Q No .1 : Sensitivity analysis has its own weaknesses. Mention them in short.
(04)
Weaknesses of sensitivity analysis
• It assumes that changes to variables can be made independently, e.g. material prices will
change independently of other variables. Simulation allows us to change more than one
variable at a time.
• It only identifies how far a variable needs to change; it does not look at the probability of such
a change.
• It provides information on the basis of which decisions can be made but it does not point to the
correct decision directl.
Q No .2 :What is ‘real options?’ Explain briefly. (05)
A real option is an economically valuable right to make or else abandon some choice that is available
to the managers of a company, often concerning business projects or investment opportunities. It is
referred to as “real” because it typically references projects involving a tangible asset (such as
machinery, land, and buildings, as well as inventory), instead of a financial instrument.
KEY TAKEAWAYS
1. A real option gives a firm's management the right, but not the obligation to undertake certain
business opportunities or investments.
2. Real option refer to projects involving tangible assets versus financial instruments.
3. Real options can include the decision to expand, defer or wait, or abandon a project entirely.
4. Real options have economic value, which financial analysts and corporate managers use to
inform their decisions.
Q No .03 :Which factors determines the cost of debt capital for a company? (03)
Cost of debt capital is associated with the amount of interest that is paid on currently outstanding by
Kd.
Factors affecting cost of debt Kd:
1. Debenture’s Rate of interest.
2. Issue at par/discount/premium
3. Floatation cost
4. Tax rate : Cost of debt is the charge against profit which saves tax.thus,Kd is always calculated
after considering tax effect.
5. Redemption at par/premium.
Q No .04 What are the limitations of the Capital Asset Pricing Model (CAPM) for the selection of a
portfolio? (05)
Answer:
CAPM has the following limitations:
1-It is based on unrealistic assumptions.
2-It is difficult to test the validity of CAPM.
3-Betas do not remain stable over time.
1-Unrealistic assumptions CAPM is based on a number of assumptions that are far from the reality.
For example, it is very difficult to find a risk-free security. A short- term, highly liquid government
security is considered as a risk-free security. It is unlikely that the government will default, but inflation
causes uncertainty about the real rate of return. The assumption of the equality of the lending and
borrowing rates is also not correct. In practice, these rates differ. Further, investors may not hold
highly diversified portfolios, or the market indices may not be well diversified. Under these
circumstances, CAPM may not accurately explain the investment behaviour of investors and the beta
may fail to capture the risk of investment.
2-Unrealistic assumptions CAPM is based on a number of assumptions that are far from the reality.
For example, it is very difficult to find a risk-free security. A short- term, highly liquid government
security is considered as a risk-free security. It is unlikely that the government will default, but inflation
causes uncertainty about the real rate of return. The assumption of the equality of the lending and
borrowing rates is also not correct. In practice, these rates differ. Further, investors may not hold
highly diversified portfolios, or the market indices may not be well diversified. Under these
circumstances, CAPM may not accurately explain the investment behaviour of investors and the beta
may fail to capture the risk of investment.
All empirical studies testing CAPM have a conceptual problem. CAPM is an ex-ante model; that is, we
need data on expected prices to test CAPM. Unfortunately, in practice, the researchers have to work
with the actual past (ex-post) data. Thus, this will introduce bias in the empirical results.
3-Stability of Beta
Beta is a measure of a security’s future risk. But investors do not have future data to
estimate beta. What they have is past data about the share prices and the market portfolio. Thus, they
can only estimate beta based on historical data. Investors can use historical beta as the measure of
future risk only if it is stable over time. Most research has shown that the betas of individual securities
are not stable over time. This implies that historical betas are poor indicators of the future risk of
securities.
Q No .05 : A company planning to grow by pursuing a policy of 'organic' internal growth, would
need to take into account certain factors. Explain these factors in brief. (05)
Organic (or internal) growth involves expansion from within a business, for example by expanding the
product range, or number of business units and location.
Organic growth builds on the business’ own capabilities and resources. For most businesses,
this is the only expansion method used.
Organic growth involves strategies such as:
- Developing new product ranges
- Launching existing products directly into new international markets (e.g. exporting)
- Opening new business locations – either in the domestic market or overseas
- Investing in additional production capacity or new technology to allow increased output and
sales volumes
Q No .06 : Debt is an important source of financing for the business. Describe five advantages of
debt for a company. (Marks 04)
1. You won't give up business ownership.
2. There are tax deductions.
3. Low interest rates are available.
4. You'll establish and build business credit.
5. Debt can fuel growth.
6. Debt financing can save a small business big money.
7. Long-term debt can eliminate reliance on expensive debt.
Capital rationing may be necessary in a business due to external factors i.e., hard capital rationing.
What causes hard capital rationing? (03)
Start-up Firms
Generally, young start-up firms are not able to raise funds from equity markets. This may happen
despite the high projected returns or the lucrative future of the company.
Poor Management/Track Record
A bad track record or poor management team of a company can also affect the external funds. The
lenders can consider such companies as a risky assets and may shy away from investing in projects of
these companies.
An increase in Opportunity Cost of Capital
Too much leverage in the capital structure makes the company a riskier investment. This leads to an
increase in the opportunity cost of capital. The companies aim to keep their solvency and liquidity
ratios under control by limiting the amount of debt raised.
Future Scenarios
The companies follow soft rationing to be ready for the opportunities available in the future, such as a
project with a better rate of return or a decline in the cost of capital. There is prudence in conserving
some capital for such future scenarios.
Describe three main reasons for hard capital rationing. (03)
Answer:
1-Start-up Firms. Generally, young start-up firms are not able to raise the funds from equity
markets. ...
2-Lender's Restrictions.
3-Poor Management / Track Record. .
4-Industry Specific Factors.
6-Promoters' Decision.
8-An increase in Opportunity Cost of Capital.
7-Future Scenarios.
Q---WHY SHARE IS AN OPTION ?
UPPER AND LOWER BOUND
OPTION
Q --A thesist on credit analysis for the guidance of lendings bankers ? Several credit principles explain
them ?
