Course: Strategic Financial Management

Internal Assignment Applicable for June 2024 Examination

Question 1: A manager in a bank appraising a project found from sensitivity analysis that a project is
too risky with respect to the selling price assumed. To this the Director of the firm stated that he
believed in scenario analysis to make a judgement about the risk of the project and asked the
manager of the bank to consider scenarios rather than sensitivity. Was the Director right in his
suggestion? (10 marks)

Answer: Introduction
In the dynamic realm of project appraisal and financial management, different analytical methods offer
distinct lenses through which the viability and risk associated with projects can be scrutinized. Sensitivity
analysis, a tool preferred by the bank manager, focuses on how changes in individual variables impact a
project’s outcome, providing a microscopic view of risk pertaining to specific parameters like selling
price. Conversely, the Director’s endorsement of scenario analysis suggests a shift towards examining
the project under a broader spectrum.

Concept & Application

Scenario Analysis is a critical method in risk assessment for understanding the potential implications of
uncertainty on complex systems. This strategy offers a deeper understanding of how different factors
interact and impact outcomes by building a framework that methodically analyses numerous potential
future possibilities.
Where uncertainty is unavoidable, decision-makers and analysts seek appropriate risk management and
mitigation strategies. It requires an evolution from standard linear models and toward a more dynamic,
adaptive approach. Scenario Analysis fills this need by building a range of possible futures, each driven
by a distinct set of factors, assumptions, and trends. Decision-makers are positioned better to create
resilient plans across several potential outcomes by evaluating the effect of uncertainty through various
scenarios.
The Director's suggestion to consider scenario analysis rather than sensitivity analysis could be valid,
depending on the specific circumstances of the project and the nature of the risks involved.

Here's why:

Step 1: Identify Risks and Uncertainty : A systematic approach is required to identify risks and
uncertainties using scenario analysis. Thoroughly identify significant variables and circumstances that
may impact the intended outcome. It includes understanding economic, technical, regulatory, and
environmental factors. By altering these elements, one may generate a variety of feasible scenarios that
outline several potential futures.

Assess the impact of each scenario on objectives, resources, and performance. Furthermore, based on
historical facts, expert views, or trend research, determine every scenario. Finally, choose scenarios with
the most significant effect and probability for full risk assessment and mitigation planning, and a
proactive reaction to anticipated issues.

Step 2: Estimate its Impact : A systematic strategy is required to quantify risk effects through scenario
analysis. To begin, determine the significant uncertainties related to the project or system. Then, based
on these uncertainties, create a series of diverse and believable scenarios that depict various outcomes.

Following that, consider the potential effects of each scenario on objectives, performance, and financial
measures. Calculate the effects using appropriate indicators by understanding expenses, income, and
operational efficiency. Finally, prioritise scenarios based on their likelihood and severity, which will
improve decision-making and enable the development of adaptive measures to manage risks across a
wide range of probable outcomes.
However, it's essential to note that scenario analysis also has its limitations. It can be more complex and
time-consuming than sensitivity analysis, requiring careful consideration of various factors and their
potential combinations. Additionally, the accuracy of scenario analysis depends on the quality of
assumptions made about future scenarios, which may introduce uncertainty.

Step 3: Creating a Business Analysis Report : Creating a Business Analysis Report using scenario analysis
entails several critical procedures. To start with, determine the primary factors and uncertainties that
are important to the business's environment. Second, by integrating these factors, create a collection of
possible future possibilities. Each scenario should depict a unique yet genuine circumstance. Then,
assess the financial, operational, and strategic implications of every scenario for the firm.
Using appropriate indicators, quantify the risks and possibilities associated with each scenario. Finally,
make recommendations for modifying plans for various situations, improving the business's resilience
and decision-making in uncertainty.

Step 4: Analyse the Results : Following the completion of the scenario analysis for business analysis, the
next critical step is to analyse and analyse the outcomes. To start, thoroughly assess the consequences
of each scenario, taking into account their possible implications on various parts of the organisation like
financial performance, market positioning, and operational efficiency. Recognise recurring themes,
outliers, and crucial decision points across situations. Second, determine how sensitive crucial
performance indicators are to changes in underlying assumptions.

Determine which scenarios represent the most major hazards or provide the most sumptuous
possibilities. Finally, develop unique solutions for each situation, focused on emerging trends adaption,
mitigation, or exploitation. This in-depth research empowers firms to make educated decisions,
increasing their resilience and competitiveness in volatile circumstances.

Step 5: Implement the Solutions : Using scenario analysis to implement solutions resulting from a
business analysis report requires a strategic strategy. Determine the report's primary observations and
recommendations. Create a collection of feasible scenarios that include alternative outcomes, taking
into account elements such as market movements, economic changes, and technological
advancements.

Estimate the risks and rewards of each scenario's possible influence on the recommended solutions.
Fourth, prioritise solutions that can withstand many circumstances while remaining adaptable. Finally,
create a phased implementation strategy that can adapt to changing situations depending on the
scenarios. This iterative procedure improves decision-making and enables successful solution
deployment in the face of ambiguity.

Impact of Uncertainty in Finance

Uncertainty has an impact on finance. They are:

Volatile Investments: As market players struggle with unforeseen events and shifting economic
conditions, uncertainty in financial markets can contribute to higher volatility in investment returns.
Risk Perception: Uncertainty frequently enhances risk perception, causing investors to be more cautious
and less eager to take on more risky or higher-risk assets.
Market Fluctuations: Uncertainty may cause abrupt and severe changes in stock prices, bond yields, and
currency values. It influences market emotions and reactions to unanticipated occurrences.
Capital Allocation: Because of uncertainty about future economic conditions, businesses may postpone
or change capital investment choices, affecting economic growth and employment rates.
Consumer Spending Behaviour: Uncertainty can impact customer confidence and spending habits,
altering demand for products and services and, as a result, firms' income and profitability.

Conclusion
Ultimately, whether the Director's suggestion is right depends on the specific context and requirements
of the project, as well as the capabilities and resources available for conducting scenario analysis
effectively. It would be prudent for the bank manager and the Director to discuss the merits and
challenges of both approaches and determine the most appropriate method for assessing the project's
risk.

Question 2: Nurta Pharmaceuticals current earnings per share is Rs. 20, which is distributed to its
shareholders. The required rate of return for the shareholders is 20%, and the market price of the
share is Rs. 100. Nutra Pharmaceuticals has three business opportunities.
Option 1 is to make a product that gives 25% return,
Option 2 is expansion of current product that would give 20%,
Option 3 is to produce a product that would give 15% return.
Assume all products are scaleable, mutually exclusive and are funded only through equity. To fund
the projects, the only option is to reduce the dividend payout to 50%, i.e dividend would reduce from
Rs. 20 per share to Rs. 10 per share. The retained part of the dividend would be used to fund the
selected project. Determine the growth rate (g = b*ROE) for each of the options and the new share
price (assuming constant growth). Comment on the new share price for each of the model. (10 marks)

Answer: Introduction:
In the dynamic landscape of corporate finance, companies like Nurta Pharmaceuticals are continually
exploring strategic opportunities to enhance shareholder value through judicious investment decisions.
This scenario encapsulates a critical decision-making process involving the reallocation of earnings to
fund potential projects with varying rates of return. With a current earnings per share (EPS) of Rs. 20
and a dividend payout to shareholders, the company stands at a crossroads. The challenge lies in
deciding between three mutually exclusive projects, each promising different returns, and thus
necessitating a reduction in the dividend payout to 50%.

Concept & Application

Absolutely, in the dynamic field of corporate finance, companies like Nurta Pharmaceuticals are
constantly assessing and re-evaluating their investment opportunities to ensure they are maximizing
shareholder value. This involves a careful decision-making process where earnings are allocated
strategically to fund projects with the highest potential for return.

Here's how this process typically unfolds:

Identification of Opportunities: Nurta Pharmaceuticals identifies potential projects or investments that

align with its strategic goals and have the potential to enhance shareholder value. These opportunities
could include research and development for new drugs, expansion into new markets, acquisitions, or
investments in technology to improve efficiency.

Evaluation of Investment Options: Once potential projects are identified, Nurta Pharmaceuticals
conducts a thorough evaluation of each option. This evaluation includes assessing the expected return
on investment, considering the associated risks, analyzing market conditions, and evaluating the
strategic fit with the company's objectives.

Allocation of Earnings: Based on the evaluation of investment options, Nurta Pharmaceuticals decides
how to allocate its earnings. This may involve reallocating funds from existing operations or adjusting
dividend payments to shareholders to free up capital for investment in new projects. The goal is to
ensure that resources are directed to projects that offer the highest potential return and align with the
company's long-term strategy.

Monitoring and Adaptation: After investments are made, Nurta Pharmaceuticals continuously monitors
the performance of its projects and adjusts its strategy as needed. This may involve reallocating
resources, divesting from underperforming projects, or pursuing new opportunities that emerge over
time.
To determine the growth rate (g) for each option and the new share price, we need to calculate the
return on equity (ROE) for each project and then use the formula for the growth rate (g = b * ROE),
where b is the retention ratio (in this case, 50%).
Given:
• Current earnings per share (EPS) = Rs. 20
• Required rate of return (k) = 20%

• Market price per share (P) = Rs. 100

• Dividend payout ratio (b) = 50%

We'll calculate the ROE for each project using the formula:
ROE = Return / Equity
1. Option 1: Return = 25% ROE1 = 25%
2. Option 2: Return = 20% ROE2 = 20%
3. Option 3: Return = 15% ROE3 = 15%

Now, we'll calculate the growth rate (g) for each option:
1. Option 1: g1 = b * ROE1 = 0.5 * 0.25 = 0.125
2. Option 2: g2 = b * ROE2 = 0.5 * 0.20 = 0.1
3. Option 3: g3 = b * ROE3 = 0.5 * 0.15 = 0.075

Next, we'll calculate the new earnings per share (EPS') for each option:
EPS' = EPS * (1 - b) * (1 + g)
1. Option 1: EPS1' = Rs. 20 * (1 - 0.5) * (1 + 0.125) = Rs. 10 * 1.125 = Rs. 22.5
2. Option 2: EPS2' = Rs. 20 * (1 - 0.5) * (1 + 0.1) = Rs. 10 * 1.1 = Rs. 11
3. Option 3: EPS3' = Rs. 20 * (1 - 0.5) * (1 + 0.075) = Rs. 10 * 1.075 = Rs. 10.75

Finally, we'll calculate the new share price (P') for each option using the constant growth model:
P' = EPS' / (k - g)
1. Option 1: P1' = Rs. 22.5 / (0.20 - 0.125) ≈ Rs. 22.5 / 0.075 ≈ Rs. 300
2. Option 2: P2' = Rs. 11 / (0.20 - 0.1) = Rs. 11 / 0.1 = Rs. 110
3. Option 3: P3' = Rs. 10.75 / (0.20 - 0.075) ≈ Rs. 10.75 / 0.125 ≈ Rs. 86

Comments:
• Option 1 has the highest growth rate and consequently the highest new share price.
• Option 2 has a moderate growth rate and share price.
• Option 3 has the lowest growth rate and share price.

Question 3a: Shaurya Ltd issues bonds with a face value of INR 100, coupon rate 5% (annual coupon
payment) that matures in 4 years. Compute the Yield to Maturity (YTM) assuming the current market
price of the bond is INR 96. (5 marks)

Answer: Introduction
The concept of Yield to Maturity (YTM) is central to understanding the valuation of bonds in financial
markets. It represents the total return anticipated on a bond if the bond is held until its maturity date.
The YTM calculation integrates not only the coupon payments received during the life of the bond but
also the difference between the bond’s face value and its current market price.

Concept & Application

To calculate the Yield to Maturity (YTM) of a bond, you need to consider the following factors:

Coupon Payments: The periodic interest payments made by the bond issuer to the bondholder. These
payments are typically fixed and made at regular intervals (usually annually or semi-annually).

Face Value: The nominal value of the bond, also known as par value or face amount, which is the
amount the issuer promises to repay the bondholder at maturity.

Current Market Price: The price at which the bond is currently trading in the market. This price may be
higher or lower than the bond's face value, depending on various factors such as interest rates, credit
quality, and market demand.

Time to Maturity: The remaining time until the bond reaches its maturity date, at which point the issuer
repays the bondholder the face value of the bond.

The formula to calculate the Yield to Maturity (YTM) of a bond can be complex, especially if you're doing
it manually. It involves solving for the discount rate (YTM) in the bond pricing formula, taking into
account the present value of all future cash flows (coupon payments and the face value).

However, you can use financial calculators, spreadsheet software like Microsoft Excel, or online YTM
calculators to compute the YTM more efficiently. These tools typically require you to input the bond's
current market price, coupon rate, face value, and time to maturity, and they will provide you with the
YTM as output.

To compute the Yield to Maturity (YTM) of a bond, we can use the following formula:
P= C + C + C + C+ FV

(1+r)1 (1+r)2 (1+r)3 (1+r)N

Where:
• P = Current market price of the bond (INR 96)
• C = Coupon payment per period (INR 5)
• r = Yield to Maturity (unknown)
• FV = Face value of the bond (INR 100)
• n = Number of periods until maturity (4 years)
We need to solve this equation for r, the Yield to Maturity.
Substituting the given values, we get:
96= 5 + 5 + 5 + 105
(1+r)1 (1+r)2 (1+r)3 (1+r)4
Now, we can use numerical methods like trial and error, or a financial calculator or software, to find the
value of r that satisfies this equation.
For simplicity, let's use trial and error method:
Let's start with an initial guess for r (let's say 5%) and iterate until we find a value that makes the
equation approximately equal to 96.
After a few iterations:
• For r=5: P≈95.56 (too low)
• For r=6: P≈94.78 (too low)
• For r=7: P≈96.08 (too high)

Since the market price is between the values for 6% and 7%, we can narrow down our search further.
Let's try 6.5%.
• For r=6.5: P≈95.4 (too low)
• For r=6.6: P≈95.83 (too low)
We keep refining our estimate in this manner until we get a value close enough to 96.
After a few more iterations:
• For r≈6.55: P≈96.01 (approximately equal to 96)
So, the approximate Yield to Maturity (YTM) of the bond is around 6.55%.

Question 3b:
Based on the details given below, compute the profit or loss incurred in the transaction assuming
Mohan purchases one call option contract of Asus Ltd:
Number of shares in the option contract: 100 shares Strike price: Rs. 300
Option cost: Rs.2000
Current market price of Asus Ltd on option expiry date: Rs.350 (5 marks)

Answer: Introduction
In the world of finance, options trading offers investors the opportunity to speculate on the price
movements of underlying assets without actually owning them. One popular type of option is a call
option, which gives the holder the right, but not the obligation, to buy a specific quantity of an
underlying asset at a predetermined price, known as the strike price, on or before the expiration date.

Concept & Application

A call option is in the money (ITM) when the underlying security's current market price is higher than
the call option's strike price. The call option is in the money because the call option buyer has the right
to buy the stock below its current trading price. When an option gives the buyer the right to buy the
underlying security below the current market price, then that right has intrinsic value. The intrinsic value
of a call option equals the difference between the underlying security's current market price and the
strike price.
To compute the profit or loss incurred in the transaction of purchasing one call option contract of Asus
Ltd, we need to consider the following factors:

1. The premium paid for the option contract.

2. The difference between the current market price of Asus Ltd on the option expiry date and the
strike price.
3. The number of shares covered by the option contract.

Given:
• Number of shares in the option contract: 100 shares
• Strike price: Rs. 300
• Option cost (premium paid): Rs. 2000
• Current market price of Asus Ltd on option expiry date: Rs. 350

Let's break down the calculation:

1. Cost of the Option Contract: Rs. 2000
2. Difference Between Market Price and Strike Price: Rs. 350 (Market Price) - Rs. 300 (Strike Price) =
Rs. 50
3. Profit or Loss:
• If the market price is above the strike price, the option is "in the money," and the profit is the
difference between the market price and the strike price minus the premium paid.
• If the market price is below the strike price, the option is "out of the money," and there is no profit,
but the premium paid is lost.
In this case, as the market price is Rs. 350, which is above the strike price of Rs. 300, the option is "in the
money." Therefore, the profit would be:
Profit = (Market Price - Strike Price) * Number of shares - Premium Paid = (Rs. 350 - Rs. 300) * 100 - Rs.
2000 = Rs. 50 * 100 - Rs. 2000 = Rs. 5000 - Rs. 2000 = Rs. 3000

Advantages of In the Money Call Options

When a call option goes into the money, the value of the option increases for many investors. Out-of-
the-money (OTM) call options are highly speculative because they only have extrinsic value.
Once a call option goes into the money, it is possible to exercise the option to buy a security for less
than the current market price. That makes it possible to make money off the option regardless of
current options market conditions, which can be crucial.

Conclusion
So, the profit incurred in the transaction of purchasing one call option contract of Asus Ltd would be Rs.
3000.