CASE I
The balance sheet and profit and loss account of GNL Limited for the year 20 x 5 are given below
| Balance Sheet, GNL Limited (Rs. in million) | ||
| 20X4 | 20X5 | |
| Liabilities and Equity | ||
| Share capital | 6.5 | 6.5 |
| Reserves and surplus | 7.4 | 9.3 |
| Long-term debt | 5.2 | 3.8 |
| Short-term bank borrowing | 8.3 | 11.7 |
| Current liabilities | 6.6 | 6.7 |
| 34.0 | 38.0 | |
| Assets | ||
| Net fixed assets | 19.6 | 23.2 |
| Current assets | ||
| Cash and bank | 0.6 | 1.1 |
| Receivable | 2.9 | 2.0 |
| Inventories | 8.2 | 9.3 |
| Other assets | 2.7 | 2.4 |
| 34.0 | 38.0 |
| Profit and Loss Account, GNL Limited (Rs. in million) | ||
| 20X4 | 20X5 | |
| Net sales | 39.0 | 57.4 |
| Cost of goods sold | 30.5 | 45.8 |
| Gross profit | 8.5 | 11.6 |
| Operating expenses | 4.9 | 7.0 |
| Operating profit | 3.6 | 4.6 |
| Non-operating surplus/deficit | 0.5 | 0.4 |
| Profit before interest and tax | 4.1 | 5.0 |
| Interest | 1.5 | 2.0 |
| Profit before tax | 2.6 | 3.0 |
| Tax | – | – |
| Profit after tax | 2.6 | 3.0 |
| Dividends | 0.9 | 1.1 |
| Retained earnings | 1.7 | 1.9 |
Required
1. Compute the key ratios for GNL Limited for the year 20 X 5
2. Prepare the Du Pont Chart for the year 20 X 5
3. Prepare the common size and common base financial statements for GNL
4. Identify the financial strength and weaknesses of GNL Limited
5. What are the problems in analyzing financial statements?
6. Discuss the qualitative factors relevant for evaluating the performance and prospects of a company.
CASE II
You have recently graduated as a major in finance and have been hired as a financial planner by Radiant Securities, a financial services company. Your boss has assigned you the task of investing Rs 1,000,000 for a client who has a 1-year investment horizon. You have been asked to consider only the following investment alternatives: T-bills, stock A, stock B, stock C, and market index.
The economics cell of Radiant Securities has developed the probability distribution for the state of the economy and the equity researchers of Radiant Securities have estimated the rates of return under each state of the economy. You have gathered the following information from them:
| Returns on Alternative Investment | ||||||
| State of the Economy | Probability | T-Bills | Stock A | Stock B | Stock C | Market Portfolio |
| • Recession | 0.2 | 6.0% | (15.0%) | 30.0% | 5.00% | 10.00% |
| • Normal | 0.5 | 6.0 | 20.0 | 5.0 | 15.0 | 16.0 |
| • Boom | 0.3 | 6.0 | 40.0 | (15.0) | 25.0 | 30.0 |
Your client is a very curious investor who has heard a lot relating to portfolio theory and asset pricing theory. He requests you to answer the following questions:
a. What is the expected return and the standard deviation of return for stocks A,B,C and the market portfolio?
b. What is the covariance of correlation between on A and B? Returns on A and C?
c. What is the coefficient of correlation between the returns on A and B? Returns on A and C?
d. What is the expected return and standard deviation on a portfolio in which stocks A and B are equally weighted? In which the weights assigned to stocks A, B, and C are 0.4, 0.4, and 0.2 respectively?
e. The beta coefficients for the various alternatives, based on historical analysis, are as follows:
Security Beta
T-bills 0.00
A 1.20
B (0.70)
C 0.90
(i) What is the SML relationship?
(ii) What is the alpha for stocks A, B, and C
f. Suppose the following historical returns have been earned for the stock market and the stock of company D.
| Period | Market | D |
| 1 | (5%) | (12%) |
| 2 | 4 | 6 |
| 3 | 8 | 12 |
| 4 | 15 | 20 |
| 5 | 9 | 6 |
What is the beta for stock D? How would you interpret it?
g. What is Capital Market Line (CML)? Security Market Line (SML)? How is CML related to SML?
h. What is systematic risk? Unsystematic risk? Present the formulae for them
i. What is the basic difference between the CAPM and the APT?
CASE III
Ravi Rao is the Chief Executive Officer of Capmart Limited, an investment advisory firm. Ravi Rao has been requested to give a seminar to a group of finance executives drawn from state run universities. He has been requested to explain the basic concepts and tools useful in bond analysis. Ravi Rao has asked you to help him to make his presentation. In particular, you have to answer the following questions.
a. How is the value of a bond calculated?
b. What is the value of a 9-year, Rs 1,000 par value bond with a 10 percent annual coupon, if its required rate of return is 8 percent?
c. What is the value of the bond described in part (b) if it pays interest semiannually, other things being equal?
d. What is the YTM of a 6-year, Rs 1,000 par value bond with a 10 percent annual coupon, if it sells for Rs 1,050?
e. What is the YTM of the bond described in part (d) if the approximate formula is used?
f. What is the yield to call of the bond described in part (d)if the bond can be called after 3 years at a premium of Rs 50?
g. What is the realized yield to maturity of the bond described in part (d) if the reinvestment rate applicable to the future cash flows from the bond is 8 percent?
h. The holders of the bond described in part (d) expect that the bond will pay interest as promised, but on maturity bondholders will receive only 90 percent of par value. What will be difference between the expected YTM and stated YTM? Use the approximate YTM formula.
i. What is the difference between the annual percentage rate and the effective annual yield?
j. What is the difference between interest rate risk and reinvestment risk?
k. List the key financial ratios that have a bearing on debt rating.
l. What is a yield curve?
m. What factors determine interest rates?
CASE IV
Anand heads the portfolio management schemes division of Phoenix Investments, a well known financial services company. Anand has been requested by Arrow Technologies to give an investment seminar to its senior managers interested in investing in equities through the portfolio management schemes of Phoenix Investments. Manish, the contact person of Arrow Technologies, suggested that the thrust of the seminar should be on equity valuation. Anand has asked you to help him with his presentation.
To illustrate the equity valuation process, you have been asked to analyze Acme Pharmaceuticals which manufactures formulations and bulk drugs. In particular, you have to answer the following questions:
a. What is the general formula for valuing any stock, irrespective of its dividend pattern?
b. How is a constant growth stock valued?
c. What is the required rate of return on the stock of Acme Pharmaceuticals? Assume that the risk-free rate is 7 percent, the market risk premium is 6 percent, and the stock of Acme has a beta of 1.2.
d. Assume that Acme Pharmaceuticals is a constant growth company which paid a dividend of Rs 5.00 yesterday (D0 =Rs 5.00) and the dividend is expected to grow at the rate of 10 percent per year forever.
(i) What is the expected value of the stock a year from now?
(ii) What is the expected dividend yield and capital gains yield in the first year?
e. If the stock is currently selling for Rs 110, what is the expected rate of return on the stock? Assume D0=Rs 5.00 and a constant growth rate of 10 percent.
f. Assume that Acme Pharmaceuticals is expected to grow at a supernormal growth rate of 25 percent for the next 4 years, before returning to the constant growth rate of 10 percent. What will be the present value of the stock under these conditions? What is the expected dividend yield and capital gains yield in year 2? Year 5? Hereafter assume D0 = Rs 5.00 and a 15 percent required return.
g. Assume that Acme Pharmaceuticals will have zero growth during the first 2 years and then resume its constant growth of 10 percent in the third year. What will be the present value of the stock under these conditions?
h. Assume that the stock currently enjoys a supernormal growth rate of 30 percent. The growth rate, however, is expected to decline linearly over the next four years before settling down at 10 percent. What will be the present value of the stock under these conditions?
i. Assume that the earnings and dividends of Acme Pharmaceuticals are expected to decline at a constant rate of 5 percent per year. What will be the present value of the stock? What will be the dividend yield and capital gains yield per year?
j. Assume that the earnings and dividends of Acme Pharmaceuticals are expected to grow at a rate of 30 percent per year for the next 3 years and thereafter the growth rate is expected to decline linearly for the following 4 years before settling down at 10 percent per year forever. What will be the present value of the stock under these conditions?
CASE V
1. The financials of MM Limited are given below:
| (Rs in million) | |||||
| 20 X 1 | 20 X 2 | 20 X 3 | 20 X 4 | 20 X 5 | |
| Net sales | 780 | 910 | 1120 | 1400 | 1780 |
| Cost of goods sold | 600 | 720 | 850 | 1030 | 1210 |
| Gross profit | 180 | 190 | 270 | 370 | 570 |
| Operating expenses | 70 | 80 | 100 | 120 | 170 |
| Operating profit | 110 | 110 | 170 | 250 | 400 |
| Non-operating surplus/deficit | 10 | 20 | 30 | 20 | 10 |
| PBIT | 120 | 130 | 200 | 270 | 410 |
| Interest | 40 | 50 | 60 | 80 | 120 |
| Profit before tax | 80 | 80 | 140 | 190 | 290 |
| Tax | 20 | 20 | 30 | 40 | 50 |
| Profit after tax | 60 | 60 | 110 | 150 | 240 |
| Dividends | 20 | 20 | 30 | 40 | 50 |
| Retained earnings | 40 | 40 | 80 | 110 | 190 |
| Equity share capital (Rs 10 par) | 300 | 300 | 300 | 300 | 300 |
| Reserves and surplus | 200 | 240 | 320 | 430 | 620 |
| Shareholder’s funds | 500 | 540 | 600 | 730 | 920 |
| Loan funds | 500 | 550 | 600 | 700 | 980 |
| Capital employed | 1000 | 1090 | 1220 | 1430 | 1900 |
| Net fixed assets | 570 | 650 | 780 | 920 | 1100 |
| Investments | 30 | 30 | 20 | 40 | 40 |
| Net current assets | 400 | 410 | 420 | 470 | 760 |
| Total assets | 1000 | 1090 | 1220 | 1430 | 1900 |
| Market price per share (End of year) | Rs 20 | 22 | 45 | 56 | 78 |
Required
(a) Calculate the following for the last five years: Return on equity; Book value per share; EPS; Bonus adjustment factor; Adjusted EPS; PE ratio (prospective); PB ratio (retrospective); Retention ratio.
(b) Calculate the CAGR of sales, CAGR of EPS, and volatility of ROE.
(c) Calculate the sustainable growth rate based on the average retention ratio and average return on equity for the past 3 years.
(d) Decompose the ROE for the last two years in terms of five factors.
(e) Estimate the EPS for the next year (20X6) using the following assumptions: (i) Net sales will increase by 15%. (ii) Cost of goods sold will increase by 16%. (iii) Operating expenses will increase by 20%. (iv) Non-operating surplus will be Rs 10 million. (v) Interest will increase by 10%. (vi) The effective tax rate will increase by 5%.
(f) Derive the PF ratio using the constant growth dividend model. For this purpose use the following assumptions: (i) The dividend payout ratio for 20X6 is set equal to the average dividend payout ratio for the period 20X3- 20X5. (ii) The required rate of return is estimated with the help of the capital asset pricing model (Risk-free rate = 10%, Beta of MM’s stock = 1.1, Market risk premium =8%). (iii) The expected growth rate in dividends is set equal to the product of the average retention ratio and the average return on equity for the previous three years.
(g) Established a value anchor.
CASE VI
Delphi Capital Management (DCM) is an investment management firm which, inter alia, offers portfolio management service to high networth individuals. Avinash Joshi, managing director of DCM, realized that many clients have interest in using options, but often do not understand the risks and rewards associated with these instruments.
You have joined DCM about six months ago. After majoring in finance you worked for a well known securities firm where you received good exposure to derivative instruments, before joining DCM. Appreciating your expertise, Avinash Joshi has asked you to educate and guide clients interested in using options
You have been approached by Pradeep Sharma, an eminent surgeon and long-time client of DCM, who wants to understand about options and the strategies based on options. You have decided to use the following data to Newage Hospitals Limited, a company in which Pradeep Sharma has equity shares, to guide him.
| Newage Hospitals Option Quotes | ||||||
| Stock Price : 325 | ||||||
| Calls | Puts | |||||
| Strike Price | Jan | Feb | March | Jan | Feb | March |
| 280 | 48 | 53 | – | – | – | – |
| 300 | 34 | 38 | 41 | 2 | 4 | 6 |
| 320 | 15 | 18 | 20 | 6 | 9 | – |
| 340 | 5 | 8 | 14 | 17 | 19 | 21 |
| 360 | 2 | 4 | 5 | – | 40 | – |
To educate your client you have to develop answers for the following questions:
a. What do the following terms mean: call option, put option, strike price (exercise price), and expiration date?
b. Which options are in –the-money and which options are out – of-the- money?
c. Assume that Pradeep Sharma owns 1000 shares of Newage Hospitals. What are the relative pros and cons of selling a call against this position using (i) January/340 versus (ii) March/300
d. What is the maximum profit, maximum loss, and break-even price associated with the strategy of simultaneously buying March/340 call while selling March/360 call?
e. What are the implications for Pradeep Sharma if he simultaneously writes March/340 call and buys March/300 put?
f. What is the profit at various stock prices of a March/340 straddle? Give the answer in the form of a graph.
g. What impact do the following have on the value of a call option?
- Current price
- Exercise price
- Options term to maturity
- Risk-free rate
- Variability of the stock price
h. What assumptions underlie the Black-Scholes option pricing model?
i. What are the three equations that constitute the Black-Scholes model?
j. What should be value of the March/320 call as per the Black-Scholes model? Assume that t = 3 months, rf=6 percent, and 0=0.30.
k. What is a collar?