Financial Management (MB211): July 2005

Financial Management (MB211): July 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. Which of the following is true?
(a) Effective rate of interest is always lower than the nominal interest rate
(b) The effective rate of interest increases with increase in the frequency of compounding
(c) The nominal interest rate increases with increase in the frequency of compounding
(d) The effective and nominal interest rates are equal if the frequency of compounding is less than
four
(e) The frequency of compounding does not affect the effective and nominal interest rates.
< Answer >
2. Who among the following players in the international capital markets collect the rupee dividends on the
underlying shares and repatriate the same to the depository in US dollars/foreign equity?
(a) Lead Managers (b) Underwriters
(c) Custodians (d) Corporate borrowers (e)
Lenders.
< Answer >
3. Which of following statements are true regarding issuance of Commercial Paper (CP)?
I. They normally have a buyback facility.
II. Corporate need prior approval of RBI for CP issue.
III. CPs are issued in multiples of Rs.1 lakh.
IV. Underwriting of a CP issue is not mandatory.
(a) Both (I) and (II) above (b) (I), (II) and (III) above
(c) Both (I) and (III) above (d) Both (I) and (IV) above
(e) All (I), (II), (III) and (IV) above.
< Answer >
4. In a forex market if an investor wants to hedge his forex payments and have minimum risk, which of the
following should the investor prefer?
(a) Sell the forex futures
(b) Enter into a forward contract to purchase the required forex
(c) Enter into a call option to purchase the required forex
(d) Buy forex futures
(e) Enter into a put option to sell the required forex.
< Answer >
5. All other things being the same, which of the following will result in an increase in stock price?
I. The firm’s beta decreases.
II. The fixed assets increase.
III. The retention ratio increases.
IV. Net profit margin decreases.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (IV) above
(e) (I), (II) and (III) above.
< Answer >
6. Recently the Rebel Furniture Company has been facing problems. As a result, its financial situation has
deteriorated. Rebel approached the Charminar Bank for a loan, but the loan officer insisted that the
current ratio (currently 0.7) be improved to at least close to 1.0 before the bank would even consider
making the loan. Which of the following actions would be the most appropriate to improve the ratio in
the short run and would likely be the least costly to Rebel?
(a) Using some cash to pay off some long-term and short-term liabilities
< Answer >
(b) Purchasing some additional raw materials on credit thereby creating an additional accounts
payable
(c) Paying off some notes payable with cash to reduce the firm’s debt
(d) Selling some fixed assets for cash
(e) Collect some current accounts receivable.
7. The traders in a futures exchange, who tend to carry positions for longer period of time are known as
(a) Position traders (b) Dual traders (c) Scalpers (d) Hedgers (e) Floor brokers.
< Answer >
8. How can investors reduce the variability of returns in their investment portfolio?
I. By adding perfectly correlated securities to their portfolio.
II. By adding securities to their portfolio that are not perfectly correlated.
III. By adding some mutual funds to their portfolio.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
9. Which of the following bonds will have the greatest percentage increase in value if all interest rates
decrease by 1 percent?
(a) 20-year, zero coupon bond (b) 10-year, zero coupon bond
(c) 20-year, 10 percent coupon bond (d) 20-year, 5 percent coupon bond
(e) 10-year, 5 percent coupon bond.
< Answer >
10. If the stock’s current P/E ratio exceeds the expected P/E, then which of the following statements is/are
true?
I. Stock is overpriced.
II. It is time to buy the stock.
III. The stock is correctly priced.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (II) and (III) above
(e) Both (I) and (II) above.
< Answer >
11. If the net present value (NPV) of an investment is positive, the impact on Benefit Cost Ratio (BCR), Net
Benefit Cost Ratio (NBCR), Internal Rate of Return (IRR) and cost of capital (K) would be
(a) IRR = K and NBCR > 1 (b) IRR = K and BCR > 1
(c) IRR > K and NBCR > 1 (d) IRR > K and BCR > 1
(e) NBCR > BCR and K > IRR.
< Answer >
12. Which of the following is a feature of secured premium notes (SPN)?
(a) It is a kind of non-convertible debenture with an attached warrant
(b) It is convertible debenture with options
(c) The warrants attached to the SPN gives the holder the right to apply for one preference share
(d) It is partly convertible debenture with attached warrants
(e) It is an example of participating preference shares.
< Answer >
13. Which of the following is false regarding private placement of securities?
(a) It involves selling out a significant portion of securities to an investor or a group of investors
(b) Private placement is made with a view to make a public issue within an agreed time frame
(c) It involves fewer procedural difficulties
(d) It enables the companies to have faster access to funds
(e) Private placement is not restricted to equity only.
< Answer >
14. The term ‘agency costs’ in the context of capital structure means
(a) The commission payable by a company to its purchasing agents
(b) The commission payable by a company to its selling agents
(c) The expenses incurred in distribution of the products of the company
(d) The costs on account of restrictive covenants imposed on a company by its lenders
(e) The dividends paid by a company to its shareholders.
< Answer >
15. When high degree of uncertainty is associated with the future cash flows of a firm < Answer >
(a) The firm should invest all the cash in equity shares
(b) The firm should maintain adequate cash balance or have an overdraft arrangement with a bank
(c) The firm should postpone the loan repayments which fall due after the current period
(d) The firm should make less cash sales
(e) The firm should maintain huge cash balance and have an overdraft arrangement with a bank.
16. Which of the following projects will you select that will give the maximum advantage to the firm?
(a) Project ‘A’ which has a positive internal rate of return
(b) Project ‘B’ which has a Net Benefit Cost Ratio less than one but more than zero
(c) Project ‘C’ which has a cost of capital higher than the internal rate of return
(d) Project ‘D’ which has the highest annual capital charge compared to all other projects
(e) Both (c) and (d) above.
< Answer >
17. Which of the following will cause a decrease in the net operating cycle of a firm?
(a) Increase in the average collection period
(b) Increase in the average payment period
(c) Increase in the finished goods storage period
(d) Increase in the raw materials storage period
(e) Increase in the work-in-progress period.
< Answer >
18. When the realized yield approach is applied for finding out the cost of equity capital, one of the implicit
assumptions is that
(a) Retained earnings have no cost
(b) The equity shareholders require a premium over the return required by bondholders
(c) The equity shareholders require a premium over the return required by preference shareholders
(d) The equity shareholders require a premium over the risk-free rate of return
(e) The equity shareholders will continue to expect the same returns from the share as in the past.
< Answer >
19. Which of the following can be said to be a spontaneous source of financing current assets?
(a) Accrued wages and salaries (b) Commercial paper
(c) Public deposits (d) Cash credit (e) Term loan.
< Answer >
20. Which of the following is/are true regarding aggressive approach to investment in current assets?
(a) The investment in current assets for a given level of sales forecast will be higher
(b) A company following this approach is subjected to a higher degree of risk than a company
following conservative approach
(c) The turnover of current assets will be less
(d) The current assets under this approach are generally financed by long-term sources
(e) The current ratio in this approach is generally high.
< Answer >
21. Which of the following statements is true with respect to the ABC system of inventory management?
(a) The ‘A’ category items are those which have the lowest rupee investment
(b) Category ‘A’ items are those which have the highest rupee investment
(c) Category ‘A’ items are those which have the least count in terms of numbers
(d) Unit cost under category ‘A’ item is very costly
(e) Unit cost under category ‘A’ item is very cheap.
< Answer >
22. Consider the following
Opening stock of finished goods = Rs.2,82,000
Closing stock of finished goods = Rs.2,50,000
Cost of production = Rs.5,16,800
Selling administration and financial expenditure= Rs. 2,950
Custom and excise duty = Rs. 5,000
Finished goods storage period (in days) for the company assuming 360 days in a year is
(a) 39 days (b) 153 days (c) 172 days (d) 192 days (e)
365 days.
< Answer >
23. If the cum-right price per share is Rs.48, the theoretical value of the right is Rs.2 and subscription price
at which the rights are issued is Rs.26 per share, the number of existing shares required for a right share
is
< Answer >
(a) 5 (b) 10 (c) 15 (d) 20 (e)
25.
24. The operating exposure
(a) Represents the exposure that arises from the need of a firm to convert values of foreign currency
denominated assets and liabilities into domestic currency values
(b) Represents the exposure that arises from foreign currency denominated transactions which a firm
is committed to complete
(c) Represents the exposure of current profits of a firm to the movements in exchange rates
(d) Represents a notional exposure, as there is no real gain or loss arising out of exchange rate
movements
(e) Arises out of the economic consequences of exchange rate movement on the value of a firm.
< Answer >
25. Which of the following is a part of the financing decision of a company?
(a) Procuring new machineries for the R & D activities
(b) Spending heavily for the advertisement of the product of the company
(c) Adopting state-of-the-art technology to reduce the cost of production
(d) Purchasing a new building at Delhi to open a regional office
(e) Designing an optimal capital structure by using suitable financial instruments.
< Answer >
26. If a security’s return is plotted above the security market line, then
(a) The risk free rate is equal to the required rate of return on the security
(b) The security’s rate of return is more than the return on the market portfolio
(c) The security’s beta is less than one and hence it is a conservative security
(d) The security is said to be overvalued
(e) The security is to be bought immediately.
< Answer >
27. Which of the following are not a source of long-term finance?
(a) Equity shares (b) Debentures
(c) Preference shares (d) Commercial papers
(e) Reserves and surplus.
< Answer >
28. Which of the following issues is considered under technical aspects of project appraisal?
(a) Past and present consumption trends
(b) Availability of the required quality and quantity of raw materials and other inputs
(c) Impact of the project on the distribution of income in the society
(d) Price and cross-elasticity of demand
(e) Production constraints.
< Answer >
29. 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 >
30. Which of the following is an assumption in the economic order quantity model?
(a) Carrying cost per unit increases as the number of units ordered increases
(b) Delivery of the material takes place within a certain time as the order is placed
(c) Purchase price per unit of the raw material increases as the number of units ordered decreases
(d) Ordering cost is constant
(e) Inventory level during the year varies as per the boom phase and recessionary phase in business.
< 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 equity shares of Cargil Industries Ltd., a food processing company, are presently trading at Rs.96 per share.
The company has recently paid a dividend of Rs.3.00 per share. A security analyst has projected the following
information for the next year:
You are required to
a. Find out the expected return and risk for the equity shares of the company.
b. Find out the expected return and risk for the market.
(5 + 4 = 9 marks) < Answer >
2. Sonal Enterprises Ltd. (SEL), a trading concern, had the following receipts of an item, coded TF05, over the last
quarter:
The opening balance of the item in January was Rs.54,000 and the closing balance of the item in March was
Rs.90,000. The purchase price of the item is Rs.18 per unit and the carrying cost is 25% of the average inventory
value per annum. The cost for placing an order is fixed and it is Rs.900 per order. The purchase price per unit of the
item has not changed in the last quarter and it is not expected to change in the next six months, which is the
planning period. Their supplier, Reddy Industries Ltd. (RIL), has offered a discount of 2.5% on order sizes of 6,000
units and above. It is assumed that the demand for the item is evenly distributed over the entire year.
You are required to find out the following:
a. The economic order quantity of the item.
b. The optimal order size for the item. Clearly show the relevant costs and benefits involved. Ignore taxes.
(5 + 7 = 12 marks) < Answer >
3. The equity capitalization rate of Ayushi Industries Ltd. is 12 percent. The company has 50,000 shares outstanding
which have a market price of Rs.200 each. The company expects a net income of Rs.7,00,000 at the end of one year
and plans to declare a dividend of Rs.6 per share at that time. The company also plans to invest Rs.10,00,000 in a
project after one year. It is assumed that the assumptions underlying the Modigliani-Miller model on dividend
policy are applicable.
You are required to show that the Modigliani-Miller model on dividend policy holds good irrespective of whether
dividends are paid or not.
(9 marks) < Answer >
4. Mr. Prashant is planning to purchase a house which costs Rs.8,00,000. He has contacted two housing finance
companies viz, Metro Housing Finance Ltd. (MHFL) and Northern Finance Company Ltd. (NFCL). MHFL has
offered 100% financing for a period of 7 years. Mr. Prashant has to repay the loan along with interest in equated
monthly installments of Rs.18,500 each, payable at the end of every month over a period of 7 years.
NFCL has offered to provide 90% finance for a period of 8 years. Mr. Prashant has to bring in 10% of the cost of
the house at the time of purchase. He will borrow the amount of his contribution from one of his relatives and will
pay back his relative Rs.40,000 and Rs.50,000 (which include the amount borrowed and the interest) at the end of
the first year and the second year respectively. The amount borrowed from NFCL has to be repaid along with
interest in equated monthly installments of Rs.12,800 each, payable at the end of every month over a period of 8
years.
You are required to find out the effective rates of interest for both the financing alternatives and advise Mr. Prashant
accordingly.
Scenario Optimistic Normal Pessimistic
Probability 30% 40% 30%
Projected share price Rs.110.00 Rs.105.00 Rs.99.00
Projected dividend Rs.4.00 Rs.3.00 Rs.3.00
Projected market return 15% 12% 8%
Month January February March
Receipts (Rs.) 63,000 72,000 81,000
Suggested Answers
Financial Management (MB211): July 2005
Section A : Basic Concepts
(11 marks) < Answer >
5. Central Industries Ltd. (CIL) is considering investing in a lathe machine. There are three machines offered by
three different manufacturers. The price quotations and operational costs for the three machines are given below:
The cost of capital for the company is 15%.
You are required to find out the machine that should be selected for investment by CIL, using a suitable appraisal
criterion.
(9 marks) < Answer >
END OF SECTION B
Section C : Applied Theory (20 Marks)
This section consists of questions with serial number 6 - 8.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.
6. Briefly explain the various sources of risk to any financial asset
(6 marks) < Answer >
7. Briefly explain the phenomena of overtrading and undertrading in the context of working capital
management and the precautionary measures for preventing the same.
(7 marks) < Answer >
8. Discuss the significance of collection program in the management of receivables.
(7 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER
Manufacturers
Eastern Engineering
Ltd.
(EEL)
Western Engineering Ltd.
(WEL)
Southern Industries
Ltd.
(SIL)
Cost of machine (Rs.) 8,00,000 12,00,000 18,00,000
Annual cost of operations
(Rs.) 1,60,000 1,20,000 1,00,000
Useful life (years) 5 8 10
1. Answer : (b)
Reason : The interest rate usually specified on an annual basis in a loan agreement or
security is known as the nominal rate of interest. If compounding is done
more than once a year, the actual rate of interest paid (or received) is called
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effective interest rate. Effective interest rate would be higher than the nominal interest
rate.
The effective rate of interest increases with increase in the frequency of
compounding. For example, the effective rate of interest under quarterly
compounding will be more than the effective rate of interest under semiannual
compounding. Hence option (b) is correct.
2. Answer : (c)
Reason : Custodians hold the underlying shares and collect rupee dividends on the
underlying shares and repatriate the same to the depository in US
dollars/foreign equity.
Hence (c) is the answer.
Lead managers undertake activities like preparation of offer circular,
marketing the issues etc.
Underwriters of the issue bear interest rate or market risks moving against
the issuer before they have placed bonds or depository receipts.
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3. Answer : (d)
Reason : CPs are normally issued in multiples of Rs.5 lakhs. Hence, III is not true. The
issuance of CPs does not require the approval of RBI. Hence, II is not true.
Underwriting of a CP issue is not mandatory and the issuers generally have a
buy back facility. Hence, I and IV are true and the answer is (d).
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4. Answer : (c)
Reason : Call option is a contract that confers the right, but not an obligation to the
holder to buy an underlying asset at a price agreed on a specific date or by a
specific expiry date. In the given case, the investor is interested to hedge his
forex payments and have a minimum risk position. Hence, it is better for him
to enter into a call option to purchase the required forex at an agreed price on
the expected future date. Thus if the exchange rate behaves against the
expectation the investor shall not exercise his right and the loss that will be
incurred will be only the premium paid by him to the writer of the option.
Hence, the answer is (c).
Though payment can be hedged through purchasing the forex futures or entering
into a forward contract to purchase, there is no downside limit to the loss that
can be incurred
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5. Answer : (a)
Reason : Increase in stock price is directly related to dividends (or decrease in
retention ratio) and decrease in required rate of return (or decrease in beta).
Hence, I will increase the stock price while II does not determine the stock
price and III decreases the stock price. The correct answer is (a).
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6. Answer : (b)
Reason : To improve the current ratio Rebel Furniture Company is evaluating the
following alternatives:
(i) Using some cash to pay off some long term and short term liabilities –
It will further deteriorate the current ratio as the amount of current assets
reduced is more than the amount of current liabilities.
(ii) Purchasing some additional raw materials on credit and thereby creating
an additional accounts payable – Current assets and current liabilities
increase by same amount and as the existing ratio is less than the one the
increase in the both the components will improve the current ratio.
(iii) Paying off some notes payable with cash – Current assets and current
liabilities will decrease by the same amount and as the existing ratio is
less than one the decrease in both the components will further reduce the
current ratio.
(iv) Selling fixed assets for cash – This will definitely improve the current
ratio.
(v) Collect some accounts receivable – The components of the current assets
will change but this will not change the current ratio.
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Hence, of the five alternatives, ii and iv will improve the current ratio but ii is
least costly and the answer is (b).
7. Answer : (a)
Reason : The traders in a futures exchange, who tend to carry positions for longer
periods are known as ‘position traders’.
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8. Answer : (e)
Reason : Variability of returns of a portfolio is reduced by adding securities to the
portfolio. The reduction would be more if the securities have negative
correlation. Hence, all the three statements are true and the answer is (e).
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9. Answer : (a)
Reason : Longer the term to maturity, higher will be the price change. Of the 20-year
zero coupon bond and 10-year zero coupon bond, price change is high in case
of 20 year bond. Smaller the coupon rates higher are the price change with a
change in YTM. Hence, of (a), (c) and (d), the change in price is higher in
case of (a).
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10. Answer : (a)
Reason : If the expected P/E exceeds the current P/E, the stock is said to be currently
overpriced and it is time to sell the stock. Hence, only I is correct.
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11. Answer : (d)
Reason : When NPV is positive ,the Internal rate of return is greater than the cost of
capital an benefit cost ratio is greater than 1. Hence option (d) is correct.
When NPV is positive IRR cannot be equal to cost of capital. And NBCR is
not greater than 1.cost of capital is not greater than IRR. Therefore option (a),
(b),(c)and (e) are incorrect.
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12. Answer : (a)
Reason : SPN is a kind of non-convertible debenture with an attached warrant. It is
neither a convertible or partly convertible debenture nor any option can be
attached to it. The warrants attached to the SPN does not gives holders the
right for the preference shares. It is also not an example of participating
preference shares. Therefore only option (a) is correct. Rest is incorrect.
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13. Answer : (b)
Reason : Private placement of securities involves selling out a significant portion of
securities to an investor or a group of investor and It involves fewer
procedural difficulties. It enables the companies to have faster access to
funds. Private placement is not restricted to equity only it can be for any other
kind of securities. But private placements are not made with a view to make
public issue. Hence b is the answer.
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14. Answer : (d)
Reason : Agency cost are cost on account of restriction imposed by creditors on the
firm in the form of some protective covenants. Commission payable by the
company to its purchasing and selling agents, the expenses incurred in
distribution of the products of the company, or the dividends paid by the
company does not come under the agency cost.
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15. Answer : (b)
Reason : Investing all cash in shares would be more riskier. Postpone of loan
repayment and making less cash sales is also dangerous. The firm should
either maintain adequate cash balance or have an overdraft arrangement with
a bank. The firm should not keep huge cash balance as idle.
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16. Answer : (b)
Reason : Project B will give the maximum advantages to the firm which has a Net
befit cost ratio is less than 1 but more than zero. So project ‘B’ should be
selected. The IRR of the project should be higher than the cost of capital.
Project ‘C’ is opposite to that. So it should not be selected. Project ‘A’ has a
positive IRR. It is not clear whether it is more than or less than the cost of
capital of the project. So it should not be selected. For the selection annual
capital charge should be lowest, but in case of project ‘D’ it is highest
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compared to other products. So it should not be selected. Hence option ‘b’ is correct.
17. Answer : (b)
Reason : Increase in the average collection period, increase in the finished goods
storage period, increase in the raw materials storage period and increase in the
work-in process period all result in increasing the operating cycle of the
firm. Only increase in the average payment period decreases the net operating
cycle of the firm. Hence option (b) is correct.
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18. Answer : (e)
Reason : In the realized yield approach one of the implicit assumptions is that the
equity shareholders will continue to expect the same returns from the share as
in the past. Hence option (e) is the correct answer.
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19. Answer : (a)
Reason : Spontaneous liabilities generally occur during the normal course of business
operations where a company will usually have a ready access to certain
sources for financing its current assets. But a company is required to take
proper initiative for the sources of finance as mentioned in the other options
to finance its current assets.
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20. Answer : (b)
Reason : In aggressive approach company generally subjected to higher degree of risk
than the company following conservative approach. Hence option (b) is
correct. The turnover of current asset will be high. The current assets under
this approach is generally not financed by long term sources. The investment
in current assets for a given level of sales forecast is not high.
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21. Answer : (b)
Reason : Category ‘A’ items are those which have the highest rupee investment. It
does not necessary that per unit cost under category ‘A’ item should be very
costly or very cheap. It is also not necessary that category ‘A’ items should
least count in terms of numbers. Hence option (b) is the correct answer.
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22. Answer : (c)
Reason : Average stock of finished goods =
= Rs.2,66,000
Cost of sales = Opening stock of finished goods + Cost of production +
Selling administration of financial expenditure + Custom
and Excise duly – Closing stock of limited goods.
= 2,82,000 + 5,16800 + 2,950 + 5,000 – 2,50,000
= Rs.5,56,750
Daily cost of sales = = 1546.52
The finished goods storage period
=
= = 172 days.
Rs.2,82, 000 2, 50, 000
2
+
5,56,750
360
Average stock of finished goods
Daily cos t of sales
2, 66, 000
1546.52
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23. Answer : (b)
Reason : Theoretical value of right =
Or 2 =
Or 2N + 2 =22
o P S
N 1
−
+
48 26
N 1
−
+
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Or 2N = 20
∴N = 10
24. Answer : (b)
Reason : Operating exposure is a result of economic consequences rather than
accounting consequences of exchange rate movements on the value of a
firm.
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25. Answer : (e)
Reason : An optimal capital structure can satisfy the return expectations of the
stakeholders at a lower cost that will result in share price of the company to a
healthier one. It is a financing decision. While the cases mentioned in the
other alternatives are the investment decisions as these may bring return to the
company over a period of time.
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26. Answer : (e)
Reason : If a security’s return plots above the security market line (SML) then the
return on the security is more than the required rate of return on the security
according to the SML. A greater return means a lesser price of the security
than its intrinsic value that implies the security is under priced and hence that
should be bought immediately to book profit in future as its price increases.
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27. Answer : (d)
Reason : Commercial papers are issued for a period of 15 days to one year by the
reputed companies to finance their working capital requirements. Equity
capital and reserves and surplus are perpetual capital with an infinite maturity
period while preference shares and debentures are generally issued for a long
term. Hence, (d) is the answer.
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28. Answer : (b)
Reason : Past and present consumption trends, Price and cross-elasticity of demand
and production constraints are the issues to be considered market aspects of
project appraisal. Impact of the project on the distribution of income in the
society is issue to be considered under economic aspects of project appraisal.
Availability of the required quality and quantity of raw materials and other
inputs is the issue relating technical aspects of project appraisal. Hence
alternative (b) is the answer.
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29. Answer : (d)
Reason : Present value factor for a perpetual annuity = .
Hence it decreases with an increase in the interest rate. Hence (d) is the
correct option.
Future Value Interest Factor = .
Hence it increases with increase in the interest rate.
Future Value Interest Factor For Annuity (FVIFA) = . FVIFA
also increases with increase in the interest rate.
Capital Recovery Factor = . It is the inverse of PVIFA, which
decreases with increase in interest rate. Therefore, Capital Recovery Factor
increases with increase in the interest rate.
Inverse of PVIFA is capital recovery factor, which increases with increase in
the interest rate.
Hence, options (a), (b), (c) and (e) are incorrect.
1
i
(1+ i)n
(1 i)n 1
i
+ −
n
n
i(1 i)
(1 i) 1
+
+ −
< TOP
>
30. Answer : (d)
Reason : The assumptions of the economic order quantities are as follows:
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>
• Constant or uniform demand of the product throughout the year
• Constant unit price of the raw material
• Constant carrying cost of the material
• Constant ordering cost
• Instantaneous delivery of the materials.
• Hence, the option (d) is the correct choice.
Section B : Problems
1. a.
Expected rate of return from the share = Σpiki
= 18.75 (0.30) + 12.5 (0.40) + 6.25 (0.30)
= 12.5%
Risk for the share =
= [(18.75 – 12.50)2 (0.30) + (12.50 – 12.50)2 (0.40) + (6.25 – 12.50)2 (0.30)]1/2
= [11.719 + 0 + 11.719]1/2
= 4.84%
b. Expected return from the market = Σpikm
= 15 (0.30) + 12 (0.40) + 8 (0.30)
= 11.70%
Risk for the market, σm = [Σpi (km - )2]1/2
= [(15 – 11.70)2 (0.30) + (12 – 11.70)2 (0.40) + (8 – 11.70)2 (0.30)]1/2
= [3.267 + 0.036 + 4.107]1/2
= (7.41)1/2 = 2.72%.
< TOP >
2. a. Economic order quality (EOQ) =
Usage (U) during the planning period:
Usage in the last quarter = Opening balance + Total receipts – closing balance
= 54,000 + (63,000 + 72,000 + 81,000) – 90,000
= Rs.180,000.
Usage in the last quarter (in units) = = 10,000 units
∴ Usage (U) in the planning period of next six months = 10,000 × 2 = 20,000 units
Fixed cost per order, F = Rs.900 (given)
Unit price P = Rs.18 (given)
Carrying cost for the entire year = 25%
∴ Carrying cost for the planning period of six months, C = = 12.5%
∴ Economic order quantity (EOQ) =
= 4,000 units
Scenario Optimistic Normal Pessimistic
Projected rate of return
=
1
P
D P
0
1 1 −
+
= 0.1875
1
96
110 4 + −
= 0.125
1
96
105 3 + −
= 0.0625
1
96
99 3 + −
i.e., 18.75% i.e., 12.5% 6.25%
Probability 0.30 0.40 0.30
[ 2 ]1/ 2
Σpi (ki − k)
km
P.C
2FU
18
180,000
2
25
18 (0.125)
2×900× 20,000
b. Let the EOQ be denoted as Q* and let the minimum required order size for getting the discount be denoted
.
Net incremental benefit, Δπ = UD + F -
Q* = 4000 units (from above)
= 6000 units (given)
Discount per unit, D = Price per unit × Percentage of discount
= = Re. 0.45
∴ Discount earned over the entire planning period = UD = 20,000 × 0.45 = Rs.9,000
Savings in ordering cost = F = = Rs.1500
Increase in carrying cost =
=
= Rs.2081.25
∴ Net incremental benefit, Δπ = 9,000 + 1,500 – 2081.25
= Rs.8418.75 (gain)
Thus we find that there is a gain of Rs.8418.75. Hence the optimal order size should be 6,000 units.
< TOP >
3. Value of the firm when dividends are paid:
Let :
Price per share after one year = P1
Price per share now = P0
Dividend per share after 1 year = D1
P0 = where ‘k’ is the equity capitalization rate.
Or 200 =
Or P1 = 1.12 × 200 – 6 = Rs.218
Since dividends will be paid the company will have to issue new shares in order to raise the amount of funds used
in paying dividends. Let n1 and P1 be the numbers of share to be issued after one year and P1 be the price per share
after 1 year respectively.
Amount to be raised:
n1P1 = Investment – (Earnings – Dividends paid)
= 10,00,000 – (7,00,000 – 50,000 × 6) = Rs.6,00,000




′
−
Q
U
Q*
U



 −
′ −
2
Q*.PC
2
Q (P D)C
Q′
100
18 (2.5)




′
−
Q
U
Q*
U
.900
6,000
20,000
4,000
20,000



 −



 −
′ −
2
Q*.PC
2
Q (P D)C
( )
2
(4,000) (18) (0.125)
2
(6,000) (18 0.45) 0.125 −
−
1 1 D P
1 k
+
+
1 6 P
1.12
+
∴
Number of new shares to be issued (n1) =
Value of the firm =
=
= Rs.1,00,00,000.
Where, n = Number of shares outstanding now.
Value of the firm when dividends are not paid:
Price per share at the end of year 1:
P0 =
200 =
P1 = 200 × 1.12 = Rs.224
Amount to be raised from the issue of new shares.
n1P1 = 10,00,000 – 7,00,000 = Rs.3,00,000
Number of new shares to be issued (n1)= =
Value of the firm =
=
= Rs.1,00,00,000
(where ‘n’ is the number of shares outstanding now)
From above we see that value of the firm remains the same both in the cases when dividends are paid and
dividends are not paid. Therefore it is proved that MM model on dividend policy holds good.
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4. Cost of house = Rs.8,00,000
Financing by MHFL:
Let the interest rate per month be ‘r’
Number of months for which payments have to be made to MHFL = 7 × 12 = 84
Amount payable at the end of every month to MHFL = Rs.18,500
∴ 8,00,000 = 18,500 PVIFA(r, 84)
or PVIFA = = 43.243
For, r = 1.7%, PVIFA = = 44.548
6, 00, 000
218
1 1
e
(n n ) P I E
1 k
+ −+
+
6, 00, 000
50, 000 218 (10, 00, 000 7, 00, 000)
218
1.12
 +  − −  
1
3, 00, 000
P
3, 00, 000
224
1 1
e
(n n ) P I E
(1 k )
+ −+
+
3, 00,000
50, 000 224 (10, 00, 000 7, 00,000)
224
1.12
 +  − −  
 
18500
800000
84
84
0.017(1.017)
(1.017) −1
For, r = 1.8%, PVIFA = = 43.141
∴ r = = 1.793%
Effective interest rate = (1 + r)12 – 1 = (1.01793)12 – 1 = 23.77% p.a. (approx.)
Financing by NFCL and relative of Mr. Prashant :
Let the interest rate be ‘r’.
Amount of finance from NFCL = 8,00,000 × 0.90 = Rs.7,20,000
Amount of finance from relative = Rs.80,000
Total amount of financing = Rs.7,20,000 + Rs.80,000 = Rs.8,00,000
Amount payable at the end of every month to NFCL = Rs.12,800
Number of months for which payments have to be made to NFCL = 8 × 12 = 96 months
Amount payable to relative :
At the end of one year (i.e. 12 months) = Rs.40,000
At the end of two years (i.e. 24 months) = Rs.50,000
∴ 8,00,000 = 12,800 PVIFA (r, 96) +
Let r = 1.2%, ∴ RHS = 12800 ×
= 12800 × 56.818 + 34665.2 + 37552.4
= Rs.7,99,488
r = 1.1% ∴ RHS = 12800 ×
= 12800 × 59.104 + 35078.9 + 38454.1 = Rs.830064.2
∴ r = 1.1 + × (800000 – 830064.2) = 1.198%
∴ Effective interest rate per annum = (1 + r)12 – 1 = (1.01198)12 – 1 = 0.1536 i.e. 15.36%.
We find from above that if Mr. Prashant borrows 90% of the cost of the house from NFCL and borrows the
remaining amount from his relative he faces a lesser effective rate of interest (15.36% per annum ) than the
effective rate of interest (23.77% per annum)he faces if he borrows 100% of the cost of the house from
MHFL. Hence he should borrow 90% of the cost of the house from NFCL and the remaining amount from
his relative.
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5. Supplier: Eastern Engineering Ltd. (EEL)
Cost of the machine = Rs.8,00,000
Annual cost of operation = Rs.1,60,000
The present value of the annual cost of operation = Rs. 1,60,000 × PVIFA (15%, 5)
= Rs. 1,60,000 × 3.352
= Rs. 5,36,320
Hence the present value of costs = Rs. 8,00,000 + 5,36,320 = Rs.13,36,320
The annual capital charge will be = Rs.
84
84
0.018(1.018)
(1.018) −1
(43.243 44.548)
(43.141 44.548)
(1.8 1.7)
1.7 × −
−
−
+
12 (1 r)24
50,000
(1 r)
40,000
+
+
+
96 12 24
96
(1.012)
50000
(1.012)
40000
0.012(1.012)
(1.012) 1 + +
−
96 12 24
96
(1.011)
50000
(1.011)
40000
0.011(1.011)
(1.011) 1 + +
−
(799488 830064.2)
(1.2 1.1)
−
−
13,36,320
PVIFA(15%,5)
= = Rs.3,98,663 (approx)
Supplier : Western Engineering Ltd. (WEL)
Cost of the machine = Rs.12,00,000
Annual cost of operation = Rs. 1,20,000
The present value of the annual cost of operation = Rs. 1,20,000 × PVIFA (15%, 8years)
= Rs.1,20,000 × 4.487 = Rs.5,38,440
Hence, the present value of cost = Rs. 12,00,000 + Rs. 5,38,440 = Rs.17,38,440
The annual capital charge will be = =
Supplier: Southern Industries Ltd. (SIL)
Cost of the machine = Rs. 18,00,000
Annual cost of operation = Rs.1,00,000
The present value of the annual cost of operations = 1,00,000 × PVIFA (15%,10) =1,00,000 × 5.019
= Rs. 5,01,900
Hence, the present value of Costs = 18,00,000 + 5,01,900
= 23,01,900
The annual capital charge = =
The annual capital charge is least for the lathe machine manufactured by WEL. Hence lathe machine
manufactured by WEL should be selected.
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Section C: Applied Theory
6. The risks which arise out of different sources and affect investments in securities and portfolios are given below:
Interest Rate Risk
Interest rate risk is the variability in a security's return resulting from changes in the level of interest rates. Other
things being equal, security prices move inversely to interest rates. This risk affects bondholders more directly than
equity investors.
Market Risk
Market risk refers to the variability of returns due to fluctuations in the securities market. All securities are
exposed to market risk but equity shares get the most affected. This risk includes a wide range of factors
exogenous to securities themselves like depressions, wars, politics, etc.
Inflation Risk
With rise in inflation there is reduction of purchasing power, hence this is also referred to as purchasing power risk
and affects all securities. This risk is also directly related to interest rate risk, as interest rates go up with inflation.
Business Risk
This refers to the risk of doing business in a particular industry or environment and it gets transferred to the
investors who invest in the business or company.
Financial Risk
Financial risk arises when companies resort to financial leverage or the use of debt financing. The more the
company resorts to debt financing, the greater is the financial risk.
Liquidity Risk
This risk is associated with the secondary market which the particular security is traded in. A security which can
be bought or sold quickly without significant price concession is considered liquid. The greater the uncertainty
about the time element and the price concession, the greater the liquidity risk. Securities which have ready markets
like treasury bills have lesser liquidity riskc.
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7. Over-trading and Under-trading
13,36,320
3.352
17,38, 440
PVIFA(15%,8)
Rs.17,38,440
Rs.3,87, 439(approx)
4.487
=
23,01,900
PVIFA(15%,10)
Rs.23,01,900
Rs.4,58,637(approx)
5.019
=
Over-trading: Overtrading is a situation which is the opposite of under-trading. The symptoms of over-trading can
be noticed from the disproportionately high turnover of assets compared to the volume of sales. In the context of
working capital over-trading can be noticed from high turnover of current assets compared to similar companies.
While increase in the turnover of current assets is generally considered to be a virtue, disproportionately high
turnover is indicative of less amount of cash invested in current assets which can create problems of liquidity at the
time of making payments for current obligations. The problem of over- trading can be restated as one of
undercapitalization.
Precautionary measures for over-trading can be taken by initially reducing the sales to a level commensurate with
the amount of assets and a final solution lies in increasing the asset base through additional finances raised through
the issuance of shares and/or obtaining loan funds.
Under-trading: A situation of under-trading arises in a company when the volume of sales is much less than the
amount of assets employed. This becomes apparent when the performance of the company is compared against
similar companies. Under-trading also indicates that funds of the company are locked up in current assets resulting
in a lower turnover of working capital. Another way of stating under-trading is that a company is over capitalised
compared to the volume of sales. As this would result in lower turnover, the company has to take precautionary
measures such as altering capital structure so that the debt-equity ratio comes down, hastening the collection
process, reducing the levels of inventory to reasonable levels compared to the sales forecast and production plans.
Unless these measures are taken, the rate of return on equity is likely to come down as a result of which the market
price of the company can be adversely affected.
Unless a company takes precautionary measures once it observes symptoms of over or under-trading, it may run
into serious working capital problems as outlined above.
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8. Significance of collection program in the management of receivables
The collection effort of a company is decided by the collection policy, which is a part of the overall credit policy
of the company. The objective of collection policy is to achieve timely collection of receivables, thereby releasing
funds locked up in receivables for a longer period than they should have been under the credit terms and to
minimize bad debt losses.
The collection program consists of the following:
• Monitoring the state of receivables;
• Despatch of letters to customers whose due date is approaching
• Telegraphic and telephonic advice to customers around the due date
• Threat of legal action to overdue accounts
• Legal action against overdue accounts.
While formulating the collection policy a company should reckon with the factor that a very rigorous collection
policy may act as an irritant to customers, thereby jeopardizing the good customer relations built over the years.
Further, the sales of the company may decline as customers with some overdues may fear to place further orders.
However, the amount of receivables and bad debt losses will reduce to a certain extent as the company increases
the collection expense associated with collection programs.
The general pattern of the relationship between collection expenses incurred and bad debt losses will be such that
initial increase may not have perceptible impact while subsequent amounts up to a certain level will have a
pronounced impact in reducing bad debt losses. This is depicted in the form of a graph below. The amount of
expenses incurred beyond the saturation point are likely to have very little impact on bad debt losses.
Figure 1 : Behavior of bad debt losses/collection expenses
Similarly, deliberate laxity on the part of the company in the rigor of collection effort is likely to increase sales,
increase average collection period, increase bad debt losses and to some extent reduce collection expenses.
Once again, the incremental financial benefits in the form of the cost of funds released by a reduction in the level
of receivables and the reduction in bad debt losses have to be compared with the incremental costs associated with
additional collection expenses and policy change is warranted only when the incremental net benefits are positive.