MGT201 mid term past old paper

MGT201…. Midterm Subjective

Suppose ABC Company is given Rs. 3 as a 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 high-risk 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/(1-g)

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 paying-off 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)

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%

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 well-aquatinted 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. MARKS-5

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 re-arrange 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 PQ-VQ-F = 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 Un-Levered) and rE = 30% then what is the WACCU of Un-levered Firm?

1) Net income = EBIT - I - Tax

= 1000 - 0 - 30% (0.3)

= 700

2) Equity (Un-L) = NI/Re

= 700/30% (0.3)

= 2334

3) WACC(Un-L) = 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 Un-levered firm.....

If the Firm takes Rs.1000 Debt at 10% Interest or Mark-up 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 (Un-L) = 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 paying-off 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 interest-bearing 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 economy-wide 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, average-risk projects for the firm. Project A has an expected life of 2 years with after-tax 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 after-tax 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 σ A 2 +XB2 σ B 2 + 2 (XA XB σ A σ 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 Un-Correlated 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+(200-100)/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 ten-year bonds (par Rs. 1,000) with an annual coupon of 8.6%. Similar ten-year 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 semi-annually, 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, I₀ = Rs 10,000

                  Cash flow in yr 1, CF₁ = Rs 6500

                  Cash flow in yr 2, CF₂ = Rs 3000

                  Cash flow in yr 3, CF₃ = Rs 3000

                  Cash flow in yr 4, CF­₄ = Rs 1000

                  Discount rate, I = 12 %

                  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 + 6500/(1.12) + 3000/(1.12)²+ 3000/(1.12)³+ 1000/(1.12)⁴

         =  Rs 966

Project Y: Initial investment, I₀ = Rs 10,000

                  Cash flow in yr 1, CF₁ = Rs 3500

                  Cash flow in yr 2, CF₂ = Rs 3500

                  Cash flow in yr 3, CF₃ = Rs 3500

                  Cash flow in yr 4, CF­₄ = Rs 3500

                  Discount rate, I = 12 %

                  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 + 3500/(1.12) + 3500/(1.12)²+ 3500/(1.12)³+ 3500/(1.12)⁴

         =  Rs 631

3. IRR:  Project X: Put NPV = 0

             NPV = - 10000 +  6500/(1+i) + 3000(1+i)²+ 3000(1+i) ³+ 1000/(1+i) ⁴

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:

1. 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
2. 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

3. Eurobonds: it issued from a foreign country
4. 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 high-risk debt with rating below BB by S&P
5. 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 Company-Specific 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 changes 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

1. Finite Investment: In this duration of our investment is limited. Cash inflow from Forecasted Selling Price must be taken into account in price estimate.
2. 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

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)

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