Taxmann's Strategic Financial Management (SFM) | CRACKER

CHAPTER-WISE MARKS

I-6

CHAPTER-WISE MARKS DISTRIBUTION

Note: N - November; M - May

PREVIOUS EXAMS TREND ANALYSIS

I-8 PREVIOUS EXAMS TREND ANALYSIS

PREVIOUS EXAMS TREND ANALYSIS I-9

I-10

PREVIOUS EXAMS TREND ANALYSIS

PREVIOUS EXAMS TREND ANALYSIS

I-11

CHAPTER-WISE COMPARISON WITH STUDY MATERIAL

PORTFOLIO MANAGEMENT 5

PART 1 THEORY

Q.1 Discuss the various kinds of Systematic and Unsystematic risk? [Practice Question]

Ans.: There are two types of risk - systematic (or non-diversifiable) and unsystematic (or diversifiable) relevant for investment - also, called as general and specific risk.

Types of Systematic Risk:

i. Market risk: Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate. Major cause appears to be changing psychology of the investors. The irrationality in the security markets may cause losses unrelated to the basic risks. These losses are the result of changes in the general tenor of the market and are called market risks.

ii. Interest Rate Risk: The change in the interest rate has a bearing on the welfare of the investors. As the interest rate goes up, the market price of existing fixed income securities falls and vice versa. This happens because the buyer of a fixed income security would not buy it at its face value if its interest rate is lower than the prevailing interest rate on a similar security.

iii. Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise profitable investment is impaired as a result of adverse legislation, harsh regulatory climate, or in extreme instance nationalization by a socialistic government.

iv. Purchasing Power Risk: Inflation or rise in prices lead to rise in costs of production, lower margins, wage rises and profit squeezing etc. The return expected by investors will change due to change in real value of returns.

PORTFOLIO MANAGEMENT

Types of Unsystematic Risk:

i. Business Risk: As a holder of corporate securities (equity shares or debentures) one is exposed to the risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products, shifts in consumer preferences, inadequate supply of essential inputs, changes in government policies etc. But quite often the principal factor may be inept and incompetent management.

ii. Financial Risk: This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problem or short term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities.

iii. Default Risk: Default risk refer to the risk accruing from the fact that a borrower may not pay interest and/or principal on time. Except in the case of highly risky debt instrument, investors seem to be more concerned with the perceived risk of default rather than the actual occurrence of default. Even though the actual default may be highly unlikely, they believe that a change in the perceived default risk of a bond would have an immediate impact on its market price.

Q.2 Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions. [May 2018] [5 marks]

Ans.: Capital Asset Pricing Model : The mechanical complexity of the Markowitz’s Portfolio model kept both practitioners and academics away from adopting the concept for practical use. Its intuitive logic, however, spurred the creativity of a number of researchers who began examining the stock market implications that would arise if all investors used this model. As a result what is referred to as the Capital Asset Pricing Model (CAPM), was developed. The capital Asset pricing model was developed by Sharpe, Mossin and Lintner in 1960. The model explains the relationship between the expected return, nondiversifiable risk and the valuation of securities. It considers the required rate of return of a security on the basis of its contribution to total risk. It is based on the premise that the diversifiable risk of a security is eliminated when more and more securities are added to the portfolio. However, the systematic risk cannot be diversified and is or related with that of the market portfolio. As per CAPM, Expected return on security = Rf + Beta (Rm - Rf).

Assumptions of CAPM:

(

(

i) The investor’s objective is to maximize the utility of terminal wealth.

ii) Investors make choices on the basis of risk and return.

(iii) Investors have identical time horizon.

(

iv) Investors have homogenous expectations of risk and return.

(

v) Information is simultaneously and freely available to all investors.

(

vi) There are no taxes, transaction costs, restrictions on short sales or other market imperfections.

(vii) Total asset quality is fixed and all assets are marketable and divisible.

Q.3 Explain the three form of Efficient Market Hypothesis. [Practice Question]

Ans.: The Efficient Market Hypothesis (EMH) is concerned with speed with which information affects the prices of securities. As per the study carried out by the technical analysts, it was observed that information is slowly incorporated in the price and it provides an opportunity to earn excess profit. However, once the information is incorporated then investor can not earn this excess profit. Level of Market Efficiency: If price reflects all information, it is the highest order of market efficiency. According to FAMA, there exist three levels of market efficiency:-

i Weak form efficiency - Price reflect all information found in the record of past prices and volumes.

ii Semi - strong efficiency - price reflect not only all information found in the record of past prices and volumes but also all other publicly available information.

iii. Strong form efficiency - price reflect all available information public as well as private.

Q.4 Explain the different challenges to Efficient Market Theory. [Practice Question]

Ans.: Some of the major challenges to efficient market theory are:

a Information Inadequacy: Information is neither freely available nor rapidly transmitted to all participants in the stock market. There is a calculated attempt by many companies to circulate misinformation.

b. Limited information processing capabilities: Human information processing capabilities are sharply limited. According to Herbert Simon every human organism lives in an environment which generates millions of new bits of information every second but the bottle necks of the perceptual apparatus does not admit more than thousand bits per second and possibly much less.

David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting information grid, the market can become a giant.

c Irrational Behaviour - It is generally believed that investors’ rationality will ensure a close correspondence between market prices and intrinsic values. But in practice this is not true. J. M. Keynes argued that all sorts of consideration enter into the market valuation which is in no way relevant to the prospective yield. This was confirmed by L.C. Gupta who found that the market evaluation processes work haphazardly almost like a blind man

5.4 PORTFOLIO MANAGEMENT

firing a gun. The market seems to function largely on hit or miss tactics, rather than on the basis of informed beliefs about the long term prospects of individual enterprise.

d. Monopolistic Influence - A market is regarded as highly competitive. No single buyer or seller is supposed to have undue influence over prices but in practice, powerful institutions and big operators wield great influence over the market. The monopolistic power enjoyed by them diminishes the competitiveness of the market.

Q.5 Buy and hold is one of the policies of portfolio rebalancing. Briefly explain other policies of portfolio rebalancing. [Dec. 2021] [4 Marks]

Ans. : There are three policies of portfolio rebalancing- Buy and hold policy, Constant mix policy, and Constant Proportion Portfolio Insurance (CPPI) policy.

(

a) Buy and Hold Policy

The following are main features of this policy:

(

a) The value of portfolio is positively related and linearly dependent on the value of the stock.

(

b) The value of portfolio cannot fall below the oor value i.e., investment in Bonds.

(

c) This policy performs better if initial percentage is higher in stock and stock out perform the bond. Reverse will happen if stock under perform in comparison of bond or their prices goes down.

(d) Since the value of portfolio is linearly related to value of stocks the pay-off diagram is a straight line.

(

e) Sometime this policy is also called ‘do nothing policy’ as under this strategy no balancing is required and therefore investor maintain an exposure to stocks and therefore linearly related to the value of stock in general.

Suitability:

This policy is suitable for the investor whose risk tolerance is positively related to portfolio and stock market return but drops to zero of below oor value.

(

b) Constant Mix Policy

This policy is a ‘Do Something Policy’. Under this policy investor maintains an exposure to stock at a constant percentage of total portfolio. This strategy involves periodic rebalancing to required (desired) proportion by purchasing and selling stocks as and when their prices go down and up respectively.

(

c) Constant Proportion Insurance Policy

In other words, this plan speci es that value of aggressive portfolio to the value of conservative portfolio will be held constant at a pre-determined ratio. However, it is important to this action is taken only there is change in the prices of share at a predetermined percentage.

Suitability:

This strategy is suitable for the investor whose tolerance varies proportionally with the level of wealth and such investor holds equity at all levels.

Under this strategy investor sets a oor below which he does not wish his asset to fall called oor, which is invested in some non- uctuating assets such as Treasury Bills, Bonds etc.

The value of portfolio under this strategy shall not fall below this speci ed oor under normal market conditions.

This strategy performs well especially in bull market as the value of shares purchased as cushion increases. In contrast in bearish market losses are avoided by sale of shares.

It is important to note that this strategy performs very poorly in the market hurt by sharp reversals. The following equation is used to determine equity allocation:

Target Investment in Shares = Multiplier (Portfolio Value - Floor Value)

Multiplier is a xed constant whose value shall be more than 1.

PART 2

NUMERICAL PROBLEMS: TOPIC WISE IN CHRONOLOGICAL ORDER

CAPITAL ASSET PRICING MODEL (CAPM)

Q.1 Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid dividend @ ` 3 per share. The rate of return on market portfolio is 15% and the risk-free rate of return in the market has been observed as 10%. The beta co-efficient of the company’s share is 1.2.

5.6 PORTFOLIO MANAGEMENT

You are required to calculate the expected rate of return on the company’s shares as per CAPM model and the equilibrium price per share by dividend growth model. [Nov. 2010] [5 Marks]

Ans. Capital Asset Pricing Model (CAPM) formula for calculation of expected rate of return is

ER = Rf + (Rm - Rf)

Where,

ER = Expected Return = Beta of Security

RM = Market Return

Rf = Risk free Rate = 10 + [1.2 (15 - 10)] = 10 + 6 = 16%

As per dividend Price model with constant growth, the equilibrium price:-

Where,

K e = Expected Return

D1 = Dividend expected after 1 year

P0= 1D Keg

P0 = 3(1.12) 0.160.12

P0 = 3.36 0.04 = ` 84

P0 = Market Price of the share

g = Growth rate

Therefore, equilibrium price per share will be ` 84.

Q.2

Calculate:

(

(

i) The expected rate of return on his portfolio using Capital Asset Pricing Method (CAPM)

ii) The average return of his portfolio. The Risk-free return is 14%. [May 2008] [10 Marks]

A holds the following portfolio:

Alternatively, first simple average of the Beta can be calculated and then the CAPM applied:

Q.3 Mr. Fed Up wants to invest an amount of ` 520 lakhs and had approached his Portfolio Manager. The Portfolio Manager had advised Mr. Fed Up to invest in the following manner:

You are required to advise Mr. Fed Up in regard to the following, using Capital Asset Pricing Methodology:

(

(

i) Expected return on the portfolio, if the Government Securities are at 8% and the Nifty is yielding 10%.

ii) Advisability of replacing Security ‘Better’ with NIFTY. [Nov. 2012] [8 Marks]

5.8

PORTFOLIO MANAGEMENT

Ans.: (i) Expected Return from Portfolio as per CAPM

Thus Expected Return from Portfolio 10.208% =10.21% (Rounded off)

Alternatively, it can be computed by calculating the weighted Beta and applying CAPM as follows:

(

As per CAPM = 8% + 1.104 (10% - 8%) = 0.10208 i.e. 10.208%

ii) As computed above the expected return from Better is 10% which is exactly the same as from Nifty, hence there will be no difference even if the replacement of security is made. The reason behind this is that the beta of security ‘Better’ is 1 which is same as that of market, so, it clearly indicates that this security shall yield same return as market return.

Q.4 Mr. Ram is holding the following securities :

Particulars of Securities Cost ` Dividends ` Market Price ` Beta

(

(

:

i) Expected rate of return in each case, using the Capital Asset Pricing Model (CAPM).

ii) Average rate of return, if risk free rate of return is 14%. [Nov. 2013] [8 Marks]

Ans.: Since, the market return is missing in the question, which is required to calculate the expected return of each security on the basis of CAPM, therefore, assuming the investments to be representing the market, rst, average return on this portfolio is calculated.

Now, taking 16.84% as market return the Rate of Return of each security using CAPM

Alternatively, It may also be calculated by first finding average Beta and then applying CAPM

Q.5 Mr. Shyam is holding the following securities:

5.10

PORTFOLIO MANAGEMENT

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. [May 2015] [8 Marks]

(

Rate of Return of each security using CAPM = Rf + B (Rm - Rf)

Note: The risk free rate is required to be calculated for the solution. As this is asked in the second part of the question, the figure of 14.69% has been taken from there.

0.5025 Average return = Risk free return + Average Beta (Market return - Risk free return)

STRATEGIC FINANCIAL MANAGEMENT

(SFM) | CRACKER

AUTHOR : K.M. BANSAL , ANJALI AGARWAL

PUBLISHER : TAXMANN

DATE OF PUBLICATION : JUNE 2023

EDITION : 8th Edition

ISBN NO : 9789357780681

NO. OF PAGES : 658

BINDING TYPE : PAPERBACK

Rs. 795 USD 41

DESCRIPTION

This book is prepared exclusively for the Final Level of Chartered Accountancy Examination requirement. It covers the questions & detailed answers strictly as per the new syllabus of ICAI.

The Present Publication is the 8th Edition for CA-Final | New Syllabus | Nov. 2023 Exams. This book is authored by CA (Dr) K.M. Bansal & CA Anjali Agarwal, with the following noteworthy features:

• Strictly as per the New Syllabus of ICAI

• Coverage of this book includes:

o All Past Exam Questions & Answers, including: CA Final | SFM | May 2023 Exam

o Questions from RTPs and MTPs of ICAI

• [Arrangement of Question] Questions in each chapter are arranged 'sub-topic' wise with additional solved practice questions

• [Trend Analysis] Previous Exam Trend Analysis from May 2019 onwards

• [Marks Distribution] Chapter-wise marks distribution from May 2016 onwards

• [Comparison with Study Material] Chapter-wise comparison with ICAI Study Material

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