SFM Paper May 2010 (Solutions)
Strategic Financial Management May 2010
Question 1. (a) (12 Marks)
XY Ltd. has under its consideration a product with an initial investment of Rs.1,00,000. Three probable cash inflow scenarios with their probabilities of occurrence have been estimated as below:
| Annual cash inflow (Rs.) | 20,000 | 30,000 | 40,000 |
| Probability | 0.1 | 0.7 | 0.2 |
The project life is 5 years and the desired rate of return is 20%. The estimated terminal values for the project assets under three probabilities alternatives, respectively are Rs.0, 20000 and 30,000. You are required to :
(i) Find the probable NPV
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of worst case, if the cash flows are perfectly positively correlated over time.
Answer to Q. No. 1 (a)
(i)
| Probability ↓ | NPV Estimate |
| 0.1 | -1,00,000 + 20,000 x 2.991 + 0 = - 40,180 |
| 0.7 | -1,00,000 + 30,000 x 2.991 + 20,000 x 0.402 = - 2,230 |
| 0.2 | -1,00,000 + 40,000 x 2.991 + 30,000 x 0.402 = + 31,700 |
Calculation of probable NPV:
-40,180(0.10) – 2230(0.7) + 31,700(0.2) = + 761
(ii) Worst-case NPV : - 40,180
Best–case NPV : +31,700
(iii) Probabilities of occurrence of worst ( CF + correlated) = 0.10
Question 1. (b) (4 Marks)
Mr. A purchased a 3-month call option for 100 shares in XYZ Ltd at a premium of Rs.30 per share, with an exercise price of Rs.550. He also purchased a 3-month put option for 100 shares of the same company at a premium of Rs.5 per share with an exercise price of Rs.450. The market price of the share on he date of Mr. A’s purchase of options is Rs.500. Calculate the profit or loss that Mr. A would make assuming that the market price falls to Rs.350 at the end of 3 months.
Answer to Q. No. 1 (b)
Profit / Loss on Options
| | Call | Put | Total |
| Premium | -30 | -5 | -35 |
| Value on Maturity | 0 | +100 | +100 |
| Total | +65 | ||
Total profit = Rs.6,500.
Question 1. (c) (Marks 4)
Explain briefly, how financial policy is linked to strategic Management.
Answer :
Financial policy: Policies are guides of company, they guide the company towards their goals. Policies are broad guidelines set by the top management in consultation with the experts. The company is expected to follow these guidelines. Financial guidelines provide guidance in the financial matters. For example, a firm’s financial policy may be to keep the debt equity ratio at low level, say, 1 by 1. The other policy may be to keep all the foreign exchange risk hedged. It may be that lives of the projects taken by the company should not be more than 10 years etc.
Financial policies are link between:
· the Management people ( they are expected to achieve the objective of wealth maximization in the long run through maximization of EPS while keeping the risk at optimum level)
· the strategic financial decisions.
The financial policies are guiding force behind the strategic financial decisions. Such policies should be based on the corporate vision and values. Hence:
(i) the policies should be framed after due consideration of the present and prospective scenarios
(ii) the policies should provide some flexibility to the people who have to take the decisions
(iii) the policies should provide their exceptions i.e. the situations when the deviation from the policies could be made
(iv) the policies should be reviewed from time to time. the policies should not be too restrictive, these should provide only broad guidelines.
Question 2. (a) (10 Marks)
P Ltd had decided to acquire a machine costing Rs,50 Lakhs through leasing. Quotations from 2 leasing companies have been obtained which are summarized:
| | Quote A | Quote B |
| Lease term | 3 years | 4 years |
| Initial lease rent | Rs.5.00 Lakhs | Rs.1.00 Lakh |
| Annual lease rent payable in arrear | Rs,21.06 Lakhs | Rs.19.66 Lakhs |
P Ltd evaluates investment proposals at 10% cost of capital and its effective rate is 30%. Terminal payment in both the cases is negligible and may be ignored.
Make calculations and show which quote is beneficial to P Ltd. Present value factors at 10% rate for years 1-4 are respectively 0.91, 0.83, 0.75 and 0.66. Considerations may be rounded off to 2 decimals in Lakhs.
Answer to Q.No. 2 (a)
DCF Analysis of each of two proposals regarding Lease
| | Rs. Lakhs | |||||
| Quote A | Quote B | |||||
| | Period | PVF/A | CF | PV | CF | PV |
| Initial lease rent | 0 | 1 | -5.00 | -5.00 | -1.00 | -1.00 |
| Tax savings on Initial lease rent | 1 | 0.91 | +1.50 | 1.37 | +0.30 | +0.27 |
| Annual lease rent less tax savings | 1-3 | 2.49 | -14.74 | -36.71 | -13.76 | -34.26 |
| ---do--- | 4 | 0.68 | | | -13.76 | -9.36 |
| NPV | -40.34 | | -44.35 | |||
| | A | B |
| Equalized Annual cost | 40.34L/2.49 =Rs.16.20L | 44.35L/3.17 = Rs.13.99L |
Quote B is recommended.
Question 2. (b) (6 Marks)
Based on the following information, determine the NAV of the regular income scheme on per unit basis:
| | Rs. Crores |
| Listed shares at cost (Ex-dividend) | 20 |
| Cash in hand | 1.23 |
| Bonds and debentures at cost Of these, bonds not listed and quoted | 4.3 1 |
| Other fixed interest securities at par | 4.5 |
| Dividend Accrued | 0.8 |
| Amount payable on shares | 6.32 |
| Expenditure incurred | 0.75 |
| No. of units (Rs.10 Face Value) | 20 Lakhs |
| Current lrealizable value of fixed income securities of face value Rs.100 | 106.5 |
| The listed shares were purchased when index was 1000. present Index is 2300. | |
| Value of listed bonds and debentures at NAV date | 8 |
| There has been a diminution of 20% in unlisted bonds and debentures. Other fixed interest are at cost. | |
Answer to Q. No.2 (b)
Note: Current realizable value of fixed income securities = Rs.106.50. It is assumed that it includes accrued interest of Rs.6.50.
| Assets: | Rs. Crores |
| Listed shares | 46.00 |
| Cash | 1.23 |
| Listed Bonds | 8.00 |
| Unlisted Bonds | 0.80 |
| Fixed income securities ( including interest accrued) | 4.7925 |
| Div. accrued | 0.8000 |
| Total | 61.6225 |
| Liabilities | Rs. Crores |
| Amount payable on shares | 6.32 |
| Expenses Accrued | 0.75 |
| Total | 7.07 |
| | |
| Net Assets | Rs.54.5525Crores |
NAV = 54.5525/0.20 = 272.7625
Question 2. (c) (4 Marks)
How is a stock market index calculated? Indicate any two important market indices.
Answer: (The answer given here is quite detailed one so that the students may understand the concept. In the exam, all these points may be given briefly)
A share price Index is used to monitor and measure the share price movements over a period of time as compared to the base year. Share market indexes (also called as indices) are meant to capture the overall behavior of equity markets. A stock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector. An Index is calculated with reference to a base period and a base index value.
Example: A small number of shares are listed on a small stock exchange in a small country. Five shares, out of the listed shares, are considered to be the representative of the stock exchange. Using the date given below, calculate (a) market capitalisation based weighted index numbers and (c) free-float based weighted index numbers at the close of 31st Dec. 2006 and 31st Dec, 2007 based on opening prices of 1st January, 2001 assuming base value to be 100.
| Equity shares of | Opening Share price | Closing share prices | Closing share prices | No. of shares |
| Girdhari Ltd | 210 | 315 | 360 | 10,000 |
| Banwari Ltd | 300 | 400 | 450 | 20,000 |
| Bihari Ltd | 410 | 600 | 660 | 5,000 |
| Murari Ltd | 80 | 160 | 200 | 25,000 |
| Ras Bihari Ltd | 50 | 80 | 100 | 50,000 |
| Total | 1050 | 1555 | 1770 | |
Assume that 40% shares of Girdhari, 45% shares of Bnawari, 50% shares of Bihari, 20% shares of Murari and 90% shares of Ras Bihari are free-float.
Answer : Working notes.
| Market capitalization | Free float market capitalization | ||||
| Opening ‘01 | Closing ‘06 | Closing '07 | Opening ‘01 | Closing ‘06 | Closing ‘07 |
| 210 x 10,000 | 315 x 10,000 | 360 x 10,000 | 210 x 10,000 x 0.40 | 315 x 10,000 x 0.40 | 360 x 10,000 x 0.40 |
| 300 x 20,000 | 400 x 20,000 | 450 x 20,000 | 300 x 20,000 x 0,45 | 400 x 20,000 x 0.45 | 450 x 20,000 x 0.45 |
| 410 x 5,000 | 600 x 5,000 | 660 x 5,000 | 410 x 5,000 x 0.50 | 600 x 5,000 x 0.50 | 660 x 5,000 x 0.50 |
| 80 x 25,000 | 160 x 25,000 | 200 x 25,000 | 80 x 25,000x .20 | 160 x 25,000x .20 | 200 x 25,000x .20 |
| 50 x 50,000 | 80 x 50,000 | 100 x 50,000 | 50 x 50,000x .90 | 80 x 50,000 x 0.90 | 100 x 50,000x .90 |
| 14,650 | 22,150 | 25,900 | 7,215 | 10,760 | 12,640 |
| | Market capitalization Based Index | |
| Date | Value | Index |
| 1.1.2001 | 14,650 | 100 |
| 31.12.06 | 22,150 | ( 22,150 / 14,650) x 100 = 151.19 |
| 31.12.07 | 25,900 | ( 25,900 / 14,650) x 100 = 176.79 |
| Examples of the method : Some index numbers of NSE, for example : S&P CNX 500. | ||
| | Free Float Market capitalization Based Index | |
| Date | Value | Index |
| 1.1.2001 | 7,215 | 100 |
| 31.12.06 | 10,760 | (10,760 / 7,215) x 100 = 149.13 |
| 31.12.07 | 12,640 | (12,640 / 7,215) x 100 = 175.19 |
| Examples of the method : All index numbers of BSE, for example : Sensex | ||
Sensex and Nifty are two important share indices in
Sensex is an index number that measures the relative average change in prices of 30 shares listed in the Bombay Stock Exchange Ltd (BSE). Though the index number measures the ups and downs in the prices of only thirty shares listed in BSE, it is considered as the representative of Indian Stock market. It is calculated on a free-float market capitalization methodology. The base year of SENSEX is 1978-79 and the base value is 100.
Nifty tracks the performance of equity share of 50 important companies listed on NSE. The companies have been selected from 22 sectors of the economy. The base of the index is the close of prices on
Question 3. (a) (12 Marks)
The following information is given for 3 companies that are identical except for their capital structure:
| | | Grape | Apple |
| Total capital invested | 1,00,000 | 1,00,000 | 1,00,000 |
| Debt /assets ratio | 0.8 | 0.5 | 0.2 |
| Shares outstanding | 6,100 | 8,300 | 10,000 |
| Pre-tax cost of debt | 16% | 13% | 15% |
| Cost of equity | 26% | 22% | 20% |
| EBIT | 25,000 | 25,000 | 25,000 |
| Net Income | 8.970 | 12,350 | 14,950 |
The tax rate is uniform 35% in all cases.
(a) compute the weighted average cost of capital for each company
(b) compute EVA for each company
(c) based on EVA, which company would be considered for best investment?
Give reasons.
(d) If the industry PF ratio is 11x, estimate the price for the share of each company.
(e) Calculate the estimated market capitalization for each of the companies.
Answer to Q. No. 3(a)
(a)
| Source of finance | Cost (X) | Weight (W) | XW |
| Debt | 10.40 | 0.80 | 8.32 |
| Equity | 26.00 | 0.20 | 5.20 |
| Weighted average cost of capital of | 13.52 | ||
| Source of finance | Cost (X) | Weight (W) | XW |
| Debt | 8.45 | 0.50 | 4.225 |
| Equity | 22.0 | 0.50 | 11.00 |
| Weighted average cost of capital of Grape | 15,225 | ||
| Source of finance | Cost (X) | Weight (W) | XW |
| Debt | 9.75 | 0.20 | 1.95 |
| Equity | 20.00 | 0.80 | 16.00 |
| Weighted average cost of capital of Apple | 17.95 | ||
(b) EVA
| Name of | Calculation of EVA EVA=EBIT – Tax on EBIT – 9WACC x Capital employed) | EVA |
| | 25,000 – 8750 – (0.1352 x 1,00,000) | 2,730 |
| Grape | 25,000 - 8750 – (0.15225 x 1,00,000) | 1,050 |
| Apple | 25,000 - 8750 – (0.1795 x 1,00,000) | -1,700 |
(c) Based on EVA,
(d) Industry’s PE is 11.
Let’s assume that
Let’s assume that Grape’s PE is 11 (because of normal financial risk on account of moderate debt /assets ratio)
Let’s assume that apple’s PE is 12 (because of low financial risk on account of low debt /assets ratio)
| Name of | EPS | PE ratio | Market price |
| | 8970/6100 = 1.47049 | 10 | Rs.14.70 |
| Grape | 12,350/8.300=1.48795 | 11 | Rs.16.37 |
| Apple | 14,950/10,000=1.495 | 12 | Rs.17.94 |
(e)
| Name of | MP/share(Rs) | No. of shares | Market capitalization (Rs) |
| | 1470 | 6,100 | 89.670 |
| Grape | 16.37 | 8,300 | 1,35,871 |
| Apple | 17.94 | 10,000 | 1,79,400 |
Question 3. (b) (4 Marks)
The rate of inflation in
Answer to Q. No.3 (b) : Spot rate : 1 USD = Rs.46
1 year forward : 1 USD(1.04) = Rs.46(1.08)
1 USD = Rs.47.77
4 year forward : 1 USD(1.04)4 = Rs.46(1.08)4
1 USD = Rs.53.50
Question 3. (c) (4 Marks)
List and briefly explain the main functions of an investment bank.
Answer (The answer given here is quite detailed one so that the students may understand the concept. In the exam, all these points may be given briefly)
Commercial banking refers to raising the funds (mainly through taking deposits) and providing commercial and retail loans. Investment banking provides all the financial services to the corporate, governments and government agencies, other business entities, non-profit organizations and high net worth individuals. They provide total financial services at one-stop shop. Their services include:
(i) issue management – public as well right issues – equity as well debt (a) advisory services – timing, size & composition and pricing of issue (b) preparation of offer documents with due care & diligence and compliance of legal formalities (c) offering the securities to the public/ shareholders (d) underwriting of the securities (e) ensuring smooth completion of the issue (f) Post issue services – allotment, exercise of Greenshoe option
(ii) Management of buy back of shares – Buy back is used by cash rich companies to (i) increase the value of shares (ii) avoid hostile takeover (iii) delisting the shares (iv) optimization of the capital structure. (a)Compliance of the provisions of Company Law and SEBI regulations (b)Smooth completion of the buy back
(iii) Loan syndication
(a) negotiation with loan provides like banks, financial institutions
(b) preparation of information memorandum
(c) presentation of information memorandum
(d) negotiating the terms
(e) smooth completion of transaction
(iv) Private placement of equity as well debt
(a) preparation of Information Memorandum
(b) legal compliances – particularly in case of listed companies
(c) placement of the securities to high net worth individuals, financial institutions and other buyers like Private equity
(v) Amalgamations and Absorptions
· Advisory services
· Valuation of both the companies for deciding the swap ratio
· Legal compliances – meetings of share holders, filing petition with High court
· Liaison with stock exchange(s) for listing of the securities issued as purchase consideration and delisting of the shares of the amalgamated company
· Ensuring completion deal
(vi) Takeover and acquisition :
· Advisory services
· Valuation of both the companies for deciding the swap ratio
· SEBI compliances – meetings of share holders, filing petition with High court
· Liaison with stock exchange(s) for listing of the securities issued as purchase consideration
· Ensuring completion deal
(vii) Research and develop opinions on securities, markets, and economies
(viii) Management of investment portfolios – cash rich companies place their surplus cash with the investment banks for investing in various securities for obtaining appropriate return and maintaining the risk at affordable levels.
(ix) Trading in the securities.
(x) Securitization Debt.
The main source of income for the investment banks is the fees they charge for providing the financial services. They also earn income from trading the securities on their own behalf.
Question 4. (a) (16 Marks) T Ltd and E Ltd are in the same industry. The former is in the negotiation for acquisition of the later. Important information about the
two companies as per their latest financial statements is given below:
| | T Ltd | E Ltd. |
| Rs.10 equity shares outstanding | 12 Lakhs | 6 Lakhs |
| Debt : 10%debentures Rs.lakhs 12.5% Institutional Loan Rs.Lakhs | 580 ---- | - 240 |
| EBIDT* Rs Lakhs | 400.86 | 115.71 |
| Market price/share (Rs.) | 220 | 110 |
* Earning Before Interest, Depreciation and tax.
T Ltd is planning to offer a price for E Ltd, business as a whole which will be 7 times EBIDTA reduced by the outstanding debt, to be discharged by own shares at market price.
E Ltd is planning to seek one share in T Ltd for every two shares in E Ltd based on the market price. Tax rate for the two companies may be assumed as 30%.
Calculate and show the following under both alternatives- T Ltd,s offer and E Ltd’s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd after acquisition
(iv) Expected market price per share of T Ltd after acquisition
(v) State briefly the advantages to T Ltd from the acquisition.
Calculations ( except EPS) may be rounded off to two decimal places in Lakhs
Answer to Q.No.4(a)(i) and (ii)
| | T Ltd’s offer | E Ltd’s plan: |
| Consideration fro share- holders | (Rs.115.71L x 7) – (Rs.240L) = Rs.569.97L | 3L x Rs.220 = Rs.660 L |
| No of shares of T to be issued | Rs.569.97L/Rs.220 = 2,59,077 shares | 3,00,000 shares |
(iii)
| | T Ltd | E Ltd |
| EBIDT Interest Deprecation (See Note 1)) Tax EAT | Rs.400.86L -Rs.58.00L -Rs.193.2L -Rs.44.898L Rs.104.762L | Rs.115.71L -Rs.30.00L -Rs.54.00L -Rs.9.513L Rs.22.197L |
| No. of shares | 12L | 6L |
| EPS | 8.7302 | 3.6995 |
Note 1: Assumption: Fixed assets are 60% of Value of business and depreciation rate is 10%
| | Market value of shares | Value debt | Total value | Fixed assets | Depre-ciation |
| T Ltd | 12Lx Rs.220= Rs.2640L | Rs.580L | Rs.3,220L | Rs.1932L | Rs.193.20 |
| E Ltd | 6Lx Rs.110 = Rs.660L | Rs.240L | Rs.99L | Rs.540L | Rs.54 |
iv)
| | T Ltd’s offer | E Ltd’s plan: |
| EPS after Acquisition | (Rs.104.762L+ Rs.22.197L)/14.59077L= Rs.8.7013 | (Rs.104.762L+ Rs.22.197L)/15L = Rs.8.4639 |
| Expected MP of T’share after acqui. | [(Rs.220 x 12L) + (Rs.110 x 6L)] / [14.59077L] = Rs.226.17 | [(Rs.220 x 12L) + (Rs.110 x 6L)] / [15L] = Rs.220.00 |
(v)
(i) Mergers and Acquisitions can generate cost efficiency through economies of scale.
(ii) The firm gains higher competitiveness resulting in increased revenue and lower business risk.
(iii) The firm gains increased market share.
(iv) Co-insurance effect i.e. lower cost of borrowings
Question 4. (b) (4) Marks)
(The answer given here is quite detailed one so that the students may understand the concept. In the exam, all these points may be given briefly) |
Exchange Traded Funds (ETFs) issue their units, referred as creative units, to the investors. These units represent some commodity or a basket of securities and are traded in the stock exchange throughout the trading day, allowing for intraday trading. Such funds are managed passively.
Basket of securities based ETFs
Such funds track a benchmark share index i.e. the underlying assets of such funds are shares which constitutes some Shares Index Number/ share price indicator. For example, Dow Jones Industrial average is world’s one of the oldest and most popular share prices indicator. It indicates the change in prices of equity shares of 30 largest and most widely held companies in the
The sponsors of the ETFs are referred as authorized participants. They are institutional investors/ super-rich individuals. They appoint a fund manager for the purpose of constituting an ETF. The authorized participants transfer shares to the fund manager. The total transfer should be in the ratio in which the shares are represented in the share market indicator they want to track. For example, if the ETF is to track the Dow Jones Industrial average, there should be equal number of shares of the 30 companies which constitute the DJIA. These are deposited with the custodian. Now the fund manager will issue the creative units to the authorized participants for the shares they have transferred. Suppose there are 10 authorized participants; they transferred in all 1,00,000 shares of each of the 30 companies. Further suppose that the fund manager issued 1,00,000 creative units , then each creative unit is representing one share of each of these 30 companies. If the fund manager issued 2,00,000 creative units, then each creative unit represents 0.50 share of each of these 30 companies.These creative units are issued to the authorized participants in the ratio of the value of the shares they transferred to the fund manager. Now these creative units are listed in the stock exchange. These are traded as the shares are traded. Any one buy/sell these creative units in the exchange at the current market price.
The authorized participants can get more creative units issued by transferring the shares to the fund manager or by making payment of these shares. Suppose, originally 1,00,000 shares of each of 30 companies were transferred to the fund manager and for these 100000 creative units were issued. Now suppose some participants transferred 30,000 shares of each of these companies to the fund manager, the fund manager will issue them 30000 creative units. Alternatively, suppose the some of the participants paid the fund manager an amount equal to price of 30000 shares of each of these 30 companies, the fund manager will buy the shares and issue creative units to the authorized participants (who made the payment).
The authorized participant (s) can accumulate minimum number ( as decided at the time of formation of the ETF) of creative units and get them converted into the shares they represent. Other investors (who purchase the creative units from the share market) can not get the creative units created or redeemed.
In
Commodity based ETFs (For example, Gold ETF)
In such ETFs, the underlying asset is some asset, say gold. The authorized participants appointed fund manager makes new fund offer to the public, the amount so collected is invested in gold and creative units are issued to the investors. (Generally, each creative unit represents 1 gm of 24 carrot gold). These units are listed, and traded in the stock exchange.
After the listing, the authorized participant (s) can transfer gold to the fund manager and get the creative units issued.
The authorized participant (s) can accumulate minimum number ( as decided at the time of formation of the ETF) of creative units and get them converted into the gold represented by these units. Other investors (who purchase the creative units from the share market) can not get the creative units created or redeemed.
Gold ETFs in
Gold ETFs offer cost effective, transparent and convenient way of investing in the gold.
Question 5. (a) (8) Marks) Consider the following data for Government securities:
| Face value ( Rs.) | Interest rate% | Maturity (years) | Current Price (Rs) |
| 1,00,000 | 0 | 1 | 91,000 |
| 1,00,000 | 10.5 | 2 | 99,000 |
| 1,00,000 | 11.0 | 3 | 99,500 |
| | 11.5 | 4 | 99,900 |
Calculate the forward interest rates.
This question is quite similar to Q. No. 5 (a) of Nov.2007 MAFA Paper
Question 5. (b) (8) Marks)
The following market data are available:
Spot : USD/JPY 116
| Deposit rates p.a. | USD | JYP |
| 3 months | 4.50% | 0.25% |
| 6 months | 5.00% | 0.25% |
Forward Rate Agreement for YEN is NIL. 1. What should be 3 months FRA at 3 months forward? 2. the 6 and 12 months LIBORs are 5% & 6.60% respectively. A bank is quoting 6/12 USD FRA at 6.50%-6.75%. Is any arbitrage opportunity available?
Calculate profit in such cases.
Answer to Q. No. 5(b)
(a) 3 months FRA rate for 3 months forward: (1.025/1.0125) – 1 =1.36%
= 5.44% p.a.
(b) Assumption: the operator can borrow at LIBOR.
For Arbitrage profit, the operator should borrow as well as lend.
(i) Borrowing and depositing for 3 months: Not possible as the rate of borrowing for 3 months
(ii) Borrowing for 6 months and depositing for 6 months : No gain as both the actions will be at 5% p.a.
(iii) Borrowing for 1 year at 6.50% and (a) depositing for 6 months at 5%p.a. (b) depositing the proceeds of the first 6 months for next 6 months ( supported by FRA at the rate of 6.50%) and (c) repaying the borrowing with interest at the end of 1 year.
CASH FLOWS :
| PERIOD → | 0 | 6 MONTHS | 1 YEAR |
| Borrowings (assumed) | + $1,000 | | |
| Depositing | -$1,000 | | |
| Deposit Proceeds | | +$1,025 | |
| Deposit | | -$1,025 | |
| Deposit Proceeds | | | +$1,025(1.0325) = + $1,058.3125 |
| Repayment of borrowing with interest | | | -$1,065.0000 |
| Loss | | | $6.6875 |
There is no arbitrage opportunity.
Question 5. (c) (4) Marks) Write a note on Debt Securitization.
Answer (The answer given here is quite detailed one so that the students may understand the concept. In the exam, all these points may be given briefly)
Debt Securitization: It is a process under which non-marketable assets such as mortgages, automobiles leases and credit card receivables ( such assets are referred as commercial / consumer credits ) are converted into marketable securities that can be traded among the investors. Under this process, the consumer / commercial credits ( which are assets for financing companies providing credit ) are sold to a specially formed separate entity called as Special Purpose Vehicle or trust . The SPV / Trust issues securities (promissory notes or other debt instruments) to the investors based on inflows of these assets. The inflows from the assets (i.e. commercial / consumer credits) are collected in a separate bank account . The investors who have invested in promissory notes or other debt instruments (issued by the SPV or Trust) are first to be paid from this account.
The securities issued by the SPV / Trust are rated independently by the credit rating agencies i.e. credit rating of these securities is based on cash flow pattern of the underlying assets ( consumer / commercial credits ) and not upon the credit worthiness of the credit originator.
Instruments of debt securitization:
(i) Pass Through certificates: In the pass through structure, investors (those who have invested in the securities issued by the SPV) are serviced as and when the cash is actually generated by the underlying assets. Even prepayments are passed on to the investors.
(ii) Pay Through certificates : A pay-through security is a general obligation of the issuer secured on a pool of mortgages. The investors (those who have invested in the securities issued by the SPV) are serviced on fixed dates.
The surplus cash generated from the underlying assets are invested for short terms.
Advantages of Debt Securitization
The advantages to the originator :
(i) ILLIQUID assets are converted into liquid assets i.e. the originator has more sources with him for the business operations. This provides the originator to earn more with the help of these resources.
(ii) It helps in achieving / improving the capital adequacy ratio.
(iii) The credit rating of the originator enhances.
The advantages to the investor: The process provides the investors a new venue of investment in asset backed securities.
The answer given below is for understanding. It may not be given in the exam
Teaching Note :
B/s of Madhav Housing Finance Ltd (MHFL) as on ……. (Rs.Crores)
| | Housing loans 100 |
Now suppose MHFL forms as trust, called, MADHAV TRUST, and sells the housing loans of Rs.100 Crores to the Trust.
B/s of MHFL as on ……. (Rs.Crores)
| | Madhav Trust 100 |
B/s of Madhav Trust as on ……. (Rs.Crores)
| MHFL 100 | Housing loans 100 |
Now suppose the trust issues the debentures of Rs.100Crores, collateral being the housing loan. For this purpose an escrow account is opened in the bank. (In case of escrow account all the deposits in the account are first used for a given purpose and only surplus cash can be used for any other purpose. In this case, the amount collected against housing Loans will be used for the purpose of serving the debentures. Cash remaining after serving the debentures fully can be used for any other purpose. Thus escrow account provides a security to the investors in the debentures issued by the Trust)
B/s of Madhav Trust as on ……. (Rs.Crores)
| MHFL 100 Debentures 100 | Housing loans 100 Bank 100 |
The trust makes payment to MHFL.
B/s of MHFL as on ……. (Rs.Crores)
| | Bank 100 |
B/s of Madhav Trust as on ……. (Rs.Crores)
| Debentures 100 | Housing loans 100 |
The trust shall be collecting money from Hosing Loans and using that amount for serving the debentures holders.
For your General Financial Knowledge
Teaching note – not to be given in the exam while answering Debt securitization.
Finance providers provide finance to the prime borrowers (i.e. to those have the capacity to pay). If finance is being provided to those who do not have capacity to repay, it is called as sub-prime lending.
In view of sharply rising prices of the real-estate in USA for past some years, the Housing Financiers have been providing housing finance very liberally (in most of the cases, the financing was up to 100%) even without considering the repaying capacity of the borrowers. In most of the cases, the loans were given on non-recourse basis i.e. if the borrower surrenders the real estate to the lender, he / she will not be liable to pay the amount borrowed and interest that will accrue after the date of surrender.
In 2006, the prices of the real estate started falling, the rents declined at shaper rate. The borrower could not meet their obligations causing huge loss to the housing financiers and this led to crisis.
There is one more dimension to this problem because of which the crisis has spread world widely. Most of the Housing Financiers in
This crisis, called as sub-prime crisis, has adversely affected the global economy. The main reasons responsible for the crisis are :
- Providing loans even to those who do not have the repaying capacity.
- Very liberal financing (in more than 95% financing in most of the cases, even 100% in some cases)
In most of the cases, the loans were given on non-recourse basis i.e. if the borrower surrenders the real estate to the lender, he / she will not be liable to pay the amount borrowed and interest that will accrue after the date of surrender.
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