Financial Management (MB211) : January 2006 Answers

Suggested Answers
Financial Management (MB211) : January 2006
Section A : Basic Concepts
1. Answer : (c)
Reason : The money that is lent for more than one day but less than 15 days is referred to as Notice
money.
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2. Answer : (d)
Reason : Present value factor for a perpetual annuity =
1
i . Hence it decreases with an increase in the
interest rate.
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3. Answer : (b)
Reason : Given the maturity, the change in the bond price will be greater with a decrease in the bond’s
YTM than the change in the bond price with an equal increase in the bond’s YTM. In other
words, for equal sized increases and decreases in the YTM, price movements are not
symmetrical.
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4. Answer : (c)
Reason : β of the security = s m
2
m
Cov (r , r )
σ
where rs is return on security and rm is market return.
Also β = sm s m
2
m
σ σ σ
σ
where σsm is the correlation coefficient of market return and stock return.
Hence, increase in the value of correlation coefficient between security and market returns, will
and increase the value of β. Hence statement III is correct and option (c) is the answer.
Statement I is false as β decreases with increase in variance of market returns. Statement II is
false as decrease in standard deviation of the security’s return will decrease the value of β.
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5. Answer : (d)
Reason : Commercial papers are short-term promissory notes issued at a discount to face value by wellknown
companies that are financially strong and carry a high-credit rating. Hence statement (d)
is not correct.
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6. Answer : (c)
Reason : One of the assumptions associated with the Capital Asset Pricing Model is that taxes do not
affect the choice of buying assets. Hence statement III is incorrect and option (c) is the answer.
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7. Answer : (a)
Reason : Diversifiable risks are those risks that are specific to a company or industry and hence can be
eliminated by diversification. When a company is not able to obtain adequate supply of raw
materials, it becomes a source of diversifiable risk. Hence option (a) is the correct choice.
Changes in tax structure, recession in the economy, the credit policy introduced by RBI and
reduction in the purchasing power of the economy are examples of non-diversifiable risks.
These risks are related to the general economy and cannot be eliminated by the process of
diversification.
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8. Answer : (a)
Reason : Arbitrageurs are participants who work towards obtaining risk free profits by simultaneously
buying and selling similar instruments in different markets. Hence, (a) is the correct choice.
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9. Answer : (c)
Reason : Sinking Fund Factor = i
(1+i)n −1
= 1
FVIFA
. Hence option (c) is correct.
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10. Answer : (d)
Reason : Average A/c payable
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= = Rs.23,43,200
Annual credit purchases = Rs.72,72,000
Therefore, Daily credit purchases = = Rs.20,200
Therefore the Average payment period =
=
11. Answer : (c)
Reason : Under the maturity factoring arrangement, the factor does not make any pre-payment. The
factor pays the client either on a guaranteed payment date or on the date of collection from the
customer. Hence option (c) is correct.
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12. Answer : (b)
Reason : When the payment float is greater than the collection float, it implies that the balance in the
books of the company is less than that in the bank’s books because of certain cheques issued by
the company that are still not paid by the bank. In such a case, the firm can play the float.
Hence, statement III is true. Collection float can be defined as the amount of cheques
deposited by a company in the bank awaiting clearance. Payment float indicates the amount of
cheques issued by a company, awaiting payment by the bank.
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13. Answer : (e)
Reason : According to net operating income approach, the overall capitalization rate and cost of debt
remain constant for all degrees of leverage. As long as kd remains constant, the cost of equity is
a constant linear function of the debt-equity ratio. Hence, statements I, III and IV are correct.
So (e) is the correct answer.
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14. Answer : (d)
Reason : Commercial paper is a short-term, unsecured promissory note issued by companies having a
high credit rating. Hence option (d) is the answer.
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15. Answer : (a)
Reason : The operating cycle= Raw material storage period + Conversion period + Finished goods
storage period + Average collection period – Average payment period
Hence increase in the raw material storage period will increase the duration of the operating
cycle and decrease in average collection period, decrease in the conversion period and increase
in the average payment period will decrease the operating cycle. Hence (a) is the correct
choice.
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16. Answer : (e)
Reason : Annual capital charge is an appraisal criterion that is useful in evaluating mutually exclusive
projects providing similar service but having differing patterns of cost and often unequal life
spans. The other appraisal criterions do not give consistent results in cases where differing
patterns of costs and life spans exist.
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17. Answer : (a)
Reason : Realized yield approach assumes that
(i) The actual returns are in line with the expected return.
(ii) The investors will continue to have the same expectations from the security.
Hence (a) is the correct answer.
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18. Answer : (a)
Reason : If credit period is lengthened, more customers are induced to take the credit and the sales tend
to increase and the there are more chances of bad debts occurring. Hence, statement II is not
true. If credit standards are made more straight, sales are likely to reduce as the customers are
expected to fulfill the rigid credit standards specified by the company. With the decrease in the
sales, the money blocked in receivables will also reduce and hence, statement I is true. If cash
discount is increased, the amounts of discount paid tend to increase even when same proportion
of customers avail the discount. As many customers tend to avail the discount and pay with in
the discount period the amount blocked in receivables will be less. Hence, statement III is true
and the answer is (a).
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19. Answer : (e)
Reason : Modigliani and Miller approach makes the following assumptions:
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i. Existence of a perfect market in which all investors are rational. There will be no
transaction and floatation costs.
ii. It is assumed that there are no differential tax rates for dividend income and capital gains.
iii. The company has a constant investment policy.
iv. Securities are infinitely divisible and hence no single investor is large enough to influence
the share value.
Hence, option (e) is incorrect.
20. Answer : (b)
Reason : Spontaneous sources of financing current assets refer to those liabilities which average in the
normal course of business. For example, earned expenses, provisions and trade credit are
spontaneous liabilities, Hence, (b) is the answer.
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21. Answer : (b)
Reason : A project will be accepted under the following situations:
i. When the Benefit Cost Ratio of the project is greater than one and the Net Benefit Ratio
of the project is greater than zero.
ii. When the Net Present Value is greater than zero (i.e. when the present value of inflows is
greater than the present value of outflows).
iii. When the project’s internal rate of return is greater than the firm’s cost of capital
iv. When a project has the minimum annual capital charge.
Based on the above criteria, we can conclude that only projects B and D can be selected and (b)
is the correct choice.
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22. Answer : (d)
Reason : The credit term 4/10, net 30 implies that 4% discount is given if paid within or on 10th day of
invoicing and credit is given for 30 days.
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23. Answer : (d)
Reason : Exchange margin is to be deducted from the bid rate and added to the ask rate, in the case of a
direct quote. In the case of a direct quote the principle is buy low - sell high. For example the
inter bank quote for US$ is 43.70/71. The exchange margin say 5 paise is to be deducted from
43.70 and added to 43.71. By this the quote now is 43.65 - 43.76. The bank buys at 43.65 from
the customer and sells at the market buying rate of 43.70. Similarly the bank sells at 43.76 to
the customer by buying at market selling rate of 43.71. Hence option (d) is correct.
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24. Answer : (b)
Reason : Reducing the local borrowing is not a hedging strategy for a likely devaluation of a currency
since as the local currency devalue, borrowing will be cheaper.
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25. Answer : (a)
Reason : CHF/CAD bid rate = 1.3591 × 0.6570 = 0.8929
CHF/CAD ask rate = 1.3593 × 0.6572 = 0.8933.
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26. Answer : (b)
Reason : Vostro account means ‘your account with us’. SBI Mumbai calls the account maintained by
Bank of the Middle East Dubai as Vostro account.
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27. Answer : (d)
Reason : Speculator is anticipating depreciation of dollar against euro, forward rate is reglecting
depreciation of euro against dollar. So in the forward market dollar is overpriced and euro
underpriced. So to make profit speculator should buy underpriced euro against overpriced
dollar in the forward market.
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28. Answer : (a)
Reason : When a forward contract is initiated, by market design, its value is Zero as far all the derivative
instruments at its initiation. After initiation its value can fluctuate and be either positive or
negative. The value of forward contract when it matures is the difference between the spot price
on that date and the initial forward price.
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29. Answer : (d)
Reason : In circus swap, two fixed – floating currency swaps are combined to form a fixed to fixed
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currency swap.
30. Answer : (a)
Reason : Protective calls and puts combines an underlying position with an option position, the resulting
position is a synthetic option as under:
Short underlying + long call = long put
Long underlying + long put = long call.
A covered write involving a position in the underlying and the option can be used to create
synthetic option as follows:
Long underlying + short call = short put
Short underlying + short put = short call.
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Section B : Problems
1. 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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2. Let Fb be the forward rate (Rs./HK$)
Suppose we borrow Rs. 100 for 6 months.
Conversion into HK$ and investment for 6 months yields.
Rs. (100/5.65) (1 + 0.04/2) (Fb)
Loan repayment = 100 (1 + 0.07/2)
To prevent arbitrage,
100 (1 + 0.07/2) > (100/5.65) ( 1 + 0.04/2) (Fb)
Or 5.73 > Fb
Or Fb < 5.73
Assume we borrow HK$ 100 for 6 months. Conversion into Rs. And investment for 6 months will yield
HK$ (100) (5.60) (1 + 0.06/2)/Fa
Loan repayment = (100) (1 + 0.05/2)
To prevent arbitrage,
(100) (1 + 0.05/2) > (100) (5.60) (1+0.06/2)/Fa
Or Fa > 5.63
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So, to prevent arbitrage, forward rates should be
Fb < Rs. 5.73/HK$
Fa > Rs. 5.63/HK$.
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3. a. Economic Order Quantity = PC
2FU
= 15625 0.25
2 1800 4900
×
× ×
= 67.2 tonnes
b.
The EOQ is less than the minimum order quantity that will enable the company to avail of the discount. So
we have to find out the change in profit that will arise if the quantity discount is availed of by ordering 80
tonnes.
Let the following notations be used:
Q* = EOQ = 67.2 tonnes
Q′ = Minimum required quantity for discount = 80 tonnes
D = Discount per tonne = 15625 x 100
0.8
= Rs.125
Δπ = Change in profit
∴ Δπ = UD +
⎥⎦
⎤
⎢⎣
⎡
′
−Q
U
Q*
U
F –
⎥⎦
⎤
⎢⎣
⎡
−
′ −2
Q*PC
2
Q (P D) C
= 4900 x 125 +
⎥⎦
⎤
⎢⎣
⎡ −
80
4900
67.2
4900
x 1800 –
⎥⎦
⎤
⎢⎣
⎡ × ×
−−2
67.2 15625 0.25
2
80(15625 125) 0.25
= 612500 + 21000 – 23750 = Rs.609750
Thus, we can see that ignoring taxes the profit increases by Rs.609750 if the company orders for 80 tonnes of
steel.
∴ The optimal order quantity is 80 tonnes.
The incremental being positive, we shall order 80 tonnes is 1st order.
∴ The optimal order quantity = 80 tonnes.
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4. a. Determination of breaking points in capital structure.
Source of
Capital
Cost (%) Range of New financing
from the source
Breaking point
(Rs. in lakhs)
Range of total new
financing (Rs. in lakhs)
Equity 15.00 0 – 140
0.40
140
= 350
0 – 350
15.50 140 – 200
0.40
200
= 500
350 – 500
16.00 200 and above – 500 and above
Term loan 7.50 0 – 150
0.40
150
= 375
0 – 375
8.00 150 – 220
0.40
220
= 550
375 – 550
8.50 220 and above – 550 and above
Debentures 8.00 0 – 90
0.20
90
= 450
0 – 450
8.50 90 and above – 450 and above
From above we can find that the breaking points in the total new financing occurs at the levels of Rs.350
lakhs, Rs.375 lakhs, Rs.450 lakhs, Rs.500 lakhs and Rs.550 lakhs. That is the weighted average cost of
capital will change when the total new financing exceeds these levels.
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Weighted average cost of capital for various ranges of total new financing:
0 – Rs.350 lakhs
Weighted average cost of capital = (0.40) 15.00 + (0.40) 7.50 + (0.20) 8.00
= 10.60%
Rs.350 lakhs – Rs.375 lakhs
Weighted average cost of capital = (0.40) 15.50 + (0.40) 7.50 + (0.20) 8.00
= 10.80%
Rs.375 lakhs – Rs.450 lakhs
Weighted average cost of capital = (0.40) 15.50 + (0.40) 8.00 + (0.20) 8.00
= 11.00%
Rs.450 lakhs – Rs.500 lakhs
Weighted average cost of capital = (0.40) 15.50 + (0.40) 8.00 + (0.20) 8.50
= 11.10%
Rs. 500 lakhs – Rs.550 lakhs
Weighted average cost of capital = (0.40) 16.00 + (0.40) 8.00 + (0.20) 8.50
= 11.30%
Above Rs.550 lakhs
Weighted average cost of capital = (0.40) 16.00 + (0.40) 8.50 + (0.20) 8.50
= 11.50%
Weighted marginal cost of capital schedule:
Range of Total New
Financing (Rs. in lakhs)
Weighted marginal
cost of capital (%)
0 – 350 10.60
350 – 375 10.80
375 – 450 11.00
450 – 500 11.10
500 – 550 11.30
550 and above 11.50
b. If the actual project cost is Rs.600 lakhs the weighted average cost of capital will be 11.50%.
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5. Initial margin = Rs.10,000
Maintenance margin = Rs.7,500
Date Futures Price Daily gain/loss
(Rs.)
Margin call
(Rs.)
Balance in Margin a/c
after margin call
1870 – 10,000
December 13 1865 – 1,000 – 9,000
December 14 1858 – 1,400 – 7,600
December 15 1853 – 1,000 3,400 10,000
December 16 1847 – 1,200 – 8,800
December 17 1849 400 – 9,200
December 20 1855 1,200 – 10,400
December 21 1872 3,400 – 13,800
December 22 1879 1,400 – 15,200
December 23 1883 800 – 16,000
b. Gain/loss from futures contract = Closing balance – Opening balance – Margin call
= 16,000 – 10,000 – 3,400 = Rs.2,600 (Gain)
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Section C: Applied Theory
6. CDs benefit both issuers and investors. From the issuers (banks) point of view, CDs are issued foreseeing the
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advantages over conventional deposits. The motives behind issuing CDs are control over cost of funds and assured
availability of funds for specific period. The banks are constrained to define an interest rate structure for their
customers across the board. It is operationally difficult to offer different rates of interest for different deposits,
especially with a wide network as seen on the Indian scenario. Consequently, most of the depositors will be paid
the same rate of interest. However, in case of Certificate of Deposit the interest is determined on a case ot case
basis. Since the volumes are large, the rates offered on CDs are more sensitive to call rates than the rates on term
deposit. It is possible to discriminate between two customers and give different rates which is not normally
possible in case of term deposits. The conventional deposits though have a fixed maturity, the depositor can
withdraw them prematurely; whereas, in case of CDs, investors have to wait till CD matures or approach
secondary market to sell CDs. Issuance of CD helps banks to maintain the market share.
From the investor’s point of view, CDs from a better way of deploying their short-term surplus funds. CDs offer
higher yields when compared to conventional deposits, while secondary market offers liquidity. They can be
assured of interest and principal payment normally.
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7. Forms of Liquidity
Cash Balance in the Current Account: This is the highest form of liquid asset a company can conceive of, but
the return provided by it is nil. However, companies maintain approximately four to five percent of their total
assets, on the average, in this form despite no returns for reasons already explained.
Keeping Reserve Drawing Power under Cash Credit/Overdraft Arrangement: This form of liquidity appears
to be quite attractive as it can have access to bank borrowing. However, constraints imposed by the banking sector
make this much less attractive than what it once used to be. Close scrutiny of the quarterly budgets of the company
by banks and imposition of penal interest of two percent over and above the normal rate of interest on under-or
over-utilization make this form more tedious and time consuming. However, a built-in cushion may possibly be
included while preparing the quarterly budgets and during some periods the full amount may be drawn. The tax
benefit on the interest makes effective after-tax-rate to be much less costly, even if part of it is held in the form of
idle cash. This not only helps as a liquid source but also helps in obtaining equal or higher limits during the
forthcoming year.
Marketable Securities: These are short-term securities of government such as treasury bills and other gilt edged
securities whose default risk is nil and, for that very reason, the return is low. It is preferable to ensure the maturity
structure of these short-term securities with the likely periods of excessive cash drain on the part of the company.
Then, the transaction costs can be considerably minimized as early liquidation prior to maturity may result in low
return from these assets.
Investment in Intercorporate Deposits: A company can invest money with other companies in the form of shortterm
deposits ranging from two or three months to five or six months at remunerative rates. However, these
deposits being unsecured in nature, are subject to considerable risk, unless the companies accepting such deposits
have excellent antecedents as to their paying habits.
From among the different forms of liquidity available to a company a deliberate choice has to be made in selecting
an appropriate mix that suits the liquidity requirements of the company and disposition of its management towards
risk.
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8. The costs involved in maintaining the accounts receivables by an organization are:
Additional fund requirement for the company
When a firm maintains receivables, some of the firm’s resources remain blocked in them because there is a time
lag between the credit sales to customers and receipt of cash from them as payment. To the extent that the firm’s
resources are blocked in its receivables, it has to arrange for additional finance to meet its own obligations towards
its creditors and employees, like payments for purchases, salaries and other production and administrative
expenses. Whether this additional finance is met from its own resources or from outside, it involves a cost to the
firm in terms of interest (if financed from outside) or opportunity costs (if internal resources which could have
been put to some other use are taken).
Administrative costs
When a company maintains receivables, it has to incur additional administrative expenses in the form of salaries to
clerks who maintain records of debtors, expenses on investigating the creditworthiness of debtors etc.
Collection costs
These are costs which the firm has to incur for collection of the amounts at the appropriate time from the
customers.
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Defaulting costs
When customers make default in payments, not only is the collection effort to be increased but the firm may also
have to incur losses from bad debts.