Question Paper

Security Analysis – II (212) : April 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’s Analysis of the Indian Fertilizer Industry.
(10 marks) < Answer >
2. a. Perform ROE analysis of Gujarat Narmada Valley Fertilizers Company Ltd.(GNFC) for last four
years based on the Financial Statements given in Annexure I.
b. Calculate Cash Earning Per Share (CEPS) of the Gujarat Narmada Valley Fertilizers Company Ltd.
(GNFC) during the last four years. Make comparative analysis of CEPS with EPS.
(8 + 5 = 13 marks) < Answer >
3. Calculate the intrinsic value of the equity of Gujarat Narmada Valley Fertilizers Company Ltd. (GNFC) as
on 1.04.2004 as per the formula given below:
P0 = 0.35 × PDDM + 0.65 × PRegression
PRegression = 47.25 + 10.25 × DP + 25.45 × GR – 0.89 beta + 45.8 ROE
Where,
DP = Average dividend Payout Ratio, (%)
GR = Average growth rate in earnings, (%)
ROE = Average Return on Equity, (%)
β = Beta of GNFC stock (relevant data appears in Annexure I to the case.)
PDDM = Price as per the DDM.
GNFC will continue to maintain a dividend rate of 25%. The growth rate in the earnings will be 20% for
the next 5 years and 10% thereafter. The face value of GNFC share is Rs 10 and risk free rate is 5.5%.
(12 marks) < Answer >
4. Comment on whether stock should be bought or sold at points A, B, C, D and E based on the chart given in
Annexure I.
(10 marks) < Answer >
5. Discuss the leading economic indicators that are significant to Fertilizer Industry.
(5 marks) < Answer >
Fertilizer Industry
Fertilizers play a vital role in the Indian economy, which still is largely dependent on agriculture, helping to
produce sufficient foodgrains for the Indian population of over 1 billion. Agriculture accounts for 25% of GDP
and the contribution of fertilizer industry to GDP is significant.
The vibrant Indian fertilizer industry, with huge capital investments is the third largest producer and consumer
of Fertilizers, next only to China and United States. It also generates substantial employment. The fertilizer
industry facilitates the country in its quest for self-sufficiency in agricultural production. Towards this end, it
aims at appropriate utilization of Fertilizers for optimum yield of crops.
The industry as such is undergoing a painful transition from the subsidized environment of earlier times towards
a de-controlled market of the post-liberalization. The industry also faces threat from the global environment on
account of removal of Qualitative Restrictions (QRs) and WTO bound rates in respect of a few Fertilizers.
Industry Structure
Fertilizers basically provide primary, secondary and micronutrients that are essential for the normal growth of plants.
Primary nutrients are Nitrogen (N), Phosphorous (P) and Potassium (K). Secondary nutrients are calcium,
magnesium, and sulfur while micronutrients are boron, chlorine, cobalt, copper, iron, manganese, molybdenum,
sodium, and zinc.
The most widely used Fertilizers include nitrogenous (N) - 70% of consumption, Phosphorous (P) - 22% and
potassic (K) - 7%. Potassic fertilizer is not manufactured in India and imports accounts for total consumption.
Urea accounts for 85% of the nitrogen consumption, followed by Di-Ammonium phosphate (DAP) and others
accounting for 15%. Likewise, over 66% of the phosphate consumption are by DAP, followed by Single Super
Phosphate (SSP) at 14%.
The production of nitrogenous Fertilizers in the country is based on various feed stocks. Of the total production
capacity nearly 20 million MT of urea, 58% comes from gas based plants, 30% from naphtha and 12% from fuel
oil / Low Sulphar Heavy Stock (LSHS) / mixed feed stocks. India is largely self-sufficient in these feed stocks
although India is a net importer of crude oil. Inadequate availability of natural gas supply is a growing cause for
concern and alternatives like import of LNG are under active consideration. Of the two other major nutrients,
phosphorus is mostly manufactured from imported rock phosphates or from phosphoric acid while all potash is
imported.
The first fertilizer manufacturing unit was set up in 1906 at Ranipet near Chennai with a production capacity of
6000 mt of Single Super Phosphate per annum. With this humble beginning the Indian fertilizer sector over the
years took a quantum leap. There are 64 large size fertilizer units in the country, manufacturing a wide range of
nitrogenous and phosphatic/complex fertilizers. Of these, 39 units produce urea, 18 units produce DAP and
complex fertilizers, 7 units produce low analysis straight nitrogenous fertilizers and 9 of the above units produce
ammonium sulphate as a by-product. Besides, there are about 79 small and medium scale units producing single
superphosphate. The total installed capacity of fertilizer production in the country is 110.71 lakh tonnes of
nitrogen and 36.48 lakh tonnes of phosphate as on 29 February 2000.
The domestic fertilizer demand was met largely by imports till mid-1970s. To reduce import dependence, the
government implemented a Retention Pricing Scheme (RPS) in 1977. The objectives of the scheme were to
increase consumption and production of fertilizers, ensure availability at an affordable price and give a
reasonable return to the producers.
Till August 1992, the fertilizer industry was fully regulated by the Government under the protective umbrella of
the RPS, a unit-wise cost-plus scheme that assured a fixed rate of return on the net worth for each unit.
However, in 1992, the Government, faced problem of mounting fertilizer subsidy bill, lifted the pricing and
distribution controls on P and K Fertilizers while retaining N Fertilizers under the regulatory regime. As of now,
urea is the only fertilizer still regulated by pricing and distribution controls.
The leading listed companies in the industry are Southern Petrochemical Industries (Spic), National Fertilizers (NFL),
Rashtriya Chemicals & Fertilizers (RCF), Gujarat Narmada Valley Fertilizers Company Ltd. (GNFC), Nagarjuna
Fertilizers & Chemicals (NFCL) Fertilizers & Chemicals Travancore (Fact), Zuari Industries, Chambal Fertilizers &
Chemicals, etc. The leading unlisted companies are Indian Farmers Fertilizer Co-operative (Iffco), Krishak Bharati
Co-operative (Kribhco).
Cost Structure
Raw materials constitute about 54% of sales, followed by power and fuel cost at 16% and other manufacturing
costs at 10%. The key raw materials used in production of Fertilizers are ammonia, phosphoric acid and sulphur.
Ammonia is the major raw material used to produce nitrogenous and complex Fertilizers. Similarly, rock
phosphate, sulphur, phosphoric and sulphuric acid are vital intermediaries for production of complex and
phosphatic Fertilizers.
Ammonia can be produced from feedstocks like natural gas, naphtha or fuel oil. However, the country is
constrained by the non-availability of the above feedstock of good quality in sufficient quantities. Though
natural gas is the cheapest raw material, currently all the above feedstock, apart from coal, is used to produce
ammonia, despite huge cost variations.
About 8% of the country's ammonia requirement are being imported, mainly from Middle East, Indonesia and
Former Russian States (FRS). Similarly, while the entire potassic Fertilizers are imported, about 68% rock
phosphate and about 79% of phosphoric acid are imported, due to non/poor availability of these
chemicals/Fertilizers in India. Hence, the cost of production in India is grossly on a higher side, and sometimes,
it is even higher than the international prices of finished product.
The industry is highly capital intensive and therefore, over 12% of sales are incurred as interest cost.
Depreciating rupee also adds to the cost, as most of the raw materials are imported.
Policy Impact
In Oct. 2002, the group of ministers, finalized a draft fertilizer policy, laying emphasis on efficiency in
operations of urea manufacturing units and envisaging switch over from the existing unit-wise retention price-
cum-subsidy (RPS) scheme to Group Concession Scheme (GCS) for indigenous urea plants in a phased manner.
The group's recommendations were broadly in line with the report of the Expenditure Reforms Commission and
is expected to substantially reduce the subsidy burden.
As per the recommendations, fertilizer units will be will be divided into six groups based on their technological
vintage and feedstock. The units in each group would be allowed concessions based upon the weighted average
retention prices.
Effective from June 2002, the pricing policy for the Seventh and Eighth pricing periods under the existing RPS
was notified.
In India, the Fertilizers providing primary nutrients nitrogen (N), phosphate (P) and potassium (K) are
subsidized by the government. Further, the fertilizer price, distribution and movement were controlled through
Fertilizer Control Order (FCO) and Fertilizer Movement Control Order (FMCO) under the Essential
Commodities Act.
Considering the strategic importance of this core sector industry, the Union Government has been addressing
issues and concerns relative to the industry through its policies. As a result of partial decontrol of the P&K
Fertilizers in August, 1992, the NPK usage in the country got adversely affected. The NPK use ratio, which was
at 5.9:2.4:1 during the pre-decontrol period deteriorated to 9.7:2.9:1 after the decontrol in 1992. This adverse
ratio was due to spurt in prices of decontrolled Fertilizers. While the prices of urea were heavily subsidized,
post-decontrol, the phosphatic fertilizer prices zoomed, thereby forcing the farmers to use more of urea than of
other Fertilizers. However, with the introduction of ad hoc concessions for P&K Fertilizers, the ratio improved
to 7:2.7:1 during the year 2000-01, against the agronomically desirable ratio of 4:2:1.
Realizing the need for balanced application of Fertilizers for optimum yield of crops, the government had
introduced ad-hoc subsidies for decontrolled Fertilizers and to set right the nutrient imbalance in the soil.
Currently Urea is the only fertilizer under the control of Retention Price System (RPS) and all other Fertilizers
are governed by ad-hoc concession scheme with the MRPs fixed by the Union Government.
In view of the overriding need to rein in the fiscal deficit, fertilizer subsidy is a major issue for the Government.
The subsidy burden of the Central government for Fertilizers went up sharply from
Rs. 505 crore in 1980-81 to Rs. 13,244 crore in 1999-2000 (revised estimate). The budgetary allocation for
2001-02 was reduced to Rs. 7370 crores from the previous level of Rs. 9500 crores and has been further reduced
to Rs. 6499 crores in 2002-03. In case of decontrolled Fertilizers, budgetary allocation for ad-hoc concession
scheme for 2002-03 has been reduced to Rs. 4224 crores against the revised estimates of Rs. 4525 crores for
2001-02.
The uncertainty in the policy environment in fertilizer industry continued during 2001-02. The
recommendations of the Expenditure Reforms Commission (ERC) for the phased de-regulation of urea and
increase in price of urea by 7% per annum beginning 1st April, 2001 has not been implemented. However,
retention prices of 13 units including 6 based on naphtha, 5 on gas and 2 on fuel oil / LSHS have been revised
downward with retrospective effect from 1st April, 2000 on the basis of interim revision in consumption norms.
The reduction in retention price is steep, particularly for naphtha-based plants and ranges from Rs.1000 to
Rs.1900 per MT.
In pursuit of its policy towards phased decontrol of the fertilizer industry, the Government has increased the selling
price of all Fertilizers by about 5%-7% the year 2002-03. As regards Complex Fertilizers, the Tariff Commission,
which was entrusted with the study of the cost of production/sale of Complex Fertilizers and suggest a formula for
future subsidy calculations, had proposed that the Complex Fertilizer manufacturers be divided into two groups viz.
Group I consisting of those using imported ammonia or manufacturing ammonia from gas and Group II comprising
of those manufacturing Ammonia from Naphtha, Fuel Oil and Mixed Feed. The 'P' manufacturers have represented to
the Government the need to have a uniform norm for calculating the concession and the need to avoid splitting the
industry into two. The Government's final decision on the matter is awaited. The Commissions recommendations, if
implemented, would put efficient manufacturers at some disadvantage as compared to high cost manufacturers of
complex Fertilizers.
Further, there was no incentive for the industry to become cost effective, as subsidy was linked to the cost of each
unit. Hence, the government plans to phase out subsidies and progressively decontrol the entire fertilizer industry, to
make it globally competitive. The basis for formulating seventh and eighth pricing periods and the formulation of a
Long Term Fertilizer Pricing Policy is under active consideration of the Government. The Industry through Fertilizer
Association of India has made rigorous representations to the Government of India for a pragmatic policy for this core
sector industry.
The Group of Ministers (GOM) has also proposed that the normative capacity utilization for all gas based units be
assessed at 95% from 1.4.2002 while the same for naphtha/fuel oil based plants be fixed at 90%. Currently, these are
assessed at 90% 1and 85% respectively.
Current Industry Status
The reduced availability of gas as feedstock is the major constraint the industry faces today. Though the recent
gas finds by ONGC and Reliance are welcome, they are still inadequate to cater to the growing need of the
fertilizer, power and other industries. Also as the fertilizer consumption is by the farming community, demand
depends on the quantum of rains in a particular year. Further, the manufacturing capacity available in the
country being close to the level of overall demand, any glut due to adverse monsoon affects the sale.
The FY 2001-02 has been a challenging one for most of the economies globally. The Indian economy was also
affected, a major contributor to the slowdown was the lower growth in the industrial sector which was partially
offset by the higher growth in the services sector and an improvement in the agricultural sector on the back of a
better than average monsoon.
The agriculture sector, after two years of stagnation has grown by 7% during FY 2001-02, thanks to the
favourable monsoon well distributed across major parts of the country. However due to downward revision in
the energy consumptions norms and upward reassessment of plant capacities and consequent reduction in the
Retention Price coupled with restrictions on production have affected the profitability of the industry in the year
2001-02. The fertilizer production in FY 2001-02 decreased 0.7% to 14566.40 thousand tonnes as against an
increase of 3% to 14667.70 thousand tonnes in FY 2000-01. However the import of manufactured fertilizer
increased by 3.6% in FY 2001-02 to 3223.51 thousand tonnes as against 54.1% fall to 3111 thousand tonnes in
FY 2000-01.
Weather and government’s subsidy policy are the two most important determinants of fertilizer use in India. The
monsoon in the current year 2002-03 has been scanty and the country had to contend with the worst drought in
13 years. Weak rains in June and very scanty rains in July have caused extensive damage to the 2002 kharif
crops. However rains were normal during August. This has improved the deficiency in the cumulative rainfall
from 32% as of end July to 23% by end August. The first offical assessment of kharif crops during 2002-03 has
placed production of all crops below the previous kharif seasons level. However the cumulative fertilizer
production during April - November 2002 was marginally higher by 2.8% to 9905.40 thousand tonnes as against
fall of 3.6% to 9636.50 thousand tonnes in the corresponding previous period.
However the country's dependence on fertilizer imports have decreased during the above period, as imports of
manufactured fertilizer dropped by 37.6% to 1402.39 thousand tonnes as against increase of 3.9% to 2246.27
thousand tonnes in the corresponding previous period.
Fertilizer industry is passing through very difficult times due to change in policy parameters, increasing cost of
production and reducing margins. However, long-term prospects remain encouraging as the increasing
population of the country necessarily requires more food production and in turn more Fertilizers consumption.
Moreover, politically and socially it will not be feasible to give preference to imports over domestic fertilizer
even if economically preferable.
Prevailing Tax Rates and Provisions
While urea is under statutory price, distribution and movement control of the Government of India, Phosphatic
and Potasic Fertilizers continue to be under the indirect control of the Central and State Governments.
The system evolved in 1977 of a unit specific retention price was expected to be replaced by the Government by
a more uniform normative policy. Over the years, the Government had appointed various committees, which
had gone into this aspect.
The Government had imposed a Special Additional Duty (SAD) of 4% on Imported Rock Phosphate and
Sulphur in addition to the basic duty of 5%.
The Finance Minister in his budget for the year 2001-02 had proposed to implement the recommendations made
by Expenditure Reform Commission (ERC). ERC had recommended replacement of the current unit-wise
retention price scheme by a group-wise retention price scheme. However there was no final decision taken on
the same in the 2002-03 budget.
Later the Government of India proposed to implement VIIth and VIIIth pricing period policy for urea subsidy
prior to the implementation of ERC recommendation.
Mounting pressure of subsidy on fiscal deficit of the country has compelled Government of India to take a decision
to gradually withdraw the subsidy, heading towards total decontrol in a phased manner. A long term policy for
fertilizer sector has been thus recently considered by the government, covering the problems of feedstock, fertilizer
pricing, total decontrol, WTO related issues, etc.
The government recently have approved a new pricing policy for urea units which will replace the existing
Retention Price Scheme and will come into effect from 1.4.2003 based on the submissions of the Group of
Ministers (GOM).
The main objective of the new pricing policy for urea manufacturing units, is to bring in greater transparency,
uniformity and efficiency in subsidy payments to the fertilizer companies. Besides, it is also to encourage them
to take measures on their own to promote efficiency and bring down the cost of production. This policy is likely
to result not only in savings in subsidy expenditure but also promote the efficient use of scarce energy resources.
The new scheme, will be implemented in stages. Stage - I would be for one year from April 1, 2003, to March 31,
2004 and Stage - II would be for two years, from April 1, 2004, to March 31, 2006 while the modalities of Stage -
III is to be decided after review of the implementation of the first two stages.
There would be six groups based on vintage and feedstock for determining the group-based concession under
the new scheme, namely, pre-1992 gas-based units, post-1992 gas-based units, pre-1992 naphtha-based units,
post-1992 naphtha-based units, Fuel Oil/ Low Sulphur Heavy Stock (FO/LSHS) based units and mixed energy
based units.Units in each group will be allowed concessions, based on weighted average retention prices.
The concession rates of for the units in each group would be determined in two steps. In the first step, the
weighted average retention price and dealer's margin of the units in the respective group as applicable on April 1
2002, is to be computed. Units having exceptionally high or low retention price, i.e., deviation of 20% and
above with reference to group average computed in Step-1 are to be treated as outliers in their respective groups.
In step-2, the final weighted average group retention price after excluding the outliers is to be computed.
Further the units in each group would receive the concession after adjustment on account of escalation/de-
escalation in the variable cost related to changes in the price of feedstock, fuel, purchased power and water. The
department will work out the modalities for this purpose for Stage-I and Stage-II on the basis of group energy
data and efficient consumption patterns of the units keeping in view the data of the eighth pricing period.
After commencement of Stage-I and also beyond Stage-II, there shall neither be any reimbursement of the
investment made by a unit for improvement in operations nor any mopping up of gains of the units as a result of
operational efficiency.
Gujarat Narmada Valley Fertilizers Company Ltd. (GNFC)
Gujarat Narmada Valley Fertilizers Company Ltd. (GNFC), is a joint sector enterprise promoted by the
Government of Gujarat and the Gujarat State Fertilizer Company Ltd.(GSFC). It was set up in Bharuch, Gujarat in
1976. Located at Bharuch in an extremely prosperous industrial belt, GNFC draws on the resources of the natural
wealth of the land as well as the industrially rich reserves of the area.
GNFC started its manufacturing and marketing operations by setting up in 1982, one of the world's largest
single-stream ammonia-urea fertilizer complexes. Over the next few years, GNFC successfully commissioned
different projects - in fields as diverse as chemicals, fertilizers and electronics. Since inception, GNFC has
worked towards an extensive growth as a corporation. A growth which respects the environment and springs
from the progressive vision of GNFC.
GNFC today has extended its profile much beyond fertilizers through a process of horizontal integration.
Chemicals/Petrochemicals, Energy Sector, Electronics/Telecommunications and Information Technology form
ambitious and challenging additions to its corporate portfolio. GNFC has an enterprising, strategic view towards
expansion and diversification.
GNFC has a diversified business model. Fertilizers & chemicals account for 58% & 41% of total sales
respectively. This diversified business model helps it tide over adverse business conditions in any particular
segment. ~ It is the lowest cost fertilizer producer in the fuel oil group. GNFC will continue to get the same
retention price as it used to get, under the new group based fertilizer policy effective from1st April '03. The
company is expected to the positively impacted in stage – III of New Fertilizer Policy, when the low cost
manufacturers are going to receive incentives for being cost efficient.
GNFC's ammonia plant has a capacity of 1350MT per day while the average capacity of other plants of
competitors is 900MT per day, which offers benefit of economies of scale to GNFC for ammonia production. It
has adopted better technology for ammonia production in order to reduce its energy consumption. It uses
Texaco process using two gasifiers as compared to Shell process using three gasifiers used by most of the
fertilizer manufacturers. The company is one of the largest manufacturers of methanol and nitric acid in India
having market shares of 37% and 56% respectively.
Recently, it has expanded capacity of methanol and nitric acid for greater market access. A section of its
Nitrophosphate group of plants has suffered an explosion on October 14, 2003 and the plant operations have
been affected but GNFC has full insurance cover for this plant. GNFC's fertilizer plant is located in the state of
Gujarat having relatively lower irrigation facility. Company's fertilizer plant is based on fuel oil and going
forward company will have to switchover to more efficient feedstock based plants because of increasing deficit
of fuel oil.
Annexure I
Profit and Loss Account
(All figures in Rs. crores)
March 2000 March 2001 March 2002 March 2003
Income
Sales Turnover 1,213.48 1,422.25 1,477.63 1,464.27
Excise Duty 60.42 82.86 72.84 86.82
Net Sales 1,153.06 1,339.39 1,404.79 1,377.45
Other Income 43.54 68.23 39.74 31.40
Stock Adjustments 24.39 8.76 -17.96 -6.22
Total Income 1,220.99 1,416.38 1,426.57 1,402.63
Expenditure
Raw Materials 496.04 615.24 608.46 551.46
Power & Fuel Cost 201.05 227.65 243.86 224.99
Employee Cost 82.28 93.08 93.19 104.79
Other Manufacturing Expenses 95.04 80.10 73.13 73.58
Selling and Admin Expenses 97.33 106.22 123.14 112.93
Miscellaneous Expenses 12.74 12.28 9.03 49.65
Preoperative Exp Capitalised 0.00 1.23 1.12 0.96
Total Expenses 984.48 1,133.34 1,149.69 1,116.44
Operating Profit 192.97 214.81 237.14 254.79
PBDIT 236.51 283.04 276.88 286.19
Interest 97.44 101.18 83.46 65.95
PBDT 139.07 181.86 193.42 220.24
Depreciation 63.41 68.91 75.23 83.86
Profit Before Tax 75.66 112.95 118.19 136.38
Extra-ordinary items 0.00 0.00 0.00 0.00
PBT (Post Extra-ord Items) 75.66 112.95 118.19 136.38
Tax 9.55 7.40 46.51 51.67
Net Profit 66.11 105.55 71.68 84.71
Total Value Addition 488.44 519.33 542.35 565.94
Preference Dividend 0.00 0.00 0.00 0.00
Equity Dividend 36.62 39.55 36.62 36.62
Corporate Dividend Tax 4.83 4.03 0.00 4.69
Equity Dividend (%) 25.00 27.00 25.00 25.00

Balance Sheet
(All figures in Rs. crores)
March 2000 March 2001 March 2002 March 2003
Sources of Funds
Total Share Capital 146.48 146.48 146.48 146.48
Equity Share Capital 146.48 146.48 146.48 146.48
Preference Share Capital 0.00 0.00 0.00 0.00
Reserves 636.07 698.03 540.37 583.77
Revaluation Reserves 0.00 0.00 0.00 0.00
Networth 782.55 844.51 686.85 730.25
Secured Loans 524.64 558.22 491.54 451.78
Unsecured Loans 343.52 286.94 262.15 261.55
Total Debt 868.16 845.16 753.69 713.33
Total Liabilities 1,650.71 1,689.67 1,440.54 1,443.58
Application of Funds
Gross Block 1,660.18 1,724.33 1,815.08 2,071.76
Less: Accum. Depreciation 842.71 903.92 977.88 1,060.71
Net Block 817.47 820.41 837.20 1,011.05
Capital Work in Progress 62.43 134.41 147.55 23.79
Investments 229.72 227.07 249.61 215.66
Inventories 226.51 243.10 225.77 221.25
Sundry Debtors 248.25 235.87 259.26 237.42
Cash and Bank Balance 18.16 17.50 25.95 57.60
Total Current Assets 492.92 496.47 510.98 516.27
Loans and Advances 338.82 354.71 295.75 331.14
Total CA, Loans & Advances 831.74 851.18 806.73 847.41
Deffered Credit 0.00 0.00 0.00 0.00
Fixed Deposits 83.83 54.70 32.98 12.87
Current Liabilities 167.34 204.87 461.86 463.53
Provisions 128.29 142.34 143.08 198.18
Total CL & Provisions 295.63 347.21 604.94 661.71
Net Current Assets 536.11 503.97 201.79 185.70
Miscellaneous Expenses 4.98 3.81 4.39 7.38
Total Assets 1,650.71 1,689.67 1,440.54 1,443.58
Contingent Liabilities 220.82 186.20 161.85 160.10

Technical charts of GNFC

Moving Average Chart

Price Line

50-day Moving Average Line

A

RSI Chart

MACD Chart
 E

Correlation matrix
Particulars Return (%) Variance (%)2
GNFC Market
GNFC 15.25 487.00 1.00 0.85
Market 25.75 625.00 0.85 1.00

END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 6 - 13.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.
Caselet 1
Read the caselet carefully and answer the following questions:
6. The caselet states that the SEBI will introduce margin trading and securities lending scheme in the
bourses from February 1, 2004. Briefly explain the process of margin trading with an example.
(8 marks) < Answer >
7. According to the caselet, margin trading provides finance and improves liquidity in stock market.
Enumerate the advantages and disadvantages of margin trading.
(10 marks) < Answer >
In an effort to make available finance and improve liquidity in stock markets, the Securities and Exchange
Board of India will introduce margin trading and securities lending scheme in the bourses from February 1,
2004, even as it expressed concern over sharp rise in sensitive index. The corporate broking entities would be
able to directly lend funds to investors to finance their trading in cash market subject to certain regulations while
any person holding securities (shares) would be able to lend them in market through stock exchange mechanism.
“The Sebi board cleared the proposals on Tuesday at a meeting in Kolkata and we will come out with detailed
notifications soon. We hope to commence working on the scheme from Febraury 1," Sebi chairman G N Bajpai
told reporters in Mumbai on Wednesday.
The facility of margin trading will be available only for stocks in Group-1 of the SEBI risk management system,
which numbers at about 150. Securities lending and borrowing system enables any investor to approach the
clearing corporations of the stock exchange to lend or borrow securities. Only Indian corporate brokers with a
minimum networth of Rs 3 crore (Rs 30 million) would be permitted to run margin trading, he added. This is a
step for development of the market, Bajpai said, adding the proposed margins trading and lending scheme did
not have any resemblance with previous badla system as new mechanism would have strict disclosure standards.
The new schemes would be reviewed after six months, he said. On the current status of the market, Sebi chief
said the regulator had been keeping a close watch on the market and was concerned over the sharp rise in index
movement. "Whenever we come across unusual movement in the market, we will take prompt remedial
measures and punish those found guilty of breaching regulations, Bajpai added.
Caselet 2
Read the caselet carefully and answer the following questions:
8. The caselet states that periodic earnings announcements do serve a purpose as they reveal information that
 would give a fair idea of the progress of the company. Briefly discuss the non-financial factors to be
examined by an investor to assess the progress of the company.
(9 marks) < Answer >
9. The caselet states that when making an investment decision, adequate discounting should be done for any
risks associated with the business. This would be based on the investor's risk-taking ability. Do you agree
? Justify.
(7 marks) < Answer >
Periodic earnings announcements may not tell the whole story but they definitely provide the jist of it. These
numbers may lead to higher or lower expectations and affect the valuation of the stock. At times the
management may also resort to window-dressing to meet the forecasts. But does it mean that these numbers are
irrelevant? What information can you glean from interim financial reports? Periodic earnings announcements do
serve a purpose as they reveal information that would give a fair idea of the progress of the company.
Additional disclosures, such as segment reporting, presentation of consolidated results and the geographical
break-up, give a lot of information that would otherwise not be available in public domain at such frequency.
Analyst presentations and conference call transcripts are also available on certain company Web sites. These are
valuable sources of information and give insights into the companies' operations and prospects. They give you a feel
of what is happening in a company and where is it heading in terms of business performance. Periodic financial
disclosures also show how the company compared with its peers. They indicate a company's market position and
control within the industry in that particular period and also point to whether a company has the potential to make the
best of the given business conditions. The absence of such periodic disclosure leaves a gap in financial information.
Worse, it could lead to selective disclosures, giving room for insider trading. Small investors would be left in the lurch
due to non-availability of information. The market might witness wider swings due to speculation and selective
disclosure. Information provided in financial statements is useful if scrutinized properly. For instance, the previous
eight quarters' earnings announcements would indicate the trend in margins and earnings growth. Sharp deviations
may require further scrutiny to judge the sustainability.
Any one-off instances having an impact on the earnings should be eliminated. Also, one has to be aware of the
external factors governing the business and their effect on the earnings performance in any period. When
making an investment decision, adequate discounting should be done for any risks associated with the business.
This would be based on the investor's risk-taking ability. It might also pay to take an independent view of the
stock without the market interest in a stock influencing your decision. Any stock that commands a higher
valuation than its earnings can support will be vulnerable to volatility. Markets generally tend to overestimate
the earnings growth potential of certain companies or get carried away by exceptional earnings announcements
without looking at the ground realities. Often, stocks zoom or slump after earnings announcements and trade at
valuations that cannot be sustained by earnings growth. It is better to avoid a stock that commands high
multiples when the business environment is uncertain. Also, avoid momentum investing in such stocks. A little
bit of caution and reasoning could protect you from extreme downside risks. But do remember that numbers are
usually factored in the stock price and should not be taken fully at face value. Future performance would depend
on a host of external factors. A fresh investment decision should be based on the general business environment
and the scope for business growth.
Caselet 3
Read the caselet carefully and answer the following questions:
10. According to the caselet, historically, pricing in commodities futures has been less volatile compared to
the equity and the bond markets, thus providing an efficient portfolio diversification option. Do you
agree? Justify.
(6 marks) < Answer >
11. The caselet says that it’s a different kind of research that you will have to do if you want to invest in
commodities. There are no balance sheets to read, no quarterly results to wait for, no dividend
announcements to factor into prices. Discuss.
(10 marks) < Answer >
For those who want to diversify their portfolios beyond shares, bonds and real estate, commodities offer another
option. But you need to look before you leap Add a new investment option to your list: commodities. Till some
months ago, this wouldn’t have made sense. For retail investors could have done very little to actually invest in
commodities like gold and silver - or oilseeds, for that matter. Reason: there was practically no retail avenue for
punting in commodities. All that’s changing now with the arrival of four new electronic, multi-commodity
exchanges, where you can trade in commodity futures. Business cycle analyst and investment guru Marc Faber
predicts that the next big boom will be in hard assets (a.k.a. commodities), not financial assets (good ol’ shares,
bonds, mutual funds, et al). In an interview he said: “Global economic recovery and the depreciation of financial
assets due to excessive printing of money will make commodities appreciate in relative terms”. You now have
an opportunity to find out for yourself if that’s true - assuming you have the interest in finding out which
commodities will boom and which one won’t. It’s a different kind of research that you will have to do if you
want to invest in commodities. There are no balance sheets to read, no quarterly results to wait for, no dividend
announcements to factor into prices.
On the other hand, like an Englishman, you will learn to appreciate the intricacies of the weather and
unpredictable government actions (What will frost in Brazil do to coffee prices? Will the Russians sell more
gold in the markets?) Commodities actually offer immense potential to become a separate asset class for market-
savvy investors, arbitrageurs and speculators. The good news: historically, pricing in commodities futures has been
less volatile compared to the equity and the bond markets, thus providing an efficient portfolio diversification option.
In fact, the size of the commodities markets in India is also quite significant. Out of the country's GDP of Rs
13,20,730 crore, commodities related (and dependent) industries constitute about 58 per cent. Currently, the various
commodities exchanges across the country clock an annual turnover of Rs 1,40,000 crore. With the introduction of
futures trading, the size of the commodities market grow many folds here on.
Like any other market, the one for commodity futures plays a valuable role in information pooling and risk
sharing. The market mediates between buyers and sellers of commodities, and facilitates decisions related to the
storage and consumption of commodities. In the process, they make the underlying market more liquid. Given
the number of players involves - from producers to consumers to investors and speculators - the commodity
futures market increases the speed with which new information is incorporated into prices. Retail investors who
claim to understand the equity markets may find the commodities market a funny kind of animal. But
commodities are actually more predictable once one understands the fundamentals of demand and supply and
the factors affecting their prices.

END OF SECTION E

END OF QUESTION PAPER

 Suggested Answers
Security Analysis – II (212) : April 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, both capital-wise and working capital-wise. The
investment for a minimum economic size urea plant (2,250 tpd) is Rs15bn. The investments for a minimum
economic size capacity in DAP (1,500 tpd) and SSP (100 tpd) plant is lower at Rs5bn and Rs0.4bn,
respectively. The working capital requirements of the industry are also high because of dedication towards
imports (if using imported raw materials, generally the case in phosphatic fertilizers) and delays in the
release of subsidies. Roughly, about 30-45% of sales is locked in working capital. This acts as a strong
barrier restricting a smooth entry of new players. Central government Policy also directly influences
pricing, production and distribution of fertilizers. This is apparent as demand for phosphatic fertilizers went
down when prices of phosphatic fertilizers went up after decontrol. Retention Price System and other adhoc
concession schemes make the pricing of fertilizers almost under control of governments. Moreover,
Maximum Retail Price (MRPs) of fertilizers are also decided by the central government. Clearly,
government regulations also act as big entry barrier to the fertilizer industry. However, undifferentiated
products allow relatively easy entry to new entrants
Bargaining power of Suppliers
This is high since the main raw materials like feedstock, gas, has alternative uses in industries such as
power and petrochemicals. Certain raw materials are imported from the foreign countries and those raw
materials are important ingredient and therefore bargaining power of suppliers is high.
Bargaining power of Customers
The farmer lobby is powerful India because of central importance of the production of food crops in India.
Government also supports the farmer by deciding the prices of the Fertilizers. Therefore, bargaining power
of buyers can be said to be high in the fertilizer industry.
Threat of Substitute
Threat of substitute is low as there are no alternatives available for the fertilizers. Undifferentiated products
do poses some threat to standardized product of the industry. For example, requirement of DAP is some
time met by cheap urea. Although use of fertilizers in such manner is harmful to the production capacity of
the land.
Competition
The competition is high in this industry as all the major companies are striving for higher market share.
< TOP >
2. a.
2000 2001 2002 2003
PAT 66.11 105.55 71.68 84.71
PBT 75.66 112.95 118.19 136.38
Net sales 1,153.06 1,339.39 1,404.79 1,377.45
TA 2025.19 2087.77 2074.07 2110.78
NW 782.55 844.51 686.85 730.25
PAT/PBT (1) 0.8738 0.934 0.606 0.621
PBT/Sales (2) 6.5617 8.433 8.413 9.901
Sales/TA (3) 0.5694 0.642 0.677 0.653
TA/NW (4) 2.5879 2.472 3.02 2.89
ROE(%) = 1 × 2 × 3 × 4 8.448 12.5 10.44 11.6

Following can be inferred from above:

i. Profit retention after tax had reduced in 2002 and picked up subsequently. This was because there was
hefty increase in the tax in 2002 and 2003.
ii. Profit before tax margin has increased throughout the period indicates better management of
 operations.
iii. Asset turnover was very low in 2002 but increased till 2002 before declining slightly in 2002 .
iv. The leverage TA/NW has increased in 2002 because of decrease in net worth and greater use of
current liabilities (primarily provisions).
As a result of above factors ROE has fallen in 2002 before recovering in 2003

PAT+Depreciation
No.of stocks outstanding
b. Cash earning per share =
2003 2002 2001 2000
(84.71 + 83.86) (71.68 + 75.23) (105.55 + 68.91) (66.11 + 63.41)
CEPS
14.648 14.648 14.648 14.648

= 11.51 =10.03 = 11.91 8.842

84.71 71.6 105.55 66.11
EPS
14.648 14.648 14.648 14.648

5.78 4.89 7.21 4.51

From the above result it is very evident that cash earning per share of the company has declined in 2002
and then increased in 2003. Even earning per share is telling the same story. EPS has decline almost by
32% in 2002 although decline in CEPS is only 15.78%. The fixed assets are gradually increasing the
depreciation change have also increased drastically but the fixed asset have got the potential to produce.
CEPS are also providing a better idea of the cash available for use within company. Since depreciation is a
non-cash charge. CEPS should be given preference to EPS when analyzing fertilizer industry because EPS
discriminates against growing companies which have block of assets compared with companies which are
growing slowly and therefore not investing in fixed assets.
< TOP >
3. Price using regression equation
σi
ρ i,m σm
Beta = ×
22.07
= 0.85 × 25 = 0.75

Dividend Payout Ratio (%)

Year Dividend Payout Ratio (%)

2000 2.5/4.51=0.554
2001 2.7/7.21 = 0.3745
2002 2.5/4.89 = 0.5112
2003 2.5/5.78 =0.4325

0.554 + 0.3745 + 0.5112 + 0.4325

Average Dividend Payout Ratio = 4
= 46.81%.
Growth Rate in Earnings
Year Earnings Growth %
2000
2001 59.66
2002 -32.1
2003 18.18
 59.66 − 32.1 + 18.18
Average Growth Rate = 3
= 15.25%.
ROE (Return on Equity)
Year ROE (%)
2000 8.45
2001 12.5
2002 10.44
2003 11.6

8.45 + 12.5 + 10.44 + 11.6

Average ROE = 4
= 10.75%
PRegression = 47.25 + (10.25 × 0.4681) + (25.45 × 0.1525) – (0.89 × 0.75) + (45.80 × 0.1075)
= 47.25 +4.798 + 3.88 – 0.6675 +4.923
= 60.18

II. Price as per DDM

The face value of GNFC share is Rs 10
DPS for the year 2003 is: 2.5.
It is given that the earnings will grow by 20% for the next 5 years and 10% later.
The required rate of return
Re = Rf + (Rm – Rf) β i
= 5.50 + (25.75 – 5.50) 0.75
= 5.50 + 15.19 = 20.69%.
Year DPS PVIF@ 20.69% PV (DPS)
2004 2.5 (1+0.2) = 3 0.8286 2.4857
2005 3 (1.2) = 3.6 0.6865 2.4715
2006 3.6 (1.2) = 4.32 0.5688 2.4574
2007 4.32 (1.2) = 5.184 0.4713 2.4433
5.184 (1.2) =
2008
6.221 0.3905 2.4294
12.287
6.221(1.1)
P5 = 0.2069 − 0.10 = 64.6
Value at the end of year 5 = 64.6× PVIF (20.69%, 5)
= 64.6 × 0.3905 = 25.22
Priceas per DDM as on 1.4.2004 = 25.22 + 12.87 = 38.09

P0 as on 1.4.2004 = 0.35 × 38.09 + 0.65 × 60.18

= Rs.52.45

< TOP >

4. a. At this point both moving average and price line has started rising it is an indication to buy
b. Price line falls below a rising moving average line – so it does not indicate any trend reversal – the
indication is to buy, to gain from the rebound in the secondary reaction.
c. RSI has touched the overbought position and price decline expected , it is an indication to Sell
d. RSI has touched the oversold position and price rise is expected, it is an indication to buy
 e. MACD indicator is almost merging with reference line so it is signal to hold the stock.
< TOP >
5. The leading indicators for the fertilizer industry are as follows:
a. Agricultural production
b. Export prospects of food grains
c. Money supply
d. Interest rates
e. Corporate profits
f. General level of stock prices
Fertilizer industry is largely dependent on the growth of the agricultural production. Export prospects of
food grain will also determine the requirement of fertilizers.
Level of corporate profits may indicate increase in demand of goods. The performance of the fertilizer
industry is dependent largely on prevailing economic conditions. Therefore, fertilizer industry will perform
well, when the economy is either recovering or performing nicely. State of economy is indicated by the
level of stock prices, money supply and interest rates.
< TOP >
Section E: Caselets
Caselet 1
6. Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from
your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on
margin, you need a margin account. This is different from a regular cash account in which you trade using
the money in the account. By law, your broker is required to obtain your signature to open a margin
account. The margin account may be part of your standard account opening agreement or may be a
completely separate agreement. An initial investment of at least Rs.2,000 is required for a margin account,
though some brokerages require more. This deposit is known as the minimum margin. Once the account is
opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the
purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to
margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages
require you to deposit more than 50% of the purchase price.
You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the
stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully
paid. Second, there is also a restriction called the maintenance margin, which is the minimum account
balance you must maintain before your broker will force you to deposit more funds or sell stock to pay
down your loan. When this happens, it's known as a "margin call." We'll talk about this in detail in the next
section.
Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral.
You'll also have to pay the interest on your loan. The interest charges are applied to your account unless
you decide to make payments. Over time, your debt level increases as interest charges accrue against you.
As debt increases, the interest charges increase, and so on.
Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment,
the greater a return you need to break even. So you see that if you hold an investment on margin for a long
period of time, the odds that you will make a profit are stacked against you.
< TOP >
7. Advantages
Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash
they invest. Leverage amplifies every point a stock goes up. If you pick the right investment, margin can
dramatically increase your profit. A 50% initial margin allows you to buy up to twice as much stock as you
could with just the cash in your account. It's easy to see how you could make significantly more money by
using a margin account than by trading from a pure cash position. What really matters is whether your
stock rises or not. The investing world will always debate whether it's possible to consistently pick winning
stocks. We won't weigh in on that debate here, but simply say that margin does offer the opportunity to
amplify your returns.
The best way to demonstrate the power of leverage is with an example. Let's imagine a situation that we'd
all love to be in--one that results in hugely exaggerated profits:
We'll keep with the numbers of Rs.20,000 worth of securities bought using Rs.10,000 of margin and
Rs.10,000 of cash. Trademark Co. is trading at Rs.100 and you feel that it will rise dramatically. Normally,
you'd only be able to buy 100 shares (100 x 100 = Rs.10,000). Since you're investing on margin, you have
the ability to buy 200 shares (200 x Rs.100 = Rs.20,000).
 Trade mark Co. and the price of shares skyrockets 25%. Your investment is now worth Rs.25,000 (200
shares x Rs.125) and you decide to cash out. After paying back your broker the Rs.10,000 you originally
borrowed, you get Rs.15,000, of which Rs.5,000 is profit. That's a 50% return when the stock went up 25
Rs. Keep in mind that, to simplify this transaction, we didn't take into account commissions and interest.
Otherwise, these costs would be deducted from you profit
Disadvantages :
It should be clear by now that margin accounts are risky and not for all investors. Leverage is a double-
edged sword, amplifying losses and gains to the same degree. In fact, one of the definitions of risk is the
degree that an asset swings in price. Because leverage amplifies these swings then, by definition, it
increases the risk of your portfolio. Returning to our example of exaggerated profits, say that instead of
rocketing up 25%, our shares fell 25%. Now your investment would be worth Rs.15,000 (200 shares x
Rs.75). You sell the stock, pay back your broker the Rs.10,000, and end up with Rs.5,000. That's a 50%
loss, plus commissions and interest, which otherwise would have been a loss of only 25%.Think a 50% loss
is bad? It can get much worse. Buying on margin is the only stock-based investment where you stand to
lose more money than you invested. A dive of 50% or more will cause you to lose more than 100%, with
interest and commissions on top of that.
In a cash account, there is always a chance that the stock will rebound. If the fundamentals of a company
don't change, you may want to hold on for the recovery. And, if it's any consolation, your losses are paper
losses until you sell. But as you'll recall, in a margin account your broker can sell off your securities if the
stock price dives. This means that your losses are locked-in and you won't be able to participate in any
future rebounds that may take place.
< TOP >
Caselet 2
8. The important non-financial parameters to be examined by an investor are as follows:
Business of the company
The investor should know whether the company is a well-established one, whether it has a good product
range and whether its lines of business have considerable potential to grow.
Top Management
The quality of top management team, particularly, the competence and the commitment of the chief
executive officer matters a lot in shaping the destiny of the company.
Product Range
Progressive companies like ITC and Hindustan Lever create competition for their existing products by
launching new products with regular frequency. Hence investors must examine whether the company under
review belongs to this group or not.
Diversification
An issue related to that of product range is diversification. To reduce the degree of business risk and
improve profitability, many companies resort to diversification. Hence this issue is to be carefully
examined by the investor.
Foreign Collaboration
Where a company has entered into technical collaboration with a foreign company, the investor must find
out more about the nature of the collaboration agreement.
Availability of Cost of Inputs
If the company depends upon imported raw materials, it is important for the investors to assess the raw
material position, because any shortage of the raw material and/or escalation in the cost of raw material will
adversely affect the profitability.
Research and Development
Progressive companies spend substantial sums of money on R&D to upgrade their existing products,
introduce new products, adapt foreign technology to suit the local conditions, achieve import substitution,
etc.
Governmental Regulations
The investor must assess the implications of governmental regulations such as MRTP Act, FERA, etc., for
the company under review.
Pattern of Shareholding and Listing
The pattern of shareholding has a bearing on the floating stock available in the market and the trading
volume of these issues will have an effect on the company, hence it will be analyzed by the investor before
taking any investment decision.
< TOP >
9. The statement is very true as discounting factor used for discounting return takes into account of risk
attached with business entity, which in turn depends on risk tolerance capacity of the investor. The required
rate of return consists of two component risk free rate of return and risk premium. The risk free return
component changes as and when real risk free return and inflation rate changes. Risk associated with any
particular business is factored in the risk premium component. For example if the firm is more risky than an
investor willing to invest in the company would be asking more return in the form of more risk premium.
The amount of risk premium would be decided on the basis of risk taking capacity of a an investor. For the
same amount of risk a risk averse investor would be asking more return compared to his counterpart who is
risk loving. Hence it is perfectly correct to say that t when making an investment decision, adequate
discounting should be done for any risks associated with the business. This would be based on the investor's
risk-taking ability.
< TOP >
Caselet 3
10. It is very much correct to say that historically, pricing in commodities futures has been less volatile
compared to the equity and the bond markets, thus providing an efficient portfolio diversification option.
The primary asset allocation categories are: stocks, bonds, and cash. But other categories are sometimes
mentioned as possible candidates—in particular gold, real estate, and commodities. For the most part, these
assets are thought to provide portfolio protection from severe economic conditions. Gold is usually viewed
as the asset of choice in times of total economic chaos. Precious metals, commodities, and real estate are
viewed as hedges during highly inflationary time periods. Typically the returns provided by the
commodities are low but steady and therefore provides balance to portfolio return in turbulent time when
normal investment categories are not performing well. One big reason for selection of these assets in
portfolio for portfolio diversification is lower correlation of the commodities with stocks bonds and other
securities. Now definitely these other assets really bring another dimension of diversification to a portfolio.
And hence for achieving diversification benefits it is possible for individuals to. effectively invest in the
commodities.
< TOP >
11. The caselet correctly mentions that a different kind of research you will have to do if you want to invest in
commodities. There are no balance sheets to read, no quarterly results to wait for, no dividend
announcements to factor into prices. Actually, while evaluating commodities the important things to be
looked into is the factor which affects their price which defines the risk and return attached with the
commodities. In the post-World Trade Organisation (WTO) era, the entire agricultural produce market
moves primarily on the basis of climatic factors (including the monsoons), various government actions
(subsidies, market support prices, etc.), and international agricultural trade pricing and policies. In non-
agricultural commodities - especially gold, silver, and non-ferrous metals - the factors influencing prices
could include global production, mining, hoarded stocks, tariffs and taxes, among other things.
WHAT IMPACTS COMMODITY PRICES
Agro produce
• • Vagaries of monsoon
• • Changes in national exim policies
• • Changes in farm support prices (subsidies, minimum support prices, etc.)
• • Storage and transportation cost
• • Changes in the sales tax and central tax structure
• • Imposition of anti-dumping, non-tariff measures at both global and domestic level
Bullion
• • Changes in the policies of official sector gold sales by global central banks
• • Changes in international hedge book position
• • Change in the country’s policy for importing gold
• • Change in tax structure
Metals
• • Change in the mining and exim policies
• • Imposition of anti-dumping, non-tariff measures at both global and domestic level
• • Change in tax structure
• • Changes in the manufacturing activity
• • Corporate actions
< TOP >
< TOP OF THE DOCUMENT >