Financial Management (MB211) – January 2006

Financial Management (MB211) – January 2006

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.
1. Which of the following money market instruments has a maturity period varying from 2 to 15 days?
(a) Call money (b) Commercial Paper (c) Notice money
(d) Treasury Bill (e) Certificate of Deposit.
< Answer >
2. Which of the following will decrease with an increase in the interest rate?
(a) Future Value Interest Factor
(b) Future Value Interest Factor For Annuity
(c) Capital Recovery Factor
(d) Present Value Interest Factor for a perpetual annuity
(e) Inverse of Present Value Interest Factor For Annuity.
< Answer >
3. Which of the following is true?
(a) A change in YTM affects bonds with a lower YTM more than it does bonds with a higher YTM
(b) Given the maturity, for equal sized increases or decreases in the YTM, price movements are not
symmetrical
(c) When the required rate of return is greater than the coupon rate, the value of the bond is more than
its par value
(d) Bond’s price is directly proportional to its YTM
(e) When the required rate of return is more than the coupon rate, the premium on the bond declines as
maturity approaches.
< Answer >
4. Which of the following statements is/are true?
I. Beta of a security increases with an increase in the variance of market returns.
II. Beta of a security increases with a decrease in standard deviation of the security’s return.
III. Beta of a security increases with an increase in the value of the correlation coefficient between the
security’s return and market return.
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Both (I) and (II) above (e) Both (I) and (III) above.
< Answer >
5. Which of the following is not true about Commercial Papers (CPs)?
(a) CPs are negotiable by endorsement and delivery
(b) The minimum maturity period of CPs is 15 days
(c) CPs are unsecured in nature
(d) CPs cannot be issued at a discount to face value
(e) Prior approval of RBI is not needed for CP issues.
< Answer >
6. Which of the following assumptions associated with Capital Asset Pricing Model (CAPM) is/are not
true?
I. The greater the perceived risk of a portfolio, the higher is the return expected by a risk-averse
investor.
II. All individuals agree on the nature of return and risk associated with each investment.
III. The choice of buying assets is affected by taxes.
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Both (I) and (II) above (e) Both (II) and (III) above.
< Answer >
7. Which of the following is an example of a diversifiable risk?
(a) Ability of a company to obtain adequate supply of raw materials
< Answer >
2
(b) Changes in the tax structure
(c) Reduction in the purchasing power of money
(d) Recession in the economy
(e) Introduction of a restrictive credit policy by RBI.
8. Who among the following categories of people try to obtain risk free profits by simultaneously buying and
selling similar instruments in different markets?
(a) Arbitrageurs (b) Speculators (c) Factors
(d) Brokers (e) Authorized Dealers.
< Answer >
9. The sinking fund factor is the inverse of
(a) Capital Recovery Factor
(b) Future Value Interest Factor
(c) Future Value Interest Factor for Annuity
(d) Present Value Interest Factor for Annuity
(e) Present Value Interest Factor.
< Answer >
10. Consider the following data
Annual credit purchase = Rs.72,72,000
Opening balance of accounts payable = Rs.17,66,400
Closing balance of accounts payable = Rs.29,20,000
The average payment period assuming 360 days in a year is
(a) 36 days (b) 66 days (c) 96 days (d) 116 days (e) 136 days.
< Answer >
11. Under which of the following factoring arrangements does the factor not make any prepayment to the
client?
(a) Recourse factoring (b) Invoice discounting (c) Maturity factoring
(d) Non-recourse factoring (e) Both (c) and (d) above.
< Answer >
12. Which of the following statements is/are true?
I. Collection float indicates the amount of cheques issued by a company, awaiting payment by the
bank.
II. If the collection float is more than the payment float, the company is said to have positive net float.
III. When the bank balance as per the books of the company is less than that in the bank’s books, the
company can play the float.
(a) Only (II) above (b) Only (III) above (c) Both (II) and (III) above
(d) Both (I) and (III) above (e) All (I), (II) and (III) above.
< Answer >
13. Which of the following statements is/are true as per the Net Operating Income Approach?
I. Overall capitalization rate remains constant for all degrees of leverage.
II. Cost of equity remains constant for all degrees of leverage.
III. Cost of equity is a constant linear function of the debt-equity ratio.
IV. Cost of debt remains constant for all degrees of leverage.
(a) Only (III) above (b) Only (IV) above (c) Both (I) and (II) above
(d) Both (II) and (IV) above (e) (I), (III) and (IV) above.
< Answer >
14. Which of the following is not the source of long-term finance?
(a) Secured Premium Notes (b) Fully Convertible Debentures
(c) Cumulative Preference Shares (d) Commercial Paper
(e) Lease Arrangement.
< Answer >
15. Which of the following will increase the duration of the operating cycle?
(a) Increase in the raw material storage period
(b) Decrease in the average collection period
(c) Increase in the average payment period
(d) Decrease in the conversion period
(e) Both (a) and (c) above.
< Answer >
16. Which of the following appraisal criteria is useful for evaluating mutually exclusive projects providing
similar service but having differing patterns of cost and unequal life spans?
< Answer >
3
(a) Net Present Value (b) Internal Rate of Return
(c) Accounting Rate of Return (d) Benefit Cost Ratio
(e) Annual Capital Charge.
17. Which of the following approaches to compute the cost of equity capital assumes that actual returns will
be in line with the expected returns?
(a) Realized Yield Approach
(b) Bond Yield Plus Risk Premium Approach
(c) Earnings-Price Ratio Approach
(d) Dividend Capitalization Approach
(e) Capital Asset Pricing Model.
< Answer >
18. Which of the following is/are not true?
I. If credit standards are made more stringent, sales are likely to decrease and less amount of money
will be locked up in receivables.
II. If credit period is lengthened, sales are likely to increase but bad debt losses are likely to decrease.
III. If cash discount is increased, discount paid is likely to increase and amount of receivable is likely to
reduce.
(a) Only (II) above (b) Only (III) above (c) Both (I) and (II) above
(d) Both (II) and (III) above (e) Both (I) and (III) above.
< Answer >
19. Which of the following is not an assumption made under the Modigliani and Miller approach for
explaining the irrelevance of dividends policy for a firm?
(a) Existence of perfect capital markets
(b) Non-existence of differential tax rates for the dividend income and capital gains
(c) Non-influence of single investor on the share value
(d) Absence of transaction costs
(e) Higher growth rate of dividends compared to cost of equity capital.
< Answer >
20. Which of the following is spontaneous source of financing current assets?
(a) Note lending (b) Trade credit (c) Cash credit
(d) Letter of credit (e) Overdraft.
< Answer >
21. Consider the following projects.
I. Project B which has a Net Benefit Cost Ratio less than one but more than zero.
II. Project C whose present value of inflows is less than the present value of outflows.
III. Project D which has a cost of capital less than the internal rate of return.
IV. Project E which has the highest annual capital charge compared to all other projects.
Which of the projects mentioned above could be accepted?
(a) Only (I) above (b) Both (I) and (III) above
(c) Both (III) and (IV) above (d) (II), (III) and (IV) above
(e) (I), (III), and (IV) above.
< Answer >
22. Which of the following statements is true about the terms of trade credit 4/10, net 30?
(a) A 10% cash discount is offered for payment before 30 days
(b) A 4% cash discount can be taken for payment before the 10th of the following month after
invoicing
(c) A 10% cash discount can be taken if paid by the fourth day after invoicing
(d) No cash discount is offered from the eleventh day onwards after the date of purchase
(e) 4% cash discount is awarded for payment on the 30th day after purchase.
< Answer >
23. Which of the following statements is true in case of a direct quote?
(a) Exchange margin is to be added to the bid rate and ask rate
(b) Exchange margin is to be added to the bid rate and deducted from the ask rate
(c) Exchange margin is to be deducted from the bid rate and the ask rate
(d) Exchange margin is to be deducted from the bid rate and added to the ask rate
(e) Exchange margin is to be added to the bid rate only.
< Answer >
24. Which of the following is not an appropriate hedging strategy for a likely devaluation of a currency?
(a) Reduce the level of cash (b) Reduce the local borrowing
(c) Delay accounts payable (d) Sell the weak currency forward
< Answer >
4
(e) Tighten credit terms.
25. The following are the exchange rates quoted in NewYork:
CHF / $ 1.3591 / 93
$ / CAD 0.6570 / 72
The synthetic quotes of Swiss Franc per Canadian dollar are
(a) CHF / CAD 0.8929 / 33 (b) CHF / CAD 0.8930 / 32
(c) CHF / CAD 2.0683 / 86 (d) CHF / CAD 2.0680 / 89
(e) CHF / CAD 0.4833 / 36.
< Answer >
26. Bank of the Middle East, Dubai is maintaining an account with SBI Mumbai. SBI Mumbai calls this
account as
(a) Nostro account (b) Vostro account (c) Loro account
(d) Mirror account (e) Shadow account.
< Answer >
27. Suppose that a speculator anticipates depreciation of US $ against Euro 3-months from now from the
current 3 months forward rate. To make profit, the speculator should
(a) Sell US $ spot and buy Euro 3-month forward
(b) Buy US $ spot and sell Euro 3-month forward
(c) Sell US $ 3-month forward
(d) Buy Euro 3-month forward
(e) Sell Euro 3-month forward.
< Answer >
28. The value of a forward contract at its initiation is
(a) Zero (b) Forward price (c) Bid - ask spread
(d) Spot price minus forward price
(e) Present value of forward price at risk less interest rate less spot price.
< Answer >
29. In a swap transaction where two fixed-floating currency swaps are combined to form a fixed to fixed
currency swap is known as
(a) Roller-coaster swap (b) Amortized swap (c) Amortizing swap
(d) Circus swap (e) Forward swap.
< Answer >
30. Which of the following equation is true?
(a) Short underlying asset + long call = long put
(b) Short underlying asset + long put = long call
(c) Long underlying asset + short call = long put
(d) Short underlying asset + long put = short call
(e) Long underlying asset + long call = short put.
< Answer >
END OF SECTION A
Section B : Problems (50 Marks)
This section consists of questions with serial number 1 – 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
1. The debenture of Marvel Graphite Ltd. is selling at a discount of 5 percent from its face value. The face value of
the debenture is Rs.100, coupon rate is 8 percent and the interest payments are made at the end of every six
months. The next interest payment will fall due at the end of six months from now. The debenture will be
redeemed in two equal annual installments; the first installment will be payable at the end of five years and six
months from now, and the second installment will be payable at the end of six years and six months from now.
You are required to determine the yield that you will realize if you invest in the debenture now and hold it till its
maturity.
(10 marks) < Answer >
5
2. You are given the following information by your banker.
Spot Rs./HK $ : 5.60 / 65
Rupee Interest rates (p.a.)
Six months : 6% / 7%
HK $ Interest rates (p.a.)
Six months : 4% / 5%
You are required to determine the limits for six-month forward rates that would prevent covered interest
arbitrage.
(10 marks) < Answer >
3. Pfizer Industries Ltd. uses 4900 tonnes of steel in a year. The purchase price is Rs.15,625 per tonne. However, the
supplier has offered a discount of 0.8 percent per tonne if the order size is at least 80 tonnes. The fixed cost per
order is Rs.1,800 and carrying cost of the inventory is 25 percent of the inventory value.
You are required to find out
(a) The economic order quantity.
(b) The optimal order quantity (ignoring taxes).
(2 + 6 = 8 marks) < Answer >
4. Horizon Industries Ltd. is planning to invest in a new project. It is estimated that the total long term financing
required by the project will be around Rs.500 lakhs. However, the actual financing requirement may vary due to
the uncertainties involved.
The company has planned to finance the long-term requirements of the project using term loan, debentures and
equity capital in the following proportions:
Equity capital 40%
Term loan 40%
Debentures 20%
The following information has been collected by the company from its investment bankers and the financial
institutions:
Source of finance Range of financing
(Rs. In lakhs) Cost (%)
Upto 140 15.00
Equity capital 140 – 200 15.50
200 and above 16.00
Upto 150 7.50
Term loan 150 – 220 8.00
220 and above 8.50
Debentures Upto 90 8.00 90 and above 8.50
You are required to
(a) Find out the marginal cost of capital schedule.
(b) Estimate with the help of the marginal cost of capital schedule, the average cost of capital if the actual
financing required is Rs.600 lakhs, the financing structure remaining the same.
(10 + 2 = 12 marks) < Answer >
5. On September 13, 2005, a trader buys one Nifty Index futures contract at 1,870. The initial margin requirement for
the contract is Rs.10,000 while the maintenance margin is 75% of initial margin. (Nifty Index futures are traded in
multiples of 200.) Its settlement prices for the next 8 trading days are as follows:
Date Settlement Price
September 13 1865
September 14 1858
September 15 1853
September 16 1847
September 17 1849
6
September 20 1855
September 21 1872
September 22 1879
On September 23, the investor closes his position when futures price was 1883.
You are required
a. Prepare the margin account showing all the cash flows (assume no amount is withdrawn from the margin
account).
b. Calculate profit/loss.
(8 + 2 = 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.
6. Briefly explain how certificates of deposit (CD) benefit both issuers and investors.
(6 marks) < Answer >
7. Explain briefly the forms in which liquidity may be maintained by an organization in order to manage the
requirements for cash.
(8 marks) < Answer >
8. Many business organizations undertake business largely on a credit basis. Briefly explain the costs associated with
maintaining receivables arising out of credit sales.
(6 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER
7
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.
< TOP >
2. Answer : (d)
Reason : Present value factor for a perpetual annuity =
1
i . Hence it decreases with an increase in the
interest rate.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
9. Answer : (c)
Reason : Sinking Fund Factor = i
(1 + i)n − 1
= 1
FVIFA
. Hence option (c) is correct.
< TOP >
10. Answer : (d)
Reason : Average A/c payable
< TOP >
8
= = 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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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).
< TOP >
19. Answer : (e)
Reason : Modigliani and Miller approach makes the following assumptions:
< TOP >
9
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
25. Answer : (a)
Reason : CHF/CAD bid rate = 1.3591 × 0.6570 = 0.8929
CHF/CAD ask rate = 1.3593 × 0.6572 = 0.8933.
< TOP >
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.
< TOP >
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.
< TOP >
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.
< TOP >
29. Answer : (d)
Reason : In circus swap, two fixed – floating currency swaps are combined to form a fixed to fixed
< TOP >
10
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.
< TOP >
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)
< TOP >
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
11
So, to prevent arbitrage, forward rates should be
Fb < Rs. 5.73/HK$
Fa > Rs. 5.63/HK$.
< TOP >
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.
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