SANJAY SARAF

Q1) Ranke Exports in Mumbai exports washing machines to Australia by importing

all the components from Sweden. The company is exporting 4,500 units at a price of
AUS$ 200 per unit. The cost of imported components is SKr 550. The fixed costs and
other variable costs per unit are Rs.1,000 and Rs.2,000 respectively. The cash flows in
foreign currencies are due in six months. The current exchange rates are as follows:
Rs./AUS$ : 33.80/85
Rs./SKr : 5.90/5.95
After six months the exchange rates (at the time of receipt and payment of foreign
currency) turn out as follows:
Rs./AUS$ : 34.30/35
Rs./SKr : 6.40/45

Required:
a. Calculate the loss/gain due to the transaction exposure.
b. Based on the following additional information, calculate the loss/gain due to
transaction and operating exposure if the contracted price of washing machine is
Rs.7,000.
• The current exchange rates change to
Rs./AUS$ : 34.00/05
Rs./SKr : 5.70/75
• Price elasticity of demand of the product in Australia is estimated as 1.5.
• Payment and receipts are to be settled/received at the end of six months

10 Marks

Solution
a. Profit at the current exchange rates = 4,500[200x 33.80 – (550 x 5.95 + 1,000 + 2,000)]
= 4,500[ 6760 - 6272.50]
= Rs.21.94 lakhs

Profit after the change in exchange rates = 4,500[200x34.30–(550x6.45+ 1,000+2,000)]

= 4,500[ 6,860- 6,547.50]
= Rs.14.06 lakhs
Loss due to transaction exposure = 21.94 – 14.06
= Rs.7.88 lakhs

b. Profit based on new exchange rates = 4,500 [7,000- (550 x 5.75+ 1,000+ 2,000)]
= 4,500 [7,000 – 6,162.50]
= Rs.37.69 lakhs

Profit after change of exchange rates at the end of six months

= 4,500 [7,000 (550 x 6.45+1000+2000)]
= 4,500 [7,000 – 7,375]
= Rs.20.36 lakhs
Decrease in profit due to transaction exposure = 37.69 – 20.36= Rs.17.33 lakhs
SANJAY SARAF

Current price of each unit in AUS$ = 7,000/33.80 = AUS$ 207.10

After the change in exchange rate, price per unit in AUS$ =7,000/34.00 = AUS$ 205.88
% reduction in price = (207.10 - 205.88)/207.10
= 0.59%
Increase in demand due to reduction price = 0.59 x1.5 = 0.89%
Size of the increased order = 4,500 x(1 + 0.0089)
= 4540.05
Say 4,540 units
Profit = 4,540 [7,000-(550 x 6.45+ 1,000+ 2,000)]
= 4,540 [7,000 – 6,547.50]
= Rs.20.54 lakh
Decrease in profit due to operating exposure
= Rs.37.69 lakh – Rs.20.54 lakh
= Rs.17.15 lakh

Q2)
The following information is available for company X and Y:

Company X Y
Profit after tax 120 crore 45 crore
Number of outstanding shares 35 crore 10 crore
Market price per share Rs.22 Rs.35

Company X is planning to acquire company Y. The acquisition is expected to be done

through swap of stocks in which 2 shares of company X will be given for every share of
company Y.
The management of X makes a projection that the combined entity will have an expected
P/E ratio of 8 with a standard deviation of 2. The shareholders of company X will accept
the merger if the probability of the merger being beneficial is more than 70%.
You are required to
a. State whether the merger is acceptable to X.
b. State whether the merger is acceptable to Y at a combined P/E of 8. Show all the
necessary calculations.
c. Price of the combined entity if the swap ratio is 2:1 and P/E is 8. Also calculate the
gain or loss to the shareholders of company Y.

10 Marks
Solution

Maximum exchange ratio acceptable company X is given by

22= [(PATx+PATy)/Nx+rNy)] x P/E
Exchange ratio is given as 2

22 = [(120+45)/(35+10 x2)] x P/E

Solving we get, P/E = 7.33
SANJAY SARAF

For the merger to be beneficial, PE ratio should be at least 7.33. However, the expected
PE is 8. The probability the merger is beneficial can calculated as follows:
Z value= (x - µ)/ð
= (7.33-8)/2
= –0.34
Probability of PE12 falling below 7.33 = 0.3632 i.e. 36.32%
The probability that the merger will be beneficial = 1 – 0.3632 = 0..6368 i.e. 63.68%
which is more than desire a 70%. Therefore merger will be acceptable to X.

Minimum exchange ratio acceptable to Y would be given by

35 = [(PATx+PATy)/Nx+ rNy)] x P/E x r
= [(120+45)/ (35+10 x r)] x 8 x r
Solving we get, r = 1.26

As the minimum exchange ratio acceptable to shareholder of Y is lower than the agreed,
merger will be acceptable.
Combined EPS after merger,

Price after merger = 3 x 8 = Rs 24

Gain to shareholders of Y = 24 x10 x 2 – 35 x 10
= Rs (480 – 350) = Rs 130 crore.
Gain to the shareholders of X = 35 x 24 – 35 x 22 = Rs 70 crore.

Q3a)
EG Projects Ltd. has undertaken a project a few years ago. The project is still running and
has a remaining useful life of 6 years. The company now feels that the project does not fit
into its overall strategy and is considering whether it should be abandoned. The following
information is available:
Year Cash flow Value if sold
(Rs.Crore) (Rs.Crore)
1 175 510
2 200 475
3 235 400
4 350 300
5 400 200
6 100 50
The cost of capital of the company is 22%.
You are required to determine whether the project should be abandoned, and if yes, in
which year.
6 Marks
Solution
SANJAY SARAF

As the value that can be obtained by continuing is higher than the abandonment value for
all years, it is not desirable to abandon the project at any point of time.

Q3b)
One of the largest FMCG producers is planning to take a venture in retail business of
consumer goods through their discount stores. Average cost of capital of this company is
12%. As the company is taking up a new project they decided to appraise the project with
risk adjusted discount rate method. They also found that the premium for the normal risk
of the firm is twice the premium for the extra risk of the project. Risk free rate prevailing
in the market is 7%. Estimated initial investment for this project is Rs.100 crores.
Company requires recovering the investment amount at risk adjusted rate within next two
years of operation. Cash flows related to this project are expected to be as follows:
(Rs. in Crores)
Year Cash Flow
0 (100)
1 60
2 55

You are required to find out the cut-off premium for normal risk of the company to
fulfill their objective.

(6 Marks)

Solution
Let’s risk adjusted discount rate (RAD) is r.
As the company wants to recover whole of its investment i.e., Rs.100 crores in first two
years of operation, then present value of projected cash flows from first two years of
operation should be equal to Rs.100 crores.
SANJAY SARAF

Where,
Initial outlay (I) = Rs.100 crores
Cash flow in year 1 = Rs. 60 crores
Cash flow in year 2 = Rs. 55 crores.

or, 100(1+ r)2 = 60 (1+r) + 55 [Multiplying both side by (1+r)2]

or, 100 (1 + 2r + r2) – 60 (1 + r) – 55 = 0
or, 100r2 + 200r + 100 – 60 – 60r – 55 = 0
or, 100r2 + 140r – 15 = 0
or 20r2 + 28r – 3 = 0 [Dividing by 5]

The minimum risk adjusted discount rate should be 10%. We know risk adjusted
discounted rate (r)
= rf + rn + ra Where,
rf = Risk free rate.
rn = The premium for normal risk of the firm
ra = The premium for the abnormal or subnormal risk of the project compared to the
normal risk of the firm.

Here rn = 2ra and rf = 7%

0.10 = 0.07 + rn + ra
or rn + ra = 0.10 – 0.07
= 0.03
or rn + 0.5rn = 0.03
or rn = 0.02
Maximum or cut-off premium for normal risk of the firm would be 0.02 or 2%.
Q4) M/s Vishal Industries have issued earlier a 11.5% convertible bond of face value
Rs.1,000 maturing in 2007 A.D. After a period of 3 years on the option of the investor
each of these bonds can be converted into 50 equity shares of face value Rs.10 at a
premium of Rs.10 each. The investment value of similar non-convertible bond is Rs.870.
The current market prices of the bond and the share are Rs.970 and Rs.18.50 respectively.
The dividend per share for 2000-2001 is Rs.2.12.
SANJAY SARAF

You are required to calculate

a. Premium over conversion value
b. Premium over investment value
c. Conversion parity price of share
d. Break even period.
8 Marks

Solution

a. Premium over conversion value = (Bond Price-Conversion Value)/Conversion

Value
= (970-18.5 x 50)/(18.50 x 50)
= 0.0486 = 4.86%
b. Premium over investment value = (Bond Price-Investment Value)/Investment
Value
= (970-870)/870
= 0.1149 = 11.49%

Conversion parity price of share = Bond Price/Number of shares on conversion

per bond
= 970/50
= Rs. 19.40
The ratio indicates that the price should rise by about 0.9 (i.e. 19.4 – 18.5) which is
4.86% of Rs.18.5 so that parity is reached.
d. Break even period = Conversion Premium/(Interest Income-
Dividends)
= (970-18.5 x 50)/(115-2.12 x 50)
= 45/9 = 5 years
The period of 5 years indicates that with the present projections the bond holders should
plan for a holding horizon of 5 year before converting into stock.

Q5) Mr. Mallik, feels that Indian stock markets recently has exhibited weak form of
market efficiency. In order to test the validity of his impression, he collected some data
relating to movement of sensex for the last 20 trading days which is as follows :

Days Open High Low Close

1 3470.94 3513.79 3438.03 3453.99
2 3453.63 3478.11 3427.82 3434.83
3 3414.06 3440.29 3397.65 3431.93
4 3434.94 3446.18 3377.58 3383.41
5 3372.92 3380.27 3352.12 3370.93
6 3375.82 3389.49 3331.42 3340.75
7 3340.89 3340.89 3310.95 3330.98
8 3326.84 3340.91 3306.17 3335.08
9 3307.16 3338.22 3296.43 3301.97
SANJAY SARAF

10 3298.64 3318.6 3254.28 3259.03

11 3260.04 3278.85 3241.66 3251.53
12 3255.92 3289.46 3249.46 3285.89
13 3288.86 3535.67 3255.98 3329.28
14 3335 3346.21 3276.72 3284.17
15 3293.83 3310.86 3278.54 3298.78
16 3300.02 3337.79 3300.02 3325.38
17 3323.36 3356.34 3322.44 3329.95
18 3322.81 3345.98 3317.44 3319.67
19 3317.51 3321.18 3294.19 3302.32
20 3290.86 3324.96 3279.62 3319.61

Test for efficiency of the market using Auto-Co-relation test.

10 Marks
Solution
Period Sensex Change Period Sensex Change
I closing (X) II closing (Y)
1 3453.99 0 11 3251.53 -7.5
2 3434.83 -19.16 12 3285.89 34.36
3 3431.93 -2.9 13 3329.28 43.39
4 3383.41 -48.52 14 3284.17 -45.11
5 3370.93 -12.48 15 3298.78 14.61
6 3340.75 -30.18 16 3325.38 26.6
7 3330.98 -9.77 17 3329.95 4.57
8 3335.08 4.1 18 3319.67 -10.28
9 3301.97 -33.11 19 3302.32 -17.35
10 3259.03 -42.94 20 3319.61 17.29

(X- Mean
X- Mean Y-Mean (X- Mean (Y- Mean X)(Y-Mean
X Y X Y X)2 Y)2 Y)
(19.16) 34.36 2.50 26.80 6.25 718.24 67.00
(2.90) 43.39 18.76 35.83 351.94 1283.79 672.17
(48.52) (45.11) (26.86) (52.67) 721.46 2774.13 1414.72
(12.48) 14.61 9.18 7.05 84.27 49.70 64.72
(30.18) 26.60 (8.52) 19.04 72.59 362.52 (162.22)
(9.77) 4.57 11.89 (2.99) 141.37 8.94 (35.55)
4.10 (10.28) 25.76 (17.84) 663.58 318.27 (459.56)
(33.11) (17.35) (11.45) (24.91) 131.10 620.51 285.22
(42.94) 17.29 (21.28) 9.73 452.84 94.67 (207.05)
(194.96) 68.08 2625.40 6230.77 1639.44
SANJAY SARAF

σx = (2626.40/8)^1/2 = 18.12
σy = (6230.77/8)^1/2 = 27.91

Cov(x,y) = 1639.44/8 = 204.93

r = 204.93/(18.12 x 27.91) = 0.405

Hence, there is moderate degree of correlation between the returns of two periods and we
can conclude the market does not exhibit weak form of efficiency.

Q6) A speculator is expecting significant depreciation of Yen against dollar over the
next six months. The current $/100¥ spot rate is 0.8805. The following European call
options are traded at the market:

The speculator wants to make profit by using above call options.

You are required to
a. Suggest an appropriate spread strategy explaining the reason for the same.
b. Show the pay-off profile and pay-off diagram for the strategy for a range of values
between 0.0080 $/¥ to 0.0090 $/¥.
c. Calculate break-even rate, maximum profit and maximum loss from the strategy.

10 Marks

Ans.
a) As the speculator is bearish on yen, so he will go for bearish call spread on Yen
options. So he will buy the higher strike call and sell the lower strike call. The spread
strategy will give profit if Yen depreciates against dollar.

b) Pay-off Profile = Buy call at 0.0087 at premium 0.0015 and sell call at 0.0083 at
premium 0.0025
SANJAY SARAF

Pay-Off Diagram

C)
Break-even rate = 0.0084 $/¥
Maximum profit = 0.0001 $/¥
Maximum loss = –0.0003 $/¥

Q7) A trader has gone long on 5 Brent crude futures for December settlement at
$26.32 per barrel. The minimum contract size for Brent futures contract is 100,000 barrel.
The initial margin is $50,000 and the maintenance margin is $30,000. The futures close at
the following prices on the next ten trading days:

Day 1 $ 26.19
Day 2 $ 26.30
Day 3 $ 26.45
Day 4 $ 26.48
Day 5 $ 26.34
Day 6 $ 26.21
Day 7 $ 25.98
SANJAY SARAF

Day 8 $ 25.87
Day 9 $ 25.90
Day 10 $ 25.95

The trader will take out the profit out of the margin account whenever he gets the
opportunity to do so.
You are required to
a. Prepare the margin account showing all the cash flows.
b. Find the profit/loss for the trader after 10 trading days.

10 Marks
Ans.
Initial margin for 5 contract = 5 x $50,000 = $2,50,000
Maintenance margin for 5 contracts = 5 x $30,000 = $1, 50,000

Profit/loss = Closing balance in Margin account + Profit withdrawn – [Opening balance

in margin account + Margin calls]
= 2,35,000 + (65,000 + 15,000) – [2,50,000 + (1,35,000 + 1,15,000)]
= ($1,85,000)

Q8) Diva Jewellery Exporters, Chennai received orders to export diamond jewellery to
USA at the rate of one consignment every month in January, February and March, 2007.
Amounts will be received at the end of each month. The company has the option to
invoice the exports either in US $ or Euro. The value of the shipments in US$ and Euro is
as under:
SANJAY SARAF

You, as the Finance Manager of the Company have the following forecast for the
exchange rates at the end of the following months:

The current forward rates in the market are as under:

You are required to find out the rupee inflows and suggest the currency of invoicing for
each consignment:
i. If the exposure is hedged.
ii. ii. If the exposure is left uncovered.

8 Marks

Ans.
Rs. / Euro rates can be calculated as follows:

Forward rates
Date (Rs. / $)bid × ($ / Euro) bid Rs.
January,2007 46.04 X 1.2803 58.95
February,2007 46.11 X 1.2822 59.12
March,2007 46.13 X 1.2828 59.18

Expected rates
Date (Rs. / Euro)bid (Rs. / $)bid × ($ / Euro) bid Rs.
January,2007 45.98 X 1.2786 58.79
February,2007 46.05 X 1.2806 58.97
March,2007 46.07 X 1.2811 59.02
SANJAY SARAF

All the three consignments have to be invoiced in Euro and hedged to receive more cash
flows.

Q9a) The following information is available for a close ended fund for the last twelve
months: Return on the market index for the twelve months is 10.45%. The standard
deviation of monthly returns on the market index is 16.25(%) and coefficient of
determination of the fund’s return with market index is 0.50. The risk free rate of return is
6.85%.
Required:
a. If an investor has bought 100 units of this mutual fund at the beginning and sold at the
end of the year, calculate his annual return.
b. Calculate the Sharpe ratio, Treynor ratio and Jensen’s alpha for the fund.

6 Marks

Ans.
SANJAY SARAF

Ans.
a.
Cost of purchasing mutual fund units = 10 x 100 = Rs.1,000
Selling price = 10.75 – 0.105 = Rs.10.645 x 100 = 1064.5
Annual return = (1064.5-1000)/1000 = 6.45%

b.

X = 12.55/12
= 1.046%, monthly average return = 1.046%
SANJAY SARAF

As we have calculated monthly SD and average return, monthly risk free return should be
used here

Q9b) The following figures are collected from the annual report of XYZ Ltd.
(Rs)
Net profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
What should be the approximate dividend pay-out ratio so as to keep the share price at Rs
42 by using Walter model?
6 Marks
Solution
EPS = Equity Earnings / n = (30 – 12% of 100) / 3 = 6
Target price = 42
Therefore = P/E ratio = 42 / 6 = 7
Therefore, Re = 1 / P/E ratio = 1 / 7 = 14.29%
As per Walter Model,
Price = [D + (E - D) x (r/Re)] / Re
42 = D – (6 – D) x (0.2/0.1429) / 0.1429
6 = D – 6 + D x 1.4
SANJAY SARAF

Therefore D = 6
i.e. Pay-out ratio has to be 100% for the price to be 42.
However, since r> Re, i.e. NPV > 0, optimum pay out ratio as per Walter = 0, i.e. D =0. If
this were followed, price would be even higher.

Q10) Global Technologies Ltd. designs, manufactures and markets all the necessary
equipment for mid range and super specialty hospitals. The company had reported
earnings per share of Rs.2.25 in the current year, and paid no dividends during the year. It
had revenues of Rs.11.84 per share, capital expenditures of Re.0.57 per share and
depreciation of Re.0.24 per share in the current year respectively. Earnings and revenues
are expected to grow 18% a year during the next five years. The growth rate is expected
to decline linearly over the subsequent five years, and then stabilize at a rate of 8%.
During the high growth and transition periods, capital spending and depreciation are
expected to grow at the same rate as earnings, but are expected to offset each other when
the firm reaches steady state. The net working capital is expected to be 70% of revenues.
The current debt ratio for the company is 12% and is expected to remain the same even in
future.
The stock is expected to have a beta of 1.25 for the high growth period, and it is expected
to decline linearly to 1.10 by the time the firm goes into steady state. The risk-free rate is
5.5%, and the market return is 10.5%.
You are required to estimate the present value of share, using the Three-Stage FCFE
model.

Ans.

Value of the stock = PV of the FCFE in the high growth period +PV of the FCFE in the
Transition phase
FCFE = Earnings-(Capital Expenditure-Depreciation)(1-debt Ratio) –(Change in WC)(1-
Debt ratio)

High Growth Period 1 2 3 4 5

Growth Rate 18% 18% 18% 18% 18%
Earnings 2.66 3.13 3.7 4.36 5.15
a. CAPEX-Depreciation 0.39 0.46 0.54 0.64 0.76
b. Change in the WC 1.49 1.76 2.08 2.45 2.89
c = a+b 1.88 2.22 2.62 3.09 3.65
c(1-Debt Ratio) 1.65 1.95 2.31 2.72 3.21
FCFE 1.01 1.18 1.39 1.64 1.94
Beta 1.25 1.25 1.25 1.25 1.25
1+Cost of Equity as per CAPM 1.1175 1.1175 1.1175 1.1175 1.1175
PV 0.90 0.94 1.00 1.05 1.11

Transition Period 6 7 8 9 10
Growth Rate 16% 14% 12% 10% 8%
SANJAY SARAF

Earnings 5.97 6.81 7.63 8.39 9.06

a. CAPEX-Depreciation 0.88 1 1.12 1.23 0
b. Change in the WC 3.03 3.08 3.01 2.81 2.48
c = a+b 3.91 4.08 4.13 4.04 2.48
c(1-Debt Ratio) 3.44 3.59 3.63 3.56 2.18
FCFE 2.53 3.22 4.00 4.83 6.88
Beta 1.22 1.19 1.16 1.13 1.1
1+Cost of Equity as per CAPM 1.1160 1.1145 1.1130 1.1115 1.1100
PV 1.30 1.49 1.65 1.80

FCFE in the Terminal Year 6.88

Terminal Value at the end of year 9(N-1) 229.33
PV of Terminal Value - a 85.51
Cost of Equity 11.10%
Total of Cash Flow of Growth Phase-b 5.01
Total of Cash Flow of Transition Phase-c 6.24
Value of Stock (a+b+c) 96.76

N-1: Terminal Value = 6.88/(0.11-.08) 229.33

Change in WC
Revenue WC =
Per 0.70* Change
Year Share Revenue in WC
0 11.84 8.29 0.00
1 13.97 9.78 1.49
2 16.49 11.54 1.76
3 19.45 13.62 2.07
4 22.96 16.07 2.46
5 27.09 18.96 2.89
6 31.42 21.99 3.03
7 35.82 25.07 3.08
8 40.12 28.08 3.01
9 44.13 30.89 2.81
10 47.66 33.36 2.48