Certified Financial Manager

Answers to Theory Questions for PROJECTS (Certified Financial Manager course)

2011-12-17T03:25:00.000-08:00

PAPER 2: PROJECT APPRAISAL AND FINANCING

Contents

PAPER 2: PROJECT APPRAISAL AND FINANCING

01. What do the critics of the goal of maximising shareholder wealth say? What is the rebuttal provided by the advocates of maximising shareholder wealth?

02. How is the finance function organised in a large company?

03. Discuss the relationship of financial management to economics and accounting?

04. Discuss the functions performed by the financial system in an economy.

05. What functions are performed by financial markets? What are the different ways of classifying financial markets?

06. What is the rationale of financial intermediaries? Describe briefly various financial intermediaries in India.

07. Discuss the important facets of project analysis.

08. What are the weaknesses found in capital budgeting in practice?

09. Explain the nature of the following portfolio planning tools:

(a) BCG Product Portfolio Matrix and

(b) General Electric Stoplight Matrix.

10. Discuss the basic strategies associated with the SPACE approach.

11. How can conglomeration help in overcoming the institutional weaknesses in the emerging markets?

12. Discuss the organisational capabilities that enable firms to exploit opportunities.

13. Discuss the forces that drive the profit potential of an industry according to Michael Porter.

14. What are the sources of positive NPV?

15. What qualities and traits are required to be a successful entrepreneur?

16. Discuss the steps involved in a sample survey.

17. Explain briefly various demand forecasting techniques.

18. Discuss the aspects covered in market planning.

19. a. What factors have a bearing on the choice of technology? b. What factors have a bearing on the plant capacity?

20. Explain the properties of the NPV rule.

21. Discuss the problems associated with IRR.

22. Discuss the guidelines to be borne in mind while estimating the cash flows of a project.

23. Discuss the biases characterising cash flow estimation.

24. Discuss the approaches used for estimating the cost of equity.

25. What are the common misconceptions surrounding cost of capital in practice? How would you dispel them?

26. What steps are involved in stimulation analysis?

27. What are the devices commonly used for managing project risk?

28. Discuss the principal sources of discrepancy between social costs and benefits on the one hand and monetary costs and benefits on the other.

29. Why a gulf may exist between strategic planning and financial analysis and show how the differences between the two may be reconciled?

30. Discuss the distorting effects of the following types of informational asymmetry on capital budgeting.(a) Informational asymmetry between shareholders and bond holders. (b) Informational asymmetry between managers and shareholders.

31. Discuss the salient features of infrastructure project finance

32. Briefly describe the key elements of a VC investment appraisal and management as a VC transaction evolves through the life cycle of a deal within a VC fund's system

33. Discuss the human aspects of project management.

34. What are the pre-requisites for successful project implementation?

35. a. What is the difference between economic accounting and mental accounting? b. Discuss measures for injecting greater rationality in project termination decisions.

01. What do the critics of the goal of maximising shareholder wealth say? What is the rebuttal provided by the advocates of maximising shareholder wealth?

ANS: Pg 7, FINANCIAL MANAGEMENT

Business objective of any company shall be:

· Maximization of returns on stakeholders capital and,

· Profit Maximization

Earlier profit maximization was given highest priority. But these days we have understood that if you want to continue in the market the prime focus shall be in maximizing returns of its stakeholders, which means maximizing the price of the stock/shares, paying back healthy dividends, issuing bonus shares when necessary, etc.

Stockholders wealth maximization is a long term goal as they are investing in a company expecting good future returns.

Much of the theory in corporate finance, based on the assumption that the goal of the firm, should be to maximize the wealth of its current shareholders. This goal has been defended by many finance scholars, economists and practitioners.

Critique	Defence
capital market skeptics argue that stock market displays myopic tendencies	In developed financial markets, share prices are the least based on estimates of intrinsic values.
Strategic visionaries are inclined towards increasing the product market goal like market share, customer satisfaction, zero defect level.	Beyond certain point the customer satisfaction comes at the cost of shareholder value. When that happens, the conflict should be resolved in favour of shareholders to enhance the long-term viability and competitiveness of the firm.
Balancers argue that a firm should seek to balance the interest of various stakeholders, viz. customers, employees, shareholders, creditors, suppliers, community and others.	This is not practical. This can lead to confusion and chaos.
Advocates of social responsibility argue that a business firm must view itself as a socially responsive entity and assume wider responsibilities.	If the businesses engage in social programmes it may become vulnerable to competitive encroachment.

02. How is the finance function organised in a large company?

ANS:

Finance functions are:

1. Financing decisions

2. Investment decisions

3. Dividend decisions

4. Liquidity decisions

1. Financing decisions

Financing Decisions are decisions regarding process of raising the funds. This function of finance is concerned with providing answers to various questions like -

+ What should be amount of funds to be raised?

+ What are the various sources available to organisation for raising the required amount of funds? For this purpose, the organization can go for internal & external sources.

+ What should be proportion in which internal & external sources should be used by organisation?

+ If organisation, wants to raise funds from different sources, it is required to comply with various legal & procedural formalities.

+ What kinds of changes have taken place recently affecting capital market in the country?

2. Investment decisions

The assets in which funds can be invested are of 2 types

+ Fixed assets: are the assets which bring returns to organisation over a longer span of time. The investment decisions in these types of assets are “capital budgeting decisions.” Such decisions include:

+ How fixed assets should be selected to make investment? What are various methods available to evaluate investment proposals in fixed assets?

+ How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity?

+ Current assets: are assets which get generated during course of operations & are capable of getting converted in form of cash within a short period of one year. Such decisions include

+ What is meaning of Working Capital management & its objectives?

+ Why need for working capital rises?

+ What are factors affecting requirements of working capital?

+ How to quantity requirements of working capital?

+ What are sources available for financing the requirement of working capital?

3. Dividend decisions

+ What are forms in which dividend can be paid to shareholders?

+ What are legal & procedural formalities to be completed while paying dividend different forms?

4. Liquidity Decisions Current assets should be managed efficiently for safe guarding firm against of liquidity & insolvency. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound technique of managing current assets.

The organisation of finance function is not similar in all businesses but it is different from one business to another. The organisation of finance function for a business depends on the nature, size financial system and other characteristics of a firm. For a /small business/, no separate officer is appointed for the finance function. Owner of the business himself looks after the functions of finance including the estimation of requirements of funds, preparation of cash budget and arrangement of the required funds, examination of all receipts and payments, preparation of credit policy, collecting debtors etc. with the increase in the size of business, specialists were appointed for the finance function and the decentralisation of the finance functionbegan. For a /medium sized business/, the responsibility of the finance function is given to a separate officer who is known as financial controller, finance manager, deputy chairman (finance), finance executive or treasurer.

Treasurer	Controller
Obtaining finance	Financial Accounting
Banking relationships	Internal Audit
Cash Management	Taxation
Credit Administration	Management Accounting
Capital Budgeting	Mgmt Acct and control

03. Discuss the relationship of financial management to economics and accounting?

ANS:

04. Discuss the functions performed by the financial system in an economy.

ANS:

05. What functions are performed by financial markets? What are the different ways of classifying financial markets?

ANS:

06. What is the rationale of financial intermediaries? Describe briefly various financial intermediaries in India.

ANS:

07. Discuss the important facets of project analysis.

ANS:

Examples: Service: 3G mobile service launch in India;

Setup a plant for advanced technology battery operated car.

1. Market Analysis (Aggregate Demand, Market Share)

Mobile broadband usage in India, Cost Structure, Elasticity of Demand, Consumer Behaviour, Distribution Channels, Administrative, Technical and legal constraints, Structure of competition.

2. Technical Analysis (Technical Viability, Sensible Choices)

Preliminary tests and studies,

Availability of raw material, power, other inputs

Scale of operation

Production Process

Equipment and machines chosen

Auxiliary equipments and supplementary engineering works

Work schedules for production

Layout of the site, buildings and plant

3. Financial Analysis (Risk, Return)

Investment outlay

Means of financing

Cost of capital

Projected profitability

Break-even point

Cash Flows of the project

Investment worthiness

Projected financial position

Level of risk

4. Economic Analysis (Benefits and Costs in Shadow Prices, Other Impacts)

Social cost benefit analysis

Impact of the project on distribution of income in the society

Level of savings and investments in the society

Self-sufficiency, employment, and social order

5. Ecological Analysis (Environmental Damage, Restoration Measures)

Likely damage to environment

Restoration measures required to ensure balance

08. What are the weaknesses found in capital budgeting in practice?

ANS:

09. Explain the nature of the following portfolio planning tools:

(a) BCG Product Portfolio Matrix and

(b) General Electric Stoplight Matrix.

ANS:

10. Discuss the basic strategies associated with the SPACE approach.

ANS:

11. How can conglomeration help in overcoming the institutional weaknesses in the emerging markets?

ANS:

12. Discuss the organisational capabilities that enable firms to exploit opportunities.

ANS:

13. Discuss the forces that drive the profit potential of an industry according to Michael Porter.

ANS:

14. What are the sources of positive NPV?

ANS:

15. What qualities and traits are required to be a successful entrepreneur?

ANS:

16. Discuss the steps involved in a sample survey.

ANS:

17. Explain briefly various demand forecasting techniques.

ANS:

18. Discuss the aspects covered in market planning.

ANS:

19. a. What factors have a bearing on the choice of technology? b. What factors have a bearing on the plant capacity?

ANS:

20. Explain the properties of the NPV rule.

ANS:

21. Discuss the problems associated with IRR.

ANS:

22. Discuss the guidelines to be borne in mind while estimating the cash flows of a project.

ANS:

23. Discuss the biases characterising cash flow estimation.

ANS:

24. Discuss the approaches used for estimating the cost of equity.

ANS:

25. What are the common misconceptions surrounding cost of capital in practice? How would you dispel them?

ANS:

26. What steps are involved in stimulation analysis?

ANS:

27. What are the devices commonly used for managing project risk?

ANS:

1. Fixed and Variable cost (FIN) change proportion of fixed vs variable. Ford getting parts from suppliers. Reduced breakeven levels.

2. Sequential Investment (FIN) start small and later expand

3. Financial Leverage (FIN)

4. Insurance (FIN)

5. Derivatives (FIN)

6. Improving Information (MKT)

7. Pricing Strategy (MKT)

8. Long term arrangements (OPR)

9. Strategic Alliance (STR)

28. Discuss the principal sources of discrepancy between social costs and benefits on the one hand and monetary costs and benefits on the other.

ANS:

29. Why a gulf may exist between strategic planning and financial analysis and show how the differences between the two may be reconciled?

ANS:

30. Discuss the distorting effects of the following types of informational asymmetry on capital budgeting.(a) Informational asymmetry between shareholders and bond holders. (b) Informational asymmetry between managers and shareholders.

ANS:

31. Discuss the salient features of infrastructure project finance.

ANS:

32. Briefly describe the key elements of a VC investment appraisal and management as a VC transaction evolves through the life cycle of a deal within a VC fund's system.

ANS:

33. Discuss the human aspects of project management.

ANS:

1. Authority – Influence, rationale, logic, project benefit.

2. Orientation – change the mindset from engineering view to managerial view.

3. Motivation – reward and punishment model. Theory of motivation (Maslow), etc

4. Group functioning – formal informal groups, ‘we/they’ attitude, team cycle – forming, storming, performing.

34. What are the pre-requisites for successful project implementation?

ANS:

1. Adequate Preparation before actual start

Any deficiencies in preliminary analysis or investigation can have unrecoverable impact at later stages. This could include superficial field investigation, incomplete assessment of input requirements, flawed judgment due to lack of experience, execution before planning or deliberate over estimation of benefits.

2. Sound Project organization

Four levels of Project Maturity Levels.

a) Hero

b) Anyone is Hero

c) Benefits

d) Portfolio Management and Strategic

3. Proper implementation planning

Planning before execution

4. Advance action

Preliminary analysis and prerequisites readiness. Activities that take large cycle time, such as Govt approvals should be initiated during early stages.

5. Timely availability of funds

Budget planning and expenses. Lineup suppliers and contacts with third parties.

6. Judicious equipment tendering and procurement

Turnkey contracts, foreign suppliers and indigenous suppliers. Dependence and over-reliances. Have at least 2 suppliers.

7. Better contract management

Choosing right partners, choosing right contract models, evaluation of buy-rent decisions.

8. Effective monitoring

Anticipate deviations and take corrective actions.

35. a. What is the difference between economic accounting and mental accounting? b. Discuss measures for injecting greater rationality in project termination decisions.

ANS:

Answers to Theory Questions for FINANCIAL MANAGEMENT (Certified Financial Manager course)

2011-12-17T02:50:00.000-08:00

FINANCIAL MANAGEMENT

Contents

FINANCIAL MANAGEMENT

1. What are the implications of market efficiency for corporate finance?

2. State the key assumptions underlying the *Modigliani and Miller theory* of capital structure. Discuss the two key propositions of their theory.

3. How does the presence of taxes, financial distress costs, and agency costs, modify the MM results?

4. Discuss the *guidelines* to be borne in mind while hammering out the *capital structure policy* of a firm?

5. Describe the key ingredients of the *Reliance Industries* financing strategy.

6. What is the traditional position on the effect of *dividend policy* on firm value? Evaluate the empirical evidence on it.

7. What is the essence of Miller and Modigliani (MM) 'dividend irrelevance' theorem? What are the criticisms of MM position?

8. Discuss the plausible reasons and dubious reasons for paying dividends.

9. Discuss the considerations relevant for determining the dividend payout ratio.

10. Describe Lintner's model of corporate dividend behaviour.

11. Discuss the rationale for share buybacks. What are the common objections to share buybacks?

12. Describe the major innovations in debt securities. Show how innovative debt instruments add value.

13. Discuss the nature of bond covenants.

14. What are the plausible reasons as well as dubious reasons for lease finance?

15. Describe and evaluate the following approaches to corporate valuation: adjusted book value approach, stock and debt approach, and direct comparison approach.

16. Discuss the important guidelines to be borne in mind while valuing a company.

17. Discuss the economic approach to valuation of intangibles.

18. Discuss the key steps in the Markon approach to value based management.

19. Discuss the key steps in the McKinsey approach to value based management.

20. Discuss the key elements of the EVA bonus plan.

21. Define the following measures used in the BCG approach to shareholder value management: (a) total shareholder return (TSR) (b) cash flow return on investment (CFROI), (c) cash value added (CVA), and (d) total business return (TBR).

22. What are the key premises of value based management (VBM)? What lessons can be gleaned from VBM adopters?

23. Discuss the key business principles followed by Berkshire Hathaway.

24. What are the plausible reasons and dubious reasons for mergers?

25. What are the major ingredients of debt restructuring in India?

26. Discuss the key steps involved in managing an acquisitions programme.

27. What are the distinctive features of a balanced scorecard? What are the advantages and pitfalls of a balanced scorecard?

28. Discuss the guidelines for total cost management.

29. Discuss the key features of corporate governance in the Anglo-American world and the German-Japanese world.

30. Suggest ways and means of reforming corporate governance in practice.

31. Why do executive compensation plans often fail to promote value creation? Discuss the guidelines relevant for designing an incentive compensation plan.

32. What are the key SEBI guidelines on Employee Stock Option Scheme? How does an indexed option work?

33. What are the common ingredients of a revival plan?

34. Discuss the key guidelines for corporate risk management.

35. What are the characteristics or features of intangible assets or intangible-intensive firms and what are their implications for financial management?

36. What are financial innovations? What factors have motivated financial innovations?

1. What are the implications of market efficiency for corporate finance?

ANSWER:

No.	Market Efficiency	Implications on Corporate Finance
1	Market prices are best proxies	Firms aim to maximize this
2	Return earned by shareholders	Judge a corporate policy or event in terms of its impact on security
3	Short term forecasts	Do not try to take advantage of timing the market
4	Financial Illusions	Financial manipulation discouraged
5	Bad stock performance (in spite of good fundamentals	Defer raising equity capital
6	Interest rates low	Debt financing (and vice vesra)
7	Security prices carry lot of information about the future	Make use of it to predict financial distress in future
8	Securities are bought for their prospective cash flows	Company should be able to sell large blocks of additional securities without depressing prices, provided it can convince investors that it does not have private information.
9	New securities issues at market prices	No concern for existing shareholders
10	Investors will not pay for what they can accomplish on their own	Securities should be capable of generating higher return

2. State the key assumptions underlying the Modigliani and Miller theory of capital structure. Discuss the two key propositions of their theory.

ANSWER:

There are two principal sources of fiannce for a business firm - equity and debt. The proportions that benefit the firm and share holders has been a debate for long. There have been several theories proposed on whether capital structure matters or not.

One such theory is M&M Theory that we will discuss now.

First, as any other theory, there are few assumptions.

Assumptions

1) Perfect Capital Market

2) Rational Investors and Managers

3) Homogeneous Expectations

4) Equivalent Risk classes

5) Absence of Taxes

Proposition I The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of capital structure.

Proposition I is identical to the Net Operating Income approach. In equilibrium, identical assets should sell for the same price, irrespective of how they are financed. MM involved arbitrage argument to prove the point.

Example of Firm A and B. A is pure equity. B is with equal proportion of Equity and Debt. An investor has a choice to replace the corporate leverage with personal leverage, by borrowing money in personal capacity. In the process he will make money that is differential arising due to average cost of capital between firms.

When investors sell their equity in firm B and buy equity in A with personal leverage, the market value of the firm B tends to decline and the market value of the firm A tends to rise. This process over period will ensure equilibrium.

Proposition II

The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt.

3. How does the presence of taxes, financial distress costs, and agency costs, modify the MM results?

ANSWER:

Corporate Taxes:

When taxes are applicable to corporate income, debt financing is advantages. While dividends and retained earnings are not tax deductible for tax purposes, interest on debt is a tax deductible expense. As a result, the total income available for both shareholders and debt holders is greater when debt capital is used.

[Impact on MM Results]

Financial Distress:

Costs of Financial distress originate from

1) Arguments between shareholders and creditors delay liquidation of assets

2) Assets sold under distress fetch less value

3) Legal and admin costs associated with bankruptcy proceedings are quite high

4) Managers become myopic

5) All stakeholders (suppliers, distributors, shareholders) dilute their commitment

Agency Costs:

The loss in efficiency on account of restrictions on operational freedom plus the cost of monitoring represent agency costs associated with debt.

4. Discuss the guidelines to be borne in mind while hammering out the capital structure policy of a firm?

ANSWER:

KEYWORDS

1) Debt

2) Flexibility

3) Risk Exposure

4) Control

5) Corporate Strategy

6) Agency Costs

7) Timing

8) Proactively

9) Credit rating

10) Innovation

11) Widen sources

12) Signal value

13) Communicate

1) Avail Tax Advantage of Debt.

2) Preserve Flexibility

Do not over commit to debt. Be flexible to take advantage of changing market conditions and financing options available in future.

3) Ensure that Total Risk Exposure is reasonable

Business risk refers to the variability of earnings before interest and taxes. It is influenced by demand, price, input prices variability and proportion of fixed costs.

Financial risk represents risk emanating from financial leverage.

Both the above risks should not be unduly high. If the firm has a low business risk profile, it can assume a high degree of financial risk otherwise not.

4) Examine the control implementations of alternative financing plans

Each of the financing options such as Rights Issues, Debt and Public issues have their on implications on dilution of control and cost. These two parameters along with risk needs to be assessed.

5) Subordinate financial policy to corporate strategy

Financial policy originates in capital market and corporate strategy originates in product market. Financial policies should get integrated to corporate strategy.

6) Mitigate Potential Agency Costs

Agency costs are involved in monitoring the financing strategy and performance of the management. This monitoring can be expensive if handed over to third party entity. Commercial banks do the job of lending money as well as monitor as watchdogs at low cost.

7) Resort to Timing Judiciously

Market is efficient most of the times, but not always. It makes sense to time the financing option, such as debt or equity accordingly. A company resolution to have equal percentage of debt and equity in capital structure need not maintain this ratio at all points of time.

8) Finance proactively not reactively

Financing and investment decisions should be decoupled. The opportunities need to be exploited by active proactively.

9) Know the norms of lenders and credit rating agencies

Financial institutions consider tangible assets like plant, machinery, etc rather than outlays on R&D or market development. Have a sound portfolio of the assets before approaching a bank.

Similarly, credit raters consider the parameters such as:

(i) earning power

(ii) business and financial risks

(iii) asset protection

(iv) cash flow adequacy

(v) financial flexibility

(vi) quality of accounting.

10)Issue innovative securities

SEBI guidelines introduced in 1992 lets issuers have considerable

freedom in designing their financial instruments.

11)Widen the range of financing sources

12)Understand the signal value of financing choices

A firm confident about future cash flows goes for debt

financing. On the other hand, if the future is highly uncertain,

they may be inclined to issue equity capital. Hence debt conveys

positive signal and equity negative.

Managers need to be aware of this signal that investors receive

when the decision reaches the market.

13)Communicate intelligently with investors

1) De-emphasise creative accounting

2) Avoid financial hype

3) Cut lead steers into planning process

5. Describe the key ingredients of the Reliance Industries financing strategy.

ANSWER: [PAGE 564][FULL ANSWER]

1) Think BIG

2) Dedicate a team to treasury management

3) Develop a steady relationship with the merchant bankers

4) Be in a state of readiness

5) Be the first

6) Delink financing and investment decisions

7) Think international

8) Ensure that primary market investor is adequately rewarded

9) Cultivate the institutional investors

10) Deepen the market for its debt (pg: 565)

6. What is the traditional position on the effect of dividend policy on firm value? Evaluate the empirical evidence on it.

ANSWER:

According to the traditional position proposed by Graham and

Dodd, the stock market places considerably more weight on

dividends than on retained earnings.

P = m(D + E/3)

In numerical terms, weight attached to dividends is four times

the weight attached to retained earnings. The weights provided

by profounder was on subjective judgments and not derived from

objective, empirical analysis.

Empirical Evidence:

PRICE = a + b {DIVIDEND} + c {RETAINED EARNINGS}

+ Limitation 1:

Limitation in empirical evidence, that risk is totally not considered in above equation. Dividend and risk are inversely proportional, hence higher risk means lower dividend. The omission of risk will lead to upward bias of b, the coefficient of dividend.

A better regression equation is :

PRICE = a + b {DIVIDEND} + c {RETAINED EARNINGS} + d /RISK/

+ Limitation 2 ::

Secondly, measurement error distorts results. It is well known that the measurement of earnings is almost invariably subject to error. The dividend figure, however, is given precisely. So, the measurement error in earnings is fully transmitted to retained earnings which are simply earnings minus dividends. In regression analysis, when a variable (retained earnings) is subject to measurement error, its coefficient is biased downward.

Considering both limitations, when b > c will mean a higher dividend payout ratio increases stock value.

7. What is the essence of Miller and Modigliani (MM) 'dividend irrelevance' theorem? What are the criticisms of MM position?

ANSWER:

*MM argument:* If a company retains earnings instead of giving it out as dividends, shareholders enjoy capital appreciation equal to the amount of earnings retained. If it distributes earnings by way of dividends instead of retaining it, the shareholders enjoy dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earnings. Hence, the division of earnings between dividends and retained earnings is irrelevant from the point of view of the shareholders.

Assumptions:

1. There is no tax advantage or disadvantage associated with dividends

2. The investment and dividend decisions of the firm are independent

3. Firms can issue stock without incurring any floatation or transaction costs to raise money for investment projects

CRITISIM of MM Position:

1. Information about prospects: Dividend payout gives information about prospects of the company. A higher dividend may indicate a promising future. A lower may indicate uncertain future. Dividends reduce uncertainty perceived by investors. Hence investors prefer dividends to capital gains.

2. Uncertainty and wide fluctuations: of share prices may tend investors not to sell their shares and expect a high payout ratio. Some investors who wish to get less current income may be hesitant to buy shares in fluctuating market. Such investors would prefer, and value more, a lower payout ratio.

3. Offering of Additional equity at lower prices: MM assume that additional equity can be sold at the same market price. In practice, firms following the advice and suggestions of merchant bankers offer additional equity at a price lower than teh current market price.

4. Issue cost: MM irrelevance proposition is based on the premise that the rupee of dividends can be replaced by a rupee of external financing. This is possible when there is no issue cost. Due to this, other things being equal, it is advantageous to retain earnings rather than pay dividends and resort to external finance.

5. Transaction costs :: Due to transaction costs, shareholders who have preference for current income, would prefer a higher payout ratio and shareholders who have preference for deferred income would prefer a lower payout ratio.

6. Differential rates of taxes: tax on capital gains is different that tax on dividends

7. Rationing: self-imposed and market-imposed. In real world, the general policy followed is to have investment policy linked with dividend policy. A firm which has many highly profitable investment opportunities and which is unwilling or unable to obtain finances from outside, would promote the interest of its shareholders by lowering the payout ratio.

8. Discuss the plausible reasons and dubious reasons for paying dividends.

ANSWER:

A. Plausible reasons:

1. Investor preference for dividends:

a. Self-control and dividends

b. Aversion to regret and dividends

2. Information signaling:

3. Clientele effect: The concentration of investors in companies with dividend policies that are matched to their preferences is called the clientele effect. The existence of this effect implies that:

a. a firm gets the investors they deserve.

b. it will be difficult for the firm to change an established dividend policy.

B. Dubious reasons:

a. Bird-in-hand fallacy

b. Existence of excess cash

9. Discuss the considerations relevant for determining the dividend payout ratio.

ANSWER:

1. Funds requirement in foreseeable future is a key factor considered in payout ratio.

2. Liquidity position has a bearing on the dividend decision. Firm may not be able to distribute more than a small portion of its earnings, despite its desire to do so, because of insufficient liquidity.

3. Access to external sources of financing. A firm with easy access to financing is less constrained in its dividend decision.

4. Shareholder preference on dividend payout

5. Difference in the cost of external equity and retained earnings

6. Dilution of control. External financing, unless it is through rights issue, involves dilution of control. If shareholders and management of the firm are averse to dilution of control, may pay less in dividends.

7. There is an indirect tax on firm in paying dividends. In the hands of investors, the dividends are tax-free (at the moment). There is taxation on long-term and short-term capital gains on investors. These factors affect the dividend payout ratio.

10. Describe Lintner's model of corporate dividend behaviour.

ANSWER:

Linterâ€™s survey of corporate dividend behaviour showed that:

1. Firms set long-run target payout ratios

2. Managers are concerned more about the change in the dividend than the absolute level

3. Dividends tend to follow earnings, but dividends follow more smoother path than earnings

4. Dividends are sticky in nature because managers have reluctance to effect dividend changes that may have to be reversed.

Linter expressed corporate dividend behavior in the form:

D_t = cr EPSt + (1 - c) D t-1

D_t = dividend per share for year t

c = adjustment rate

r = target payout rate

EPS_t = earnings per share for year t

D_{t-1} = dividend per share for year t-1

11. Discuss the rationale for share buybacks. What are the common objections to share buybacks?

ANSWER:

1. Better use of surplus cash: Some senior managers enter into mergers and acquisitions to make use of excess cash. Managers sitting on pile of cash may lead to incorrect decisions to diversify or grow. Some companies take the right call to buy back shares that increases the investor confidence.

2. Price stability - if a company buys back its shares when the price looks depressed to the management (which presumably is better equipped to assess its value), the repurchase action of the management tends to have a buoying effect in an otherwise bearish market

3. Tax advantage - A share buyback produces long-term capital gains and is tax-advantageous compared to a dividend payment.

4. Control - share buybacks can be used as an instrument to increase the insider control in firms.

5. Voluntary character - When a firm distributes dividends, investors do not have any option. However when a firm announces a share buyback programme, investors have an option to sell or not to sell.

6. No implied commitment - Unlike dividend payments, share buybacks are one time exercises (not periodic).

Objections to share buybacks:

1. Unfair advantage - zero sum game between selling and non-selling group of investors. In fact, this is not the case. Due to different goals and investment horizons, it is NOT a zero-sum game. The exercise benefits all, depending on individual investment goals.

2. Manipulation - by management to get attractive offers. Defocus from main business to stock market games in creating attractive offers of share buyback.

12. Describe the major innovations in debt securities. Show how innovative debt instruments add value.

ANSWER:

A wide range of innovative debt securities have been created, particularly from the middle 1970s. Various factors like increased volatility of interest rates and frequent changes in tax and regulatory framework. Deregulation in financial markets and competition played a significant role in innovation.

1. Deep discount bonds or zero coupon bonds. Attractive for investors who want to be immune to reinvestment rate risk. For issuer the advantage of conserving cash flows during the life of bonds.

Example: In 1996, IDBI bonds at Rs.5300 maturity period of 25 years with face value of Rs.2 lakhs.

A major drawback of this bond is the balloon payment at the end of the term by issuer. Arranging for funds at the end could be a challenge and hence investor is subject to higher risk.

2. Floating rate bonds – Conventional bonds have a fixed rate of interest. Floating rate bonds interest rate (coupon rate) is variable and is linked with a benchmark rate such as Treasury bill interest rate. These bonds are to counter the inflation risk.

Example: In 1993, SBI issued 5 million unsecured redeemable, subordinated floating interest rate bonds in the nature of promissory notes carrying interest at 3 percent per annum over the bank’s maximum term deposit rate.

3. Commodity linked bonds

Payoff from a commodity linked bond depends to some extent on the price of a certain commodity. These bonds are having been a response to volatility in commodity prices. Such bonds enable the producer of the commodity to cope with price fluctuations. The purchaser is typically the consumer of the commodity. This gives the purchaser an effective way to counter the expenditure on the commodity.

For example: Issuer: In June 1986, Standard Oil Corporation issued zero coupon notes which would mature in 1992. The payoff from each note was defined as: $1000 + 200 [price per barrel of oil in dollars - $25].

Buyer: Power plant that uses oil as fuel.

4. Bonds with embedded options

Convertible bonds – give the bond holder the right (option) to convert them into equity shares on certain term.

Callable bonds give issuer the right (option) to redeem them prematurely on certain terms

Puttable bonds give the investor the right to prematurely sell them back to the issuer on certain terms.

5. Extendable Notes

Short-term debt instruments (1 – 5 years), gives investors an option to redeem on maturity at prevailing interest rates or extend maturity.

6. Structured Notes

A debt obligation derived from another debt obligation is called structured notes. First structured notes were created by backing zero-coupon bonds with Non-cancellable Treasury bonds. Another type of structured notes is securitized debt instruments.

7. Inverse floaters

Floating rate note (or bond) is tied with a reference/benchmark rate such as LIBOR. The movement is in tandem with the Floating rate note. When the LIBOR increase, the Floating rate note increases proportionately. For example FRN = LIBOR + 1%

The interest rate of an inverse floater moves counter to a benchmark rate. For example: IF = 14% - LIBOR.

8. Junk Bonds

Bonds that have a credit rating of BB or lower by S&P and ‘Ba’ or lower by Moody’s are referred to as junk bonds. Since the name “junk” is used in negative connotation, the industry word for such bonds is “high yield bonds” as they pay above average returns.

Sources of value:

Innovative Debt security devices are essentially Positive NPV devices. They add value in one or more of the following ways:

1. Risk reallocation / Yield Reduction

2. Lower Issuance Cost

3. Tax Arbitrage

4. Reduced Agency Costs

5. Enhanced Liquidity

13. Discuss the nature of bond covenants.

ANSWER:

Bond covenant is a legally binding promise by Bond issuer to the bond holder. A covenant is meant to protect bondholders. Suppliers of bond capital are fully aware that shareholders and their agent – Managers can hurt their interest.

The following actions by the firm increase the default risk:

1. Dividend payment: Not considering the cash flow needs to honour claims of bond holders.

2. Claim dilution: Issuing another debt with same or higher priority than existing

3. Asset substitution: Low risk projects to high-risk projects

4. Underinvestment - Firm with large outstanding debt, it may reject positive NPV proposals as the same may benefit the bondholders primarily.

Positive Covenants

1. Periodically furnish financial reports to lenders

2. Maintain certain working capital

3. Setup a sinking fund for redemption of debt

4. Maintain certain net worth

5. Mortgage its assets

Negative Covenants

1. Firm cannot raise additional long term debt

2. Cannot undertake a diversification project or acquire another firm or merge with another firm

3. May not dispose or lease its major assets

4. May not pay dividends in excess of certain percentage

14. What are the plausible reasons as well as dubious reasons for lease finance?

ANSWER:

Plausible Reasons:

1. Convenience, compared to buy and sell for short period.

2. Benefits of standardization through regular format of contracts and economies of scale. This reduces the overhead costs in contract administration and transaction costs.

3. Better utilization of Tax Shields - a firm that cannot on its own avail of tax benefits of owning an asset may share a part of that benefit in the form of lower lease rentals by taking the assets on lease from a firm that enjoys tax benefits in full.

4. Fewer Restrictive Covenants - compared to term loans which need the firm to disclose financial position and maintain healthy liquidity ratios.

5. Lower cost of obsolescence risk

6. Expeditious Implementation compared to debt financing from lending institutions (such as project appraisal, supporting documents, processing time, etc). Debt financing could take 3 months or more. But lease finance takes only few days.

7. Matching of lease rentals to cash flow capabilities in contrast to rigid debt repayment. Tailor made lease rentals are possible. Seasonal lease rental may appeal to firms which have pronounced seasonality in their operations. Stepped-up lease rentals are suitable for firms which are likely to experience a gradual increase in revenues over a period of time. Deferred lease rental makes sense when there is a long gestation period before revenues are generated.

Dubious Reasons:

1. Hundred percent financing. Whether firm goes for the leasing option or the borrowing-cum-buying option, it incurs a similar liability, while preserving cash. So there is nothing special about leasing.

2. Circumvention of certain controls - certain organizations consider leasing decision as operational, rather than capital budgeting decision. Hence line and middle managers could opt for leasing, to circumvent the tedious approval process.

3. Favorable Financial Ratios - Traditionally, leases (both operating and financial) have been regarded as off-balance sheet sources of finance in India. This have favorable impact on debt/equity ratios.

15. Describe and evaluate the following approaches to corporate valuation: adjusted book value approach, stock and debt approach, and direct comparison approach.

ANSWER:

A. ADJUSTED BOOK VALUE APPROACH

1. Relies on information found in balance sheet.

2. Two ways of using balance sheet information

a. Book values of investor claims

b. Total assets minus total non-investor claims (like accounts payable and provisions)

Limitations of book value approach

1. Does not consider inflation

2. Due to technological changes, assets become obsolete

3. Organizational capital is not accounted, like human resources, knowledge, etc.

Adjusting Book Value to reflect Replacement Cost:

Various assets, such as Cash, Debtors, Inventories, Other current assets, Fixed Tangible Assets, Non-operating Assets are valued differently.

In this approach, the net book values are replaced with Replacement costs.

a. Cash has no issue in valuation. Simplest form of valuation.

b. Debtors – Generally debtors are valued at face value. If the quality of debtors is doubtful, prudent calls need to be taken for allowance of bad debts.

c. Inventories – can be classified into three categories – raw materials, work-in-process and finished goods. Raw materials may be valued at their most recent cost of acquisition. Work-in-progress may be approached from cost point of view or selling price point of view. Cost point = cost of raw materials + cost of processing; selling point = selling price – cost of sales). Finished goods inventory is generally appraised by determining the sale price realizable in the ordinary course of business less expenses to be incurred in packaging, holding, transporting, selling and collection of receivables.

d. Other current assets – like deposits, prepaid expenses and accruals are valued at their book value.

e. Fixed Tangible assets – land, buildings and civil works, and plant and machinery fall into this category. Land is valued as if it is vacant and available for sale. Buildings and civil works may be valued at replacement cost less physical depreciation and deterioration. The value of plant and machinery may be appraised at market price of similar (used) asset plus the cost of transportation and installation.

f. Non-Operating assets – Assets not required for meeting the operating requirements of the business are referred to as non-operating assets. These are valued at fair market value.

Adjusting Book Value to Reflect Liquidation Value:

Estimate the value of each asset in the secondary market, assuming the firm is immediately liquidated. In the lack of such market for each asset, the estimation is hypothetical. This approach is a serious drawback of not estimating for Organizational capital. This approach works better when the firm is already dead.

Book Value Approach has limited applicability in real life.

B. STOCK AND DEBT APPROACH (Market Approach)

1. When securities of the firm are traded publicly, the value can be obtained by adding the market value of all outstanding shares.

2. The problem of stock volatility. Averaging? If stock market is believed to be efficient, then there is no justification for averaging.

C. DIRECT COMPARISION APPROACH

1. Simple logic that similar items sell at same price.

2. The principle heavily rests on identifying a similar asset.

3. Steps in applying direct comparison approach

1. Analyze the economy

2. Analyze the industry

3. Analyze the subject company

4. Select comparable companies

5. Analyze financial aspects of subject and comparable companies

6. Choose observable financial variable

7. Value the subject company

16. Discuss the important guidelines to be borne in mind while valuing a company.

ANSWER:

1. Understand pros and cons of valuation approaches (adjusted book value, stock and debt approach, direct comparison approach, discounted cash flow approach)

2. Use at least two different approaches. Final amount can be valuated based on the weighted average of the valuation figures.

3. Work with a Value Range considering 2 to 3 scenarios

4. Go behind numbers such as return on invested capital, growth rate, and cost of capital. Also evaluate entry barriers like economies of scale, product differentiation, technological edge, patent protection, etc.

5. Value Flexibility: Consider flexibility in selecting future options. This is especially required when using Discounted Cash Flows. DCF takes into account the future expected cash flows based on current conditions.

6. Blend theory with judgment - quantitative analysis to qualitative judgment

7. Avoid reverse financial engineering

8. Beware of possible pitfalls

a. Use of shortcuts

b. Belief in hockey stick

c. Short forecast horizons

9. Adjust for control premia and non-marketability factor – when valuating a partial business, instead of whole. Add 20 to 60 percent, to the prorate value of the firm.

10. Debunk the myths surrounding valuation

a. Valuation is objective exercise

b. Well done valuation is timeless

c. The end product is important, and not the process

17. Discuss the economic approach to valuation of intangibles.

ANSWER: [more reading required: pg1074, 1075, 1076]

The most important types of intangible assets are:

1. Brands

2. Publishing rights

3. Intellectual Property

4. Licenses

There are three different approaches to valuing intangible assets:

1. Cost approach – aggregating the costs such as historical costs and replacement costs incurred in developing the intangible asset. This approach is not relevant for intangible assets. A highly expensive research program may generate less value compared to less expensive research application that has major benefit to consumers.

2. Market approach – comparable to similar asset. This approach is difficult because of the uniqueness of each intangible asset. The activity in the market has limited transactions.

3. Economic approach – (detailed below)

The value of an intangible asset is determined by estimating the cash flows or earnings expected to be generated by the intangible asset and then capitalizing it by using an appropriate discount rate or earnings multiple.

Steps involved in valuation of intangibles using Economic Approach:

1. Estimate the cash flow/earnings

a. Direct identification method – If the only significant asset of the business is the intangible asset, it is possible to readily identify the cash flows / earnings associated with the intangible asset.

b. Brand contribution method

i. utility cost method

ii. return on capital method

iii. premium profits method

iv. retail premium method

c. Royalty method

2. Capitalize the cash flow/earnings

a. Discounted Cash Flow method

b. Earnings multiple method

18. Discuss the key steps in the Markon approach to value based management.

ANSWER:

The key steps in the Marakon approach are:

1. Specify the financial determinants of value

2. Understand the strategic drivers of value

3. Formulate higher value strategies

4. Develop superior organizational capabilities

1. Specify the financial determinants of value

Marakon approach is based on a market-to-book ratio model. The book value, B, measures approximately the capital contributed by shareholders, where as the market value of equity, M, reflects how productively the firm has employed capital contributed by the shareholders, as assessed by stock market.

Hence, the management creates value for shareholders if M exceeds B, decreases value if M is less than B, and maintains value if M is equal to B.

M = Market value of equity

B = Book value of equity

r = return on equity

g = growth rate in dividends

k = cost of equity

2. Understand the strategic determinants of value

The key financial determinants of value are the spread and growth rate of dividends. Spread is the difference between return on equity and the cost of equity. The two primary strategic determinants of spread and growth and hence value creation are:

a. Market economies

b. Competitive position

a. Market Economics: refers to structural factors which determine the average equity spread as well as growth rate applicable to all competitors in a particular market segment. Market economics consists of: Intensity of direct competition, Intensity of indirect competition, Threat of entry, Supplier pressures, Regulatory pressures, Customer pressures.

b. Competitive Position: is shaped by product differentiation and economic cost position.

3. Formulate higher value strategies

Value is created by participating in attractive markets and/or building competitive advantage. Thus, the key elements of a firm’s strategy are its participation strategy and competitive strategy.

4. Develop superior organizational capabilities to overcome internal barriers to value creation.

1. A competent and energetic chief executive who is fully committed to the goal of value maximization

2. Corporate governance mechanism that promotes highest degree of accountability

3. Top management compensation

4. Resource allocation system based on

i. Zero-based allocation

ii. Principle of funding strategies

iii. Principle of no capital rationing

iv. Principle of zero tolerance for bad growth

5. A performance management process

19. Discuss the key steps in the McKinsey approach to value based management.

ANSWER:

The key steps in the McKinsey Approach to VBM are:

1. Ensure the supremacy of value maximization - preach top-down

2. Find the value drivers - business unit level and group level

3. Establish appropriate managerial processes - strategy development, target setting, action plan/budget, performance management.

4. Implement value-based management properly - assess if the company performance oriented, decisions value based, low-cost value based management

20. Discuss the key elements of the EVA bonus plan.

ANSWER:

The key elements of EVA bonus plan are:

1. Bonus is linked to increases in EVA - this makes managers think and act like managers. They will enhance operating efficiency, make profitable investments, withdraw unproductive capital, and select financing strategies to reduce cost of capital.

2. There is no floor or ceiling on the bonus - the ceiling is lowered below zero and no limit on bonus amount.

3. The target bonus is generous - than traditional, as the bonus plan is risky than before.

4. Performance targets are set by formula, not negotiation

5. A bonus bank is established

21. Define the following measures used in the BCG approach to shareholder value management:

(a) Total Shareholder Return (TSR)

(b) Cash Flow Return on investment (CFROI),

(c) Cash Value Added (CVA), and

(d) Total Business Return (TBR).

ANSWER:

A. Total Shareholder Return (TSR)

B. Cash Flow Return on Investment (CFROI)

A sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firm’s assets.

C. Cash Value Added (CVA)

D. Total Business Return (TBR)

22. What are the key premises of value based management (VBM)? What lessons can be gleaned from VBM adopters?

ANSWER:

A. Key Premises

1. Value of a company is equal to the present value of future cash flows

2. Conventional accounting earnings is not a sufficient indicator of value creation because they are not the same as cash flow, do not reflect risk, do not include opportunity cost of capital, do not consider time value of money.

3. For managing shareholder value, firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management

4. A well design performance measurement and compensation system is essential to motivate employees to focus their attention on creating shareholder value

B. Lessons learnt

1. Top Management support and involvement is essential

2. A good incentive plan is necessary

3. Employees should be properly educated

4. The choice of value metric per se is not critical

5. VBM works well in certain cases

6. One size doesn’t fit all

23. Discuss the key business principles followed by Berkshire Hathaway.

ANSWER:

1. Regard shareholders as partners (HR)

2. Attract and retain high quality owners (HR)

3. Centralize financial decisions and decentralize operating decisions (FIN)

4. Allocate capital flexibly (FIN)

5. Stay within your circle of competence (STRATEGY)

6. Apply stiff criteria for acquisitions (STRATEGY)

7. Make long-term commitments (STRATEGY)

8. Minimize the use of debt (FIN)

9. Finance proactively, not reactively (FIN)

10. Retain earnings only when you can create value (FIN)

11. Hire well, manage little and be a cheerleader (HR)

24. What are the plausible reasons and dubious reasons for mergers?

ANSWER:

A merger refers to a combination of two or more companies into one company. It may involve absorption or consolidation. In absorption, one company acquires another company. Example: Google buying YouTube; Tata acquiring Corus, Tata acquiring Jaguar+Land Rover. In a consolidation, two or more companies combine to form a new company. Example: Time-Warner; Mahindra and Satyam

Mergers may be classified into several types:

a. Horizontal - same line of business

b. vertical - different stages of producting in same industry

c. conglomerate - unrelated line of business

A. PLAUSIBLE REASONS

a. Strategic benefit

b. Economies of Scale

d. Economies of Scope

e. Economies of Vertical Integration

f. Complementary Resources

g. Tax Shields

h. Utilization of Surplus funds

i. Managerial effectiveness

B. DUBIOUS REASONS

a. Diversification

b. Lower financing costs

c. Earnings growth

25. What are the major ingredients of debt restructuring in India?

ANSWER: [supplement - pg: 43, 44, 45]

Debt restructuring is a part of the reconstruction of a balance sheet that relates to the borrowing obligations of a company.

1. To reduce cost of borrowing - by retiring high cost existing debt with fine rates.

2. To improve liquidity and working capital position

3. To rehabilitate a company that is insolvent

26. Discuss the key steps involved in managing an acquisitions programme.

ANSWER:

5. Manage the pre-acquisition phase

6. Screen candidates

7. Evaluate the remaining candidates

2. Determine the mode of acquisition (Three major modes of acquisition - merger, purchase of assets, takeover)

3. Negotiate and consummate the deal

4. Manage the post-acquisition integration

27. What are the distinctive features of a balanced scorecard? What are the advantages and pitfalls of a balanced scorecard?

ANSWER:

The Balanced Scorecard Approach pioneered by Robert Kaplan, David Norton, and others seek to develop an integrated performance management system.

Distinctive Features: [REVISE FIGURES on pg 1001]

1. Balanced scorecard is strategy driven comprehensive

2. performance management system

3. Covers four important perspectives of business:

a. Financial â€“ attractive to shareholders?

b. Customer â€“ does the company provide value to customer?

c. Internal business â€“ what is the company good at?

d. Learning and growth â€“ does company improve and innovate continually?

4. Balanced scorecard represents a linked series of objectives and measures.

Pros and Cons

1. Focuses managerial attention on a handful of measures that are critical to the company’s success

2. It summarizes the competitive agenda of the company

3. Guards company from sub-optimization, as managers are forced to look at all the measures together.

4. Establishing reliable cause-effect relationships is very difficult

5. Managers are likely to be fixated on financial results

6. Measurement overall possible

7. BSC does not assign weights to different measures. This leads to difficulty in specifying trade-offs between financial and non-financial measures.

8. The supplier perspective has been ignored.

28. Discuss the guidelines for total cost management.

ANSWER:

1. Understand your cost drivers

2. Focus on the entire value chain

3. Combine Total Cost Management to Business process Reengineering

4. Do it right the first time as total quality management demands

5. Exercise rigorous cost control at the design and product development stage

6. Team up with your vendors

7. Benchmark against the best

8. Resort to flexible manufacturing systems

9. Switch to just-in-time systems

10. Rely on activity based costing

11. Stretch your brands

12. Watch your Ad spend

13. Rationalize your distribution and servicing structure

14. Use information technology to cut costs

15. Manage Human Resources (HR) costs effectively

16. Trim Non-manufacturing overheads

29. Discuss the key features of corporate governance in the Anglo-American world and the German-Japanese world.

ANSWER:

Anglo-American

1. Ownership of companies is more or less equally divided between individual and institutional investors

2. Companies are typically run by professional managers

3. Directors are rarely independent of management

4. Institutional investors do not actively participate or hold commitment

5. Institutional investors neither have inclination nor ability to monitor effectively

6. Legal system is well developed. The disclosure norms are comprehensive, rules against insider training, etc are strict.

7. Fairly active market to take over under performing firms.

German-Japanese

1. Banks and financial institutions have substantial stakes in the equity capital of companies.

2. Institutional investors view themselves as long-term investors.

3. Disclosure norms, checks on insider trading, emphasis on liquidity not effective. Hence the efficiency of the capital market may be impaired

4. There is hardly any market for corporate control. Takeovers, hostile or otherwise are very rare.

30. Suggest ways and means of reforming corporate governance in practice.

ANSWER:

1. Strengthen the hands of Institutional investors

2. Separate management from control - The function of management must vest with the chief executive officer and his team and the function of control with Board of Directors.

3. Expand the role of non-executive directors

4. Limit the size of the board

5. Ensure that the board is informationally well equipped

6. Link Managerial compensation to performance

7. Enhance contestability - if the management consistently under-performs, there should be real possibility to dislodge it through market for corporate control. Takeovers are treated as positive actions in realizing this.

8. Introduce to the cumulative voting system (pg984)

9. Improve corporate accounting and reporting practices

31. Why do executive compensation plans often fail to promote value creation? Discuss the guidelines relevant for designing an incentive compensation plan.

ANSWER:

1. Linkage between size and pay

2. Emphasis on short-term performance

3. Reliance on accounting measures

Designing the Incentive Compensation Plan

1. Integrate the incentive plan into the total compensation architecture

2. Choose the appropriate level of risk posture and time focus

3. Use objective criteria

4. Select the right set of performance measurement

5. Reward relative performance

6. Discourage narrowly restrictive behavior

7. Abandon attempts to measure what executives control

8. Strengthen the decision making horizon of the executives

9. Employ stock options judiciously

10. Ensure tax-efficiency (simple measure = post-tax benefit to manager/post-tax cost to company)

32. What are the key SEBI guidelines on Employee Stock Option Scheme? How does an indexed option work?

ANSWER:

1. Eligibility - an employee should not be a promoter and not a director who holds more than 10 percent of the outstanding equity shares.

2. Compensation committee â€“ company should contains a compensation committee which shall be a committee of the board of directors consisting of majority independent directors.

3. Shareholder approval for ESOS

4. Pricing - company has freedom to decide the exercise price of the options to employees

5. Lock-in period and rights of the option holder - minimum of one year period between grant and vesting of options.

6. Accounting treatment - Accounting treatment of options may be determined using Black scholes model or as the difference between market price (when options are granted) and exercise price.

The Case of Indexed options:

33. What are the common ingredients of a revival plan?

ANSWER:

1. Settlement with creditors :: FINANCE (1)

2. Provision of additional capital :: FINANCE (2)

3. Divestment and disposal :: FINANCE (3)

4. Reformation of product-market strategy :: MARKETING (1)

5. Modernization of plant and machinery :: OPERATIONS (1)

6. Reduction in manpower :: HR (1)

7. Strict control over costs :: FINANCE (4)

8. Streamlining of operations :: OPERATIONS (2)

9. Improvement in managerial systems :: HR (2)

10. Workers' participation :: HR (3)

11. Change of management :: HR (4)

34. Discuss the key guidelines for corporate risk management.

ANSWER:

1. Align risk management with corporate strategy

2. Proactively manage uncertainties

3. Employ a mix of real and financial methods

4. Know the limits of risk management tools

5. Don’t put undue pressure on corporate treasuries to generate profits

6. Learn when it is worth reducing risk

35. What are the characteristics or features of intangible assets or intangible-intensive firms and what are their implications for financial management?

ANSWER:

1. Intangibles involve a large fixed (sunk) costs and negligible variable cost

2. Hazy property rights (and spillovers)

3. Investment in intangibles is comparatively riskier

4. Do not have organized and competitive markets

5. A very large portion of the value of an intangible-intensive firm is accounted for by the future growth value.

6. Find the real worth of an intangible asset

Implications for Financial Management:

1. High-risk and high return proposition

2. Hazy property rights give considerable challenge in financial management

3. Managers in an intangible-intensive business have to cope with a rapidly changing environment. Managers must constantly strive to convert potential value into actual value.

4. Rely primarily on equity financing

a. Business risk of such a firm is high, debt financing adds financial risk.

b. Lenders are typically averse to grant loans against intangible assets

c. Intangible-intensive firms have valuable growth options. Such firms need greater financial flexibility

5. Meaningful investor communication is important

36. What are financial innovations? What factors have motivated financial innovations?

Answers to Theory Questions - Investment Analysis and Portfolio Management

2010-02-01T18:57:00.000-08:00

1 Exam Theory Questions

1.1 Discuss the attributes relevant for evaluating an investment avenue.

ANSWER:
Five key attributes relevant for evaluating the investment
avenue are:

Rate of return
Risk
Marketability
Tax Shelter
Convenience
Return is computed on the principal amount invested for
duration. The rate of return takes into account the
current yield and the capital gains/losses. The current
yield is the short term returns on the actual
investment, in the form of interest or
dividends. Current yield has an impact on the overall
return as it is received at different time periods. The
overall capital appreciation is the increase in the
principal amount invested and is received only after
termination of the investment tenure.
```
Annual Income    (End Price - Beginning Price)     
        Rate of Return = ------------------ + -----------------------------
                             Beginning Price    Beginning Price

                         =  Current Yield   +  Capital Appreciation
```
Hint: Give examples of bond and gold to contrast.

Risk
Is defined as the variability of the rate of return. An instrument that has fixed return and guaranteed, has less risk. For example: Govt. NSCs. The variance of return in possible in investments like Mutual funds and equities, where the variance is huge, is considered a high risk investment. Variance This is the mean of the squares of deviations of individual returns around their average value. Standard Deviation This is the square root of variance. Beta This reflects how volatile is the return from an investment in response to market swings.
Marketability/Liquidity
An investment is highly marketable or liquid if: (a) it can be transacted quickly (b) the transaction cost is low (c) the price change between two successive transactions is negligible
Tax Shelter
(a) Initial tax benefit (b) Continuing tax benefit (c) Terminating tax benefit
Convenience
refers to the ease with which the investment can be made and looked after. For example, can the investment be made readily? Can the investment be looked after easily? Savings bank account and chasing real estate property are two different extremes.

1.2 What qualities are required for successful investing? [Jan 2009]

ANSWER:

Contrary Thinking
Patience
Composure
Flexibility and openness
Decisiveness

1.3 Describe the following types of insurance policies: endowment assurance, money back plan, whole life assurance, term assurance, and deferred annuity.

ANSWER:

Endowment Assurance (Non-Participating and Participating): a. Non-Participating endowment policy assures a guaranteed amount at the maturity date of the policy in exchange for a single premium. b. Participating Endowment Policy enhances the initial sum assured with payment of bonuses to policyholder. Eg. LIC Jeevan Anand, Jeevan Mitra
Money Back Plan: Savings cum protection plan as it provides lumpsum at periodic intervals. Eg. LIC Jeevan Surabhi, Jeevan Bharati
Whole Life Assurance: provides a benefit on the death of the policyholder whenever that might occur. Eg. LIC Jeevan Anand, Jeevan Tarang
Term Assurance: A pure protection policy that provides benefit on the death of the policyholder within the specified term stated in the policy. Eg. LIC Anmol Jeevan
Deferred Annuity: Pension scheme Eg. LIC Jeevan Nidhi

1.4 Discuss the major changes that have occurred in the equity market in India since 1992.

ANSWER:

In 1990, there was a major capital market scam where bankers and
brokers were involved. With this, many investors left the
market. Later there was a securities scam in 1991-92 which revealed
the inefficiencies and inadequacies of the Indian financial system
and called for reforms in the Indian Equity Market.

1994 - National Stock Exchange of India (NSE) and OCTEI (Over the
Counter Exchange of India) were established.
1995-96 - Securities Contracts (Regulation) Act was ammended to
introduce options trading.
1995-96 - NSCC and NDSL were setup for demutualized trading,
clearing and settlement.
In February 2000, permission was given for internet trading and
from June, 2000, futures trading started.
From 1st July 2001, ‘Badla' was discontinued and there was
introduction of rolling settlement in all scrips, after Ketan
Parekh scam.
Till 2001, India was the only sophisticated market having account
period settlement alongside the derivatives products. From middle
of 2001, uniform rolling settlement and same settlement cycles were
prescribed creating a true spot market.
The VaR based margining system was introduced in mid 2001
India is one of the few countries to have started the screen based
trading of government securities in January 2003.
In June 2003 the interest rate futures contracts on the screen
based trading platform were introduced.

1.5 Discuss the key features of the G-sec market in India.

ANSWER:
G-Secs or Government of India dated Securities are Rs.100
face-value units / debt paper issued by Government of India
in lieu of their borrowing from the market. These can be referred
to as certificates issued by Government of India through the
Reserve Bank acknowledging receipt of money in the form of debt,
bearing a fixed interest rate (or otherwise) with interests payable
semi-annually or otherwise and principal as per schedule, normally
on due date on redemption.

Key features of G-Sec are:

Issue of G-Secs is regulated by RBI under the Public Debt
Act. G-Secs are issued through an auction mechanism.
Participants Banks are the largest holders of G-Secs. About
one-third of the net demand and time liabilities of the banks
are invested in G-Secs maintly to meet the statutory liquidity
requirements and partly for investment purposes. Other
participants include insurance companies, provident funds,
mutual funds, primary and satellite dealers and trusts.
SGL Account facility is provided by RBI to large banks and
financial institutions so that they can hold their G-secs and
treasury bills in electronic book entry form.
Primary dealers are important intermediaries in the G-sec
market. They serve as underwriters in debt market, act as market
makers in secondary debt market, and enable investors to access
the SGL account.
Secondary market for G-secs As soon as G-secs are issued, they
are deemed to be listed and eligible for trading. The NSE has a
Wholesale Debt Market (WDM) which is a fully automated screen
based trading system.
Transactions in G-secs are settled through the delivery versus
payment (DVP) mode.

1.6 Why do companies manipulate the bottom line? What devices are used to do so?

ANSWER:

To project an image that the company is a low-risk company
To enhance managerial compensation, if the same is linked in
some way to reported earnings
To promote a perception that the management of the firm is
competent.
To communicate more meaningfully about the long-term
prospects of the firm.

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1.7 Discuss the problems and issues faced in financial statement analysis.

ANSWER:

Heuristical in nature - the financial analysis does not result in
concrete financial position of the firm. It only gives clues
for further study or decision making. There are no established
rules that directly give the results about the financial
health of the firm.
Relies on benchmarks - Financial analysis is based on
comparison of firms financial ratios against the industry
average ratios. This comparison for a multi-industry
corporation is not only difficult, but at times
impossible. Because, there might be no firm of similar
industry mix to get a industry standard benchmark.
Easy Window dressing - It is easy to manipulate and project
balance sheet to produce favorable financial ratios. To
overcome this, the auditor should do a deep dive into the
parameters under study. For example: A firm with a very
comfortable liquidity position and a high turnover of
inventories.
Price Level changes - In India the financial accounting
does not take into account the price level changes that have
impact on financial statements.
Variations in Accounting Policies - Business firms have
some freedom in accounting treatment of items like
depreciation, valuation of stocks, research and development
expenses, foreign exchange transactions, installment sales,
etc. Due to diversity of policies found in practice,
comparative financial statement analysis may be vitiated.
Subjectivity in Interpretation - It is difficult to judge
whether certain ratio is good or bad. A high current ratio,
for example, may indicate a strong liquidity position
(something good) or excessive inventories (something bad). But
is becomes difficult when a firm has good as well as bad
financial ratios.
Correlations among ratios - Financial ratios of a firm show
a high degree of correlation as most ratios share either
numerator or denominator.

1.8 Explain the single index model proposed by William Sharpe.

ANSWER:

William Sharpe model was proposed to overcome the limitation of
Markowitz model. In Markowitz model, the number of computations of
covariance increases dramatically with increase in number of stocks
under consideration. If there are n securities, Markowitz model
requires n expected returns, n variance terms, and n(n-1)/2
covariance terms. For example, if an analyst is considering 100
securities, Markowitz model requires 100 expected returns, 100
variance terms and 4950 covariance terms.

To simplify analysis, the single-index model assumes that there is
only 1 macroeconomic factor that causes the systematic risk
affecting all stock returns. This factor can be represented by
the rate of return on a market index, such as the S&P

According to this model, the return of any stock can be

decomposed into the expected excess return of the individual stock
due to firm-specific factors, commonly denoted by its alpha
coefficient (α), the return due to macroeconomic events that
affect the market, and the unexpected microeconomic events that
affect only the firm.
http://thismatter.com/money/investments/single-index-model.htm

R_it = a_i + b_i R_Mt +e_it

R_it = Return on security i in period t
R_Mt = return on the market index in period t
a_i = constant return
b_i = measure of the sensitivity of the security i return to
the return on the market index (popularly called beta)
e_it = error term

Assumptions in the single index model
1. The error term (e_it) has an expected value of zero and a
  finite variance
2. The error term is not correlated with the return on the market portfolio
  Cov(e_it, R_Mt) = 0
3. Securities are related only through their common response to
  the return on the market index. This implies that the error
  term for security i is not correlated with the error term for
  any other security:
  
  Cov(e_it, e_jt) = 0
Single index model has computational advantages of magnitude
defined below:
- To compute Markowitz model you need n(n+3)/2 computations;
  Single index model you only need 3n+2 estimates (100 sec, 302
  inputs).

1.9 Discuss the procedure commonly used in practice to test the CAPM.

ANSWER: READ Page 256

The Capital Asset Pricing Model (CAPM) is an economic model for
valuing stocks, securities, derivatives and/or assets by relating
risk and expected return. CAPM is based on the idea that investors
demand additional expected return (called the risk premium) if they
are asked to accept additional risk.

The CAPM model says that this expected return that these investors
would demand is equal to the rate on a risk-free security plus a
risk premium. If the expected return does not meet/beat the
required return, the investors will refuse to invest and the
investment should not be undertaken.

The CAPM formula is:

Expected Security Return = Riskless Return + Beta x (Expected Market
Risk Premium)

A consequence of CAPM-thinking is that it implies that investing in
individual stocks is pointless, because one can duplicate the
reward and risk characteristics of any security just by using the
right mix of cash with the appropriate asset class. This is why
die-hard followers of CAPM avoid stocks, and instead build
portfolios merely out of low-cost index funds.

The Capital Asset Pricing Model is a ceteris paribus model. It is
only valid within a special set of assumptions. These are:

Investors are risk averse individuals who maximize the expected
utility of their end of period wealth.
Implication: The model is a one period model.
Investors have homogenous expectations (beliefs) about asset
returns.
Implication: all investors perceive identical opportunity
sets. This is, everyone have the same information at the same
time.
Asset returns are distributed by the normal distribution.
There exists a risk free asset and investors may borrow or lend
unlimited amounts of this asset at a constant rate: the risk free rate.
There is a definite number of assets and their quantities are
fixed within the one period world.
All assets are perfectly divisible and priced in a perfectly competitive marked.
Implication: e.g. human capital is non-existing (it is not
divisible and it can’t be owned as an asset).
Asset markets are frictionless and information is costless and
simultaneously available to all investors.
Implication: the borrowing rate equals the lending rate.
There are no market imperfections such as taxes, regulations, or
restrictions on short selling.

Commonly followed procedure involves three basic steps:

Set up the sample data
Compute:
- R_it = Returns on n securities over the t period of time
- R_Mt = Returns on a market portfolio proxy over the t month period
- R_ft = Return on risk free investment over t month period
Estimate the Security Characteristics Line (Beta)
- R_it = a_i + b_i R_Mt + e_it
- R_it - R_ft = a_i + b_i (R_Mt-R_ft) + e_it
Estimate the Security Market Line
With the Beta estimates of various securities, you can estimate the SML.
- R_i = Y₀ + Y₁ b_i + e_i

If CAPM holds

The relationship should be linear.
Y₀, the intercept, should not be significantly different
from risk free return, R_f
Y₁, the slope coefficient should not be significantly
different from R_M-R_f
No other factors, such as company size or total variance,
should affect R_i
The model should explain the significant portion of
variation in returns among securities.

1.10 Discuss the following approaches to beta estimation:

(a) betas based on fundamental information and
(b) betas based on accounting information.
ANSWER:

Factors employed for predicting betas based on fundamental
information are:
- Industry Affiliation: Beta varies across industries.
- Corporate Growth: Growth and Beta are correlated.
- Earnings Variability: Greater the variability of
  earnings over time, greater beta.
- Financial Leverage: Greater the financial leverage,
  higher the beta is likely to be.
- Size: Larger the size of a company, smaller the beta.
One can estimate the beta of a company using the accounting
information rather than the traded prices. This involves
regressing the changes in company earnings (on a quarterly or
annually) against changes in the earnings for the market (the
aggregate earnings of all the companies included in the market
index which is used as the proxy for the market).

Limitations of this approach:
1. Accounting earnings are generally smoothed out, relative to
  the value of the company.
2. Accounting earnings are influenced by non-operating factors
  like extraordinary gains or losses and changes in
  accounting policy with respect to depreciation, inventory
  valuation, and so on.
3. Compared to stock prices which are observed on a daily
  basis, accounting earnings are measured at less frequent
  intervals. This means that regression analysis using accounting
  data will have fewer observations and have lesser power.

1.11 Discuss the Arbitrage Pricing Theory.

ANSWER:

http://www.money-zine.com/Investing/Stocks/Arbitrage-Pricing-Theory-or-APT/

APT model was first described by Steven Ross. The APT assumes
that each stock's (or asset's) return to the investor
is influenced by several independent factors.

The APT Formula

Furthermore, Ross stated that the return on a stock must follow a
very simple relationship that is described by the following APT
formula:

Expected Return = r_f + b₁ x (factor 1) + b₂ x (factor 2)… + b_n x (factor n)

Where:

r_f = The risk free interest rate is the interest rate the
investor would expect to receive from a risk free
investment. Typically, US Treasury Bills are used for
US dollars and German Government bills are used for
the Euro
b = the sensitivity of the stock to each factor
factor = the risk premium associated with each factor

The APT model also states that the risk premium of a stock
depends on two factors:

The risk premiums associated with each of the factors described
above
The stock's own sensitivity to each of the factors - similar
to the beta concept

Risk Premium = r - r_f = b₁ x (r factor(1) - r_f) + b₂ x (r factor(2) - r_f… + b_n x (r factor(n) - r_f

If the expected risk premium on a stock were lower than the
calculated risk premium using the formula above, then investors
would sell the stock. If the risk premium were higher than the
calculated value, then investors would buy the stock until both
sides of the equation were in balance. Arbitrage is term used to
describe how investors could go about getting this formula, or
equation, back into balance.

Factors Used in the Arbitrage Pricing Theory

It's one thing to describe the APT theory in terms of simple
formulas, but it's another matter entirely to identify the
factors used in this theory. That's because the theory itself
does not tell the investor what those factors are for a
particular stock or asset - and for very good reason. In
practice, and in theory, one stock might be more sensitive to one
factor than another. For example, the price of a share of
ExxonMobil might be very sensitive to the price of crude oil,
while a share of Colgate Palmolive might be relatively
insensitive to the price of oil.

In fact, the Arbitrage Pricing Theory leaves it up to the
investor, or analyst, to identify each of the factors for a
particular stock. So the real challenge for the investor is to
identify three things:

Each of the factors affecting a particular stock
The expected returns for each of these factors
The sensitivity of the stock to each of these factors

Identifying and quantifying each of these factors is no trivial
matter and is one of the reasons that the Capital Asset Pricing
Model remains the dominant theory to describe the relationship
between a stock's risk and return.

Keeping in mind that the number and sensitivities of a stock to
each of these factors is likely to change over time, Ross and
others identified the following macro-economic factors they felt
played a significant role in explaining the return on a stock:

Inflation
GNP or Gross National Product
Investor Confidence
Shifts in the Yield Curve

With that as guidance, the rest of the work is left to the stock
analyst.

APT versus the Capital Asset Pricing Model

As mentioned, the APT and the Capital Asset Pricing Model (CAPM)
are the two most influential theories on stock and asset pricing
today. The APT model is different from the CAPM in that it is
far less restrictive in its assumptions. APT allows the
individual investor to develop their model that explains the
expected return for a particular asset.

Intuitively, the APT makes a lot of sense because it removes the
CAPM restrictions and basically states "the expected return on an
asset is a function of many factors and the sensitivity of the
stock to these factors." As these factors move, so does the
expected return on the stock - and therefore its value to the
investor.

In the CAPM theory, the expected return on a stock can be
described by the movement of that stock relative to the rest of
the stock market. The CAPM theory is really just a simplified
version of the APT, whereby the only factor considered is the
risk of a particular stock relative to the rest of the stock
market - as described by the stock's beta.

From a practical standpoint, CAPM remains the dominant pricing
model used today. When compared to the Arbitrage Pricing Theory,
the Capital Asset pricing model is both elegant and relatively
simple to calculate versus what's required by the APT formula.

1.12 Describe the common misconceptions about the Efficient Market Hypothesis. How would you dispel them?

ANSWER:

Misconception	Answer
<30>	<30>
The efficient market hypothesis implies that the market has perfect forecasting capabilities.	The EMH merely implies that prices impound all available information. This does not mean taht the market possesses perfect forecasting capabilities.
As prices tend to fluctuate, they would not reflect fair value.	Unless prices fluctuate, they would not reflect fair value. Since the future is uncertain, the market continually surprised. As prices reflect these surprises they fluctuate.

Inability of institutional portfolio managers to achieve superior investment performane implies that they lack competence.	In an efficient market, it is ordinarily not possible to achieve superior investment perf. Market efficiency exists because portfolio mgrs are doing their job well in a competitive setting.
The random movement of stock prices suggests that the stock market is irrational.	Randomness and irrationality are two different matters. If investors are rational and competitive, price changes are bound to be random.

1.13 What steps are involved in an 'event study'? What steps are involved in a 'portfolio study'?

ANSWER:
An event examines the market reactions to and the excess market
returns around a specific information event like acquisition
announcement or stock split.

Involved in event study:

Identify the event to the studied and pinpoint the date on
which the event was announced.
Event studies presume that the timing ofthe event can be
specified with a fair degree of precision. Because, financial
markets react to the announcement of an event, rather than the
event itself, event studies focus on announcement date of the
event.
Collect returns data around the announcement date. This is the
retuns window (number of dates before and after).
Calculate the excess returns, by period, around the
announcement date for each firm in the sample.
The excess return is calculated by making adjustment for
market performance and risk. For example, if the CAPM is
employed to control for risk the excess return is calculated
as:

ER_jt = R_jt - Beta_j x R_mt

where
- E R_jt = excess return on firm j for period t
- Beta_j = beta of firm j
- R_mt = returns on market for period t
Compute the average and the standard error of excess
returns across all firms.
Assess whether the excess returns around the announcement
date are different from zero.

In a portfolio study, a portfolio of stocks having the observable
characteristic (low price earnings ratio or whatever) is created
and tracked over time to see whether it earns superior
risk-adjusted returns.

Define study the variable (characteristic) on which firms
will be classified
Classify firms into portfolios based upon the magnitude of
the variable
Compute the returns for each portfolio
Calculate the excess returns on each portfolio
Assess whether the average excess returns are different
across the portfolios

1.14 Discuss the alternative paradigm of 'noise trading and limited arbitrage' as articulated by Scheifer, Summers, and others.

ANSWER:
Noise Trading:
Many investors trade on pseudo-signals, or noise, and not on
fundamentals. As long as these investors trade randomly, their
trades cancel out and are likely to have perceptible impact on
demand. True, this happens to some extent because the market is
thronged by noise traders who employ different models and, hence,
cancel each other out. However, a good portion of noise traders
employ similar strategies, as they suffer from similar judgmental
bias while processing information. For example:

a. They tend to be overconfident and hence assume more risk
b. They tend to extrapolate past time series and hence chase
trends
c. They tend to put lesser weight on base rates and more weight
on the information and hence overreact to news
d. They follow market gurus and forecasts and act in similar
fashion.

Limits of Arbitrage:

One can expect the irrationality of noise traders to be
countered by the rationality of arbitrageurs as the latter are
supposed to be guided by fundamentals and immune to
sentiments. However, arbitrage in the real world is limited by
two types of risk. The first risk, is fundamental. Buying
undervalued securities tends to be risky because the market may
fall further and inflict losses. The fear of such a loss may
restrain arbitrageurs from taking large enough long positions
that will push price to fully confirm to fundamentals.

The second is resale price risk and it arises mainly from the
fact that arbitrageurs have infinite horizons for two reasons:

i) arbitrageurs usually borrow money or securities to implement
their trades and therefore have to pay fees periodically. So,
they can ill-afford to keep an open position for long horizon.

ii) Portfolio managers are evaluated every few months. This
limits their horizon to arbitrage.

1.15 Discuss the investment implications of the Efficient Market Hypothesis.

ANSWER:

Random walk theory is against the technical analysis and
both parties debate over it. There is much evidence to the
nature of randomness in stock price behaviour.
Routine and conventional fundamental analysis is of not
much help in identifying profitable courses of action, more
so when you are looking at actively traded
securities. Market is imperfect.
The key levers for earning superior rate of return are:
- early action on any new development
- Sensitivity to market imperfections, and
  innovative mode of analysis
- Use of original, unconventional, and innovative
  modes of analysis
- Access to inside information and its sensible
  interpretation
- An independent judgment that is not affected my
  market psychology

1.16 Discuss the risks that debt instruments are subject to.

ANSWER:

Interest Rate Risk

Interest rates tend to vary over time and affect bond prices. They are inversely related. Also referred to as market risk. Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Inflation Risk

As interest rates are defined in nominal terms, the real return decreases and makes it less attractive to the buyers. Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up inteh form of higher prices. Inflation risk is also referred to as purchasing parity risk. This term just means that money doesn't buy as much as it used to. Since financial contracts are stated in nominal term, the real interest rate should be adjusted for the expected inflation. According to Fisher Effect, the following relationship holds between nominal rate r, real rate a, and the expected inflation rate alpha. r = 1 + alpha + a x alpha When the inflation is higher than expected, the borrower gains at the exposure of the lender and vice-versa.

Real Interest Rate Risk

Shifts in supply and/or demand for funds change the real interest rate. The company giving debt might itself earn less on (leasing, selling) assets and may be paying more debt interest due to real interest rate.

Default Risk

Borrower may not pay interest and/or principal on time. Also, referred to as Credit Risk is normally gauged by the rating assigned by debt instrument by an independent credit rating agency (like CRISIL, ICRA or CARE). Other things being equal, bonds which carry a higher default risk (lower credit rating) trade at higher yield to maturity.

Call Risk

The issuer has an option to call intermittently before maturity period. At that point the investor is subject to call risk as he cannot reinvest the money in any other comparable instrument. Many bonds include a call feature that allows the issuer to redeem or call all or part of the issue before the maturity date. The issuer usually retains this right in order to have flexibility to refinance the bond in the future if the market interest rate drops below the coupon rate. This implies three risks from the investor:

The cash flow pattern becomes uncertain,
The investor becomes exposed to reinvestment risk
because the issuer will call the bond when interest
rates drop, and
The capital appreciation potential of a bond will be
reduced, because the price of a callable bond may not
rise much above the price at which the issuer will
call the bond.

Liquidity Risk

All other debt instruments, other than Govt. sponsored to not have much liquidity in market.

1.17 What are the important properties of duration?

ANSWER:

Duration of a bond is the weighted average maturity of its
cash flow stream, where the weights are proportional to the
present value of cash flows.

Duration is the key concept in bond analysis for two reasons:

It measures the interest rate sensitivity of a bond
It is a useful tool for immunising against interest rate
risk.

Properties of duration:

Duration of a zero-coupon bond is same as its maturity
For a given maturity, a bond′ s duration is higher when its
coupon rate is lower
For a given coupon rate, a bond`s duration generally
increases with maturity
Other things being equal, the duration of a coupon bond
varies inversely with the yield to maturity.
The duration of a level of perpetuity is:
(1 + yield)/yield

The duration of a level annuity approximately is:

(1 + yield)         Number of payments
         ---------------  -  -----------------------------------
             yield           (1 + yield)^{number of payments} - 1

The duration of a coupon bond approximately is:

1+y             (1+y) + T(c-y)
        -----   -     -----------------------------------
          y             c [(1+y)T-1] + y

1.18 What is debt rating? What are the functions of debt ratings (or debt rating firms)?

ANSWER:
Debt ratings are the grading system given to bonds to assess
their investment qualities, like timely payment of interest,
principal. Higher the rating, higher the chances of investor
getting back his money. This can also be considered,
peace-of-mind indicator for the investor.

Functions of Debt Rating:

Provide superior information
Offer low-cost information
Serve as a basis for a proper risk-return trade-off
Impose healthy discipline on corporate borrowers
? Lend greater credence to financial and other representations
Facilitate the formulation of public policy guidelines on
institutional investment.

Some of the debt rating firms are, Moody's, Standard and
Poor's, Australian Ratings.

1.19 Discuss the key determinants of interest rates. [Jul 2009]

ANSWER:
Four factors that determine the interest rates are:

Short Term Risk-free interest rate
STRI = Expected Real Rate of return - Expected rate of inflation
Maturity premium represents the difference between the
yield to maturity on a short term (one year) risk-free
security and the yield to maturity on a risk-free security
of a long maturity.
Default Premium - applicable for non-Govt bonds. Credit
rating agencies consider several factors such as business
risk, financial risk, size of business, etc.
Special features like call and put, floating rate of
interest, zero coupon bonds at deep discount, etc.

1.20 Describe briefly the strategies followed by passive bond investors and active bond investors.

ANSWER:
Passive Strategies:

Buy and Hold Strategy
Indexing Strategy - Building a portfolio with well known bond index.
Immunization Strategy - ensure that the duration of his
bond portfolio is set equal to a predetermined investment
horizon for the bond portfolio.

Active Strategies:

Forecasting interest rate changes
Exploiting mis-pricings among securities

1.21 Discuss the key macroeconomic variables and their impact on the stock market. [Jan 08]

ANSWER:

Growth rate of gross domestic product (GDP)
Industrial growth rate
Agriculture and monsoons
Savings and investments
Government budget and deficit
Price level and inflation
Interest rates
Balance of payments, forex reserves, and exchange rates
Infrastructural facilities and arrangements
Sentiments

1.22 Describe and evaluate the rules of thumb employed by investment analysts to establish benchmark price-earnings multiples.

1.23 Describe the industry life cycle. What are its implications for the investor? [Jul 09]

ANSWER:

Pioneering stage
Rapid growth stage
Maturity and stabilization stage
Decline stage

1.24 Discuss the important technical indicators. [Jan 08]

ANSWER:

Breadth indicators

Advance-Decline line
New Highs and lows
Volume
Sentiment indicators

Short-interest ratio

Total Number of Shares sold short
          ----------------------------------------------
          Average daily trading volume

Mutual fund liquidity
If the mutual fund liquidity is low, it means that mutual funds
are bullish. So contrarians (who think crowd is wrong) argue that
the market is at, or near, a peak and hence likely to
decline. Thus, low mutual fund liquidity is considered as bearish
indicator.

(similarly expand on other way).

Put/Call Ratio

Number of puts purchased
      -----------------------------
      Number of calls purchased

1.25 Evaluate technical analysis.

ANSWER:
Advocates of Technical Analysis:

Under influence of crowd psychology, trends persist for quite
some time.
Shifts in demand and supply are gradual rather than
instantaneous.
Fundamental information about a company is absorbed and
assimilated by the market over a period of time.
Charts provide a picture of what has happened in the past and
hence give a picture of volatility that can be expected from the
stock.

Detractors of Technical Analysis:

Most technical analysts are not able to offer convincing
explanations for the tools employed by them.
Empirical evidence in support of the random-walk hypothesis
casts its shadow over the usefulness of technical analysis
By the same time an uptrend or downtrend may have been signaled
by technical analysis, it may already have taken place
Technical analysis is a self-defeating proposition. As more and
more people use it, the value of such analysis tends to
decline.
The numerous claims that have been made for different chart
patterns are simply untested assertions.
There is a great deal of ambiguity in the identification of
configurations as well as trend lines and channels on the
charts.

1.26 Discuss the following option strategies: protective put, covered call, straddle, and spread. [Jul 08]

ANSWER:

Protective Put: This strategy is a defense option to limit your

potential losses. Suppose you are investing in a stock that has
good potential, but you see a likely chance of stock price fall,
you use the protective put strategy. In this you invest in the
stock and simultaneously purchase a put option on it.

Covered call
Straddle
Spread

1.27 Discuss the key features of a futures contract.

1.28 What is the conventional wisdom on asset mix. [Jan 09]

ANSWER:

Other things being equal, an investor with greater tolerance for
risk should tilt portfolio in favor of stocks.
Other things being equal, an investor with longer investment
horizon should tilt his portfolio towards stocks. Investor with
shorter time horizon should tilt towards bonds.

1.29 Explain the principal vectors of an active portfolio strategy.

ANSWER:
An active portfolio strategy is followed by most investment
professionals and aggressive investors who strive to earn superior
returns, after adjustment for risk.

Four principal vectors of an active strategy are:

Market timing
Sector rotation
Security selection
Use of a specialized concept
is based on an explicit and implicit forecast
of general market movements. The advocates of market timing
employ a variety of tools like business cycle analysis, moving
average analysis, advance-decline analysis, and econometric models.

A careful study on market timing argues that the investment
manager must forecast the market correctly 75 percent of the
time just to break-even, after taking into account the cost of
errors and the costs of transactions.
This concept applies to stocks as well as
bonds. Tilt the portfolio towards growth industries and sectors,
compared to market selection.

With respect to bonds, sector rotation implies a shift in the
composition of bond portfolio in terms of quality, coupon rate,
term of maturity, and so on. If you anticipate rise in interest
rates, you may shift from long term bonds to medium or short
term. Remember that long-term bonds are more sensitive to
interest rate variation compared to a short-term bond.
Most commonly used vector in active
portfolio strategy is the search under-priced security. If you
resort to active stock selection, you may employ fundamental
and/or technical analysis to identify stocks which seem to
promise superior returns and concentrate the stock component of
your portfolio on them.
like growth stocks,
neglected or 'out of favor' stocks, asset-rich stocks,
technology stocks, cyclical stocks.

1.30 Discuss the basic guidelines with respect to investing.

ANSWER:

Accord top priority to a residential house
Integrate life insurance in your investment plan
Choose a risk posture consistent with your life stage in
investor life cycle
Limit investment in precious objects
Avail tax shelters
Adopt a suitable formula plan (objectivity and avoid fear-greed)
Select fixed income instruments judiciously
Focus on fundamentals, but keep eye on technicals
Diversify moderately
Periodically review and revise your portfolio

1.31 Discuss the key tenets of Warren Buffett's strategy for investing. [Jul 09]

1.32 Distill Peter Lynch's advice presented in his book One Upon Wall Street.

ANSWER:

Peter Lynch was responsible for phenomenal growth of Fidelity
Magellan Fund. Under his stewardship, Magellan Fund became largest
mutual fund in history, with $12 billion in assets in 1987. Time
Magazine called him the "#1 Money Manager".

His bestseller book One Up on Wall Street has a number of secrets
and offers a number of valuable suggestions.

CATEGORIES:

PD: Personal Discipline
IST: Investment Strategy
AV: Avoid

–

(PD) Address basic personal issues before buying shares
(PD) Devote time and effort
(PD) Try going it alone
(IST) Invest in something you know or understand
(IST) Look for companies that are "off the radar scope of the market"
(IST) Apply simple fundamental criteria: Lynch relies on fundamental
analysis and avoids technical analysis. He looks at
price-earnings (p/e) ratio carefully. Other factors are cash
position, debt factor, dividends, book value, cash flow, and
profit after tax.
(AV) Don't try to predict the market
(AV) Avoid market timing
(AV) Avoid generic formulae
(IST) Diversify flexibly
(PD) Be patient
(IST) Carefully prune and rotate based on fundamentals
(AV) Avoid financial derivatives

1.33 Expound the rules of contrarian investment strategy articulated by David Dreman. [Jul08]

1.34 Discuss the Swiss investment wisdom as embodied in Zurich axiom.

1.35 Explain the key financial numbers relating to a mutual fund scheme.

1.36 Explain the following: (a) prospect theory, (b) mental accounting, and (c) narrow framing.

1.37 Explain the important heuristic-driven biases and cognitive errors that impair judgment.

1.38 Discuss the argument of behaviouralists about market efficiency. [Jan 2009]

2 Chapter End Review Questions

3 General Theory (Notes)

3.1 Objective type questions

Nifty is a: value weighted index
Interest coverage ratio is a: leverage ratio
Largest reduction in risk by diversifying investment across two stocks that are: perfect negetive correlation
Narrow framing leads to: Myopic risk aversion
Immunisation attempts to balance: price risk and reinvestment risk
Riskier stocks have lower P/E multiple and Higher variance
To check inflationary expectations a central back may: increase bank rate
Low mutual fund liquidity is supposed to forecast: a bearish trend
Value of a call option increases when: volatility is high
For good downside protection and riding a bull market you will adopt a: CPPI policy
All other things being equal, payment of cash dividend have on Times Interest earned and Debt/Equity Ratio:* No Effect, Increase
Book buliding is used to help in better: price discovery
An investor for whom the certainity equivalent is less than expected value, is: Risk averse
For a depositor, when frequency of compounding is increased: additional gains dwindle
A portfolio consists of stock and a treasury bill. Its covariance is: zero
Features of yield curve attractive to a bond investor: convexity
A current deficit is indicative of: Excess of investments over savings
If you anticipate a stable market, you will go for: short straddle
A forward contract is a type of futures contract
An investor who extensively analyses publicly available information is a: value based transactor
Open ended mutual schemes are ordinarily listed in stock exchange: True
An example of a collateralized short term lending transaction
is: Repo
What is the expected return of a zero-beta security: Risk-free rate of return
Single index model requires: 3n+2 estimates
Strong-form efficiency supports technical analysis: False
Horizon arbitrage is limited for a portfolio manager because:
Evaluation once every few months
Ratios of special interest for a person investing in corporate
bonds: Fixed charges coverage ratio
An ascending yield curve means: short-term rates are expected to rise in future
Bullish signal for a technical analyst: A high short-interest ration
Appropriate measure of risk used in Treynor measure is: Beta

Author: Janardan Revuru
<janardan@yahoo.com>

Date: 2010-02-02 08:25:49 XXX

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