Download Test Paper - Security Analysis - Institute of Chartered Financial Analyst of India - Oct. 2004 and more Study notes Security Analysis in PDF only on Docsity!
Question Paper
Security Analysis – I (211) : April 2004
Section A : Basic Concepts (30 Marks)
- This section consists of questions with serial number 1 - 30.
- Answer all questions.
- Each question carries one mark.
- Maximum time for answering Section A is 30 Minutes. 1. Which of the following scrips is not included at present in S&P CNX Nifty?
(a) Corporation bank (b) HPCL (c) ACC (d) Sun Pharma (e) Satyam Computers.
< Answer >
2. Which of the following is/are true according to H model? I. According to the model, if the current growth rate is greater than the normal long run growth rate, the growth rate eventually decreases II. In the model, we make an assumption that in H years the growth decreases from the abnormal growth rate to the normal growth rate III. The intrinsic value of a share according to the model is equal to the value based on the normal growth rate plus premium due to abnormal growth rate.
(a) Only (I) above (b) Only (II) above (c) Both (I) and (II) above (d) Both (I) and (III) above (e) All (I), (II) and (III) above.
< Answer >
3. Which of the following statements is/are true of “market extraction method” to derive the capitalization rate of real assets? I. In this method, net operating income is divided by sales price to get the capitalization rate II. In this method, the rates on equity as well as debt financing rates are weighted according to their proportions to calculate the capitalization rate III. In this method, the capitalization rate is the sum of the return required on an asset for its being non-liquid, and the risk free rate IV. In this method, comparable property is selected to choose a rate which reflects market sentiments. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Only (IV) above (e) Both (I) and (IV) above.
< Answer >
4. Which of the following principles is true while analyzing trend line penetrations? (a) The lesser the number of peaks/troughs that touch a trendline, the greater its significance (b) The breadth of a trendline indicates whether a penetration is significant or not (c) A steep trendline is easily violated by small sideward movements in the price chart, and is not particularly useful in identifying reversals (d) Penetration of a steep trendline results in a corrective movement after which the new trend starts (e) When the peaks of rallies penetrate the trend line and then return, the recurrence of this tendency indicates that the trend “obeys” the trendline.
< Answer >
5. Which of the following is not an application of SML?
(a) Evaluating the performance of portfolio manager (b) Tests of asset pricing theories (c) Tests of market efficiency (d) Identifying mispriced securities (e) Identifying the factors of pricing of an asset.
< Answer >
6. The market rate of interest on 2 years bond is 9.75% while the rate on one year bond is 9.25%. The forward rate on a one year bond one year from now is 9.5%. The liquidity premium to induce investors to hold the 2 year bond is
(a) –0.25% (b) 0.38% (c) 0.75% (d) 1.20% (e) 2.25%.
< Answer >
7. Consider the following data:
Ratios 2002 2003
PBT/NS
PAT/PBT
< Answer >
NS/TA
TA/NW
ROE%
The fall in ROE has taken place in 2003 primarily due to
(a) Fall in profit margin (b) Increase in leverage (c) Fall in tax efficiency (d) Increase in asset turnover (e) Both (a) and (b) above.
8. Which of the following is true in case of the pioneering stage of the industry life cycle:
I. It is difficult to predict which firms will succeed and which firms will fail II. Firms pay a high level of dividends III. Industry growth is very rapid.
(a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) Both (II) and (III) above.
< Answer >
9. In an efficient market the correlation coefficient between stock returns for two non-overlapping time periods should be (a) Positive and large (b) Positive and small (c) Negative and large (d) Negative and small (e) Zero.
< Answer >
10. (^) β measures the sensitivity of return of the security vis-à-vis the market return. It is estimated from the
following regression specification: r (^) i = α + β r (^) m + ei where, the notations are in their standard use.
Which of the following is not an assumption in regression analysis regarding error term?
(a) E(e (^) i ) = 0 (b) Cov (ei , r (^) m) = 0 (c) Cov (ei , e (^) j ) = 0 (d) Var (e (^) i ) = 0 (e) None of the above.
< Answer >
11. Earnings per share of Piston Ltd. expected at the end of the year 2004-2005 is Rs.18.00. The earnings per share in the year 2003-2004 is Rs.16.00. The required rate of return is 25% p.a. and the dividend payout ratio is 30% which is expected to remain constant. If the earnings are expected to grow at the historical growth rate, the value of the share of the company at the beginning of 2004-2005 is
(a) Rs.72.00 (b) Rs.43.20 (c) Rs.38.40 (d) Rs.21. (e) Cannot be determined as the growth rate is higher than the required rate of return.
< Answer >
12. Which of the following aspects of investing in real assets differ from investing in securities?
I. The type of income derived II. The manner in which the assets are valued III. The way inflation affects real assets.
(a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) All (I), (II) and (III) above.
< Answer >
13. Which of the following statements is/are true?
I. A unique characteristic line is plotted for each security II. For a characteristic line, the x-axis represents betas for different securities III. The slope of the characteristic line is the difference between the market returns and risk-free returns. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (II) and (III) above.
< Answer >
21. Which of the following can be a form of utility function at expected security return ranging between 10 - 12%?
[U(r) is the expected utility of the investor at the level of return r]. (a) U(r) = 25r – r 2 (b) U(r) = 3r – 10r 2 (c) U(r) = 72r + 3r 2 (d) U(r) = 6r – 7r 2 (e) Both (b) and (d) above.
< Answer >
22. A stock which is less risky than the market will have
I. A beta greater than 1 II. A beta that is less than its correlation coefficient with the market index III. A beta less than 1. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (II) and (III) above.
< Answer >
23. A portfolio holding 90 percent of its assets in S &P CNX Nifty stocks in proportion to their market capitalization and 10 percent in treasury bills is more sensitive to a. Systematic risk b. Unsystematic risk c. Interest rate risk d. Index risk e. Both (c) and (d) above.
< Answer >
24. Other things being equal call option premiums for a given asset tend to increase when
(a) The price of the underlying asset decreases (b) The volatility of the returns on underlying asset decreases (c) The time to expiration of the option increases (d) The exercise price of the option increases (e) None of the above.
< Answer >
25. Which of the following graphs depicts a lead indicator? (a)
(b)
(c)
(d)
(e) Both (b) and (c) above.
< Answer >
26. Consider the following information related to a bond: Par Value Rs. 1000
Time to Maturity 20 years
Coupon rate ( Interest payable annually) 10%
Current Market Price Rs. 851
Yield to Maturity (YTM) 12%
Other things remaining the same, if the bond starts paying interest semi-annually, then the change in the market price of the bond will be approximately (a) – 0.2% (b) – 0.1% (c) + 0.1% (d) + 0.2% (e) No change.
< Answer >
27. Which of the following is/are true if a firm has a required rate of return equal to the ROE?
I. The amount of earnings retained by the firm does not affect market price or the P/E II. The firm can increase market price and P/E by increasing the growth rate III. The P/E ratio is inversely proportional to the ROE of the firm.
(a) Only (I) above (b) Both (I) and (II) above (c) Both (I) and (III) above (d) Both (II) and (III) above (e) All (I), (II) and (III) above.
< Answer >
28. Mr. Arvind holds a stock of company X. Company X is presently paying a dividend of Rs.2 per share and required rate of return for Mr. Arvind is 20 percent. If the dividends are expected to grow at a constant rate of 10 percent, duration of equity is
(a) 20 years (b) 5 years (c) 11 years (d) 30 years (e) 40 years.
< Answer >
29. Rajan is bearish on the stock of the Jindal Corporation and purchased six 3-month put option contracts. The strike price is Rs.45 and premium is Rs.5 per stock. After 3 months, market price of Jindal was Rs.30. The current market price is Rs.44. If contract size is 100, profit realized by Rajan is
(a) Rs. 3,000 (b) Rs. 9,000 (c) Rs.12,000 (d) Rs. 6,000 (e) Rs. 500.
< Answer >
30. Which of the following statements is/are true about ‘gaps’?
I. The lowest price of the period after the gap is higher than the highest price of the preceding period II. The lowest price of the period after the gap is lower than the highest price of the preceding period III. A series of runaway gaps is an indication of exhaustion gap IV. The highest price of the period after the gap is lower than the lowest price of the preceding period.
(a) Only (I) above (b) Both (I) and (II) above (c) Both (II) and (III) above (d) (I), (III) and (IV) above (e) All (I), (II), (III) and (IV) above.
< Answer >
END OF SECTION A
The analyst estimates that the appropriate leading P/E 1 multiplier for the stock to be 14 and the required rate of return on PCDS (partly convertible debenture) is around 12% p.a compounded semi-annually.
You are required to
a. Calculate the intrinsic value of the PCD using the estimates prepared by the analyst and the other data. State the assumptions underlying your calculation.
b. Calculate the conversion value of stock under Part A of PCD assuming that your required rate of return is 17%
p.a .You believe that an indicative P/E 1 is defined as P/E 1 = Where, b = average payout ratio, k (^) e = required rate of return, g = sustainable growth rate, is more appropriate for valuing equity shares made available on conversion.
(6 + 4 = 10 marks) < Answer >
2. During the year 2003-04, three companies Polar Software Ltd., Sonata Airways and Time Auto Ltd. have announced higher dividends on December 31, 2003. A financial analyst working in a brokerage firm wanted to test the consistency of the semi-strong form of market efficiency. He estimated the characteristic lines for a period of 4 years on a monthly basis upto September 30, 2003. The relationship between the returns on these three companies and the market index are represented by following equations.
rP,t = 1.50% + 0.75rmt
rS,t = 1.26% + 1.15 r (^) mt
rt,t = 1.98% + 1.35 r (^) mt
Where rP , (^) t r (^) S,t and rt,t are the returns of Polar Software, Sonata Airways and Time Auto during period t and r (^) m,t is return of the market index during the same period. The following data pertains to the returns of the companies and market for the period 3 months before and 3 months after the dividend was declared.
Period
(Months)
Actual return (%) Market return (%)
rP,t rS,t rt,t rm,t
Sep 30, 2003
Oct 31, 2003
Nov 30, 2003
Dec 31, 2003
Jan 31, 2004
Feb 29, 2004
Mar 31, 2004
Using event studies approach you are required to verify the validity of semi-strong form of market efficiency in the Indian stock market.
(8 marks) < Answer >
3. Suppose the assumptions of CAPM are valid and unlimited borrowing and lending at risk-less rate of interest is possible. You are required to determine the unknown quantities in the following table.
Stock Expected Return (%) Standard Deviation (%) Beta Unsystematic Risk (%)^2
Super Cements 12 ?
15
Cresent Pharma ? 8
9
DFL Plastics
You are required to
a. Calculate the P/E ratios for both companies. b. Discuss two possible reasons for the difference in the PE ratios of the two companies. c. Calculate the long-term growth rate expected by the market if Company B’s stock is currently trading at twelve times its next period forecasted earnings. (5 + 2 + 2 = 9 marks) < Answer >
6. The values of S&P CNX Nifty during the last two weeks of January 2004 are given below:
Date Open High Low
- 16-Jan- Close
- 19-Jan-
- 20-Jan-
- 21-Jan-
- 22-Jan-
- 23-Jan-
- 27-Jan-
- 28-Jan-
- 29-Jan-
You are required to
a. Calculate the Relative Strength Index of the Nifty as on 29 January 2004.
b. Interpret the results obtained in (a) above.
(4 + 1 = 5 marks) < Answer >
END OF SECTION B
Section C : Applied Theory (20 Marks)
This section consists of questions with serial number 7 - 8. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.
7. Real estate has for long been viewed as a life time investment in which one does not trade for profit. This perception is now changing. What are the aspects in which investments in real assets differ from other investments? Explain.
(10 marks) < Answer >
8. FMCG, Pharmaceuticals, IT, Oil and gas, Auto, Engineering, and Banking is the order in which sector (industry) preferences have moved in the last five years in India. As an analyst, what are the important characteristics you would analyze before you identify an industry for investment? Discuss.
(10 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers Security Analysis – I (211) : April 2004
Section A : Basic Concepts
- Answer : (a)
Reason : HPCL, ACC, Sun Pharma and Satyam Computers are present in Nifty. only corporation bank is not present..
< TOP >
- Answer : (d)
Reason : According to H model there are two phases of growth – abnormal growth rate and long run normal growth rate and it is assumed that in 2H years the growth decreases from abnormal growth rate to normal growth rate. Hence, statement (II) is not correct.
< TOP >
- Answer : (e)
Reason : Statement II relates to Bond of Investment method. Statement III relates to Built-up method
< TOP >
- Answer : (c)
Reason : a is not correct as more than number of peaks and trough that touch a trend line greater its significance.
b. is not correct as it is not breadth but the length of the trend line which indicates whether a penetration is significant or not.
d. is not correct as penetration of steep trend line results in a corrective movement after which the previous trend continues.
e. is not correct as the peaks of rallies when penetrate the trend line that indicates shift in trend.
< TOP >
securities. Hence, II is not true. The slope of the security represents the beta of the particular security involved. Hence, III is also not true. Difference between market returns and risk-free return is the slope of Security Market Line.
- Answer : (c)
Reason : Variance of the portfolio of two stocks is calculated as
σ 12 w 12 + σ 22 w 22 + 2σ 1 σ 2 w 1 w 2 , where σi is variance of the stock wi is weight of the stock
is the correlation coefficient of two stocks, In the given case,
484 × 0.5 2 + 256 × 0.5 2 + 2 × 0.5 × 0.5 = 132
< TOP >
- Answer : (e)
Reason : Head and Shoulders pattern is by far the most reliable, and widely used, of all reversal patterns. The left shoulder signifies the penultimate rally in the bull market. The right shoulder confirms the beginning of a bear market, as it fails to climb above the previous rally (the head). This pattern occurs at the end of a bull market and is characterized by two smaller rallies flanking a higher rally just as the head lies in between two shoulders. Hence, (I) is not true. A series of minor rallies and reactions, which have almost identical peaks and troughs signal the formation of a rectangle. A rectangle indicates equal pressure being exercised by buyers and sellers, and the combat is indecisive until a breakout occurs. The price line may breakout on either side. A rectangle therefore may be a consolidation pattern or result in reversal. Hence (III) is also not true and (e) is the answer. A diffusion index or momentum index is computed by calculating the rate at which a certain group of stocks change price over a given period of time. A rise in the index signals the onset of a bull market and vice versa. Hence, (II) is true
< TOP >
- Answer : (a)
Reason : The depreciation calculated under the written down value method is higher than that calculated under the straight line method in the initial years of the life of the asset, and is considerably lower under WDV method than under straight line method in the later years. Thus, switching from straight line method to WDV method in the later years will increase the profit figure and vice versa. Hence, (I) is true. The amortization of preliminary expenses and other miscellaneous expenditure of a capital nature offers ample scope for increasing or decreasing the profits. There is no legal rule prescribed for the write-off of such expenditure. When the expenses are written off over a period of time, the profits during those periods will be low and if such expenses are capitalized, the profits will be high. Hence, statement (II) results in lower profits. Under inflationary circumstances, a company may switch over from the LIFO method to FIFO method and increase its profits and switching from FIFO to LIFO during decreasing prices result in increased profits. During decreasing prices, under FIFO method of inventory valuation, the value of stock consumed will be high and profits will be low whereas under LIFO, the stock consumed will be low and profits will be high. Hence, switching from LIFO to FIFO the profits will be decreased and statement (III) is incorrect and the answer is (a).
< TOP >
- Answer : (a)
Reason: Financial policies become firmly established at the expansion stage. Hence (a) is the correct answer.
< TOP >
- Answer : (c)
Reason : P 0 =
P 0 =
< TOP >
- Answer : (b)
Reason : According to H-model P0 =
= Value based on normal growth rate + Premium due to abnormal growth rate
= = = Rs.4.235.
< TOP >
- Answer : (e)
Reason : Futures margin depend on the price volatility of the underlying asset. Exchanges generally set this margin equal to μ + 3 σ then μ is the average daily absolute change in the value of contract and σ is standard deviation of these changes over a period of time. Hence only (I) and (III) are correct and therefore (e) is the answer.
< TOP >
- Answer : (a)
Reason : Utility function is always an increasing function of r but at a decreasing rate. Therefore, a utility function’s first derivative with respect to r should be positive whereas second derivative should be negative
i.e. For a normal level of return of 10 – 12% range, utility function given in option (a) only satisfies the above criteria.
< TOP >
- Answer : (e)
Reason : β = = =
If σ (^) i < σm then β < ρ (^) im as we know that correlation coefficient can have maximum value of 1. Therefore beta will be less than 1.
< TOP >
- Answer : (a)
Reason : Investing in CNX Nifty stocks in proportion to their market capitalization means investing in the market portfolio. The investment in market portfolio is affected by the market movements. If the markets rise, the portfolio gains and vice-versa. The portfolio will be affected positively or negatively by the market and the portfolio will be more sensitive to systematic risk. Hence the correct answer is (a).
< TOP >
- Answer : (c)
Reason : The time to expiration is directly related to the option premium. Longer the time to expiration, higher is the option premium. Thus, other things being equal, call option premiums for a given asset tend to increase when the time to expiration increases.
< TOP >
- Answer : (c)
Reason : A lead indicator is one which peaks out well before the economy peaks and bottoms out well before the economy does. Economists use these indicators for forecasting trends in the economy. Graph C clearly depicts this behavior and hence reflects a lead indicator. Graph B also appears to depict a lead indicator but a closer examination reveals that it is not giving crystal clear signals. Hence the answer is (c).
< TOP >
- Answer : (a)
Reason : The equation expressing the relationship between Market Price of the bond and YTM is as follows P (^) o = C (^) o × PVIFA (^) (k, n) + F × PVIF(k, n) Substituting the given values in the equation, we get Po= 50 × PVIFA(6%, 40) + 1000 × PVIF(6%, 40)
< TOP >
The lowest price of the period after the gap is lower than the highest price of the preceding period is false regarding gaps. A series of runaway gaps is an indication of exhaustion gap is true. The highest price of the period after the gap is lower than the lowest price of the preceding period is true. Hence the option (d) is the correct answer. Hence the other options (a),(b),(c) and (e) are incorrect.
Section B : Problems
1. a. We will work half year as the unit of time
PV (Part A) = 100X(0.10/2) X PVIFA (6,2) + (Estimated MV of the Share) X PVIF(6,2) Estimated Market value of the stock on 1.2.2005 = Projected EPS for 2005-06 × Appropriate PE = 21.22 /0.834 × 14 = Rs. 356. PV (Part A) = 5 × 1.8334 + 356.21 × 0.89 = Rs. 326. PV (Part B) = 100X(0.10/2) × PVIFA (6,8) + 50X PVIF(6,8)
- 50 × (0.10/2) × PVIFA (6,2) × PVIF(6,8) + 50X PVIF(6,10) = 5 × 6.21 + 50 × 0.627 + 2.5 × 1.8334 × 0.627 + 50 × 0. = 31.05 + 31.35 + 2.874 + 27. = Rs. 93. PV (Part A + Part B) = 356.21 + 93.174 = Rs449. b. The payout ratio and the long run sustainable growth rate for computing the indicative P/E have been determined by averaging the relevant data provided in the table:
Average Payout =
Estimated retention ratio = 1 – 0.156 = 0.
Average ROE =
Estimated Sustainable growth rate = 0.179 X 0.844 = 0. Indicative P/E = 0.156/(0.17 –0.151) = 8. Conversion value = Projected EPS for 2005-06 X Indicative PE = 21.22 /0.834 X 8. = Rs. 208. < TOP >
2. First we should find out abnormal return by deducting the actual return from the expected return
Polar Software Limited
Period Actual return Market return Expected return Abnormal return
(r Pt) (rmt) (%) (1.50 + 0.75 rmt)
Sonata Airways
Period Actual return Market return Expected return Abnormal return
Expected return Abnormal return
(r (^) T,t) (r (^) mt) (1.98 + 1.35 r (^) mt)
We will now estimate the average abnormal return to each of the months before and after the dividend was announced
Third month before the announcement of dividend
AAR (–3) = (0.8625 – 0.1375+ 0.6975) = 1.
Second month before the announcement of dividend
AAR (–2) = (0.8875- 0.3525 +0.5625) = 1.
First month before the announcement of dividend
AAR (–1) = (1.2125 + 0.0325+0.1975) = 1.
Month during which the dividend was announced
AAR (0) = (1.2625+0.4025 + 0.0375) = 1.
First month after the announcement of dividend
AAR (1) = (1.4125 + 0.1025 – 0.0625) = 1.
Second month after the announcement of dividend
AAR (2) = (1.3125 + 0.0525-0.1825) = 1.
Third month after the announcement of dividend
AAR (3) = (0.7625 - 0.2775 –0.5125) = -0.
Now we will compute the cumulative Average Abnormal returns for the period of three months before and after the announcement of dividend. CAAR = (1.4225 + 1.0975 + 1.4425 + 1.7025 + 1.4525+1.1825 + -0.0275) = 8.2725%.
As the value of CAAR is not close to zero, we conclude that market is not efficient in the semi-strong form. < TOP >
3. According to CAPM
R (^) i = Rf + β (Rm – Rf )
RS = Rf + βS (Rm – R (^) f) - (I)
RD = Rf + βD (Rm – R (^) f) - (II)
(I) – (II)
R (^) S – RD = (β (^) S – βD) (R (^) m – R (^) f)
3 = (1.52 – 0.80) (Rm – Rf )
3 = 0.72 (R (^) m – R (^) f)
= 4.167 = (R (^) m – R (^) f) Now putting the value of (Rm – Rf ) in equation (I)
12 = Rf + 1.52 ×4.
R (^) f = 12 – 6.333 = 5.667%
R (^) C = 5.667 + 0.96 × 4.167 = 9.
= 9.667%.
Total risk = Systematic risk + Unsystematic risk
=
(8) 2 =
64 = (0.96)^2 + 9
(64 – 9) = 0.
