K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 1
K-Square
KONVEXITY KHRONICLES
OFFICIADUNT
Page 1
From Konvexity Desk
Page 2
Nerdy Boyzz! - The Book
Review Series
Page 4
Comprehensive Test 1
Page 14
Comprehensive Test 2
Page 24
Our Programs
The expert in anything was once a beginner.
FROM KONVEXITY DESK
Greetings from Team Konvexity. We hope that your preparations for the
CFA exams are going on a right track.
During our preparations for financial certifications, we desired for more
practice question papers especially in test format which could test our
knowledge about the specific subject in a comprehensive manner. There
were no options available to us. So we came out with the concept of
newsletter whose main focus will be to provide comprehensive subject
specific test papers for the students.
In this edition, we have included question papers of “Derivatives” and
“Corporate Finance”. The duration of each test is 90 minutes and is designed
to test thorough knowledge of the subject. We will be providing test papers
related to each subject in our subsequent editions.
Apart from that, we would be providing book reviews about classic books
related to finance and markets to stir your further interest. This is just a start
from us and we need your inputs/feedbacks so that we can improve upon the
things and can serve you guys in a better way. Do write to us at
[email protected] and provide your valuable suggestions. Please do
inform other candidates as well who might not be aware of this newsletter so
that they can also benefit. All they need to do is to visit our website and
subscribe for the newsletter. Hoping to see a positive reply from your side!!
You can also join our Facebook group here for any doubt clarification.
Team Konvexity
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 2
The first principle is that you must not fool yourself - and you are the easiest person to fool. – R. FEYNMAN
NERDY BOYZZ! - THE BOOK REVIEW SERIES
The little Book That Beats the Market – Joel Greenblatt
How can we outperform the market? What we need to learn to beat the market? Will doing an MBA from an Ivy
League B-school solve the problem and help us stay ahead of the crowd? Or do we have to gain knowledge from
comprehensive finance certifications like CFA to be a better investment manager? Does education guarantee the
performance? Can we start investing in the stock market and outperforming the average investor (i.e. the market
index) after completing our CFA? Or do we need to understand complex quantitative finance and various
derivative techniques to really beat the market? Should we follow the growth investment strategy or the value
investment strategy? Or by following the simplest of all (purchasing stocks on tips) can help us in building the
wealth? Or should we do all kind of research and would doing research guarantee the return? What if the market
doesn’t think like us?
To tell you the truth, I don’t know what would work for you. There are many investors who have made fortunes
by following one of the above strategies (barring the strategy where one buys stock on tips unless one has the
correct insider information and contacts). But then the numbers are very few. Only few investors have been beat
the market in each category. It needs focus and belief in your strategies and diligently following those strategies
that lead to successful investing career. One can make money by both technical and fundamental analysis.
But if you have little knowledge about finance and do not want to understand complex finance terms or do not
have the adequate time to do research for yourself. Then there can be few things which you can do with your
money to grow it as higher return. Either you can invest in mutual fund or market index fund. Studies have shown
that more than 80% of the mutual funds fail to beat the returns generated by the market index funds. Benjamin
Graham advises common investor to invest in index funds and use dollar averaging to enhance the returns.
However, if you are willing to do some research and want to acquire some solid wisdom to succeed in market,
then the book – “The Little Book That Beats the Market” is for you.
The author promises in the introduction that by reading this book you will learn:
How to view the stock market
How to find good companies are bargain price
How you can beat the market by yourself
The way he explains everything in this book in simple and precise manner, it looks like that we are reading some
kind of light novel rather than obscure financial book with loads of terminologies. You don’t need to spend
money and time on doing MBA or CFA if your only purpose is to gain financial wisdom. You would learn a lot of
formulas and financial terms in those degrees and certifications. But the actual difference is made by
understanding the simple things which have been taught by this book.
The author borrows the analogy of Mr. Market from the book Intelligent Investor authored by Benjamin
Graham. Mr. Market is a crazy guy who behaves erratically. You will find lots of opportunities to invest in the
market because of that guy. There will be times when you will be finding many good companies with a large
margin of safety.
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 3
The book is centred on a magical formula. By applying that one magic formula, you can consistently beat the
market. But earning the returns from the market by applying that formula is the very easy and very tough as well.
It is very easy to find the stocks to invest in using that formula but it is very difficult to hold on to those stocks. If
you can control your emotions, then you can beat the market by huge margin and you don’t need to know
anything else to succeed in the markets.
Apart from that magical formula, the author gives general wisdom to invest in the markets which are extremely
important to understand. The basic things involve:
Businesses that earn a high return on capital are better than businesses that earn a low return on capital.
Buying good businesses at bargain prices is the secret to making lots of money.
Choosing individual stocks without any idea of what you’ve looking for is like running through a dynamite
factory with a burning match. You may live, but you’re still an idiot.
He gives a magic formula which works for both large and small companies. The author tests the formula on a
broader range of stocks and the results have always beaten the market by a wide margin. The good thing about the
magic formula is that it ranks the stocks in order and one can find plenty of opportunities to invest in the market
using the formula.
You all must be wondering what that magical formula is. The author also doesn’t provide the magical formula till
the very end of the book. You will be running through the chapters at a rapid space to get to know the formula to
find it at the very end. But the book is very much readable and enjoyable. One can easily finish it in 4-5 hours. It’s
a very nice read with lots of anecdotes and stories. The magical formula is about screening the stocks and then
ranking them according to few factors and then invests according to those factors.
I won’t kill your curiosity to know about that formula. But one can visit this site to know more about the formula.
The book is based on this very simple magical formula which anyone can apply in the market and can beat the
market on a consistent basis. It’s not some formula based on complex mathematical formulas but on the very
basic fundamental formulas. I am sure you would love this book and if you can apply the pearls of wisdom given
in this book in your investment, you can earn a fortune.
Indian investors can screen their stock by visiting this website which is free of cost. Happy investing!
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 4
It always seems impossible until it’s done. – NELSON MANDELA
Comprehensive Test 1
Derivatives – Quiz (90 minutes)
Christina Vardanyan Case Scenario
Christina Vardanyan is a derivatives analyst at Prometey Bank. She deals in forward and futures currency markets.
Prometey Bank is based out of Armenia where the local currency is Armenian Dram (ADM). The company is
expected to receive $50 million of US dollars after 6 months. Christina’s primary job is to hedge the currency
risk. The data related to USA and Armenia is given in the Exhibit 1.
Exhibit 1
Current spot exchange rate between USD and ADM 404 ADM/USD
Interest rate(annual) for 6-months in USA 3.0%
Interest rate (annual) for 6-months in Armenia 6.0%
She calculates the forward price of the exchange rate between the currencies and finds out that there is no
arbitrage opportunity in the market i.e. the forward exchange rate is fairly priced. She takes the position in the
forward market worth $50 million.
Her manager, Robert Paulson, notices that the forward and futures exchange rate between the two currencies are
different. He thinks that the rates should be equal and there must be some arbitrage opportunity in this
discrepancy. He asks her about the difference in the exchange rates.
She explains that the difference can be attributed to two factors: the cost of borrowing of funds and the
reinvestment rate. If the interest rate curve is upward sloping, then the profitable positions can invest the money at
a higher rate and will be happy to pay a premium for mark-to-market facility which is present in futures contracts.
Similarly, the higher borrowing cost will make investors pay a premium for the futures position.
Robert Paulson is also concerned about the credit risk. He wants to eliminate the credit risk. He asks her whether
the credit risk can be removed. Christina replies that the credit risk in the forward contracts cannot be completely
eliminated. However, the credit risk can be reduced by the netting of positions. She also adds that the credit risk
in case of futures contract are almost zero as they are regulated and clearing house acts as the counterparty.
Robert also asks her whether the futures exchange rate is a biased or unbiased predictor of the expected spot
exchange rate between the currencies. Christina replies that as the futures price is greater than the expected spot
price, it is a situation of a normal contango and the futures price is unbiased predictor of the expected spot price.
The spot exchange rates after 3 months and 6 months are given in the Exhibit 2.
Exhibit 2
Spot exchange rate after 3 months 412 ADM/USD
Spot exchange rate after 6 months 408 ADM/USD
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 5
1. What is the position taken by Christina in the forward market and at what price?
a) Short position at 409.84 ADM/USD
b) Long position at 409.84 ADM/USD
c) Long position at 398.24 ADM/USD
2. The reasons given by Christina for explaining the difference between the price of forward contract and
futures contract are
a) Both correct
b) Reinvestment rate reason is correct and Cost of borrowing reason is incorrect
c) Reinvestment rate reason is incorrect and Cost of borrowing reason is correct
3. Is the statement made by Christina regarding the reduction of credit riskiness of forward contracts
correct?
a) Yes
b) No, because the credit risk can be reduced by marking-to-market and not netting
c) No, because the netting increases the credit risk
4. Are the statements made by Christina about the expected spot rates and futures prices are correct?
a) Yes
b) No, because it is called normal backwardation when the expected spot rates are lesser than the futures
rates
c) No, because the futures rates are called the biased estimator of expected spot rate when they are not
equal in value
5. What is the net profit/loss from the forward position to the bank?
a) Profit of ADM 92.06 million
b) Loss of ADM 92.06 million
c) Loss of ADM 200 million
6. What is the value of the forward position after 3 months from the contract initiation to the Prometey
Bank?
a) ADM 5.05 million
b) -ADM 5.05 million
c) -ADM 252.62 million
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Yuya Takagi Case Scenario
Yuya Takagi is a CFA level II candidate. He is working in Snex Inc. which deals with various derivatives
instruments. Yuya’s job responsibility is to do delta hedging for the portfolios of clients.
Vaibhav Agarwal, a client, wants his portfolio hedged by using put options. The delta of one put option with one
unit of his portfolio is -0.60. The details of his portfolio are given in Exhibit 1.
Exhibit 1
Price per unit $12.00
Total number of units 2.5 million
Annual volatility of portfolio 18%
Hedging required for 3 months
Yuya discusses about the position with his colleague Shashank Sharma.
Yuya: It is very difficult to do perfect dynamic delta hedging as it involves lots of buying and selling as the delta of
the option changes with change in the underlying price.
Shashank: Yes. You should take position in the contract for which the changes in delta is less. The changes in the
delta of at-the-money options are very less. You must take position in the at the money options.
Yuya takes position in at the money, 3-month put options. 10 days after the position, the underlying price changes
to $13.5.
Yuya attends one seminar about option Greeks. He learns many details about the option Greeks in the seminar
and takes a learning session in his organization. He tells the following statements in his session:
Statement 1: The gamma is the change in delta of the underlying with the change in underlying price. Gamma is
maximum for at-the-money options. It is minimum for deep out-of-money and deep-in-the money options.
Statement 2: The vega measures the change in option price per unit change in volatility of the underlying. The call
option increases in value with increase in volatility and the put option decreases in value with decrease in volatility.
Statement 3: The theta of an option is generally negative. But it can be positive as well for deep out-of-money
American put options.
Statement 4: The rho measures the change in option price with change in the risk-free rate. With an increase in
risk-free rate, the call option value increases and the put option value decreases.
Statement 5: The delta of call option ranges from zero to +1 and the delta of put option ranges from -1 to zero.
Yuya also checks the inputs from the BSM model for strike of $10 and the underlying price of $13.5 which are
given in Exhibit 2.
Exhibit 2
N(d1) 0.55
N(d2) 0.30
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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7. What should be the position of Yuya Takagi in the put options for delta hedging and how many put
options does he need to buy/sell in the beginning?
a) Long position, 4.167 million
b) Short position, 4.167 million
c) Short position, 1.5 million
8. Is the statement made by Shashank correct regarding the changes in delta?
a) Yes
b) No, the changes in delta is maximum for at-the-money options
c) No, the changes in delta is zero for at-the money options
9. What is the most likely value of the delta of the put option after 10 days?
a) -0.75
b) -0.60
c) -0.45
10. Using Exhibit 2, calculate the position and quantity of the put options taken by Yuya after 10 days for the
delta hedging?
a) Long position in 1.389 million put options
b) Short position in 0.32 million put options
c) Long position in 0.32 million put options
11. Which of the statements made by Yuya are accurate?
a) Statement 1 and 5
b) Statement 1,4 and 5
c) Statement 1,2,4 and 5
12. Theta of an option can be positive for
a) Deep out-of-money European put option
b) Deep in-the-money European put option
c) Deep out-of-money American put option
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Anna Jain Case Scenario
Anna Jain, an entrepreneur, is an owner of a photography club. She took a loan of $100,000 for expanding the
business. The loan was a floating rate loan with floating interest payments as LIBOR+2% spread. The interest on
the loan is paid on a quarterly basis and the principal is due in 1 year. She is now worried about the interest rates.
She thinks that the interest rates can rise in future. So, she wants to take position into a vanilla fixed floating swap
as a fixed rate payer. The interest rates are given in the Exhibit 1.
Exhibit 1
90 days LIBOR 4.5%
180 days LIBOR 5.0%
270 days LIBOR 5.5%
360 days LIBOR 6.0%
She takes position into the fixed-floating swap. The 90-days LIBOR after 90 days changes to 5.2%. After 150
days, the interest rate changes. The interest rates after 150 days are given in Exhibit 2.
Exhibit 2
30 days LIBOR 5.5%
120 days LIBOR 6.3%
210 days LIBOR 7.0%
After doing this swap position, she gets more curious about the working and different types of swaps. She
discusses those swaps with her friend, Amna Ahmed, a CFA level II candidate. Amna explains that there are
various kinds of swaps in the market. Swaps can be on interest rates, equity, and currency swaps.
Anna Jain: Do all kind of swaps are of fixed-floating type?
Amna Ahmed: No. Swaps can be fixed-fixed and floating-floating type as well. There is a swap where the fixed
rate party may have to pay floating payment in some special scenario.
Anna Jain: Wow. That seems interesting. Tell me more about different kind of swaps.
Amna Ahmed: There is a swap where the notional principal declines with the level of interest rates and makes it
similar to asset-backed securities. In swap, you can also put a cap and floor on the floating rate payment. In some
swaps, the floating rate is set at the end of the period rather than at the beginning of the period and is paid also at
the same time.
Anna Jain: And what if the counterparty does not pay?
Amna Ahmed: There is always a credit risk in swaps as they are customized instrument. However, one can
decrease the credit risk by making use of netting.
Anna Jain: What do you mean by netting?
Amna Ahmed: In netting, only that party has to pay which has suffered the loss. For example, if the fixed
payment from one side is $250 and the floating side payment is $300. Then, instead of paying $250 and $300 to
each other, only the floating side can pay net $50 to the fixed side.
Anna Jain: That seems a great way to reduce the credit risk. But what about the last payment, especially in the
currency swaps. That’s a real big amount and if the other party defaults on that, then there is a big credit risk.
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Amna Ahmed: Yes. For currency swaps, credit risk is higher at the later stages of the swap. For other kinds of
swaps, the credit risk is maximum at the beginning of the swap.
Anna Jain: Thanks for the information. I think I also need to register for the CFA exam so that I can also learn
many things about the fascinating world of finance which can help me in my business.
Amna Ahmed: That’s great.
13. What is the fixed swap rate for Anna Jain?
a) 7.75%
b) 5.85%
c) 5.75%
14. What is the value of her swap position after 150 days?
a) $465.3
b) $503.7
c) $565.3
15. In which kind of swap, the fixed party might have to pay the floating rate payment?
a) Interest rate swap
b) Currency swap
c) Equity swap
16. In which kind of swap, the notional principal declines with the level of interest rates?
a) Constant maturity swap
b) Amortizing swap
c) Arrears swap
17. In which kind of swap, the floating rate is set at the end of the period rather than at the beginning of the
period and is also paid at the same time?
a) Basis swap
b) Overnight index swap
c) Arrears swap
18. Are the statements made by Amna Ahmed regarding the credit riskiness of different types of swaps
correct?
a) Yes
b) No, because the credit risk for the currency swap is maximum at the middle of the swap period
c) No, because the credit risk for the swaps other than the currency swaps, is maximum at the middle of
the swap period
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Shorya Gupta Case Scenario
Shorya Gupta is a derivatives trader in a commodity trading company. He trades futures contract and options
contract. He is expecting the gold prices to be quite volatile in coming future and wants to take position in the
option contracts of gold. The detail regarding gold price and volatility is given in Exhibit 1.
Exhibit 1
Spot price of gold $1,500
Up side movement (quarterly) 20%
Down side movement (quarterly) 20%
Risk-free rate (annually) 6%
He calculates the price of the American call option with 6-month to expiry and exercise price as $1,200. He finds
out that the price of the option is same as the price calculated by him and takes a long position in the option
contract. He calculates the price of the contract using two period binomial option pricing methodology. The
contract has 200 units of gold.
His colleague, Shubham, asks him why he didn’t use the Black-Scholes-Merton model of option pricing to
calculate the value of option. Shorya replies that the BSM model is used only to value European options and that
model cannot be used to value the American options.
They start discussing about the pricing of various kinds of options on forwards and futures contract.
Shubham: Gold is more liquid in forward and futures market. Are there any option contracts on forward and
futures market as well?
Shorya: Yes. There are option contracts on forward and futures market as well. But the option market is not that
liquid.
Shubham: What about the pricing of the contract on forward and futures market? Do the American and
European options have different value on forward and futures contract as well?
Shorya: The value of American and European option is same in case of option on futures contract. In case of
options on forward contract, the American option has more value than the European option.
At the expiry, the spot price of gold moves to $1,750. Shorya keeps the options till expiry.
The company has taken a long term loan. The loan is a floating rate annual coupon paying loan where the floating
rate is LIBOR+1.0%. Shorya’s manager Prashant Rajput, calls him and tells him that the company wants to
minimize the interest rate risk on the loan for the next year. The current LIBOR rate is 6% per annum. The
company does not want to pay interest more than 10% per annum. Also, the company does not mind paying
interest of 5%. The company wants to minimize the option premium.
Shorya advises that the company should buy a collar. The price of interest rate options for with one year to expiry
on a notional principal of $100,000 are given in the Exhibit 2.
Exhibit 2
Price of call option with 10% as exercise price $450
Price of put option with 5% as exercise price $550
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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19. What is the price of call option calculated by Shorya?
a) $353.04
b) $385.04
c) $392.07
20. What was his profit/loss in the position in the option contract? Assume that he bought only one contract.
a) $39,392.10
b) $32,992.55
c) $31,586.04
21. Is Shorya correct regarding the price difference between American and European options on forward and
futures contracts?
a) Yes
b) No, the price of American option is greater than or equal to European option when the option is on
futures contract and the prices of both American and European options are same when the option is
on forward contract
c) No, the price of American option is greater than or equal to European option in case of options on
both forward and futures contracts
22. What should be the collar position taken by Shorya?
a) Long call option and short put option
b) Long both call and put options
c) Short call option and long put option
23. What is the total interest saving at the end of 2nd
year from the call position if the LIBOR rate next year for
one year becomes 11%? Assume that the company’s outstanding loan is $1 million. Ignore the option cost
in this problem.
a) $20,000
b) $15,000
c) $10,000
24. What is the net profit from the collar transaction if the LIBOR rate next year for one year becomes 4%?
Assume that the company’s outstanding loan is $1 million.
a) -$9,900
b) -$9,000
c) $1,000
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Kapoor & Tiwari Case Scenario
Saurabh Gupta is a derivative trader at Kapoor & Tiwari Corporation. He mainly trades 10-year German
Government bonds known as bunds. He has taken long position in 10-year bonds. He is worried about the recent
PIIGS crisis where few countries defaulted on the scheduled payments of interest and principal. He doesn’t want
to take that risk. He is thinking of the ways to remove this credit risk. He along with his colleague trader, Ankit
Goyal, went to Nitesh Bansal, who is the research head of the organization, to discuss about the management of
credit risk.
Saurabh: I want to remove the credit risk of my portfolio which mainly consists of 10-year government bonds.
How can I do that?
Nitesh: You can go to the CDS market and buy the protection for your portfolio. You need to pay some CDS
premium to the protection provider. In case of default, the protection provider will pay you the difference
between the portfolio market value and the par value.
Ankit: I have taken almost the exact position taken by Saurabh. I want to take the excess credit risk. Isn’t it
possible that we both enter into a swap ourselves over the counter?
Nitesh: That would be perfect. CDS market is customized market only although it is becoming standardized in
recent years. You both can negotiate the swap premium and can enter into a swap. But the problem with this
customized swap would be that you might not be able to sell it back in the market because there might be very few
buyers for your swap. If Ankit defaults, then Saurabh has to buy the protection from the market at a higher price.
Ankit: How can we estimate the premium amount?
Nitesh: That would depend on the default probabilities for each period. You guys can ask Sagar Vedula about
valuation. He can explain you guys the valuation of CDS spreads.
Saurabh: Is there any other pay to protect myself from the credit risk?
Nitesh: You can also go for the total return swap. That would also take care of the credit risk.
After discussion with Nitesh, they went to Sagar Vedula to understand the valuation of CDS premium and finally
entered into the CDS position. The probability of the default is given in the Exhibit 1.
Exhibit 1
Year Probability of default
1 15%
2 10%
3 8%
4 8%
5 10%
They settled for a CDS of 80 basis points. The notional principal amount was $10 million. The spread was paid
by Saurabh to Ankit on an annual basis. The position will expire in 5 years.
The probability of default of the portfolio rises after the end of 3rd
year and the loss given default decreases.
Because of this the CDS increases to 135 points.
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25. In what scenario Ankit Goyal would be gaining from the CDS position?
a) Fall in credit risk leading to decrease in CDS
b) Rise in credit risk leading to increasing in CDS
c) None of the above
26. What is the annual amount received by Ankit in the 2nd
year if the market value of the spread increased to
120 basis points?
a) $40,000
b) $80,000
c) $120,000
27. Which of the following will take care of both interest rate risk and the credit risk?
a) CDS
b) Credit spread option
c) Total return swap
28. Suppose in the 2nd
year, Ankit goes bankrupt when the CDS spread has been increased to 120 basis
points. What kind of risk is faced by Saurabh because of that?
a) Double default risk
b) Replacement risk
c) CDS volatility risk
29. What is the cumulative probability of default after year 4? Use exhibit 1 for calculations.
a) 35.25%
b) 41.00%
c) 64.75%
30. What is the impact of the increase in probability of default and decrease in loss given default to the CDS?
a) CDS is directly proportional to the probability of default and inversely proportional to the loss given
default
b) CDS is indirectly proportional to the probability of default and directly proportional to the loss given
default
c) CDS is directly proportional to both the probability of default and the loss given default
The solutions can be downloaded from here.
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
© Konvexity 2012. All Rights Reserved. 14
Inaction breeds doubt and fear. Action breeds confidence and courage. If you want to conquer fear, do not sit
home and think about it. Go out and get busy. – DALE CARNEGIE
Comprehensive Test 2
Corporate Finance – Quiz (90 minutes)
Apple Mango Case Scenario
Apple is a renowned company in footwear making business. Sadiqa Rehana is CEO of apple. She is concerned
about the recent negotiations with its distributors. The distributors are demanding a high premium for selling
Apple’s products. Sadiqa is looking for acquiring one of the distributor company so that the cost of distribution
can be curtailed and they don’t have to spend too much time on negotiations and business could run smoothly.
She discussed it with Tran Nguyen, who is CFO of the company.
Tran Nguyen checks all the companies in footwear distribution business and finds out that Mango is a perfect
company for Apple to acquire because of its close proximity to Apple outlets. She expects that the synergy value
on acquiring Mango would be the largest than acquiring any of other distributors.
Sadiqa asks Tran about the procedure to acquire Mango. Tran says that there are two ways by which they can
acquire other company. One is by stock purchase and another is by asset purchase. Then she explains in detail
the advantages or disadvantages of these methods. Sadiqa states that Apple doesn’t want to take the liabilities of
the target company i.e. Mango’s liabilities. She also says that it would be better if they don’t have to require
Mango’s shareholder approval.
By considering various other factors they decide for the stock purchase method. They chose the comparable
company analysis method for valuation of the target company. The data for the comparable companies are
provided in Exhibit 1.
Exhibit 1
Comparable companies’ data
Valuation Variables Watermelon Orange Banana
Current stock price 15.00 18.00 12.00
Earnings per share 1.00 1.15 0.85
Cash flow per share 3.00 3.50 2.50
Book value per share 8.00 9.00 5.50
The data for the Mango are given in the Exhibit 2.
Exhibit 2
Mango Company Data
Earnings per share 1.80
Cash flow per share 5.00
Book value per share 12.00
The data for the recent takeovers similar to the target company is given in Exhibit 3.
Exhibit 3
Recent takeover transactions
Target Company Stock price prior to takeover Takeover price
Cucumber 12.00 15.00
Onion 10.00 13.00
Tomato 16.00 20.50
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They calculate the target’s price according to the mean of various comparable multiples and finally negotiate at a
price of $33. The stock of Mango is trading at $28 before the merger. The total outstanding shares of Mango are
2 million. The expected synergy from the transaction is $12 million.
1. What method Apple should choose for acquiring Mango as per Sadiqa’s comments?
a) Asset purchase method for liability point and stock purchase method for shareholder approval point
b) Stock purchase method for liability point and asset purchase method for shareholder approval point
c) Asset purchase method for both liability and shareholder approval points
2. What kind of merger is Apple doing with Mango?
a) Horizontal merger
b) Backward integration
c) Forward integration
3. What is the value of Mango according to mean price multiples if all the components (earnings per share,
book value per share, and cash flow per share) are given equal weightage?
a) $25.33
b) $26.50
c) $27.66
4. What is the estimated takeover price of the target? Use takeover premium as the mean of the takeover
premiums from Exhibit 3.
a) $32.35
b) $32.93
c) $33.84
5. What is the expected value of Apple after acquiring Mango? Assume that the pre-merger market value of
Apple was $120 million.
a) $120 million
b) $122 million
c) $132 million
6. According to the given expected synergy, how much percentage of the synergy’s benefits has been
awarded to the Mango’s shareholders?
a) 50.00%
b) 66.66%
c) 83.33%
K-SQUARE - THE NEWSLETTER ISSUE 1.1 - January 2013
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Désir Mporamazina and Konrad Biniewicz Case Scenario
Désir Mporamazina is a corporate finance manager of Vamro Corporation. His responsibilities are to make the
dividend policy for the firm. The firm wants to maximize shareholders’ wealth. Konrad Biniewicz is colleague of
Desir and works in the same department. Vamro is a cyclical company and is currently sitting at a good amount of
cash on its balance sheet. Desir and Konrad are thinking about what to do with this cash. There are not many
opportunities available which can take the intake of all the cash. The company has never paid dividend so far.
Konrad: The investors prefer dividend paying companies. The price multiples of dividend paying companies is
higher than the price multiples of non-dividend paying companies. Initiation of dividend will lead to a sharp rise
in Vamro’s price as the initiation of dividend is always taken as a positive signal.
Desir: You are right. But I am worried about the cyclicality nature of our business. We might not be able to
continue the dividend payment on a regular basis. That could have a negative impact on our share price.
Konrad: Since our business is a cyclical one, the payment of dividends will also lead to reduction of agency costs.
Desir: The tax rate on dividends payment is 30% and the capital gain tax rate is 25%. The floatation costs are also
rising. The expected volatility of the future earnings is decreasing. We need to consider all these factors into
account before going for the dividend payout.
Konrad: The firm comes under impairment of capital rule as well i.e. it cannot pay dividends in excess of retained
earnings. So, in future, it would be difficult for us to maintain a constant dividend payment stream considering the
cyclical nature of our business.
After discussing all the pros and cons of dividend payout policies, they decide for following the residual dividend
payout policy for Vamro. The data for Vamro is given in Exhibit 1.
Exhibit 1
Vamro Corporation Data
Earnings in last year $230 million
Capital budget required for next year $150 million
Target D/E ratio 0.50
Marginal tax rate 40%
The company is in a country which follows a double taxation system i.e. the earnings are taxed first at the
corporate levels and then dividends are taxed again.
The company is also considering repurchasing some of the shares. The management has asked the opinion of
Desir about this. The current book value is $12 per share and the repurchase price is $15 per share. The
company doesn’t have adequate money to buy back the shares. It has to raise the debt to fund the shares. The
current market yield of the debt raised by the company is 10%. The earning yield on the company’s shares is 8%.
Desir: Since the earning yield is less than the yield of the company’s debt, it will lead to an decrease in EPS. A
decrease in EPS would have negative consequences for the company.
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7. There are three factors mentioned by Desir which need to be considered before forming a dividend
payout policy. Which of the factors mentioned would have positive impact on the dividend payout ratio?
a) Tax rate on dividends and capital gain
b) Expected volatility of future earnings
c) Floatation costs
8. Which of the following statements made by Konrad is least likely to be accurate?
a) Regarding initiation of dividends
b) Regarding agency costs
c) Regarding impairment of capital rule
9. What is the dividend amount distributed to the shareholders for the current period according to residual
dividend payout policy?
a) $80 million
b) $130 million
c) $155 million
10. What is the effective tax rate for dividend payment for Vamro Corporation?
a) 42.00%
b) 58.00%
c) 70.00%
11. What will be the impact of share repurchase on the book value per share of the company?
a) Book value per share will decrease after the share repurchase
b) No impact on the book value per share
c) Book value per share will increase after the share repurchase
12. What will be the impact on the EPS if the company plans to borrow debt to repurchase the shares?
a) Increase in EPS
b) No impact on EPS
c) Decrease in EPS
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Shiv Mehta Case Scenario
Shiv Mehta is a project manager for Mehta Medicos. Mehta Medicos is a company in medical equipment
business. The primary business of the company is to manufacture medical equipment.
The company wants to replace old equipment manufacturing machine which is working inefficiently now. The
existing machine was bought 5 years ago at a cost of $20,000. It is being depreciated using straight line
depreciation method assuming a useful life of 10 years and a salvage value of $2,000.
The new machine can be purchased for $30,000 including transportation and installment charges. Its estimated
life is 8 years and it is depreciated using U.S. MACRS, 7-year recovery period. The depreciation rates under U.S.
MACRS for a 7-year recovery period are given in the Exhibit 1.
Exhibit 1
Depreciation rates under U.S. MACRS (7-year recovery period)
Year 1 2 3 4 5 6 7 8
Depreciation rate 14.29% 24.49% 17.49% 12.49% 8.93% 8.93% 8.93% 4.45%
The estimated salvage value for the new machine is $5,000. The current market value of the old machine is
$4,000. The marginal tax rate of the company is 40%. Net working capital requirement for the new machine will
increase by $2,000 at the time of replacement.
On replacing the older machine with the newer one, there will be a reduction in the operating costs. The
operating costs are estimated to decrease as per the Exhibit 2.
Exhibit 2
Decrease in operating costs due to new machine
Year Decrease in operating
costs
1 $9,000
2 $9,000
3 $8,000
4 $8,000
5 $8,000
6 $7,000
7 $6,000
8 $5,000
Shiv Mehta raises the capital for the project using D/E ratio of 2.0. He also calculates the NPV of the project
which comes out to be positive.
The CEO of the firm asks Shiv Mehta to make changes in few of the variables and see the impact of those
changes in the NPV of the project. Shiv Mehta makes three cases: the most likely case, the worst case, and the
best case. The NPV for those three cases comes out to be $3,000, -$2,000 and $10,000 respectively.
The CEO of the firm checks the NPV calculation done by the Shiv Mehta and notices the following things:
(A)The sunk cost has not been taken into account
(B) The opportunity cost of the project has not been taken into account
(C) The cash outflows due to financing of capital has not been subtracted from the cash flows
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13. What is the initial investment outlay for the replacement of old machine with the new machine?
a) $25,200
b) $25,600
c) $28,000
14. What are the operating cash flows for the 3rd
year?
a) $6,098.8
b) $6,178.8
c) $9,378.8
15. What is the value of terminal year cash flows?
a) $3,534
b) $5,000
c) $8,534
16. Assuming that the profitability index value for the project is 1; compute the cost of capital of the project.
a) 15.72%
b) 17.47%
c) 18.36%
17. What kind of analysis has been done by Shiv Mehta for the project as specified by the CEO of the
company?
a) Sensitivity analysis
b) Scenario analysis
c) Simulation analysis
18. Which of the following points will lead to incorrect estimation of NPV of the project?
a) Point A
b) Point B
c) Point C
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Mona Rajpal Sadeeza Case Scenario
Mona Rajpal Sadeeza is director at Monalisha International. Monalisha International is in hospitality business.
The company has been a pioneer in hospitality and acquired a niche among its customers. Because of the
customer delight, it has been able to grow exponentially. The company is sitting on a heavy pile of cash. But the
stock of the company has not shown that much growth. The stock is still ignored by many investors.
Mona calls the newly hired CFO of the company, Priyanka Jhunjhunwala. She tells her about the problem the
company is facing. The company doesn’t have those many projects to reinvest all the cash it has got. The
company is debt free and has 100% equity in its capital structure. She asks her about the optimal capital structure
that the company should follow.
Priyanka replies that the reason for the low stock price is due to high cost of capital. The company is not taking
advantage of the cheaper cost of debt. The cost of debt is cheaper than the cost of equity. The interest on debt is
also tax-deductible. However, there is one problem with raising too much debt. With raising debt, the bankruptcy
cost increases and that leads to further increase in cost of debt and cost of equity. There is one point where the
capital structure is optimal i.e. the point where the cost of capital is minimum. We should find that optimal point
and try to maintain that target capital structure.
Then she talks about the agency costs. There are three kinds of agency costs: monitoring costs, bonding costs, and
residual losses. She mentions that raising debt will lead to increase in agency costs.
Priyanka estimates the before-tax cost of debt and cost of equity for various proportions of debt and equity. The
data is given in Exhibit 1.
Exhibit 1
Proportion of debt Cost of debt Proportion of equity Cost of equity
0% - 100% 12%
20% 8% 80% 12%
40% 9% 60% 13%
50% 10% 50% 13%
60% 12% 40% 16%
80% 15% 20% 20%
100% 20% 0% -
Priyanka calculates the cost of capital for different proportions and finds out the optimal target capital structure.
She submits her findings to Mona. She looks at her recommendations and asks whether they always have to
follow this capital structure or they can have some deviation from it.
Priyanka: The firm can fluctuate from its target capital structure. Changes in market value of debt and equity can
lead to different capital structure weight temporarily. Management can also exploit specific financing source and
can deviate from the target capital structure.
She also adds that the changes in marginal tax rate can also impact the capital structure. The marginal tax rate for
the company is 40%.
Finally Mona asks her about the impact of macroeconomic factors like inflation and GDP growth rate on the
usage of debt in the capital structure.
Priyanka: The higher inflation rate will lead to lower usage of debt and the higher GDP growth rate will lead to
higher usage of debt.
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19. Which capital structure theory Priyanka is talking about when she mentioned about an optimal capital
structure?
a) MM Proposition II (With taxes)
b) Pecking order theory
c) Static trade-off theory
20. Which kind of agency cost is borne by the management?
a) Monitoring costs
b) Bonding costs
c) Residual losses
21. Is Priyanka accurate about her statement regarding the affect of raising debt on agency costs?
a) Yes, because the company has to pay regular payments on debt which would decrease liquidity
b) Yes, because it can lead to residual losses
c) No, because raising debt will make management more efficient and thus reducing the monitoring
costs and cost of asymmetric information
22. What is the optimal structure capital structure for Monalisha International?
a) 20% debt and 80% equity
b) 40% debt and 60% equity
c) 50% debt and 50% equity
23. Suppose the equity becomes undervalued in the market and the management decides to exploit this
source of financing. What is the most likely impact of this step by management on the target capital
structure?
a) The proportion of equity will rise in the capital structure
b) There will be no impact
c) The proportion of equity will fall in the capital structure
24. Is Priyanka correct about the impact of macroeconomic factors on the capital structure weights?
a) Correct for both inflation and GDP growth rate
b) Correct for inflation and incorrect for GDP growth rate
c) Incorrect for inflation and correct for GDP growth rate
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Rubik’s Cube Addict Case Scenario
Ashish Gupta is co-founder of Rubik’s Cube Addict company. The company has grown at a tremendous rate
mainly due to inorganic growth. The company is into entertainment business. It has acquired many small
companies. The motivation for acquiring most of the companies has been bootstrapping earnings. The company
has been able to manage to increase the EPS after acquiring these companies. The list of companies acquired and
their pre-acquiring details have been provided in the Exhibit 1.
Exhibit 1
Company Garbage Bin Troll India Faking News Troll Football Aap CFA Hain
Stock Price $50 $20 $12 $40 $60
EPS $2.5 $0.8 $0.5 $2 $1.5
P/E 20 25 24 20 40
Total shares
outstanding
50,000 100,000 150,000 80,000 120,000
Ashish has done hostile mergers most of the times rather than friendly mergers. While acquiring Troll India, he
bypassed the company’s CEO and submitted the merger proposal directly to the company’s board of directors.
The acquisitions of the companies have not always been smooth. Many companies have tried pre-offer and post-
offer defense mechanisms to stop the acquisition.
Garbage Bin had a mechanism set in that the shareholders of it have the right to receive the shares of the
acquiring company at a significant discount.
Troll India had a mechanism set by which the management executive will receive lucrative payouts, usually several
years’ worth of salaries, if they leave the company following a change in corporate control.
Faking news sold off its most profitable subsidiary to a third party during the acquisition process.
Troll Football tried a defense technique known as white squire where the target seeks a friendly party to buy a
substantial minority stake in the target- enough to block the hostile takeover without selling the entire company.
Aap CFA Hain had the policy that the shareholders who have recently acquired large blocks of stock would not
be able to vote without the approval of the company’s board.
The pre-merger Herfindahl-Hirshman Index (HHI) and change in HHI after the acquisition of the companies
has been given in Exhibit 2.
Exhibit 2
Company Acquired Pre-merger HHI Change in HHI
Garbage Bin 1,340 230
Troll India 1,570 70
Faking News 1,640 140
Troll Football 1,780 75
Aap CFA Hain 1,855 40
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25. What is the percentage increase in the EPS of the company after acquiring Faking News? Assume that the
company had 200,000 shares outstanding before acquiring and EPS of $4 and the stock price was trading
at a P/E multiple of 30. It paid the Faking News’ shareholders by issuing 1 share for 10 shares of Faking
News.
a) 1.12%
b) 1.74%
c) 2.58%
26. Which of the companies given in the Exhibit 1 is least likely to be acquired for the bootstrapping
earnings? Use the data from the previous question to support your answer.
a) Garbage Bin
b) Troll India
c) Aap CFA Hain
27. The tactic applied by Ashish to acquire Troll India is known as:
a) Bear hug
b) Tender offer
c) Proxy fight
28. The provision set by Garbage Bin to avoid the acquisition is known as:
a) Flip-in-pill
b) Flip-over-pill
c) Dead-hand provision
29. Which of the following companies didn’t try pre-offer defense mechanism?
a) Garbage Bin
b) Faking News
c) Aap CFA Hain
30. What is the possible Government action during merger of Troll Football and Rubik’s Cube Addict?
a) No regulatory action
b) Possible regulatory action
c) Challenge the merger
The solutions can be downloaded from here.
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