Sa 1 0107

Question Paper Security Analysis - I (MB331INV) : January 2007 Section A : Basic Concepts (30 Marks) • • • •

1.

If Ramesh buys a 5 year, 10% annuity deposit certificate for Rs.30,328, the annuity he is entitled to receive over the 5 year period is (a) (b) (c) (d) (e)

2.

(a) (b) (c) (d) (e)

4.

(c) (d) (e) 5.

Only (I) above Only (II) above Both (I) and (III) above Both (II) and (III) above All (I), (II) and (III) above.

< Answer >

SML represents normal trade-off between return and risk The vertical distance of the security’s plot on the graph from the SML is called the security’s alpha SML is same as the characteristic line for any security Ex-post SMLs are used to evaluate the performance of portfolio managers The slope of the characteristic line is the beta for the particular security involved.

The beta of stock A is 2.0 and is currently in equilibrium. The required return on the stock is 15% and the expected return on the market is 10%. Suddenly owing to economic conditions, the expected return on the market increases to 15%. Other things remaining the same, what would be the new required return on the stock? (a) (b) (c) (d) (e)

< Answer >

98 105 112 120 125.

Which of the following statements is not true about the Security Market Lines (SML)? (a) (b)

< Answer >

The investors should be able to dispose of his stock at the most competitive price. It provides liquidity to the investors without any loss. The resulting transaction costs are minimum for the investor.

The number of unique covariance terms required to be calculated in order to calculate the risk of portfolio of 15 securities by the Markowitz model is (a) (b) (c) (d) (e)

< Answer >

Rs.5,000 Rs.6,000 Rs.7,000 Rs.8,000 Rs.9,000.

Which of the following statements is/are true regarding functions of secondary market? I. II. III.

3.

This section consists of questions with serial number 1 - 30. Answer all questions. Each question carries one mark. Maximum time for answering Section A is 30 Minutes.

17.5% 20.0% 22.5% 25.0% 30.0%.

< Answer >

(e) 6.

Which of the following statements is/are true with respect to Beta? I. Beta is the slope of the Security Market Line. II. Beta measures the non-diversifiable risk. III. Beta greater than one is referred to as an aggressive security. (a) (b) (c) (d) (e)

7.

30.0%. < Answer >

Only (I) above Only (II) above Both (I) and (II) above Both (II) and (III) above All (I), (II) and (III) above.

Which of the following is/are main objectives of International Organization of Securities Commissions (IOSCO)?

< Answer >

I.

To exchange information on their respective experiences in order to promote the development of domestic markets. II. To cooperate and promote high standards of regulation in order to maintain just, efficient and sound markets. III. To unite their efforts to establish standards and effective surveillance of international securities transaction. (a) (b) (c) (d) (e) 8.

Which of the following departments of SEBI is responsible for regulations regarding underwriters, registrars to issue, credit rating agencies, share transfer agents, debenture trustees, merchant bankers, bankers to an issue and portfolio managers? (a) (b) (c) (d) (e)

9.

(e) 11.

(a) (b) (c) (d) (e)

< Answer >

Filling up transfer deeds and lodging the same with the company for transfer is necessary There would not be any bad deliveries Exemption from paying stamp duty on transfer of shares Shares purchased in electronic form will be transferred to the investor’s name within a day of completion of settlement No scope for forgery of share certificates.

Which of the following is/are true in case of the pioneering stage of the industry life cycle? I. II. III.

< Answer >

Public Listed Corporates Scheduled Banks Mutual Funds Venture Capital Funds Banking Subsidiaries.

Which of the following is not true with respect to the depository system? (a) (b) (c) (d)

< Answer >

Primary market department Secondary market department Collective investment schemes department Venture capital department Investigation, enforcement and surveillance department.

Who among the following cannot become members of OTCEI? (a) (b) (c) (d) (e)

10.

Only (II) above Both (I) and (II) above Both (I) and (III) above Both (II) and (III) above All (I), (II) and (III) above.

It is difficult to predict which firms will succeed and which firms will fail. Firms pay a high level of dividends. Industry growth is very rapid. Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above.

< Answer >

(e) 12.

The major source of exit barriers is/are I. II. III. (a) (b) (c) (d) (e)

13.

15.

17.

18.

(a) (b) (c) (d) (e)

< Answer >

Labor intensive Capital intensive Control over raw material Learning curve Economies of scale. < Answer >

3.11 3.41 3.91 4.51 5.61.

Which of the following is/are true regarding three-stage dividend discount model? I. II. III.

< Answer >

Market capitalization of the company Industry representation Trading interests in the scrips Stock exchanges covered Fundamentals of the company.

A company has an ROE of 0.25 and book value of Rs.15.63. The EPS for this company is (a) (b) (c) (d) (e)

< Answer >

Utilization of manufacturing capacity Residential construction Corporate profits Level of stock prices Unemployment.

Which of the following entry barriers is not considered as natural barrier? (a) (b) (c) (d) (e)

< Answer >

Rs. 6.00 Rs. 7.50 Rs.10.00 Rs.12.50 Rs.15.00.

Under CRISIL 500 equity index, which of the following is not the parameter for selection of the company? (a) (b) (c) (d) (e)

16.

Only (I) above Only (III) above Both (I) and (II) above Both (II) and (III) above All (I), (II) and (III) above.

Which of the following is not a leading economic indicator? (a) (b) (c) (d) (e)

< Answer >

Specialized assets. Emotional barriers. Strategic interrelationships.

The cash earning per share for Anandam Ceramics Ltd. is 12. The net sales and the depreciation are Rs.1,000 crores and Rs.20 crores respectively. The net profit margin for the company is 10%. The earning per share for the company is (a) (b) (c) (d) (e)

14.

Both (II) and (III) above.

An initial period of high-growth. An intermediate period during which the growth declines. A final stable-growth phase. Only (I) above Only (III) above Both (I) and (II) above Both (II) and (III) above All (I), (II) and (III) above.

< Answer >

(e) 19.

All (I), (II) and (III) above.

Book-building process is different from fixed price process for raising share capital from public. Which of the following statement(s) is/are true about Book-building process compared to fixed price process?

< Answer >

I.

Price at which securities will be offered/allotted is not known in advance to investor. Only an indicative price range is known. II. Demand for the securities offered can be known everyday. III. Payment is made at the time of subscription. (a) (b) (c) (d) (e) 20.

Which of the following statements is/are not true with respect to an Exchange Traded Fund (ETF)? I. II. III. (a) (b) (c) (d) (e)

21.

(a) (b) (c) (d) (e) 23.

Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above.

< Answer >

It is primarily used for evaluating the performance of management. It serves as a proxy for measuring a firm’s stock performance. It can be applied to capital budgeting like NPV. Only (I) above Only (II) above Only (III) above Both (I) and (III) above All (I), (II) and (III) above.

Which of the following statements should an appraiser take into consideration while determining the discount? I. Decreased executive’s actual duties and areas of active involvement. II. Ability of existing successor management to move up the organization ladder. III. Compensation necessary for replacing the key executive. IV. Damages that are likely to arise from risks which the company is exposed to as a result change in the key position. (a) (b) (c) (d) (e)

< Answer >

7.32 8.57 9.34 10.25 11.25.

Which of the following is/are true regarding advantages of Economic Value Added (EVA)? I. II. III.

< Answer >

ETFs primarily invest in the securities of companies that are included in a selected market index. The NAV of the ETF is equal to the value of the underlying index. ETFs cannot be bought or sold on a daily basis like stocks.

The required rate of return on a stock is 12.5% and it is showing a constant growth rate of 9%. If the stock’s retention rate is 70%, its P/E ratio should be (a) (b) (c) (d) (e)

22.

Only (I) above Only (II) above Only (III) above Both (I) and (II) above Both (I) and (III) above.

Both (I) and (III) above Both (II) and (IV) above (I), (II) and (III) above (II), (III) and (IV) above All (I), (II), (III) and (IV) above.

of

< Answer >

(e) 24.

The leverage ratio used in ROE analysis is (a) (b) (c) (d) (e)

25.

All (I), (II), (III) and (IV) above. < Answer >

Sales ratio Profit margin Total assets to net worth Tangible net worth to total assets Long-term debt to equity ratio.

Which of the following statement(s) is/are not true regarding the Price/Sales ratio?

< Answer >

I. P/S ratio is useful for valuing companies even with no dividends at all. II. P/S ratio can be positive or negative. III. Firms with low profit margins and high P/S ratio are undervalued. IV. P/S ratio is not influenced by accounting methods. (a) (b) (c) (d) (e) 26.

Which of the following is not an application of SML? (a) (b) (c) (d) (e)

27.

29.

< Answer >

Filter test Residual analysis Event studies Trading by mutual fund managers Calendar studies.

ABC Ltd. issues right shares which increases the market value of the shares of the company by Rs.150 crore. The aggregate market value of all the shares included in the index before the right issue made is Rs.2,500 crore. If new base year average after the rights issue is Rs.1,010 crore, what is the base year average before rights issue? (a) (b) (c) (d) (e)

< Answer >

Stock prices fully reflect all historical price information Runs test is used to test the semi-strong form of market efficiency Stock prices fully reflect all relevant information including insider information Stock prices are not predictable using the publicly available information Relationship between the historical P/E ratios and risk-adjusted market performance supports semi-strong form of market efficiency.

Which of the following is a test for examining weak form of market efficiency? (a) (b) (c) (d) (e)

< Answer >

Evaluating the performance of portfolio manager Tests of asset pricing theories Tests of market efficiency Identifying mispriced securities Identifying the factors of pricing of an asset.

Which of the following statements is true regarding the semi-strong form of Efficient Market Hypothesis? (a) (b) (c) (d) (e)

28.

Only (I) above Only (II) above Both (I) and (III) above Both (II) and (III) above (II), (III) and (IV) above.

Rs.1,070.60 crore Rs.1,005.94 crore Rs. 952.83 crore Rs. 949.40 crore Rs. 823.23 crore.

< Answer >

30.

< Answer >

On April 01, 2003 Deepak Fertilisers purchased a machine costing Rs.2 lakhs. The company provides depreciation @10% on SLM. With effect from April 01, 2006 it was decided to change the method of depreciation to WDV method. The rate being the same, the amount of depreciation to be charged for the year 2006-07 is (a) (b) (c) (d) (e)

Rs. 8,000 Rs.14,000 Rs.22,000 Rs.30,000 Rs.34,000.

END OF SECTION A

Section B : Problems/Caselet (50 Marks) • • • • • 1.

This section consists of questions with serial number 1 – 5. Answer all questions. Marks are indicated against each question. Detailed workings/explanations should form part of your answer. Do not spend more than 110 - 120 minutes on Section B. < Answer >

The dividend ratio of a company for the current year is 25%. The expected dividend ratios in future are follows: Years

Dividend ratios (%)

1

20

2

30

3

35

Thereafter it is expected that annual dividend amount will be growing at 8% per annum for an infinite period. The face value of the firm’s stock is Rs.10 and its beta is 1.25. If the risk free rate and risk premium on the market are 5% and 5.6% respectively, you are required to calculate the intrinsic value of the stock. (8 marks) 2.

Construction of a complex, Industrial trade center is proposed to be financed by way of issue of bonds and equity shares in the proportion of 7:3. The details of the instruments are as under: i.

Bonds are bearing a coupon rate of 12% per annum maturing in 7 years. The interest will be compounded semi-annually. To redeem the bonds a sinking fund is established. The coupon payment is tax deductible.

ii.

Equity investors require a return of 16%.

< Answer >

The expected net operating income from the property is Rs.75 lakhs and the effective tax rate applicable is 35%. You are required to calculate a.

Capitalization rate.

b.

Market value of property. (7 + 3 = 10 marks)

3.

The stock of Hindustan Oil Exploration Ltd. (HOE) is currently trading at Rs.105.95. Based

< Answer >

3.

The stock of Hindustan Oil Exploration Ltd. (HOE) is currently trading at Rs.105.95. Based on the current market price, the P/E ratio is 16.18, P/B ratio is 3.91 and P/S ratio is 6.73. Other fundamentals of HOE are given below: Sales Net profit Net worth Dividend per share Number of shares of Rs.10 each. Beta

Rs.924.54 millions Rs.384.84 millions Rs.1593.25 millions Re.1 Rs.58.75 millions 2

The yield on the one-year treasury bill is 5.5% and the equity risk premium in the market is 8.00%. You are required to a.

Determine the required rate of return for equity holders and the sustainable growth rate of HOE Ltd.

b.

Estimate the P/E, P/B and P/S ratios justified by the fundamentals.

c.

Explain whether the stock is fairly valued, overvalued or undervalued based on your answer in part (b). (3 + 6 + 3 = 12 marks)

Caselet Read the caselet carefully and answer the following questions: 4.

The caselet states that periodic earnings announcements do serve a purpose as they reveal information that would give a fair idea of the progress of the company. Briefly explain the non-financial factors to be examined by an investor to assess the progress of the company.

< Answer >

(10 marks) 5.

As an analyst, discuss the important characteristics that you would analyze before you identify an industry for investment.

< Answer >

(10 marks) Periodic earnings announcements may not tell the whole story but they definitely provide the gist of it. These numbers may lead to higher or lower expectations and affect the valuation of the stock. At times the management may also resort to window-dressing to meet the forecasts. But does it mean that these numbers are irrelevant? What information can you glean from interim financial reports? Periodic earnings announcements do serve a purpose as they reveal information that would give a fair idea of the progress of the company. Additional disclosures, such as segment reporting, presentation of consolidated results and the geographical break-up, give a lot of information that would otherwise not be available in public domain at such frequency. Analyst presentations and conference call transcripts are also available on certain company web sites. These are valuable sources of information and give insights into the companies' operations and prospects. They give you a feel of what is happening in a company and where is it heading in terms of business performance. Periodic financial disclosures also show how the company compared with its peers. They indicate a company's market position and control within the industry in that particular period and also point to whether a company has the potential to make the best of the given business conditions. The absence of such periodic disclosure leaves a gap in financial information. Worse, it could lead to selective disclosures, giving room for insider trading. Small investors would be left in the lurch due to non-availability of information. The market might witness wider swings due to speculation and selective disclosure. Information provided in financial statements is useful if scrutinized properly. For instance, the previous eight quarters' earnings announcements would indicate the trend in margins and earnings growth. Sharp deviations may require further scrutiny to judge the sustainability. Any one-off instances having an impact on the earnings should be eliminated. Also, one has to be aware of the external factors governing the business and their effect on the earnings performance in any period. When making an investment decision, adequate discounting should be done for any risks associated with the business. This would be based on the investor's risk-taking ability. It might also pay to take an independent view of the stock without the market interest in a stock influencing your decision. Any stock that commands a higher valuation than its earnings can support will be vulnerable to volatility. Markets generally tend to overestimate the earnings growth potential of certain companies or get carried away by exceptional earnings announcements without looking at the ground realities. Often, stocks zoom or slump after earnings announcements and trade at valuations that cannot be sustained by earnings growth. It is better to avoid a stock that commands high multiples when the business environment is

earnings growth. It is better to avoid a stock that commands high multiples when the business environment is uncertain. Also, avoid momentum investing in such stocks. A little bit of caution and reasoning could protect you from extreme downside risks. But do remember that numbers are usually factored in the stock price and should not be taken fully at face value. Future performance would depend on a host of external factors. A fresh investment decision should be based on the general business environment and the scope for business growth. END OF SECTION B

Section C : Applied Theory (20 Marks) • • • •

6.

This section consists of questions with serial number 6 - 7. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.

Listing means admission of securities for trading on a stock exchange. It is done through a formal agreement between the stock exchange and the company. In this context, explain how listing of securities is advantageous to the company as well as to the investor. Also explain various types of listing of securities.

< Answer >

(10 marks) 7.

It is more difficult to liquidate a minority interest in a closely held company than liquidate in a controlling interest. Discuss the various methods of valuing minority interest. (10 marks) END OF SECTION C END OF QUESTION PAPER

Suggested Answers Security Analysis - I (MB331INV) : January 2007 Section A : Basic Concepts

< Answer >

1.

Answer : (d)

Reason: 2.

30,328 PVIFA(10,5)

30,328 = Rs.8, 000. Annuity = = 3.791 Hence (d) is the correct answer.

Answer: (e) Reason: The functions of secondary markets are: •

The investors should be able to dispose of his stock at the most competitive price. The most competitive price in case of selling is the highest price, while for buying it is the lowest price.

•

It provides liquidity to the investors without any loss.

• 3.

That resulting transaction costs are minimum for the investor. Hence (e) is the correct answer.

Answer : (b) Reason : Number of unique covariance terms is given by : 2

n −n 2

2

=

15 − 15

= 105

2

.

Hence (b) is the answer.

4.

Answer : (c) Reason : a. b. c.

d. 5.

SML typically represents the average or normal trade-off between risk and return for a group of securities, where risk is measured typically, in terms of the securities betas. Statement (a) is true. The amount by which a security’s return differed from the normal return for its level of risk is simply the vertical distance of the security’s plot on the graph from the SML. Statement (b) is true. & e. SML is not same as the characteristic line for a simple security. For the characteristic line, the y-axis represents the returns for a particular security and the x-axis represents the returns for the market index. The slope of the characteristic line is the beta for the particular security involved. Therefore statement (c) is not true and statement (e) is true. Ex-post SMLs are used to evaluate the performance of portfolio managers. Statement (d) is true.

Answer : (d) Reason : 15 = Rf + 2 (10 – Rf) i.e., Rf = 20 – 15 = 5% Revised R = 5 + 2 (15 – 5) = 25%

6.

7.

Answer : (d) Reason : Beta is the slope of the regression line (characteristic line). Beta measures non-diversifiable risk also known as systematic risk.Beta greater than one is referred to as an aggressive security. Therefore, Option (d) is the correct answer. Answer : (e) Reason : The main objectives of IOSCO are: •

To cooperate and promote high standards of regulation in order to maintain just, efficient and sound markets.

•

To exchange information on their respective experience in order to promote the development of domestic markets.

•

To unite their efforts to establish standards and effective surveillance of international securities transactions.

•

To provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offences. Hence, all statements (I), (II) and (III) are correct. Hence, option (e) is the correct answer.

8.

Answer : (a) Reason: The department looks after the policy matters and regulaltory issues concerning the primary market. The department is responsible for regualations regarding underwriters, registrars to issue, credit rating agencies, share transfer agents, debenture trustees, merchant bankers, bakers to an issue and portfolio managers. Hence, option is (a) is the correct answer.

9.

Answer : (a) Reason : The following can become members of OTCEI : Public financial institutions Scheduled banks Mutual funds Venture capital funds and venture capital companies NBFCs Banking subsidiaries. All the above can become members of OTCEI by fulfilling the eligibility norms laid down by OTCEI such as network, approval of SEBI, infrasructure, standing and experience, etc., Hence (a) is the answer.

10.

Answer : (a) Reason: The advantages of depositary syatem to the investors are : Filling up transfer deeds and lodging the same with the company for transfer is not necessary. There would not be any bad deliveries Exemption from paying stamp duty on transfer of shares Shares purchased in electronic form will be transferred to the investor’s name within a day of completion of settlement Faster payments on sale of shares No scope for forgery of share certificates. Hence (a) is the correct answer.

11.

Answer : (d) Reason : Statement II is not true for pioneering stage as the dividends become payable only at growth stage and high dividends can be expected only at stabilization stage.

12.

Answer : (e) Reason: The major source of exit barriers are as follows: 1. Specialized assets 2. Fixed costs of exit 3. Strategic interrelationships 4. Emotional barriers 5. Government and social restrictions. Hence (e) is the correct answer.

13.

Answer : (c) Reason : Net profit margin = PAT/Sales ∴ PAT = 100 crores PAT + Depreciation No. of shares

Cash earning per share = ∴ Number of shares = 10 crores ∴ Earning per share = 100/10 = Rs.10 Therefore, Option (c) is the correct answer.

14.

Answer : (e) Reason : The lead indicator approach is an important forecasting method to forecast the general economic conditions by identifying economic indicators that turn ahead of the change in general level of economic activity. Some of the leading economic indicators are the utilization of manufacturing capacity, residential construction, corporate profits, and the general level of stock prices. All the first four alternatives are the leading economic indicators, while the last alternative is a lagging economic indicator. Therefore answer is (e).

15.

Answer : (d) Reason : Selection of the companies has been made on the basis of four parameters: Market capitalization of the company a. b. Industry representation c. Trading interests in the scrips. d. Fundamentals of the company. Hence, option (d) is the correct answer.

16.

Answer : (c) Reason : Control over raw material is an artificial barrier and not a natural. All other are the natural barriers. Therefore, option (c) is the correct answer.

entry

17.

Answer : (c) Reason: EPS = ROE × book value = 0.25 × 15.63 = 3.91.

18.

Answer : (e) Reason: Three-stage Dividend Discount Model It is a combination of two-stage model and H-model. This model assumes three stages of growth: I. An initial period of high-growth II. An intermediate period during which the growth declines. III. A final stable-growth phase. Hence (e) is the correct answer.

19.

Answer : (d) Reason : In book-building process, payment is made only after allocation. In fixed price process payment is made at the time of subscription whereas refund is possible after allocation. Hence (d) is the answer.

20.

Answer : (e) Reason : An ETF will primarily invest in the securities of companies that are included in a selected market index. The NAV of the ETF is equal to a fraction of the the value of the underlying index. ETFs can be bought or sold on a daily basis like stocks. Hence (e) is the answer.

21.

Answer : (c)

Reason :

P0 =

E 0 (1 − R.R) (1 + g) ke − g

P0 = P0 E0

=

(1 − R.R) (1 + g) ke − g

(1 − 0.70)1.09 = 22.

0.125 − 0.09

0.327

= 0.035 = 9.34

Answer : (e) Reason: Advantages of EVA : •

EVA ia primarily used for evalating the performance of management..

•

It serve as a proxy for measuring for measuring a firm ‘s stock performance.

• EVA can be applied to capital budgeting like NPV. Hence (e) is the correct answer. 23.

Answer : (e) Reason: An appraiser, while determining the discount, should take into consideration the following: I. Decreased executive’s actual duties and areas of active involvement. II. Ability of existing successor management to move up the organization ladder. III. Compensation necessary for replacing the key executive. IV. Damages that are likely to arise form risks which the company is exposed to as a result of change in the key position. Hence (e) is the correct answer.

24.

Answer : (c) Reason : According to the Du Pont analysis Return on equity = Net profit margin x Asset turnover ratio x Asset – Equity ratio Leverage ratios measure the long-term solvency of a firm. Total assets to net worth is the leverage ratio used in ROE analysis.

25.

Answer : (d) Reason : P/S ratio is useful for valuing companies even with no earnings, viz., no dividends at all. P/S ratio can never be negative. Firms with low profit margins and high P/S ratio are overvalued and those with high profit margins and low P/S ratios are undervalued. P/S ratio is not influenced by accounting methods used fro depreciation, inventory, etc., Statements (I) and (IV) are true, and statements (II) and (III) are not true. Hence (d) is the answer.

26.

Answer : (e) Reason : Alternatives a), b) and c) are applications of ex-post SML. Whereas alternative d) is an application of ex-ante SML. Alternative e) is not an application of SML.

27.

Answer : (d) Reason : Weak form of efficiency assert that stock prices fully reflect all historical price information. Runs test is used to test the weak form of EMH. Super strong form of efficiency Stock prices fully reflect all relevant information including insider information. Semi-strong form of efficiency implies that market prices reflect all publicly available information concerning past trading as well as fundamental aspects of the firm. Hence stock prices are not predictable using the publicly available information. Relationship between the historical P/E ratios and risk-adjusted market performance is evidence against the semi-strong form of market efficiency. Hence (d) is the answer.

28.

Answer : (a) Reason: Residual analysis, event studies and calendar studies are tests for examinig semi-strong form of market efficieny. Trading by mutual fund managers is a method for examinig strong form of market efficiency. While filter test is a method for examining weak form of market efficiency. Hence, option (a) is the correct answer.

29.

Answer : (c) ×

Reason:

OldMarketValue

New Base year Average = Old Base Year Average X×

NewMarketValue

(2500 + 150)

2500 1010 = X = 952.83 Thus, Old Base Year Average is Rs. 952.83 crore. Hence, option (c) is the correct answer.

30.

Answer : (b) Reason : SLM
2, 00,000 2003-04 (20,000) 1,80,000 04-05 (20,000) 1,60,000 05-06 (20,000) 1,40,000 Therefore for 2006-07 is (1,40,000)10% = Rs.14,000

Section B : Problems/Caselet 1.

Dividend declared during the current year =Rs. 10 × 0.25 = 2.5 Future Dividend

< TOP >

First year = 10 × 0.20 = Rs. 2.00 Second year = 10 × 0.30 = Rs. 3.00 Third year = 10 × 0.35 = Rs. 3.50 Required rate of return = Rf + βA (RM – Rf) = 5 + 1.25 × 5.6 = 12% Intrinsic value of the share = D1/(1+K) + =

D2/(1+K)2

+ D3/(1+

k)3

D4 /(1 + K)3 K − g +

2.00 3.00 3.50 3.50 ×1.08 + + + 2 3 (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)3 (0.12 − 0.08)

= 1.785 +2.392+2.4912+ 67.26 = Rs. 73.93. 2.

a.

Payments to Bond-holders consists of paying the interest and regular contribution to the sinking fund to pay the principal. Contribution to the sinking fund every 6 month for 7 years

i 0.12 f 2 n ×f 7×2  i 1 +  − 1 1 + 0.12  − 1 f 2  =  =  = 0.0476 Alternately, Consider bond price Rs.100 the sinking fund every six month

100

< TOP >

A=

100 FVIFA(6%, 14)

100 = 21.015 = 4.759 i.e. 0.0476 per rupee for six months

Hence, per annum the contribution will be (1 + 0.0476)2 – 1 = 0.0975 After tax effective annual interest = (1 + 0.06)2 – 1 –0.12 × 0.35 = 0.0816 Therefore, total payments on bond = 0.0816 + 0.0975 = 0.1791 Calculation of weighted rates Instruments

% Employed

Bonds Equity

70 30

Required of return (%) 17.91 16.00

Weighted rates (%) 12.54 4.80 17.34

Therefore, the capitalization rate is 17.34%.

3.

b.

Market value of the property =

a.

Required rate of return Here,

Net operating Income Capitalization rate

.

384.84 = 41.63% 924.54

Net Pr ofit m arg in =

b.

EPS =

< TOP >

= 5.5 + 2 (8) = 21.5%

g = ROE × b = 0.2415 × 0.8473 = 20.46%

Re turn on equity =

75,00,000 = 0.1734 = 4,32,52,595.16

384.84 = 24.15% 1593.25

384.84 = Rs. 6.55 58.75

Dividend pay out ratio =

1 = 15.27% 6.55

Retention ratio = 1-0.1527 = 0.8473

P/E = 1.

P/B = 2. P/S =

3. c.

4.

(1 − b )(1 + g ) Ke − g

=

0.1527 × 1.2046 = 17.68 0.215 − 0.2046

ROE − g 0.2415 × 0.2046 = = 4.75 0.2150 − 0.2046 Ke − g NPM × (1 − b ) × (1 + g ) Ke − g

=

0.4163 × 0.1527 ×1.2046 = 7.36 0.2150 − 0.2046

The calculated P/E is more than the current P/E, Therefore as per P/E stock is undervalued. The calculated P/B is less than the current P/B, Therefore as per P/B stock is slightly overvalued. The calculated P/S is greater than the current P/S, Therefore as per P/S stock is undervalued.

The important non-financial factors to be examined by an investor are as follows: Business of the company The investor should know whether the company is a well-established one, whether it has a good product range and whether its lines of business have considerable potential to grow. Top Management The quality of top management team, particularly, the competence and the commitment of the chief executive officer matters a lot in shaping the destiny of the company. Product Range Progressive companies like ITC and Hindustan Lever create competition for their existing products

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Progressive companies like ITC and Hindustan Lever create competition for their existing products by launching new products with regular frequency. Hence investors must examine whether the company under review belongs to this group or not. Diversification An issue related to that of product range is diversification. To reduce the degree of business risk and improve profitability, many companies resort to diversification. Hence this issue is to be carefully examined by the investor. Foreign Collaboration Where a company has entered into technical collaboration with a foreign company, the investor must find out more about the nature of the collaboration agreement. Availability and Cost of Inputs If the company depends upon imported raw materials, it is important for the investors to assess the raw material position, because any shortage of the raw material and/or escalation in the cost of raw material will adversely affect the profitability. Research and Development Progressive companies spend substantial sums of money on R&D to upgrade their existing products, introduce new products, adapt foreign technology to suit the local conditions, achieve import substitution, etc. Governmental Regulations The investor must assess the implications of governmental regulations such as MRTP Act, FERA, pollution control regulations etc., for the company under review. Pattern of Shareholding and Listing The pattern of shareholding has a bearing on the floating stock available in the market and the trading volume of these issues will have an effect on the company, hence it will be analyzed by the investor before taking any investment decision. 5.

Before taking a decision for making an investment, every industry has to be analysed thoroughly. The most important of the characteristics that are to be evaluated for an industry are given below: • Past sales and earnings performance • Performance of the industry. • The attitude of the government towards the industry. • Labor conditions within the industry. • The competitive conditions as reflected by the existence of the entry barriers and • The stock prices of the firms in the industry relative to their earnings. Past sales and earnings performance: For an analyst, past sales and earnings performance of the firm form a crucial input in forecasting future trends. This is because by examining the contribution of various factors in the past sales reveals the relevance of these factors individually and relatively under present conditions. In any firm sales and the earnings play an important role. These variables will exhibit a degree of consistency only when the firm has weathered a variety of economic conditions. The analyst form the observation of these variables will be able to judge the stability of the performance in terms of sales and earnings as well as the growth rates. Another crucial factor is that of the relationship between the sales and the fixed costs. The more the fixed costs, the higher will be the breakeven point and higher will be the sales volume to be achieved. Performance of the industry: By performance, we understand the products and the technology of a particular industry not becoming obsolete in a short span of time .If the industry is not permanent, then investing in that industry altogether becomes a loosing proportion. In some of he cases a product with additional features manufactured by employing superior technology makes the existing product totally irrelevant or at least results in the manufacturing process becoming a commercially enviable proposition. In this age of rapid technological developments, this factor plays a crucial role in industry analysis. The Government’s role is also important factor affecting the performance of the industry. The attitude of the government towards the industry: It is imperative for an analyst that he should be well aware of the various Government policies and

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It is imperative for an analyst that he should be well aware of the various Government policies and regulations with reference to an industry in which investment is considered. The government policies like deregulating an industry by allowing foreign investment,, imposing high tariffs on imports and restrictive legislation have a bearing on their performance. Some of the legal restrictions result in the profits being very low for a particular industry. Thus an analyst, for that matter, an investor should be thorough with various government regulations and their implications and should be able to predict, at least broadly, the changes likely to take place in the regulations in the near future. Labor conditions within the industry: This is an important factor to be considered in industries which are labor intensive .An analyst should examine the various provisions of the labor laws and also go into the possible reasons that may halt the production process and its fallout on the profits of the industry .In case of a prolonged strike ,a labor intensive firm will not only lose its customers and goodwill but also may not be able to cover its fixed costs in certain cases. Competitive conditions: While analyzing this situation, the three general types of barriers that an analyst should concentrate on ,are • Existence of product differentiation • Absolute cost advantages Advantages rising form economies of scales The existence of the first barrier assures that a new entrant will not be able to charge as much by the existing firms. Also he has to spend large amounts of money on advertising to capture an acceptable share of the market as this situation is usually found in cases where the customers exhibit a high degree of brand loyalty. By absolute cost advantages, we understand that the existing firms are capable of producing and distributing the products at lower costs than the new entrants irrespective of the volume produced. As a result, they enjoy wider profit margins. This may be due to the fact that the existing firms may have exclusive patents ,own the resources or superior management skills that are not available to new entrants. Economies of scale are usually realized when the production are quite high. A new entrant in this case also has to garner a significant market share so that he can avail the benefits from economies of scale. An analyst or a prospective investor should consider investment in an industry which is well protected. Industry share prices relative to its earnings In addition to the above factors an analyst also has to look at the present share prices. In this case an underpriced share would be the best bet. Also an analyst should examine the fact that the share prices are not high due to the overzealous nature of the investors to acquire the shares of the firms in a new industry. Usually the shares of these companies experience high fluctuations depending on the crowd behavior.

Section C: Applied Theory 6.

Advantages of Listing Listing of securities on the stock exchanges is advantageous to the company as well as to the investors as seen hereunder: a. To the Company i. The company enjoys concessions under Direct Tax Laws - In such companies the public is substantially interested resulting in lower rate of income tax payable by them; ii. The company gains national and international importance by its share value quoted on the stock exchanges; iii. Financial institutions/bankers extend term loan facilities in the form of rupee currency and foreign currency loan; iv. It helps the company to mobilize resources from the shareholders through ‘Rights Issue’ for programs of expansion and modernization without depending on the financial institutions in line with the government policies; v. It ensures wide distribution of shareholding thus avoiding fears of easy takeover of the organization by others. b. To the Investors i. Since the securities are officially traded, liquidity of investment by the investors is well

i.

Since the securities are officially traded, liquidity of investment by the investors is well ensured; ii. Rights entitlement in respect of further issues can be disposed of in the market; iii. Listed securities are well preferred by bankers for extending loan facility; iv. Official quotations of the securities on the stock exchanges corroborate the valuation taken by the investors for purposes of tax assessments under Income Tax Act, Wealth Tax Act, etc.; v. Since securities are quoted, there is no secrecy of the price realization of securities sold by the investors; vi. The rules of the stock exchange protect the interest of the investors in respect of their holdings; vii. Listed companies are obligated to furnish unaudited financial results on a half-yearly basis within two months of the expiry of the period. The said details enable the investing public to appreciate the financial results of the company in between the financial year; viii. Takeover offers concerning listed companies are to be announced to the public. This will enable the investing public to exercise its discretion on such matters. Types of Listing Listing of securities is of five types as follows: Initial Listing A company, whose securities have not been listed earlier in a recognized stock exchange, if desirous of listing its securities, should follow procedures applicable to initial listing. Listing of Public Issue of Shares and/or Debentures A company whose shares are listed on a recognized stock exchange may issue shares and/or debentures to the public for subscription. In such cases the company under the Listing Agreement has to submit necessary application to the stock exchange(s) for listing of its securities. It may so happen that a green field company, i.e., a company shortly after incorporation may issue its shares and/or debentures to the public for subscription. In that event, it has to comply with the formalities applicable to initial listing. Listing of Rights Issue of Shares and/or Debentures Companies whose securities are already listed may issue shares and/or debentures by way of ‘rights’ to the existing shareholders. Under the listing agreement, such companies have to list shares and/or debentures allotted by way of rights to the shareholders with stock exchange(s). Listing of Bonus Issue of Shares Companies which issue bonus shares by capitalization of its reserves, pursuant to the listing agreement should enlist with the stock exchange(s). Bonus shares should issue by submitting necessary application form for official quotation of the bonus shares. Listing of Shares Issued on Amalgamation, Mergers, etc. Amalgamated companies, which issue shares to the shareholders have to get the shares listed on the stock exchanges to enable the erstwhile shareholders with such shares. 7.

Methods of Valuing Minority Interests 1 Top down approach 2. Horizontal approach 3 Bottom-up approach TOP-DOWN APPROACH Steps involved in this method are, 1. Estimate the value of the equity of the firm on control basis 2. Calculate the minority owner’s pro rata interest in the total 3. Estimate the amount of discounts, if nay. In addition, estimation of a further discount for lack of marketability should also be made. Step 1 Value of a firm is defined as the value of the classes of equity taken as a whole, assuming no long-term debt is involved Any of the methods discussed in the earlier part of this chapter can be used to estimate the value of equity of a firm. There is a significant difference between control evaluation and non-control evaluations due to the difference in the way business is analyzed by control buyers and non- control buyers. Control buyers analyze asset values based on only a few situations. Non-control buyers tend to place emphasis on only

analyze asset values based on only a few situations. Non-control buyers tend to place emphasis on only earnings. Step 2 If there is only a single class of stock, (i.e., no warrants or any sort of contingent claims are outstanding) the proportionate value per share is nothing but the firm value divided by the number of shares outstanding. But when there are different classes of interests, firm value must be allocated among them thereby reflecting any dilution from any contingent interest. Step 3 Discounting is done in two steps. In the first step, discounting is done for minority interest and then in the second step, it is done for marketability. HORIZONTAL APPROACH A minority interst may be valued relatively by referring to other minority interest transactions. When the value calculated using the valuation approach is a “publicly traded equivalent value”, then the value needs to be discounted only for lack of marketability. If the value is compared directly with other closely held minority interests, no interests or premiums may be necessary. But in the absence of past transactions in company’s own stock, it is very difficult to find reliable data on minority transactions in representative closely held company stocks. BOTTOM-UP APPROACH Minority interest holders realize income in the form of dividends and capital gains (proceeds on the sales) In this approach, first the dividend cash flows (timing and amounts) should be estimated followed by projection of capital gains (timing and amount). These two cash flows have to be then discounted at an appropriate discount rate, which reflects the degree of uncertainly of realizing the expected return at the time and in the amounts projected. The lack of marketability of the closely held minority interest can be captured in the discount rate. < TOP OF THE DOCUMENT >