Financial Management (MB211): April 2006 Questions

Question Paper
Financial Management (MB211): April 2006
Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.
1. Other things being equal, which of the following will cause an increase in the yield to maturity?
(a) Decrease in coupon rate
(b) Increase in the issue price
(c) Decrease in the amount repayable at maturity
(d) Decrease in the maturity period
(e) Increase in the market price of the bond.
< Answer >
2. Which of the following situations lead to an increase in volatility in the call money market?
(a) Reduction in cash reserve ratio
(b) Prepayment of term loans by a large number of borrowers
(c) Entry of the financial institutions (FIs) into the market
(d) Payment of large amount of advance taxes by the banks and FIs
(e) Decrease in the demand for loanable funds in the economy.
< Answer >
3. Which of the following would result in an increase in the debt-to-equity ratio? (Assume there are no
flotation costs).
(a) A firm issues common stock and uses the proceeds to repurchase an equal amount of preferred
stock
(b) A firm issues preferred stock and uses the proceeds to repurchase an equal amount of bonds
(c) A firm with positive additions to retained earnings uses the cash it generates to retire the existing
debt
(d) A firm uses excess cash to repurchase common stock in an amount equal to additions to retained
earnings for the year
(e) A firm issues bonds and uses the proceeds to purchase short-term assets.
< Answer >
4. Solana Ltd. follows a policy of fixed dividend payout of 80%. The earning per share for the year 2005-
2006 is Rs.4.50 per share and the same is expected to grow by 20% during the year 2006-2007. The
firm earns a return of 18% on its investments. The cost of equity of the company is 15%. The value of
the share based on Gordon model would be (approximately)
(a) Rs.31.58 (b) Rs.33.85 (c) Rs.35.75 (d) Rs.39.55 (e) Rs.40.00.
< Answer >
5. Which of the following is a disadvantage of bought-out-deals?
(a) It is difficult to convince a wholesale investor
(b) The promoters of the company do not get the funds immediately
(c) It is a very time consuming procedure
(d) The issue expenses are more than that of a public issue
(e) Sponsor may exploit the situation.
< Answer >
6. Which of the following will decrease with an increase in the interest rate?
(a) Future Value Interest Factor
(b) Future Value Interest Factor of Annuity
(c) Capital Recovery Factor
(d) Present Value Interest Factor of a perpetual annuity
(e) Inverse of Present Value Interest Factor of Annuity.
< Answer >
2
7. Which of the following is correct with respect to under-trading?
(a) Low amount of assets employed in the business of an entity
(b) Low amount of working capital required by a company
(c) Less amount of sales turnover achieved by a company in comparison to the level of working
capital
(d) It is very risky situation in relation to the working capital management of a company
(e) Low cost of funds employed in the management of working capital.
< Answer >
8. Which of the following is an indirect method of financing current assets with the support of a bank?
(a) Purchase/discount of bills (b) Letter of credit
(c) Cash credit (d) Overdraft (e) Factoring.
< Answer >
9. Walter’s model on dividend policy assumes that
(a) The firm offers an increasing amount of dividend per share at a given level of price per share
(b) The firm has a finite life
(c) The cost of capital of the firm is variable
(d) The internal rate of return on the firm’s investments is gradually decreasing
(e) The retained earnings are the only source of finance available to the firm.
< Answer >
10. Which of the following is a spontaneous source of financing current assets?
(a) Accrued wages and salaries (b) Commercial paper
(c) Public Deposits (d) Cash credit (e)
Overdraft.
< Answer >
11. Which of the following is an example of systematic risk?
(a) Risk of non-availability of a major raw material to a company making aluminium bars
(b) Death of the finance manager of a company providing financial services
(c) Unexpected entry of a multi-national company in the tea industry
(d) Reduction of tax rate by the government
(e) Sudden strike called by the workers of a jute manufacturing company demanding for the wage
revision.
< Answer >
12. Which of the following is/are false regarding capital structure theory as stated by Miller & Modigliani?
I. If agency costs are considered, the expected agency costs increases as the debt-equity ratio
decreases.
II. With the given assumptions, there is no optimal capital structure.
III. In the presence of taxes, the market value of the firm decreases by the tax shield of debt.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (II) above (d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
13. Which of the following may cause a reduction in the economic order quantity for a firm when other
things are held constant?
(a) An increase in carrying cost as a percentage of unit price
(b) An increase in the fixed ordering cost per order
(c) An increase in the purchase price of the inventory items
(d) Increasing the delivery time of the materials
(e) Availing the discount for purchasing the materials.
< Answer >
14. Which of the following is true with regard to supplier’s line of credit?
(a) It is similar to the letter of credit issued by banks
(b) It is the deferred credit facility offered by the suppliers of machineries
(c) It is a credit facility offered by the banks to meet the working capital requirements
(d) It is an interest free credit offered by the government to promote industrial development in the
backward areas
(e) It is a credit facility offered by the financial institutions to meet the working capital requirements.
< Answer >
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15. Which of the following statements is true if the net present value (NPV) of a project is positive?
(a) Internal rate of return(IRR) is more than the cost of capital
(b) The pay-back period of the project is less than one year
(c) The discount rate is equal to the risk free rate of return
(d) Benefit cost ratio is less than unity
(e) Accepting the project has an indeterminate effect on shareholders.
< Answer >
16. A Commercial Paper (CP) with a face value of Rs.25,00,000 is issued at a discounted value of
Rs.24,03,846. The term and the rate of the CP respectively are
(a) 3-month and 8%
(b) 3-month and 16%
(c) 6-month and 12%
(d) 9-month and 8%
(e) 12-month and 6%.
< Answer >
17. A company has retained earnings of Rs.72 lakhs and equity capital of Rs.38 lakhs. If the equity
investors expect a rate of return of 17% and the cost of issuing fresh equity is 6%, the cost of the
retained earnings to the company is
(a) 16.4% (b) 17.0% (c) 17.7% (d) 18.1% (e) 19.1%.
< Answer >
18.
Average Daily
Usage (Units)
Probability Lead Time
(No. of days)
Probability
600 0.6 4 0.3
800 0.4 6 0.7
Normal consumption during lead time will be
(a) 1776 units (b) 2720 units
(c) 3672 units (d) 4080 units
(e) 4800 units.
< Answer >
19. The rates available in the market are:
Rs./$ Spot 43.78 / 79
£/$ 0.5285 /86
If an Indian importer requires pounds, the rate quoted to him is
(a) Rs.82.82/£ (b) Rs.82.72/£ (c) Rs.82.79/£ (d) Rs.82.86/£ (e) Rs.82.84/£.
< Answer >
20. Which of the following is not a feature of futures contract?
(a) Standard volume (b) Liquidity (c) Customized maturity
(d) Counterparty guarantee (e) Intermediate cash flows.
< Answer >
21. An ageing schedule gives particulars about
(a) Profit and present value
(b) Accounts receivable and proportion of sales
(c) Employees and age of their service
(d) Age-wise distribution of accounts receivable
(e) Current ratio and the corresponding year.
< Answer >
22. Which of the following is not a merit of using book values as weights for calculating the weighted
average cost of capital?
(a) The book value weights are independent of the fluctuations of the market prices
(b) The calculation of weights is simple
(c) The book values of the different sources of finance are approximately related to their present
economic values
(d) The book value weights are suitable for a firm whose securities are not traded regularly
(e) The book value weights are the most suitable for the unlisted firms.
< Answer >
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23. If a security’s return is plotted above the security market line, then
(a) The risk free rate is equal to the required rate of return on the security
(b) The security’s rate of return is more than the return on the market portfolio
(c) The security’s beta is less than one and hence a conservative security
(d) The security is said to be overvalued
(e) The security is to be bought immediately.
< Answer >
24. Which of the following appraisal methods is preferred for comparing mutually exclusive projects
providing similar service but have unequal life spans?
(a) Annual capital charge (b) IRR
(c) NPV (d) Accounting rate of return
(e) Pay-back period.
< Answer >
25. The discount yield on a 90 day US T-bill futures of size $ 1,000,000 traded at $992,420 is
(a) 2.95% (b) 3.03% (c) 3.06% (d) 3.20% (e) 3.25%.
< Answer >
26. Which of the following is/are important principles do not underlie the measurement of costs and
benefits of a project?
(a) All costs and benefits must be measured in terms of cash flows
(b) Interest on short-term loans must not be included for determining the net cash flows
(c) Interest on long-term loans must not be included for determining the net cash flows
(d) The cash flows must be measured in incremental terms
(e) Opportunity costs associated with utilization of resources should be considered.
< Answer >
27. An Indian exporter bought put option on dollar at Rs.46.50 by paying a premium of Rs.0.30. On the
date of delivery if spot rate is Rs.46.75, then the net amount realized per dollar will be (ignore time
value of money)
(a) Rs.46.20 (b) Rs.46.45 (c) Rs.46.50 (d) Rs.46.75 (e) Rs.47.05.
< Answer >
28. Mr. Naresh deposited Rs.2,000 at the beginning of every month in a bank for five years, if the interest
rate is 12% p.a. compounded monthly, then the accumulated amount he will get after 5 years is
(a) Rs.89,910 (b) Rs.1,34,400 (c) Rs.1,63,340 (d) Rs.1,64,973 (e) Rs.1,92,000.
< Answer >
29. Following is the probability distribution of rates of return of a stock:
Return (%) 10 12 15 20
Probability 0.30 0.10 0.40 0.20
The expected rate of return from the stock is
(a) 12.0% (b) 14.2% (c) 15.0% (d) 16.8% (e) 20.0%.
< Answer >
30. Net working capital is equal to
(a) Current assets – Current liabilities.
(b) Fixed assets – current assets
(c) Current Assets – Cash
(d) Long term loans – short term loans
(e) Current liabilities – provisions.
< Answer >
END OF SECTION A
5
Section B : Caselets /Problems (50 Marks)
• This section consists of questions with serial number 1 – 6.
• Answer all questions.
• Marks are indicated against each question.
• Detailed explanations /workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.
Caselet
Read the caselet carefully and answer the following questions:
1. What are the advantages and disadvantages of forward-integration for GCL? Discuss.
(7 marks) < Answer >
2. What are the other survival strategies available for GCL and which of them is the best-recommended strategy?
Why?
(7 marks) < Answer >
Anurag Galgotia, 29, already CEO of his 50-year-old family textiles firm, Galgotia Cotton Looms (GCL), is
experiencing the thrill of a turnaround.
"Still relishing the numbers?" asked the CFO, Sadashiv Godbole, referring to GCL's Q3 results for 2002, which showed
a Rs.1.5 crore profit against a Rs.21 crore loss for the same quarter of 2001. "We're back in business," said Godbole,
sinking into the upholstery.
Nearly twice Galgotia's age, Godbole was a 20-year GCL veteran. He had signed up with Anurag's father Kishorilal
Galgotia, who had started the firm in 1952, in Ludhiana, to make cotton textiles. Cotton sheets, shirtings, cambric, and
mazril were the first products, and it seemed like only yesterday that the firm went public-before getting into synthetic
fibre and even steel.
By the early 1990s, the GCL tapestry, once richly interwoven with natural, synthetic and steel threads, had started
fraying. First, the polyester division became a drag, and then, steel-as competitive dynamics started changing. Polyster
division was turning red and the falling prices of steel added more misery to GCL .
By 1998, GCL conglomerate had got to what then seemed like a point of no return. Debt had mounted to a staggering
Rs.1,300 crore, almost equivalent to the group turnover. Financial institutions threatened to pull the plug on the
company, and the pink papers went to town with obituaries on GCL.
The diversification was unnatural to start with, said critics. In his time, Galgotia Sr., a cotton loyalist himself, used to
respond philosophically, arguing that so long as people were discerning of what was natural and what was man-made,
and the business was not deceiving anyone, there was no cause for worry.
Galgotia Jr., who had just returned from Wharton, had only hard options left. Painful as it was, he had to restructure the
group. The uncompetitive polyester division was sold off to the Keshwani group for Rs 620 crore. Financial institutions
got a chunk of preference shares. At the end of it all, GCL came out lean, mean and still weak-with residual debt of
Rs.680 crore.
In spite of all that, young Galgotia had defied the doomsayers, and managed to haul GCL out of the red. "Ask Vishesh
to see me," Galgotia told his secretary. Godbole knew what was coming. A three-way brainstorming session with
Vishesh Pradhan, the Group Marketing Head. Galgotia preferred such informal sessions to pretentious boardroom
antics.
"Terrific results," began Pradhan, on entering the corner office "To be frank, I did not expect our cost-saving efforts to
show results so soon."
Galgotia could see that his top honchos had been motivated by GCL's showing. But he was keen on knowing what his
best minds thought of GCL's future. "We all know that this recovery was due to three factors: the staff optimisation
drive, coupled with aggressive technology implementation in the plants; the performance of our textiles division, which
was mainly due to the 25 per cent slump in cotton prices; and the successful diversification of the filament division into
lucrative thermoplastic and engineering grade nylon. My question is: where do we go from here?"
Cost-cutting couldn't be a perpetual strategy, nor could GCL expect cotton prices to remain low forever. Pradhan spoke:
"I think it's time we decided what GCL is. I don't think we can continue being a textiles-nylon-steel player, and still
work wonders."
"Be direct," said Godbole.
"I'm talking about steel," said Pradhan, "We'll never be a steel major, so why are we making steel?"
6
"You must be joking," interjected Godbole. "Our debt is off the danger mark, and if only you'd read the balance sheet
carefully, you'd have noticed that the steel division was our productivity topper. Besides, we'll never fetch a half-decent
price for it."
Pradhan cleared his throat for a response: "I still think we should stick with cloth fibre and cloth, that's it, but integrate
the business either backward or forward. Backward routes are blocked by heavy competition in polyester-it's a scale-ofoperations
game. That leaves cotton farming, which could be complicated. But forward? Shouldn't we redouble our
efforts in getting closer to the consumer? It's almost an axiom now. The link closest to the consumer sits on the fattest
margins."
"What's wrong with GCL as a consumer brand?" asked Galgotia.
"Nothing, it's just that textiles aren't what people talk about anymore, even if we have product distinction. They talk
about Fashion Weeks and all that, and those are the actual brands young people have in mind. Value-addition has
moved forward, from cloth to the design-that's where we should be headed as well."
"We're a high-volume industrial group," said Godbole, "not a boutique for the urban brat-pack."
"Well," retorted Pradhan, "I meant a mass-market initiative. The market's cotton versus synthetic balance affects our
bottomline directly, and we have a big stake in tomorrow's clothing trends-we should be out there, shaping them. Cotton
is a winner, so long as consumers turn discerning and see clothing as a means of communication rather than a shield
against the elements."
"We have no power over that," said Godbole.
Galgotia looked unmoved by either of them. "Now, let me suggest something," said the CEO, "I understand you guys
are keen on some radical strategies. But let's realise that we're barely out of the woods yet."
The group fell silent. Godbole and Pradhan recognised the tone of voice the young chief had spoken with. Some soulspeak
was on its way. "I think we should begin with the basics," Galgotia began, leaving his seat and walking up to the
window overlooking the crowded central Delhi market. "First of all, we should infuse some much-wanted capital into
the textile and filament divisions. Let's replace old looms. On the front-end, let's go after exports, big time. We must not
miss the 2005 world trade opportunity, and the natural versus synthetic trends are clearer in the high-margin western
markets. Cotton wins."
"Great," muttered Pradhan, turning to Godbole. "Now if only we had that much-wanted capital to infuse."
"I think we have," smiled back Godbole. "We have been current for the last one-and-a-half years with all our financiers.
I have it covered"
"Getting the priorities set is the first task. I have just spelt out a survival strategy. Something we must do. But what we
need next is a clincher. Something that will tell our shareholders that GCL is game for the long haul. I suggest we break
up and reassemble on Monday with an imaginative plan on everybody's mind."
Galgotia turned around and gazed at the horizon. He had given himself another green ribbon. But were Pradhan's ideas
the ones that would propel him to it?
3. Laxmi Printers Pvt. Ltd. (LPPL) uses a printing machine which has a book value of Rs.5 lakh and a useful life of
five years. It may be sold at present for Rs.4 lakh. After five years the salvage value of the machine is expected to
be Rs.1 lakh. The machine is presently being depreciated on a straight line basis.
Pioneer Machine Tools Ltd. (PMTL) has recently offered to sell a new printing machine to LPPL. The new
machine will replace the old machine. The investment required on the purchase and installation of the new
machine is Rs.10 lakh. The new machine is expected to reduce labour cost by Rs.50,000 per year and electricity
costs by Rs.20,000 per year. Moreover, the new machine can also be productively used for other types of printing
works and it is expected to increase the profits by Rs.1,20,000 per year. After five years the salvage value of the
new machine is expected to be Rs.4 lakh. The new machine will be depreciated on a straight line basis.
The cost of capital of LPPL is 12 percent. The tax rate applicable is 36 percent.
You are required to
a. Derive the net cash flows associated with the replacement decision.
b. Appraise the replacement proposal using the net present value criterion and advise accordingly.
(8 + 2 = 10 marks) < Answer >
4. A Foreign Institutional Investor (FII) is planning to invest $10 million in an Indian security with a beta of 1.40 and
standard deviation of returns 10% p.a. The holding period of investment will be one year. The current rupee dollar
exchange rate is Rs.48/$. The FII expects the rupee to depreciate against dollar by 4% over next one-year period,
with a volatility of 8% p.a. The expected return from the market portfolio in India is 12% p.a., and the standard
deviation of returns on the market portfolio is 9% p.a. Correlation between the return on the security and the
exchange rate is 0.15. The risk free rate of return in India is 6% p.a.
7
You are required to calculate the expected return and risk for the FII.
(10 marks) < Answer >
5. The debenture of Infotek Ltd. is selling at a discount of 5 percent from its face value. The face value of the
debenture is Rs.100, coupon rate is 8 percent and the interest payments are made at the end of every six months.
The next interest payment will fall due at the end of six months from now. The debenture will be redeemed in two
equal annual installments; the first installment will be payable at the end of five years and six months from now,
and the second installment will be payable at the end of six years and six months from now.
You are required to determine the yield that you will realize if you invest in the debenture now and hold it till its
maturity.
(8 marks) < Answer >
6. The manager of a departmental store is deliberating on the quantity of a particular bath soap to be ordered. The
sales of the bath soap over the next six months, which is the planning period, is forecasted to be 9000 cakes. The
purchase price of the soap is Rs.8.00 per cake. The ordering cost is Rs.400 per order and the carrying cost is 20
percent of the average inventory value per annum. The company which manufactures the soap has offered a
discount of 6.25 percent on the price for orders of 4000 cakes and above.
You are required to answer the following questions:
a. What was the economic order quantity of the product before the introduction of the discount?
b. What would be the optimal order size after the introduction of the discount? Clearly show the relevant costs
and benefits. Ignore taxes.
(2 + 6 = 8 marks) < Answer >
END OF SECTION B
Section C : Applied Theory (20 Marks)
• This section consists of questions with serial number 7 - 8.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.
7. Briefly explain the various factors that influence the choice of liquidity mix by the organizations.
(10 marks) < Answer >
8. In a large manufacturing concern, the finance function interfaces with the production and marketing functions as
well as the top management. Briefly explain these interfaces.
(10 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER