CA Final November 2023 Suggested Answers Paper 6B Financial Services and Capital Markets (Old Scheme)

FOR CA FINAL EXAM PREPARATION

CA Final 2023
Suggested Answers ·
Paper 6B Financial
Services and Capital
Markets (Old Scheme)
EXAM YEAR TYPE

CA Final 2023 Suggested Answers
SUBJECT DATE

Paper 6B Financial Services and Capital Markets (Old Scheme) November 2023

Notes · Sample Papers · Previous Year Papers · Mock Tests

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This Suggested Answer hosted on the website do not constitute the basis for evaluation of the

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student’s answers in the examination. The answers are prepared by the Faculty of the Board of

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Studies with a view to assist the students in their education. Alternate Answers have been

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aerrorg or omission is noticed, the same may be brought to the attention of the Director of Board
incorporated, wherever necessary. While due care is taken in preparation of the answers, if any

of Studies. The Council of the Institute is not in anyway responsible for the correctness or

otherwise of the answers published herein.

Further, in the Elective Papers which are Case Study based, the solutions have been worked

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out on the basis of certain assumptions/views derived from the facts given in the question or

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. to work out the solution to the case studies
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language used in the question. It may be possible

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in a different manner based on the assumptions

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2 FINAL EXAMINATION: NOVEMBER, 2023

PAPER 6B: FINANCIAL SERVICES AND CAPITAL MARKETS - ELECTIVE PAPER

The Question Paper comprises five case study questions. The candidates are required to
answer any four case study questions out of five.

While answering the multiple choice question, candidates are required to indicate the alphabet
of their choice in capital letters.

In case, any candidate answers extra question(s)/ sub-question(s) over and above the
required number, then only the requisite number of questions first answered in the answer
book shall be valued and subsequent extra question (s) answered shall be ignored.

CASE STUDY - 1
West Coast Metals Limited (WCML) is the premier inventor, developer, and producer of nickel
and copper alloy with a portfolio of over 70 alloy compositions, wrought products, and welding
consumables. WCML got listed on the stock exchange a few years ago an d since then there
has been no instances of non- compliances, shareholder's grievances. However, the Company's
shareholders are unhappy with the returns because the stock always returned below its peers
and the stock index. WCML's share price closed at an all-time high of INR 250 on the stock
exchange on Friday, August18, 2023. The surge in the stock price is driven by WCML's robust
first-quarter earnings and it's first-ever buy-back proposal of INR 2750 million. Before the
announcement of WCML's buy-back of shares, an investor Mr. Tulip shorted 1,000 shares of
WCML at INR 220 per share, using a 50% margin. Mr. Tulip's initial margin account's balance
was INR 1,10,000 in the form of equity shares of XYZ and an equal amount in the form of debt
instrument. WCML is an all-equity-financed firm with 100 million shares outstanding and has
reported INR 1225 million of earnings after tax in FY 2022-23. An extract of the Company's
financials for the year ending March 31, 2023 is tabulated below.
Extract of WCML for the year ended on March 31, 2023
Particulars Amount
Earnings Before Interest and Tax (EBIT) (INR million) 1750
Interest (INR million) 0
Taxable Income (INR in million) 1750
Taxable @ 30% (INR million) 525
Net Income (INR million) 1225
No. of shares outstanding 100 million
Earnings Per Share (INR) 12.25
The Company's market value as of August 18, 2023 is INR 25,000 million (considering the
closing price on August 18, 2023).

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 3

Share Buy-Back Proposal
After realizing that WCML's shares are undervalued in the market mainly because the Company
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is not currently enjoying tax advantages on the interest, the CFO Ms. Alva has been asked to

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evaluate buy-back of shares. She is in the process of evaluating a proposal to buy-back shares

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at a fixed price of INR 275 per share. The CFO is in a dilemma, whether to fund the buy-back
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of shares from its retained earnings or borrow at a competitive interest rate by issuing debt

l a 1: To avail of a tax shield on debt, WCML plans to borrow INR 2750 million at 12%a
securities and use the proceeds to finance the buyback.
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ainterest by issuing debt securities and use the proceeds to buy- back 10% of outstanding shares.
Option

The Company's marginal tax rate is 30%.
Option 2: The total estimated buyback value is INR 2750 million. Therefore, borrow INR 1750
million at a 10% interest rate and use INR 1000 million from its retained earnings.
The CFO is confident that, after the buyback, WCML's share will trade at the industry average
price-to-earnings (P/E) ratio of 25x. The CFO also wants to ensure that buy-back is in

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compliance with the SEBI regulations.
Interview of Ms. Alva
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Robust performance in the last quarter and m
s eWCML. A leading financial newspaper has carried
possibility of a buy-back are the reasons many

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financial newspapers have started covering

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a consider a buy-back proposal every year if share price is
a detailed interview with Ms. Alva regarding
mentioned that the Company might
not reflecting its true value. The objective of this statement was to give signal to the market
about its current and future performances. In addition to this, she discussed many issues;
excerpts of the same are given below.
Newspaper: Of course, your Company's share price is not doing that great! Why did you
propose the buy-back of shares.?
CFO: One way to create shareholder value is to keep paying dividends. The Company has

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enough surplus beyond the requirements of the operations, so the Company decided to go for

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buyback,

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s e that doesn't create any real value. Do you agree?
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CFO: That's true only in some situations; companies do a buy-back for
example, when a company thinks its shares are undervalued, and wants to signal optimism to
the stock market or find another way to distribute profits to shareholders, it goes for buy -back
of its shares.

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4 FINAL EXAMINATION: NOVEMBER, 2023

Newspaper: Your Company is into the metal's business. What are your views on rising
commodity prices, sticky inflation, and interest rates? Do they affect WCML's performance?
CFO: After a series of increases in benchmark interest rates by the RBI, interest rates have
peaked. However, we hope for the rest of the year, metal prices are to be stable if interest rates
are dropped towards the end of 2023. Therefore, it depends on the obvious monetary policy. As
per the RBI reports on the Indian economy, it looks like a 7.5% GDP growth with a 4% -6%
inflation band. So I'm confident, we will have stable metal prices and it may be a correction down
towards the end of the year.
Newspaper: Considering the GDP growth and projected inflation, what is your advice to foreign
portfolio investors?
CFO: It’s important to note that there be inflation, currency prices, and stock prices can be
complex and vary depending on various including the magnitude of inflation, the central bank's
response, market sentiment, and global economic conditions. Investors should consider these
factors, risk tolerance, and investment goals when making decisions in an inflationary
environment. The return to foreign institutional Investors must be adjusted for currency
appreciation/depreciation.
Newspaper: Thank you for enlightening our readers and sparing your valuable time CFO: It's
my pleasure.
CFO: It’s my pleasure.
The CFO is extensively engaged in the next quarter accounts finalization, presentation to the
Board and communication to media on a regular basis. She has some work to do which has
been requested by a Board member named Mr. Padnabhan. As she has not been able to focus
on the issues, she sought your help. The relevant information related to the issues is given
below.
(A) Mr. Padnabhan holds the American Depository Receipts (ADRs) of a foreign company
called "Smart Tech." Smart Tech announced a dividend of EURO 2.50 per share to its
shareholders. The ADR-to-underlying share ratio is 1 ADR for every 2 underlying shares.
The current exchange rate is 1 FURO = USD1.20. There are 5 million ADRs of Smart Tech
that are outstanding.
(B) WCML wants to make investment in a small country named Windland. The real GDP
growth rate is one of the key factors for deciding the proposed investment. The nominal
GDP of Windland was USD 500 billion in FY 2021 and USD 550 billion in FY 2022. The
GDP deflator was 120 in FY 2021 and 130 in FY 2022.

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 5

(C) In 2022, India's government bond yield curve flattened after RBI announced monetary
policy amid tight domestic liquidity. The spread between one-year and 10-year bond yields

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has dropped to its lowest over four years.

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(D) Mr. Raman is a close friend of Mr. Padnabhan. Mr. Raman, after working for three decades

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in the United States, returned to India. In Mr. Raman's understanding many Indian
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companies reward their shareholders better than US companies. On April 1,2021, he sold

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shares worth USD 1,00,000 in US markets and invested in an Indian company, ABC
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Limited, at a price of INR 3200 per share. On April 1, 2021, the exchange rate of USD to
INR was INR 84.00. After two years, i.e., on March 31, 2023, the ABC stock price has
increased to INR 3850 per share, and the exchange rate USD to INR was INR 85.00.
Raman sold his shares on March 31, 2023. He also received INR 200 per share as dividend
for FY 2022 and an interim dividend of INR 150 per share was paid to him in March 2023.
Choose the correct alternative for the following (MCQs):
1.1 Once the share price of WCML reached to INR 250, Mr. Tulip received a maintenance
margin call. At this point, Mr. Tulip must transfer sufficient funds to bring ma rgin account

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in equity back to 50%. How many additional funds must be added to the margin account of

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Mr. Tulip assuming no change in the share price of XYZ?
(A) INR 65,000
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(B) INR 55,000
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(C) INR 45,000 a
(D) INR 30,000 (2 Marks)
1.2 Which one of the following is correct regarding per ADR dividend in USD that Mr.
Padnabhan will receive ?
(A) USD 1.50 per share
(B) USD 6.00 per share

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. (2 Marks)
(C) USD 5.00 per share

c. o 1.3 (D) USD 5.50 per share

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What was the real GDP growth of Windland between FY 2021 and FY 2022?

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(A) 1.54%
(B) 1.65%
(C) 1.50%
(D) 1.45% (2 Marks)

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6 FINAL EXAMINATION: NOVEMBER, 2023

1.4 Mr. Padnabhan wants to understand different types of yield curves. Structures of four yield
curves are depicted below.

Refer to the above yield curves and decide which of the following statements are correct
regarding yield curve?
(A) Figure -1 is an inverted yield curve, and Figure -2 is a normal yield curve
(B) Figure -2 is a normal yield curve, and Figure- 3 is an inverted yield curve
(C) Figure-4 is a normal yield curve, and Figure 3 is an inverted yield curve
(D) Figure-1 is a normal yield curve, and Figure 2 is an inverted yield curve (2 Marks)
1.5 Suppose you are asked to supervise buy-back of WCML. Which one of the following is not
incorrect regarding buy-back of its own share in terms of SEBI Regulations?
(A) Buy-back can be undertaken out of its free reserves
(B) Buy-back can be undertaken out of its securities premium account
(C) Buy-back can be undertaken out of the proceeds of an earlier issue of the same kind
of share
(D) Buy-back can be undertaken of the issue of any shares or other specified securities
2 Marks)

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 7

Answer the following questions:
1.6 Evaluate the CFO's proposal to buy-back the shares based on the expected EPS and

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market value of the Company after the buy-back of shares under option 1 and option 2

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mentioned in the Case Study and assuming the same level of EBIT. (7 Marks)

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1.7 Refer to the CFO's interview with the Newspaper and based on the conversation, highlight

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the role of monetary policy in containing inflation and how it would impact interest rates.
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(4 Marks)

g Calculate annualized return on Raman's investment in USD.
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ANSWER TO CASE STUDY - 1
1.1 (C)
1.2 (B)
1.3 (A)
1.4 (A)

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1.5 (C)
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(` In millions)

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Before Buyback Option 1 Option 2
EBIT
Less: Interest
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1750
330
1750
175
Taxable Income 1750 1420 1575
Less: Tax @ 30% 525 426 472.5
Net Income 1225 994 1102.5
No. of O/S shares 100 million 90 million (100-10) 90 million (100-10)
EPS 12.25 11.04 12.25
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MPS * 250 as on 276 (after 306.25 (after

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Buyback proposal buyback) buyback)

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date (18/08/23)

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*Note: The current market price is due to the announcement

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shares, and the actual traded price was much lower.
Evaluation
1. EPS is same before buyback as well as in option 2. But EPS has declined in
option 2.

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8 FINAL EXAMINATION: NOVEMBER, 2023

2. The MPS of the company is escalated to 276 in option 1 and ` 306.25 in option 2
after buyback.
Hence, it can be said that investors who have not availed the buyback have reaped capital
gain on account of increase in share prices after buyback. Though, EPS is same after
buyback if the company has opted for option 2, it has also benefitted because of high share
prices.
Furthermore, the option to borrow ` 1750 million at a 10% would be a better option.
1.7 One of the foremost responsibilities of RBI is to control inflation and maintain the stability
of prices.
Achieving economic growth is also one of the most important objectives of Credit Policy of
RBI. In fact, the primary objective is to maintain a judicious balance between maintenance
of price stability and achieving economic growth. So, achieving economic growth is not a
direct objective. GDP growth and job creation is primarily the government function. Credit
policy is primarily targeted to keep inflation in check and maintain sufficient liquidity into
the system which will spurs demand and leads to economic growth.
The RBI plays an important role in management of rate of interest. And the fate of many
industries depends upon the interest rate policy pursued by the Central Bank. They expect
that interest rates be reduced so that loans can be available at cheaper rate. On the other
hand, in case of inflation, general perception is to increase the rate of interest. Therefore,
the RBI evaluates the pros and cons of its every prospective decision and decides interest
rate policy to be pursued.
Hence, the role of RBI is to tread on a cautious path. People expect that inflation shall be
contained and stay within a reasonable limit so that goods and services are available to
them in a cheap manner. At the same time, people expect that unemployment should be
reduced and more and more jobs should be available. So, trade-off is required between
controlling inflation and rising unemployment.
Alternative Answer
Monetary policy, through interest rate adjustments and control of the money supply, is a
potent tool for containing inflation. These actions directly impact Interest rates, influencing
borrowing costs and economic activity. They also indirectly affect currency exchange rates
by altering the relative attractiveness of the domestic currency to investors and traders.
Therefore, central banks must carefully consider the potential consequences of their
monetary policy decisions on both inflation and broader economy.
1. Containing Inflation:
• Interest Rates: Central banks use monetary policy tools to Influence Interest
rates. One primary tool is the policy Interest; by adjusting this rate, central banks
can control the cost of borrowing for banks and, subsequently, for consumers
and businesses.

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 9

• Money Supply: Central banks can influence the money supply through open
market operations, reserve requirements, and discount rates. Tightening

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monetary policy involves reducing the money supply, making borrowing more

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expensive, and encouraging saving rather than spending, which can h elp rein

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2. Impact on Interest Rates:

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a money. As a results, consumers spending, and investment tend to decrease.
• Lowering Interest Rates: During economic slowdown or low inflation periods,
central banks may lower interest rates to stimulate borrowing and spending.
Lower interest rates make borrowing money for consumption and investment
cheaper, boosting economic activity. However, this can lead to currency
depreciation if investors seek higher returns elsewhere.

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1.8 Annualized Yield on the Investment of USD 1,00,000 on 1 st April,2021 and sold on

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31st March 2023 is shown below.

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Details of Investment and Sale Proceeds $
1 April,2021, Investment ([email protected])
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8400000

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The stock price at the time of purchase
Total Number of shares purchased
3200
2625
Dividend Income in 2021-22@ `200 per share 525000
Dividend Income in 2022-23 @150 per share 393750
Total Dividend Income ` 918750
On 31st March,2023 Sold stock at `3850 – Sale Proceeds 10106250
Total Proceeds from the Investment 11025000

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USD to INR on 31 st March 2023 ` 85.00

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Total Proceeds (equivalent value in USD on 31 st March 2023)
Annualized Rate of Return (%) = [(Ending Value / Beginning Value) ^ (1/n)m
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– 1] x 100

las Where:
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• Beginning Value = $ 100,000
• n=2 years

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10 FINAL EXAMINATION: NOVEMBER, 2023

Now, put these values into the formula:
Annualized Rate of Return (%) = [$129,706 / $100,000) ^ (1/2) – 1] x 100
Annualized Rate of Return (%) = [(1.29706) ^ (1/2) -1] x 100
Annualized Rate of Return (%) = [1.1394) -1] x 100
Annualized Rate of Return (%) = 13.94%
The annualized rate of return for this investment over the two years is 13.94%.
CASE STUDY- 2
Mr. Anand is an active investor. The portfolio of Mr. Anand contains investment in mutual funds,
stocks of select companies, corporate (convertible) bonds, GOI bonds and preference shares.
He always looks for better opportunities for investment. Information related to his investment in
mutual fund and proposed investment in various securities are presented below for necessary
analysis.
Mutual Fund Investment
(A) Mr. Anand invested INR 10,00,000 in the Growth-Equity Fund and INR 5,00,000 in the
High-Grade Bond Fund on April 1, 2022. Mr. Anand is examining the scheme information
documents of the mutual funds he invested in. He observed that the Growth-Equity Fund
returned 20.5% per annum over one year, ending March 31, 2023. At the same time, the
High- Grade Bond Fund returned 13% per annum. From a naive total return perspective,
the Growth-Equity Fund's performance has been better than High-Grade Bond Fund.
However, the average market (represented by the NIFTY 50 Equity Index) returned 22%
over the same period, while the NIFTY Composite Debt Index returned 8.5%.
Investment Performance
Particulars Growth- NIFTY High- NIFTY Treasury
Equity 50 Grade Composite Bill
Found Equity Bond Debt Index
Index Fund
Actual Return (R i) 20.50% 22.00% 13.00% 8.50% 6.5%
Downside Risk (σ D) 10.25% 11.90% 5.00% 1.75% 0
Total Risk (σ T) 13.60% 14.85% 5.50% 2.00%
After reading the scheme information documents, Mr. Anand was puzzled over one
question; as an investor, he is only concerned about the downside risk. Therefore, he
wants to understand the performance of his investments in mutual funds, considering both
the downside risk and total risk.
(B) Mr. Anand has further made investment in a Fast Growth-Equity Fund. A further analysis
of Mr. Anand's investment in Fast Growth-Equity Fund as on August 30, 2023, indicates
the following:

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 11

Sl. No. Name of the Company No of Shares Market Price (INR)
August 30, 2023

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1 XYZ Limited 1250 574
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2 PTC Limited 5500 310

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3 1200 132

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a(C) Relevant information of Mr Anand's investment in SunStar Mutual Fund is given below:
5 XYU Limited 3250

SunStar Fund starts the year with a NAV of INR 12. By year end NAV equals INR 12.10.
At the beginning of the year the fund was selling at 2% premium to the NAV and at the end
of the year it is selling at a 7% discount to NAV. The Fund paid year end distributions of
income and capital gains of INR 1.50.
Proposed investment in MNR Ltd.

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Mr. Anand is considering investing in the equity of a blue-chip company, MNR Limited. The

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stock returned 28.175% in the current year, and its beta (B) value is 1.45. On the other hand ,

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the broad market index returned 18%, and the Treasury-Rill returned 6.5% during the same

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period. After making risk - adjusted analysis, he may consider investing in the same. MNR Ltd.

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has minimum required number of directors and it falls in the top 2000 listed companies.

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However, MNR Ltd. does not have a regular non-executive chairperson. MNR Ltd. has asked
you to carry out compliance audit covering fees, compensations, sitting fees and stock options
paid to the directors.
PQR Ltd.
Mr. Anand has prompted a company named PQR Limited. The Company is known far and wide
for its innovative technology products and commitment to excellence. However, like many
companies, PQR needs to raise capital to fund its expansion plans. PQR has issued 3 - year
bond with a face value of INR 1,000 each, a coupon rate of 8.5%, and a maturity of three years,
designed to attract investors seeking a balance of steady income and moderate risk. The market

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price of the bond on the issue date is INR 950. After three years, the redemptio n price of the

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bond is INR 1000.

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Mr. Anand along with his friends has promoted another company which

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business in India and abroad. The airline industry has been one of the

present economic condition and geo-political factors. Due to cascading effect of Covid-19
pandemic and other factors, Sky Jet's outstanding dues towards its vendors, aircraft lessors,
creditors etc. have increased enormously in the last few years.

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12 FINAL EXAMINATION: NOVEMBER, 2023

In order to restructure outstanding lease liabilities towards certain aircraft lessors, the Board of
Directors of Sky Jet in its meeting held on April 27, 2023 has proposed to issue equity shar es
on a preferential basis to these aircraft lessors consequent upon conversion of their existing
outstanding lease payment liabilities equivalent to an amount not exceeding US$29.5 million at
price of INR 48.00 per equity share or such price as may be determined in accordance with
SEBI ICDR Regulations, whichever is higher, in accordance with the relevant provisions of the
Companies Act, 2013 and other applicable laws and subject to approval of the shareholders of
the Company and receipt of applicable regulatory approvals.
Choose the correct alternative for the following (MCQ):
2.1 Which of the following is correct regarding Jenson alpha () of MNR Ltd.'s equity stock?
(A) 21.33%
(B) 5.00%
(C) 16.67%
(D) 18.33% (2 Marks)
2.2 Which of the following is correct regarding each unit's Net Asset Value (NAV) of Fast
Growth- Equity Fund as on August 30, 2023, given that the number of Mutual Fund units
outstanding was 1,25,000?
(A) INR 41.00
(B) INR 39.00
(C) INR 40.00
(D) INR 40.29 (2 Marks)
2.3 Which one of the following is the correct return for the year of Sun Star Fund based on the
information given in the Case Study?
(A) 2.29%
(B) 4.19%
(C) 3.59%
(D) 5.39% (2 Marks)
2.4 Which one of the correct regarding minimum independent directors on the Board of MNR
Ltd.?
(A) 3
(B) 2
(C) 4
(D) None of the above (2 Marks)

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 13

2.5 Which of the following is incorrect regarding fees, compensation sitting fees and stock
options given to directors of MNR Ltd.?

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(A) After recommendation by the Board all fees, compensation paid to non-executive

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directors including independent directors require approval of shareholders in general

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(B) After. recommendation by the Board all fees, compensation paid to non-executive e m
meeting except payment of sitting fees to non-executive directors.

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edirectors
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a of the Central Government.
the limit prescribed under the Companies Act, 2013 which does not require approval

(C) Non-executive directors can get stock option provided it is within limit approved by
the Board.
(D) Independent directors cannot get stock option. (2 Marks)
Answer the following questions:
2.6 Compute and comment on the risk-adjusted performances of Growth Equity Fund and

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High-Grade Bond Fund which meet the requirements of Mr. Anand based on the

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2.7 The standard deviation of stock PTC Limited. included in Fast Growth- Equity Fund based
information given in the Case Study. (5 Marks)

e mare 252 trading days in a year, what would be
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on daily returns is 1.25%. Assuming there
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the annualized volatility of stock PTC (2 Marks)
2.8 (A) Calculate the duration and a modified the duration of the three-year bond (3issued
PQR Ltd given that the current market interest rate is 10%.
by
Marks)
(B) In the case of a decrease in market interest rates by 2%, what will be the impact on
the value of the three-year bond? (1 Marks)
2.9 Whether the proposed issue of equity shares on a preferential basis adjusting the money
payments to be made to the aircraft lessors, who will be allotted new equity shares, shall
be a part of preferential issue in terms of ICDR regulations and whether the lock-in period

m
of six months from the date of trading approval will be imposed on aircraft lessors. Give

co
your reasoned answer? (4 Marks)

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ANSWER TO CASE STUDY - 2

em la se
las 2.2 (C)
a g
ag 2.3 (B)
2.4 (A) or (B)
2.5 (A)

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14 FINAL EXAMINATION: NOVEMBER, 2023

Rp - R
2.6 Risk adjusted return based only on downside risk = Sortino Ratio = f
σ
d
Where:
Rp = Actual or expected portfolio return
Rf= Risk tree rate
Od= downside volatility
E(Rp -R )
Risk adjusted return based on total risk = Sharpe Ratio = f
σt
Where:
Rp = Actual portfolio return
Rf= Risk free rate
σ t = Total Volatility
Performance Growth NIFTY 50 High-Grade NIFTY Composite
Indicator Equity Fund Equity Index Bond Fund Debt Index
Sortino Ratio 1.37 1.30 1.30 1.14
Sharpe Ratio 1.03 1.04 1.18 1.00
Based on Sortino ratio both Growth Equity Fund and High-Grade Bond Funds have
outperformed the respective indices but based on Sharpe ratio, the Growth Equity Fund
has underperformed the index whereas High-Grade Bond Fund has outperformed the
index. As investor is mainly concerned with negative volatility and, hence, based on this,
Growth Equity Fund has outperformed High- Grade Bond Fund.
2.7 Annualized volatility of PTC Ltd.
= 1.25% x 252 trading days
= 19.84
2.8 (A) Duration of the bond
= (PV of cash flows x Time)/PV of cash flows
Time Cash Flow PVF @ 10% PV PV x Time
1 85 0.909 77.265 77.265
2 85 0.826 70.21 140.42
3 1085 0.751 814.84 2444.52
962.32 2662.21

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 15

So, Duration = 2662.21/962.32 = 2.77 years
Modified Duration = Duration/ (1+ Market Price at the time of Issue)

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= 2.77/ (1 + 0.10) = 2.52 years

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(B) If the yield decreases (market interest decrease by 2%) i.e., from 10% to 8%, %
s e m
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change in the value of bond = - 2.52 x (-2) = 5.04%
la
l a s
2.9 Regulation 158 (1) of SEBI (ICDR) Regulations, 2018 specifically states that the provisions
a g
ag
of this Chapter shall not apply where the preferential issue of equity shares is made
pursuant to conversion of a loan or an option attached to convertible debt ins truments in
terms of sub-section (3) and (4) of section 62 of the Companies Act, 2013, whichever is
applicable.
However, lease repayments are different from loan. So, it seems that the proposed
preferential issue can take place as per the SEBI (ICDR) Regulations, 2018.
As per Regulation 167 (2) of the said regulations, the specified securities allotted on a
preferential basis to persons other than the promoters and promoter group and the equity

m
shares allotted pursuant to exercise of options attached to warrants issued on preferential

c o
basis to such persons shall be locked-in for a period of six months from the date of trading
approval.
m . or warrants which are not listed on stock
e in for a period of one year from the date of
exchanges, such securities shall beslocked
Provided that in case of convertible securities

g la
a
allotment.
Alternative Solution
In this case, the company has an outstanding liability of paying rent to the aircraft lessors
and it has opted to issue preferential equity shares to the lessors as a means of fulfilling
its rental obligations. This would amount to issuing preferential shares in lieu of cash, being
the monetary liability which the company is subjected to.
In view of the above, the proposed issuance of equity shares, which will serve to offset
monetary obligations owed to the aircraft lessors and will be allocated to these lessors as

o m
new equity shares, will not be covered under the provisions of Regulation 163(3) of the

m It has further been observed that Regulation 167(2) of the SEBI (ICDR) Regulations c
. shall
ICDR Regulations.

c. o s
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e months will be
em l a
apply to the proposed issuance of equity shares and a lock in period of six

las imposed on such aircraft lessors from the date of trading
a g
approval.

ag CASE STUDY - 3
Auto Components Company (ACC)
ACC was founded in 1980. It is a privately owned and independently operated auto component
manufacturing company. ACC manufactures pistons, bearings, and gears. Over the years,

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16 FINAL EXAMINATION: NOVEMBER, 2023

automobile sales and the demand for auto components have skyrocketed globally. At ACC, the
Company ensures that they always succeed in delivering the required products to the customers
on time with the promised quality. Due to increasing demand, the Company is gearing up to
increase its plant capacity to match the demand in the future. However, the Company is also
worried about rising Whole sale Price Index (WPI) and Consumer Price Index (CPI).
The capacity expansion plan would require an additional investment of INR 200 million and a
working capital of INR 50 million. The Company is proposing to raise INR 250 million through
an equity offering and has appointed a lead manager. The Company is exploring two options:
book building and fixed price issue. The management of ACC has asked to you explain the role
of a lead manager on observations made by the SEBI during pre-issue management.
Fixed Price IPO: The IPO is a fixed-price issue at INR 50.00 per share, and the total issue size
is INR 250 million. Thus, the number of shares to be issued is 50,00,000, with a face value of
INR 10.00 per share. Recently, a few IPOs were subscribed but got listed below the issue price.
Therefore, investors are skeptical about the upcoming IPO issues. The Company is concerned
about the likely under subscription to the IPO. Hence, ACC entered an agreement wi th an
underwriter named Stock Merchant.
Underwriting Agreement: The primary responsibility of Stock Merchant is to reduce price
volatility and support the stock's trading within a certain price range. Stock Merchant will act as
a price stabilization agent and provide Green Shoe option, market-making, and information-
gathering services.
Price Stabilizing Agent: Stock Merchant will act as a stabilizing agent to the extent of 15% of
the issue size, and the stabilization period is 30 days from the date of listing.
Green Shoe Option: The underwriting agreement also includes a Green Shoe option, which
allows Stock Merchant to sell an additional 15% of shares (million shares) at a price of INR 50
per share. As per the agreement, the promoters of ACC would lend 0.75 million (15%) shares
to Stock Merchant for 30 days from the listing date.
ACC – IPO details
IPO Date August 18 to August 22, 2023
Listing Date August 30,2023
Face Value INR 10.00
Issue Price INR 50.00
Issue Size 50,00,000 shares
Fresh Issue 50,00,000 shares
Issue Type Fixed Price
Lot Size 200 shares
Shareholding Pre-Issue 1,00,00,000 shares
Shareholding Post Issue 1,50,00,000 shares

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 17

PharmBig
PharmBig is a listed subsidiary of ACC. It is a mid-size manufacturer of pharmaceuticals located

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in Indore. It could not grow its business due to financial constraints. Particularly, PharmBig

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needs help for financing its permanent as well as temporary working capital needs. It is facing

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growth constraints as result of working capital problem. In this context, PharmBig is evaluating

em
three alternative proposals.

l a s
l s
aissue to the public 15% convertible debentures of INR 100 each at par with a maturitya
Proposal 1: Convertible Debentures
g
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aperiod
It can
of 6 years for INR 1000 lakhs. On maturity, each debenture will be converted into 1.5
equity shares of the Company. The risk free rate of return is 10%, market risk premium is 18%
and beta is 1.25. PharmBig has paid dividend of INR12.76 per share which is growing @ 5%
per annum growth rate.
Proposal 2: Bank loan
An alternative source of financing is available from StarBank. It has offered a short -term loan
@ 17%.

m
Proposal 3: Factoring

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PharmBig has unusually high trade receivables at the moment with a carrying amount of INR

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2800 lakhs. The sales are mainly in the domestic market. The average collection period is 90

a s
days and presently its receivable collection cost is INR 35 lakhs p.a. so it coul d therefore be
l
g
sold to a Factor to improve cash position. As per terms of factoring arrangement, the Factor will

a
provide for an advance payment of 80% (maintaining factor reserve of 20% to provide for
disputes and deductions relating to the bills assigned) of the value of factored receivables for
90 days. The advance will carry a rate of interest of 12% per annum. In addition to interest, the
Factor will charge factoring commission @ 2.5% of the value of factored receivables. Both the
interest and commission shall be collected by the Factor on upfront basis.
While the management of PharmBig is waiting for the evaluation of all three proposals they have
identified certain issues and provided certain information that need to be addressed by the CFO
in the next meeting for answering questions of the management.

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(A) Whether PharmBig can go for Forfaiting instead of Factoring.

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(B) PharmBig has issued a 90-day Commercial Paper with a face value of INR 10,00,000. The

se
Commercial Paper is sold at a discount of INR 9,75,000. The management objective

em l a
always has been to offer yield to the investors at least equal to what competitors are

las (C) It has come to the notice of the management of PharmBig that a
offering
g
ag a rights issue to its existing shareholders. The details of the
a company XYZ is offering
rights issue are as follows:
Market Price of Company XYZ's Stock during the ex-right period: INR 50 per share
Subscription Price for Right Share: INR 40 per share

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18 FINAL EXAMINATION: NOVEMBER, 2023

The ratio of Right Share to Existing Shares: 1 Right Share for every two shares held
Choose the correct alternative for the following (MCQs):

3.1 The price discovery in the IPO market is dynamic and market-driven, which is possible only
in case of
(A) Fixed Price IPO
(B) Book Building
(C) Private Placements
(D) Qualified Institutional Buyers (QIBs) (2 Marks)
3.2 Factoring and Forfaiting are both financial transactions that involve the sale of accounts
receivable (usually invoices) to a third party for cash. Which one of the following is correct
regarding Factoring and Forfaiting?
(A) Forfaiting is typically used for longer-term international transactions, whereas
Factoring is typically used for short-term, domestic transactions.
(B) Factoring is typically used for longer-term international transactions, whereas
Forfaiting is typically used for short-term, domestic transactions.
(C) Forfaiting is typically used for the import of goods on credit, whereas Factoring is
typically used to export goods on credit.
(D) Forfaiting is typically a short-term bank loan, whereas Factoring is typically used for
export credit. (2 Marks)
3.3 Which of the following is incorrect regarding WPI and CPI?
(A) WPI reflects change in average price for bulk sale of commodities whereas CPI
reflects the average change in prices at retail level
(B) WPI is used as deflator for estimating GDP
(C) CPI is used as deflator for estimating GDP
(D) Global investors track both CPI and WPI (2 Marks)
3.4 Which of the following is the correct yield on the Commercial Paper discussed in the Case
Study? (Use 360 days in a year as a convention)
(A) 10%
(B) 10.26%
(C) 9.26%
(D) 11.26% (2 Marks)
3.5 Which one of the following is correct regarding the theoretical value of a right based on the
information given in the Case Study?

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 19

(A) INR 10.00
(B) INR 5.00

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(C) INR 5.50

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(D) None of the above (2 Marks)

m s e
e la
Answer the following questions:

l a s
3.6 The underwriter Stock Merchant is evaluating two possible scenarios and wants to
a g
ag Scenario 1: ACC stock is listed at INR 45 per share, i.e., 10% below the issue price.
understand the possible profit or loss to them.

Scenario 2: ACC stock is listed above the issue price at INR 60 per share.
Explain the financial implications of both scenarios to Stock Merchant and ACC
(4 Marks)
3.7 Answer the following questions related to the funding proposals of PharmBig mentioned in
the Case Study?

m
(A) Provide a reasoned recommendation, advising whether it is appropriate to choose the

c. o
proposal of the Factor in comparison to short-term bank loan or convertible

m if the clause of 'on recourse basis' is
debentures? (Use 360 days in a year as a convention). (7 Marks)
(B) Whether your advice would be echanged
negotiated on non-recourse a
l s
ag
basis' keeping the other terms of agreement with the
Factor as the same. The experience indicates that bad debt losses on sales are 2%
of sales. (1 Mark)
3.8 What role does the lead manager play after the issuance of observations by SEBI during
pre-issue management? (3 Marks)
ANSWER TO CASE STUDY - 3
3.1 (B)
3.2 (A)
3.3 (D)
o m
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c. o 3.5 (B) m
3.4 (B)

m s e
s e the fact regarding the listing of the stock is given in the question, g
l a
a
3.6 The Stock Merchant’s responsibility is to manage the price volatility after the issue. As

l a sold 15% more shares
ag
the allotment is assumed
to have been already done and the underwriter has already
considering the Green Shoe option.
Underwriter will sell 50,00,000 plus 7,50,000 shares to the pubic @ ` 50. Initially, will treat
extra 7,50,000 share sold as short position by the underwriter in the shares.

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20 FINAL EXAMINATION: NOVEMBER, 2023

Financial implication on underwriter:
(A) If Price lists at ` 45.
Underwriter will not exercise the Green Shoe option and rather will prefer to buy the
shares from the market and give it back to company. In other words, underwriter will
buy the shares from the market to cover its short position in shares. Underwriter
buying in open market which will provide support to the price and help in curbing
volatility. The difference between the average buying price and ` 50 (issue price)
shall be the profit of Underwriter apart from the underwriting commission.
The investors of ACC will suffer as the company lists below the issue price.
Consequently, the company may suffer because the future investors will be less
inclined to invest in the company and affects its profitability position in prospective
years also.
(B) If the Price Lists at ` 60.
Underwriter will exercise the Green Shoe option and will get extra 7,50,000 shares
form the company and shall give it back to the company. In this case Underwriter will
not be able to make any profit from its short position of 7,50,000 shares and will get
only the underwriting commission.
The investors will rake in profits as there will be an opportunity for capital gain. The
company’s profitability position may get a boost as more and more investors will be
looking to invest in the company.
3.7 (A) Average level of receivables = ` 2800 lakhs x 90/360 = ` 700 lakhs
Factoring commission = ` 700 x 2.5/100 = ` 17.5 lakhs
Factoring reserve = ` 700 x 20/100 = ` 140 lakhs
Amount available in advance = 700 – (17.5 + 140) = ` 542.5 lakhs
Factor will deduct his interest at 12%
12 90
Interest = 542.5 × × = ` 16,27,500
100 360
Amount to be paid = ` 5,42,50,000 - ` 16,27,500 = ` 5,26,22,500
Annual cost of Factoring
Factoring commission (` 17,50,000 x 360/90) = ` 70,00,000
Interest charges (` 16,27,500 x 360/90) = ` 65,08,000
Total = ` 1,35,08,000
Firms’ savings on taking factoring services.
Receivables collection cost = ` 35,00,000

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 21

Net cost to the firm = ` 1,35,08,000 – ` 35,00,000 = ` 1,00,08,000
1,00,08,000

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Effective rate of interest to the firm = x100 = 19.02%

c. o
5,26,22,500

o m m
c
Ke =.Rf + β (Rm – Rf)
Calculation of Cost of Convertible Debentures:
s e
m la
se= 10% + 1.25(18%) = 32.50%
la Price of share after 6 years a g
g
a = 12.76 (1.05) ^ 0.325 – 0.05
= 12.76 x 1.407/0.275
= ` 65.28
Redemption Value of Debentures
= ` 65.28 x 1.5 = ` 97.92

m
Cost of Debentures = 15 + (97.92 – 100)/6 ÷ (97.92 + 100)/2
= 14.81%
c. o
Since the effective annual cost of m
e
s of debenture i.e., 14.81%, it is not appropriate to
a
factoring i.e., 19.02% is higher than the cost of

g l
short-term loan i.e., 17% and cost

a
choose the factoring of receivables in comparison to short term loan or debentures.
So, option of proposal 1: Convertible Debentures is acceptable.
Alternative Solution
The calculation upto factoring is same. So, the effective annual cost of factoring is
19.02%. S.T. bank loan is better as rate of interest is 17%
The cost of convertible debentures is 15%. So, it is even better.
So, option of proposal 1: Convertible Debentures is acceptable.

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(B) On a non-recourse basis, bad debts will be considered in the firms’ savings.

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c. o m
So, Saving = ` 35,00,000 + 56,00,000 = 91,00,000

em
Net Cost = ` 1,35,08,000 – ` 91,00,000 = ` 44,08,000

la se
las 44,08,000
a g
g
Effective rate of interest to the firm = x100 = 8.38%

a
5,26,22,500
Thus, PharmBig should consider the factoring proposal if it is on a non-recourse
basis.

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22 FINAL EXAMINATION: NOVEMBER, 2023

Alternative Solution
If terms of agreement are negotiated from Recourse Factoring to Non-Recourse Factoring
keeping the other terms of agreement same, it is not advisable to opt for ‘on Non-Recourse
Basis’ clause since it will reduce the effective cost of factoring to 17.02% (19.02% - 2.00%)
which is lower than the cost of short-term loan i.e. 18% but still higher than the cost of
debentures i.e. 16.06%.
3.8 The lead manager(s) shall submit the following documents to the Board after issuance of
observations by the Board or after expiry of the period stipulated in sub -regulation (4) of
regulation 25 if the Board has not issued observations:
(a) a statement certifying that all changes, suggestions and observations made by the
Board have been incorporated in the offer document;
(b) a due diligence certificate as per Form C of Schedule V, at the time of registering of
the offer document;
(c) a copy of the resolution passed by the board of directors of the issuer for allotting
specified securities to promoter(s) towards amount received against promoters’
contribution, before opening of the issue;
(d) a certificate from a statutory auditor, before opening of the issue, certifying tha t
promoters’ contribution has been received in accordance with these regulations,
accompanying therewith the names and addresses of the promoters who have
contributed to the promoters’ contribution and the amount paid and credited to the
issuer’s bank account by each of them towards such contribution;
(e) a due diligence certificate as per Form D of Schedule V, in the event the issuer has
made a disclosure of any material development by issuing a public notice pursuant to
para 4 of Schedule IX.
CASE STUDY - 4
FinEX gold and diamonds is a brand owned by Fine Quality Gold Limited (FQGL) with a legacy
of over two decades. The promoters of FQGL are well known in the gold and diamond market
in India. The Company was incorporated in 2003 in Hyderabad and it is known for its innovative
designs and gold quality. The Company imports gold from Switzerland but is invoiced in USD.
As per the demand forecast, it requires 5,000 ounces of gold (oz) for its jewelry manufacturing
unit in the next three months.
The CFO of FQGL learned that derivatives can be used to hedge against commodity price risk,
and this can be done by using commodity futures and options. Therefore, the CFO gathered the
data from the spot and futures markets. The correlations of spot prices (S) and futures contra cts
(F) of Gold are given by the following correlation matrix:

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 23

S F
S 1.0000 0.8950

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F 0.8950 1.0000

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The standard deviations of the returns on these assets are given by:

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σ(S) = 0.32

s e g l
Eachlagold future contract is 100 oz, and the CFO also collected the current trading prices ofa
σ(F) = 0.25

g
a the spot market and future market:
gold in
Gold Spot Price: USD 1450 per oz
Three-month Gold futures contract price: USD 1525 per oz
The Company can borrow at 6.25%.
The CFO wants to find the optimal hedge ratio using Gold futures contracts and check whether
any arbitrage opportunities exist at the above market conditions.

m
There are number of issues relating to credit derivatives like Credit Default Swaps (CDS),

. co
Collateralized Debt Obligations (CDOs), mezzanine financing that need to be discussed in the

em
next Board meeting along with Reverse Mortgage possibility for an employee who would be

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retiring in next few months. The Board also directed the CFO to make a presentation on the

l a
market risk, financial risk external and internal business risk of FQGL and Master Direction

g
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issued by the RBI on credit derivatives. You have agreed to help the CFO in these respects.
CDO
Mr. Ashav who is son of MD & CEO of FQGL has interest in debt market. He has no interest in
the commodity market and therefore he has not joined FQGL even after obtaining an MBA
degree from a leading B-School in the USA. On the advice of MD & CEO he joined as a Credit
Analyst in a Credit Rating firm. During the orientation program, he was introduced to practica l
elements of CDO. One of the instructors explained about the CDO as under:
 CDOs are structured Asset-Backed Security (ABS) that allow for pooling various types of

m
debt, such as mortgages, auto loans, credit card debt, and more.

m .c o
c. o  The pooled debt is divided into different tranches based on risk characteristics.
 CDOs are meant to create a diversified portfolio; different types of debt are collected and
pooled together as a pool of debt.
e m
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lare used to pay the
l as  As the underlying debt generates cash flows, those cash flows
a g
ag
investors in the different tranches.
The junior, mezzanine, and senior debt tranches receive interest and principal proceeds in the
order of their seniority. Most senior tranche holders receive their payments first, more junior
tranche investors receive payments only if more prioritized payments are in line with the

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24 FINAL EXAMINATION: NOVEMBER, 2023

documentation of the structure.
Mr. Ashav needs clarification about the importance of correlations among defaults of the
underlying assets and how such correlations affect the value of the tranches.
Estimation of Credit Risk
Mr. Ashay is tasked with analyzing the credit risk of GSP Limited which is a steel manufacturing
company located in Chhattisgarh State.
Recently, many mid-sized steel manufacturing firms defaulted on loans, leading to debate on
the credit risk steel industry. Like any other industry, the steel industry also faces credit risk.
However, the credit risk of steel manufacturing firms has been on the rise due to various
reasons.
GSP borrowed three times its equity capital. Of course, it generates around 40% operating
profits, but considering the debt/equity ratios, the lenders are concerned about the repaying
capacity of the Company. To know the probability of default of GSP, Ashav explored different
approaches to credit risk assessment and finally decided to use Altman's Z score to evaluate
credit risk and prepare a report.
Ashav collected the most recent relevant financial information from the annual reports of GSP,
which are presented below.
Financials of GSP (INR lakhs)
FY 2022-23 FY 2021-22
Revenue 27500 25600
EBIT 11250 9575
Total Current Assets 18500 16750
Goodwill and Intangibles 0 0
Total Assets 65250 58550
Total Current Liabilities 13500 12400
Total Liabilities 43250 42150
Retained Earnings 25400 22530
Market Capitalization 80250 74500

Ashav started working on assessing the credit risk of GSP. He knew that the below -mentioned
five ratios are used in estimating the Z-score and interpreting the credit risk level.
X1 = Working Capital/Total Assets.
X2 =Retained Earnings/Total Assets
X3 =Earnings Before Interest and Taxes/Total Assets

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 25

X4 =Market Value of Equity/Book Value of Total Liabilities
X5 =Sales/Total Assets
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Where working capital is = (Current Assets - Current Liabilities) and

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Z =1.21 X1 +1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5

m Z score.
eAltman's l a
s g
Mr. Ashav has also been provided with the following information for making a final conclusion

l a
g of discrimination:
based on
a
aZones
Z>2.99"safe" zone
1.81<Z < 2.99 – “grey” zone
Z < 1.81 – “distress” zone
Choose the correct alternative for the following (MCQs):
4.1 Type of risks along with their explanations are listed below.

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List - 1 List - 2
.
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(i) Market Risk (a) Associated with the efficiency with which a firm

s
conducts its operations within the broader

l a
a(b)g Arises
environment imposed upon it.
(ii) Financial Risk due to change in operating conditions
caused b conditions thrust upon the firm which
are beyond its control.
(iii) External Business (c) Variations in price sparked off due to real,
Risk social, political and economic events.
(iv) Internal Business (d) Associated with the capital structure of a firm.
Risk

m
Which one of the following combination is correct?

m (B) (1)-(c), (ii)-(d), (iii)-(b), (iv)-(a) .co
(A) (1)-(a), (ii)-(b), (iii)-(c), (iv)-(d)

c. o se
m
em (C) (1)-(c), (ii)-(a), (iii)-(b), (iv)-(d)
l a
las (D) (i)-(d), (ii)-(c), (iii)-(a), (iv)-(b)
a g (2 Marks)

ag 4.2 Mezzanine financing is (i)___ and its default risk is (ii)___
(A) (i) is unsecured subordinated debt (ii) low
(B) (i) is unsecured subordinated debt (ii) high

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26 FINAL EXAMINATION: NOVEMBER, 2023

(C) (i) secured subordinated debt (ii) high
(D) (i) subordinated debt (ii) low (2 Marks)
4.3 As per Master Direction issued by the Reserve Bank of India (RBI), "Market-makers" are
required to report all OTC CDS transaction to the
(A) Clearing Corporation of India Limited (CCIL) within 30 (thirty) minutes of such
transaction.
(B) Securities and Exchange Board of India (SEBI) within 60 (sixty) minutes of such
transaction.
(C) Reserve Bank of India (RBI) within 60 (sixty) minutes of such transaction.
(D) National Securities Depository Limited within 30 (thirty) minutes of such transact ion.
(2 Marks)

4.4 As per the Master Direction issued by the RBI which of the following entities is not eligible
to act as market-makers in credit derivatives?
(A) Scheduled Commercial Banks
(B) Small Finance Banks
(C) Non-Banking Financial Companies (NBFCs)
(D) Export Import Bank of India (2 Marks)
4.5 Which one of the following is correct regarding "Reverse Mortgage"?
(A) Homeowners, typically senior citizens, can convert a portion of their home equity into
taxable cash without selling their home or paying monthly mortgage payments.
(B) Homeowners, typically senior citizens, can convert a portion of their home equity into
tax-free cash without selling their home and paying only monthly mortgage payments.
(C) Homeowners, typically senior citizens, can convert a portion of their home equity into
cash with an agreement to sell the house within ten years.
(D) Homeowners, typically senior citizens, convert a portion of their home equity into tax -
free cash without having to sell their home or make monthly mortgage payments.
(2 Marks)
Answer the following questions:
4.6 Suppose you have been hired by the CFO of FQGL to answer the following questions
based on the information given in the Case Study.
(A) Estimate the optimal hedge ratio to minimize the variance based on the information
provided in the Case Study regarding Gold spot and future prices, and related
correlation. (1 Mark)

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 27

(B) Should FQGL go long or short in Gold futures position and how many Gold futures
contracts should they trade? (2 Marks)

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(C) Do any arbitrage opportunities exist? Explain with calculations. (3 Marks)

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4.7 As number of assignments given to Mr. Ashav are still pending, he requested you to help

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him in assessing credit risk of GSP using Altman's Z score. Refer to GSP's financial

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information given in the Case Study and comments on the credit risk of GSP using Altman's

s
a you are evaluating a CDO with three tranches. Tranche 'A' comprises a pool ofa
4.8 lSuppose
Z-score. (5 Marks)
g
g
a debt and gets the first claim for all the cash flows from the collateral. Tranche 'B' gets a
second claim. Tranche 'C' is the equity tranche. What would be the likely impact on the
values of two tranches 'A' & 'B' assuming that the level of default risk increases but the
correlations among defaults of individual assets within the pool decrease? (4 Marks)

ANSWER TO CASE STUDY - 4
4.1 (B)

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4.2 (B)

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4.3 (A)

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4.4 (B)
4.5 (D)
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4.6 (A) Optimal Hedge Ratio = ρ x (σs / σf)
g
i.e., Coefficient of Correlation x (Standard Deviation of Spot/ Standard Deviation of
Future)
px 0.895
σ Spot 0.32
σ Futures 0.25
Optimum Hedge Ratio = 1.1456

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(B) No, the company FQGL shall neither buy nor sell Future. It will rather take loan

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@6.25% p.a. and take the delivery of gold right now.

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Futures Price = Spot price x [1+ rf (days to expiry/365)]– d

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Where, Spot price = 1450

ag Rf = Risk free rate of interest
d = Dividend
So, futures price =1450 x [1 + 0.0625 (3/12)]-0

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28 FINAL EXAMINATION: NOVEMBER, 2023

= 1472.62625
We can use 6.25% as risk free rate of interest as the decision has to be taken between
taking loan now and buying the spot today or buying future and taking the delivery
later.
Thus no point in buying the future, rather it would be beneficial to raise money
@6.25% and buy the Spot right now.
Calculation :
If Buy3 months Future
Loss incurred as Future expires at Spot
(i) price
75 (1525-1450)
Lot Size 100 Oz For 100 Oz for 5000 Oz
Loss 75 USD 3750

Amount of loan 1450 USD
(for 100 Oz Gold)

Interest @ 6.25 % for 3 months
= 1450 x 6.25/100 x 3/12
= $ 22.65625 for 100 oz
And, for 5000 oz = 1132.8125
buying 3-month future today is not profitable option
Selling Future is not recommended as the company needs Gold after 3 months
Thus, the company shall take loan and buy Spot.
Moreover, the number of contracts to be purchased = 5000/100 x 1.1456
= 50 x 1.1456 = 57.28 or 57 contracts
(C) Yes, arbitrage opportunity is available here
Justified Future price is 1472.66
Actual Future price is 1525
Thus, future is overvalued and therefore an arbitrage opportunity for buy Spot and
Sell Future
Assume 1 lot is taken
Buy spot @ 1450 and sell 3 months future @1525

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 29

Future will expire at spot price thus the gain of 75 USD per 100 oz.
Raise loan to buy spot and the cost of loan is less than the benefit availed.

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through arbitrage.

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4.7

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No Ratios 2022-23 2021-22 Weights Score Score

a s
l 1 Working Capital /Total 1.2 0.0920 0.0892 a
2022-23
g
2021-22

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0.0766 0.0743
Assets.
2 Retained Earnings / 0.3893 0.3848 1.4 0.5450 0.5387
Total Assets
3 Earnings Before 0.1724 0.1635 3.3 0.5690 0.5397
Interest and Taxes /
Total Assets
4 Market Value of 1.8555 1.7675 0.6 1.1133 1.0605

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Equity/ Book value of

c. o0.4372
Total Liabilities

em
5 Sales / Total Assets 0.4215 1 0.4215 0.4372
Z-Score
s
a Z score for both years, the company is not in
Based on the above criteria and lestimated
2.7407 2.6653

g
the safe zone and just belowathe safe zone. Therefore, it is categorized as a grey zone.
However, the company can improve its financials regarding earnings, efficient utilization of
assets and increasing sales.
4.8 In a CDO with multiple tranches like the one mentioned in the question, changes influence
the values of these tranches in default risk and correlation of default among the underlying
assets. Let’s break down the likely impact on the values of the two tranches, i f the level of
default risk increases but correlations decrease:

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1. Tranche A:

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Tranche A is the senior most tranche and has the first claim on all cash flows

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from the collateral. It is the least exposed to default risk among the three

em la
tranches.

las •
a g
As default risk increases across the entire pool of assets, Tranche A’s value may

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decrease slightly due to the likelihood of individual defaults within the pool.
However, it is still relatively safe because the lower tranches protect it.
• The decrease in correlation among defaults can potentially benefit Tranche A. If
individual assets’ defaults become less correlated, the likelihood of multiple
defaults occurring simultaneously decreases. This can enhance the

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30 FINAL EXAMINATION: NOVEMBER, 2023

diversification effect and provide some protection to Tranche A, helping to
stabilize its value.
2. Tranche B:
• Tranche B is the mezzanine tranche, sitting between the senior and equity
tranches regarding risk exposure.
• With increased default risk, Tranche B is more vulnerable to losses than Tranche
A. It may experience a more significant decrease in value as the overall pool’s
credit quality deteriorates.
• The decrease in correlation among defaults can have a mixed impact on
Tranche B. On one hand, it reduces the likelihood of systemic shocks affecting
the entire pool, which is positive. On the other hand, it increases the dispersion
of individual asset defaults, which can be detrimental to Tranche B’s value as it
is exposes to the risk of a higher number of defaults.
The impact of decreased correlations among defaults is more nuanced, as it can
provide some protection to the senior tranche (Tranche A) but may have mixed effects
on the mezzanine tranche (Tranche B).
CASE STUDY - 5
Mr. Collier is the sole promoter of RAMA Ltd. which is a public listed company. RAMA Ltd,
manufactures copper piping for commercial and industrial use in transporting water and gas.
Mr. Collier is also looking for acquisition of Shark Ltd, which is a strategic -fit for RAMA Ltd. For
this acquisition, the management wants to carry out Leveraged Buy Out (LBO) analysis.
(A) There have been number of compliance issues in the past and the Board of the Company
has taken a serious view of the same. Instances of few insiders trading were also
discovered that included from the promoters family. Mr. Bharat, who is the Company
Secretary of RAMA Ltd, reported to the Company on January 4, 2023 that one of the
members from the promoter's family has made trading of approx. INR 20 lakhs in the
shares of RAMA Ltd. on December 30, 2022. The delay in reporting was explained by Mr.
Bharat as December 31, 2022 and Jan 1 2023 were non-trading days. An independent
review by internal audit team revealed that Mr. Bharat reported the said transaction to the
stock exchange on Jan 7, 2023. The Board is concerned whether promoter family member
can trade in the shares of RAMA Ltd. and whether there is a delay in reporting of the said
transaction. Further issues related to RAMA Ltd. that requires attention of the Board are
discussed below:
(i) Few shareholders have alleged that RAMA Ltd. along with some brokers is indulging
in price manipulation of the shares of RAMA Ltd. The Board wants to examine the
powers of SEBI in this respect if this allegation is found to be correct.
(ii) The SEBI has received a complaint from Ms Koyal that the CEO of RAMA Ltd. Mr.
Albert has indulged in the trading of shares of RAMA Ltd. based on Unpublished Price

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 31

Sensitive Information (UPSI). It is expected that SEBI will take action against Mr.
Albert.

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(iii) Mr. Sahil has obtained an order from the SEBI against RAMA Ltd. But RAMA Ltd.

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failed to redress the grievance of Mr. Sahil within the time fixed by the SEBI. As a

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result of this SEBI imposed penalty on RAMA Ltd. but the Company failed to pay the

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penalty.

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(B) Mr. Collier's son run a private equity firm named PETrue that is registered with the SEBI.
a g
ag  The acquisition will be financed with 65% debt and 35% equity.
PETrue is considering purchase of a company named TPS Ltd. that is valued at INR 1500
million. The following information is also available about the acquisition of TPS Ltd.

 The PETrue expects to exit the investment in 4 years at a projected value of 1.60
times the initial cost.
 The equity investment of INR 525 million is composed of: INR 325 million in
preference shares. These preference shares belong to the PETrue and offer an
annual dividend of 12% (compounded annually and payable upon exit). The

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remaining equity of INR 200 million is divided between PETrue which hold INR 175

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million and the remaining equity is held by the promoters of TPS Ltd.

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 The PETrue firm will receive 87.5% of TPS Ltd’s residual value (after accounting for

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payments to preference shareholders) at exit, while management will receive the

l a
agflow.off INR 500 million of the initial INR 975 million in debt
remaining 12.5%.
 By exit, TPS expects to pay
by utilizing operating cash
(C) Mr. Collier also wants his son to supervise acquisition of Park Ltd. which is a listed
company. The P/E of RAMA Ltd. is 16x and that of Park Ltd. is 13x.
(D) Mr. N.R. Raghav, who is friend of Mr. Collier, is the founder and Chief Executive Officer of
New Tech Corp Private Limited (NTC). He has been working on a detailed valuation of his
latest venture, Learn Tech (learning platform), to be presented to Mr. Arjun Pandey, partner
of ACE Ventures Limited, a venture capital firm, on August 14, 2023. Mr. Raghav hopes to

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convince ACE Ventures Limited to invest the required amount of INR 500 lakhs.

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Mr. Raghav wondered what valuation method he could use to reflect the fair value of his

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new venture, Learn Tech. The second issue is, if ACE Ventures is convinced to invest INR

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500 lakhs in Learn Tech, how much stake should be offered to ACE Ventures for an

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investment of INR 500 lakhs?

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ACE Ventures believes that the Educational Technology Industry will grow at 15% per
a annum, and currently, the e-learning market is valued at USD 100 billion. It also forecasts
this value to reach USD 200 billion by 2029. As per the reports, there are about 35 EdTech
unicorns in this space. Learn Tech also has the potential to become a major player in the
EdTech industry in the next five years.

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32 FINAL EXAMINATION: NOVEMBER, 2023

Learn Tech incorporates a subscription-based revenue model and generates recurring
revenue as customers periodically pay a fee for exclusive access to specific products and
services.
Free Cash Flow to Equity (FCFE) Forecast (INR Lakhs)
Today 1st Year 2nd Year 3rd Year 4th Year 5th Year
FCFE 119 194 269 379 434 469
Mr. Raghav indicated to Mr. Arjun that his research suggested a ten (10) times FCFE
multiple at the end of the 5th year would be reasonable. Arjun was convinced by Raghav's
Proposal and told him that ACE Ventures' required rate of return from this project is a
minimum of 20%. Both agreed to the above terms.
Choose the correct alternative for the following (MCQs):
5.1 Which of the following is correct regarding the circumstances under which a strategic buyer
can use LBO analysis?
(A) To determine the debt capacity of its company
(B) To determine the price a financial sponsor bidder can afford to pay when competing
for an asset in an auction process
(C) For assistance in comparable company's analysis
(D) For assistance in common size statement preparation (2 Marks)
5.2 Assuming all else being equal and further assuming that RAMA Ltd. acquires Park Ltd. in
an all-stock deal, the transaction is ________
(A) Accretive
(B) Dilutive
(C) Breakeven
(D) Cannot be determined (2 Marks)
5.3 Which of the following is incorrect regarding the power of SEBI in case price manipulation
by RAMA Ltd. along with some brokers is found to be correct?
(A) Suspend trading of RAMA Ltd’s shares on the stock exchange.
(B) Cannot suspend trading of RAMA Ltd's shares on the stock exchange.
(C) Restrain RAMA Ltd. from accessing the security market.
(D) Restrain brokers to buy, sell or deal in securities market. (2 Marks)
5.4 Which of the following is incorrect regarding the power of SEBI in the matter of Ms Koyal's
allegation against Mr. Albert ?

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 33

(A) Direction to not dispose of any asset forming part of any transaction which is under
investigation

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(B) Direction to not alienate of any asset forming part of any transaction which is under

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investigation

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(C) Imprisonment of five years

s ewithmregulations
(D) Amount disgorged pursuant to a direction can be utilised by the SEBI in
(2 Marks) la
accordance
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a
5.5glWhich one of the following is incorrect regarding recovery of penalty by imposed by SEBIa
a on RAMA Ltd. in the matter of Mr. Sahil?
(A) Attachment and sale of movable property
(B) Attachment and sale of immovable property
(C) Attachment of bank account
(D) Recovery of money from the bank account equal to the penalty and transfer to the
central government. (2 Marks)

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Answer the following questions:
5.6 Based on the information given in Part (A) of the Case Study, evaluate the transaction

s emholders, preference shareholders and equity
carried out by a family member of Rama Ltd. from compliance angle. (3 Marks)
5.7 Calculate the amount that the debt
g l a
a to PETrue and the management at the time of exit?
shareholders (PETrue and the management) of TPS Ltd. will receive at the time of exit?
What will be the pay-off multiple
(6 Marks)
5.8 Answer the following questions based on the information given in the Case Study.
(A) What would be the value of Learn Tech today if the required rate of return is 20%?
(2 Marks)
(B) What percentage of the stake should be offered to ACE Ventures if their required rate

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of return is 20% and for an investment of INR 500 lakhs? (2 Marks)

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(C) What is its expected gain to ACE Ventures assuming it invests INR 500 lakhs for five

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years in Learn Tech? (2 Marks)

s em g la
l a 5.1 (B)
a
ag 5.2 (A)
5.3 (B)
5.4 (C)

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34 FINAL EXAMINATION: NOVEMBER, 2023

5.5 (D)
5.6 In case of insider trading in the shares of the company by promoter or member of the
promoter group or by any director of the company, the below mentioned provision of SEBI
(Prohibition of Insider Trading) Regulations 2015 would be relevant which is as follows:
Regulation 7(2) – Continual Disclosures
(a) Every promoter, member of promoter groups and director of every company shall
disclose to the company the number of such securities acquired or disposed of within
two trading days of such transaction if the value of the securities traded, whether in
one transaction or a series of transactions over any calendar quarter, aggregates to
a traded value more than ten lakh rupees or such value as may be specified.
(b) Every company shall notify the particulars of such trading to the stock exchange on
which the securities are listed within two trading days of receipt of the disclosure or
from becoming aware of such information.
(Transaction type include buy/sales /pledge/revoke/invoke)
The above disclosures shall be made in such form and such manner as specified by SEBI
from time to time. Family member of promoter can do transactions. However, it was a
reportable transaction as the value of transaction exceeds the prescribed limit in thi s
respect.
The transactions were made on 30 th December,2022 while it is reported to the company
on 4th January,2023, the two trading days were expired on 3 rd January 2023 (as 31 st
December,2022 and 1 st January 2023 were non trading days on account of being Saturday
and Sunday). Since the transactions were reported to company after the expiry of 2 trading
days, it would be non- compliance of the above referred provisions by the members of the
promoters group.
It would be appropriate that the company report such transactions to the concerned stock
exchange within 2 days of the receipt of such information i.e. 6 th January,2023. Since it
was reported on Jan 7,2023 and hence it is another case of non-compliance.
5.7 Calculating amounts that can be paid to all providers of capital at the time of exit. First, we
compute the exit value:
Exit value = 1,500m x 1.6= ` 2,400m
Then we compute the payoffs to each of the company’s providers of capital:
Debt holders receive the amount outstanding after accounting for the `500m that were paid
off using operating cash flows before exit.
Payment to debt holders = 975m- 500m=`475m
Preferred shareholders receive the face value of their investment plus preferred dividends
compounded over 4 years at 12%.

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PAPER – 6B: FINANCIAL SERVICES & CAPITAL MARKETS 35

Payment to preferred shareholders = ` 325m x (1.12) ^4 = ` 511.39m.
Equity holders receive the residual value of the firm after preferred shareholders have been

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paid off:

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Payments to equity holders:
•
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PETrue: (2,400-475-511.39) x 0.875 =`1,236.91m
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•
s eManagement: (2,400-475-511.39) x 0.125= `176.70m g la
lCalculating a
ag The total payoff to the PE True equals the sum of the payoffs on its preference shares and
the payoff multiple for equity holders:

equity stake in the company.
Total payoff for PE True = 511.39 + 1236.91 = ` 1748.3m
Total payoff PE True = 1,748.3/ (325+175) = 3.5 times
The total payoff to management equals its pro rata share of the company’s residual value.
Total payoff for management = 176.70 million

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Payoff multiple for management = 176.70/25 = 7.07 times
5.8 (A) Value of Learn Tech if required rate of return is 20%

s em PV Factor @ 20%
a
FCFE Year Present Value

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119 0 1 119
194 0.833 161.6
269 2 0.694 186.69
379 3 0.579 219.44
434 4 0.482 209.19
469 5 0.402 188.54
1084.46

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469 x1.15
Terminal Value = = 10787
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0.20 - 0.15

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10787

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Or = 10787 x 0.402 = 4336.37

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(1+ 0.20)5

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So, Present Value = 1084.46 + 4336.37 = 5420.83
Investment
(B) % of stake offered to ACE ventures =
Post money valuation

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36 FINAL EXAMINATION: NOVEMBER, 2023

Exit value = 10 x ` 469 lakhs = ` 4690 lakhs
4690
Post money valuation = = ` 1883.53 lakhs
(1.20)5
Equity % = 500/1883.53 = 26.55%
(C) Gain to ACE ventures
= Exit Value x Equity % of ACE Ventures – Initial Investment
= 1245.20 - 500 = ` 745.20 lakhs

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