Subject: Financial Management

Question A (1) Mr. Nimish holds the following portfolio. Share Alpha Beta Carrot Beta 0.9 1.5 1.0 Investment Rs.12, 00,000 Rs. 3, 50,000 Rs. 1, 00,000

What is the expected rate of return on his portfolio, if the risk rate is 7 per cent and the expected return on the market portfolio is 16 per cent?

Answer A (1): For given bata (), the required rate of return is obtained as E(rp) = rf + (rm rf)
E(rp) = Expected return from portfolio rf = Risk free rate of return
(Note: individual investments may consider as risk free)

rm (rf = 7% = 0.07,

= Systematic risk of asset, beta = Expected rate on market portfolio

rm = 16% = 0.16)

Therefore, E(rp) = 0.07 + (0.16 0.07) = 0.07 + 0.09 Share Alpha Beta Carrot Portfolio Beta 0.9 1.5 1.0 1.033 E(r) = rf + (rm-rf) 0.151 0.205 0.160 0.163 Investment (Rs.) 12,00,000 3,50,000 1,00,000 16,50,000 Weight 0.727 0.212 0.061 1.000 Weighted Return 0.110 0.043 0.010 0.163

Portfolio Beta is the simple weighted average of the betas of three shares. ie, portfolio = 0.9 X 0.727 + 1.5 X 0.212 + 1 X 0.061 = 1.033

Question A (2) A share is selling for Rs.60 on which a dividend of Rs.4 per share is expected at the end of the year. The expected market price after dividend declaration is to be Rs.70. Compute the following: (i) (ii) (iii) The return on investment in shares. Dividend yield Capital Gain Yield

Answer A (2): (i) Return on Investment per share = Net profit after taxes Dividend Average ordinary share or net worth X 100

(70 60) 4 X 100 60

= 10 %

(ii)

Dividend Yield

Dividend per ordinary share (DPS) Market Value per Share 4 X 100 = 5.714 % 70

X 100

(iii)

Capital Gain Yield = Earnings per share (EPS) X 100 Market value per share = 60 X 10% X 100 70

= 8.571 %

Question B: DIC Ltd. provides the following data: Comparative trial balance March 31 year 2 Debit Balance Cash Working capital (other than cash) Investment (Long term) Building and equipment Land Total 20 Rs.190 100 500 40 850 March 31 year 1 10 Rs. 90 200 400 50 750 Increase(Decrease) 10 Rs.100 (100) 100 (10) 100

Credit Accumulated Depreciation Bonds Reserves Equity Shares Total

200 150 350 150 850

160 100 350 140 750

40 50 --10 100

Income Statement For the period ending March 31, year 2

(Amount in Rs lakh)

Sales Cost of Goods Sold Selling Expense Administrative Expenses Operating Income Other charges Gain on sale of building and equipment Loss on sale of investments Interest Taxes Net Income after taxes Notes: (a) (b)

Rs.1000 500 Rs.50 50 100 400

Rs 5 (10) (6) (189)

(200) 200

The depreciation charged for the year was Rs.60 Lakh The Book value of the building and equipment disposed was Rs 10 Lakh

Prepare a Cash Flow Statement (Based on AS-3)

Answer B: Cash Flow Statement of DIC Limited (Indirect Method)

Particulars Cash flow from operating activities: Net profit before taxation and extraordinary items Adjustment for Depreciation Gain on sale of building and equipment Interest expense Loss on sale of Investments Operating profit before working capital changes Increase in working capital Cash generated from operation Income tax paid Net cash from operating activities Cash flow from investing activities: Proceeds from sale of long term Investments (working notes 1) Proceeds from sale of land Proceeds from sale of building and equipment (Rs.10 lakh + Rs.5 lakh gain) Purchase of building and equipment (working notes 2) Net cash used in investing activities Cash flow from financing activities: Proceeds from issuance of bonds (150 100) Proceeds from issuance of equity shares (150 140) Interest Dividend to equity share holders (working notes 3) Net cash used in financing activities Net increase in cash Cash at the beginning of year 2 Cash at the end of year 2
Working Notes

Amount in Rs. Lakh 389 60 (5) 6 10 460 (100) 360 189 171

90 10 15 (130) (15)

50 10 (6) (200) (146) 10 10 20

1) Proceeds from sale of long term investments: Investments at beginning of year 2 Less investment of year 2 end Book value of investment sold Less loss on sale of investments Sale proceeds

(Amount in Rs. Lakh) 200 100 100 (10) 90

2) Purchase of building and equipment: (Amount in Rs. Lakh) Original cost of building and equipment at the beginning of year 2 400
Less original cost of building and equipment sold daring year 2 (book value Rs. 10 lakh + accumulated depreciation Rs. 20 lakh) Original cost of building and equipment at year 2 end Difference represents purchases of building and equipment (30) 370 500 130

3) Dividend to equity share holders:

Since there is no increase in reserves (Rs. 350 lakhs), the entire net income after taxes of Rs. 200 lakhs represent payment of dividend to equity shareholders.

Accumulated depreciation account (Amount in Rs. Lakh) Particulars To Building & Equipment (accumulated depreciation on sale, balancing figure) To Balance c/d Amount 20 200 220 Particulars By Balance b/f By Profit and Loss account (depreciation of current year) Amount 160 60 220

Question C (1) - A. Ltd. produces a product which has a monthly demand of 4,000 units. The product requires a component X which is purchased at Rs.20. For every finished product one

unit of component is required. The ordering cost is Rs.120 per order and the holding cost is 10 per cent per annum. You are required to calculate: (i) Economic order quantity (ii) If the minimum lot size to be supplied is 4, 000 units, what is the extra cost, the company has to incur? (iii) What is the minimum carrying cost, the company has to incur? Answer C (1): (i) Determination of EOQ EOQ = 2 AB
C A = Annual usage of inventory (units) B = Buying cost per order C = Carrying cost per unit

A = 4,000 units per month & 12 months = 48,000 units B = Rs. 120 C = Rs. 20 cost per unit X 0.10 = Rs. 2 per unit per annum Therefore, EOQ = 2 X 48,000 X 120 2

= 2,400 Units (ii) Determination of Extra cost when lot size is 4,000 units
Sl. No. 1 2 3 4 5 6 7 8 9 Particulars Annual usage (units) Size of order Number of orders (1 + 2) Cost per order Total ordering costs (3 X 4) Carrying cost per unit per annum Average inventory (size of order/2) Total carrying cost (6 X 7) Total costs (5 + 8) Cost when lot size is 4,000 units 48,000 4,000 12 Rs. 120 1,440 2 2,000 4,000 5,400 2,400 units 48,000 2,400 20 Rs. 120 2,400 2 1,200 2,400 4,800

Extra costs to be incurred is Rs. 640 (Rs. 5,440 Rs. 4,800), when the order size is 4,000 units.

There is a positive relationship between the total carrying cost the firm incurs and the size of the average inventory it carries; this average size of inventory, in turn, is positively related to the size of order. In view of these facts, the minimum carrying costs the firm is to incur is Rs. 2,400 (corresponding to EOQ of 2,400 units and the average inventory level of 1,200 units). Question D - A stock is currently trading for Rs.29. The risk less interest is 7 % p.a continuously compounded. Estimate the value of European call option with a strike price of

(iii)

Rs.30 and a time of expiration of 4 months. The standard deviation of the stocks annual return is 0.45. Apply BS model. Answer D:
Spot price of the share Exercise price of the call option Risk free interest rate Time remaining for expiration = 4 months = 4/12 (year) Volatility of the stock

S E r t

Rs. 29.00 Rs. 30.00 0.07 0.33 0.45

The value of European call option can be obtained by using Black-scholes option pricing model.

C = S N(d1) Ee-rt N(d2)

Computation of call option essentially requires calculation of three values, viz., d1, d2 and present value of the exercise price (Ee-rt). d1 = In S/E + (r + 2/2) t t Substituting values from the information given above we get d1 = In (29/30) + (0.07 + (0.45)2 / 2) 0.33 0.45 0.33

d1 = In (0.9667) + (0.07 + 0.1013) 0.33 0.45 (0.5744) In (0.9667) = Log10 (0.9667) X 2.3026 = (-1.9853) X 2.3026 = (-1 + 0.9853) X 2.3026 = -2.3026 X 2.2688 In (0.9667) = -0.0338 d1 = -0.0338 + 0.0565 0.2585 d1 = 0.0227 0.2585 d1 = 0.0879

d2 = d1

t 0.33

d2 = 0.0879 (0.45)

d2 = 0.0879 (0.45) 0.5744 d2 = 0.0879 0.2585 d2 = -0.1706 Ee-rt = 30 e-(0.07 X 0.33) = 30

-0.02 e

and

Ee-rt = 30 e-0.22 {e-0.22 = 0.9802 as per Table A 7) Ee-rt = 30 (0.9802) Ee-rt = 29.406 The equation of call option looks like C = 29 N(0.0879) 29.406 N(-0.1706) The next step is to look up the values of a cumulative standardized normal probability distribution at (0.0879) and (-0.1706) N(0.0879) = N(0.08) + 0.79 [ N(0.09) N(0.08) ] = 0.5319 + 0.79 (0.5359 0.5319) = 0.5319 + 0.79 (0.004) = 0.5319 + 0.00316 = 0.53506

N(-0.1706) = N(-0.17) 0.06 [ N(-0.17) N(-0.18) ] = 0.4325 0.06 (0.4325 0.4286) = 0.4325 0.06 (0.0039) = 0.4325 0.000234 = 0.432266
[Values as per cumulative standardized normal distribution table]

Therefore,

C = 29 (0.53506) 29.406 (0.432266) = 15.51674 12.71121 = 2.8055

Thus, the value of European call option is Rs. 2.81.