Financial Management (MB211): January 2005

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Question Paper

Financial Management (MB211): January 2005

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. Rs.1,00,000 was borrowed at an interest rate of 10 percent per annum. The amount has to be repaid with
interest in ten equal annual installments. Each installment is payable at the end of every year. What will
be amount of each installment?
(a) Rs.16,273 (b) Rs.17,225 (c) Rs.18,750 (d) Rs.13,469
(e) Rs.13,758.
< Answer >
2. Which of the following is an example of systematic risk?
(a) Risk of non-availability of a major raw material to a company making aluminum 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 >
3. Which of the following decreases working capital?
(a) Payment of funds to the holders of commercial paper on maturity
(b) Discounting bills receivable
(c) Issue of partly convertible debentures
(d) Issue of bonus shares
(e) Redemption of preference shares.
< Answer >
4. Which of the following is not a spontaneous source of financing current assets?
(a) Accrued wages and salaries (b) Provision for dividends
(c) Provision for taxes (d) Cash credits/Over drafts (e) Trade credit.
< Answer >
5. Which of the following is not a motive for non-finance companies for holding cash in the normal course
of business?
(a) Transaction motive
(b) Precautionary motive
(c) Speculative motive
(d) Lack of proper synchronization between cash inflows and outflows
(e) Capital investments.
< Answer >
6. Which of the following situations lead to the 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 >
7. Which of the following is false regarding Commercial Paper (CP)?
(a) It is issued in multiples of Rs.5 lakh
(b) It has a minimum maturity of 15 days and a maximum up to one year
(c) It has to be mandatorily underwritten
(d) The issue of a CP attracts stamp duty
(e) It is an unsecured instrument.
< Answer >
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8. Which of the following is not a feature of Certificate of Deposit (CD)?
(a) It is issued at a discount to face value
(b) It is issued in bearer form only
(c) It is a document of title to a time deposit
(d) It has virtually no default risk
(e) It can be freely transferred by endorsement and delivery.
< Answer >
9. A repo is a
(a) Security which is traded in the stock market
(b) Contract to buy a specific security at a future date at the price on that date
(c) Contract which gives the holder an option to buy a specific security in future at the predetermined
price
(d) Contract in which one party sells a specific security to another party with an agreement to buy it
back on a specified future date at a specified price
(e) Contract to sell a specific security at a future date at the price on that date.
< Answer >
10. Which of the following is not a feature of an optimal capital structure?
(a) Profitability (b) Liquidity (c) Flexibility (d) Control (e) Solvency.
< Answer >
11. Which of the following is false with regard to the Internal Rate of Return (IRR) criterion?
(a) It considers the time value of money
(b) It considers the cash flow stream over the entire investment horizon
(c) It remains unaffected by the pattern of cash inflows and outflows
(d) It is the rate of return which equates the present value of cash inflows to the present value of cash
outflows
(e) If the net cash flows are discounted by the IRR, the net present value will be equal to zero.
< Answer >
12. Which of the following is/are false regarding capital structure theory as stated by Miller & Modigliani?
(a) If the given assumptions hold, the total market value of the firm is independent of the degree of
leverage
(b) If taxes are considered, the combined income of stock holders and debt holders increases when
debt capital is used
(c) If bankruptcy costs are considered, the expected cost of bankruptcy increases, when the debtequity
ratio increases
(d) Capital markets are perfect
(e) Both (b) and (c) above.
< Answer >
13. The annual interest cost associated with credit terms of 1/10, net 30 (assuming 360 days in a year) is
approximately
(a) 12.65% (b) 15.37% (c) 17.18% (d) 18.18% (e) 24.49%.
< Answer >
14. Which of the following is true regarding the effective and nominal rates of interest?
(a) Effective rate of interest is always lower than the nominal interest rate
(b) Given the nominal interest rate, the frequency of compounding does not affect the effective
interest rate
(c) Given the nominal interest rate, the effective rate of interest increases with increase in the
frequency of compounding
(d) Given the nominal interest rate, the effective interest rate decreases with increase in the frequency
of compounding
(e) Effective interest rate is always equal to nominal interest rate.
< Answer >
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15. Which of the following statements are true according to the bond value theorems?
I. When the required rate of return is equal to the coupon rate, the value of the bond is equal to its
par value.
II. If the required rate of return is less than the coupon rate, the value of the bond is more than its par
value.
III. If the required rate of return is greater than the coupon rate, the discount on the bond increases as
maturity approaches.
IV. A bonds price is inversely proportional to the yield to maturity (YTM).
V. For a given difference between the YTM and the coupon rate of the bonds, the longer the term to
maturity, the lesser will be the change in price with a change in the YTM.
(a) (I), (II) and (III) above (b) (I), (II) and (IV) above
(c) (I), (III) and (IV) above (d) (I), (II), (III) and (IV) above
(e) (I), (II), (IV) and (V) above.
< Answer >
16. Which of the following is/are false regarding aggressive financing policy for current assets?
I. The financing mix will be tilted towards equity
II. Risk of technical insolvency will be high
III. The cost of financing tends to be high.
(a) Only (I) above (b) Both (I) and (II) above
(c) Both (II) and (III) above (d) Both (I) and (III) above
(e) All (I), (II), and (III) above.
< Answer >
17. According to the basic Economic Order Quantity model, which of the following assumptions is false?
(a) Demand is uniform over the planning period
(b) Purchase price remains unaltered irrespective of the order size
(c) The delivery is instantaneous
(d) The ordering costs decline with increase in order size
(e) The orders are independent of each other.
< Answer >
18. Which of the following is not a principle for determining the costs and benefits of projects?
(a) Interest on long term funds must be excluded from the determination of net cash flows
(b) All revenues and costs accrued must be considered as benefits and costs respectively
(c) The cash flows must be determined in incremental terms
(d) All costs and benefits must be measured in terms of cash flows
(e) Cash flows must be defined in post tax terms.
< Answer >
19. In the true context which of the following is transferred in a Foreign Exchange market?
(a) Currency (b) Rate (c) Assets (d) Purchasing power (e) Commodities.
< Answer >
20. Which of the following is false regarding a futures market?
(a) Futures contracts are highly uniform and well specified commitments for a carefully described
commodity to be delivered at a certain time and in certain manner
(b) It also specifies the quantity and quality of the commodity that can be delivered to fulfill the
futures contract
(c) The futures contracts are traded on an organized exchange without standardized terms of contract
(d) The trading is usually done through brokers, as hedgers are not located on the floor of the
exchange
(e) A trader can trade on his own account and bear the losses or enjoy profits arising from trading.
< Answer >
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21. The balance of payments (BOP) is a record of one country’s trade dealings with the rest of the world.
Which of the following statements is false with regard to BOP?
(a) BOP account shows the country’s trading position and changes in its net position as lender or
borrower
(b) BOP account shows the changes in a country’s official reserve holding
(c) Current account is a record of investment and payment flows between a country and the rest of the
world
(d) A deficit on the current account means that more goods and services have been imported into the
country than have been sold abroad
(e) A surplus on the current account means that more goods and services have been
exported than imported.
< Answer >
22. Which of the following trade theories focuses on factor endowments of the trading nations?
(a) The Theory of Absolute advantage (b) The Theory of Comparative advantage
(c) The Heckscher-Ohlin theory (d) The International Product Life Cycle theory
(e) Imitation-Gap theory.
< Answer >
23. Purchasing Power Parity (PPP) theory states that the exchange rates between two currencies are in
equilibrium when their purchasing power is the same in both the countries and is based on the law of
one price. Which of the following is false with regard to the law of one price?
(a) There must be competitive markets for the goods and services in both the countries
(b) Transportation and transaction costs can be significant
(c) Transportation and transaction costs are insignificant
(d) The law of one price applies only to tradable goods
(e) When a country’s domestic price level increases, that country’s exchange rate must depreciate, so
that PPP is restored.
< Answer >
24. Covered Interest Rate Parity does not hold good because of which of the following factors?
I. Transaction costs
II. Political risks
III. Taxes
IV. Liquidity preference
V. Capital controls
(a) Both (I) and (II) above (b) Both (III) and (IV) above
(c) Both (I) and (V) above (d) (I), (II), and (III) above
(e) All (I), (II), (III), (IV) and (V) above.
< Answer >
25. The shares of X Ltd. are quoted at Rs.267. Put options with strike price of Rs.280 are quoting at a
premium of Rs.20. What is the intrinsic value and time value of the put option?
(a) Rs.13 and Rs.7 respectively (b) Rs.20 and Rs.Nil respectively
(c) Rs.Nil and Rs.20 respectively (d) Rs.7 and Rs.13 respectively
(e) Rs.13 and Rs.20 respectively.
< Answer >
26. A 90-day T-bill futures expires in 100 days. Spot price of the 190-day T-bill is $98. A 100-day risk-free
interest rate is 3.5% p.a. The yield on this futures contract is
(a) 2.25% (b) 2.45% (c) 3.35% (d) 4.35% (e) 4.55%.
< Answer >
27. Which of the following is true about a callable swap?
(a) The fixed rate receiver has the right to terminate the swap at any time before its maturity
(b) The fixed rate payer has the right to extend the swap beyond maturity
(c) The fixed rate payer has the right to terminate the swap at any time before its maturity
(d) Both fixed rate payer and receiver have the right to terminate the swap at any time before its
maturity
(e) Both fixed rate payer and receiver have the right to extend the swap beyond maturity.
< Answer >
28. In a single period binomial option-pricing model, the underlying stock is currently selling for Rs.80 and
will rise or fall by 15% over the next period. A call option with an exercise price of Rs.95 would have a
premium of
(a) Zero (b) Rs.3 (c) Rs.5 (d) Rs.8 (e) Rs.15.
< Answer >
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29. Goetzmann AG, an integrated steel producer in Germany, is worst hit by recession wave. In 2001, the
entire company was broken into eight new entities and Goetzmann ceased to exist. This technique of
restructuring is called
(a) Spin off (b) Split off (c) Split up (d) Divesture
(e) Equity carve out.
< Answer >
30. When a firm is a target of hostile tender offer, the target firm invites other friendly bidder. This strategy
of takeover defense is called
(a) Poison pills (b) Crown jewels (c) White knights (d) Golden parachute
(e) Green mail.
< Answer >
END OF SECTION A
Section B : Caselets (50 Marks)
· This section consists of questions with serial number 1 – 6.
· Answer all questions.
· Marks are indicated against each question.
· Detailed explanations should form part of your answer.
· Do not spend more than 110 - 120 minutes on Section B.
Caselet 1
Read the caselet carefully and answer the following questions:
1. Can these schemes (POMIS, KVP and NSC) evolve as a viable alternative to stocks and bonds/debentures issued
by corporates?
(5 marks) < Answer >
2. What is SML? How do these instruments place on the SML?
(5 marks) < Answer >
Judging by the copious inflows, the change in the rates on post office savings schemes in January, 1999 was, perhaps, a
significant event for Indian investors. In such a context, interest rate cuts may have ordinarily meant considerable
changes in the investment plans for the investor. However, with the yields on comparable investment options also
declining, the small savings schemes still reigned supreme.
With effect from January 2000, the Government reduced the interest rates on all except two schemes (the Public
Provident Fund scheme and the National Savings Scheme). The rates were reduced on schemes such as the Post Office
Savings Account, Post Office Monthly Income Scheme (POMIS), Post Office Time Deposits, Post Office Recurring
Deposit Scheme, Kisan Vikas Patra and the National Savings Certificate. The rates of interest on deposit schemes for
retired government and PSU employees were also reduced. Notably, only the interest rates were changed. All the other
terms and features of the schemes were left unchanged.
The rate of interest on POMIS was reduced from 13 percent to 12 percent. This led to a reduction in the yield to
maturity (YTM) from around 15 percent to 13.9 percent. For those who do not reinvest in the interest receipts, the yield
declined from 10.9 percent to 10.5 percent. Yet the yield on this scheme is still better than that on comparable investment
options such as the monthly income bonds offered by the financial institutions.
The same can be said about the Post Office Time Deposit Account Schemes. The fall in the yields, post-reduction, is
sharp. Still, except for the one-year option, yields are generally better than those offered for term deposit schemes of
Indian banks. There are only a few private or public sector banks which offer comparative or better yields.
The decline in yields on the post office recurring deposit schemes is equally significant (from 13.1 percent to 12 percent
per annum). However, it would still serve as an important adjunct to POMIS. If the monthly income receipts are
reinvested in the recurring deposit scheme, the yield for such an investment would be around 13.5 percent. Though this
is down from 14.6 percent, the yields are far higher than those available on any cumulative investment option. It
remains an attractive investment proposition.
The reduction in the yields of Kisan Vikas Patra (KVP) has been even more prominent. The Government indicated that
the yields on this particular instrument were brought down to align with the yields available on money multiplier bonds
issued by the financial institutions. Investments in KVPs now double in six years (it was five-and-a-half years before).
In a way KVPs, post office time deposit accounts, bank term deposits and money multiplier bonds can all be considered
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alternative investment options. While the risk in the first three is minimal (for bank deposits of less than Rs.1 lakh),
investing in money multiplier bonds is higher.
Among the available tax-saving options, the national savings certificate offers much better yields, especially to
investors in the lower tax bracket. This is mainly because the yearly interest amount in the case of NSC is deemed to be
reinvested and as such is also eligible for tax deduction. This facility increases the yield on the investment.
Earlier, an investment of Rs.1,000 in NSC would double to Rs.2,015 in six years. Now, after six years an investment of
Rs.1,000 grows to Rs.1,956. For investors who can claim deduction under Section 80-L, the yield declines from the
earlier 19.07 percent to 18.39 percent now.
3. Mark & Spielberg, a French company, is planning to set-up a plant in India. The whole plant has been imported
from USA at a cost of $1 million on January 1, 2005. Mark & Spielberg will be settling the dollar liability on
March 30, 2005. The market quotes on January 1, 2005 were as follows:
Spot $/€ : 1.2283
March $/€ Futures : 1.1493
3-month $/€ Forward Rate : 1.1483
You are required to
a.Explain how the company can hedge currency risk using futures.
b. Calculate the effective cost in Euros, if the following rates materialize on March 30, 2005:
Spot $/€ : 1.2073
March $/€ Futures : 1.1293
Assume that the standard size of a futures contract is € 1,25,000.
(6 + 2 = 8 marks) < Answer >
4. Lucky 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.
(10 + 2 = 12 marks) < Answer >
5. The investors of ICBDI Flexi bonds are entitled to opt for two options of Retirement Bonds, as per the following
terms:
Particulars Option A Option B
Face value Rs.5,000 Rs.5,000
Date of allotment January 6, 2005 January 6, 2005
Repayment of principal Nil 50% of face-value
Wait period for commencement of annuity 3 years 6 years
Annuity payment for the bond Rs.1,500 Rs.2,085
No. of annuities 7 5
Date of first annuity payment January 6, 2008 January 6, 2011
Date of last annuity payment January 6, 2014 January 6, 2015
Date of repayment of principal – January 6, 2010
The yield to maturity (YTM) is the sole criterion for choosing the option for investment.
You are required to find out the option which should be chosen for investment on the basis of YTM.
(10 marks) < Answer >
6. Mr. Raghav, an investor in options market, believes that in next three months, market will not move significantly
in either direction. He wants to create an option strategy to get the benefits from his view and at the same time he
wants to keep his initial investment low. Mr. Raghav has collected the following information of European call
options on a stock, which is currently trading at Rs.82:
Strike price (Rs.) Call price (Rs.) Maturity
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88 7 3 months
81 10 3 months
74 15 3 months
You are required to suggest the suitable option strategy to Mr. Raghav, and also show the payoff profile with the
maximum profit/loss and breakeven point(s) for such a strategy considering the following stock prices on maturity:
Stock prices (Rs.)
70 75 76 81 86 88 90
(10 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. When a Financial Institution is involved in multi-currency operations, it is exposed to Foreign Exchange risk. In
this context, explain the various categories of Foreign Exchange risk based on the nature of the exposure.
(10 marks) < Answer >
8. Surplus cash is generally maintained for exploiting some unforeseen profitable opportunities. Instead of keeping
the surplus cash idle, it may be invested over short-term in suitable instruments. Briefly explain the important
criteria that should be considered for investing the surplus cash.
(10 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER
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Suggested Answers
Financial Management (MB211): January 2005
Section A : Basic Concepts
1. Answer : (a)
Reason : The amount of each installment will be =
1,00,000 1,00,000
PVIFA(10%,10years) 6.145
= =
16,273.393
= 16,273(approx)
< TOP >
2. 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.
< TOP >
3. Answer : (e)
Reason : Redemption of preference shares reduces the outstanding cash balance and hence decreases
the working capital and the answer is (e). Payment of funds to the holder of commercial
paper on maturity reduces both current assets and current liabilities and hence does not
change the working capital. Discounting bills receivables changes the composition of the
working capital but does not change the working capital. Issue of bonus shares does not
affect the working capital. Issue of partly convertible debentures increases the working
capital.
< TOP >
4. Answer: (d)
Reason: Spontaneous sources of financing include those sources of finance to which a firm has ready
access during the normal course of business operations. These include accrued expenses,
provisions for taxes, dividends, etc and trade credit. Cash credit/overdraft arrangement with
the bank is not a part of these.
< TOP >
5. Answer: (e)
Reason: Capital investments decisions are special decisions and are not undertaken as routine
business activity. Hence, a company does not require readily available cash to undertake
capital investments. All other alternatives state the motives for holding cash.
< TOP >
6. 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.
< TOP >
7. Answer: (c)
Reason: Commercial paper is an unsecured short-term promissory note issued in multiples of 5 lakhs
with minimum maturity of 15 days and maximum up to one year. The issue of a CP attracts
stamp duty. The underwriting of CPs is not mandatory.
< TOP >
8. Answer: (b)
Reason: CD is a document of title to a time deposit and is distinct from conventional time deposit in
respect of negotiability and marketability. CDs are considered as virtually risk less
instruments as the default risk is almost nil. CDs are issued at a discount to face value. CDs
may be either registered or in a bearer form. CDs can be freely transferred by endorsement
and delivery. Hence the answer is alternative (b).
< TOP >
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9. Answer: (d)
Reason: Repo is a security, which is traded in the money market. This is a contract entered into by
two parties, which may include the RBI, a bank or a NBFC. According to this contract, one
party sells certain securities to the second party with an agreement to buy them back on a
predetermined future date at a predetermined rate. This transaction raises short-term funds to
the party selling the securities. Therefore (a), (b), (c), and (e) are false and (d) is true. Thus
(d) is the answer.
< TOP >
10. Answer: (b)
Reason: Liquidity is a feature of the investments made out of the funds raised. It is not a feature of
the capital structure of the company.
< TOP >
11. Answer: (c)
Reason: Alternatives (a), (b), (d) and (e) are true with regard to the internal rate of return. Alternative
(c) is not true because the pattern of cash inflows and outflows affect the internal rate of
return.
< TOP >
12. Answer: (e)
Reason: As per the capital structure theory stated by Miller & Modigliani, It is assumed that Capital
markets are perfect and If the given assumptions hold, the total market value of the firm is
independent of the degree of leverage . Existence of Taxes and Bankruptcy costs are
imperfections of the MM theory. The statements made on them i.e. If taxes are considered,
the combined income of stock holders and debt holders increases when debt capital is used
AND If bankruptcy costs are considered, the expected cost of bankruptcy increases, when
the debt-equity ratio increases, are not according to the Capital structure theory as stated by
MM. Hence the options (b) and (c) are not true.
< TOP >
13. Answer: (d)
Reason: Annual interest cost = 1 Discount rate
Discount rate
- ´ Credit period Discount period
360
-
=
0.01 360
1 0.01 (30 10)
´
- - = 0.1818 i.e., 18.18%
< TOP >
14. Answer: (c)
Reason: The interest rate usually specified on an annual basis in a loan agreement or security is called
the nominal rate of interest. If compounding is done more than once a year, the actual rate of
interest paid (or received) is different from the nominal rate and is called effective interest
rate. Effective interest rate is always higher than the nominal interest rate. Therefore (a) and
(e) are false.
The effective rate of interest increases with increase in the frequency of compounding.
Therefore the frequency of compounding affects the effective interest rate. For example, the
effective rate of interest under quarterly compounding will be more than the effective rate of
interest under semi-annual compounding. Hence option (b) and (d) are false and (c) is true.
Thus (c) is the answer.
< TOP >
15. Answer: (b)
Reason: (III) is not true because, when the required rate of return is greater than the coupon rate the
discount on the bond declines as the maturity approaches. (V) is not true because, for a given
difference between YTM and coupon rate of the bonds the longer the term to maturity, the
greater will be the change in price with a change in YTM.
< TOP >
16. Answer: (d)
Reason: In an aggressive financing policy for current assets, the financing mix is tilted more towards
short term sources of financing. Therefore option (I) is not true. Risk of technical insolvency
is high in aggressive current asset financing policy, as the debt servicing obligations are high
in the short run. Therefore option (II) is true. Cost of financing is usually low in aggressive
current asset financing policy. Therefore option (III) is not true. Hence (d) is the answer.
< TOP >
17. Answer: (d)
Reason: The EOQ model assumes that ordering costs are constant irrespective of the size of the
order.
< TOP >
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18. Answer: (b)
Reason: According to the principles for determining the costs and benefits of projects only cash flows
(cash inflows and outflows) are considered as benefits and costs. All revenues accrued may
not result in actual cash inflows and all expenses accrued may not result in actual cash
outflows.
< TOP >
19. Answer: (d)
Reason: Foreign Exchange market makes it possible to transfer the purchasing power of one currency
into another currency.
< TOP >
20. Answer: (c)
Reason: The futures contracts always are traded on an organized exchange with standardized terms of
contract.
< TOP >
21. Answer: (c)
Reason: Capital account is a record of investment and payment flows between a country and the rest
of the world.
< TOP >
22. Answer: (c)
Reason: (a) The Theory of Absolute advantage holds that by specializing in the production of
goods which they can produce more efficiently than others, nations can increase their
economic well-being.
(b) The Theory of Comparative advantage holds that nations should produce those goods
for which they have the greatest relative advantage.
(c) The Heckscher-Ohlin theory extends the concept of comparative advantage by bringing
into consideration the endowment and costs of factors of production and helps explain
why nations with relatively large labor forces will concentrate on producing laborintensive
goods, whereas countries with relatively more capital than labor will
specialize in capital-intensive goods.
(d) The International Product Life Cycle Theory deals wit the stages of production of a
product with new know-how, which is first produced by the parent firm, ten by its
foreign subsidiaries, and finally anywhere in the world where costs are the lowest.
< TOP >
23. Answer: (b)
Reason: Purchasing Power Parity (PPP) theory states that the exchange rates between two currencies
are in equilibrium when their purchasing power is the same in both the countries. When a
country’s domestic price level increases, that country’s exchange rate must depreciate so that
PPP is restored. PPP is based on the law of one price and there are three caveats with the law
of one price: (i). Transportation costs, trade barriers, and transaction costs are insignificant.
(ii). There must be competitive markets for the goods and services in both the countries. (iii).
The law of one price applies only to tradable goods and not to immobile goods such as
houses and local services.
< TOP >
24. Answer: (e)
Reason: Covered Interest Rate Parity does not hold good perfectly because of the following reasons
Transaction costs, Political risks, Taxes, Liquidity preference, Capital controls.
< TOP >
25. Answer: (a)
Reason: Intrinsic value = X – S = 280 – 267 = Rs.13
Time value = Premium – Intrinsic value = 20 – 13 = Rs.7.
< TOP >
26. Answer: (d)
Reason: T-bill futures price = 98 x (1.035)100/360 = 98.94
This price is equivalent to yield of (100/98.94)4 – 1 = 4.35%.
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27. Answer: (c)
Reason: A callable swap gives the holder, i.e. the fixed rate payer, the right to terminate the swap at
any time before its maturity. Should the interest rates fall, the fixed rate payer exercises his
right and terminates the swap since the funds will be available at a lower rate. Hence (c) is
the answer.
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28. Answer: (a)
Reason: The price after one year can be either Rs. 92 or Rs. 68. The call option with exercise price of
Rs. 95 will be out-of-the money, so the value of call will be zero according to binomial
option pricing model.
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29. Answer: (c)
Reason: In a split-up the entire firm is broken up in several new firms. The parent company no longer
exists and only new offsprings survive. So, the alternative (c) is the answer.
A spin-off is a transaction in which a company distributes on a pro rata basis all of the shares
it owns in a subsidiary to its own shareholder. So the alternative (a) is not the answer.
In a split-off, a new company is created to takeover the operations of an existing division or
unit. A portion of the existing shareholders receives stock in a subsidiary or new company in
exchange for parent company. So the alternative (b) is also not correct.
A divesture is a sale of a portion of the firm to an outside party, generally resulting in an
infusion of cash to the parent. So the alternative (d) is not the answer.
An equity carve out involves the sale of a portion of the firm through an equity offering to
outsiders. So the alternative (e) is also not the answer.
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30. Answer: (c)
Reason: When a company is the target of an un wanted bid or the threat of a bid from a potential
acquirer, it may seek the help of a white knight or another company which is more
acceptable suitor for target This method of takeover defense is called white knight.
Poison pills is a defense strategy which involves issuing new securities which would be
convertible into equity at low price in event of an hostile take over of the firm.
Crown jewels strategy involves creating mechanism to ensure that a raider, in event of a
hostile takeover, is denied access to the jewels.
Golden parachutes are agreement that provides for payment of huge severance packages to
the senior management executives in case of takeover of the firm.
Green mail is a form of targeted share repurchase. It refers to the repurchase of a block of
shares from specific share holder(s), at a substantial premium, to prevent a hostile tender
offer on the company.
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Section B : Problems
1. Schemes such as POMIS, KVP and NSC were primarily meant for mobilizing funds from the small investor who
cannot afford to invest in risky instruments like stocks and corporate debentures (debentures do not carry high
risks such as stocks but still they have their associated risks) and who do not have the wherewithal to do so. Also,
these schemes served as an alternative for retirement planning. Further their characteristics differ. If we consider
liquidity these schemes do not have secondary markets like stocks or debentures but the facility of taking loans
against these deposits after a certain time period is as good as having liquidity. The other characteristic is that the
availability of various tax rebates on these schemes makes the post-tax yields (on a risk-free basis) quite high if
compared with the yields from bonds and debentures and return on equity from some of the poorly performing
companies. Of course the returns from blue-chip companies are much higher. A person with average income can
never aspire to buy these stocks, leave alone analyzing the risks associated with such investments.
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2. A security market line (SML) is a line which reflects the combinations of risk and return available on all the
alternative investments available in the market at a point or a plot wherein the betas denoting the systematic risk
and the associated returns are taken on X and Y-axis respectively and a line of best fit obtained by employing
regression analysis. It indicates that the investors demand a risk premium and increase it accordingly when they
feel that the risk has increased. The slope of the SML indicates the required rate of return per unit of risk. Now, if
we consider these schemes with respect to the SML, beta and returns from a market index can be safely ignored.
This leaves us only with the risk-free rate, which these instruments give. Now, if the risk-free rate decreases there
is a parallel shift in the SML. In other words, the SML moves downwards by the interest rate differential. Since
the investments which plot above the SML represent undervalued assets and since the number of such investments
increase after a fall in the risk-free rate the investment options for an investor increase.
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3. Since the company has payables and futures are quoted in euros, it should sell euro futures in order to hedge the risk
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a. By selling futures
Number of Euro futures required for hedging
= [1000000/(1.2283)]/125000
= 6.5 contracts (approx)
Loss incurred in spot market:
= € [(1000000/1.2073)- (1000000/1.2283)]
= € 14161
Gain in futures market
= $ [6.5x125000x (1.1493-1.1293)]
= $ 16250
= € 16250/1.2073(the gain is converted into Euros at the spot rate prevailing in March)
= € 13460
Net Loss = € (14161-13460)
= € 701
After reversing position in the futures market the French company can buy dollars in the spot market.
b. Effective cost
= € [(1000000/1.2073)+ 701]
= € 828995
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4. 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.60,244
Since the NPV is positive, the replacement should be done.
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5. Let the YTM under options A and B be k and k¢ respectively.
For option A:
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5000 = 1500 (PVIFA k%, 7) PVIF(k%,3)
for k = 12%
RHS = 1500 ´ 4.564 ´ 0.712 = Rs.4874.352
for k =10%
RHS = 1500 ´ 4.868 ´ 0.751 = 5483.802
By interpolation,
k = 10% + (12-10)% ´
483.80
609.45 = 10 +1.586 = 11.58%
For Option B:
5000 = 2500 (PVIF k%, 5) + 2085 (PVIFA k%, 5) (PVIF k%, 6)
For k¢ = 12%, RHS = 2500 ´ 0.567 + 2085 ´ 3.605 ´ 0.507
= 1417.5 + 3810.82
= Rs.5228.32
for k¢ = 14%, RHS = 2500 ´ 0.519 + 2085 ´ 3.433 ´ 0.456 = Rs.4561.45
By interpolation,
k¢ = 12% + (14 – 12) ´
228.32
666.87
= 12 + 0.68 = 12.68%
As the YTM in option A is 11.58% and in option B is 12.68%, the investor should prefer option B over A.
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6. The appropriate strategy is long butterfly spread.
Mr. Raghav could create a long butterfly spread by buying one call option each at strike prices Rs.88 and Rs.74
and selling two call options at the intermediate strike price Rs.81.
Initial investment = 7 + 15 – (2 ´ 10) = Rs.2.
Pay-off table
(in Rs.)
Stock price Pay-off from long call
(strike price Rs.88)
Pay-off from long call
(strike price Rs.74)
Pay-off from
short calls Net pay-off
70 0 0 0 –2
75 0 0 0 –2
76 0 2 0 0
81 0 7 0 5
86 0 12 10 0
88 0 14 14 –2
90 2 16 18 –2
Therefore maximum possible profit = Rs.5
Maximum possible loss = Rs.2
Breakeven points are Rs.76 and Rs.86
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Section C: Applied Theory
7. Foreign exchange risk can be classified into three categories based on the nature of the exposure. Listed below are
the three kinds of forex exposures:
· Transaction exposure
· Translation exposure
· Operating exposure.
These three foreign exchange exposures and the risks faced by the financial institutions due to the same, are
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discussed below.
Transaction exposure
Transaction exposure is the exposure that arises from foreign currency denominated transactions which an entity is
committed to complete. In other words, it arises from contractual, foreign currency, future cash flows. For
example, if a firm has entered into a contract to sell computers to a foreign customer at a fixed price denominated
in a foreign currency, the firm would be exposed to exchange rate movements till it receives the payment and
converts the receipts into the domestic currency. The exposure of a company in a particular currency is measured
in net terms, i.e. after netting off potential cash inflows with outflows.
Translation exposure
Translation exposure is the exposure that arises from the need to convert values of assets and liabilities
denominated in a foreign currency, into the domestic currency. For example, company having a foreign currency
deposit would need to translate its value into its domestic currency for the purpose of reporting at the time of
preparation of its financial statements. Any exposure arising out of exchange rate movement and the resultant
change in the domestic-currency value of the deposit would classify as translation exposure. It needs to be noted
that this exposure is mostly notional, as there is no real gain or loss due to exchange rate movements since the
asset or liability does not stand liquidated at the time of reporting. Hence, it is also referred to as accounting
exposure. This fact makes the measurement of translation exposure dependent on the accounting policies followed
for the purpose of converting the foreign-currency values of assets and liabilities into the domestic currency.
Operating exposure
Operating exposure is defined by Alan Shapiro as “the extent to which the value of a firm stands exposed to
exchange rate movements, the firm’s value being measured by the present value of its expected cash flows”.
Operating exposure is a result of economic consequences (rather than accounting consequences, as in the case of
transaction and translation exposure) of exchange rate movements on the value of a firm, and hence, is also known
as economic exposure.
The future cash flows of a firm are dependent not only on the exchange rate movements, but also on the relative
rates of inflation prevailing in different countries. The interplay of these two forces determine the future cash
flows and their variability, and hence, the operating exposure faced by a firm. If the change in the exchange rates
is matched by an equal change in the price levels, i.e. Relative PPP is maintained (or in other words, the real
exchange rate remains unchanged), the relative competitive positions of domestic and foreign firms will not
change, and hence, there will be no change in the cash flows of the domestic firm due to exchange rates. Hence,
there will be no economic exposure. On the other hand, in case of a change in the real exchange rate, the relative
prices (i.e. the ratio of the domestic goods’ prices to the prices of foreign goods) will change, case Relative PPP
holds good, even a widely fluctuating and unpredictable exchange rate will not result in operating exposure. On
the other hand, even a relative stable exchange rate can result in operating exposure if it is not matched by
appropriate changes in the price levels.
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8. Criteria for investment: In most of the companies there are usually no formal written instructions for investing
the surplus cash. It is left to the discretion and judgement of the Finance Manager. While exercising such
discretion or judgement, he usually takes into consideration the following factors:
a. Security: This can be ensured by investing money in securities whose price remains more or less stable and
where a minimum return is guaranteed.
b. Liquidity: This can be ensured by investing money in short-term securities including short-term fixed
deposits with the bank.
c. Yield: Of course most corporate managers give less emphasis to yield as compared to security and liquidity
of investment. They, therefore, prefer short-term Government securities for investing surplus cash. However,
some corporate managers follow aggressive investment policies which maximize the yield on their
investments.
d. Maturity: Surplus cash is not available for an indefinite period. Hence, it will be advisable to select
securities according to their maturities keeping in view the period for which surplus cash is available. If such
selection is done carefully, the Finance Manager can maximize the yield as well as maintain the liquidity of
investments.
For example, a firm can divide the surplus cash available with it in three categories:
i. Surplus cash, which is to be made available for meeting unforeseen disbursements. Such cash should,
therefore, be invested in securities which can be immediately sold without much loss. In case of such
cash, liquidity is more important than yield.
ii. Surplus cash, which is to be made available on certain definite dates for making specific payments such
as those on account of tax, dividends, capital expenditure, etc. Such cash should, therefore be invested
in securities whose maturities coincide with the dates of payment. iii. Surplus cash, which is a sort of
general reserve and not required to meet any specific payment. Such cash can therefore, be invested in
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securities with relatively longer maturities and more favorable yields.
iii. Surplus cash, which is a sort of general reserve and not required to meet any specific payment. Such
cash can therefore, be invested in securities with relatively longer maturities and more favourable
yields.