2.Based on your analysis, does the HDFC Bank Stock have the right attributes to be a long-term investment for the equity portfolio of a pension fund? Provide a reasoned justification for your answer.

On the evening of September 24, 2018, two analysts who worked for a pension fund were discussing a request they had been given by their employer. They were asked to select a banking stock for the purpose of long-term investment as part of an equity portfolio. The assignment involved evaluating and identifying a banking stock that possessed core fundamental strength. During fiscal year (FY) 2017-18, the banking industry had witnessed stressed balance sheets with rising non-performing assets (NPA),2 although growth in credit was offering a more positive outlook for the coming years. Losses incurred by some banks, coupled with deterioration in asset quality, made it imperative for the two analysts to identify and select a set of banks that were fundamentally strong and that would keep the portfolio's exposure away from unnecessary event risk.

In their management program, the two analysts had learned about an analysis approach that covered capital adequacy, asset quality, management quality, earning ability, liquidity, and sensitivity to market risk (CAMELS). This framework, would help them evaluate the relative performance of banks to screen and identify a bank that was potentially strong and stable. In the first stage of their analysis, they used the CAMELS approach to identify HDFC Bank Ltd. (HDFC Bank) for further study and valuation. In the next stage, they applied the traditional discounted cash flow (DCF) technique to arrive at the final valuation of HDFC Bank's stock price. On September 24, 2013, the bank's stock price was ?639.3 By the time the two analysts were conducting their valuation on September 24, 2018, the stock had risen to ?1,925.70 (see Exhibit 1). Their own final analysis resulted in a stock price of ?2,254.14 per share as of September 24, 2018. Given the strong fundamentals of HDFC Bank, was this the bank stock that the two analysts were looking for to be part of the pension fund portfolio's long-term investment strategy?

THE INDIAN BANKING INDUSTRY

India's central bank, the Reserve Bank of India (RBI), regulated the Indian banking system. The structure of the banks in India was broadly based on the classification given by the RBI. Banks were broadly categorized as scheduled and non-scheduled. On September 24, 2018, the total number of banks comprised 21 private banks, 27 public sector banks, 49 foreign banks, 56 regional rural banks, 1,562 urban co- operative banks, and 94,384 rural co-operative banks. In addition to these classifications of the banking sector, there were several other categories that included co-operative credit institutions and various financial institutions across all of India or at the state level.4

The banking industry had witnessed a significant increase in demand for credit from 2007 to 2018, at a compounded annual growth rate of 10.55 per cent,5 which included demand from the retail and corporate segments. Deposits also witnessed a growth trajectory of 11.66 per cent during that period. This growth could be attributed to rising disposable incomes fuelling savings and, thereby, demand (see Exhibit 2).

FY 2018 saw a decline in the asset quality of public sector banks, primarily due to poor credit appraisal systems with gaps in the management of post-sanction monitoring and standards. Private banks had relatively better asset quality, with higher provisioning in their books and improved recovery that translated into lower gross NPAs. Overall gross NPAs as a percentage of gross advances were 11.2 per cent in FY 2018, compared to 9.3 per cent in 2017. They were 3.8 per cent for foreign banks, 4.7 per cent for private banks, and 14.6 per cent for public sector banks.6

From 2017 to 2018, with the rapid pace of re-monetization, growth in deposits of current accounts and savings accounts was diluted in both public sector and private banks despite an increase in foreign banks7 (see Exhibit 3). In March 2018, the shares of current, savings, and term deposits stood at 9.7 per cent, 32.1 per cent, and 58.2 per cent, respectively. Term deposits also saw an increase, although returns were inadequate compared to other financial investment avenues such as mutual funds, pension funds, and others. The bulk of deposits was contributed by the household sector, followed by the foreign sector and the financial sector.

In 2018, the banking industry evolved as a result of two major initiatives. First, the RBI issued a directive to banks to resolve bad loans and breakthrough in India, which was coupled with the Insolvency and Bankruptcy Code of 2016 for the resolution of stressed assets. Second, urban co-operative banks could convert to small finance banks to gain a presence across the country. Since 2014, India's prime minister had set a major objective for the overall financial inclusion of all the citizens in the country. The Jan Dhan Yojana financial inclusion program was a major step toward this goal, which led to the establishment of non-banking finance companies, small banks, and payments banks. A new version of the Unified Payments Interface also positioned the banking system to reap benefits from technology.8 All these steps helped widen the reach of banks across the country and provided access to a good banking system for all citizens. A positive outlook for the Indian banking sector seemed assured.

HDFC Bank was incorporated in 1994 with a registered office in Mumbai. It was among the first to receive an "in principle" RBI approval to be set up as a private bank. It was set up as a part of the liberalization program of the Indian banking industry and commenced operations as a scheduled commercial bank in January 1995. With this legacy and backing, HDFC Bank proceeded to augment its core values of operational excellence, customer focus, product leadership, people, and sustainability. As of March 31, 2018, the bank had 4,787 branches across 2,691 cities, which were centrally linked on a real-time basis.13 This was a reflection of customer satisfaction, which was exhibited in the bank's performance over the year (see Exhibit 5).

In 2018, HDFC Bank's ratio of NPAs to net advances was 0.4 per cent, which was considerably lower than its peers. The bank also had a diversification advantage. HDFC Bank was not limited to retail banking; it actively pursued interests in treasury, wholesale banking, and other banking services. The contribution of these sectors was 49.91 per cent of the bank's total revenue for FY 2018, whereas the profit contribution was 62.64 per cent (see Exhibit 5).14

FINANCIAL PERFORMANCE AND MANAGEMENT OUTLOOK

HDFC Bank reported a net profit of ?1.7487 billion for FY 2017-18, registering a growth of 20.2 per cent over the previous financial year. With the implementation of the government's demonetization program15. and the goods and services tax (India's biggest indirect tax reform, introduced on July 1, 2017), the Indian banking system went through a phase of economic adjustment in 2018.

The bank earned 65.6 per cent of its revenue from interest on advances, 18 per cent from interest on investments, and 12 per cent through commissions, exchange, and brokerage. The net interest income witnessed a growth of 21 per cent, while other sources also showed an upward trend (see Exhibit 6). The capital adequacy ratio stood at 14.8 per cent, well above the regulatory minimum of 10.875 per cent. Gross NPAs were 1.30 per cent of gross advances, and net NPAs were 0.4 per cent, among the lowest in the industry. The asset position of the bank was robust thanks to its prudent credit evaluation procedures and diversified loan book across customer segments, products, and sectors.16

The bank's total balance sheet size stood at ?106.3934 billion as of March 31, 2018. Deposits were ?78.8771 billion, for an increase of 22.5 per cent over the previous year, while advances stood at ?65.8333 billion, for an increase of 18.7 per cent over the previous year. The return on capital was registered at 18.2 per cent (see Exhibit 6). RBI identified HDFC Bank as a systemically important domestic bank. Following a trend in the Indian economy, HDFC Bank had digitized 85 per cent of all transactions by the end of March 2018.17

VALUING HDFC BANK: DISCOUNTED CASH FLOW VALUATION METHOD

The DCF method18 involved estimating HDFC Bank's future cash flows, which could stem from different growth outlooks, and then discounting them back to present values by the current cost of capital of the entity. The value thus obtained represented the intrinsic value of the firm. Subsequent decisions could be made by analyzing this intrinsic value to the traded value in the stock market.

The process of DCF valuation included four steps. The first step was to estimate the discount rate or rates to use in the valuation. The second step was to estimate the future earnings and cash flows for the firm being valued, generally by estimating an expected growth rate in earnings. The third step was to estimate when the firm would reach "stable growth" and what characteristics (risk and cash flow) it would have at that point. The fourth step was to calculate the value of the firm by adding the explicit phase and the terminal phase.

Free cash flow to the firm (FCFF) could be defined using the following formula:

Present Value of FCFF = ????[1????]?[?????????]?????(1+?)

In the formula, EBIT represented earnings before interest and tax, Capex represented capital expenditures, NWC represented net working capital, K represented the discount rate or cost of capital, and N represented the year for the free cash flow.

Terminal Growth Phase

In the existing scenario, it was assumed that the bank would maintain its high growth rate for a specific period. It would then experience a transitional period, where its characteristics would change gradually toward stable growth levels. The complete process would comprise a three-stage model. To determine the length of the extraordinary growth phase, size of the firm, existing growth, and excess returns, the magnitude and sustainability of its competitive advantage were considered.

The terminal growth rate was the constant rate at which a firm's expected free cash flows were assumed to grow indefinitely. This growth rate was used in a DCF model beyond the forecast period for the end of the forecasting period into perpetuity. The terminal growth rate value was based on the going concern concept for HDFC Bank, with cash flows growing forever at a constant rate. Therefore, the terminal growth phase value of the firm was calculated using the following formula:

?????+1= ???(1+?)???

In the formula, FCFFn represented free cash flow to the firm in the last year of the explicit growth phase, K represented the cost of capital or discount rate in the terminal growth phase, and g represented the growth rate for the stable growth phase.

FORECASTING CASH FLOWS FOR DISCOUNTED CASH FLOW VALUATIONS

DCF valuation primarily focused on three components: growth rates over the forecasted period, cost of capital of the company, and present-day FCFF. The two pension fund analysts knew that both cost of capital and FCFF could be calculated based on the publicly available reported figures, but they were uncertain about the growth rates because their approximation was highly subjective. Therefore, they determined the growth rate for the forecasted period, followed by the growth rate for the terminal phase. They referred to HDFC Banks's investor presentation and its financial statements to determine forecasted cash flows. One factor advocating significant and sustained growth in the future for the bank was its strong corporate governance, reflected in the composition of its board of directors, with high eminence and credibility in the financial markets. Also, given the strong indicators for the bank as reflected in the CAMELS analysis, both analysts were convinced about using a three-stage DCF model, with two stages of explicit growth followed by a constant growth. Loans and advances showed growth of almost 18.7 per cent over the previous year, while gross advances increased by 23.8 per cent in 2018.19

The two analysts followed the growth rate computation using return on equity and retention ratio variables and arrived at 12.62 per cent for the first five years, followed by 10 per cent for the next five years, and converged the growth rate to 6 per cent in the terminal phase.20 For the cost of capital calculation, beta was determined as 1.05 for the explicit growth phase, converging toward a market beta of 1.0 in the terminal phase. The risk-free rate was taken from the 10-year Treasury bond rate, which was 7.75 per cent in September 2018. They followed Damodaran's model21 to determine a country's equity risk premium and identified it as 7.87 per cent for India. This was based on an average of historical and implied risk premium determined for the Indian markets. For the cost of debt, they used the credit rating assigned to HDFC Bank.

Part two.

PART 1 FlowCash Company PU- 1 Balance Sheet as of December 31 2018 2017 $37,750 $20,000 41,500 14,000 Assets Cash 17,000 20,000 Accounts Receivable 96,250 54,000 Inventory Total Current Assets 75,000 50,000 (32,000) (24,000) Equipment Accumulated Depreciation 35,000 50,000 $174,250 $130,000 Land Total Assets $38,000 $15,000 Liabilities Accounts Payable 3,000 8,000 Income Taxes Payable 41,000 23,000 Total Current Liabilities 25,000 33,000 Long-term Notes Payable Total Liabilities 66,000 56,000 Stockholders Equity 6,000 4,000 Common Stock 32,000 10,000 Paid in Capital in Excess Retained Earnings 70,250 60,000 Total Stockholders Equity 108,250 74,000 Total Liabilities and Equity $174,250 $130,000 FlowCash Company Income Statement for the Year Ended December 31 2018 2017 Sales $500,000 $450,000 Cost of Goods Sold (200,000) Gross Profit (185,000 300,000 Selling & Admin. Expense 265,000 (225,000) Depreciation Expense (210,000) (8,000) Interest Expense (5,000) Gain on Sale of Land (10,000) (8,000) Income before Taxes 4,250 0 Income Taxes 61,250 42,000 Net Income (23,000) (19,000) $38,250 $23,000 Additional Information: New equipment was purchased for cash during 2018 -- no equipment was sold during 2018. sale of $4,250. Land was sold for $19,250 cash during 2018. The cost of the land was $15,000 with a gain on the Cash was paid to pay-off a portion of the Long-term Notes Payable during 2018. 2,000 shares of $1 par value Common Stock were issued for cash during 2018. The selling price of the Common Stock was $12.00 per share. A cash dividend was declared and paid during 2018.Pg 2 Multiple Choice Questions Identify the letter of the choice that best completes the statement or answers the question. place your answers to questions 1 to 30 on the scantron form. The first 30 questions are worth 5 points a piece Use FlowCash Company's Balance Sheet, Income Statement, and Additional Information shown on pa. 1 to answer questions 1 to 8. You can use the Cash Flow Worksheet that is provided with your test to help organize your cash flow data. Your Cash Flow Worksheet will not be graded - and you are not required to use the Cash Flow Worksheet. Note: All questions refer to how the amounts would appear on the Statement of Cash Flows. The questions do not refer to how the amounts appear on the Cash Flow Worksheet. 1 . On FlowCash Company's 2018 Statement of Cash Flows, the change in Cash would be shown as: A. Increase in Cash from January 1, 2018 to December 31, 2018 ... $17,750 B . Decrease in Cash from January 1, 2018 to December 31, 2018 ... $17,750 C . Increase in Cash from January 1, 2018 to December 31, 2018 ... ($17,750) D . Decrease in Cash from January 1, 2018 to December 31, 2018 ...($17,750) E . none of the above. 2. On FlowCash Company's 2018 Statement of Cash Flows - Sale of Land would be A. shown in the Operating Activities section as a $19,250 positive amount. B. shown in the Investing Activities section as a $15,000 positive amount. C . shown in the Operating Activities section as a $15,000 positive amount. D. shown in the Investing Activities section as a $19,250 positive amount. E . none of the above. On FlowCash Company's 2018 Statement of Cash Flows - Pay-Off of Long Term Notes 3. Payable would be A. shown in the Investing Activities section as a $8,000 negative amount. shown in the Financing Activities section as a $8,000 negative amount. B. . shown in the Operating Activities section as a $8,000 positive amount. shown in the Financing Activities section as a $8,000 positive amount. D. E. none of the above. On FlowCash Company's 2018 Statement of Cash Flows - Issue Common Stock would be 4. shown in the Investing Activities section as a $2,000 positive amount. shown in the Financing Activities section as a $2,000 positive amount. shown in the Financing Activities section as a $24,000 positive amount. own in the Investing Activities section as a $24,000 positive amount. ne of the above.Check my work 2 Mean Beans, a local coffee shop, has the following assets on January 1, 2020. Mean Beans prepares annual financial statements and has a December 31, 2020 year-end. The company's depreciation policy is to use the straight-line method to depreciate its assets. a. On January 1, 2020, purchase equipment costing $15,900 with an estimated life of five years. Mean Beans will scrap the equipment after five years for $0. b. On July 1, 2020, purchase furniture (tables and chairs) costing $21,800 with an estimated life of ten years. Mean Beans estimates that it can sell the furniture for $2,300 after ten years. c. On January 1, 2018, Mean Beans had purchased a car costing $43,500 with an estimated life of eight years. Mean Beans estimates that it can sell the car for $8,700 after eight years. Required: 1-a. For each transaction, calculate the current year annual depreciation expense. a. Annual depreciation expense on equipment b. Annual depreciation expense on furniture C. Annual depreciation expense on car 1-b. For each transaction, record the adjusting entry on December 31, 2020. View transaction list Journal entry worksheet 2 3 > Record annual depreciation on equipment.DJ only the balance sheet 9) Why does an accountant prepare the income statement first? A) Net income must be computed first to properly complete the other financial statements. B) It is easier to adjust income statement accounts first than it is to adjust balance sheet accounts. ") Management, being profit oriented, is more interested in the company's net income than in the assets the company owns and the debts it owes. D) There is no particular order in which financial statements must be prepared. 10) When preparing a bank reconciliation, which of the following items would be subtracted from the bank balance on the bank statement? A) deposits in transit B) bank service charges C) EFT cash payments D) outstanding cheques 1 1) In a bank reconciliation, bank service charges are: A) added to the bank balance on the bank statement B) deducted from the bank balance on the bank statement C) added to the bank balance in the general ledger D) deducted from the bank balance in the general ledger 12) If the bank records a deposit of $50 as $150, the error would be shown on a bank reconciliation as: A) a deduction from the book balance of $100 B) an addition to the book balance of $100 ") a deduction from the bank balance of $100 D) an addition to the bank balance of $100 13) Barley & Hops Company was formed in 2014. During the year the company had the following events occur: 1. The company issued $100.000 in common shares for cash. 2. The company purchased equipment for $15,000, paying $5,000 down and signing a I-year. 8% note for the balance. 3. The company hired 4 employees. 4. The company had sales of $250,000. All sales were on account. 5. The company incurred the following expenses: rent: $2,000, salaries: $20,000, advertising $2,000 and utilities $4.000. All expenses were paid in cash. Required: Prepare the journal entries to record the above transactions.Question 3 (10 points) True/False Explain whether the following statements are true or false. Motivate your answer in a brief but rigorous way, making explicit reference to the relevant theory. Lack of proper explanations will result in zero points. a) In a standard IS-LM model with fixed investment, i.e. I = /, an increase in government spending (G) leads to an decrease in total (i.e. private plus public) saving b) Bank A grants a mortgage (loan) of (100 to Mr. Buyer, crediting the loan on his account in the same bank. Mr. Buyer uses this money to buy a house from Ms. Seller, paying with a check. Ms. Seller deposits the check in Bank B. These operations increase the supply of broad money by E100