Fundamentals of Investment 2079 Board Question Paper

Meaning of an Investment Plan

An investment plan is a written, individualized roadmap outlining an investor’s financial goals, investment horizon, risk tolerance, liquidity constraints, and strategic asset allocation across asset classes.

Key Uses of a Stock Market Index

1. Serves as a benchmark to assess mutual fund and active portfolio performance.
2. Acts as a barometer of overall investor sentiment and national economic health.
3. Provides a proxy for the market portfolio return ($R_m$) in the Capital Asset Pricing Model.

Role of the Primary Market

The primary market facilitates the direct channelization of public savings into productive corporate investments, enabling companies and governments to raise fresh equity and debt capital through IPOs and rights offerings.

Market Order vs. Limit Order

• Market Order: An order executed immediately at prevailing market prices; guarantees execution speed but not price.
• Limit Order: An order specifying a maximum buy price or minimum sell price; guarantees price execution but may remain unfulfilled if market prices move away.

Investment Yield Calculation:

• $PV = \text{Rs. } 10,000$, $FV = \text{Rs. } 15,000$, $n = 5$ years.
  $$r = \left(\frac{15,000}{10,000}\right)^{1/5} - 1 = (1.50)^{0.20} - 1 = 1.08447 - 1 = \mathbf{8.45\%}$$
  Recommendation: No, reject the investment. The realized return (8.45%) is below the required return of 9.0%.

Expected Return on Constant Growth Stock:

• $D_0 = \text{Rs. } 40$, $g = 6\%$, Current Price $P_0 = \text{Rs. } 500$.
  $$D_1 = D_0(1 + g) = 40(1.06) = \text{Rs. } 42.40$$
  $$\hat{r} = \frac{D_1}{P_0} + g = \frac{42.40}{500} + 0.06 = 0.0848 + 0.06 = 0.1448 = \mathbf{14.48\%}$$
  Conclusion: The expected rate of return is 14.48%.

CAPM Required Return Calculation:

• $R_f = 5\%$, $R_m = 15\%$, $\beta = 1.8$.
  $$k_s = R_f + \beta(R_m - R_f) = 5\% + 1.8(15\% - 5\%) = 5\% + 18\% = \mathbf{23.0\%}$$
  Decision: Do NOT purchase. Since the expected return (20.0%) is lower than the required return (23.0%), the stock is overpriced and yields negative alpha.

Interpretation of Jensen’s Alpha = +1.2%

A positive Jensen’s Alpha of +1.2% demonstrates that the portfolio earned an average annual excess return of 1.2% above its CAPM risk-adjusted benchmark, proving superior managerial security selection and market timing.

Intrinsic Value of Put Option:

• Strike Price ($X$) = $\text{Rs. } 160$, Market Price ($S$) = $\text{Rs. } 140$.
  $$\text{Value of Put} = \max(0, X - S) = \max(0, 160 - 140) = \mathbf{\text{Rs. } 20}$$
  Conclusion: The put option has an intrinsic value of Rs. 20.

Condition for Exercising a Call Option

A call option is exercised only when it is in-the-money, meaning the current market price of the underlying stock ($S$) strictly exceeds the contractual strike price ($X$), i.e., $S > X$.

Status of Investment Environment in Nepal

1. Regulatory Framework: SEBON serves as apex securities regulator; CDSC operates electronic clearing and C-ASBA settlement.
2. Market Structure: Overwhelmingly dominated by financial institutions (commercial banks, microfinance) and emerging hydropower companies.
3. Technological Progress: Shift to 100% online trading via TMS and Meroshare, broadening retail participation.
4. Current Challenges: High interest rate cyclicality, limited derivative hedging mechanisms, and concentrated market capitalization.

Meaning and Major Types of Fixed Income Securities

Fixed income securities are debt financial contracts that provide investors with fixed, periodic interest cash flows and return of principal at maturity.

Major Types:

1. Treasury Bills: Short-term sovereign discount debt issued by NRB.
2. Government Development Bonds: Multi-year sovereign debt instruments.
3. Corporate Debentures: High-yielding corporate bonds issued primarily by commercial banks.
4. Preference Shares: Hybrid fixed-dividend senior equity.

Short Sale Margin Analysis (500 Shares at Rs. 200):

• Total Sale Proceeds $= 500 \times 200 = \text{Rs. } 100,000$.

• Initial Margin ($IM$) = $60\%$, Maintenance Margin ($MM$) = $30\%$.

• a. Initial Account Balances:

  • Initial Equity $= 100,000 \times 0.60 = \mathbf{\text{Rs. } 60,000}$.
  • Total Account Assets $= 100,000 + 60,000 = \text{Rs. } 160,000$.
  • Initial Debt (Stock Liability) $= \mathbf{\text{Rs. } 100,000}$.

• b. Stock Price Increases to Rs. 250:

  • Current Debt (Stock Liability) $= 500 \times 250 = \mathbf{\text{Rs. } 125,000}$.
  • Equity $= 160,000 - 125,000 = \mathbf{\text{Rs. } 35,000}$.
  • Actual Margin:
    $$AM = \frac{\text{Equity}}{\text{Stock Liability}} = \frac{35,000}{125,000} = 0.28 = \mathbf{28.0\%}$$

• c. Margin Call Decision: Since Actual Margin (28.0%) has fallen below the maintenance margin threshold (30.0%), the investor WILL RECEIVE A MARGIN CALL requiring additional cash deposit.

Three-Stock Index Construction (2018 to 2019):

• Stock A: 2,000 shares, $P_{18} = 300$, $P_{19} = 700$.

• Stock B: 8,000 shares, $P_{18} = 300$, $P_{19} = 380$.

• Stock C: 8,000 shares, $P_{18} = 200$, $P_{19} = 260$.

• a. Price-Weighted Index:

  • $PWI_{18} = (300 + 300 + 200) / 3 = 800 / 3 = \mathbf{266.67}$.
  • $PWI_{19} = (700 + 380 + 260) / 3 = 1340 / 3 = \mathbf{446.67}$.
  • $\% \text{ Change} = \frac{446.67 - 266.67}{266.67} = \mathbf{67.50\%}$.

• b. Market Value-Weighted Index:

  • $MV_{18} = (2k \times 300) + (8k \times 300) + (8k \times 200) = 600k + 2400k + 1600k = \text{Rs. } 4,600,000$.
  • $MV_{19} = (2k \times 700) + (8k \times 380) + (8k \times 260) = 1400k + 3040k + 2080k = \text{Rs. } 6,520,000$.
  • $\% \text{ Change} = \frac{6,520,000 - 4,600,000}{4,600,000} = \mathbf{41.74\%}$.

• c. Equally-Weighted Index:

  • Individual Returns: $R_A = \frac{700 - 300}{300} = 133.33\%$, $R_B = \frac{380 - 300}{300} = 26.67\%$, $R_C = \frac{260 - 200}{200} = 30.0\%$.
  • $\% \text{ Change} = \frac{133.33 + 26.67 + 30.0}{3} = \mathbf{63.33\%}$.

• d. Discussion: PWI is heavily skewed by Stock A’s huge price jump to Rs 700. VWI reflects the true aggregate market wealth change (41.74%) because large-cap stocks B and C dampen Stock A’s small-cap influence.

Closed-End Fund & Mutual Fund Advantages:

• a. Market Price of Closed-End Fund:

  • Assets = $\text{Rs. } 2,250\text{M}$, Liabilities = $\text{Rs. } 50\text{M}$, Shares = $100\text{M}$.
    $$NAV = \frac{2,250 - 50}{100} = \frac{2,200}{100} = \text{Rs. } 22.00$$
  • At $8\%$ discount:
    $$\text{Market Price} = 22.00 \times (1 - 0.08) = 22.00 \times 0.92 = \mathbf{\text{Rs. } 20.24}$$

• b. Advantages and Disadvantages of Mutual Funds:

  • Advantages: Instant portfolio diversification, professional fund management desk, low entry capital, high liquidity.
  • Disadvantages: Management expense drag, lack of individual portfolio customization.

Pokhara Foods Financial Ratios:

Given: Net Income = $\text{Rs. } 7.5\text{M}$, Sales = $\text{Rs. } 60\text{M}$, Shares = $1\text{M}$, Total Assets = $\text{Rs. } 150\text{M}$, Equity = $\text{Rs. } 110\text{M}$, Dividend/share = $\text{Rs. } 4.5$, Stock Price = $\text{Rs. } 300$, Growth = $5\%$.

• a. EPS: $\frac{7.5\text{M}}{1\text{M}} = \mathbf{\text{Rs. } 7.50}$.
• b. BVPS & P/B Ratio:
  $$BVPS = \frac{110\text{M}}{1\text{M}} = \mathbf{\text{Rs. } 110.00}, \quad P/B = \frac{300}{110} = \mathbf{2.73}$$
• c. P/E Ratio & Net Profit Margin:
  $$P/E = \frac{300}{7.50} = \mathbf{40.0}, \quad \text{NPM} = \frac{7.5\text{M}}{60\text{M}} = 0.125 = \mathbf{12.5\%}$$
• d. Dividend Payout & Dividend Yield:
  $$\text{Payout} = \frac{4.50}{7.50} = \mathbf{60.0\%}, \quad \text{Dividend Yield} = \frac{4.50}{300} = \mathbf{1.50\%}$$
• e. PEG Ratio:
  $$PEG = \frac{P/E}{\text{Growth Rate}} = \frac{40}{5} = \mathbf{8.0}$$

The Systematic Investment Process and Lifecycle Considerations

1. Steps in Investing: Investment Policy Statement (IPS) formulation, macro and industry analysis, asset valuation, portfolio construction, performance attribution.
2. Lifecycle Factors: Young accumulation phase (high-growth equities), consolidation phase (balanced growth/income), retirement spending phase (capital preservation, fixed-income debentures).

Stock A and B Portfolio and Valuation Analysis ($w_A = 0.5, w_B = 0.5$):

• $E(R_A) = (0.3 \times -5) + (0.4 \times 10) + (0.3 \times 15) = -1.5 + 4.0 + 4.5 = \mathbf{7.0\%}$, $\sigma_A = \mathbf{7.81\%}$.
• $E(R_B) = (0.3 \times 20) + (0.4 \times 15) + (0.3 \times -10) = 6.0 + 6.0 - 3.0 = \mathbf{9.0\%}$, $\sigma_B = \mathbf{12.61\%}$.
• Covariance: $Cov(A, B) = \mathbf{-96.0}$, Correlation: $\rho = \frac{-96.0}{7.81 \times 12.61} = \mathbf{-0.975}$.
• Portfolio: $E(R_p) = \mathbf{8.0\%}$, $\sigma_p = \mathbf{2.55\%}$.
• CAPM Check ($R_f = 4\%$, $R_m = 10\%$):
  • Required A: $4 + 0.5(6) = 7.0\% \implies$ Fairly priced ($E(R) = 7.0\%$).
  • Required B: $4 + 1.1(6) = 10.6\% \implies$ Overvalued ($E(R) = 9.0\% < 10.6\%$).

Comprehensive Bond Valuation Suite:

• Bond A (Semi-annual): $n = 10$, coupon $8\%$, rate $10\% \implies V_B = \mathbf{\text{Rs. } 875.38}$.
• Bond B (Callable after 2 yrs): Expected call price at par $\implies V_B = \mathbf{\text{Rs. } 1,054.24}$.
• Bond C: Selling at Rs 939, coupon 9% $\implies \text{Current Yield} = \frac{90}{939} = \mathbf{9.58\%}$, $YTM \approx \mathbf{10.0\%}$.
• Bond D Duration: 10% coupon, 4 years, YTM 12% $\implies D = \mathbf{3.43 \text{ years}}$.
• Bond E vs F: Bond F (10 yrs) has greater maturity than Bond E (5 yrs); therefore, at a discount market rate of 10%, Bond F suffers greater price discount due to interest rate risk.