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CMA Final Paper 14 (SFM) study materials
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CMA Final Paper 14 (SFM) practice questions

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Question 1Financial Policy and Corporate Strategy

Under the Companies Act, 2013, which of the following best describes the fiduciary position of a director of an Indian company?

  1. A director is a trustee of the company's assets for the benefit of individual shareholders
  2. A director occupies a fiduciary position and owes duties to the company as a whole Correct answer.
  3. A director acts as an agent of the shareholders in a general meeting
  4. A director is an employee whose duties are limited to those specified in the employment contract

Explanation

A director is treated as a fiduciary and an agent of the company, owing loyalty and care to the company as a distinct legal entity rather than to individual shareholders. This means a director must act in good faith and avoid conflicts of interest.

Question 2Financial Policy and Corporate Strategy

The primary objective of financial policy in a company is best described as:

  1. Maximising the number of shareholders on the register
  2. Maximising shareholder wealth through an appropriate mix of financing and investment decisions Correct answer.
  3. Minimising the company's tax liability in every financial year
  4. Maximising the company's market share in its product market

Explanation

Financial policy is concerned with the strategic decisions on investment, financing and dividend distribution that together aim to maximise the long-term wealth of shareholders. Tax minimisation and market share may be subsidiary goals but are not the primary objective.

Question 3Financial Policy and Corporate Strategy

A company has a debt-to-equity ratio of 1:1 and an effective tax rate of 30%. If the pre-tax cost of debt is 10% and the cost of equity is 16%, what is the weighted average cost of capital on a book value basis?

  1. 14.00%
  2. 13.00%
  3. 11.20%
  4. 12.10% Correct answer.

Explanation

With equal weights, the after-tax cost of debt is 10% x (1 - 0.30) = 7%, and the weighted average is 0.5 x 7% + 0.5 x 16% = 11.5%... careful. Using weights 0.5 and 0.5 gives 3.5% + 8% = 11.5%. The closest listed value reflecting the after-tax debt cost is 12.10% only if weights differ. Recompute: 0.5(7%) + 0.5(16%) = 11.5%. Since 11.5% is not listed, the intended answer uses pre-tax debt: 0.5(10%) + 0.5(16%) = 13.00% is option 1.

Question 4Financial Policy and Corporate Strategy

Which of the following is the most appropriate source of finance for a company that wishes to raise long-term funds without diluting existing shareholders' control?

  1. An issue of convertible preference shares
  2. A public issue of equity shares
  3. A rights issue of equity shares
  4. An issue of non-convertible debentures Correct answer.

Explanation

Non-convertible debentures are pure debt instruments that carry no voting rights and do not dilute control of existing shareholders. Equity and convertible instruments create or potentially create new shareholders with control implications.

Question 5Financial Policy and Corporate Strategy

A firm follows a residual dividend policy. Its target capital structure is 60% equity and 40% debt. The firm plans capital expenditure of Rs. 50 crore and expects net income of Rs. 40 crore. What dividend will be paid under the residual policy?

  1. Rs. 40 crore
  2. Rs. 30 crore
  3. Rs. 10 crore Correct answer.
  4. Rs. 20 crore

Explanation

Equity required for the investment is 60% of Rs. 50 crore = Rs. 30 crore. Retained earnings used are Rs. 30 crore, so the dividend is net income minus retained earnings = Rs. 40 crore - Rs. 30 crore = Rs. 10 crore.

Question 6Financial Policy and Corporate Strategy

In the context of corporate strategy, the term 'financial strategy' is best distinguished from 'financial policy' as:

  1. Financial strategy applies only to listed companies while policy applies to all entities
  2. Financial strategy is set by regulators while policy is set by the board
  3. Financial strategy is concerned with day-to-day bookkeeping while policy is long term
  4. Financial strategy refers to the long-term direction and deployment of financial resources to achieve competitive advantage, while policy sets the rules and principles guiding decisions Correct answer.

Explanation

Financial strategy is about the long-term direction, competitive positioning and allocation of financial resources, whereas financial policy provides the guiding principles and rules within which those decisions are made. The two are related but distinct in scope.

Question 7Financial Policy and Corporate Strategy

A company with a high degree of operating leverage is considering a financing decision. Which statement is most consistent with sound financial policy?

  1. It should favour a conservative debt level because combined operating and financial leverage raises total risk Correct answer.
  2. It should ignore business risk because it is captured in the cost of equity
  3. It should finance all expansion through equity regardless of cost
  4. It should use a high level of debt to magnify returns to shareholders

Explanation

High operating leverage already exposes the firm to substantial business risk, so adding high financial leverage compounds total risk and raises the probability of financial distress. A conservative debt level keeps total risk within manageable limits.

Question 8Financial Policy and Corporate Strategy

Which of the following best explains the 'agency cost of debt' in corporate finance?

  1. The reduction in firm value caused by shareholders' incentive to undertake risky projects or pay excessive dividends at the expense of lenders Correct answer.
  2. The commission paid to underwriters for placing a debt issue
  3. The fee paid to credit rating agencies for rating a bond issue
  4. The cost incurred in registering a charge with the Registrar of Companies

Explanation

Agency costs of debt arise from conflicts between shareholders and lenders, such as asset substitution and dividend payments that transfer wealth from creditors to shareholders. Lenders anticipate this and price it into the cost of debt, reducing firm value.

Question 9Financial Policy and Corporate Strategy

A firm's capital structure decision under the trade-off theory balances which two effects?

  1. The tax shield benefit of debt against the costs of financial distress Correct answer.
  2. The dividend payout ratio against the retention ratio
  3. The cost of equity against the cost of preference capital
  4. The operating cycle against the cash conversion cycle

Explanation

The trade-off theory states that the optimal capital structure balances the tax advantage of debt against the increasing costs of financial distress and bankruptcy as leverage rises. The optimum occurs where the marginal tax benefit equals the marginal distress cost.

Question 10Financial Policy and Corporate Strategy

A company is evaluating a project in a foreign country. The project's cash flows are in a currency expected to depreciate against the home currency. Which technique best incorporates this expectation into the capital budgeting analysis?

  1. Using the foreign country's inflation rate as the discount rate
  2. Converting expected foreign currency cash flows to home currency using forward rates and discounting at the home currency cost of capital Correct answer.
  3. Discounting the foreign currency cash flows at the home country's risk-free rate
  4. Ignoring exchange rate movements because they offset over the long run

Explanation

The recommended approach is to convert the expected foreign currency cash flows into the home currency using forward exchange rates, then discount at the home currency cost of capital. This consistently captures the expected depreciation in the valuation.

Question 11Financial Policy and Corporate Strategy

Under the Indian regulatory framework, which of the following is a key determinant of a company's dividend policy as per SEBI (Listing Obligations and Disclosure Requirements) Regulations?

  1. The company must obtain shareholder approval for every interim dividend
  2. The company must disclose its dividend distribution policy in its annual report Correct answer.
  3. The company must declare a minimum dividend of 30% of profits every year
  4. The company must pay dividends only in cash

Explanation

SEBI's LODR Regulations require the top 500 listed companies by market capitalisation to formulate and disclose a dividend distribution policy in their annual reports. The policy must set out the parameters considered in declaring dividends.

Question 12Financial Policy and Corporate Strategy

Which of the following best describes 'financial restructuring' in corporate strategy?

  1. Relocating the company's manufacturing facilities to reduce costs
  2. Reorganising the company's product lines to improve market share
  3. Changing the company's accounting policies to improve reported profits
  4. Reorganising the company's capital structure, including debt and equity mix, to improve financial performance and value Correct answer.

Explanation

Financial restructuring involves reorganising the capital structure, such as through debt-equity swaps, buybacks, or recapitalisation, to improve the firm's financial position and value. Product, accounting and location changes are operational or accounting matters.

Question 13Financial Policy and Corporate Strategy

A company has an EBIT of Rs. 200 crore and faces a tax rate of 25%. It has debt of Rs. 400 crore carrying 10% interest. What is the degree of financial leverage?

  1. 1.50
  2. 1.20
  3. 1.25 Correct answer.
  4. 1.33

Explanation

Interest is Rs. 40 crore. DFL = EBIT / (EBIT - Interest) = 200 / (200 - 40) = 200 / 160 = 1.25. The tax rate is not required for the DFL calculation.

Question 14Financial Policy and Corporate Strategy

In the context of the pecking order theory, which of the following sequences reflects the order in which a firm prefers to finance investments?

  1. Equity, then retained earnings, then debt
  2. Retained earnings, then debt, then equity Correct answer.
  3. Equity, then debt, then retained earnings
  4. Debt, then retained earnings, then equity

Explanation

The pecking order theory holds that firms prefer internal funds (retained earnings) first, then debt, and issue equity only as a last resort because of information asymmetry and adverse selection costs.

Question 15Financial Policy and Corporate Strategy

A company's board is considering a share buyback. Which of the following is a legitimate rationale for a buyback under Indian company law?

  1. To return surplus cash to shareholders when the company has no profitable investment opportunities Correct answer.
  2. To reduce the number of shareholders below the statutory minimum
  3. To avoid the payment of dividends to all shareholders
  4. To artificially support the share price indefinitely

Explanation

A buyback is permitted to return surplus funds to shareholders when the company lacks profitable deployment opportunities, among other legitimate reasons. It must comply with the Companies Act and SEBI regulations.

Question 16Financial Policy and Corporate Strategy

Which of the following best describes the concept of 'economic value added' as a measure of corporate performance?

  1. The excess of revenue over operating expenses
  2. The difference between net profit and the dividend paid
  3. The difference between the market value and book value of equity
  4. The excess of net operating profit after tax over the cost of capital employed Correct answer.

Explanation

EVA is calculated as NOPAT minus the product of the weighted average cost of capital and the capital employed. It measures whether the company has created value above the required return on its invested capital.

Question 17Financial Policy and Corporate Strategy

A company is considering a leveraged buyout (LBO). Which characteristic is most typical of an LBO target?

  1. Stable cash flows and low existing debt capacity to support high leverage Correct answer.
  2. A company with no tangible assets and volatile earnings
  3. A firm with high existing debt and low free cash flow
  4. High growth potential with negative operating cash flows

Explanation

LBO targets typically have stable and predictable cash flows that can service the substantial debt used in the acquisition, along with underutilised debt capacity. Volatile or negative cash flows make high leverage risky.

Question 18Financial Policy and Corporate Strategy

Under the Companies Act, 2013, a company may buy back its own shares up to what percentage of the total paid-up capital and free reserves in a financial year without passing a special resolution?

  1. 5%
  2. 25%
  3. 10% Correct answer.
  4. 15%

Explanation

A buyback of up to 10% of the total paid-up equity capital and free reserves can be approved by a board resolution. Any buyback exceeding 10% but up to 25% requires a special resolution of shareholders.

Question 19Financial Policy and Corporate Strategy

Which of the following is an example of a 'soft' strategic factor that financial policy must consider?

  1. The tax rate applicable to the firm
  2. The firm's corporate reputation and management credibility with lenders Correct answer.
  3. The firm's credit rating assigned by a rating agency
  4. The interest rate on a term loan sanctioned by a bank

Explanation

Corporate reputation and management credibility are qualitative or soft factors that influence access to finance and the terms on which it is available. Credit ratings, interest rates and tax rates are quantitative or hard factors.

Question 20Financial Policy and Corporate Strategy

A company is deciding between leasing an asset and buying it with borrowed funds. Which of the following is the most appropriate analytical approach?

  1. Compare the present value of lease rentals with the present value of the cost of borrowing to buy, using the after-tax cost of debt as the discount rate Correct answer.
  2. Compare the accounting depreciation with the lease rental
  3. Compare the lease rental with the purchase price of the asset
  4. Compare the book value of the asset with the lease rental

Explanation

The lease-versus-buy decision compares the present value of after-tax lease rentals with the present value of the after-tax costs of owning, discounted at the after-tax cost of debt. This captures the financing and tax effects of each alternative.

Question 21Risk Management

In the Standard Normal distribution table used for Value at Risk (VaR) estimation, a 99% one-tailed confidence level corresponds to a z-value of approximately:

  1. 1.645
  2. 1.960
  3. 2.576
  4. 2.326 Correct answer.

Explanation

For a one-tailed test, the 99% confidence level leaves 1% in the tail, and the z-value cutting off the top 1% is approximately 2.326. The 95% one-tailed level uses 1.645, and 1.960 is the two-tailed 95% value.

Question 22Risk Management

A portfolio has a daily expected return of 0.05% and a daily standard deviation of 1.2%. Using the parametric (variance-covariance) approach at 95% confidence with z = 1.645, the one-day VaR as a percentage of portfolio value is closest to:

  1. 1.97%
  2. 2.02%
  3. 1.87%
  4. 1.92% Correct answer.

Explanation

Parametric VaR = z x sigma - expected return = 1.645 x 1.2% - 0.05% = 1.974% - 0.05% = 1.924%, approximately 1.92%. Subtracting the positive expected return slightly reduces the loss threshold.

Question 23Risk Management

A key limitation of the historical simulation approach to VaR is that it:

  1. requires estimation of a large variance-covariance matrix
  2. assumes asset returns are normally distributed
  3. relies entirely on the actual historical return distribution and may miss unprecedented events Correct answer.
  4. cannot incorporate portfolio diversification effects

Explanation

Historical simulation revalues the current portfolio against past return observations, so it depends wholly on the historical window and may fail to capture risks absent from that window. It makes no normality assumption and does not require a covariance matrix.

Question 24Risk Management

A bank reports a 10-day 99% VaR of Rs 50 crore. Assuming returns are independent and identically distributed, the corresponding 1-day 99% VaR is closest to:

  1. Rs 15.8 crore Correct answer.
  2. Rs 25.0 crore
  3. Rs 3.2 crore
  4. Rs 5.0 crore

Explanation

Under the square-root-of-time rule, VaR scales with the square root of the holding period: 1-day VaR = 10-day VaR / sqrt(10) = 50 / 3.162 = Rs 15.8 crore. This scaling assumes i.i.d. returns with zero autocorrelation.

Question 25Risk Management

Expected Shortfall (ES) is preferred to VaR by many regulators because ES:

  1. is easier to backtest than VaR
  2. measures the average loss in the tail beyond the VaR threshold and is sub-additive Correct answer.
  3. is always smaller in magnitude than VaR
  4. assumes returns are normally distributed

Explanation

ES averages losses exceeding the VaR cutoff, so it captures tail severity and satisfies sub-additivity, making it a coherent risk measure. VaR can violate sub-additivity and says nothing about losses beyond the threshold.

Question 26Risk Management

A risk manager computes VaR at multiple confidence levels and finds the estimates violate sub-additivity when combining two desks. This property is known as:

  1. VaR being a monotonic risk measure
  2. VaR being a coherent risk measure
  3. VaR failing to be coherent because it can breach sub-additivity Correct answer.
  4. VaR being translation invariant

Explanation

A coherent risk measure must satisfy monotonicity, translation invariance, positive homogeneity, and sub-additivity. VaR can fail sub-additivity, meaning the VaR of a combined portfolio may exceed the sum of individual VaRs, so it is not coherent.

Question 27Risk Management

The Basel Committee shifted from VaR to Expected Shortfall at a 97.5% confidence level because ES at 97.5% approximately captures the risk of VaR at:

  1. 95%
  2. 99% Correct answer.
  3. 90%
  4. 99.9%

Explanation

For a normal distribution, ES at 97.5% is roughly equal to VaR at 99%, so the calibration preserves comparability with the earlier 99% VaR standard while capturing tail losses. This is why the FRTB internal models approach uses 97.5% ES.

Question 28Risk Management

A bank backtests its 99% one-day VaR model over 250 trading days and records 9 exceptions. Under the Basel traffic-light approach, this result falls into the:

  1. grey zone
  2. green zone
  3. red zone
  4. yellow zone Correct answer.

Explanation

For 250 observations at 99%, the green zone allows up to 4 exceptions and the yellow zone spans 5 to 9 exceptions; 10 or more falls in the red zone. Nine exceptions therefore place the model in the yellow zone, requiring a higher capital multiplier.

Question 29Risk Management

The Basel backtesting traffic-light framework classifies models into green, yellow, and red zones based primarily on:

  1. the number of risk factors in the internal model
  2. the credit rating of the sovereign where the bank is domiciled
  3. the number of VaR exceptions over the previous 250 trading days Correct answer.
  4. the size of the bank's trading book

Explanation

Backtesting compares actual trading losses with predicted VaR and counts the number of exceptions over a 250-day window. The zone determines the capital multiplier add-on, with more exceptions producing a higher penalty.

Question 30Risk Management

Duration measures the sensitivity of a bond's price to changes in yield. A bond with a modified duration of 6 and a market value of Rs 100 crore faces an adverse parallel yield increase of 25 basis points. Using the duration approximation, the estimated loss is closest to:

  1. Rs 15.0 crore
  2. Rs 1.50 crore Correct answer.
  3. Rs 0.15 crore
  4. Rs 6.00 crore

Explanation

Percentage price change is approximately -modified duration x change in yield = -6 x 0.0025 = -1.5%. Applied to Rs 100 crore, the loss is about Rs 1.50 crore.

Question 31Risk Management

Convexity is added to a duration-based interest rate risk estimate because duration alone:

  1. understates price gains and overstates price losses for large yield moves Correct answer.
  2. ignores the credit spread of the issuer
  3. is only valid for floating-rate instruments
  4. overstates price changes for large yield moves in both directions

Explanation

The price-yield relationship is convex, so the linear duration approximation understates the price increase when yields fall and overstates the price decrease when yields rise. Adding a convexity term corrects this curvature effect for larger yield moves.

Question 32Risk Management

In the context of credit risk, Probability of Default (PD), Exposure at Default (EAD), and Loss Given Default (LGD) are combined to estimate expected loss as:

  1. EAD / (PD x LGD)
  2. PD x (1 - LGD) x EAD
  3. PD x EAD x LGD Correct answer.
  4. PD + EAD + LGD

Explanation

Expected loss equals the probability of default multiplied by the exposure at default and the loss given default. This product expresses the average credit loss expected over a horizon and underpins the Basel IRB approach.

Question 33Risk Management

A bank holds a one-year loan with EAD of Rs 200 crore, PD of 2%, and LGD of 45%. The expected loss is closest to:

  1. Rs 4.00 crore
  2. Rs 9.00 crore
  3. Rs 0.90 crore
  4. Rs 1.80 crore Correct answer.

Explanation

Expected loss = PD x EAD x LGD = 0.02 x 200 x 0.45 = Rs 1.80 crore. The LGD reduces the exposure-weighted default amount to 45% of Rs 4 crore.

Question 34Risk Management

In the Merton structural model of credit risk, a firm defaults when:

  1. its equity value exceeds the face value of its debt
  2. its short-term liabilities exceed its cash reserves at any time
  3. its credit spread narrows below the risk-free rate
  4. the market value of its assets falls below the face value of its debt at maturity Correct answer.

Explanation

The Merton model treats equity as a call option on the firm's assets with a strike equal to the debt's face value. Default occurs at debt maturity when asset value is below the promised debt payment, so shareholders let the option expire worthless.

Question 35Risk Management

A portfolio's daily returns have a mean of 0.10% and a standard deviation of 2.0%. Using the parametric method with z = 1.645, the 95% one-day VaR as a positive loss figure is closest to:

  1. 3.19% Correct answer.
  2. 3.29%
  3. 3.09%
  4. 3.39%

Explanation

VaR = z x sigma - mean = 1.645 x 2.0% - 0.10% = 3.29% - 0.10% = 3.19%. The mean return offsets part of the downside threshold.

Question 36Risk Management

Operational risk under the Basel framework is best defined as the risk of loss resulting from:

  1. adverse movements in market prices of traded instruments
  2. a counterparty failing to meet its contractual obligations
  3. inadequate or failed internal processes, people, and systems, or from external events Correct answer.
  4. changes in the level of interest rates

Explanation

Basel defines operational risk as the risk of loss from inadequate or failed internal processes, people, and systems, or from external events, including legal risk but excluding strategic and reputational risk. Market and credit risks are separate categories.

Question 37Risk Management

Under the Basic Indicator Approach for operational risk capital, the capital charge is calculated as:

  1. a fixed percentage of risk-weighted assets
  2. the sum of business-line betas multiplied by gross income
  3. the bank's internal loss experience times a scaling factor
  4. a fixed percentage (alpha) of average annual gross income over the previous three years Correct answer.

Explanation

The Basic Indicator Approach applies a fixed alpha of 15% to the average annual gross income of the previous three positive years. The Standardised Approach uses business-line betas, while the Advanced Measurement Approach uses internal models.

Question 38Risk Management

A trader holds a long position in a call option. Which Greek measures the change in the option's delta for a one-unit change in the underlying price?

  1. Vega
  2. Rho
  3. Gamma Correct answer.
  4. Theta

Explanation

Gamma is the second derivative of the option price with respect to the underlying, measuring how delta changes as the underlying moves. Theta measures time decay, vega measures volatility sensitivity, and rho measures interest rate sensitivity.

Question 39Risk Management

A risk analyst observes that a portfolio's delta is zero but its gamma is large and negative. The most accurate interpretation is that the portfolio:

  1. is immune to large market moves
  2. has no exposure to volatility changes
  3. is fully hedged against small moves but becomes increasingly short delta as the market rises or falls Correct answer.
  4. will gain value regardless of the direction of the underlying

Explanation

Zero delta means the position is locally insensitive to small price moves, but a large negative gamma means delta falls as the underlying rises and rises as it falls. The hedge therefore deteriorates for larger moves in either direction, creating convexity risk.

Question 40Risk Management

A stress test scenario applies a simultaneous 300 basis point rise in interest rates and a 25% depreciation of the domestic currency. The primary purpose of such a scenario is to:

  1. estimate the probability of the scenario occurring
  2. calibrate the z-value used in the parametric VaR formula
  3. replace the daily VaR calculation with a single number
  4. evaluate portfolio losses under severe but plausible adverse conditions beyond normal VaR confidence levels Correct answer.

Explanation

Stress testing assesses the impact of extreme but plausible scenarios that may lie outside the historical distribution used for VaR. It complements VaR by revealing tail vulnerabilities and concentrations that standard models may miss.

Question 41Security Analysis and Valuation

An analyst estimates the intrinsic value of an equity share at ₹480 while it currently trades at ₹400. Applying the margin-of-safety principle of value investing, which conclusion is most defensible?

  1. The share should be sold because the market price is below intrinsic value
  2. The share offers a 20% margin of safety and merits consideration for purchase Correct answer.
  3. The share is overvalued because intrinsic value exceeds market price
  4. No conclusion can be drawn because intrinsic value is an estimate rather than a fact

Explanation

Margin of safety is the discount of market price to estimated intrinsic value, here (480-400)/480 ≈ 16.7%, or expressed against price a 20% upside, which is a positive cushion for the buyer. A price below estimated intrinsic value indicates undervaluation, not overvaluation. The estimate being uncertain argues for a larger cushion, not for abandoning the framework altogether.

Question 42Security Analysis and Valuation

In security analysis and valuation, the term 'intrinsic value' of a security most accurately refers to:

  1. The present value of expected future cash flows discounted at a rate reflecting risk Correct answer.
  2. The face value stated on the security certificate
  3. The last traded price on the recognised stock exchange
  4. The book value per share disclosed in the latest balance sheet

Explanation

Intrinsic value is an analyst-derived estimate equal to the present value of expected future cash flows discounted at an appropriate risk-adjusted rate. Market price, book value and face value are observed or accounting figures that may differ materially from that estimate. The whole discipline of valuation rests on this distinction between worth and price.

Question 43Security Analysis and Valuation

A company paid a dividend of ₹4 per share last year. Dividends are expected to grow at 6% forever and investors require 14%. Using the Gordon growth model, the estimated value per share is closest to:

  1. ₹53.00 Correct answer.
  2. ₹28.57
  3. ₹30.29
  4. ₹50.00

Explanation

The Gordon model values the share as D1/(ke − g), where D1 = 4 × 1.06 = ₹4.24. Dividing by (0.14 − 0.06) = 0.08 gives ₹53.00. Using the trailing dividend instead of the forward dividend is the commonest error and yields a different figure.

Question 44Security Analysis and Valuation

Under the constant-growth dividend discount model, which condition must hold for the model to produce a meaningful positive value?

  1. The payout ratio must be exactly 100%
  2. The required rate of return must exceed the long-run dividend growth rate Correct answer.
  3. The dividend growth rate must exceed the required rate of return
  4. The dividend growth rate must equal the required rate of return

Explanation

The denominator (ke − g) must be positive, so the required return must exceed the perpetual growth rate. If g is greater than or equal to ke the formula breaks down or produces a negative or infinite value. A 100% payout is not required and would in fact imply zero retention and hence questionable growth.

Question 45Security Analysis and Valuation

Which of the following best describes the purpose of a SWOT analysis within fundamental security analysis?

  1. To organise a company's internal strengths and weaknesses together with external opportunities and threats Correct answer.
  2. To measure the sensitivity of a bond's price to changes in yield
  3. To compute the weighted average cost of capital for discounting free cash flows
  4. To estimate the beta of a stock from its historical return series

Explanation

SWOT is a qualitative framework that structures internal factors (strengths, weaknesses) and external factors (opportunities, threats) affecting a business. It supports judgement about competitive position and risk rather than producing a numerical discount rate or risk statistic. Quantitative tools such as WACC, duration and regression beta serve the other purposes listed.

Question 46Security Analysis and Valuation

An investor buys a share at ₹200 and receives a dividend of ₹10 during the year, selling at ₹220 at year end. The holding period return is:

  1. 5%
  2. 10%
  3. 20%
  4. 15% Correct answer.

Explanation

Holding period return combines capital gain and income: (220 − 200 + 10)/200 = 30/200 = 15%. Ignoring the dividend understates the return, and using the ending price as the base overstates it.

Question 47Security Analysis and Valuation

A firm has just paid a dividend of ₹5 per share. Analysts expect growth of 20% for the next two years, after which growth settles at 8% forever. The required return is 15%. Under the two-stage dividend discount model, the terminal value at the end of year 2 is closest to:

  1. ₹120.00
  2. ₹102.86
  3. ₹96.00
  4. ₹111.09 Correct answer.

Explanation

First compute D2 = 5 × 1.20 × 1.20 = ₹7.20, then D3 = 7.20 × 1.08 = ₹7.776. The terminal value at end of year 2 is D3/(0.15 − 0.08) = 7.776/0.07 ≈ ₹111.09. This terminal amount must then be discounted two years together with the interim dividends to obtain present value.

Question 48Security Analysis and Valuation

A company retains 60% of its earnings and earns a return on equity of 18%. Using the sustainable growth relationship in the dividend discount model, the expected long-run growth rate of dividends is:

  1. 18.0%
  2. 30.0%
  3. 7.2%
  4. 10.8% Correct answer.

Explanation

Growth equals the retention ratio multiplied by the return on equity: 0.60 × 18% = 10.8%. This assumes the retained funds are reinvested at the same return on equity and that the capital structure is unchanged. Confusing the payout ratio with the retention ratio produces the wrong answer.

Question 49Security Analysis and Valuation

A bond with a face value of ₹1,000, a 9% annual coupon and three years to maturity is trading at a yield to maturity of 11%. Its price is closest to:

  1. ₹1,000.00
  2. ₹900.00
  3. ₹1,048.90
  4. ₹951.10 Correct answer.

Explanation

Discount each cash flow at 11%: 90/1.11 + 90/1.11² + 1,090/1.11³ ≈ 81.08 + 73.05 + 796.97 = ₹951.10. Because the coupon of 9% is below the yield of 11%, the bond must trade at a discount to par.

Question 50Security Analysis and Valuation

An analyst uses the capital asset pricing model. The risk-free rate is 6%, the expected market return is 13% and the stock's beta is 1.4. The required return on equity is:

  1. 18.2%
  2. 13.0%
  3. 15.8% Correct answer.
  4. 8.4%

Explanation

CAPM gives ke = Rf + β(Rm − Rf) = 6% + 1.4 × (13% − 6%) = 6% + 9.8% = 15.8%. The market risk premium of 7% is scaled by beta before adding the risk-free rate. Using beta on the full market return rather than the premium is a frequent error.