Finance End Term 2015

Question 1 (Marks 1+1)

Standard deviation of market portfolio is 30% and expected return on the portfolio is 15%. Assume
riskless asset has an expected return of 5%. In the CAPM world, what proportion of investor ABC’s
wealth would you suggest investing in market portfolio and riskless asset if

a. ABC desires a portfolio with 12% standard deviation

b. ABC desires a portfolio with an expected return of 12%

Question 2 (Marks 1+1)

a. Standard deviation of market return is 20%. XYZ holds a poorly diversified portfolio which has a
standard deviation of 20%. What can you conclude about the beta of XYZ’s portfolio
b. Market portfolio has an expected return of 0.12 and standard deviation of 0.40 and the risk free
rate is 0.04. What is the slope of the security market line?

Question3 (Marks 1+1+5)

Regression of returns of stock DEF on the CNX 50 index gave the following output:

Intercept = 0.06%

Slope of the Regression = 0.46

R squared = 5%

There are 20 million shares outstanding, current market price is Rs.2 per share. Firm has Rs. 2 crore in
debt outstanding. Tax rate is 36%.

a. What will an equity investor in DEF require as a return if Treasury Bill rate is 6% and market risk
premium is 5.5%?
b. What proportion of company’s risk (variance of returns) is diversifiable?
c. DEF has three divisions of equal size. It is divesting one of the divisions for Rs.2 crores and
acquiring another for Rs.5 crores by taking Rs.3 crores as debt for this transaction. The division it
is divesting is in a business where average unlevered beta is 0.20 and division it is acquiring is in
a business where average unlevered beta is 0.80. What is the beta of DEF after this acquisition?

Question 4 (Marks 3)

IIMU needs a software for timely preparation of control reports. One such software can be procured for
Rs. 15 lakhs with a operation and maintenance cost of Rs.2,50,000 per year. If this software is adopted,
there will be a savings in clerical costs of Rs.6,00,000 per annum and other savings of Rs. 1,00,000 per
annum. The software has an economic life of five years and can be depreciated at the rate of 33.33 per
cent per year per the WDV (accelerated depreciation) method. After five years, the software can be
disposed off for value equal to its book value. Tax rate is 50%. What would be the projected cash flows of
this capital budgeting proposal for submission to the Board of Directors?
Question 5 (Marks 5)

A company is looking to increase its sales from current levels by relaxing credit standards. As of now,
they take 30 days to collect receivables. They have the following alternatives to choose from:

Policy P

Increase in Sales: Rs.28 lakh; Average Collection Period for Increased Sales: 45; Bad debt losses on
incremental sales: 3%

Policy Q

Increase in Sales: Rs.18 lakh; Average Collection Period for Increased Sales: 60; Bad debt losses on
incremental sales: 1%

Policy R

Increase in Sales: Rs.12 lakh; Average Collection Period for Increased Sales: 90; Bad debt losses on
incremental sales: 0%

Policy S

Increase in Sales: Rs.6 lakh ; Average Collection Period for Increased Sales: 10; Bad debt losses on
incremental sales :

Given price of the product is Rs.30 per unit, variable cost is Rs.27 per unit; Company has an opportunity
cost of funds of 30%, which policy should it pursue? (Assume a 360 day year).

Question 6 (Marks 4)

A company has 6 crores in sales. Average collection period is 45 days. In order to increase demand, it is
thinking of changing its credit terms. With the new terms being enforced, sales will increase by 15%.
Average collection period would be 75 days, with both old and new customers taking 75 days. Should the
company extend its credit period, given variable costs are Rs.8 for Rs.10 of sales; prevalent interest rates
are 20%. (Assume a 360 day year)

Question 7 (Marks 1+1+1)

An investor buys for Rs.3 a put with strike price of Rs.35 and sells for Rs 1 a put with strike price of
Rs.30. What are the gross and net payoffs if

a. Stock price is above 35

b. Stock price is below 30
c. Stock price is between 30 and 35

Question 8 (Marks 4)

Stock A has an expected return of 12% and standard deviation of 15%. Stock B has an expected return of
15% and standard deviation of 20%. David invests his money in a combination of these two stocks such
that he has an expected return of 13.8%. The expected standard deviation of his portfolio is 16.32%. What
will be the standard deviation of Goliath’s portfolio if he is investing in the same two stocks and his
portfolio gives a return of 14.4%?

Question 9 (Marks 1.5+1.5+2)

The following four types of instruments are available in the market. 

       i.          A European call option on 1 share of XYZ Corporation with a strike price of INR 50 and 1
month to maturity

      ii.          A European put option on 1 share of XYZ Corporation with a strike price of INR 50 and 1
month to maturity

     iii.          A GOI zero coupon bond with INR 50 as face value and 1 month to maturity

     iv.          Shares of XYZ Corporation

Jack and Jill wish to invest in some combination of these stocks. Today is 31 st December 2015. They
approach the professors at IIMU for advice. Prof. Sanan advises Jack to purchase 1 call option and invest
in the zero coupon bond. Prof. Aggarwal advises Jill to purchase 1 share of XYZ Corporation and 1 put
option. Jack and Jill follow the instructions of the professors. Calculate the following:-

a.      What is the value of Jack’s and Jill’s portfolio if the share price of XYZ Corporation at maturity
(31st January 2016) is INR 55?

b.      What is the value of Jack’s and Jill’s portfolio if the share price of XYZ Corporation at maturity
(31st January 2016) is INR 45?

c.      Assuming that the relationship between the value of Jack’s and Jill’s portfolios as found in parts (a)
and (b) above holds for all values of the share price, what is the risk free interest rate in the market if it is
given that the share price, call price and put price  at time of purchase (31st December 2015) were 48, 5
and 6 respectively?