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April 2010

Time Allowed: 3 Hours

Question 1 The Mayfair Rubber Industry Ltd. (MRIL) manufactures small rubber components for the local market. It is presently using 8 machines which were acquired 3 years ago at a cost of Rs.18 lakh each having a useful life of 8 years with no salvage value. The policy of the company is to depreciate all machines in 5 years. Their production capacity is 37 lakh units while the annual demand is 30 lakh units. The MRIL has received an order from a leading automobile company of Singapore for the supply of 20 lakh rubber bushes at Rs.15 per unit. The existing machines can be sold @Rs.12 lakh per machine. It is estimated that the removal cost of each machine would be Rs.60,000. In order to meet the increased demand, the MRIL can acquire 3 new machines at an estimated cost of Rs.100 lakh each which will have a combined production capacity of 52 lakh units. The operating parameters of the existing machines are as follows: (i) Labour requirements (Unskilled-18; Skilled-18; Supervisor-3; and Maintenance-2) and their per month salaries are Rs.3,500; Rs.5,500; Rs.6,500 and Rs.5,000 each respectively with an increase of 10 percent to adjust inflation. (ii) Raw materials cost, inclusive of wastage is 60 per cent of revenues. (iii) Maintenance cost years 1-5 (Rs.22.5 lakh), and years 6-8 (Rs.67.5 lakh). (iv) Operating expenses Rs.52.10 lakh expected to increase annually by 5 percent. (v) Insurance cost/premium year 1,2 per cent of the original cost of the machine, afterwards discounted by 10 per cent. (vi) Selling Price Rs.15 per unit. The projected operating parameters with the replacement by the new machines are as follows: (i) Additional working capital Rs.50 lakh. (ii) Savings in cost of utilities Rs.2.5 lakh. (iii) Maintenance cost years 1-2 (Rs.7.5 lakh); years 3.5 (Rs.37.5 lakh). (iv) Raw materials cost 55 per cent of sales. (v) Employee requirement (6 skilled at monthly salary of Rs.7,000 each and one for maintenance at monthly salary of Rs.6,500). (vi) Laying off cost of 34 workers (Unskilled-18; Skilled-12; Supervisors-3; and maintenance-1) Rs.9,21,000, that is equivalent to six months salary. (vii) Insurance cost/premium-2 per cent of the Purchase cost of machine in the first year and discounted by 10 percent in subsequent years. (viii) Life of machines 5 years and salvage value Rs.10 lakh per machine. The company follows straight line method of depreciation and the same is accepted for tax purposes. Corporate tax rate is 35 per cent and the cost of capital is 20 percent. As the Finance Manager of MRIL, prepare a report for submission to the top management with your recommendations about the financial viability of the replacement of the existing machine. (20 Marks)

Question 2 (a) Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity. Both the bonds have a face value of Rs. 1,000 and coupon rate of 8% (with annual interest payments) and both are selling at par. Assume that the yields of both the bonds fall to 6%, whether the price of bond will increase or decrease? What percentage of this increase/decrease comes from a change in the present value of bonds principal amount and what percentage of this increase/decrease comes from a change in the present value of bonds interest payments? (8 Marks) (b) Consider a bond selling at its par value of Rs. 1,000, with 6 years to maturity and a 7% coupon rate (with annual interest payment), what is bonds duration? (6 Marks) If the YTM of the bond in (b) above increases to 10%, how it affects the bonds duration? And why? (3 Marks) Why should the duration of a coupon carrying bond always be less than the time to its maturity? (3 Marks)

(c)

(d)

Question 3 (a) (i) The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%. The current spot rate of US $ in India is Rs.43.40. Find the expected rate of US $ in India after one year and 3 years from now using purchasing power parity theory. (4 Marks) (ii) On April 1, 3 months interest rate in the UK and US $ are 7.5% and 3.5% per annum respectively. The UK /US $ spot rate is 0.7570. What would be the forward rate for US $ for delivery on 30th June? (4 Marks) K. Ltd. is considering acquiring N. Ltd., the following information is available: Company Profit after tax Number of Equity Market value per shares share K. Ltd. 50,00,000 10,00,000 200.00 N. Ltd 15,00,000 2,50,000 160.00

(b)

Exchange of equity shares for acquisition is based on current market value as above. There is no synergy advantage available : Find the earning per share for company K. Ltd. after merger. Find the exchange ratio so that shareholders of N. Ltd. would not be at a loss.

(12 Marks)

Question 4 (a) Following information is available for X Companys shares and Call option: Current share price Rs.185 Option exercise price Rs.170 Risk free interest rate 7% Time of the expiry of option 3 years Standard deviation 0.18 Calculate the value of option using Black-Scholes formula. (4 Marks) (b) Mr. X established the following spread on the Delta Corporations stock : (i) Purchased one 3-month call option with a premium of Rs.30 and an exercise price of Rs.550. (ii) Purchased one 3-month put option with a premium of Rs.5 and an exercise price of Rs.450.

Delta Corporations stock is currently selling at Rs.500. Determine profit or loss, if the price of Delta Corporations : (i) Remains at Rs.500 after 3 months. (ii) Falls at Rs.350 after 3 months. (iii) Rises to Rs.600. Assume the size option is 100 shares of Delta Corporation. (4 Marks) (c) ABC Ltd., presently leasing computers on a yearly basis rental amounting Rs.10,00,000 per year. These computers can also be purchased by the company for Rs.50,00,000. This purchase can be financed by 16% loan repayable in 4 equal annual installments. The economic life of the computer is that of 4 years. It is estimated that the computers would be sold for Rs.20, 00,000 at the end of 4 years. The company uses the straight line method of depreciation. Corporate tax rate is 50%. (i) Whether computer should be acquired or leased? (ii) Analyse the financial viability from the point of view of lessor, assuming 14% cost of capital. (iii) Determine the minimum rent which will yield an IRR of 16% to the lessor. (12 Marks) Question 5 (a) Calculate the expected return and standard deviation of the investments A and B. What will be the return if total investment is divided one half in each? Economic climate Probability Returns from Returns from Dull 0.2 Stable 0.5 Growth 0.3 Also calculate the covariance and correlation. A% 10 14 20 ( 8 marks) (b) Returns on shares of ABC Ltd. and PQR Ltd. for the past two years are as follows: ABC Ltd. PQR Ltd. Year 1 11% 20% Year 2 17% 8% B% 6 15 11

Calculate the following : (i) Expected return of portfolio made up 50% per cent of ABC Ltd. and 50 per cent of PQR Ltd. (ii) Expected return of portfolio made up 60% per cent of ABC Ltd. and 40 per cent of PQR Ltd. (iii) Standard deviation of each stock. (iv) Covariance and coefficient of correlation between the two. (v) Portfolio risk if both are invested in the ratio of 2:1 (vi) Overall portfolio risk if the ratio of investment is 1:1. (6 marks) (c) Following is the capital structure of A Ltd. on 31.3.2006 : Equity Share Capital (of Rs.10 each) Security Premium Reserves and surplus Net worth

10, 00, 000 15, 00, 000 5, 00, 000 30, 00, 000

Mr. X purchased 100 shares of A Ltd. on 1.4.2002 at the market price of Rs.30. On 1.4.2006 the company made a bonus issue of 2:5. he sold all the shares on 31.3.2008 at the market price of Rs. 50 per share (cum- dividend). He had to pay tax @ 20% on his dividend income and 15% on capital gains. If the company pays a regular dividend @ 10%, find out whether X was able to earn his required rate of return of 10% on his investment. (Present value factors @ 10% for 1-6 years are.91, .83, .75, .68, .62, and .56). Assume that dividend income is taxable in the hands of shareholder. (6 marks) Question 6 Write short note on (a) Credit derivatives (b) Translation exposure (c) Random walk hypothesis (d) Distinguish between capital market and money market. (45= 20 marks)

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