 MARKET ANALYSIS & CORPORATE LAWS ICWAI - FINAL GROUP III PAPER 11 First Edition : May 2011Published :Directorate of StudiesThe Institute of Cost and Works Accountants of India12, Sudder Street, Kolkata-700 016Works Accountants of India and prior permission from the Institute isnecessary for reproduction of the whole or any part thereof.Printed at :Repro India Limited50/2 T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai - 400710.Copyright of this Compendium is reserved by the Institute of Cost and COMPENDIUM ON CAPITAL MARKET ANALYSIS & CORPORATE LAWS FINAL GROUP III PAPER 11 INDEX Sl. No. CHAPTER NAME Page Nos. 1. PORTFOLIO MANAGEMENT 1 232. MUTUAL FUNDS 24 293. INDIAN STOCK MARKET 30 414. FOREX 42 585. MERGERS AND ACQUISITIONS 59 766. COMPANIES ACT,1956 77-97 7. SEBI 98-99 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 1 1 PORTFOLIO MANAGEMENT Question 1 As an investment manager you are given the following information: Investment in equity shares of Initial price Dividends Market price at the end of the year Beta risk factor Rs. Rs. Rs. Rs. A. Cement Ltd. 25 2 50 0.8 Steel Ltd. 35 2 60 0.7 Liquor Ltd. 45 2 135 0.5 B. Government of India Bonds 1,000 140 1,005 0.99 Risk free return may be taken at 14% You are required to calculate: (i) Expected rate of returns of portfolio in each using Capital Asset Pricing Model (CAPM). (ii) Average return of portfolio. Answer (i) Let us first calculate the Expected return on Market portfolio which is not provided. Total Investment Dividends Capital gains Rs. Rs. Rs. A. Cement Ltd. 25 2 25 Steel Ltd. 35 2 25 Liquor Ltd. 45 2 90 B. Government of India Bonds 1,000 140 5 Total 1,105 146 145 26.33% Rs.1,105145 146 Rs. portfolio market on return Expected Capital Asset Pricing Model: E(Rp) = Rf + Bp [E (RM Rf] Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 2Where, E(Rp) = Expected return of the portfolio Rf = Risk free rate of return Bp = Portfolio beta i.e. market sensivity index E (RM) = Expected return on market portfolio. [E (RM Rf] = Market risk premium. By substituting the figures in the above equation we can calculate expected rate of returns of portfolio in each using Capital Assets Pricing Model (CAPM) as under: (ii) Average return of the portfolio 23.22%426.21 20.17 22.63 23.86 OR Average of Betas = (0.8 + 0.7 + 0.5 + 0.99)/4 = 0.7475 Average return = 14 + 0.7475 (26.33 14) = 23.22% Question 2 An investor is seeking the price to pay for a security, whose standard deviation is 4.00 per cent. The correlation coefficient for the security with the market is 0.8 and the market standard deviation is 2.2 per cent. The return from government securities is 5.2 per cent and from the market portfolio is 9.8 per cent. The investor knows that, by calculating the required return, he can then determine the price to pay for the security. What is the required return on the security? Answer Now, required return on the security: Rate of return on risk free security + beta coefficient (required return on market portfolio rate of return on risk free security) = 5.2 + 1.454 (9.8 5.2) = 5.2 + 6.688 = 11.89% Cement Ltd. = 14 + 0.8 (26.33 14) = 23.86% Steel Ltd. = 14 + 0.7 (26.33 14) = 22.63% Liquor Ltd. = 14 + 0.5 (26.33 14) = 20.17% Government of India Bonds = 14 + 0.99 (26.33 14) = 26.21% Correlation coefficient between the security and the market Std. deviation of the security return Beta coefficient = Std. deviation of the market return
= =(.8) (.04) 1.454(.022)Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 3 Question 3 Hari Types of Security Nos. Annual Coupon % Maturity Years Yield % Bond A (Rs. 1,000) 10 9 3 12 Bond B (Rs. 1,000) 10 10 5 12 Preference shares C (Rs. 100) 100 11 * 13* Preference shares D (Rs. 100) 100 12 * 13* *likelihood of being called at a premium over par. C Answer : (i) 10 Nos. Bond A, Rs. 1,000 par value, 9% Bonds maturity 3 years: Rs. Current value of interest on bond A 1-3 years: Rs. 900 Cumulative P.V. @ 12% (1-3 years) = Rs. 900 2.402 2,162 Add: Current value of amount received on maturity of Bond A End of 3rd year: Rs. 1,000 10 P.V. @ 12% (3rd year) = Rs. 10,000 0.712 7,120 9,282 (ii) 10 Nos. Bond B, Rs. 1,000 par value, 10% Bonds maturity 5 years: Current value of interest on bond B 1-5 years: Rs. 1,000 Cumulative P.V. @ 12% (1-5 years) = Rs. 1,000 3.605 3,605 Add: Current value of amount received on maturity of Bond B End of 5th year: Rs. 1,000 10 P.V. @ 12% (5th year) = Rs. 10,000 0.567 5,670 9,275 (iii) 100 Preference shares C, Rs. 100 par value, 11% coupon 0.131,100 13%100 Rs. Nos. 100 11% 8,462 (iv) 100 Preference shares D, Rs. 100 par value, 12% coupon 0.131,200 13%100 Rs. Nos. 100 12% 9,231 17,693 Total current value of his portfolio [(i) + (ii) + (iii) + (iv)] 36,250 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 4Question 4 Z Ltd. has an expected return of 22% and Standard deviation of 40%. Y Ltd. has an expected return of 24% and Standard deviation of 38%. Z Ltd. has a beta of 0.86 and Y Ltd. a beta of 1.24. The correlation coefficient between the return of Z Ltd. and Y Ltd. is 0.72. The Standard deviation of the market return is 20%. Suggest: (i) Is investing in Y Ltd. better than investing in Z Ltd.? (ii) If you invest 30% in Y Ltd. and 70% in Z Ltd., what is your expected rate of return and portfolio Standard deviation? (iii) What is the market portfolios expected rate of return and how much is the risk-free rate? (iv) What is the beta of Portfolio if Z L Y L Answer (i) Z Ltd. has lower return and higher risk than Y Ltd. investing in Y Ltd. is better than in Z Ltd. because the returns are higher and the risk, lower. However, investing in both will yield diversification advantage. (ii) Let , rA = Return for Z Ltd. & rB = Return for Y Ltd. rAB = .22 0.7 + .24 0.3 = 22.6% .1374 .38 .40 0.72 0.3 0.7 2 0.3 .38 0.7 .402 2 2 2 2AB 2AB AB * 37% .37 .1374 * Answer = 37.06% is also correct and variation may occur due to approximation. (iii) This risk-free rate will be the same for Z and Y Ltd. Their rates of return are given as follows: rA = 22 = rf + (rm rf) 0.86 [rA = Return for Z Ltd. & rB = Return for Y Ltd.] rB = 24 = rf + (rm rf) 1.24 rA rB = 2 = (rm rf) (0.38) rm rf = 2/0.38 = 5.26% rA = 22 = rf + (5.26) 0.86 rf = 17.5%* rB = 24 = rf + (5.26) 1.24 rf = 17.5%* rm 17.5 = 5.26 rm = 22.76%** Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 5 *Answer = 17.47% might occur due to variation in approximation. **Answer may show small variation due to approximation. Exact answer is 22.736%. (iv) AB = A WA + B WB = 0.86 0.7 + 1.24 0.3 = 0.974 Question 5 Following is the data regarding C or to invest 100% in E. Answer (i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for the same return. Hence, among them A dominates. For the same degree of risk 4, security D has only a return of 4%. Hence, D is also dominated by A. Securities C and E remain in reckoning as they have a higher return though with higher degree of risk. Hence, the ones to be selected are A, C & E. (ii) The average values for A and C for a proportion of 3: 1 will be : Risk =4) 12 1 ( ) 4 3 ( = 6% Return = 4) 12 1 ( ) 8 3 (= 9% Therefore: 75% A E 25% C _ Risk 6 5 Return 9% 9% For the same 9% return the risk is lower in E. Hence, E will be preferable. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 6Question 6 An investor is holding 1,000 shares of a Company. Presently the rate of dividend being paid by the company is Rs. 2 per share and the share is being sold at Rs. 25 per share in the market. However, several factors are likely to change during the course of the year as indicated below: Existing Revised Risk free rate 12% 10% Market risk premium 6% 4% Beta value 1.4 1.25 Expected growth rate 5% 9% In view of the above factors whether the investor should buy, hold or sell the shares? Also explain why? Answer On the basis of existing and revised factors, rate of return and price of share is to be calculated. Existing rate of return = Rf + Beta (Rm Rf) = 12% + 1.4 (6%) = 20.4% Revised rate of return = 10% + 1.25 (4%) = 15% Price of share (original) 13.63 Rs..15410 . 2 .05 - .204(1.05) 2 g - Kg) (1 D Peo Price of share (Revised) 36.33 Rs..0618 . 2 .09 - .15(1.09) 2 Po In case of existing market price of Rs. 25 per share, rate of return (20.4%) and possible equilibrium price of share at Rs. 13.63, this share needs to be sold because the share is overpriced (Rs. 25 13.63) by Rs. 11.37. However, under the changed scenario where growth of dividend has been revised at 9% and the return though decreased at 15% but the possible price of share is to be at Rs. 36.33 and therefore, in order to expect price appreciation to Rs. 36.33 the investor should hold the shares, if other things remain the same. Question 7 An investor is holding the following securities: Particulars of Securities Cost Rs. Dividends Rs. Market Price Rs. BETA Equity Shares: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 7 Co. A 8,000 800 8,200 0.8 Co. B 10,000 800 10,500 0.7 Co. C 16,000 800 22,000 0.5 PSU Bonds 34,000 3,400 32,300 1.0 Assuming a Risk-free rate of 15%, calculate: Expected rate of return in each, using the Capital Asset Pricing Model (CAPM). Average return of the portfolio. Answer Calculation of expected return on market portfolio (Rm) Investment Cost (Rs.) Dividends (Rs.) Capital Gains (Rs.) Shares A 8,000 800 200 Shares B 10,000 800 500 Shares C 16,000 800 6,000 PSU Bonds 34,000 3,400 1,700 68,000 5,800 5,000 15.88% 10068,0005,000 5,800 Rm Calculation of expected rate of return on individual security: Security: Shares A : 15 + 0.8 (15.88 15.0) = 15.70% Shares B : 15 + 0.7 (15.88 15.0) = 15.62% Shares C : 15 + 0.5 (15.88 15.0) = 15.44% PSU Bonds : 15 + 1.0 (15.88 15.0) = 15.88% Calculation of the Average Return of the Portfolio: 415.88 15.44 15.62 15.70 = 15.66%. Question 8 The rates of return on the security of Company X and market portfolio for 10 periods are given below: Period Return of Security X (%) Return on Market Portfolio (%) 1 20 22 2 22 20 3 25 18 4 21 16 5 18 20 6 5 8 7 17 6 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 88 19 5 9 7 6 10 20 11 (i) What is the beta of Security X? (ii) What is the characteristic line for Security X? Answer (i) Period XR MR XX R R MM R R ( ) XX R R ( ) MM R R ( )2MM R R 1 20 22 5 10 50 1002 22 20 7 8 56 643 25 18 10 6 60 364 21 16 6 4 24 165 18 20 3 8 24 646 -5 8 -20 -4 80 167 17 -6 2 -18 -36 3248 19 5 4 -7 -28 499 -7 6 -22 -6 132 3610 20 11 5 -1 -5 1 150 120 357 706 RX RM ) R R )( R (R MMXX
2MM) R R (
X R = 15 M R = 12 (RM M R)2 706 2 M = = = 78.44 n 1 9 (RX X R) (RM M R) 357 CovX, M = = = 39.66 n 1 9 CovX, M 39.66 Betax = = = .505 2 M 78.44 (ii) X R = 15 M R = 12 y = + x 15 = + 0.505 12 Alpha () = 15 (0.505 12) = 8.94% Characteristic line for security X = + RM where, RM = Expected return on Market Index Characteristic line for security X = 8.94 + 0.505 RM Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 9 Question 9 Following is the data regarding six securities: U V W X Y Z Return (%) 10 10 15 5 11 10 Risk (%) (Standard deviation) 5 6 13 5 6 7 (i) Which of three securities will be selected? (ii) Assuming perfect correlation, analyse whether it is preferable to invest 80% in security U and 20% in security W or to invest 100% in Y. Answer (i) When we make risk-return analysis of different securities from U to Z, we can observe that security U gives a return of 10% at risk level of 5%. Simultaneously securities V and Z give the same return of 10% as of security U, but their risk levels are 6% and 7% respect ively. Security X is giving only 5% return for the risk rate of 5%. Hence, security U dominates securities V, X and Z. Securities W and Y offer more return but it carries higher level of risk. Hence securities U, W and Y can be selected based on indivi dual preferences. (ii) In a situation where the perfect positive correlation exists between two securities, their risk and return can be averaged with the proportion. Assuming the perfect correlation exists between the securities U and W, average risk and return of U and W together for proportion 4 : 1 is calculated as follows: Risk = (4 .05 + 1 .13) 5 = 6.6% Return = (4 .10 + 1 .15) 5 = 11% When we compare risk of 6.6% and return of 11% with security Y with 6% risk and 11% return, security Y is preferable over the portfolio of securities U and W in proportion of 4 : 1 Question 10 Given below is information of market rates of Returns and Data from two Companies A and B: Year 2009 Year 2010 Year 2011 Market (%) 12.0 11.0 9.0 Company A (%) 13.0 11.5 9.8 Company B (%) 11.0 10.5 9.5 Required: Determine the beta coefficients of the Shares of Company A and Company B. Answer Company A: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 10Year Return % (Ra) Market return % (Rm) Deviation R(a) Deviation Rm D Ra DRm Rm2 1 13.0 12.0 1.57 1.33 2.09 1.77 2 11.5 11.0 0.07 0.33 0.02 0.11 3 9.8 9.0 1.63 1.67 2.72 2.79 34.3 32.0 4.83 4.67 Average Ra = 11.43 Average Rm = 10.67 Covariance = 2.4224.83 1.032.342.42 Company B: Year Return % (Ra) Market return % (Rm) Deviation R(a) Deviation Rm D Ra D Rm Rm2 1 11.0 12.0 0.67 1.33 0.89 1.77 2 10.5 11.0 0.17 0.33 0.06 0.11 3 9.5 9.0 0.83 1.67 1.39 2.79 31.0 32.0 2.34 4.67 Average Ra = 10.33 Average Rm = 10.67 Covariance = 1.1722.34 0.502.341.17 Question 11 The Investment portfolio of a bank is as follows: Government Bond Coupon Rate Purchase rate (F.V. Rs. 100 per Bond) Duration (Years) G.O.I. 2006 11.68 106.50 3.50 G.O.I. 2010 7.55 105.00 6.50 G.O.I. 2015 7.38 105.00 7.50 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 11 G.O.I. 2022 8.35 110.00 8.75 G.O.I. 2032 7.95 101.00 13.00. Answer Calculation of Actual investment of Portfolio Security Purchase price Investment (Rs. in lakhs)GOI 2006 106.50 532.50* GOI 2010 105.00 525.00GOI 2015 105.00 525.00GOI 2022 110.00 550.00GOI 2032 101.00 505.00 Total 2,637.50 *
Rs. 5 crores Rs. 106.50Rs. 100 1,00,000 + + + +=3.5 6.5 7.5 8.75 13.00Average Duration 5 = =39.25 7.85 5 Suitable action to churn out investment portfolio in following scenario.To reduce risk and to maximize profit or minimize losses. (1) Interest rates are expected to be lower by 25 basis points in such case increase the average duration by purchasing GOI 2032 and Disposing of GOI 2006. +=39.25 - 3.5 13Revised average duration shall be 5 = =48.75 9.75 years5 (2) Interest rates are expected to rise by 75 basis points in such case reduce the average duration by (*) Purchasing GOI 2010 and disposing of GOI 2032. +=39.25 - 13 6.5Revised average duration shall be 5 = =32.75 6.55 years5 (*) Purchasing of GOI 2006 is not beneficial as maturity period is very short and 75 basis points is comparatively higher change. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 12Question 12 Your client is holding the following securities: Particulars of Securities Cost Dividends/Interest Market price Beta Rs. Rs. Rs. Equity Shares: Gold Ltd. 10,000 1,725 9,800 0.6 Silver Ltd. 15,000 1,000 16,200 0.8 Bronze Ltd. 14,000 700 20,000 0.6 GOI Bonds 36,000 3,600 34,500 1.0 Average return of the portfolio is 15.7%, calculate: (i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM). (ii) Risk free rate of return. Answer Particulars of Securities Cost Rs. Dividend Capital gain Gold Ltd. 10,000 1,725 200 Silver Ltd. 15,000 1,000 1,200 Bronz Ltd. 14,000 700 6,000 GOI Bonds 36,000 3,600 1,500 Total 75,000 7,025 5,500 Expected rate of return on market portfolio = 16.7% Risk free return Average of Betas = 0.75 Average return = Risk free return + Average Betas (Expected return Risk free return) 15.7 = Risk free return + 0.75 (16.7 Risk free return) Risk free return = 12.7% Expected Rate of Return for each security is Rate of Return = Rf + B (Rm Rf) + Dividend Earned Capital appreciation * 100Initial investment +=Rs. 7,025 Rs. 5,500 * 100 75,000 + + +=0.6 0.8 0.6 1.0Average of Betas 4 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 13 Gold Ltd. = 12.7 + .6 (16.7 12.7) = 15.10% Silver Ltd. = 12.7 + .8 (16.7 12.7) = 15.90% Bronz Ltd. = 12.7 + .6 (16.7 12.7) = 15.10% GOI Bonds = 12.7 + 1.0 (16.7 12.7) = 16.70% Question 13 1 l Probability Return % F P 0.30 30 -10 0.40 20 20 0.30 0 30 ? l the covariance between the market portfolio and security and beta for the security. Answer Security F Prob(P) Rf PxRf Deviations of F (Rf ERf) (Deviation)2 of F (Deviations)2 P 0.3 30 9 13 169 50.7 0.4 20 8 3 9 3.6 0.3 0 0 -17 289 86.7 ERf=17 Varf =141 STDEV f = 141 = 11.87 Market Portfolio, P RM % PM Exp. Return RM x PM Deviation of P (RM- ERM) (Deviation of P)2 (Deviation)2 PM Deviation of F) x P Deviation of F x x P -10 0.3 -3 -24 576 172.8 -312 -93.6 20 0.4 8 6 36 14.4 18 7.2 (Deviation of ) (PDeviationof ) (Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 1430 0.3 9 16 256 76.8 -272 -81.6 ERM=14 Var M=264 M=16.25 =Co Var PM =- 168 Beta 636 .264168 P Var Co2MM Question 14 X Co., Ltd., invested on 1.4.2009 in certain equity shares as below: Name of Co. No. of shares Cost (Rs.) A Ltd. 1,000 (Rs.100 each) 2,00,000 B Ltd. 500 (Rs.10 each) 1,50,000 In September, 2009, 10% dividend was paid out by A Ltd. and in October, 2009, 30% dividend paid out by B Ltd. On 31.3.2010 market quotations showed a value of Rs.220 and Rs.290 per share for A Ltd. and B Ltd. respectively. On 1.4.2010, investment advisors indicate (a) that the dividends from A Ltd. and B Ltd. for the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the probabilities of market quotations on 31.3.2011 are as below: Probability factor Price/share of A Ltd. Price/share of B Ltd. 0.2 220 290 0.5 250 310 0.3 280 330 You are required to: (i) Calculate the average return from the portfolio for the year ended 31.3.2010; (ii) Calculate the expected average return from the portfolio for the year 2010-11; and (iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the standard deviation in each case. Answer Calculation of return on portfolio for 2009-10 A B Dividend received during the year 10 3 Capital gain/loss by 31.03.10 Market value by 31.03.10 220 290 Cost of investment 200 300 (Calculation in Rs./share) Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 15 Gain/loss 20 (-)10 Yield 30 (-)7 Cost 200 300 % return 15% (-)2.33% Weight in the portfolio 57 43 Weighted average return 7.55% Calculation of estimated return for 2010-11 Expected dividend 20 3.5 Capital gain by 31.03.11 (220x0.2)+ (250x0.5)+(280x0.3) 220=(253-220) 33 (290x0.2)+(310x0.5)+(330x0.3) 290= (312 290) 22 Yield 53 25.5 *Market Value 01.04.10 220 290 % return 24.09% 8.79% *Weight in portfolio (1,000x220): (500x290) 60.3 39.7 Weighted average (Expected) return 18.02% (*The market value on 31.03.10 is used as the base for calculating yield for 2010-11) Calculation of Standard Deviation. A Ltd. Expected market value Expected gain Expected dividend Expected yield Deviations Square of deviations Probability factor Sq. of d x prob. 220 0 20 20 -33 1089 0.2 217.80 250 30 20 50 -3 9 0.5 4.50 280 60 20 80 27 729 0.3 218.70 441.00 Standard deviation 21 B Ltd. Expected market value Expected gain Expected dividend Expected yield Deviations Square of deviations Probability factor Sq. of d x prob. 290 0 3.5 3.5 -22 484 0.2 96.80 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 16310 20 3.5 23.5 -2 4 0.5 2.00 330 40 3.5 43.5 18 324 0.3 97.20 196.00 Standard deviation 14 Share of company A Ltd. is more risky as the S.D. is more than company B Ltd. Question 15 Expected returns on two stocks for particular market returns are given in the following table: Market Return Aggressive Defensive 7% 4% 9% 25% 40% 18% You are required to calculate: %. (d) The Alphas of the two stocks. Answer (a) The Betas of two stocks: Aggressive stock - 40% - 4%/25% - 7% = 2 Defensive stock - 18% - 9%/25% - 7% = 0.50 (b) Expected returns of the two stocks:- Aggressive stock - 0.5 x 4% + 0.5 x 40% = 22% Defensive stock - 0.5 x 9% + 0.5 x 18% = 13.5% (c) Expected return of market portfolio = 0.5 x 7% + 0.5% x 25% = 16% Market risk prem. = 16% - 7.5% = 8.5% SML (d) Alpha for stock A = 0.22 (0.075 + 2 x 0.085) = -2.5% Alpha for stock B = 0.135 (0.075 + 0.5 x 0.085) = 1.75% Question 16 The historical rates of return of two securities over the past ten years are given. Calculate the Covariance and the Correlation coefficient of the two securities: Years: 1 2 3 4 5 6 7 8 9 10 Security 1: 12 8 7 14 16 15 18 20 16 22 (Return per cent) Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 17 Security 2: 20 22 24 18 15 20 24 25 22 20 (Return per cent) Answer Calculation of Covariance Year R1 Deviation ) R R (1 1 R2 2 2R R ( Deviation Product of deviations 1 12 -2.8 20 -1 2.8 2 8 -6.8 22 1 -6.8 3 7 -7.8 24 3 -23.4 4 14 -0.8 18 -3 2.4 5 16 1.2 15 -6 -7.2 6 15 0.2 20 -1 -0.2 7 18 3.2 24 3 9.6 8 20 5.2 25 4 20.8 9 16 1.2 22 1 1.2 10 22 7.2 20 -1 -7.2 8 . 1410148R1 2110210R2 -8.00 Covariance = N] R R [ ] R R [2 2 1 1N1 i = -8/10 = -0.8 For calculation of correlation, the standard deviation of the two securities are also required. Calculation of Standard Deviation Year R1 R12 R2 R22 1 12 144 20 400 2 8 64 22 484 3 7 49 24 576 4 14 196 18 324 5 16 256 15 225 6 15 225 20 400 7 18 324 24 576 8 20 400 25 625 9 16 256 22 484 10 22 484 20 400 148 2398 210 4494 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 18 Standard deviation of Security 1: 221211N) R ( R N = 10021904 2398010 10) 148 ( ) 2398 10 (2 = 76 . 20 = 4.56 Standard deviation of Security 2: 222222N) R ( R N = 10 10) 210 ( ) 4494 10 (2 10044100 44940 = 100840 = 4 . 8 = 2.90 Correlation Coefficient 2 112Covr = 22 . 138 . 090 . 2 56 . 48 . 0 = -0.0605 Question 17 XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future capital expenditure, likely to happen after several months, are invested in a portfolio of short-term equity investments, details for which are given below: Investment No. of shares Beta Market price per share Rs. Expected dividend yield I 60,000 1.16 4.29 19.50% II 80,000 2.28 2.92 24.00% III 1,00,000 0.90 2.17 17.50% IV 1,25,000 1.50 3.14 26.00% The current market return is 19% and the risk free rate is 11%. Required to: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 19 (i) C x?Z -term investment portfolio relative to that of the market; (ii) Whether XYZ should change the composition of its portfolio. Answer (i) Computation of Beta of Portfolio Investment No. of shares Market Price Market Value Div. Yield Dividend Compo-sition Weighted I. 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27 II. 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48 III. 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18 IV. 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53 11,00,500 2,46,282 1.0000 1.46 Return of the Port Folio 2238 . 0500 , 00 , 11282 , 46 , 2 Beta of Port Folio 1.46 Market Risk implicit 0.11) Or, 42 . 108 . 011 . 0 2238 . 0 M 1 compared to the market. (ii) The decision regarding change of composition may be taken by comparing the dividend yield (given) and the expected return as per CAPM as follows: Expected return Rs as per CAPM is: Rs = IRF + (RM I RF) For investment I Rs = IRF + (RM IRF) = .11 + (.19 - .11) 1.16 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 20 = 20.28% For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24% For investment III, Rs = .11 + (.19 - .11) .90 = 18.20% For investment IV, Rs = .11 + (.19 - .11) 1.50 = 23% Comparison of dividend yield with the expected return Rs shows that the dividend yields of investment I, II and III are less than the corresponding Rs,. So, these investment are over-priced and should be sold by the investor. However, in case of investment IV, the dividend yield is more than the corresponding Rs, so, XYZ Ltd. should increase its proportion.. Question 18 P Ltd. invested on 1.4.2009 in Equity shares as below: Company Number of Shares Cost (Rs.) M Ltd. 1,000 (Rs. 100 each) 2,00,000 N Ltd. 500 (Rs. 10 each) 1,50,000 In September, 2009, M Ltd. paid 10% dividend and in October, 2009, N Ltd. paid 30% dividend. On 31.3.2010, market price of shares of M Ltd. and N Ltd. were Rs. 220 and Rs. 290 respectively. P Ltd. have been informed by their investment advisers that: (i) Dividends from M Ltd. and N Ltd. for the year ended 31.3.2011 are likely to be 20% and 35% respectively. (ii) Probabilities of market quotations on 31.3.2011 are: Probability Price of share Price of share Factor of M Ltd. of N Ltd. 0.2 220 290 0.5 250 310 0.3 280 330 You are required to: (i) Calculate the average return from the portfolio for the year ended 31.3.2010. (ii) Calculate the expected average return from the portfolio for the year 2010 11. (iii) Advise P Ltd. of the comparative risk of two investments by calculating the Standard deviation in each case. Answer: (i) Calculation of average return from portfolio for the year ended 31.03.2010 Rs./Share M Ltd. N Ltd. Dividend received during the year 10 3 Capital Gain/Loss to 31.03.2010 Market Value 220 290 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 21 Cost of Investment 200 300 Gain (Loss) 20 (10) Yield 30 (7) Cost 200 300 % Return 15 (2.33) Weight in the portfolio 57 43 Weighted average return (0.57 0.15) + (0.43 -0.0233) = 0.0755 7.55% Expected average Return for 2010-11 Expected Dividend 20 3.5 Capital Gain (Loss) to 31.03.2011 (220 0.2) + (250 0.5) + (280 0.3) [253-220] 33 (290 0.2) + (310 0.5) + (330 0.3) [312 290] 22 Yield 53 25.5 Market Value 220 290 % Return 24.09 8.79 Weighted Average (expected) Return (0.57 0.2409) + (0.43 0.0879) = 17.51% (iii) Calculation of Standard Deviation Expected Market Value Expected Gain Expected Dividend Expected Yield Devia- (D) Square of D Probab factor (p) D2 x p M Ltd. 220 - 20 20 -33 1089 0.2 217.80 250 30 20 50 -3 9 0.5 4.50 280 60 20 80 27 729 0.3 218.70 SD 21 441.00 N Ltd 290 - 3.5 3.5 -22 484 0.2 96.80 310 20 3.5 23.5 -2 4 0.5 2.00 330 40 3.5 43.5 18 324 0.3 97.20 SD 14 196.00 Share of M Ltd. is more risky as the SD is more than that of N Ltd. Question 19 A company has a choice of investments between several different equity oriented mutual funds. The company has an amount of Rs.1 crore to invest. The details of the mutual funds are as follows: Mutual Fund Beta A 1.6 B 1.0 tions Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 22C 0.9 D 2.0 E 0.7 Required: (i) If the company invests 20% of its investment in the first two mutual funds and an equal amount in the mutual funds C, D and E, what is the beta of the portfolio? (ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal amount in the other two mutual funds, what is the beta of the portfolio? (iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios expected return in both the situations given above? Answer With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of various securities calculated as below: (i) Investment BETA Investment (Rs. Lacs) Weighted Investment A 1.6 20 32 B 1 20 20 C 0.9 20 18 D 2 20 40 E 0.7 20 14 100 124 Weighted BETA = 1.24; Expected Return = 1.24*12 = 14.88% (ii) With varied percentages of investments portfolio beta is calculated as follows: BETA Investment (Rs. Lacs) Weighted Investment A 1.6 15 24 B 1 30 30 C 0.9 15 13.5 D 2 30 60 E 0.6 10 6 100 133.5 Weighted BETA = 1.335 Expected Return 1.335*12 = 16.02% (iii) Expected return of the portfolio with pattern of investment as in case (i)= 12% x 1.24=14.88% Expected Return with pattern of investment as in case (ii) = 12% 1.335 i.e., 16.02%. Question 20 Mr. D is interested to invest Rs.5,00,000 in the securities market. He selected two securities B and D for this purpose. The risk return profile of these securities are as follows : Security Risk ( ) Expected Return (ER) X 10% 12% Y 18% 20% Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 23 Co-efficient of correlation between X and Y is 0.15. You are required to calculate the portfolio return of the following portfolios of X and Y to be considered by D for his investment. (i) 100 percent investment in X only; (ii) 50 percent of the fund in X and the rest 25 percent in Y; (iii) 75 percent of the fund in X and the rest 25 percent in Y; and (iv) 100 percent investment in Y only. Also indicate that which portfolio is best for him from risk as well as return point of view? Answer We have Ep = W1E1 + W3E3 WnEn a p = j i ij j inl jnl i 2 / 1 Substituting the respective values we get, (a) All funds invested in X Ep = 12%
p = 10% (b) 50% of funds in each of X & Y Ep = 16%
p = 10.9% (c) 75% in X and 25% in Y Ep = 14%
p = 9.4% (d) 25% in X and 75% in Y Ep = 18%
p = 14.15% (e) All funds in Y Ep = 20%
p = 18.0% In the terms of return, we see that portfolio (e) is the best portfolio. In terms of risk we see that portfolio (c) is the best portfolio. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 24 2 MUTUAL FUNDS Question 1 A mutual fund that had a net asset value of Rs. 20 at the beginning of month - made income and capital gain distribution of Re. 0.0375 and Re. 0.03 per share respectively during the month, and then ended the month with a net asset value of Rs. 20.06. Calculate monthly return Answer Calculation of monthly return on the mutual funds: 1 - tt t 1 - t tNAV G I ) NAV - (NAV r Where, r = Return on the mutual fund NAVt = Net assets value at time period t NAVt 1 = Net assets value at time period t 1 It = Income at time period t Gt = Capital gain distribution at time period t 20 0.03 Re. 0.0375 Re. 20.00 Rs. - 20.06 Rs. r 200.0675 0.06 0.006375200.1275 or r = 0.6375% p.m. or say = 7.65% p.a. Question 2 Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is considering a recently announced equity based mutual fund scheme in which initial expenses are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much should the mut ual fund earn to provide Mr. A a return of 16 per cent? ( ( ) )Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 25 Answer Personal earnings of Mr. A = R1 Mutual Fund earnings = R2 Mutual Fund earnings = 18.43% Question 3 A has invested in three Mutual Fund Schemes as per details below: MF A MF B MF C Date of investment 01.12.2010 01.01.2011 01.03.2011 Amount of investment Rs. 50,000 Rs. 1,00,000 Rs. 50,000 Net Asset Value (NAV) at entry date Rs. 10.50 Rs. 10 Rs. 10 Dividend received upto 31.03.2011 Rs. 950 Rs. 1,500 Nil NAV as at 31.03.2011 Rs. 10.40 Rs. 10.10 Rs. 9.80 Required: What is the effective yield on per annum basis in respect of each of the three schemes to Mr. A upto 31.03.2011? Answer Scheme Investment Unit Nos. Unit NAV 31.3.2011 Total NAV 31.3.2011 Rs. Rs. Rs. MFA 50,000 4761.905 10.40 49,523.812 MFB 1,00,000 10,000 10.10 1,01,000 MFC 50,000 5,000 9.80 49,000 R2 = +
11R Recurring expenses (%) 1 Initial expenses (%) = +
116% 1.5%1 0.055 = 18.43% Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 26Scheme NAV (+) / () Dividend Received Total Yield Number of days Effective Yield (% P.A.) Rs. Rs. Rs. MFA ()476.188 950 473.812 122 2.835% MFB (+)1,000 1,500 2,500 91 10.027% MFC ()1,000 Nil ()1,000 31 ()24% Question 4 Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-ended equity oriented scheme C C l 1 A Dividend Re- 8 8 C Growth Plan. At the time of Initial Public Offer on 1.4. 2000, Mr. Anand, Mr. Bacchan & Mrs. Charu, three investors invested Rs. 1,00,000 each & chos 8 C A The History of the Fund is as follows: Date Dividend % Bonus Ratio Net Asset Value per Unit (F.V. Rs. 10) Plan A Plan B Plan C 28.07.2004 20 30.70 31.40 33.42 31.03.2005 70 5 : 4 58.42 31.05 70.05 31.10.2008 40 42.18 25.02 56.15 15.03.2009 25 46.45 29.10 64.28 31.03.2009 1 : 3 42.18 20.05 60.12 24.03.2010 40 1 : 4 48.10 19.95 72.40 31.07.2010 53.75 22.98 82.07 per cent only on sale/redemption of units. 4. Ignore Education Cess Answer (a) Mrs. Charu Plan A Dividend Reinvestment (Amount in Rs.) Date Investment Rate Units Balance 01.04.2000 1,00,000.00 10.00 10,000.00 10,000.00 28.07.2004 20,000.00 30.70 651.47 10,651.47 31.03.2005 74,560.29 58.42 1,276.28 11,927.75 30.10.2008 47,711.00 42.18 1,131.13 13,058.88 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 27 15.03.2009 32,647.20 46.45 702.85 13,761.73 31.03.2009 N.A. N.A. N.A. 13,761.73 24.03.2010 55,046.92 48.10 1,144.43 14,906.16 Redemption value 14,906.16 53.75 8,01,206.10 Less: Security Transaction Tax (S.T.T) is .2% 1,602.41 Net amount received 7,99,603.69 Less: Short term capital gain tax @ 10% 1,144.43 (53.64 48.10) 6,340 i.e. 53.75 S.T.T. .2% 634 Net of tax 7,98,969.69 Less: Investment 1,00,000.00 6,98,969.69 Annual average return (%) 67.64 10012412 1,00,0006,98,969 Mr. Anand Plan B Bonus (Amount in Rs.) Date Units Balance NAV per unit 01.04.2000 10,000 10,000 10 31.03.2005 12,500 22,500 31.05 31.03.2009 7,500 30,000 20.05 24.03.2010 7,500 37,500 19.95 Redemption value 37,500 22.98 8,61,750.00 Less: Security Transaction Tax (S.T.T) is .2% 1,723.50 Net amount received 8,60,026.50 Less: Short term capital gain tax @ 10% 7,500 (22.93 19.95) 22,350 i.e. 22.98 S.T.T. .2% 2,235.00 Net of tax 8,57,791.50 Less: Investment 1,00,000.00 Net gain 7,57,791.50 Annual average return (%) 73.33 10012412 1,00,0007,57,791 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 28Mr. Bacchan Plan C Growth (Amount in Rs.) Redemption value 10,000 Annual average return (%) 69.59 10012412 1,00,0007,19,058 Question 5 A Mutual Fund having 300 units has shown its NAV of Rs.8.75 and Rs.9.45 at the beginning and at the end of the year respectively. The Mutual Fund has given two options: (i) Pay Rs.0.75 per unit as dividend and Rs.0.60 per unit as a capital gain, or (ii) These distributions are to be reinvested at an average NAV of Rs.8.65 per unit. What difference it would make in terms of return available and which option is preferable? Answer (i) Returns for the year: (All changes on a Per -Unit Basis) Change in Price: Rs.9.45 Rs.8.75 = Re.0.70 Dividends received: Re. 0.75 Capital gains distribution Re. 0.60 Total reward Rs. 2.05 Holding period reward : % 43 . 2375 . 8 . Rs05 . 2 . Rs  Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 29 = 346.82 units x Rs.9.45 = Rs.3277.45 Price Paid for 300 Units at the beginning of the year = 300 units x Rs.8.75 = Rs.2,625.00 Holding Period Reward Rs.(3277.45 2625.00) = Rs.652.45 % of Holding Period Reward % 85 . 2400 . 2625 . Rs45 . 652 . Rs Conclusion: Since the holding period reward is more in terms of percentage in option-two i.e., reinvestment of distributions at an average NAV of Rs.8.65 per unit, this option is preferable. Question 6 Mr. X on 1.7.2008, during the initial offer of some Mutual Fund invested in 10,000 units having face value of Rs.10 for each unit. On 31.3.2009 the dividend operated by the M.F. was 10% and Mr. X found that his annualized yield was 153.33%. On 31.12.2010, 20% dividend was given. On 31.3.2011 Mr. X redeemed all his balance of 11,296.11 units when his annualized yield was 73.52%. What are the NAVs as on 31.3.2009, 31.12.2010 and 31.3.2011? Answer Yield for 9 months = (153.33 x 9/12) = 115% Amount receivable as on 31.03.2009 = 1,00,000/- + (1,00,000x 115%) = Rs.2,15,000/- Therefore, NAV as on 31.03.2009 = (2,15,000-10,000)/10,000= Rs.20.50 Therefore, units as on 31.03.2009 = 10487.80 i.e., (2,15,000/20.50) Dividend as on 31.03.2010 = 10,487.80 x 10x0.2 = Rs.20,975.60 Therefore, NAV as on 31.03.2010 = 20,795.6/(11,296.11- 10,487.80) = Rs.25.95 NAV as on 31.03.2011 = 1,00,000 (1+0.7352x33/12)/11296.11 = Rs.26.75 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 30 3 INDIAN STOCK MARKET Question 1 Following information is available in respect of dividend, market price and market condition after one year. Market condition Probability Market Price Dividend per share Rs. Rs. Good 0.25 115 9 Normal 0.50 107 5 Bad 0.25 97 3 The existing market price of an equity share is Rs. 106 (F.V. Re.: Market Condition Probability Total Return Cost (*) Net Return Good 0.25 Rs. 124 Rs. 100 Rs. 24 Normal 0.50 Rs. 112 Rs. 100 Rs. 12 Bad 0.25 Rs. 100 Rs. 100 Rs. 0 Expected Return = (24 0.25) + (12 .050) + (0 0.25) = 12% 10010012 The variability of return can be calculated in terms of standard deviation. V SD = 0.25 (24 12)2 + 0.50 (12 12)2 + 0.25 (0 12)2 = 0.25 (12)2 + 0.50 (0)2 + 0.25 (12)2 = 36 + 0 + 36 72 SD SD = 8.485 or say 8.49 (*) The present market price of the share is Rs. 106 cum bonus 10% debenture of Rs. 6 each; hence the net cost is Rs. 100 (There is no cash loss or any waiting for refund of debenture amount). Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 31 M/s X Finance company has offered the buy back of debenture at face value. There is reasonable 10% rate of interest compared to expected return 12% from the market. Considering the dividend rate and market price the creditworthiness of the company seems to be very good. The decision regarding buy-back should be taken considering the maturity period and opportunity in the market. Normally, if the maturity period is low say up to 1 year better to wait otherwise to opt buy back option. Question 2 1 A8C -up with a multinational company. This has induced the market price to move up. If the rumour is false, the ABC corporation stock price will probably fall dramatically. To protect from this an investor has bought the call and put options. He purchased one 3 months call with a striking price of Rs.42 for Rs.2 premium, and paid Re.1 per share premium for a 3 months put with a striking price of Rs.40. (i) u l A8C C to Rs.43 in 3 months. (ii) u l ails and the price of the stocks falls to Rs.36 in 3 months. Answer Cost of call and put options = (Rs.2 per share) x (100 share call) + (Re.1 per share) x (100 share put) = Rs.2 x 100 + 1 x 100 = Rs.300 (i) Price increases to Rs.43. Since the market price is higher than the strike price of the put, the investor will exercise it. Ending position=(Rs.300 cost of option)+(Re.1 per share gain on call) x 100 = Rs.300 + 100 Net Loss = Rs.200 (ii) The price of the stock falls to Rs.36. Since the market price is lower than the strike price, the investor may not exercise the call option. Ending Position: = ( Rs.300 cost of 2 option)+(Rs.4 per stock gain on put)x100 = Rs.300 + 400 Gain = Rs.100 Question 3 Abhishek Ltd. has a surplus cash of Rs.90 lakhs and wants to distribute 30% of it to the shareholders. The Company decides to buyback shares. The Finance Manager of the Company estimates that its share price after re-purchase is likely to be 10% above the buyback price; if the buyback route is taken. The number of shares outstanding at present is 10 lakhs and the current EPS is Rs.3. You are required to determine: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 32(a) The price at which the shares can be repurchased, if the market capitalization of the company should be Rs.200 lakhs after buyback. (b) The number of shares that can be re-purchased. (c) The impact of share re-purchase on the EPS, assuming the net income is same. Answer (a) Let P be the buyback price decided by Abhishek Ltd. Market Capitalisation After Buyback: 1.1 P (Original Shares Shares Bought back) = Plakhs 90 of % 30Lakhs 10 ( P 1 . 1 = 11 Lakhs x P 27 lakhs x 1.1 = 11 lakhs x P 29.7 lakhs Market capitalization rate after buyback is 200 lakhs. Thus, we have: 11 Lakhs x P 29.7 lakhs = Rs.200 lakhs OR 11P = 200 + 29.7 OR P = 88 . 20 . Rs117 . 229 (b) Number of shares to be bought back: 88 . 20Lakhs 27 (c) New Equity Shares = (10 1.29) lakhs = 8.71 lakhs EPS = 44 . 3 . RsL 71 . 8L 30lakhs 71 . 8lakhs 10 3 Thus EPS of Abhishek Ltd., increases to Rs.3.44 Question 4 From the following data for certain stock, find the value of a call option: Price of stock now = Rs.80 Exercise price = Rs.75 Standard deviation of continuously compounded annual return = 0.40 1.29 lakhs (Approximately)Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 33 Maturity period = 6 months Annual interest rate = 12% Given Number of S.D. from Mean, (z) Area of the left or right (one tail) 0.25 0.4013 0.30 0.3821 0.55 0.2912 0.60 0.2578 e 0.12x0.05 = 1.0060 In 1.0667 = 0.0645 Answer Applying the Black Scholes Formula, Value of the Call option now: Where, C = Theoretical call premium S = Current stock price t = time until option expiration K = option striking price r = risk-free interest rate N = Cumulative standard normal distribution e = exponential term = Standard deviation of continuously compounded annual return. In = natural logarithim 5 . 0 40 .) 08 . 0 ( % 12 ( ) 0667 . 1 ( Ind5 . 01 = 7071 . 0 40 . 0) 2 . 0 ( 0645 . 05 . 0 = 2828 . 01645 . 0 The Formula C = ) d ( N K ) d ( SN2) rt (e 1
d1 = In (S/K) + ( ) 2 / r 2 + t t d d1 2 = Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 34 = 0.5817 d2 = 0.5817 0.2828 = 0.2989 Nd1 = N (0.5817) Nd2 = N (0.2989) ) d ( N eE) d ( N S ice Pr2rt 1 o = (80 x Nd1) 75/[1.0060 x N[d2] Value of option = 80 Nd1- 2Nd 0060 . 175 Nd1 = N (0.5817) = 0.7190 + 0.000578 = 0.7195 Nd2 = N(0.2989) = 0.6141 + 0.003382 = 0.6175 Price = 80 x 0.7195 6175 . 0 0060 . 175 = 57.56 74.55 x 0.6175 = 57.56 46.04 = Rs.11.52 Question 5 The 6-months forward price of a security is Rs.208.18. The borrowing rate is 8% per annum payable with monthly rests. What should be the spot price? Answer Calculation of spot price The formula for calculating forward price is: A = P (1+r/n) raised to nt Where A = Forward price P = Spot Price r = rate of interest n = no. of compoundings t = time Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 35 Using the above formula, 208.18 = P (1 + 0.08/12) raised to 6 Or 208.18 = P x 1.0409 P = 208.18/1.0409 = 200 Hence, the spot price should be Rs.200. Question 6 (a) XYZ Ltd. a US firm will need 3,00,000 in 180 days. In this connection, the following information is available: Spot rate 1 = $ 2.00 180 days forward rate of as of today = $1.96 Interest rates are as follows: U.K. US 180 days deposit rate 4.5% 5% 180 days borrowing rate 5% 5.5% A call option on that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04. XYZ Ltd. has forecasted the spot rates 180 days hence as below: Future rate Probability $ 1.91 25% $ 1.95 60% $ 2.05 15% Which of the following strategies would be most preferable to XYZ Ltd.? (i) a forward contract (ii) a money market hedge (iii) an option contract (iv) no hedging Show calculations in each case Answer (i) Forward contract: Dollar needed in 180 days = 3,00,000 x $ 1.96 = $5,88,000/- (ii) Money market hedge: - Borrow $, convert to , invest , repay $ loan in 180 days Amount in to be invested = 3,00,000/1.045 = 287081 Amount of $ needed to convert into = 2,87,081 x 2 = $ 5,74,162 Interest and principal on $ loan after 180 days = $5,74,162 x 1.055 = $ 6,05,741 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 36(iii) Call option: Expected Spot rate in 180 days Prem./unit Exercise Option Total price per unit Total price for 3,00,000 xi Prob. Pi pixi 1.91 0.04 No 1.95 5,85,000 0.25 1,46,250 1.95 0.04 No 1.99 5,97,000 0.60 3,58,200 2.05 0.04 Yes 2.01 6,03,000 0.15 90,450 5,94,900 (iv) No hedge option: Expected Future spot rate Dollar needed Xi Prob. Pi Pi xi 1.91 5,73,000 0.25 1,43,250 1.95 5,85,000 0.60 3,51,000 2.05 6,15,000 0.15 92,250 5,86,500 The probability distribution of outcomes for no hedge strategy appears to be most preferable because least number of $ are needed under this option to arrange 3,00,000. Question 7 BSE 500 Value of portfolio Rs.10,10,000 Risk free interest rate 9% p.a. Dividend yield on Index 6% p.a. Beta of portfolio 1.5 We assume that a future contract on the BSE index with four months maturity is used to hedge the value of portfolio over next three months. One future contract is for delivery of 50 times the index. Based on the above information calculate: (i) Price of future contract. (ii) The gain on short futures position if index turns out to be 4,500 in three months. Answer (i) Current future price of the index = 5000 + 5000 (0.09-0.06) = 5000+ 50= 5,050 8 8 (ii) Hedge ratio = = 6 contracts 412
10100001.5252500Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 37 Index after there months turns out to be 4500 Future price will be = 4500 + 4500 (0.09-0.06) 31=4,545 1 C = Rs.1,51,500 Alternative solution when BSE index is considered to be as 500 (i) Current future price of index = 500 + 500 (0.09 0.6) = 500 + 5 = 505 Price of the future contract = Rs.50 x 505 = Rs.25,250. (ii) Hedge Ratio = Index after three months turn out to be 4,500. Future Price will be = 4,500 + 4,500 (0.09 0.06) = 4,545 Therefore, gain from the short future position is = 60 x (505 = -12,12,00,00. Question 8 From the following data for Government securities, calculate the forward rates: Face value (Rs.) Interest rate Maturity (Year) Current price (Rs.) 1,00,000 0% 1 91,500 1,00,000 10% 2 98,500 1,00,000 10.5% 3 99,000 Answer Consider one year treasury bill. 412 =10,10,000,1.5 60contracts25,250 31=+1,00,00091,500I rI 1+r1 = 100,00091500 = 1.092896 r1 = 0.0929 or 0.093 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 38Consider two year Government Security 98,500 = ) 2 r 1 ( 093 . 1 (000 , 10 , 1093 . 1000 , 10 98500 = 9149.131 + ) 2 r 1 ( 093 . 1000 , 10 , 1 89350.87 = 2 r 14 . 100640 1 + r2 = 1.126351 r2 = 0.12635 = > r2 = 0.1263 Consider three year Government Securities: 99,000= ) 3 r 1 ( 1263 . 1 093 . 1500 , 10 , 11263 . 1 093 . 1500 , 10093 . 1500 , 10 99000 = 9606.587 + 8529.65+ 3 r 142 . 89764 80863.763 = 3 r 142 . 89764 1+r3 = 1.1100697 r3 = .1100697 Question 9 Given below is the Balance Sheet of S Ltd. as on 31.3.2011 : Liabilities Rs. (in lakh) Assets Rs. (in lakh) Share capital (share of Rs. 10) Reserves and surplus Creditors 100 40 30 170 Land and building Plant and machinery Investments Stock Debtors Cash at bank 40 80 10 20 15 5 170 You are required to work out the value of the Company's, shares on the basis of Net Assets method and Profit-earning capacity (capitalization) method and arrive at the fair price of the shares, by considering the following information: (i) Profit for the current year Rs. 64 lakhs includes Rs. 4 lakhs extraordinary income and Rs. 1 lakh income from investments of surplus funds; such surplus funds are unlikely to recur. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 39 (ii) In subsequent years, additional advertisement expenses of Rs. 5 lakhs are expected to be incurred each year. (iii) Market value of Land and Building and Plant and Machinery have been ascertained at Rs. 96 lakhs and Rs. 100 lakhs respectively. This will entail additional depreciation of Rs. 6 lakhs each year. (iv) Effective Income-tax rate is 30%. (v) The capitalization rate applicable to similar businesses is 15%. Answer Rs. lakhs Net Assets Method Assets: Land & Buildings 96 Plant & Machinery 100 Investments 10 Stocks 20 Debtors 15 Cash & Bank __5 Total Assets 246 Less: Creditors __30 Net Assets 216 Value per share (a) Number of shares 000 , 00 , 1010000 , 00 , 00 , 1 (b) Net Assets Rs.2,16,00,000 6 . 21 . Rs000 , 00 , 10000 , 00 , 16 , 2 . Rs Profit-earning Capacity Method Profit before tax 64.00 Less: Extraordinary income 4.00 Investment income (not likely to recur) 1.00 5.00 59.00 Less: Additional expenses in forthcoming years Advertisement 5.00 Depreciation 6.00 11.00 Expected earnings before taxes 48.00 Less: Income-tax @ 30% 14.40 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 40Future maintainable profits (after taxes) 33.60 Value of business 224Capitalisation factor 15 . 060 . 33 Less: External Liabilities (creditors) 30 194 Value per share = 4 . 19 . Rs000 , 00 , 10000 , 00 , 94 , 1 Fair Price of share Rs. Value as per Net Assets Method 21.6 Value as per Profit earning capacity (Capitalisation) method 19.4 Fair Price= 5 . 20 . Rs24124 . 19 6 . 21 Question 10 Calculate the price of 3 months PQR futures, if PQR (FV Rs.10) quotes Rs.220 on NSE and the three months future price quotes at Rs.230 and the one month borrowing rate is given as 15 percent and the expected annual dividend yield is 25 percent per annum payable before expiry. Also examine arbitrage opportunities. Answer l S Dividend F = 220 + 220 0.15 0.25 0.025** 10 = 225.75 ** Entire 25% dividend is payable before expiry, which is Rs.2.50. Thus we see that futures price by calculation is Rs.225.75 which is quoted at Rs.230 in the exchange. Analysis: Fair value of Futures less than Actual futures Price: Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock in the cash market. Step I He will buy PQR Stock at Rs.220 by borrowing at 15% for 3 months. Therefore his outflows are : Cost of Stock 220 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 41 Add: Interest @ 15 % for 3 months i.e. 0.25 years 8.25 (220 0.15 0.025) Total Outflows (A) 228.25 Step II He will sell March 2000 futures at Rs.230. Meanwhile he would receive dividend for his stock. Hence his inflows are 230 Sale proceeds of March 2000 futures 2.50 Total inflows (B) 232.5 Inflow Outflow = Profit earned by Arbitrageur = 232.5 228.25 = 4.25 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 42 4 FOREX Question 1 A 8 Swiss Francs 10,000 at the rate of Rs. 27.25 comes to the bank after 2 months and requests cancellation of the contract. On this date, the rates, prevailing, are: Spot CHF 1 = Rs. 27.30 27.35 One month forward Rs. 27.45 27.52 What is the loss/gain to the customer on cancellation? Answer The contract would be cancelled at the one month forward sale rate of Rs. 27.52. Rs. Francs bought from customer under original forward contract at: 27.25 It is sold to him on cancellation at: 27.52 Net amount payable by customer per Franc 0.27 At Rs. 0.27 per Franc, exchange difference for CHF 10,000 is Rs. 2,700. Loss to the Customer: Exchange difference (Loss) Rs. 2,700 Note: The exchange commission and other service charges are ignored. Question 2 (a) On 1st April, 3 months interest rate in the US and Germany are 6.5 per cent and 4.5 per cent per annum respectively. The $/DM spot rate is 0.6560. What would be the forward rate for DM for delivery on 30th June ?  could the dealer use arbitrage in profit from this situation and how much profit is earned? Answer (a) USD DM Spot 0.6560 1.000 Interest rate p.a. 6.5% 4.5% Interest for 91 days 0.0106 0.0112 Amount after 91 days 0.6666 1.0112 Hence forward rate 0.6666 1.0112 0.6592 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 43 OR 510.045 1510.0 5 1 0. 5 0 = 0.6592 (b) Buy 62500 1.2806 = $ 80037.50 Sell 62500 1.2816 = $ 80100.00 Profit $ 62.50 Alternatively if the market comes back together before December 15, the dealer could unwind his position (by simultaneously buying 62,500 forward and selling a futures contract. Both for delivery on December 15) and earn the same profit of $ 62.5. Question 3 In March, 2010, the Multinational Industries makes the following assessment of dollar rates per British pound to prevail as on 1.9.2010: $/Pound Probability 1.60 0.15 1.70 0.20 1.80 0.25 1.90 0.20 2.00 0.20 (i) What is the expected spot rate for 1.9.2010? (ii) If, as of March, 2010, the 6-month forward rate is $ 1.80, should the firm sell forward its pound receivables due in September, 2010? Answer (i) Calculation of expected spot rate for September, 2010: $ for Probability Expected $/ (1) (2) (1) (2) = (3) 1.60 0.15 0.24 1.70 0.20 0.34 1.80 0.25 0.45 1.90 0.20 0.38 2.00 0.20 0.40 1.00 EV = 1.81 Therefore, the expected spot value of $ for for September, 2010 would be $ 1.81. (ii) If the six-months forward rate is $ 1.80, the expected profits of the firm can be maximised by retaining its pounds receivable. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 44Question 4 (a) ABC Co. have taken a 6 month loan from their foreign collaborators for US Dollars 2 millions. Interest payable on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR is 2%. Enquiries regarding exchange rates with their bank elicit the following information: Spot USD 1 Rs. 48.5275 6 months forward Rs. 48.4575 (i) What would be their total commitment in Rupees, if they enter into a forward contract? (ii) Will you advise them to do so? Explain giving reasons. (b) A company operating in Japan has today effected sales to an Indian company, the payment being due 3 months from the date of invoice. The invoice amount is 108 lakhs yen. At today's spot rate, it is equivalent to Rs. 30 lakhs. It is anticipated that the exchange rate will decline by 10% over the 3 months period and in order to protect the yen payments, the importer proposes to take appropriate action in the foreign exchange market. The 3 months forward rate is presently quoted as 3.3 yen per rupee. You are required to calculate the expected loss and to show how it can be hedged by a forward contract. Answer (a) Firstly, the interest is calculated at 3% p.a. for 6 months. That is: USD 20,00,000 3/100 6/12 = USD 30,000 From the forward points quoted, it is seen that the second figure is less than the first, this means that the currency is quoted at a discount. (i) The value of the total commitment in Indian rupees is calculated as below: Principal Amount of loan USD 20,00,000 Add: Interest USD 30,000 Amount due USD 20,30,000 Spot rate Rs. 48.5275 Forward Points (6 months) () 0.0700 Forward Rate Rs. 48.4575 Value of Commitment Rs. 9,83,68,725 (ii) It is seen from the forward rates that the market expectation is that the dollar will depreciate. If the firm's own expectation is that the dollar will depreciate more than what the bank has quoted, it may be worthwhile not to cover forward and keep the exposure open. If the firm has no specific view regarding future dollar price movements, it would be better to cover the exposure. This would freeze the total commitment and insulate the firm from undue market fluctuations. In other words, it will be advisable to cut the losses at this point of time. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 45 Given the interest rate differentials and inflation rates between India and USA, it would be unwise to expect continuous depreciation of the dollar. The US Dollar is a stronger currency than the Indian Rupee based on past trends and it would be advisable to cover the exposure. (b) Spot rate of Re. 1 against yen = 108 lakhs yen/Rs. 30 lakhs = 3.6 yen 3 months forward rate of Re. 1 against yen = 3.3 yen Anticipated decline in Exchange rate = 10%. Expected spot rate after 3 months = 3.6 yen 10% of 3.6 = 3.6 0.36 = 3.24 yen per rupee Rs. (in lakhs) Present cost of 108 lakhs yen 30 Cost after 3 months: 108 lakhs yen/ 3.24 yen 33.33 Expected exchange loss 3.33 If the expected exchange rate risk is hedged by a Forward contract: Present cost 30 Cost after 3 months if forward contract is taken 108 lakhs yen/ 3.3 yen 32.73 Expected loss 2.73 Suggestion: If the exchange rate risk is not covered with forward contract, the expected exchange loss is Rs. 3.33 lakhs. This could be reduced to Rs. 2.73 lakhs if it is covered with Forward contract. Hence, taking forward contract is suggested. Question 5 The United States Dollar is selling in India at Rs. 45.50. If the interest rate for a 6-months borrowing in India is 8% per annum and the corresponding rate in USA is 2%. (i) do you expect United States Dollar to be at a premium or at discount in the Indian forward market; (ii) what is the expected 6-months forward rate for United States Dollar in India; and (iii) what is the rate of forward premium or discount? Answer (i) Under the given circumstances, the USD is expected to quote at a premium in India as the interest rate is higher in India. (ii) Calculation of the forward rate: o1fhEF R 1R 1 Where: Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is end of Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 46the period forward rate, and Eo is the spot rate. (iii) Rate of premium: Question 6 Which position on the index future gives a speculator, a complete hedge against the following transactions: (i) The share of Right Limited is going to rise. He has a long position on the cash market of Rs. 50 lakhs on the Right Limited. The beta of the Right Limited is 1.25. (ii) The share of Wrong Limited is going to depreciate. He has a short position on the cash market of Rs. 25 lakhs on the Wrong Limited. The beta of the Wrong Limited is 0.90. (iii) The share of Fair Limited is going to stagnant. He has a short position on the cash market of Rs. 20 lakhs of the Fair Limited. The beta of the Fair Limited is 0.75. Answer Sl. No. Company Name Trend Amount (Rs.) Beta Index Value (Rs.) Position (i) Right Ltd. Rise 50 lakh 1.25 62,50,000 Short (ii) Wrong Ltd. Depreciate 25 lakh 0.90 22,50,000 Long (iii) Fair Ltd. Stagnant 20 lakh 0.75 15,00,000 Long 25,00,000 Short Question 7 Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60 days hence. They are worried about the falling USD value which is currently at Rs. 45.60 per USD. The concerned L C L 8 uSu 1 l 8 have quoted a 60-day forward rate of Rs. 45.20. Therefore ( )( )+=+11 0.08/2 F 1 0.02 / 2 45.50 +=+1F 1 0.04 1 0.01 45.50 or ( ) =1 1.04 45.50 F1.01 or =147.32 F1.01 or F1 = 46.85 =46.85 - 45.50 12 100 5.93%45.50 6 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 47 Calculate: (i) Rate of discount quoted by the Bank (ii) The probable loss of operating profit if the forward sale is agreed to. Answer (i) Rate of discount quoted by the bank 5.38%60 45.20100 365 45.60) - (45.20 (ii) Probable loss of operating profit: (45.20 45.50) 1,00,000 = Rs. 30,000 Question 8 A customer with whom the Bank had entered into 3 months forward purchase contract for Swiss Franks 1,00,000 at the rate of Rs. 36.25 comes to the bank after two months and requests cancellation of the contract. On this date, the rates are: Spot CHF 1 = Rs. 36.30 36.35 One month forward 36.45 36.52 Determine the amount of Profit or Loss to the customer due to cancellation of the contract. Answer Original contract for Swiss Francs 1,00,000 @ 36.25 amount receivable by the customer.To cancel the purchase contract 1 month before the due date The contract will be cancelled at 1 month forward sale rate i.e. Swiss Francs 1 = 36.52 payable by the customer. Hence, Swap profit / loss to the customer: Rs. 36.52 payable by the customer Rs. 36.25 receivable by the customer Rs. 0.27 Net payable by the customer i.e. loss Therefore, total loss to the customer is Swiss Francs 1,00,000 Rs. 0.27 = Rs. 27,000 Question 9 On January 28, 2011 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the remittance only on February 4, 2011. The interbank market rates were as follows: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 48January, 28 February 4 Bombay US$1 = Rs. 45.85/45.90 45.91/45.97 London Pound 1 = US$ 1.7840/1.7850 1.7765/1.7775 Pound 1 = SGD 3.1575/3.1590 3.1380/3.1390 The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of .0001) Answer On January 28, 2011 the importer customer requested to remit SGD 25 lakhs. To consider sell rate for the bank: US $ = Rs. 45.90 Pound 1 = US$ 1.7850 Pound 1 = SGD 3.1575 Therefore, SGD 1 = 3.1575 SGD 1.7850 * 45.90 Rs. SGD 1 = Rs. 25.9482 Add: Exchange margin (0.125%) Rs. 0.0324 Rs. 25.9806 On February 4, 2011 the rates are US $ = Rs. 45.97 Pound 1 = US$ 1.7775 Pound 1 = SGD 3.1380 Therefore, SGD 1 = 3.1380 SGD 1.7775 * 45.97 Rs. SGD 1 = Rs. 26.0394 Add: Exchange margin (0.125%) Rs. 0.0325 Rs. 26.0719 Hence, loss to the importer = SGD 25,00,000 (Rs.26.0719 Rs.25.9806) = Rs. 2,28,250 Question 10 You as a dealer in foreign exchange have the following position in Swiss Francs on 31st October, 2010: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 49 Balance in the Nostro A/c Credit 1,00,000 Opening Position Overbought 50,000 Purchased a bill on Zurich 80,000 Sold forward TT 60,000 Forward purchase contract cancelled 30,000 Remitted by TT 75,000 Draft on Zurich cancelled 30,000 What steps would you take, if you are required to maintain a credit Balance of Swiss Francs 30,000 in the Nostro A/c and keep as overbought position on Swiss Francs 10,000? Answer Exchange Position/Currency Position: Particulars Purchase Sw. Fcs. Sale Sw. Fcs. Opening Balance Overbought 50,000 Bill on Zurich 80,000 Forward Sales TT 60,000 Cancellation of Forward Contract 30,000 TT Sales 75,000 Draft on Zurich cancelled 30,000 ________ 1,60,000 1,65,000 Closing Balance Oversold 5,000 _______ 1,65,000 1,65,000 Cash Position (Nostro A/c) Credit Debit Opening balance credit 1,00,000 TT sales ________ 75,000 1,00,000 75,000 Closing balance (credit) _______ 25,000 1,00,000 1,00,000 The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account to Sw. Fcs. 30,000. This would bring down the oversold position on Sw. Fcs. As Nil. Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy forward Sw. Fcs. 10,000. Question 11 You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at Rs. 5.70 & covered yourself in London market on the same day, when the exchange rates were Swiss Francs Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 50US$ 1 = H.K.$ 7.5880 7.5920 Local inter bank market rates for US$ were Spot US$ 1 = Rs. 42.70 42.85 Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage. Answer The bank (Dealer) covers itself by buying from the market at market selling rate. Rupee Dollar selling rate = Rs. 42.85 Dollar Hong Kong Dollar = HK $ 7.5880 Rupee Hong Kong cross rate = Rs. 42.85 / 7.5880 = Rs. 5.6471 Profit / Loss to the Bank Amount received from customer (1 crore 5.70) Rs. 5,70,00,000 Amount paid on cover deal (1 crore 5.6471) Rs. 5,64,71,000 Profit to Bank Rs. 5,29,000 Question 12 Given the following information: Exchange rate Canadian dollar 0.665 per DM (spot) Canadian dollar 0.670 per DM (3 months) Interest rates DM 7% p.a. Canadian Dollar 9% p.a. What operations would be carried out to take the possible arbitrage gains? Answer: (i) Borrow Can$ 1000 at 9 per cent for 3- months; (ii) Change this sum into DM at the spot rate to obtain DM = (1000/0.665) = 1503.7 (iii) Place DM 1503.7 in the money market for 3 months to obtain a sum of DM Principal: 1503.70 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 51 Add: Interest @ 7% for 3 months = 26.30 Total 1530.00 (iv) Sell DM at 3-months forward to obtain Can$= (1530x0.67) = 1025.1 (v) Refund the debt taken in Can$ with the interest due on it, i.e., Can$ Principal 1000.00 Add: Interest @9% for 3 months 22.50 Total 1022.50 Net arbitrage gain = 1025.1 1022.5 = Can$ 2.6 Question 13 x?Z L M 1 C currency. Its receipt of US $ 1,00,000 is due on September 1, 2010. Market information as at June 1, 2010. Exchange Rates Currency Futures US $/Rs. US $/Rs. Contract size Rs.4,72,000 Spot 0.02140 June 0.02126 1 Month Forward 0.02136 September 0.02118 3 Months Forward 0.02127 Initial Margin Interest Rates in India June Rs.10,000 7.50% September Rs.15,000 8.00% On September 1, 2010 the spot rate US $Re. is 0.02133 and currency future rate is 0.2134. Comment which of the following methods would be most advantageous for XYZ Ltd. (a) Using forward contract (b) Using currency futures (c) Not hedging currency risks. It may be assumed that variation in margin would be settled on the maturity of the futures contract. Answer Receipts using a forward contract = 1,00,000/0.02127 = Rs.47,01,457 Receipts using currency futures The number of contracts needed is (1,00,000/0.02118)/4,72,000 = 10 Initial margin payable is 10 x Rs.15,000 = Rs.1,50,000 On September 1 Close at 0.02133 Receipts = US$1,00,000/0.02133 = 46,88,233 Variation Margin = [(0.02134 0.02118) x 10 x 472000/-]/0.02133 OR (0.00016x10x472000)/.02133 = 755.2/0.02133 35,406 47,23,639 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 52Less: Interest Cost 1,50,000 x 0.08 x 3/12 ____Rs.3,000 Net Receipts Rs.47,20,639 Receipts under different methods of hedging Forward contract Rs.47,01,457 Futures Rs.47,20,639 No hedge US$ 1,00,000/0.02133 Rs.46,88,233 The most advantageous option would have been to hedge with futures. Question 14 Spot rat 1 US $ = Rs.48.0123 180 days Forward rate for 1 US $ = Rs.48.8190 Annualised interest rate for 6 months Rupee = 12% Annualised interest rate for 6 months US $ = 8% Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is willing to borrow Rs.40,00,000 or US $83,312. Answer Spot Rate = Rs.4000000/- /83312 = 48.0123 Forward Premium on US$ = [(48.8190 48.0123)/48.0123] x 12/6 x 100 = 3.36% Interest rate differential = 12% - 8% = 4% (Negative Interest rate differential) Since the negative Interest rate differential is greater than forward premium there is a possibility of arbitrage inflow into India. The advantage of this situation can be taken in the following manner: 1. Borrow US$ 83312 for 6 months Amount to be repaid after 6 months = US $ 83312 (1+0.08 x 6/12) = US$86644.48 2. Convert US$ 83312 into Rupee and get the principal i.e. Rs.40,00,000 Interest on Investments for 6 months Rs.4000000/- x 0.06 = Rs.240000/- Total amount at the end of 6 months = Rs.(4000000 + 240000/-) = Rs.4240000/- Converting the same at the forward rate = Rs.4240000/- / Rs.48.8190= = US$ 86851.43 Hence the gain is US $ (86851.43 86644.48) = US$ 206.95 OR Rs.10103 i.e., ($206.95 x Rs.48.8190) Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 53 Question 15 Following are the details of cash inflows and outflows in foreign currency denominations of MNP Co. an Indian export firm, which have no foreign subsidiaries: Currency Inflow Outflow Spot rate Forward rate US $ 4,00,00,000 2,00,00,000 48.01 48.82 French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12 U.K. 3,00,00,000 2,00,00,000 75.57 75.98 Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40 (i) Determine the net exposure of each foreign currency in terms of Rupees. (ii) Are any of the exposure positions offsetting to some extent? Answer (i) Net exposure of each foreign currency in Rupees Inflow Outflow Net Inflow Spread Net Exposure (Millions) (Millions) (Millions) (Millions) US$ 40 20 20 0.81 16.20 FFr 20 8 12 0.67 8.04 UK 30 20 10 0.41 4.10 Japan Yen 15 25 -10 -0.80 8.00 (ii) The exposure of Japanese yen position is being offset by a better forward rate Question 16 AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K. Forecasts of surplus funds for the next 30 days from two subsidiaries are as below: U.S. $12.5 million U.K. 6 million Following exchange rate informations are obtained: $/Rs. /Rs. Spot 0.0215 0.0149 30 days forward 0.0217 0.0150 Annual borrowing/deposit rates (Simple) are available. Rs. 6.4%/6.2% $ 1.6%/1.5% 3.9%/3.7% The Indian operation is forecasting a cash deficit of Rs.500 million. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 54It is assumed that interest rates are based on a year of 360 days. (i) Calculate the cash balance at the end of 30 days period in Rs. for each company under each of the following scenarios ignoring transaction costs and taxes: (a) Each company invests/finances its own cash balances/deficits in local currency independently. (b) Cash balances are pooled immediately in India and the net balances are invested/borrowed for the 30 days period. (ii) W Answer Cash Balances: Acting independently Capital Interest Rs. in 30 days India -5,00,000 -2,666.67 -5,02,667 U.S. 12,500 15.63 5,76,757 U.K. 6,000 18.50 4,01,233 4,75,323 Cash Balances:- Immediate Cash pooling Rs. India 5,00,000 U.S. 0215 . 0500 , 12= 5,81,395 U.K. 0149 . 0000 , 6= 4,02,685 4,84,080 Immediate cash pooling is preferable as it maximizes interest earnings Note: If the company decides to invest pooled amount of Rs.4,84,080/- @ 6.2% p.a. for 30 days an interest of Rs.2,501/- will accrue. Question 17 Following information relates to AKC Ltd. which manufactures some parts of an electronics device which are exported to USA, Japan and Europe on 90 days credit terms. Cost and Sales information: Japan USA Europe Variable cost per unit Rs.225 Rs.395 Rs.510 Export sale price per unit Yen 650 US$10.23 Euro 11.99 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 55 Receipts from sale due in 90 days Yen 78,00,000 US$1,02,300 Euro 95,920 Foreign exchange rate information: Yen/Rs. US$/Rs. Euro/Rs. Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180 3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178 3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179 A AkC L currency risk or not. Answer If foreign exchange risk is hedged. Total (Rs.) Sum due Yen 78,00,000 US$1,02,300 Euro 95,920 Unit input price Yen 650 US$10.23 Euro11.99 Unit sold 12000 10000 8000 Variable cost per unit Rs.225/- 395 510 Variable cost Rs.27,00,000 Rs.39,50,000 Rs.40,80,000 Rs.1,07,30,000 Three months forward rate for selling 2.427 0.0216 0.0178 Rupee value of receipts Rs.32,13,844 Rs.47,36,111 Rs.53,88,764 Rs.1,33,38,719 Contribution Rs.5,13,844 Rs.7,86,111 Rs.13,08,764 Rs.26,08,719 Average contribution to sale ratio 19.56% If risk is not hedged Rupee value of receipt Rs.31,72,021 Rs.47,44,898 Rs.53,58,659 Rs.1,32,75,578 Total contribution Rs.25,45,578 Average contribution to sale ratio 19.17% AKC Ltd. Is advised to hedge its foreign currency exchange risk. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 56 Question 18 A company is considering hedging its foreign exchange risk. It has made a purchase on 1st. January, 2010 for which it has to make a payment of US $ 50,000 on September 30, 2010. The present exchange rate is 1 US $ = Rs. 40. It can purchase forward 1 US $ at Rs. 39. The company will have to make a upfront premium of 2% of the forward amount purchased. The cost of funds to the company is 10% per annum and the rate of Corporate tax is 50%. Ignore taxation. Consider the following situations and compute the Profit/Loss the company will make if it hedges its foreign exchange risk: (i) If the exchange rate on September 30, 2010 is Rs. 42 per US $. (ii) If the exchange rate on September 30, 2010 is Rs. 38 per US $. Answer (Rs.) Present Exchange Rate Rs.40 = 1 USD If company purchases USD 50000 forward premium is 50000 39 2% 39,000 Interest on Rs.39,000 for 9 months at 10% 2,925 Total hedging cost 41,925 If exchange rate is Rs.42 Then gain (Rs.42 39) for USD 50000 1,50,000 Less: Hedging cost 41,925 Net gain 1,08,075 If USD = Rs.38 Then loss (39 38) for USD 50000 50,000 Add: Hedging Cost 41,925 Total Loss 91,925 Question No. 19 Sun Ltd. in planning to import an equipment from Japan at a cost of 3,400 lakh yen. The company may avail loans at 18 percent per annum with quarterly rests with which it can import the equipment. The company has also an offer from Osaka branch of an India based bank extending credit of 180 days at 2 percent per annum against opening of an irrecoverable letter of credit. Additional information : Present exchange rate Rs.100 = 340 yen Rs.100 = 345 yen Commission charges for letter of credit at 2 per cent per 12 months. Advice the company whether the offer from the foreign branch should be accepted. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 57 Answer Option I (to finance the purchases by availing loan at 18% per annum): Cost of equipment Rs. in lakhs 3400 lakh yen at Rs.100 = 340 yen = 1000 Add: Interest at 4.5% I Quarter = 45 Add: Interest at 4.5% II Quarter = 47.03 (on Rs.1045 lakhs) Total outflow in Rupees = 1092.03 Alternatively, interest may also be calculated on compounded basis, i.e., Rs.1000 [1.045] = Rs.1092.03 Option II (To accept the offer from foreign branch): Cost of letter of credit Rs. in lakhs At 1 % on 3400 lakhs yen at Rs.100 = 340 yen = 10.00 Add: Interest I Quarter = 0.45 Add: Interest II Quarter = 0.47 (A) = 10.92 Payment at the end of 180 days: Cost 3400.00 lakhs yen Interest at 2% p.a. [3400 2/100 180/365] 33.53 lakhs yen 3433.53 lakhs yen Conversion at Rs.100 = 345 yen [3433.53 / 345 100] (B) = Rs.995.23 Total Cost: A + B = 1006.15 lakhs Comments: Option no.2 is cheaper by (1092.03 1006.15) lakh or 85.88 lakh Hence, the offer may be accepted. Question 20 Followings are the spot exchange rates quoted at three different forex markets : USD/INR 48.30 in Mumbai GBP/INR 77.52 in London GBP/USD 1.6231 in New York The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction costs, explain whether there is any arbitrage gain possible from the quoted spot exchange rates. Answer The arbitrageur can proceed as stated below to realize arbitrage gains. (i) Buy I. Rs. from USD 10,000,000 At Mumbai 48.3 10,000,000 Rs.483,000,000 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 58(ii) Convert I. Rs. to GBP at London 52 . 77000 , 000 , 483 GBP = 6,230,650.155 (iii) Convert GBP to USD at New York 6,230,650.155 1.6231 USD = 10,112,968.26 There is net gain of USD = 10,112968.26 less 10,000,000 i.e USD = 112,968.26 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 59 5 MERGERS AND ACQUISITIONS Question. Answer (a) (i) Mergers effect on EPS (Exchange ratio in proportion to relative EPS) (in Rs.) Company Existing No. Of shares EPS Total earnings X 3,00,000 4.00 12,00,000 Y 2,00,000 2.25 4,50,000 Total earnings 16,50,000 No. of shares after merger 3,00,000 + 1,12,500 = 4,12,500 Note: 1,12,500 may be calculated as4.002.252 00 000 EPS for Co X after merger4 12 5001 50 000 = Rs. 4.00 Equivalent EPS of Co. Y Before merger Rs. 2.25 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 60 After merger (EPS before merger Share exchange ratio on EPS basis) 2.25 .5625 = Rs. 4.00 Merger effect on EPS with share exchange ratio of 0.5 : 1 Total earnings after merger Rs. 16,50,000 No. of shares post merger (3,00,000 + 1,00,000 (.5 2,00,000) 4,00,000 EPS 16,50,000 4,00,000 4.125 (ii) Impact on EPS C x Rs. EPS before merger 4.00 EPS after merger i.e. (16,50,000 4,00,000) 4.125 Increase in EPS 0.125 Co. Y' Shareholders Equivalent EPS before merger 2.25 0.5 4.5 EPS after the merger 4.125 Decrease in EPS 0.375 Question 2 x?Z L A8C L x?Z L 8 l 2,50,000 shares outstanding and its earnings after taxes (EAT) amount to Rs. 5,00,000. ABC Ltd., has 1,25,000 shares outstanding; its current market price is Rs. 10 and its EAT are Rs. 1,25,000. The merger will be effected by means of a stock swap (exchange). ABC Ltd., has agreed to a plan under which XYZ Ltd., will offer the current marke A8C L (i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies? (ii) l A8C L L W W x?Z L -merger EPS be? (iii) W x?Z L -merger and post-merger EPS are to be the same? Answer (i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd. Particulars XYZ Ltd. ABC Ltd. Earning after taxes 5,00,000 1,25,000 Number of shares outstanding 2,50,000 1,25,000 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 61 EPS 2 1 Market Price per share 20 10 P/E Ratio (times) 10 10 (ii) Current Market Price of ABC Ltd. if P/E ratio is 6.4 = Rs. 1 6.4 = Rs. 6.40 Question 3 M Co. Ltd., is studying the possible acquisition of N Co. Ltd., by way of merger. The following data are available in respect of the companies: Particulars M Co. Ltd. N Co. Ltd. Earnings after tax (Rs.) 80,00,000 24,00,000 No. of equity shares 16,00,000 4,00,000 Market value per share (Rs.) 200 160 (i) If the merger goes through by exchange of equity and the exchange ratio is based on the current market price, what is the new earning per share for M Co. Ltd.? (ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders will not be diminished by the merger. What should be the exchange ratio in that case? Exchange ratio = Rs.206.40- = 3.125 Post merger EPS of XYZ Ltd. = ++ Rs. 5,00,000 Rs. 1,25,000Rs. 2,50,000 (Rs. 1,25,000/3.125) = Rs. 6,25,000 Rs. 2,90,000 = 2.16 (iii) Desired exchange ratio Total number of shares in post-merged company = Post-merger earningsPre- merger EPS of XYZ Ltd = Rs.6,25,0002= 3,12,500 Number of shares required to be issued = 3,12,500 2,50,000 = 62,500 Therefore, the exchange ratio is = 62,5001,25,000 = 0.50 62,500 1,25,000 :Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 62Answer (i) Calculation of new EPS of M Co. Ltd. No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd. = 4,00,000 shares Rs. 1.6/Rs. 2.0 = 3,20,000 shares Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd. = 16,00,000 + 3,20,000 = 19,20,000 Total earnings after tax [after acquisition] = 80,00,000 + 24,00,000 = 1,04,00,000 EPS = = Rs. 5.42 (ii) Calculation of exchange ratio which would not diminish the EPS of N Co. Ltd. after its merger with M Co. Ltd. Current EPS: M Co. Ltd. = = Rs. 5 N Co. Ltd. = = Rs. 6 Exchange ratio = 6/5 = 1.20 No. of new shares to be issued by M Co. Ltd. to N Co. Ltd. = 4,00,000 1.20 = 4,80,000 shares Total number of shares of M Co. Ltd. after acquisition = 16,00,000 + 4,80,000 = 20,80,000 shares EPS [after merger] = = Rs. 5 Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd. = 4,80,000 Rs. 5 = Rs. 24,00,000 Recommendation: The exchange ratio (6 for 5) based on market shares is beneficial to shareholders of 'N' Co. Ltd. Rs. 1,04,00,00019,20,000 equity sharesRs. 80,00,00016,00,000 equity sharesRs. 24,00,0004,00,000 equity sharesRs. 1,04,00,00020,80,000 sharesCompendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 63 Question 4 ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following information is available in respect of the companies: ABC Ltd. XYZ Ltd. Number of equity shares 10,00,000 6,00,000 Earnings after tax (Rs.) 50,00,000 18,00,000 Market value per share (Rs.) 42 28 Required: (i) What is the present EPS of both the companies? (ii) If the proposed merger takes place, what would be the new earning per share for ABC Ltd.? Assume that the merger takes place by exchange of equity shares and the exchange ratio is based on the current market price. (iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings to members are as before the merger takes place? Answer (i) Earnings per share = Earnings after tax /No. of equity shares ABC Ltd. = Rs. 50,00,000/10,00,000 = Rs. 5 XYZ Ltd. = Rs. 18,00,000 / 6,00,000 = Rs. 3 (ii) n S x?Z A8C L share = Rs. 28/ 42 6,00,000 = 4,00,000 shares Total number of equity shares of ABC Ltd. after merger = 10,00,000 + 4,00,000 = 14,00,000 shares Earnings per share after merger = Rs. 50,00,000 + 18,00,000 / 14,00,000 = Rs. 4.86 (iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd. to earn the same as was before merger: Shares to be exchanged based on EPS = (Rs. 3/Rs. 5) 6,00,000 = 3,60,000 shares EPS after merger = (Rs. 50,00,000 + 18,00,000)/13,60,000 = Rs. 5 Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. = 3,60,000 Rs. 5 = Rs. 18,00,000. Exchange ratio based on market price is beneficial to shareholders of XYZ Ltd. because of higher Earnings available to them i.e. (4,00,000 shares Rs. 4.86 = Rs. 19,44,000). Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 64Question 5 The following information is provided related to the acquiring Firm Mark Limited and the target Firm Mask Limited: Firm Mark Limited Firm Mask Limited Earning after tax (Rs.) 2,000 lakhs 400 lakhs Number of shares outstanding 200 lakhs 100 lakhs P/E ratio (times) 10 5 Required: (i) What is the Swap Ratio based on current market prices? (ii) What is the EPS of Mark Limited after acquisition? (iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio of Mark Limited remains unchanged? (iv) Determine the market value of the merged firm. (v) Calculate gain/loss for shareholders of the two independent companies after acquisition. Answer Particulars Mark Ltd. Mask Ltd. EPS Rs. 2,000 Lakhs/ 200 lakhs Rs. 400 lakhs / 100 lakhs = Rs. 10 Rs. 4 Market Price Rs. 10 10 = Rs. 100 Rs. 4 5 = Rs. 20 (i) The Swap ratio based on current market price is Rs. 20 / Rs. 100 = 0.2 or 1 share of Mark Ltd. for 5 shares of Mask Ltd. No. of shares to be issued = Rs. 100 lakh 0.2 = Rs. 20 lakhs. (ii) EPS after merger = lakhs 20 lakhs 200 lakhs 400 Rs. lakhs 2,000 Rs. = Rs. 10.91 (iii) Expected market price after merger assuming P / E 10 times. = Rs. 10.91 10 = Rs. 109.10 (iv) Market value of merged firm = Rs. 109.10 market price 220 lakhs shares = 240.02 crores Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 65 (v) Gain from the merger Post merger market value of the merged firm Rs. 240.02 crores Less: Pre-merger market value Mark Ltd. 200 Lakhs Rs. 100 = 200 crores Mask Ltd. 100 Lakhs Rs. 20 = 20 crores Rs. 220.00 crores Gain from merger Rs. 20.02 crores Appropriation of gains from the merger among shareholders: Mark Ltd. Mask Ltd. Post merger value 218.20 crores 21.82 crores Less: Pre-merger market value 200.00 crores 20.00 crores Gain to Shareholders 18.20 crores 1.82 crores Question 6 The following information is provided relating to the acquiring company Efficient Ltd. and the target Company Healthy Ltd. Efficient Ltd. Healthy Ltd. No. of shares (F.V. Rs. 10 each) 10.00 lakhs 7.5 lakhs Market capitalization 500.00 lakhs 750.00 lakhs P/E ratio (times) 10.00 5.00 Reserves and Surplus 300.00 lakhs 165.00 lakhs P n 4.75 lakhs 5.00 lakhs Board of Directors of both the Companies have decided to give a fair deal to the shareholders and accordingly for swap ratio the weights are decided as 40%, 25% and 35% respectively for Earning, Book Value and Market Price of share of each company: (i) C ion. (ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.? (iii) What is the expected market price per share and market capitalization of Efficient Ltd. after acquisition, assuming P/E ratio of Firm Efficient Ltd. remains unchanged. (iv) Calculate free float market capitalization of the merged firm. Answer Swap Ratio Efficient Ltd. Healthy Ltd. Market capitalisation 500 lakhs 750 lakhs No. of shares 10 lakhs 7.5 lakhs Market Price per share Rs. 50 Rs. 100 P/E ratio 10 5 EPS Rs. 5 Rs. 20 Profit Rs. 50 lakh Rs. 150 lakh Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 66Share capital Rs. 100 lakh Rs. 75 lakh Reserves and surplus Rs. 300 lakh Rs. 165 lakh Total Rs. 400 lakh Rs. 240 lakh Book Value per share Rs. 40 Rs. 32 (i) Calculation of Swap Ratio EPS 1 : 4 i.e. 4.0 40% 1.6 Book value 1 : 0.8 i.e. 0.8 25% 0.2 Market price 1 : 2 i.e. 2.0 35% 0.7 Total 2.5 Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of Efficient Ltd. Hence, total no. of shares to be issued 7.5 lakh 2.5 = 18.75 lakh shares 2.5 = 12.5 lakh shares) = 17.25 lakh i.e. 100 = 60%. Calculation of EPS, Market price, Market capitalization and free float market capit alisation (ii) Total No. of shares 10 lakh + 18.75 lakh = 28.75 lakh Total capital 100 lakh + 187.5 lakh = Rs. 287.5 lakh EPS = Rs. 6.956 (iii) Expected market price EPS 6.956 P/E 10 = Rs. 69.56 Market capitalization = Rs. 69.56 per share 28.75 lakh shares = Rs. 1,999.85 lakh (iv) Free float of market capitalization = Rs. 69.56 per share (28.75 lakh 40%) = Rs. 799.94 lakh Question 7 The following information is relating to Fortune India Ltd. having two division, viz. Pharma Division and Fast Moving Consumer Goods Division (FMCG Division). Paid up share capital of Fortune India Ltd. is consisting of 3,000 Lakhs equity shares of Re. 1 each. Fortune India Ltd. decided to de-merge Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2011. Details of Fortune India Ltd. as on 31.3.2011 and of Fortune Pharma Ltd. as on 1.4.2011 are given below: Particulars Fortune Pharma Ltd. Fortune India Ltd. Rs. Rs. Outside Liabilities Secured Loans 400 lakh 3,000 lakh Unsecured Loans 2,400 lakh 800 lakh Current Liabilities & Provisions 1,300 lakh 21,200 lakh += =Total profit 50 lakh 150 lakh 200 No. of shares 28.75 lakh 28.75 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 67 Assets Fixed Assets 7,740 lakh 20,400 lakh Investments 7,600 lakh 12,300 lakh Current Assets 8,800 lakh 30,200 lakh Loans & Advances 900 lakh 7,300 lakh Deferred tax/Misc. Expenses 60 lakh (200) lakh Board of Directors of the Company have decided to issue necessary equity shares of Fortune Pharma Ltd. of Re. 1 each, without any consideration to the shareholders of Fortune India Ltd. For that purpose following points are to be considered: 1. Transfer of Liabilities & Assets at Book value. 2. Estimated Profit for the year 2011-12 is Rs. 11,400 Lakh for Fortune India Ltd. & Rs. 1,470 lakhs for Fortune Pharma Ltd. 3. Estimated Market Price of Fortune Pharma Ltd. is Rs. 24.50 per share. 4. Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to be expected for both the companies. Calculate: 1. The Ratio in which shares of Fortune Pharma are to be issued to the shareholders of Fortune India Ltd. 2. Expected Market price of Fortune India Ltd. 3. Book Value per share of both the Companies immediately after Demerger. Answer ^ Particulars Fortune India Ltd. Fortune Pharma Ltd. Fortune India (FMCG) Ltd. Assets 70,000 25,100 44,900 Outside liabilities 25,000 4,100 20,900 Net worth 45,000 21,000 24,000 1. Calculation of Shares of Fortune Pharma Ltd. are to be issued to shareholders of Fortune India Ltd. Fortune Pharma Ltd. Estimated Profit (Rs. in lakhs) 1,470 Estimated market price (Rs.) 24.5 Estimated P/E 25 Estimated EPS (Rs.) 0.98 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 68No. of shares lakhs 1,500 Hence, Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune India Ltd. 2. Expected market price of Fortune India Ltd. Fortune India (FMCG) Ltd. Estimated Profit (Rs. in lakhs) 11,400 No. of equity shares (Rs. in lakhs) 3,000 Estimated EPS (Rs.) 3.8 Estimated P/E 42 Estimated market price (Rs.) 159.6 3. Book value per share Fortune Pharma Ltd. Fortune India (FMCG) Ltd. Net worth (Rs.in lakhs) 21,000 24,000 No. of shares (Rs. in lakhs) 1,500 3,000 Book value of shares Rs. 14 Rs. 8 Question 9 Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries Ltd. (SIL). The particulars of 2 companies are given below: Particulars Reliable Industries Ltd Sunflower Industries Ltd. Earnings After Tax (EAT) Rs.20,00,000 Rs.10,00,000 Equity shares O/s 10,00,000 10,00,000 Earnings per share (EPS) 2 1 PE Ratio (Times) 10 5 Required: (i) What is the market value of each Company before merger? (ii) Assume that the management of RIL estimates that the shareholders of SIL will accept an offer of one share of RIL for four shares of SIL. If there are no synergic effects, what is the market value of the Post-merger RIL? What is the new price per share? Are the shareholders of RIL better or worse off than they were before the merger? (iii) Due to synergic effects, the management of RIL estimates that the earnings will increase by 20%. What is the new post-merger EPS and Price per share? Will the shareholders be better off or worse off than before the merger? Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 69 Answer (i) Market value of Companies before Merger Particulars RIL SIL EPS Rs.2 Re.1 P/E Ratio 10 5 Market Price Per Share Rs.20 Rs.5 Equity Shares 10,00,000 10,00,000 Total Market Value 2,00,00,000 50,00,000 (ii) Post Merger Effects on RIL Rs. Post merger earnings 30,00,000 Exchange Ratio (1:4) No. of equity shares o/s (10,00,000 + 2,50,000) 12,50,000 EPS: 30,00,000/12,50,000 2.4 Market Price per share 10.00 Market Value 10 x 2.4 24 Total Value (12,50,000 x 24) 3,00,00,000 Gains From Merger: Rs. Post-Merger Market Value of the Firm 3,00,00,000 Less: Pre-Merger Market Value RIL 2,00,00,000 SIL 50,00,000 2,50,00,000 Total gains from Merger 50,00,000 Apportionment of Gains between the Shareholders: Particulars RIL SIL Post Merger Market Value: Rs. Rs. 10,00,000 x 24 2,40,00,000 -- 2,50,000 x 24 - 60,00,000 Less: Pre-Merger Market Value 2,00,00,000 50,00,000 Gains from Merger: 40,00,000 10,00,000 Thus, the shareholders of both the companies (RIL + SIL) are better off than before Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 70(iii) Post-Merger Earnings: Increase in Earnings by 20% New Earnings: Rs.30,00,000 x 20% = Rs.36,00,000 No. of equity shares outstanding: 12,50,000 EPS: Rs. 36,00,000/12,50,000 = Rs.2.88 PE Ratio = 10 Market Price Per Share: = Rs.2.88 x 10 = Rs.28.80 Shareholders will be better-off than before the merger situation. Question 11 AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is to be based on the recommendation of merchant bankers and the consideration is to be discharged in the form of equity shares to be issued by AB Ltd. As on 31.3.2011, the paid up capital of AB Ltd. consists of 80 lakhs shares of Rs.10 each. The highest and the lowest market quotation during the last 6 months were Rs.570 and Rs.430. For the purpose of the exchange, the price per share is to be reckoned as the average of the highest and lowest market price during the last 6 months ended on 31.3.11. x? L 8 S 11 is summarised below: Rs. lakhs Sources Share Capital 20 lakhs equity shares of Rs.10 each fully paid 200 10 lakhs equity shares of Rs.10 each, Rs.5 paid 50 Loans 100 Total 350 Uses Fixed Assets (Net) 150 Net Current Assets 200 350 An independent firm of merchant bankers engaged for the negotiation, have produced the following estimates of cash flows from the business of XY Ltd.: Year ended By way of Rs. lakhs 31.3.12 after tax earnings for equity 105 31.3.13 do 120 31.3.14 Do 125 31.3.15 Do 120 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 71 31.3.16 Do 100 terminal value estimate 200 It is the recommendation of the merchant banker that the business of XY Ltd. may be valued on the basis of the average of (i) Aggregate of discounted cash flows at 8% and (ii) Net assets value. Present value factors at 8% for years 1-5: 0.93 0.86 0.79 0.74 0.68 You are required to: (i) Calculate the total value of the business of XY Ltd. (ii) The number of shares to be issued by AB Ltd.; and (iii) The basis of allocation of the shares among the shareholders of XY Ltd. Answer Price/share of AB Ltd. for determination of number of shares to be issued: (Rs.570 + Rs.430)/2 Rs. 500 Value of XY Ltd based on future cash flow capitalization (105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) Rs. lakhs 592.40 Value of XY Ltd based on net assets Rs. lakhs 250.00 Average value (592.4+250)/2 421.20 No. of shares in AB Ltd to be issued 42120000/500 Nos. 84240 Basis of allocation of shares Fully paid equivalent shares in XY Ltd. (20+5) lakhs 2500000 Distribution to fully paid shareholders 84240x20/25 67392 Distribution to partly paid shareholders 84240-67392 16848 Total Question 12 AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies are 10,00,000 and 5,00,000 respectively: (i) Calculate the increase in the total value of BCD Ltd. resulting from the acquisition on the basis of the following conditions: Current expected growth rate of BCD Ltd. 7% Expected growth rate under control of AFC Ltd., (without any additional capital investment and without any change in risk of operations) 8% Current Market price per share of AFC Ltd. Rs. 100 Current Market price per share of BCD Ltd. Rs. 20 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 72Current Dividend per share of BCD Ltd. Re. 0.60 (ii) On the basis of aforesaid conditions calculate the gain or loss to shareholders of both the companies, if AFC Ltd. were to offer one of its share for every four shares of BCD Ltd. (iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd. pays Rs.22 for each share of BCD Ltd., assuming the P/E Ratio of AFC Ltd. does not change after the merger. EPS of AFC Ltd. is Rs.8 and that of BCD is Rs.2.50. It is assumed that AFC Ltd. invests its cash to earn 10%. Answer (i) For BCD Ltd., before acquisition The cost of capital of BCD Ltd. may be calculated by using the following formula: % Growthice PrDividend Cost of Capital i.e., Ke = (0.60/20) + 0.07 = 0.10 After acquisition g (i.e. growth) becomes 0.08 Therefore, price per share after acquisition = 0.60/(0.10-0.08) = Rs.30 The increase in value therefore is = Rs.(30-20) x 5,00,000 = Rs.50,00,000/- (ii) To share holders of BCD Ltd. the immediate gain is Rs.100 Rs.20x4 = Rs.20 per share The gain can be higher if price of shares of AFC Ltd. rise following merger which they should undertake. To AFC Ltd. shareholders (Rs. (In lakhs) Value of Company now 1,000 Value of BCD Ltd. __150 1,150 No. of shares 11.25 Value per share 1150/11.25= Rs.102.22 Gain to shareholders of BCD Ltd. = Rs.102.22 Rs.(4 x 20) = Rs.22.22 Gain to shareholders of AFC Ltd. = Rs.102.22 Rs.100.00 = Rs.2.22 (iii) Gain to shareholders of AFC Ltd:- Earnings of BCD Ltd. (5,00,000 x 2.50) = Rs.12,50,000/- Less: Loss of earning in cash Rs.11,00,000/- (5,00,000/- x 22 x 0.10) Net Earning Rs.1,50,000/- Number of shares 10,00,000 Net increase in earning per share 0.15 P/E ratio of AFC Ltd. = 100/8 = 12.50 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 73 Therefore, Gain per share of shareholders of AFC Ltd. = 0.15x12.50 = Rs.1.88 Gain to the shareholders of BCD Ltd. Rs. (22-20) = Rs.2/- per share Question 13 A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one share of T Ltd.). Following information is provided: A Ltd. T. Ltd. Profit after tax Rs.18,00,000 Rs.3,60,000 Equity shares outstanding (Nos.) 6,00,000 1,80,000 EPS Rs.3 Rs.2 PE Ratio 10 times 7 times Market price per share Rs.30 Rs.14 Required: (i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd. (ii) What is the EPS of A Ltd. after the acquisition? (iii) Determine the equivalent earnings per share of T Ltd. (iv) What is the expected market price per share of A Ltd. after the acquisition, assuming its PE multiple remains unchanged? (v) Determine the market value of the merged firm. Answer (a) (i) The number of shares to be issued by A Ltd.: The Exchange ratio is 0.5 New Shares = 1,80,000 x 0.5 =90,000 (ii) EPS of A Ltd. After a cquisition: Total Earnings (18,00,000+3,60,000) Rs.21,60,000 No. of Shares (6,00,000 + 90,000) 6,90,000 EPS (21,60,000)/6,90,000) Rs.3.13 (iii) Equivalent EPS of T Ltd.: No. of new Shares 0.5 EPS Rs.3.13 Equivalent EPS (3.13 x .5) Rs.1.57 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 74 (iv) New Market Price of A Ltd. (P/E remaining unchanged): Present P/E Ratio of A Ltd. 10 times Expected EPS after merger Rs.3.13 Expected Market Price (3.13 x 10) Rs.31.30 (v) Market Value of merged firm: Total number of Shares 6,90,000 Expected Market Price Rs.31.30 Total value (6,90,000 x 31.30) Rs.2,15,97,000 Question 14 BA Ltd. and DA Ltd. both the companies operate in the same industry. The Financial statements of both the companies for the current financial year are as follows: Balance Sheet Particulars BA Ltd. (Rs.) DA Ltd. (Rs.) Current Assets 14,00,000 10,00,000 Fixed Assets (Net) 10,00,000 5,00,000 Total (Rs.) 24,00,000 15,00,000 Equity capital (Rs.10 each) 10,00,000 8,00,000 Retained earnings 2,00,000 -- 14% long-term debt 5,00,000 3,00,00 Current liabilities 7,00,000 4,00,000 Total (Rs.) 24,00,000 15,00,000 Income Statement BA Ltd. (Rs.) DA Ltd. (Rs.) Net Sales 34,50,000 17,00,000 Cost of Goods sold 27,60,000 13,60,000 Gross profit 6,90,000 3,40,000 Operating expenses 2,00,000 1,00,000 Interest 70,000 42,000 Earning before taxes 4,20,000 1,98,00 Taxes @ 50% 2,10,000 99,000 Earning after taxes (EAT) 2,10,000 99,000 Additional Information : No. of Equity shares 1,00,000 80,000 Dividend payment ratio (D/P) 40% 60% Market price per share Rs.40 Rs.15 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 75 Assume that both companies are in the process of negotiating a merger through an exchange of equity shares. You have been asked to assist in establishing equitable exchange terms and are required to : (i) Decompose the share price of both the companies into EPS and P/E components; and also segregate their EPS figures into Return on Equity (ROE) and book value/intrinsic value per share components. (ii) Estimate future EPS growth rates for each company. (iii) 8 8A L uA share would be Rs.20 per share on its acquisition. You are required to develop a range of justifiable equity share exchange ratios that can be offered by BA Ltd. to the shareholders of DA Ltd. Based on your analysis in part (i) and (ii), would you expect the negotiated terms to be closer to the upper, or the lower exchange ratio limits and why? (iv) Calculate the post-merger EPS based on an exchange ratio of 0.4 : 1 being offered by BA Ltd. Indicate the immediate EPS accretion or dilution, if any, that will occur for each group of shareholders. (v) 8 8A L -merger P/E ratio will continue after the merger, estimate the post-merger market price. Also show the resulting accretion or dilution in pre-merger market prices. Answer Market price per share (MPS) = EPS SP/E ratio or P/E ratio = MPS/EPS (i) Determination of EPS, P/E ratio, ROE and BVPS of BA Ltd. and DA Ltd. BA Ltd. DA Ltd. Earnings After Tax (EAT) 210000 99000 No. of Shares (N) 100000 80000 EPS (EAT/N) 2.1 1.2375 Market price per share (MPS) 40 15 P/E Ratio (MPS/EPS) 19.05 12.12 Equity Funds (EF) 1200000 800000 BVPS (EF/N) 12 10 ROE (EAT/EF) 100 17.50% 12.37% (ii) Estimation of growth rates in EPS for BA Ltd. and DA Ltd. Retention Ratio (1-D/P ratio) 0.6 0.4 Growth Rate (ROE Retention Ratio) 10.50% 4.95% (iii) Justifiable equity shares exchange ratio (a) Intrinsic value based = Rs.20 / Rs.40 = 0.5:1 (upper limit) )b) Market price based = MPSb/MPSa = Rs.15 / Rs.40 = 0.375:1 (lower limit) Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 76Since, BA Ltd. has a higher EPS, ROE, P/E ratio and even higher EPS growth expectations, the negotiable terms would be expected to be closer to the lower limit, based on the existing share prices. (iv) Calculation of post merger EPS and its effects Particulars BA Ltd. DA Ltd. Combined EAT (Rs.) (i) 210000 99000 309000 Share outstanding (ii) 100000 80000 132000* EPS (Rs.) (i) / (ii) 2.1 1.2375 2.341 EPS Accretion (Dilution) (Re.) 0.241 (0.301***) (v) Estimation of Post merger Market price and other effects Particulars BA Ltd. DA Ltd. Combined EPS (Rs.) (i) 2.1 1.2375 2.341 P/E Ratio (ii) 19.05 12.12 19.05 MPS (Rs.) (i) / (ii) 40 15 44.6 MPS Accretion (Rs.) 4.6 2.84*** * Shares outstanding (combined) = 100000 shares + (.40 80000) = 132000 shares ** EPS claim per old share = Rs.2.34 .04 = Re.0.936 EPS dilution = Rs.1.2375 Re.0.936 = Re.0.3015 ***S claim per old share (Rs.44.60 0.4) 17.84 Less: MPS and per old share 15.00 2.84 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 77 6 COMPANIES ACT, 1956 Question 1 The Board of Directors of M/s ABC Consultants Limited, registered in Mumbai, proposes to hold the next board meeting in the month of May, 2011.They seek, your advice in respect of the following matters: (i) Can the board meeting be held in Chennai, when all the directors of the company reside at Mumbai? (ii ) Whether the board meeting can be called on a public holiday and that too after business hours as the majority of the directors of the company have gone to Chennai on vacation. (iii) Is it necessary that the notice of the board meeting should specify the nature of business to be transacted? Advise with reference to the relevant provisions of the Companies Act. Answer (i) There is no difficulty at all in holding the board meeting at Chennai even if all the directors of the company reside at Mumbai and the registered office is situated at Mumbai provided requirements regarding signing of register of contracts, etc. are complied with. (ii) Under provisions of Section 166 of the Companies Act, 1956, the annual general meeting shall be held during business hours and on a day that is not a public holiday. There is no similar provisions in the Act with regard to board meetings. Therefore, in the absence of any specific restrictive provision, the board meeting can be held even on a public holiday and out of the business hours. (iii) If the articles of association of the company are silent, the notice of board meeting is not required to specify the nature of business to be transacted thereat [Compagnie de Mayville v. Whitley (1896) 1 Ch. 788 (CA)]. If, however, the articles provide otherwise, then the notice must specify the nature of business to be transacted. All said and done, a better course seems to be that the notice should specify the purpose of the meeting, if it is an extra-ordinary or special meeting . Question 2 Happy Ltd. maintains the Minutes Book of the Board Meetings in loose-leaf system and get them bound once in three months. Can it do so? Board meetings were held on 24th March, 2011 and 15th April, 2011. Mr. Sameer , who was the Chairman of these two Board Meetings died on 1.5.2011, without signing the Minutes. How should be the Minutes be signed and by whom? Answer Ordinarily minutes cannot be kept in loose-leaf system. Section 193(1) of the Companies Act, 1956 enjoins the Minutes must be entered within 30 days of the conclusion of the relevant meeting. Ordinarily Minutes cannot be kept in loose-lead system. The Department of Company Affairs, however, has expressed that it would refrain from taking any action against a company which maintained its minutes in Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 78the loose-leaf form, provided that adequate safeguards are taken against falsification, and loose-leaves are bound in books at reasonable intervals, say six months. In this case, since the Minutes Book leaves are bound once in three months (January to March, 2011), and as such the same is in order. The minutes of the Board Meeting are required to be written within a period of 30 days from the date of the meeting held. [Section193(1)]. But there cannot be any insistence that the same must be signed 8 M u n 1.9.1976). According to section 193(1A), the minutes of a Board Meeting may be signed by the Chairman of the said meeting or the Chairman of the next succeeding meeting. In this case, Mr. Sameer, who was the Chairman of the Board Meeting, held on 24.3.2011 and 15.4.2011 died on 1.5.2011 without signing the minutes. The Chairman of the Board Meeting held after 15th April, 2011 for the first time may sign the minutes of Board Meeting, held on 15th April, 2011 in accordance with section 193(1A)(a). According to the provisions of section 193(1) read with section 193(1A) the minutes of Board Meeting held on 24th March, 2011 should have been signed by Mr. Sameer himself as he was the Chairman of the Board Meeting held on 24th March, 2011 as well as the Chairman of the next succeeding meeting. There is no specific provision in the Companies Act, 1956 as to the person who can sign the minutes of Board Meeting held on 24th March, 2011 in this case. Hence a board meeting may be convened and the Chairman of the said meeting may sign the minutes of Board Meeting held on 24th March, 2011. Question 3 Advise the company with reference to the relevant provisions of the Companies Act about sending notice of board meetings to the following directors: (i) Mr. Ajay, a director, who intimates his inability to attend the next board meeting. (ii) Mr. Zaheer, who has gone abroad for four months and an alternate Director has been appointed in his place. (iii) Mr. Hari is a director residing abroad representing the foreign collaborator and the Articles of Association of the company provide for sending notice to such directors. Answer According to Section 286 of the Companies Act, 1956 notice of every board meeting shall be given in writing to every Director for the time being in India and at his usual address in India to every other Director. (i) Notice should be given even if Mr. Ajay expressed his inability to attend the next board meeting. Otherwise Section 286(i) will be violated. [In re Portigese Consolidated Copper Mines Ltd (1889)42 Ch.D. 160 9CA)] (ii) Although there is no legal precedent in this regard, it would be a prudent practice (under section 286)that notice should be served to both, the alternative director as well as the original director Mr. Zaheer, who is outside India, at his usual address in India. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 79 (iii) In the case of a company having foreign collaboration, Articles generally provide that notice of Board Meeting should be sent by Air Mail. But a question crops up whether such provisions are valid, as section 286(1) requires services of such notice to a Director to be sent at his usual address in India. Despite provision contained in the Articles and in the Act, 1956, it is advisable as a good secretarial practice and taking into account the fact that it is a foreign collaboration agreement, and to avoid unnecessary legal nitty-gritties, the company may also send notice of the Board Meeting to the director residing abroad. Question 4 Mr. B, a Chartered Accountant is a Director in Z Limited. The company proposes to appoint/engage the firm B & Co. in which Mr. B is a partner in one or more of the following capacities: (i) Consultants on regular retainer basis. (ii) Authorised representatives to appear before tribunals. Discuss whether the provisions of Section 314 of the Companies Act are attracted in the above situations. Answer Apparently the prohibition under Sub-section (1) & (1B) of the Section 314 of the Companies Act, 1956 is not applicable to remuneration/compensation given to concerned persons (i.e. directors) for the services of a professional nature rendered by them to the company in their professional capacity such as advocate, chartered accountant, solicitor etc. However, prohibition will apply to them if they bind themselves on regular retainer ship basis. Therefore, (i) Chartered Accountants appointed by a company on a regular retainer basis as advisers, consultants, internal auditors, etc., also hold the position or place of consultant or adviser and accordingly such appointments are hit by the restrictive provisions of Sub-sections (1) and (1B) of Section 314. (ii) Based on the above analogy as contained above the bare engagement of a Chartered Accountant in a particular case and the payment to him of his professional fees in that case would not attract the provisions of Sub-sections (1) and (1B) of Section 314 of the Companies Act. Engaging a person in his professional capacity for performing a par ticular function, say, for attending to a particular case or for undertaking a particular assignment of consultancy, or rendering advice on a specific matter, would not by itself constitute appointment to an office or place of profit in or under the company. But if the terms of engagement of a Chartered Accountant are that he should attend to all the tax cases or act as adviser in all connected matters, whether generally or in a particular city or town, then even though he may be paid on a case by case basi Question 5 Discuss the validity of the arguments of the Director in the following cases: (a) In the General Meeting of X Ltd., held on 2.5.2011, Mr. D was appointed as a Director. On that day, he was not holding any equity shares in X Ltd. As per the Articles of Association of X LTD, the share qualification is the holding of 500 equity shares. On 15.6.2011 Mr. D applied for 1,000 equity shares in X Ltd and the shares were allotted on 10.7.2011. Mr. D Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 80claims that he was holding the qualification shares within the time specified in Companies Act. (b) Mr. Kathal holding 3% shares in OPQ Ltd., became a director of this company on 1.5.2011. The company, prior to his appointment as director, had commenced transactions with A Ltd. In the next Board Meeting to be held on 10.5.2011, the Board proposes to discuss about price revisions sought for by A Ltd. Briefly explain: (i) Whether Mr. Kathal should make a disclosure of his interest in A Ltd., assuming that the company is going to have transactions with A Ltd. on a continuous basis; if yes, when and how? When should it be renewed? (ii) Can he vote in the price revision resolution in the Board Meeting? You are informed that Mr. Kathal holds 1.5% of the share capital of A Ltd and that his wife holds another 3% of the share capital of A Ltd. Answer Under Section 270 of the Companies Act, 1956, the director must obtain qualification shares within two months from the date of appointment. In this case, he was appointed on 2.7.2011 and therefore he must obtain qualification shares on or before 2nd July, 2011 but the shares were allotted on 10th July, 2011. Only after the date of allotment, he was looking those shares and not on the date of application. Therefore, the argument of A is not correct. Kathal is interested before his appointment as a director in OPQ Ltd. The issue is whether Mr. Kathal should disclose his interest in A Ltd. Section 299(2)(b) of the Companies Act, 1956 applies to a case of contract or arrangement in which a person was concerned or interested before he becomes a director and also to a case of a contract or arrangement in which he becomes concerned or interest after he becomes a director. The words l case of a person who was actually concerned or interested in the contract or arrangement, the liability for disclosure arises the moment he accepts office as director (M.O. Varghese v. Thomas Stephen & Co. Ltd. (1970) 40 CC 1131 Kerala). Further, in this case, the Board proposes to discuss in the Board meeting to be held on 10.5.2011 the price revision sought by A Ltd. In view of the above, Mr. Kathal should make a disclosure of his interest in the first meeting to be held on 10.5.2011 after he became a director. Such disclosure may be made by a general notice under section 299(3) to the effect that he is a member or a director of a specified body corporate. Such notice is valid only for the financial year in which it is given and therefore, it should be renewed in the last month of every year, where necessary. Another issue is whether Mr. Kathal can vote in the price revision resolution in the Board Meeting. As per section 300. As per sub-section (2) the provision of sub-section (a) (b) (i) OPQ Ltd. entered into certain transactions (arrangement/contract) with A Ltd. in which Mr. (ii)Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 81 (1) shall not apply to any contract or arrangement entered into or to be entered into with a public company, in which the interest of the director aforesaid consists solely in his being a member holding not more than two percent of its paid-up share capital. In the given case, Mr. Kathal is holding 1.5% of the share capital of A Ltd., and his wife is holding another 3% in the share capital of A Ltd. and, therefore, it cannot be said he is interested only to the extent of less than 2% of the paid- A L 1 section 300(2) (d)]. Hence Mr. Kathal should not participate and vote in the Board Meeting to be held on 10.5.2011. Question 6 The Board of Directors of Unhappy Ltd. at a meeting held on 15.1.2011 resolved to borrow a sum of Rs. 45 crores from a nationalized bank. Subsequently the said amount was received by the company. One of the Directors, who opposed the said borrowing as not in the interest of the company has raised an issue that the said borrowing is outside the powers of the Board of Directors. The Company seeks your advice and the following data is given for your information: (i) Share Capital Rs. 15 crores (ii) Reserves and Surplus Rs. 15 crores (iii) Secured Loans Rs. 45 crores (iv) Unsecured Loans Rs. 15 crores Advice the management of the company. Answer According to the provisions of Section 293(1)(d) of the Companies Act, 1956 there are restrictions on the borrowing powers to be exercised by the Board of directors. According to that section, the borrowings should not exceed the aggregate of the paid up capital and free reserves. While calculating the limit, the temporary loans obtained by the company from its bankers in the ordinary course of business will be excluded. However, from the figures available in the present case the proposed borrowing of Rs. 45 crores will exceed the limit mentioned. Thus the borrowing will be beyond the powers of the Board of directors. However the share holders have the power to ratify the act of the Board of Directors, if it is not beyond the powers of the company as laid down in the memorandum of association. In that case the shareholders can ratify as it is intra vires the company even though it may be beyond the powers of the Board of Directors. Thus the management of Unhappy Ltd., should take steps to convene the annual general meeting and pass a resolution by the members in the meeting as stated in Section 293(1)(d) of the Act. Then the borrowing will be valid and binding on the company and its members. Question 7 Mr. Doubtful was appointed as the Managing Director of Carefree Industries Ltd. for a period of five years with effect from 1.4.1998 on a salary of Rs. 12 lakhs per annum with other perquisites. The Board of Directors of the company, on coming to know of certain questionable transactions, terminated the services of the Managing Director from 1.3.2001. Mr. Doubtful termed his removal as Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 82illegal and claimed compensation from the company. Meanwhile the company paid a sum of Rs. 5 lakhs on ad hoc basis to Mr. Doubtful pending settlement of his dues. Discuss whether: (i) The company is bound to pay compensation to Mr. Doubtful, and, if so, how much; (ii) The company can recover the amount of Rs. 5 lakhs paid on the ground that Mr. Doubtful is not entitled to any compensation, because he is guilty of corrupt practices. Answer Section 318 to 328 of the Companies Act, 1956 contain elaborate provisions for regulating payment of compensation to directors for loss of office. According to Section 318, such compensation can be paid only to Managing Director or Whole Time Directors or directors who are full time employees of the company. The compensation payable is limited to the average remuneration actually earned by such director during the three years period immediately preceeding the date on which he ceased to hold the office and multiplied for the unexpired period of his term or for three years whichever is shorter. Further no compensation will be payable to such a director if the company goes into compulsory winding up within a period of 12 months from the date of cessation of his office. The company is not bound to pay compensation to Mr. Doubtful if he has been found guilty of any fraud or breach of trust or gross negligence and mismanagement of the affairs of the company. [Section 318(3)(e)]. However, it is not proper for the company to with hold the payment of compensation on the basis of allegations unless there is a proper finding on the involvement of Mr. Doubtful in corrupt practices. The compensation payable is Rs. 25 lakhs i.e., at the rate of Rs. 12 lakhs per annum for unexpired period of 2 years and 1 month. Regarding the ad hoc payment of compensation to Mr. Doubtful, it will be difficult to recover the amount already paid. In the case of Bell Vs. Lever Brothers it was held that the director was not bound to refund the money because he failed to disclose his fiduciary obligation. In the said case Lever Bros. removed the managing director by paying him compensation. Later on it was discovered, that the managing director could have been removed without paying any compensation for the malpractices committed by him. Action was initiated for recovery of the compensation money paid. Held no recovery was possible because Managing Director was not bound to disclose his fiduciary obligations so as to give an opportunity to the company to dismiss him. Question 8 Mr. Influential is already a director of 19 companies. He is being appointed as a director of another company named M/s Expensive Remedies Ltd. Advise Mr. Influential in regard to the following: (i) Restrictions on the number of directorships to be held by an individual and whether he can accept the new appointment in view thereof. (ii) What are the companies to be excluded for the purpose of calculating the ceiling on the appointment of directors? Answer (i) After the commencement of the Companies (Amendment) Act, 2011, (i.e, w.e.f. 14.12.2011), no Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 83 person, shall save as otherwise provided in section 276, hold office at the same time as director in more than 15 companies (Section 275). Earlier the limit was 20 companies. For calculating the limit certain companies are to be excluded as provided in section 278(1). Any person holding office as Director in more than 15 companies immediately before the commencement of the Companies (Amendment) Act, 2011, has to make a choice of 15 companies in which he wishes to continue as Director. He has to make this choice within 2 months from the commencement of the Companies (Amendment) Act, 2011 (i.e. 12.2.2001) [Section 276(1)]. No such person shall act as a director in more than 15 companies after the expiry of 2 months from the commencement Companies (Amendment) Act, 2011 [Section 276 (3) (1)]. In view of the above, it is not possible for Mr. Influential to be a director in 19 companies after excluding the companies listed in section 278 (1). In the absence of information about companies, it is not possible to ascertain the exact number of directorship held by Mr. Influential for the purpose of section 275. There are two possibilities. Either Mr. Influential is a director in less than 15 companies (say 14 Companies) or 15 Companies. If he is a director in 14 Companies he can accept the directorship of M/s Expensive Remedies Limited. If he is already a director in 15 companies, he must within 15 days of his appointment as a director in M/s Expensive Remedies Ltd., relinquish any of his directorship. If he does not exercise the option within 15 days and does not vacate his directorship in any of the 15 companies, the appointment in M/s Expensive Remedies Ltd., shall become void immediately on the expiry of the 15 days [Section 277(1)]. (ii) For calculating the limit of 15 companies the following companies can be excluded: (i) a private company which is neither a subsidiary nor a holding company of a public company. (ii) An unlimited company. (iii) An association not carrying on business for profit or which prohibits the payment of a dividend. (iv) A company in which the person is only acting as alternate director.[Section 278(1)]. In making the above said calculation, any company referred to in (I), (ii) & (iii) above shall be excluded for a period of 33 months from the date on which the company ceases to fall within the purview of these clauses [Section 278(2)]. Question 9 Mr. Rehan is a director of M/s Doubtful Industries Ltd. He along with other two directors has been running the Company for the past twenty years without declaring any dividends or giving any benefit to the shareholders. Frustrated by this, some shareholders are desirous of giving notice to pass a resolution with the support of other shareholders for his removal as a director in the Annual General Meeting of the Company to be held in the month of December of 2001. State the procedure t o be followed for the removal of Mr. Rehan as a director and the right of Mr. Rehan to defend his position. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 84Answer Mr. Rehan a director of M/s Doubtful Industries Ltd., can be removed by following the procedure laid down in Section 284 of the Companies Act, 1956. The procedure is as under: (i) An ordinary resolution is required to be passed at the general meeting of the company. (ii) A special notice, as provided in Section 190 of the Act is required to be given to the company at least 14 days before the general meeting. (iii) On receipt of the notice, the company has to send a copy of the notice to Mr. Rehan and he is entitled to be heard on the resolution at the meeting. (iv) Mr. Rehan is also entitled to make a representation in writing to the company and the same has to be sent to all the members by the company. (v) In case the representation has reached or the same could not be sent to all the members the same has to be read out at the meeting. (vi) Such a representation need not be sent to the members or read out at the meeting if on the application of the company or any person aggrieved, the Company Law Board is satisfied that the rights conferred under this section are being abused to secure needless publicity for defamatory matter and passes an order to this effect. If at the general meeting the resolution is passed by a simple majority, Mr. Rehan will have to step down from the office as director of the company. Question 10 Mr. X is a director of M/s ABC Ltd. He has approached M/s Housing Finance Co. Ltd. for the purpose of obtaining a loan of Rs.50 crores to be used for construction of building his residential house. The loan was sanctioned subject to the condition that M/s ABC Ltd. should provide the guarantee for repayment of loan instalments by Mr. X. Advise Mr. X. Answer According to section 295 of the Companies Act, 1956, no company shall make a loan or give any guarantee, or provide any security in connection with a loan made by any other person to any director of the lending company unless the previous approval of the Central Government is obtained in this behalf. Thus, Mr. X has to approach his company ABC Ltd by stating the full details of the loan transaction and the stipulation of M/s Housing Finance Company Ltd. Thereafter M/s ABC Ltd has to make an application to the Central Government for approval under Section 295 along with the prescribed fees. Only on receipt of the approval M/s ABC Ltd can provide guarantee to M/s Housing Finance Co. Ltd. The company is also required to comply with the provisions of section 292 (i.e. Board Resolution) and section 372A (special resolution in a general meeting if required). Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 85 Question 11 1 8 S f RBS Ltd, contains the following information and figures: As at As at As at 31.03.2009 31.03.2010 31.03.2011 Rs. Rs. Rs. Paid up Capital 50,00,000 50,00,000 75,00,000 General Reserve 45,00,000 50,00,000 60,00,000 Debenture Redemption Reserve 15,00,000 20,00,000 25,00,000 Reserve Secured Loans 10,00,000 15,00,000 30,00,000 Net Profit for the year 12,50,000 19,00,000 34,50,000 (as calculated in accordance with the provisions of Section 349 and 350 of the Companies Act, 1956) In the ensuing Board Meeting scheduled to be held on 5th September,2011, among other items of agenda, following item is also appearing: 1 - Based on above information, you are required to find out as per the provisions of the Companies Act, 1956, the amount upto which the Board can borrow from financial institutions without seeking the approval in general meeting? Answer As per section 293 (1)(d) of the Companies Act, 1956, the Board of Directors of a public company or a private company which is a subsidiary of a public company, without obtaining the approval of shareholders in a general meeting, can borrow the funds including funds already borrowed upto an amount which does not exceed the aggregate of paid up capital of the company and its free reserves. Such borrowing shall not include temporary loans obtained from the company's bankers in ordinary course of business. Here, free reserves do not include the reserves set apart for specific purpose. Since the decision to borrow is to be taken in a meeting to be held on 5th September, 2011, the figures relevant for this purpose are the figures as per the Balance Sheet as at 31.03.2011. According to the above provisions, the Board of Directors of RBS Ltd. can borrow, without obtaining approval of the shareholders in a general meeting, upto an amount calculated as follows: Paid up capitalRs. 75,00,000/- General Reserve (being free reserve) Rs. 60,00,000/- Debenture Redemption Reserve (This reserve is not to be considered since it is kept apart for specific purpose of debenture redemption) Aggregate of paid up capital and free reserve Rs. 1,35,00,000/- Total borrowing power of the Board of Directors of the company. i.e., 100% of the aggregate of paid up capital and free reserves Rs. 1,35,00,000/- Less amount already borrowed as secured loans Rs. 30,00,000/- Amount upto which the Board of Directors can further Rs 1,05,00, 000/- borrow without the approval of shareholders in a general meeting. It is presumed that the amount already borrowed as secured loans are Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 86 L ll Section 293. Question 12 From the following information extracted from the Balance Sheet of VCD Ltd. as at 31st March, 2011, Board of Directors of the Company decide to grant a loan of Rs. 80 crores to another company JN Ltd. Rs. (in crores) Paid-up Share Capital: Equity Share Capital 50 Preference Share Capital 10 General Reserves 100 Debentures 5 Debenture Redemption Reserve 5. Answer Problem on Inter-Corporate Investment In accordance with the provisions of the Companies Act, 1956, as contained in Section 372A, Companies Act, 1956 a company cannot grant any loans or inter corporate investment exceeding 60% of its paid up capital and free reserves or 100% of its free reserves, whichever is more. st Paid-up share Capital: Equity Share Capital : Rs. 50 crores Preference Share Capital: Rs. 10 crores General Reserves Rs. 100 crores Total Rs. 160 crores. (60% of Rs. 160 crores = Rs. 96 crores) 100% of Reserves & Surplus (i.e. General Reserve) Rs. 100 crores. As 100% of free reserves, i.e. Rs. 100 crores is more than 60% of paid up share capital (both Equity and Preference share Capital) and free reserves, i.e. Rs. 96 crores, therefore, the overall limit for release of loan is Rs. 100 crores. The company has already granted loan / given guarantee as under: (i) Peters Ltd. Rs. 5 crores (ii) Steel India Ltd. Rs. 10 crores (iii) Corporate Guarantee Rs. 10 crores Total Rs. 25 crores Balance of limit upto which further loans/guarantee can be given = Rs. 100 crores 25 crores = Rs. 75 crores In case of VCD Ltd. the position as at 31 March, 2011 is as under: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 87 Therefore, the company can grant loan upto Rs. 75 crores to JN Ltd. Loan upto Rs. 80 crores as proposed under Section 372A of the Companies Act, 1956. It may however, be noted that the special resolution as required must be passed through postal ballot in accordance with the rule 4 of the Companies (Passing of the Resolution by Postal Ballot) Rules, 2001. Question 13 Following is the latest audited Balance Sheet of XYZ Ltd.: Capital and Liabilities Rs. Assets Rs. Equity Share Capital 10,00,000 Goodwill 1,00,000 (10,000 shares of Rs.100 each) Land and Buildings 10,50,000 Less: Calls unpaid 10,000 Plant and Machinery 20,25,000 9,90,000 Equity shares in A Ltd. 1,25,000 Preference Share Capital 1,50,000 Preference Shares in B Ltd. 50,000 Securities Premium a/c 1,50,000 Debentures in C Ltd. 1,00,000 Capital Redemption Reserve 2,25,000 Shares in P Ltd. 2,25,000 General Reserve 5,00,000 Capital in Z & Co. 1,00,000 Profit & Loss A/c 2,20,000 Current Assets 55,000 Sinking Profit Reserve 1,10,000 Dividend Equalisation Reserve 60,000 Loan from TICC 10,00,000 Deposits from S Ltd. 2,00,000 Current Liabilities 1,25,000 Provision for Taxation 1,00,000 ________ 38,30,000 38,30,000 The following is the additional relevant information: (i) Of the equity share capital, 3,000 shares have been issued as rights shares and 2,000 shares as bonus shares. (ii) B Ltd. is subsidiary of XYZ Ltd. with 90% shareholding, whereas A Ltd. is wholly owned subsidiary of XYZ Ltd. (iii) Z & Co. is a partnership firm. The directors seek advice as to whether the following additional investments can be made by a decision taken in a Board Meeting: Rs. (i) Loan to A Ltd. 10,00,000 (ii) Debentures in B Ltd. 2,25,000 (iii) Purchase of shares of Shree Ltd. in the open market 95,000 State reasons. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 88Answer By virtue of Explanation (b) to Section 372A, securiti es of any other body corporate, exceeding sixty per cent of its paid-up share capital and free reserves, or hundred per cent of its free reserves, whichever is more. Hence, it becomes necessary to compute the paid-up capital and free reserves first. Paid up Share Capital Equity share capital 10,00,000 Less: Calls unpaid 10,000 9,90,000 Preference share capital 1,50,000 11,40,000 Free reserves Securities premium A/c 1,50,000 General reserve 5,00,000 Profit and Loss A/c 2,20,000 Dividend Equilisation Reserve 60,000 9,30,000 A L A l per the latest audited balance sheet of the company, are free for distribution as dividend and shall include balance to the credit of the securities premium account but shall not include share application money. Capital redemption reserve sinking fund are not available for free distribution of dividend and hence not included. Ceiling limits 60% of paid-up capital and free reserves = 60% of (11,40,000 & 9,30,000). = 60% of 20,70,000 i.e. Rs.12,42,000 100% of free reserves = 9,30,000 60% of paid-up capital & free reserves being higher than 100% of free reserves, inter -corporate loans and investments may be made upto Rs.12,42,000. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 89 Investments as per the Balance Sheet Preference Shares in B Ltd. 50,000 Debentures in C Ltd. 1,00,000 Shares in P Ltd. 2,25,000 3,75,000 Note: Equity shares in A Ltd are not considered, since by virtue of Section 372A(8)(e), acquisition of shares by a holding company in its wholly owned subsidiary are outside the purview of Section 372A. Additional investments within the purview of Section 372A: Debentures in B Ltd. (loans including debentures As per explanation (a) to section 372 A) 2,25,000 Shares in Shree Ltd. 95,000 3,20,000 Note: Loan to A Ltd. A Ltd. being a wholly owned subsidiary, is to be excluded by virtue of section 372(8)(c). Total permissible investment 60% of paid up capital and free reserves 12,42,000 Less: investments already made 3,75,000 Further investment possible 8,67,000 Since the additional proposed investment is well within the above limit, the directors may by passing a resolution at a meeting of the Board, for which the consent of all the directors present at the meeting is obtained. Special resolution is not necessary and so also the prior approval of the financial institution like TI, however, the prior approval of a public financial institution shall not be required where the aggregate of the loans and investments so far made, the amount. [Proviso to section 372A(2)]. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 90Question 14 M/s Sharda Fertilizers Ltd. proposes to acquire equity shares of ABC Ltd. worth Rs.19 lakhs. On the basis of the following information advise Sharda Fertilizers Ltd. about the requirements to be complied with under Companies Act, 1956 for the proposed investment in ABC Ltd. Rs. Authorised Share Capital 50,00,000 Issued, subscribed and paid up Capital 25,00,000 Free Reserves 5,00,000 Answer The provisions regarding inter corporate loans and investments are contained in Section 372A of the Companies Act, 1956 which provide that no company shall directly or indirectly make loan or give guarantee or provide security and acquire by way of subscription, purchase or otherwise securities of any other body corporate exceeding 60% of its paid up capital and free reserves, or 100% of the free reserves whichever is more, without the previous approval of the members by way of special resolution in general meeting. The amount of proposed investment by Sharda Fertilizers ltd., in the equity shares of ABC Ltd. for Rs. 19.00 lakhs may be considered in the following manner as per the financial data given in the question: (i) 60% the paid-up capital and free reserves i.e. 60% (Rs. 25.00 lakhs + Rs. 5.00 lakhs) (ii) 100% of the free reserves = Rs. 500 lakhs = Rs. 18.00 lakhs rupees Hence the maximum permissible limit for the bank is only Rs. 18.00 lakhs. However, the Sharda Fertilizer purposes to invest Rs. 19.00 lakhs in the shares of ABC Ltd. which can only be done with the approval of the members by way of special resolution with general meeting. Therefore, Sharda fertilizers in advised to comply with the following requirements: (a) Checks the provisions of the Articles and Memorandum of the Company, regarding powers of the company and of its Board to make investment in other corporate body. If the powers are not available, take appropriate action to amend the Articles. (b) Hold a Board meeting for consideration of the investment proposal and to call a general meeting of the members to obtain their approval by way of special resolution. The Board resolution must be passed for investment at the meeting of the Board with the consent of all the directors present. The nature of such general meeting should specifically indicate the following particulars in the explanatory statement: (i) The specific limit is not less than Rs. 19.00 lakhs. (ii) The particulars of ABC Co. Ltd. (iii) The purpose of investment Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 91 (iv) Specification of the availability of funds of interest of directors, if any, (v) Any other material detail or disclosure of interest of directors, if any, (c) Check that there has been no default on the part of the company in repayment of loan installment or interest thereon. (d) Check that the company has not defaulted either directly or indirectly in complying with the provisions of Section 58A. (e) After investment, make entry in the Register of Investment within 7 days from the date of investment. (f) File Form No. 23 with the Registration within 30 days from the date of passing the resolution. Question 15 Following information is available from the audited Balance Sheet as at 31st March, 2011 of ASK Ltd.: Share Capital: Rs. Equity Share Capital (5,00,000 shares of Rs.10 each fully paid up in cash) 50,00,000 Less: Calls in arrear 50,000 49,50,000 Preference Share Capital 15,00,000 Share Application Money 10,00,000 Reserves and Surplus: Securities Premium 15,00,000 Capital Redemption Reserve 12,00,000 Fixed Assets Revaluation Reserve 10,50,000 Sinking Fund Reserve 11,00,000 General Reserve 40,00,000 Profit and Loss Account 22,00,000 Dividend Equalisation Reserve 6,00,000 Secured Loans: Cash Credit facility from Bank 1,00,00,00You are required to find out, explaining the relevant provisions of the Companies Act, 1956, the amount upto which the Board of Directors can invest in securities of other bodies corporate and/or give loans. Answer According to the provisions of section 372A of the Companies Act, 1956, a public company and a private company, which is a subsidiary of the public company shall not, directly or indirectly: Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 92(a) make any loan to any other body corporate (b) give any guarantee, or provide security, in connection with a loan made by any person to, or other person, by any body corporate; and (c) acquire, by way of subscription, purchase or otherwise the securities of any other body corporate exceeding 60% of its Paid up Share Capital and free reserves or 100% of its free reserves, which more without prior authorization by way of a special resolution passed in a general meeting.(Section 372 A (1). cash) Rs. 50,00,000/- Less: Calls in arrear Rs. 50,000/- Add: Preference Share Capital Rs.49,50,000/- Rs.15,00,,000/- Total of Paid up Share Capital Rs.64,50,000/- Free-Reserves: Securities Premium Rs. 15,00,000/- General Reserve Rs. 40,00,000/- Profit & Loss Account Rs. 22,00,000/- Dividend Equalisation Reserve Rs. 6,00,000/- Total Free Reserves Rs. 83,00,000/- Total of Paid up Share Capital and Free Reserves Rs. 1,47,50,000/- As per explanation to the said section, "Free Reserves" means those reserves, which, as per audited balance sheet of the company, are free for distribution as dividend and shall include balance to the credit of the securities premium account but shall not include share application money. (explanation (b) to section 372A). Accordingly, for the purpose of calculating the amount of Free Reserves, the amounts lying in the accounts of Share Application Money and reserves not available for distribution as dividend being Capital Redemption Reserve,/- Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 93. It may be noted that the amount of secured loan given in question has no relevance in determining the limit up to which investments/loans can be made. Question 16 Following information is available from the audited Balance Sheet as at 31st March, 2011 of ASK Ltd.: Capital & Liabilities Rs. Assets Rs. Share Capital: Fixed Assets: Equity Share Capital Goodwill 10,00,000 (5,00,000 shares of Rs. 10 each fully paid up in cash) Land & Buildings 75,00,000 Plant & Machinery 1,50,00,000 50,00,000 Furniture & Other Less: Calls in arrear 50,000 Assets 2,50,000 49,50,000 Investments: Less: Calls in arrear 15,00,000 Equity Shares in wholly owned Subsidiary Company - Share Application Money 10,00,000 Reserves & Surplus: Securities Premium 15,00,000 KMC Ltd. 12,50,000 Capital Redemption Reserve 12,00,000 Equity Shares representing 90% of MTC Ltd. Fixed Assets Revaluation Reserve 10,50,000 Share Capital of MTC Ltd. 4,50,000 General Reserve 40,00,000 Debentures in SKT Ltd. Profit and loss Account 22,00,000 SKT Ltd. 12,00,000 Dividend Eualisiation Reserve 6,00,000 Preference Shares in HUT Ltd. 5,00,000 Secured Loans: Cash credit facility from Bank 1,00,00,000 Capital account balance in Partnership Firm - BKP & Co. 8,00,000 Current Assets: Fixed Deposits (From general 20,00,000 Stock and Book Debts 14,00,000 Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 94public maturing after Current Liabilities & Provisions: Cash & Bank Balances 1,00,000 Current Liabilities 12,50,000 Loans & Advances: Provision for Taxation 10,00,000 Inter-corporate Deposits 25,00,000 Business Advances 14,00,000 3,33,50,000 3,33,50,000 The directors of the company want to make further investments stated below by taking a decision in the meeting of Board of Directors without seeking approval of the shareholders : Rs. (a) Loan to KMC Ltd. 25,00,000 (b) Loan to MTC Ltd. 15,00,000 (c) Purchase of further debentures in SKT Ltd. 8,00,000 (d) Purchase of shares from the open market in Glaxo Ltd. 15,00,000 You are required to state, with reference to the relevant provisions of the Companies Act, 1956, whether the directors can do so and mention the relevant calculations. Answer According to the provisions of section 372A of the Companies Act, 1956, a public company and private company, which is a subsidiary of the public company shall not, directly or indirectly: (a) make any loan to any other body corporate. (b) give any guarantee, or provide security, in connection with a loan made by any person to, or to any other person, by any body corporate; and (c) acquire, by way of subscription, purchase or otherwise the securities of any other body corporate. exceeding 60% of its Paid up Share Capital and free reserves or 100% of its free reserves, whichever is more without prior authorization by way of a special resolution passed in a general meeting. Rs. 5,000,000/- 31.02.2012) Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 95 cash) Less: Calls in arrear Rs. 50,000/- Rs. 4,950,000/- Preference Share Capital Rs. 1,500,000/- Total of Paid up Share Capital Rs. 6,450,000/- Free Reserves: Rs. 1,500,000/- Rs. 4,000,000/- Rs. 2,2011,000/- Rs. 600,000/- Total Free Reserves Rs. 8,300,000/- Total of paid up share capital and Free Reserves: Rs. 14,750,000/- A l 8 latest, audited balance sheet of the company, are free for distribution as dividend and shall include balance to the credit of the securities premium account but shall not include share application money. Accordingly, for the purpose of calculating the amount of Free Reserves, the amounts lying in the accounts of Share Application Money and reserves not available for distribution as dividend being Capital Redemption Reserves,. For arriving at a decision for further investments, the extent of present investment is to be determined and the directors can make further loans and investments upto the residual amount. The present investments and loans of ASK Ltd. calculated as per the provisions of section 372A of the Companies Act, 1956 are as follows: L S S C KMC Ltd. (not to be counted since as per provisos of Section 372(8)(e), investments in wholly owned subsidiary company is outside the purview of this section) Equity Shares representing 90% of share capital of MTC Ltd. Rs. 4,50,000/- Debentures in SKT Ltd. Rs. 12,00,000/- Preference shares in HUT Ltd. Rs. 5,00,000/- Inter-corporate Deposits Rs. 25,00,000/- Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 96Total investments of ASK Ltd. within the meaning of Section 372A Rs. 46,50,000/- Limit upto which directors can make investments as calculated above Rs. 88,50,000/- Less existing investments Rs. 46,50,000/- special resolution Rs. 42,00,000/- Proposed additional investments within the meaning of section 372 is to be calculated as follows: (a) Loan to KMC Ltd. -- (Not to be counted since as per provisions of section 372 (8)( c ) Loan to Wholly owned subsidiary company is outside the purview of this section) (b) Loan to MTC Ltd. Rs 15,00, 000/- (c) Purchase of further debentures in SKT Ltd. Rs 8,00,000/- (d) Purchase of share from the open market in Glaxo Ltd. Rs 15,00,000/- 38,00,000/- Since the proposed additional investment is within the amount permissible as calculated above, the directors, by passing a unanimous resolution in a Board Meeting, can make the proposed additional investment, Since the total investments do not exceed the limit as calculated above, the directors are not required to obtain the approval of shareholder, In absence of any term loan from any public financial institution, the question of their permission does not arise. Moreover, the fixed deposits from public are not yet due for repayment and hence there is no default on this account. In the light of above, it can be concluded that the directors can make the proposed investments. Question 17 The Board of Directors of XYZ Ltd. has agreed in principal go 8 MnC ltd. on the basis of the following information. Advise XYZ Ltd. about the requirements to be complied with under the Companies Act, 1956 for the proposed inter-corporate loan to MNC Ltd. (i) Authorized share capital Rs. 1,00,00,000 (ii) Issued, subscribed and paid up capital Rs. 50,00,000 (iii) Free reserves Rs. 10,00,000 Answer Inter corporate loans and investments are governed by the provisions of Section 372A of the Companies Act, 1956. As per this Section, a company can advance loans to other companies or invest in the securities, of other companies up to 60% of the paid-up capital and free reserves or upto 100% of free reserves, which is more. Further no loan or investment exceeding the said limits can be made by a company unless authorized by a previous special resolution passed in this regard. Compendium: Capital Market Analysis & Corporate Laws The Institute of Cost and Works Accountants of India Page 97 First determine whether a special resolution is required for providing loans to MNC Ltd. This can be determined as follows: Paid up capital of the company (A) 50,00,000 Free reserves (B) Rs. 10,00,000.00 Aggregate of paid up capital and free reserves (C) Rs. 60,00,000.00 60% of aggregate of paid up capital and free reserves (D) Rs. 36,00,000.00 Higher of (B) or (D) i.e. the ceiling limit for incorporate loan and investment etc. without requiring a special resolution Rs. ,000.00 Proposed loans to MNC Ltd. Rs. 38,00,000.00 Since the proposed loan exceeds the ceiling limit a special resolution is required. The company shall adopt the following procedure for providing loan to MNC Ltd. (i) Unanimous approval of the Board shall be obtained by passing a resolution at a Board meeting. (ii) A special resolution shall be passed in the general meeting The notice of special resolution shall stake the specific limits, particulars of the company to which loan is proposed to given, specific source of funding and other relevant details. The c ompany shall file a copy of special with the registrar within 30 days of passing the special resolution. If the company is listed company, it shall pass the resolution by postal ballot as prescribed under Section 192A. (iii) the company shall obtain the prior approval of the Public Financial Institution, if any, from whom it has taken a term loan. (iv) the company can provide such loan to other companies only if no default in respect of public deposits is subsisting. (v) the prescribed particulars shall be entered in the register maintained under Section 372A(5). C C M A C L Tle Institute of Cost anu Woiks Accountants of Inuia Page SLCUkI1ILS LkCnANGL 8CAkD CI INDIA SL8I YS
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