Financial Management (MB211): April 2006 - Answers

Suggested Answers
Financial Management (MB211): April 2006
Section A : Basic Concepts
1. Answer: (d)
Reason: Other things being equal, if there is a decrease in maturity period, the redemption price is
received earlier and hence the discounted price will be more compared to the discounted price
in case of a higher maturity period. Hence, the yield on the bond will be more in case of lower
maturity period. Hence (d) is true. Decrease in coupon rate will decrease the cash inflows and
hence decrease the yield to maturity. Hence, (a) is not true. Increase in the issue price will
increase the cash outflow (issue price) for the same inflows (amount repayable at maturity and
coupon payments) and hence decrease the yield to maturity. Hence (b) is also not true.
Decrease in the amount repayable at maturity will decrease the cash inflows and hence the
yield. Hence, (c) is also not true.
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2. Answer : (d)
Reason : The volatility in the call money market increases with the reduction of the liquidity in the
market. It generally comes down with the following reasons:
• Increase in cash reserve ratio (CRR)
• Larger amount borrowed by several borrowers following an increase in demand for the
loanable funds
• Withdrawal of funds by the banks and financial institutions suddenly to meet their
respective corporate requirements
Payment of a large amount of advance taxes by the banks and FIs will lead to the reduction in
liquidity in the system thereby increases the volatility in the call money market. Hence, the
option (d) is the answer.
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3. Answer : (e)
Reason : If a firm issues bonds and uses the proceeds to purchase short-term assets, the debt equity ratio
will increase, for all the other alternatives the debt equity ratio will decrease or remain same.
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4. Answer : (a)
Reason : Retention ratio of the firm =1- pay out ratio = 1 − 0.80 = 0.20
According to the Gordon model, the expected value of the share is
0
0
Y (1 b)
P
k br
−
=
− =
4.50(1 0.2)
0.15 0.2 0.18
−
− × =3.6/0.114 = Rs.31.58.
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5. Answer : (e)
Reason : Since, in a bought-out-deal, the shares are initially offered to the sponsor and the sponsor has
the discretion to offload the shares to the public at an appropriate time in future as per the
discretion of the sponsor. The sponsor may exploit the situation where the promoter of the
company may be in the dire need for funds by offering a substantially low price and may also
misuse its discretion to divest the shares in favor of the public. All these facts may affect the
interests of the promoters of the company. The points as stated in the other options are not
correct with respect to bought out deals.
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6. Answer: (d)
Reason: Present value factor for a perpetual annuity =
1
i .
Hence it decreases with an increase in the interest rate. Hence (d) is the correct option.
Future Value Interest Factor =
(1+ i)n .
Hence it increases with increase in the interest rate.
Future Value Interest Factor For Annuity (FVIFA) =
(1 i)n 1
i
+ −
. FVIFA also increases with
increase in the interest rate.
Capital Recovery Factor =
n
n
i(1 i)
(1 i) 1
+
+ − . It is the inverse of PVIFA, which decreases with
increase in interest rate. Therefore, Capital Recovery Factor increases with increase in the
interest rate.
Inverse of PVIFA is capital recovery factor, which increases with increase in the interest rate.
Hence, options (a), (b), (c) and (e) are incorrect.
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7. Answer : (c)
Reason : The problem of under-trading is observed in a company, if a less amount of sales turnover is
achieved by the company in comparison to the level of current assets employed by the
company. It is a very risky situation, not in relation to the working capital management, but in
terms of the operational efficiency of the company.
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8. Answer : (b)
Reason : In letter of credit, a bank assures the payment to be made to the supplier, in case of default
committed by the buyer, the client of the bank. Hence, it may be termed as an indirect method
of financing current assets with the support of a bank. In cash credit, overdraft and purchase or
discount of bills, the banks generally offer direct cash to the client. Factoring services are
offered by the factors, not the banks.
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9. Answer : (e)
Reason : The assumptions under Walter’s model are as follows:
• Retained earnings is the only source of finance available to a firm, with no outside debt
or additional equity used
• Cost of capital and return on investment are constant for a firm
• Firm has an infinite life
• For a given value of the firm, the dividend per share and earnings per share remain
constant
Hence, the option (e) is the answer.
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10. Answer : (a)
Reason : Spontaneous liabilities generally occur during the normal course of business operations where a
company will usually have a ready access to certain sources for financing its current assets. But
a company is required to take proper initiative for the sources of finance as mentioned in the
other options to finance its current assets.
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11. Answer : (d)
Reason : Reduction of tax rate by the government will affect all the companies in the market and so can
be considered as a systematic risk. While the factors mentioned in the other options will affect
a particular company or the companies belonging to a particular industry. Hence, these factors
may be termed as non-systematic risk.
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12. Answer : (d)
Reason : As per Miller and Modigliani’s model, there is no optimal capital structure. Other two options
are not the assumptions of the Miller and Modigliani’s model. Hence the statements I and III
are false.
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13. Answer : (a)
Reason : The economic order quantity (EOQ) is directly related to the annual usage and the fixed cost
per order while inversely related to the carrying cost of the inventories. An increase in the
carrying cost for the inventories will decrease the EOQ for a company while the conditions as
mentioned in the other options will increase the economic order quantity. Hence, the option (a)
is the correct one.
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14. Answer : (b)
Reason : Through letter of credit (L/C), a bank stands as a guarantee for the buyer to honor the payment
obligation. A bank generally disburses funds in the form of cash credit, overdraft, key credit,
etc. to finance the working capital requirements of any company. If any business entity cannot
afford to pay the purchase price of machinery in lump sum, it may buy the same in installments
spread over a period of time; this type of scheme is known as deferred credit facility (also
known as supplier’s line of credit), offered by the supplier of machinery.
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15. Answer : (a)
Reason : If cost of capital is less than IRR of a project, the NPV of the project will be positive. Similarly,
the benefit cost ratio is less than unity indicates the present value of the benefits is less than the
present value of costs at a given cost of capital, thereby making the NPV a negative one.
Similarly, a discount rate is greater than the IRR will make the NPV a negative one and hence
for a project of benefit cost ratio is less than unity. Such a project will have a positive effect on
the wealth of the shareholders, not an indeterminate effect.
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16. Answer : (b)
Reason : Yield = 24,03,846
25,00,000 − 24,03,846
= 4.00%
So, only matching answer is 3 month and 16%.
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17. Answer : (b)
Reason : Retained earnings is the amount due to equity holder which has not been paid to them.
Therefore, the cost of retained earnings will be equal to expected return of equity holder. And
as there is no cost of issue involved it will be 17%.
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18. Answer : (c)
Reason : Expected average daily usage = 600 × 0.6 + 800 × 0.4 = 680 units
Expected lead time = 4 × 0.3 + 6 × 0.7 = 5.4 days
Hence, normal consumption during lead time = 680 × 5.4 = 3672 units.
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19. Answer : (d)
Reason : The rate to be quoted to the Importer is the ask rate
= (Rs./$) ask × ($/£) ask
= (Rs./$) ask ×(1/£/$) bid
= 43.79 × (1/0.5285) = Rs.82.86/£
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20. Answer : (c)
Reason : Futures contract have standard maturity and hence customized maturity is not a feature of a
futures contract. All the others are the features of a futures contract.
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21. Answer : (d)
Reason : Comparison of ageing schedule at periodic intervals helps to identify changes in the payment
behaviour of customers.
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22. Answer : (c)
Reason : The book values of the different sources of finances may not be related to their current
economic values e.g. the land price may appreciate, the machine may become obsolete, etc.
The reasons stated in the other options are the advantages of using book values as the basis of
the weights for the calculation of the cost of capital.
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23. Answer : (e)
Reason : If a security’s return plots above the security market line (SML) then the return on the security
is more than the required rate of return on the security according to the SML. A greater return
means a lesser price of the security than its intrinsic value that implies the security is under
priced and hence that should be bought immediately to book profit in future as its price
increases.
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24. Answer : (a)
Reason : For two mutually exclusive projects providing similar service but have unequal life spans one
can compare only with respect to what is the equivalent annual expenditure.
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25. Answer : (b)
Reason : Discount Yield =
1, 000, 000 992, 420 360
x x100%
1, 000, 000 90
−
= 3.03%
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26. Answer : (b)
Reason : Project cash flows follows long term funds principle. Hence, interest on long term funds should
be excluded. However, for the short term funds the interest cost must be included. Except (b)
all the other alternatives are the principles for measurement of costs and benefits.
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27. Answer : (b)
Reason : If spot is Rs.46.75, put will not be exercised, and dollar will be sold at spot market.
∴ Net amount realized per dollar = 46.75 – 0.30 = Rs.46.45
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28. Answer : (d)
Reason : FVIFA (annuity due) = FVIFA (1 + interest rate)
FVIFA (1%, 60) =
⎥⎦
⎤
⎢⎣
⎡ −
0.01
(1.01)60 1
(1.01)
= 82.486
∴ Amount receivable in future = 82.486 × 2000 = Rs.1,64,973
(Note that 12% compounded monthly means 1% interest for each month for 12 x 5 = 60
months).
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29. Answer : (b)
Reason : Expected rate of return = Σ ri pi
= (10 × 0.30) + (12 × 0.10) + (15 × 0.40) + (20 × 0.20)
= 14.2%.
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30. Answer : (a)
Reason : Net working capital is the difference between current assets and current liabilities.
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Section B : Caselet/Problems
1. The company can get into the garment manufacturing business, as more and more buyers are wanting to buy
everything under one roof.
There is immense potential waiting to be tapped in exports. With winds of globalization sweeping all the
industries, outsourcing has become the norm. In such a scenario, GCL can tap exports better, if it gets into garment
manufacturing: it can be more cost-competitive in the exports market.
This also requires GCL to link up closely with international trends, which are as much driven by fabric as by
styling. GCL can therefore assume the role being the market leader in manufacturing cutting-edge fabrics.
There are opportunities for innovations on fabrics. Value addition is derived through both fabric and with styling.
In an era of undifferentiated products, new innovations in fabric will go a long way in driving salience and sale.
By focusing on value added fabrics, performance fabrics, superior quality and specialized textiles and hybrid yarns
(cotton/non-cotton), GCL can drive its sale through sheer product brilliance. Through value engineering, it can
drive not just sales but also higher margins and profits.
Disadvantages of Forward Integration
Increase in debt burden which could impact profitability
Creating a consumer brand is time-consuming and expensive.
Building a strong brand in the consumer's mind is a complex task, especially given the existing high clutter levels
in the market.
High level of competition in the retail segment could make it difficult to penetrate the market and build volumes in
a short time
Will increase exposure to the textile industry, and hence less scope for diversifying risk.
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2. Acquisitions: GCL should focus on its existing role as the supplier of fabric in the current scenario. GCL can
build on its fine capabilities in the textile industry, by looking out for undervalued firms for acquisition targets.
Strategic alliances with overseas textile firms: There are several countries-like South Africa and Bangladeshwhich
enjoy the status of the most-preferred trading partner with countries like the US. It makes sense for GCL to
lease manufacturing facilities in such countries and export to the US and Europe from there, by using its own
fabric, to be competitive.
GCL can also become competitive by moving into value-added niche markets through the route of joint ventures
and strategic tie-ups with world-class, cost-effective Asian producers: access to global technology is imperative in
enhancing product quality.
Since tariff barriers in India will be progressively reduced, the two-pronged strategy outlined above will build
upon the company's strengths, leverage its JV partners' technology and brand image, and help it to develop its
domestic and external markets. It would also help GCL to focus on improving its core business processes and gain
competitive advantage by producing quality products, which at the same time would meet WTO stipulations.
Backward integration into the cultivation of cotton: Land laws in India are still not amenable to such an
approach. But it may be beneficial to forge relationships with major cotton growers. A control over the supplychain
gives the company a tremendous staying power.
Go for domestic alliances: GCL should identify niche segments within each product category towards enhancing
revenues from domestic sales. These would be areas where the customer is assured of a value added offering.
GCL seems to be on the right track, with the first step to exit the polyester business and re-structure the residual
companies, bringing the overall debt down to a manageable level.
GCL has been current with the financial institutions and banks for a year and a half, which has strengthened the
company's credibility amongst vital stakeholders. In general, the company must strive to improve its performance
so as to let the world know that it is once again a force to be reckoned with.
Restructuring: The Company needs to analyze what businesses are their core competence. In steel, GCL should
evaluate whether it can focus adequate resources to survive and grow in the complex and highly competitive
environment. If possible, it should explore any opportunity that might exist in making specialized products in steel
so as to lift itself out of the mass-market dynamics, thereby driving margins and profits.
Given the initial success in thermoplastic and engineering grade nylon, GCL should look at strengthening this
division so as to exploit any further opportunities, which exist. This would help them consolidate and grow in this
emerging new area of operation.
The impending rationalization of the Customs duty structure as recommended by the WTO would open the Indian
marketplace to global players. GCL has to think global markets, to develop into a global provider of mass-use
fashion fabrics based on commercializing emerging technologies in a cost competitive manner. Given the
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opportunities on the horizon, GCL must make a strong thrust towards exports. Here value addition could prove to
be a key success factor. To begin with, the domestic readymade garments market, which has attained critical mass,
could be a focus area.
GCL needs therefore focus on investing on product innovation, value engineering and quality so as to grow
aggressively in the textile business.
In order to remain competitive in the textile business, GCL needs to move out of areas where the company
competes with the unorganized sector, and move into areas of higher value addition
In the meantime, the cost-cutting measures that the company has been focusing which have yielded positive results
must be continued.
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3. a. The net cash flows associated with the replacement decision are given below:
(Rs. ‘000)
Year 0 1 2 3 4 5
A. Net investment (600)
B. Incremental cost savings (Rs.50,000 + Rs.20,000) 70 70 70 70 70
C. Incremental profits 120 120 120 120 120
D. Incremental depreciation1 40 40 40 40 40
E. Incremental pre-tax profits E = B + C – D 150 150 150 150 150
F. Taxes 54 54 54 54 54
G. Incremental post-tax profits 96 96 96 96 96
H. Initial flow (600)
I. Operating flow (G + D) 136 136 136 136 136
J. Terminal flow2 300
K. Net cash flow (H + I + J) (600) 136 136 136 136 436
Working notes:
1. Annual depreciation on old machine =
5,00,000 1,00,000
5
−
= Rs.80,000
Annual depreciation of new machine =
10,00,000 4,00,000
5
−
= Rs.1,20,000
∴Incremental depreciation per year on new machine = 1,20,000 – 80,000 = Rs.40,000
2. Terminal flow = Incremental salvage value = 4,00,000 – 1,00,000 = Rs.3,00,000.
b. Net present value = 1,36,000 PVIFA (12%, 4) + 4,36,000 PVIF (12%,5) – 6,00,000
= 1,36,000 × 3.037 + 4,36,000 × 0.567 – 6,00,000
= Rs.60244
Since the NPV is positive the replacement should be done.
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4. Expected return from the security = Rf +β (Rm – Rf)
= 0.06 + 1.40 (0.12 – 0.06)
= 14.4%
Let the rupee dollar exchange rate after one year will be x
∴
1 1
48 x
1
48
−
= 0.04
or
1 1
48 x
−
= 0.04 ×
1
48
or
1
x =
1 0.041
48 48
⎡⎢⎣ − × ⎤⎥⎦
x = 50
The FII invested $10 million ‘m’ Indian security.
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The amount invested in rupees = 10 × 48
= Rs.480 million
The value of investment after one year = 480 (1.144)
= Rs.549.12 million
Value of investment in terms of dollars =
549.12
50 = $ 10.9824
$ return on investment =
10.9824 10
10
−
= 9.824%
∴ Expected return to FII = 9.824%
Variance of domestic currency return on foreign investment
= Var (rf) + Var (s) + 2 Cov (rf × S)
Variance of returns = (10)2 + (8)2 + 2 × 0.15 × 10 × 8
= 188
Total risk of investment = 13.71%
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5. The cash flow pattern for the debentures will be as follows:
Purchase Price = Rs.95
Half-yearly coupon payment = Rs.4 each upto five years and six months, and then a coupon amount of Rs. 2
each at the end of 6 years and at the end of 6 years and 6 months.
Redemption payment = Rs.50 each at the end of 5 years and 6 months, and at the end of 6 years and
6 months.
Let the realized yield be i for every half year.
So,
95 = 4 x PVIFA (i,10) + 54 x PVIF (i, 11) + 2 x PVIF (i, 12) + 52 x PVIF (i, 13)
At i =4%, RHS = 4 x 8.111 + 54 x 0.650 + 2 x 0.625 + 52 x 0.601
= 32.444 + 35.100 + 1.250 + 31.252 = 100.046
At i=5%, RHS = 4 x 7.722 + 54 x 0.585 + 2 x 0.557 + 52 x 0.530
= 30.888 + 31.59 + 1.114 + 27.56 = 91.152
By interpolation, we get. i =
(4 5 4) (95 100.046)
(91.152 100.046)
−
+ × −
−
= 4.567%
Hence, the realized yield will be = {(1.04567)2 −1}×100
= 9.34% (approx)
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6. a. Economic order quantity (Q*) =
2FU
PC
Given : F = Rs.400
U = Rs.9000 cakes
P = Rs.8.00
Carrying cost, C = 20 percent annum.
∴For the planning period of six months, C = 10 percent = 0.10
∴Q* =
2 9000 400
8 0.10
× ×
× = 3000 cakes.
b. Since the minimum order size for availing the discount, Q′ , is 4000 which is
higher than the EOQ, Q*, the incremental benefits and costs associated with
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the discount offer have to be calculated.
Total discount available in planning period if the order size is 4000 cakes
= UD = 9000 × 8 × 0.0625 = Rs.4500
..….(1)
Savings due to reduction in ordering costs
=
U U F
Q* Q
⎛ ⎞
⎜⎝ − ′⎟⎠×
=
9000 9000
3000 4000
⎛⎜ − ⎞⎟
⎝ ⎠400 = Rs.300 ……..(2)
Incremental carrying cost
=
Q'(P D)C Q*PC
2 2
−
−
=
4000(8 0.50) 0.10
2
−
–
3000 8 0.10
2
× ×
= 1500 – 1200 = Rs.300 ……. (3)
Net incremental benefit = (1) + (2) – (3) = Rs.4,500
Since the net incremental benefit is positive the optimal order size would be 4000 cakes of the soap.
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Section C: Applied Theory
7. The choice of selecting the portfolio of cash and near cash assets also known as the choice of liquidity mix is
governed by a variety of factors which are briefly explained below:
Uncertainty Surrounding Cash Flow Projections: It is generally said that the only certain factor in the corporate
environment is its uncertainty. Even if cash flow projections have been made with the utmost care the general
uncertainty can at times make the projections go away. However, the degree of uncertainty is more in certain types
of industries than inothers. For example, general engineering industry is more recession prone than others.
Consequently, the onset of recession which was not anticipated may call for a thorough revision of cash flows and
policy changes in respect of production plans, dividend payments etc. similarly tea plantations can get adversely
affected with an untimely hailstorm. Even within the same company which is stable and growing certain types of
cash flows, especially collections and payables tend to be more uncertain than others. When the degree of
uncertainty is high as evidenced by the sensitivity of cash forecasts to adverse changes in some of the underlying
assumptions, the company will do well to have the liquidity mix tilted largely towards cash balance and in so far
as possible reserve drawing power under the cash credit/overdraft arrangement and to a less extent gilt-edged
securities.
On the other hand certain types of industries such as synthetic fabrics, electrical appliances enjoy stable and
growing demand. Once a company has established its image the degree of uncertainty surrounding cash flow
projections will be comparatively less. Consequently, the liquidity mix of such companies will be tilted more
towards marketable securities and intercorporate deposits and a lower proportion of marketable securities and cash
balances.
Attitude of the Management towards Risk: When the management of the company attaches greater importance
to a given percentage increase in return than to the same percentage increase in liquidity, the portfolio of liquid
assets held by such company will have a higher proportion of intercorporate deposits and a lower proportion of
marketable securities and cash balances.
When the attitude of the management towards risk is quite conservative the liquidity mix chosen tends to have a
higher proportion of cash balance and marketable securities and a lower proportion of intercorporate deposits.
Ability to Raise Non-bank Funds and/or Control its Cash Flows: When a company is favorably placed in a
position to have ready access to non-bank funds it can afford to have less proportion of cash and more of
intercorporate deposits and marketable securities. This kind of a situation arises mostly in the case of group
companies. For example, when a manufacturing company promoted by a group faces cash shortage, a finance and
investment company promoted by the same group can come to its rescue by providing funds. Such a company
need not maintain a large portion of its liquidassets in the form of cash. Similarly, companies which can control its
cash flows effectively need not hold a large proportion of idle cash in their liquidity mix. This kind of situation can
arise in the case of companies that have horizontal or vertical integration. For example a manufacturing company
which has got substantial interest and/or has promoted another company for the supply of raw materials the
company can exercise greater control on payables.
On the other hand, companies which do not enjoy ready access to non-bank sources of funds and/or not in a
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position to control cash flows may have to have greater proportion of cash and reserve drawing power in their
liquidity mix.
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8. INTERFACE BETWEEN FINANCE AND OTHER FUNCTIONS
One common factor among all managers is that they use resources and since resources are obtained in exchange
for money, they are in effect making the investment decision and, in the process of ensuring that the investment is
effectively utilized they are also performing the control function. The interfaces between the finance and other
functions, as well as the top management can be understood from the following:
Marketing-Finance Interface
There are many decisions which the Marketing Manager takes which have a significant impact on the profitability
of the firm. For example, he should have a clear understanding of the impact of the credit extended to the
customers on the profits of the company. Otherwise in his eagerness to meet the sales targets he is likely to extend
liberal terms of credit which may put the profit plans out of gear. Similarly, he should weigh the benefits of
keeping a large inventory of finished goods in anticipation of sales against the costs of maintaining that inventory.
Other key decisions of the Marketing Manager, which have financial implications are pricing, product promotion
and advertisement, choice of product mix and distribution policy.
Production-Finance Interface
In any manufacturing firm, the Production Manager controls a major part of the investment in the form of
equipment, materials and men. He should so organize his department that the equipments under his control are
used most productively, the inventory of work-in-process or unfinished goods and stores and spares is optimized
and the idle time and work stoppages are minimized. If the production manager can achieve this, he would be
holding the cost of the output under control and thereby help in maximizing profits. He has to appreciate the fact
that, whereas the price at which the output can be sold is largely determined by factors external to the firm like
competition, government regulations, etc., the cost of production is more amenable to his control. Similarly, he
would have to make decisions regarding make or buy, buy or lease, etc. for which he has to evaluate the financial
implications before arriving at a decision.
Top Management-Finance Interface
The top management, which is interested in ensuring that the firm’s long-term goals are met, finds it convenient to
use the financial statements as a means for keeping itself informed of the overall effectiveness of the organization.
We have so far briefly reviewed the interface of finance with the non-finance functional disciplines like
production, marketing, etc. Besides these, the finance function also has a strong linkage with the functions of the
top management. Strategic planning and management control are two important functions of the top management.
Finance function provides the basic inputs needed for undertaking these activities.