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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


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

mailto:[email protected]

http://konvexity.com/

http://www.facebook.com/groups/176580792480036/



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.



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!

magicformulainvesting.com

http://www.screener.in/



It always seems impossible until it’s done. – NELSON MANDELA


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



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



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



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



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.



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



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



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



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.



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.

http://www.facebook.com/groups/176580792480036/220012788136836/



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


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



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%



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.



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



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



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



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.



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



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



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.

http://www.facebook.com/groups/176580792480036/220012788136836/



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