Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 1 Answers to questions are to be given only in English except in the case of candidates who have opted for Hindi medium. If a candidate who has not opted for Hindi medium, answers in Hindi, his answers in Hindi will not be valued. Question No. 1 is compulsory. Answer any four questions from the rest. Figures in the margin indicate marks allotted to each question.- Working notes should form part of the answer. Qn. 1. (a) Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs Rs. 36,000 and project B Rs. 30,000. You have been given below the net present value probability distribution for each project : Project A Project B NPV estimates (Rs.) Probability NPV estimates (Rs.) Probability 15,000 0.2 15,000 0.1 12,000 0.3 12,000 0.4 6,000 0.3 6,000 0.4 3,000 0.2 3,000 0.1 (i) Compute the expected net present values of projects A and B. (ii) Compute the risk attached to each project i.e. standard deviation of each probability distribution. (iii) Compute the profitability index of each project. (iv) Which project do you recommend ? State with reasons. [ 14 marks ] Ans. i) Calculation of expected NPV Projcet A = (15000 X 0.2 ) + ( 12000 X 0.3 ) + ( 6000 X 0.3 ) + ( 3000 X 0.2 ) = 9000/- Project B = (15000 X 0.1 ) + ( 12000 X 0.4 ) + ( 6000 X 0.4 ) + (3000 X 0.1) = 9000/- ii) Calculation of Standard deviation Project A = ( 15000 – 9000 )2 X 0.2 + ( 12000 – 9000)2 X 0.3 + ( 6000 – 9000 )2 X 0.3 + ( 3000 – 9000 )2 X 0.2 = 198,00,000 S D = √ 198,00,000 = 4449.72 Project B = ( 15000 – 9000 )2 X 0.1 + ( 12000 – 9000 )2 X 0.4 + ( 6000 – 9000 )2 X 0.4 + ( 3000 – 9000 ) X 0.1 = 144,00,000 S D = √ 144,00,000 = 3794.74 iii) Computation of profitability Index Project A P.I = P.V of expected each Inflow P.V of cash out flow = 36000 + 9000 =1.25 times. 36000 Project B P.I = 30000 + 9000 = 1.30 times. Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 2 3,00,000 iv) Out recommendation [Analysis] Cash of Expected σ P. I It flow NPV Project A 36000 9000 4449.72 1.25 Project B 30,000 9000 3794.74 1.30 Above analysis shows that project ‘A’ is more risky than project ‘B’ and P.I. of project B is greater than project ‘A’ Therefore we adopt project ‘B’ (b) Presently a company is working with an earning before interest and taxes (EBIT) of Rs. 90 lakhs. Its present borrowings are as follows : Rs. in lakhs 12% term loan 200 Working capital borrowings : 90 Borrowing from bank at 15% Fixed deposits at 11% 200 90 The sales of the company are growing and to support this, the company proposes to obtain additional borrowing of Rs. 100 lakhs at a cost of 16%. The .increase in EBIT is expected to be 18%. Calculate the present and the revised interest coverage ratio and comment. [ 6 marks ] Ans. Interest coverage ratio = EBIT Total Interest Present situation Total Interest 12% Tern loan ( 3,00,00,000 X 42% ) = 36,00,000 15% Borrowing from Bank (20,00,000 X 15% ) = 30,00,000 11% Fined deposit (90,00,000X11%) = 9,00,000 75,90,000 Interest coverage ratio = 90,00,000 = 1.186 times. 75,90,000 Revised situation EBIT = 90,00,000 + 18% = 106,20,000/- Total Interest Calculation above = 75,90,000 Add: Additional Borrowings ( 10,00,000 X 16% ) = 16,00,000 91,90,000 Interest coverage ratio = 106,20,000 = 1.156 times. 91,90,000 Comment Companies Present interest coverage ratio = 1.186 and Revised ratio =1.156 Fall in coverage ratio due to addition Borrowing and therefore additional Borrowing is not suitable for company. Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 3 Qn 2 (a) Following information is provided relating to the acquiring company Mani Ltd. and the target company Ratnam Ltd. : Mani Ltd. Ratnam Ltd. Earnings after tax (Rs. lakhs) 2,000 4,000 No. of shares outstanding (lakhs) 200 1,000 P/E ratio (No. of times) 10 5 Required : (i) What is the swap ratio based on current market prices ? (ii) What is the EPS of Mani Ltd. after the acquisition ? (iii) What is the expected market price per share of Mani Ltd. after the acquisition, assuming its P/E ratio is adversely' affected by 10% ? (iv) Determine the market value of the merged Co. (v) Calculate gain/loss for the shareholders of the two independent entities, due to the merger. [ 10 marks ] Ans. ( Rs. In lakha ) Calculation of current market price per share Particulars Mani Ltd. Ratnam Ltd. (a) Earning after tax 2000 4000 (b) No. of Equity share out standing 200 1000 (c) Earning per share (a/b) 10 4 (d) P E Ratio ( No. of times ) 10 5 (e) Market Price per share [ (c) X (d) ] 100 20 i) Swap ratio based on current market price i.e. 20:100 or 1:5 ∴ Every 5 Equity Share of Ratnam Ltd. Mani Ltd. Will issue 1 share only. ii) EPS of mahi Ltd. After acquisition ( 2000 + 4000) = 6000 No. of Equity Share after acquisition [200 + (100 X 1/5)] = 400 EPS = 6000 = 15% per share. 400 iii) Expected market Price per share of Mani Ltd. After marjer. EPS of Mani Ltd. = 15/- P.E. of Mani Ltd. = 10 – 10 = 9 times. Market Price pershare =EPS X PE ratio = 15 X 9 = 135/- iv) Market value of the marged company = No. of Equity Share X market value Per Share = 400 X 135/- = 5400/- v) Calculation of gain or loss due to M/S Mani Ltd. Pre-merger market value of company ( 200 X 100/-) = 20,000 After merger market value of company ( 200 X 135/-) = 27,000 Merger gain 7,000 Ratnam Ltd. Pre-marger market value of company (1000 X 20 ) = 20,000 After marger market value company (200 X 135/-) = 27,000 Marger gain 7,000 Total marger gain = 14,000/- Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 4 (b) X Ltd. reported a profit of Rs. 65 lakhs after 35% tax for the financial year 2007-08. An analysis of the accounts revealed that the income included extraordinary items Rs. 10 lakhs and an extraordinary loss Rs. 3 lakhs. The existing operations, except for the extraordinary items, are expected to continue in the future; in addition, the results of the launch of a new product are expected to be as follows : Rs. in lakhs Sales 60 Material costs 15 Labour costs 10 Fixed costs 8 You are required to : (a) Compute the value of the business, given that the capitalisation rate is 15%. (b) Determine the market price per equity share, with X Ltd.'s share capital being comprised of 1,00,000 11% preference shares of Rs. 100 each and 40,00,000 equity shares of Rs. 10 each and the P/E ratio being 8 times. [ 10 marks ] Ans. Calculation of operating profit after tax Profit after tax 65,00,000 Add: tax @ 35%[65,00,000 X 35] 35,00,000 100 – 35 100,00,000 Less: Income include extraordinary income 10,00,000 Add: Income include extraordinary loss 3,00,000 93,00,000 Add: Profit a result of new product 27,00,000 Sale ( Rs in lakh) 60 Less: Variable cost Material cost 15 Labors cost 10 25 Contribution 35 Less: Fixed cost 8 Net Profit 27 ------------------ Total Profit 120,00,000 Less: tax @ 35% operating 42,00,000 Net operating Profit after tax 78,00,000 (a) Computation of value of Business = 78,00,000 = 520 lakh. 15% (b) Calculation of market price per equity share Reported profit after tax = 78 lakh Less: Preference dividend ( 100 lakh X 11% ) 11.00 lakh 67,00,000 (a) Earning available to Equity share holder (b) No. of Equity Share 40 lakh. EPS ( a/b) 71.55/40 = 1.675/- P/E ratio = 8 times. Market price per share = EPS x PE ratio = 1.675 X 8 Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 5 = 13.4/- per share Qn 3. (a) Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket of 35%. For the acquisition of a machinery worth Rs. 10,00,000, it has two options—either to acquire the asset by taking a bank loan @ 15% p.a. repayable in 5 yearly instalments of Rs. 2,00,000 each plus interest or to lease the asset at yearly rentals of Rs. 3,34,000 for five (5) years. In both the cases, the instalment is payable at the end of the year. Depreciation is to be applied at the rate of 15% using 'written down value' (WDV) method. You are required to advise which of the financing options is to be exercised and why. Year 1 2 3 4 5 P.V. factor @ 16% 0.862 0.743 0.641 0.552 0.476 [ 14 marks ] Ans. (I) Loan option Year Principal amount Interest Interest after tax Total cash out flow 1 2,00,000 1,50,000 97500 2,97,500 2 2,00, 000 1,20,000 78000 2,78,000 3 2,00,000 90,000 58500 2,58,500 4 2,00,000 60,000 39000 2,39,000 5 2,00,000 30,000 19500 2,19,500 Year Total amount flow Dep. Taxshield Net outflow D.F.@ 16% DCF 1 297500 52500 245000 0.862 211190/- 2 278000 44625 233375 0.743 173398/- 3 258500 37931 220569 0.641 141385/- 4 239000 32242 206758 0.552 114130/- 5 219500 27405 142095 0.476 91437/- P.V. of cash out flow 7,31,540/- ii) Lease option Year Lease Rent Tax benefit Lease rent after tax Cumulative D.F @ 16% 1to 5 334000 116900 2,17,100 3.274 P. V of cash outflow = 217100 X 3.274 = 710785 Conclusion Net cash outflow in loan option are Rs. 731540/- and lease option are 710785 /- ∴ we prefer lease option. (b) Briefly explain the term "capital rationing". Ans. A project of positive NPV earns more than its cost of capital. This being so, an enterprise can raise any amount for investment in these projects. This means, so far as projects of positive NPV are concerned, capital is not scarce. Since only projects yielding positive NPV need to be ranked, the use of relative measures, e.g. IRR and PI for ranking of projects are not rational. In situations of capital rationing, e.g. when the management of an enterprise puts a cap on total investment in projects, the capital becomes scarce. In these situations, the relative measures, e.g. IRR and PI should be used for ranking of projects, provided they are not mutually exclusive and are divisible. An enterprise may have idle funds even in situations of capital rationing, if projects are mutually exclusive or are indivisible. The absolute measures, e.g. NPV or APV give rational ranking in these situations of capital rationing. Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 6 4. (a) The equity share of VCC Ltd. is quoted at Rs. 210. A 3-month call option is available at a premium of Rs. 6 per share and a 3-month put option is available at a premium of Rs. 5 per share. Ascertain the net payoffs to the option holder of a call option and a put option, given that : (i) the strike price in both cases is Rs. 220; and (ii) the share price on the exercise day is Rs. 200, 210, 220, 230, 240. Also indicate the price range at which the call and the put options may be gainfully exercised. [ 10 marks ] Ans. Current market price of share = 210/- Strive price = 220/- Option ‘A’ call option premium paid =6/- Option ‘B’ put option premium paid = 5/- Net premium paid = 6 + 5 = 11/- Possible market Option exercise Price differential Net benefit price as exercise (paid)/Received Day. 200 B 20/- 09/- 210 B 10/- 1/- 220 No option exercise Nil (11/-) 230 A 10/- 1/- 240 A 20/- 09/- No such price Range at which point both option are exercise gain fully. Because of both options strike price are Same i.e. 220/- (b) A mutual fund that had a net asset value of Rs. 16 at the beginning of a month, made income and capital gain distribution of Re. 0.04 and Re. 0.03 respectively per unit during the month, and then ended the month with a net asset value of Rs. 16.08. Calculate monthly and annual rate of return. [ 4 marks ] Ans. Calculation of total Return Capital gain distribution 0.03 Income 0.04 Price appreceiation ( 16.08-16) 0.08 0.15 % Income (monthly) = 0.15/16X 100 = 0.9375% % Income (Annually) = 0.9375 X 12 =11.25% (c) Explain the term "debt securitisation". [ 6 marks ] Ans. Debt securitisation is the process by which financial assets such as loan receivables, mortgage backed receivables, credit card balances, hire-purchase debtors, lease receivables, trade debtors, etc., are transformed into securities. Debt Securitisation is different from 'factoring1. 'Factoring1 involves transfer of debts without transformation thereof into securities. A securitisation transaction, normally, has the following features: Financial assets such as loan assets, mortgages, credit card balances, hire-purchase debtors, trade debtors, etc., or defined rights therein, are transferred, fully or partly, by the owner (the Originator) to a Special Purpose Entity (SPE) in return for an immediate cash payment and/or other consideration. The assets so transferred are the 'securitised assets' and the assets or rights, if any, retained by the Originator are the 'retained assets'. The SPE finances the assets transferred to it by issue of securities such as Pass Through Certificates (PTCs) and/or debt securities to investors. Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 7 A usual feature of securitisation is 'credit enhancement', i.e. an arrangement which is designed to protect the holders of the securities issued by an SPE from losses and/or cash flow mismatches arising from shortfall or delays in collections from the securitised assets. The arrangement often involves one or more of the following: • Provision of cash collateral, i.e., a deposit of cash which in specified circumstances can be used by the SPE for discharging its financial obligation in respect of the securities held by the investors. • Over collaterisation, i.e., making available to the SPE assets in excess of the securitised assets, the realisation of which can be used in specified circumstances to fund the shortfalls and/or mismatches in fulfillment of its financial obligations by the SPE. • Resource obligation accepted by the Originator. • Third party guarantee, i.e., a guarantee given by a third party by accepting the obligation to fund any shortfall on the part of the SPE in meeting its financial obligations in respect of the securitisation transaction. • Structuring of the instruments issued by an SPE into senior and subordinated securities so that the senior securities (issued to investors) are cushioned against the risk of shortfalls in realization of securitised assets by the subordinated securities (issued normally to the Originator). Payments on subordinated securities are due only after the amounts due on the senior securities are discharged. The Originator may continue to service the securitised assets (i.e., to collect amounts due from borrowers, etc.) with or without servicing fee for the same. The Originator may securities or agree to securities future receivables, i.e., receivables that are not existing at the time of agreement but which would be arising in future. IN case of such securitisation, the future receivable are estimated at the time of entering into the transaction and the purchase consideration for the same is received by the Originator in advance. Securitisation can also be in the form of 'Revolving Period Securitisation' where future receivables are transferred as and when they arise or at specified intervals; the transfers being on prearranged terms. Debt securitisation is thus a financial market process by which individual /retail debts are pooled and restructured into a security instrument. Such restructured instrument assumes appropriate personality to be recognized in a larger market, bought and sold. Essentially, there are three phases in a securitisation process: (i) The origination phase: In this phase, a borrower seeks a loan from a financial institution. The latter assesses the creditworthiness of the borrower, determines the terms and conditions and extends the loans. (ii) The pooling phase: Many small loans are pooled together to create an underlying pool of receivables/assets. (iii) The securitisation phase: The pooled assets are often transferred to a Special Purpose Vehicle (SPV) which structures the market security based on the underlying pool. The SPV issues pass through securities or some other types of securities to beneficiaries (retail investors). Securitisation helps to reduce the cost of capital and improves recycling of funds. Usually SPV takes the form of a trust. Qn 5 (a). The following 2-way quotes appear in the foreign exchange market : Spot 2 -Months Forward RS/US $ Rs. 46.00/Rs. 46.25 Rs. 47.00/Rs. 47.50 Required : (i) How many US dollars should a firm sell to get Rs. 25 lakhs after 2 months ? (ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot market ? (iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee investment is 10% p.a. Should the firm encash the US $ now or 2 months later ? [ 6 marks ] Ans. Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 8 Spot rate 1$ = Rs. 46.00 – Rs. 46.25 2 month forward rate 1$ = Rs. 47.00 – Rs. 47.50 i) 25,00,000 = $ 53191.49 required. 47.00 ii) Rs. 46.25 X $2,00,000 = Rs. 42,50,000/- required iii) option ‘A’ encash present day. Then Rupee received = $69,000 X 46 = Rs. 31,74,000/- and deposit in Rupee investment @ 10% then after 2 month received Rupee = 31,74,000 X ( 1+ 10/100X2/12) = 32,26,900/- Option B Not encash present day, encash after 2 month then Rupee received will be $ 69,000 X 47 = Rs. 32,43,000/- Conclusion Firm shared encash $ 69,000/- after 2 month because Rupee amount will be more. (b) X & Co. is contemplating whether to replace an existing machine or to spend money in overhauling it. X & Co. currently pays no taxes. The replacement machine costs Rs. 95,000 and requires maintenance of Rs. 10,000 every year at the year end for eight years. At the end of eight years, it would have a salvage value of Rs. 25,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls each year as follows : Year Maintenance (Rs.) Salvage (Rs.) Present 0 40,000 1 10,000 25,000 2 20,000 15,000 3 30,000 10,000 4 40,000 0 The opportunity cost of capital for X & Co. is 15%. You are required to state, when should the firm replace the machine : (Given : Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15%—4.4873; present value of Re. 1.00 to be received after 8 years at interest rate of 15%—0.3269) [ 10 marks ] Ans. The company has two alternative as current date. i) Buy the new machine and dispose off the old machine ii) Keep the old machine as machine as farther year Annualized cost of new machine Year C.F. D. F. @ 15% DCF 0 95,000 1.00000 95,000 1 to 8 10,000 4.4873 44,873 8 25,000 0.3269 (8172.5) Total Outflow 131700.50 Annulized outflow or cost = 131700.50 4.4873 = 29349.61/- Annulised cost for old machine Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 9 Year Particulars C.F. D.F. @ 15% DCF O Salvage value 40,000 1.0000 40,000 1 Maintenance cost 10,000 .8696 8,696 1 Salvage value (25,000) .8696 (21,740) 26,956 Annualized cost = 26,956 = 30,998/- 0.8696 Conclusion:- The machine should be replace now. Because of annualized cost of new machine is Rs. 29,349.61/- and annualized cost of old machine is Rs. 30,998/- is more. (c) According to the position taken by Miller and Modigliani, dividend decision does not influence value. Please state briefly any two reasons, why companies should declare dividend and not ignore it. [ 4 marks ] Ans. According to modizliani and miller, dividend decision doesnot influence value companies should declare dividend because of the following reasons : - (i) Uncertainty associated with realization of capital appreciation : - mm considers dividend and capital appreciation to be perfect substitutes of one another. In practice, this is not likely to be true. In a fluctuating capital market, many investors may prefers to have current income in the form of dividend than to wait for future capital appreciation, which is uncertain. (ii) Tax implication :- non assumed that investors are indifferent between a rupee of dividend and a rupee of capital gain. In practice dividend and capital gain are subject to different rates of taken and exemptions. As such even if before tax dividend and capital appreciation are same, it is not likely to be so, once incidence of tax is taken into account. Qn 6 (a) What is sensitivity analysis in Capital budgeting ? [ 6 marks ] Ans. Sensitivity Analysis (Also called What-if analysis): Value of a project depends on several uncertain factors; e.g. selling price, demand, variable costs, fixed costs, tax rates, cost of capital, length of project life and the like. More sensitive NPV of a project is, to change in an uncertain factor; greater is the uncertainty of NPV and hence greater is the risk. Sensitivity of NPV to change in an uncertain factor can be computed as ratio between percentage change in NPV and percentage change in uncertain factor. For example, if 10% change in demand results in 20% change in NPV, the sensitivity ratio is 2. Higher the sensitivity ratio greater is the uncertainty of NPV and hence greater is the risk. The sensitivity analysis begins by establishing a general relation between the basic underlying factors and the NPV. At the next step, the general relationship is used to measure NPV of the project on the basis of most likely values of the underlying factors. NPV of the project under study is then recomputed for a possible change in any one of underlying factors. Finally, the recomputed NPV is compared with the most likely value of the NPV. The comparison can be expressed as the sensitivity ratio and the process can be repeated for each possible change of each underlying factor. Sensitivity analysis can be carried out for other project evaluation criteria like APV or IRR in the same way as indicated above for NPV. (b) Z Co. Ltd. issued commercial paper worth Rs. 10 crores as per following details : [ 4 marks ] Date of issue : 16th January, 2009 Date of maturity : 17th April, 2009 No. of days : 91 Interest rate 12.04% p.a. What was the net amount received by the company on issue of CP ? (Charges of intermediary may be ignored) Solved by: CA Arvind Jain, Jain Classes, Jamsedpur Solved Answer MAFA CA Final June 2009 10 Ans. Net amount received by the company = = Issue Price – Interest paid. = 10 Crores – (10 X 12.04/100X 91/365) = 10 Crores – 0.300 = 9.70 Crores (c) Explain briefly the advantages of investing in mutual funds. [ 5 marks ] Ans. Mutual funds are trusts which pool resources from large number of investors through issue of units for investments in capital market instruments such as shares, debentures and bonds and money-market instruments, such as commercial papers, certificates of deposits and treasury bonds. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. The process converts individual savings, which would otherwise have remained idle, into funds usable in industries. Reinvestments are spread over wide cross section of industries and sectors through careful analysis by experts. The diversification eliminates unsystematic risks and the investors can expect better returns for lesser risks. Such diversifications are usually not attainable by individual investors due to fund constraints and lack of necessary expertise. The large-scale operations allow the mutual funds to save transaction costs, which further augment the returns. In addition, the operations of mutual funds make the capital market more vibrant. For an ordinary small investor, the advantages of investing in a Mutual Fund are: • High security of funds due to professional management and regulations • Reduced risks through diversification • Higher Return Potential • Lower transaction costs due to high volume • Liquidity through marketability of units • Flexibility available through diversity of schemes offered • Tax benefits (d) Write a brief note on the Small Industries Development Bank of India. [ 5 marks ] Ans. Small Industries development in India is in a great pace. Man new bank, financial institution have been established for promotion many new financial institutions are being promoted by the government of India to provide long term finance to corporate borrowers. They made significant contribution to India’s industrial development by providing funds at concessional rate for corporate ventures; some of such financial institutions are IFCI, IDBI, ICICI and many more. Government is also providing subidy to such enterprises to grow and such an profit leading to overall economic development.