets the needs of both parties.

Types of Credit Derivatives

The product menu in the credit derivatives market is changing every day, but there are four majorinstruments that make up the bulk of the trading volume today: Total Return Swaps, CreditDefault Swaps, Credit Spread Options and Credit Linked Notes. Terminology varies amongmarket participants, sometimes based on geography. For example, Credit Default Swaps aresometimes called Credit Swaps.

The benefits associated with credit derivatives:

A loan portfolio manager can achieve any of the following objectives through credit derivatives:Control credit risks of any debt instrument or basket of instruments by selling or transferring thecredit exposure of the portfolio.Reduce a particular risk concentration in the portfolioCreate synthetic assets tailored to meet their needsProvide a diverse menu of global exposures to achieve portfolio diversificationGain exposure to another banks loan portfolio without participating in the syndicate.


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b) Translation ExposureTranslation exposure is the risk of the change in the domestic financial performance and positionbecause of the fluctuating value of assets and liabilities denominated in foreign currencies. Itdoes not represent real movements of cash between different currency systems, but can clearlyimpact both the profit and loss account and the balance sheet on stand alone basis as well as on

consolidated basis. The balance sheet effects are often dismissed as illusory since they have nocash impact. However the level of assets and liabilities can affect financial ratios calculated usingbalance sheet figures, which causes practical problems where the company has restrictions on itslevel of borrowings placed by covenants.Translation exposure is the difference between exposed assets and exposed liabilities. A greateramount of exposed assets than liabilities will give rise to a positive exposure while a greateramount of liabilities than assets will give rise to a negative exposure. Companies have at leastthree available methods for managing their translation exposure:

Adjusting fund flows Entering into forward contracts Exposure netting

Basic hedging strategy for reducing translation exposure is to increase hard currency (likelyto appreciate) assets and decrease soft currency (likely to depreciate) assets, whilesimultaneously decreasing hard currency liabilities and increasing soft currency liabilities.Thus if devaluation appears likely, the basic hedging strategy would be:

Reduce level of cash Tighten credit terms to decrease accounts receivable Increase local currency borrowing Delay accounts payable Sell the weak currency forward.

c) Random Walk HypothesisThe random walk hypothesis claims that stock prices follow a random or erratic pattern. That is,people who believe is this theory claim that price movements are unpredictable and as a result,theres little that you can do to predict future behavior. An efficient market is one in which themarket price of the security always fully reflects available all information, so it is difficult, if notimpossible to consistently outperform the market by picking undervalued stocks. It is argued thatin an efficient market, random price movements simply reflect a highly competitive marketwhere investors quickly use and digest any new information. This competition holds securityprices close to their correct (justified) level; as new information becomes available (in a randommanner); adjustments in price are random and quick to follow.

To outperform the market, one must consistently earn more than the required rate of return onsecurities. In other words, one must be able to consistently find stocks selling below theirjustified prices, and then realize the expected return on the security. In an efficient market,current prices reflect all information; therefore, current prices equal justified prices, and investorscan expect to earn only the required (risk- adjusted) rate of return.

I. Efficient markets do not make high rates of return unavailable, but they make it (nearly)impossible to consistently earn returns higher than the rates of return required for the risk


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levels of the securities purchased. Hence a stock with high rates of return will also be morerisky.

II. Investors can earn high rates of return through luck, or through accepting stocks withhigher risks. They can also minimize transaction and tax expenses, along with unnecessaryrisk, to make their returns more satisfactory.

Random walks offer a serious challenge to technical analysis. If prices fluctuations arepurely random, charts of past behavior cannot produce significant trading profits. If themarket is efficient, shifts in supply and demand occur so rapidly that technical measuressimply measure the past and have no implications for the future Whats more, in anefficient market, extreme competition among investors will keep security prices at or veryclose to their justified levels, so fundamental analysis will not lead to returns above thoserequired by the amount of risk exposure.

d) Capital Market and Money MarketCapital market Money marketCapital market id classified into primary

and secondary marketNo such classification exists

Long term Financial instruments are usedmeeting long term fund requirements

Short term financial instruments are usedfor short term financial needs or investmentof surplus fund

Regulated by SEBI Regulated by RBI/ FIMMDA

Typical instruments are shares, debts andmutual fund

Typical instruments are commercial papers,T-Bill, G-sec etc

Participants are mainly institutional playersas well as retail investors

Participants are mainly banks/ FIs, RBI andhighly rated corporate

Exchange traded OTC

Pen & Paper Final Group I SFM April 10 Test 1 Answer

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