Question Paper

Security Analysis – II (212) : July 2004

 Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 5.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Perform Michael Porter analysis of the Indian Sugar Industry.
(10 marks) < Answer >
2. Comment on the financial health of Balrampur Chini Mills Ltd. (BCML) based on the financial statements
and ratios given in the Annexure- I
(10 marks) < Answer >
3. From the data provided in Annexure- I, you are required to estimate the probability that the return from
the stock of Balrampur Chini Mills Ltd. (BCML) would be between zero and 40% during January –June
2004.
(7 marks) < Answer >
4. Based on the information given in Annexure-I, you are required to
a. Estimate the regression equation (Security Market Line) depicting the relationship between beta and
expected return. Price Line
b. Calculate required rate of return on the share of Balrampur Chini Mills Ltd, using the relationship
found in (a).
20 days SMA
c. Calculate the perpetual dividend growth rate required by the Balrampur Chini Mills Ltd according to
Line
the dividend discount model to support its stock price of Rs.414.80.Assume that dividend paid
during the year 2003-04 was Rs.10.00 per share.
(4 + 6 + 3 =13 marks) < Answer >
5. A at points A, B, C, D and E based on the
Comment on whether the stock should be bought, sold and held
share price charts given in Annexure I.
(10 marks) < Answer >
Indian Sugar Industry
India is the second largest producer of sugarcane next to Brazil, with approximately about 4 mn hectares of
land under sugarcane. The average yield is to the extent of 70 tonnes per hectare. However, in the current sugar
MACD
season, India has emerged as the world’s leading B This
producer, pushing Brazil to the second place.
achievement has not brought much cheer to the Line
domestic sugar industry, as the industry has been already been
burdened with huge opening stock. The additional production of 18.2 mn tonnes has led to a further pile-up due
to a slow growth in offtake.
The Indian Sugar industry is the country’s second largest agro-processing industry with the production capacity
of over 18 mn tonnes of white crystal sugar annually. Presently, the total turnover of the industry is about Rs
200 bn with the total capital employed at about Rs 160 bn. Nearly 45 mn farmers and their families depend
directly on sugar industry.
In the FY 99-00, India’s sugar output of 18.2 mn tonnes raw value has broken all its past records. Per capita
consumption, however, is only a little over half the global average, 16 kgs versus 26 kgs internationally.
Sugar is an important food item, with a weight of 4.06% in the wholesale price index. In a country like India,
where inflation affects voting pattern, sugar prices has an impact on future voter behavior. Politics is an
important determinant of the industry policy. Powerful sugarcane lobbies influence political fortunes in states
of Uttar Pradesh and Maharashtra.
Over the last four decades sugar production has grown at a CARG of 6%. Both, capacities and production in
E
the sugar industry have kept pace with increases in consumption and the growth in population.
According to an International study, India ranks second in field cost of sugarcane, next only to Australia.
Presently, about 2.2% of cultivated area is under sugarcane. India thus offers great potential for expansion of
area and sugarcane and sugar production.
INDUSTRY STRUCTURE

D C
 Suggested Answers
Security Analysis – II (212) : July 2004
Section D : Case Study

1. Barriers to Entry
Entry barriers are high in this industry due to uncertain government regulations and capital intensive nature
of the industry. The industry is capital intensive, Indian sugar industry is highly fragmented with organized
and unorganized players. The unorganized players mainly produce Gur and Khandari, the less refined
forms of sugar. The government had a controlling grip over the industry, which has slowly yet steadily
given way to liberalization. Central government Policy also directly influences pricing, production and
distribution of sugar. Maximum Retail Price (MRP) of sugar is also decided by the central government.
Clearly, government regulations also act as big entry barrier to the industry.
Bargaining power of Suppliers
The sugarcane producer enjoys central importance of the government. The minimum price at which sugar
companies can purchase the sugarcane is decides by central govt. and state govt. Government also supports
the farmer by deciding the prices of the Sugars. Therefore, bargaining power of suppliers can be said to be
high in the sugar industry.
Bargaining power of Customers
Individually, customers have very little bargaining power with retail stores selling sugar. It is very difficult
to bargain a general shopkeeper for a better price on sugar. But organized and large institutional consumers
such as hotels, confectionery manufacturers, soft drink manufacturers and the food processing industry may
demand high quality products at bargain prices.
Threat of Substitute
Threat of substitute is low as there are no direct alternatives available for sugar. However, sweetening
agents such as jaggery, lactose, sorbitol, honey, liquid glucose do pose some threat to standardized product
of the industry.
Competition among the existing Players
As the industry is a fragmented one, even leading players do not control more than 4 percent market in
India. However, the situation is changing and players off late are striving to increase their market share
either by acquiring smaller mills or by going for green field capacity additions. The competition is high in
this industry as all the major companies are striving for higher market share.
< TOP >
2. a. The profitability of the company is showing fluctuating trend. During year 1999-2000 and 2002-03 it
fell down sharply. The profit after tax has gone down drastically during 1999-2000 and 2002-03
however topline (sales) has increased considerably during both year and declined during 2001-02.
Raw material cost, other manufacturing expenses and selling cost have increased substantially during
1999-2000 and 2002-03 causing huge drain in the profitability of the company during these years.
b. Gross profit margin, return on networth, return on capital employed and EPS have confirmed the
decline in the profitability during the year 1999-2000 and 2002-03 .
c. The current ratio of the company is not very comfortable which is apparent from its continuous
decline during the last five years. Debt-equity ratio and interest coverage ratio are at comfortable
levels.
d. The turnover ratios except debtor turnover ratio have been steadily improving, both relating to fixed
assets as well as inventory. The debtor turnover ratio however, is declining.
e. Interest payments have decreased during year 2001-02 indicating repayment of some loan and it has
further decreased during 2002-03 due to switch over by the company towards cheaper unsecured
loans.
f. In the year 1999-2000 and 2000-2001, total preference capital have been repaid. Unsecured loan has
increased drastically during 2002-03. Decline in investment during the last five years have been
compensated by increase in capital work-in progress.
< TOP >
3. Stock (%) Market(%)
 11.007 -20.04
-10.86 -3.713
44.105 10.581
-10.23 0.5564
18.745 15.1
103.29 74.729
26.011
Mean return on the stock = 26.011%
The standard deviation of the return of BMCL stock = 43.01 %
Probability that the return will be between zero and 5% can be calculated as follows:
0 − (26.011) 40 − (26.011)
<Z<
43.01 43.01
−26.011 13.989
or 43.01 < Z < 43.01
or -0.6047 < Z <0.3252
From the normal distribution table, the area for
-0.6047→0.2727
0.3252→0.6274
Z = 0.6274 – 0.2727 = 0.3547 = 35.47%
< TOP >
4. a. The equation for SML can be derived by running a regression between the beta values given and the
corresponding return:
X Y X2 XY
0.25 10 0.0625 2.5
0.5 11.5 0.25 5.75
0.75 13 0.5625 9.75
1.25 16 1.5625 20
1.5 17.5 2.25 26.25
2 20.5 4 41
2.25 22 5.0625 49.5
2.5 23.5 6.25 58.75
11 134 20 213.5

∑X = 11, ∑Y= 134, n = 8

∑XY=213.5, ∑X2 = 20
X = 1.375 , Y = 16.75
∑ XY − nXY 213.5 − 8 ×1.375 × 16.75
2
The coefficient of regression (Slope) b = ∑ X − nX =
2 20 − 8 × (1.375) 2 =
29.25/ 4.875 = 6

The Y intercept a = Y − b X = 16.75 – 6 × 1.375 = 8.5

Value of A (Rf) = 8.50
 Value of B (Rm – Rf) = 6.0
The equation is 8.50 + 6.0β
Where β is the beta of the stock.
b. The beta of Apollo Tyres can be determined based on the returns from the stock and the returns on the
index.
Date Return on Balrampur Chini Mills Ltd. (%) (Y) Returns on Index (%) (X)
January 01, 2001
June29, 2001 11.007 -20.04
January 01, 2002 -10.86 -3.713
June 28, 2002 44.105 10.581
January 01, 2003 -10.23 0.5564
June 30, 2003 18.745 15.1
January 01, 2004 103.29 74.729

X Y X2 XY
-20.04 11.01 401.54 -220.57
-3.713 -10.9 13.786 40.3135
10.58 44.1 111.96 466.667
0.556 -10.2 0.3096 -5.6905
15.1 18.74 228.01 283.045
74.73 103.3 5584.4 7719.1
77.21 156.1 6340 8282.87
∑X = 77.21, ∑Y= 156.1, n = 6
∑XY=8282.87, ∑X2 = 6340
X = 12.87 , Y = 26
∑ XY − nXY 8282.87 − 6 ×12.87 × 26

The coefficient of regression (Slope) Beta = ∑ X − nX =

2 2 6340 − 6 × (12.87) 2 =
6275.15/5346.17 = 1.174
Beta = 1.174
Beta of Apollo Tyres = 1.174
Expected return from Apollo = 8.50 + 1.174 X 6 = 15.54%

c. According to DDM,
D1 10.0 × (1 + x)
k−g
P0 = or 414.80 = 0.1554 − x
414.80 × 0.1554 –414.8x = 10 +10x
64.46 – 10.0 =414.8x +10x
54.46
x = 424.8 = 12.82%.
< TOP >
5. A. At this point both moving average and price line have started rising hence it is an indication to buy
the stock.
B At this point MACD line is well above its reference line and about to decline therefore stock should be
 sold.
C. As ROC line has started moving up it is an indication to buy the stock.
D. RSI has touched the oversold position and price rise is expected, it is an indication to buy the stock.
E. RSI has touched the overbought position and price decline is expected, it is an indication to sell.
< TOP >

Section E: Caselets
Caselet 1

6. Investors should strip out the effects of the bubble. Market data from the past three to five years would be
an appropriate basis for beta estimates only if we expected historical correlations of performance and
relative valuations among sectors to persist in the future. However, sharp declines in TMT valuations
suggest that past few years were indeed an extraordinary period, unlikely to be repeated in the future.
Indeed, the TMT sector share of the total market capitalization is already back to its average 20-year
historical levels. Moreover, analysis of the past months indicates that betas for many nontech sectors are
increasing as TMT valuations decline. For many sectors, these recent beta estimates are also much more in
line with their pre-1998 values. To eliminate the distortion of the high-tech bubble, practitioners should
combine historical estimates of betas prior to 1998 with data from after 2000. For example, eliminating the
impact of the TMT boom implies a beta of 0.65 for the food, beverage, and tobacco sector. A beta at that
level is more consistent with the sector’s average historical beta of 0.85 between 1980 and 1998, and it
contrasts sharply with the low 0.02 beta that an unadjusted approach would produce. The impact of the
TMT bubble on beta calculations in some sectors is all too obvious, first leading to decline and then, in the
past several months, to recovery.
< TOP >
7. Shortcomings of CAPM
• • The model does not appear to adequately explain the variation in stock returns. Empirical
studies done in the past 15 years show that low beta stocks may offer higher returns.
• • What is the Market portfolio? Does it include the bond market? Real estate? Commodities?
Private placements?
• • The Market portfolio, and hence its return, are not observable and have to be estimated.
• • The model assumes that all investors are risk adverse. Some investors (e.g., some day
traders), are not risk adverse.
• • The model assumes that all investors create mean-variance optimized portfolios. There are
many investors who don't know what a mean-variance optimized portfolio is.

< TOP >

Caselet 2

8. In each of these companies, there has not been any significant change in the business fundamentals to
warrant the magnitude of the price spurt. Bonus offers and stock splits are wealth-neutral. Immediate
gains may also be transitory. Such corporate actions can have a sustained positive effect on valuation,
which may, however, be reflected only over a longer time frame. The enhanced number of shares may
lead to higher liquidity in the stock. This may lead to a higher price-earnings multiple (PEM). The
likelihood of a higher PEM will also be valid only if the earnings growth story does not lose momentum
Bonus issues also show that companies are taking recourse to an internal source of finance by
capitalising free reserves. This route also pleases shareholders however, immediate and sudden price
rise cannot be justified.

< TOP >

9. There are several reasons companies may consider this corporate action.
The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the
price is too high to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share
 price down to a more attractive level. The actual value of the stock doesn't change one bit, but the lower
stock price may affect the way the stock is perceived and therefore entice new investors. Splitting the stock
also gives existing shareholders the feeling that they suddenly have more shares than they did before. A
final motivation for splitting the stock is to increase a stock's liquidity, which increases with the stock's
number of outstanding shares. None of these reasons or potential effects jive with financial theory. Splits
are a good demonstration of how the actions of companies and the behaviors of investors do not always fall
intoline with financial theory.

Advantages for Investors

There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. One
side says a stock split is a good buying indicator, signaling that the company's share price is increasing and
therefore doing very well. This may be true, but on the other hand, you can't get around the fact that a stock
split has no affect on the fundamental value of the stock and therefore poses no real advantage to investors.
Historically, buying before the split used to be a good strategy because of commissions that were weighted
by the number of shares you bought. Buying a stock before rather than after it split was advantageous only
because it saved you money on commissions. This isn't such an advantage today because most brokers offer
a flat fee for commissions, so you pay the same amount whether you buy ten shares or 1000 shares. Some
online brokers have a limit of 2000 or 5000 shares for that flat rate, but most investors don't buy that many
shares at once. The flat rate therefore covers most trades, so it does not matter whether you buy before or
after the split.
< TOP >
Caselet 3
10. Fundamental analysis is based on an analysis of the overall health of a company and its potential to earn
profits in future. This analysis also involves a study of the industry in which the company operates and the
economy as a whole. Technical analysis, in contrast, is based on study of the price trends studies made on
these two styles of investing in the US have shown that each of these worked very well but in different
periods. Each of the two approaches also has its defects. The biggest defect of financial analysis is that it is
mechanical and does not consider the qualitative factors, while fundamental analysis contains analysis of
some qualitative factors, the significance of which is difficult to objectively estimate. Similarly, it is said
that technical analysis becomes a self-fulfilling prophecy when every one in the market applies the same
technique, while fundamental analysts face the problem of availability of the required information at a
suitable time.
In sum, it can be said that both the types of analysis have their strengths and weaknesses, a middle of the
road approach could be to use fundamental analysis to select stocks and also depend on technical analysis
to time the market.
< TOP >
11. A typical head and shoulders pattern looks like the one given in the graph below. The shoulders are marked
as S1 and S2 and the head as H. The lowest points reached between S1 and H and between H and S2 are
marked as L1 and L2 respectively.

When the price reaches S1, the sellers feels the stock in overpriced and start selling and the price falls. At
L1, the buyers feel the stock is underpriced and start buying thereby pushing up the price to a level higher
than the earlier peak but again, the sellers feel the stock is overpriced and start selling to bring it back to the
earlier level, which is indicated as L2 for the second time, the buyers take over and push the prices up. But,
this time round, they are not very powerful and therefore before the price reaches the earlier peak (H), the
sellers overpower them and, they bring the price below the levels touched earlier low levels is what
completes this formation.
< TOP >

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