Financial Management (MB211) : July 2006

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Question Paper

Financial Management (MB211) : July 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. The objective of financial management is to
(a) Maximize the revenues
(b) Minimize the expenses
(c) Maximize the return on investment
(d) Minimize the risk
(e) Maximize the wealth of the owners by increasing the value of the firm.
< Answer >
2. Mr. Sharma wishes to purchase a 91 day T-bill of face value Rs.100, maturing after 60 days. If, on
maturity, he wishes to earn a yield of 11.5%, the purchase price of T-bill for Mr. Sharma should be
(a) Rs.88.50
(b) Rs.92.21
(c) Rs.97.22
(d) Rs.98.14
(e) Rs.99.03.
< Answer >
3. If the return on a security lies below the security market line,
(a) The security is conservative security
(b) The security is aggressive security
(c) The ris k free rate of return is more than the expected return from that security
(d) The security is over priced
(e) The security is under priced.
< Answer >
4. A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5
percent. What is the market risk premium?
(a) 1.30%
(b) 6.30%
(c) 6.50%
(d) 7.25%
(e) 15.00%.
< Answer >
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5. Which of following statements is/are true with respect to rights issue?
I. It involves the issue of securities to the existing shareholders and to the public simultaneously.
II. It involves the issue of securities to the existing shareholders at a price, which is generally lower
than the current market price.
III. It generally entails lower cost of issue.
IV. It is generally made to high networth individuals.
(a) Only (I) above
(b) Only (III) above
(c) Both (II) and (III) above
(d) Both (II) and (IV) above
(e) All (I), (II), (III) and (IV) above.
< Answer >
6. The cost of debt remains more or less constant up to a certain degree of leverage but rises there after at
an increasing rate. This proposition is based on
(a) Net income approach on capital structure
(b) Net operating income approach on capital structure
(c) Traditional approach on capital structure
(d) Modigliani and Miller approach
(e) Merton Miller’s argument.
< Answer >
7. Which of the following statements is/are true regarding the capital recovery factor?
I. It is the inverse of the PVIF factor.
II. It represents the amount that has to be invested at the end of every year for a period of ‘n’ years at
the rate of interest ‘k’ in order to accumulate Re.1 at the end of the period.
III. It can be applied to find out the amount to be invested periodically to liquidate a loan over a
specified period at a given rate of interest.
(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 >
8. As the number of securities in a portfolio increases,
(a) The portfolio variance increases
(b) The portfolio variance depends more on average covariance
(c) The portfolio variance depends more on average expected value
(d) The portfolio variance depends more on average variance
(e) The portfolio variance does not change.
< Answer >
9. Which of the following can be inferred from the Miller and Modigliani model on dividend policy?
(a) As the dividend payout ratio increases, the share price decreases, if the rate of return is greater
than the cost of capital
(b) As the dividend payout ratio decreases, the share price decreases, if the rate of return is less
than the cost of capital
(c) The dividend policy of the firm does not influence its value
(d) Irrespective of the rate of return and cost of capital the share price increases, as the amount of
dividend payout ratio increases
(e) The optimal dividend pay out ratio should be 100% to ma ximize the value of the firm.
< Answer >
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10. Which of the following statements is/are true?
I. Current yield is equal to the coupon rate, if the market price is equal to the face value of the bond.
II. When the required rate of return (kd) is greater than the coupon rate, the value of the bond is less
than its par value.
III. Current yield is equal to the interest paid divided by the face value of the bond.
(a) Only (I) above
(b) Both (I) and (II) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
11. In a world with corporate taxes but no possibility of firm’s financial distress, the value of the firm will
be maximized, when
(a) Pure debt is used
(b) Pure equity is used
(c) Debt and equity are used in equal proportion
(d) Debt-equity ratio is 2:1
(e) Debt-equity ratio is 3:2.
< Answer >
12. Consider the following data regarding a product:
Total cost of ordering and carrying inventory Rs.870
Quantity per order 1,000 units
Carrying cost as a percentage of the purchase price 3%
Fixed cost per order Rs.100
Purchase price Rs.10
The annual usage of the material is
(a) 3,000 units
(b) 7,200 units
(c) 8,900 units
(d) 9,000 units
(e) 9,950 units.
< Answer >
13. Which of the following statements is/are true 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 will be high.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer >
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14. Which of the following statements is/are not true?
I. If the spread between credit period and cash discount period is greater, the cost of trade credit
will be higher.
II. If the spread between credit period and cash discount period is lower, the cost of trade credit will
be higher.
III. If the discount rate increases, the cost of trade credit decreases.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer >
15. If the material is priced at the value that is realizable at the time of issue, such pricing method is
referred to as
(a) Standard price method
(b) Replacement method
(c) LIFO method
(d) Weighted average cost method
(e) FIFO method.
< Answer >
16. Which of the following is not a relevant factor in cash management?
(a) Prompt billing and mailing the same to the customers
(b) Branch wise collection of receivables
(c) Centralized purchases and payments to the suppliers
(d) Availing of term loans to the maximum possible limit
(e) Prompt depositing of the cheques received from customers in the bank.
< Answer >
17. The weakness/es of the internal rate of return approach is/are that
I. It does not directly consider the timing of the cash flows from a project.
II. It fails to provide a straightforward decision-making criterion.
III. It cannot be a meaningful criterion for the projects with multiple internal rates of return, whose
cash inflows and outflows are interspersed.
(a) Only (I) above
(b) Only (III) above
(c) Only (II) above
(d) Both (II) and (III) above
(e) Both (I) and (III) above.
< Answer >
18. An investment project is expected to generate earnings before taxes (EBT) of Rs.60,000 per year.
Annual depreciation from the project is Rs.30,000 and the firms’ tax rate is 40 percent. The project’s
annual net cash flows are
(a) Rs.36,000
(b) Rs.40,000
(c) Rs.48,000
(d) Rs.54,000
(e) Rs.66,000.
< Answer >
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19. In the presence of floatation costs, the cost of external equity is
(a) More than the cost of existing equity capital
(b) Less than the cost of existing equity capital
(c) Equal to the cost of existing equity capital
(d) Equal to the cost of long-term debt
(e) Equal to the cost of short-term debt.
< Answer >
20. Which of the following is/are the limitation(s) of Walter model on dividend policy?
I. Exclusive financing by retained earnings makes the model suitable only for all equity firms.
II. In case of high investments the return on investment will not be constant.
III. The business risk of the firm has a direct impact on the value of the firm, thus cost of equity
capital cannot be constant.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
21. Overtrading means
(a) The firm has disproportionately high amount of working capital with respect to the level of
sales
(b) The firm has disproportionately low amount of working capital with respect to the level of sales
(c) The firm has disproportionately high level of receivables with respect to total assets
(d) The firm has disproportionately high level of cash with respect to total assets
(e) The firm has been experiencing low turnover of working capital.
< Answer >
22. Which of the following foreign exchange exposures refers to the impact on the value of firms
operations due to unanticipated changes in the exchange rates?
(a) Transformation exposure
(b) Transaction exposure
(c) Translation exposure
(d) Currency exposure
(e) Economic exposure.
< Answer >
23. The rates available in the market are:
Rs./$ Spot 43.78 / 79
£/$ 0.5285 /86
If an Indian importer requires pounds, the rate quoted to him is
(a) Rs.82.82/£
(b) Rs.82.72/£
(c) Rs.82.79/£
(d) Rs.82.86/£
(e) Rs.82.84/£.
< Answer >
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24. If interest rate parity holds and the transaction costs are zero, covered foreign financing will result in
an effective borrowing rate that is
(a) Less than domestic interest rate
(b) Greater than domestic interest rate
(c) Equal to domestic interest rate
(d) Less than domestic interest rate if forward rate is in discount
(e) Negative.
< Answer >
25. In a swap-out deal, the foreign currency is
(a) Bought both spot and forward
(b) Sold both spot and forward
(c) Sold spot and bought forward
(d) Sold forward with different maturities
(e) Bought forward with different maturities.
< Answer >
26. The system under which the exchange rates are determined by the demand and supply position for the
currencies in the foreign exchange market is known as
(a) Target zone arrangement system
(b) Crawling peg system
(c) Fixed exchange rate system
(d) Floating exchange rate system
(e) Currency board system.
< Answer >
27. The following are the exchange rates quoted in Singapore market:
S$/Euro : 2.0118/21
S$/US$ : 1.7384/86
The synthetic rates of US $/Euro are
(a) 1.1572/73
(b) 1.1571/74
(c) 0.8640/41
(d) 0.8639/42
(e) 3.4977/79.
< Answer >
28. Following information is available for two firms:
Firm Objective Fixed interest Floating interst
Sealine Floating rate 9.00% Libor + 0.25%
Desert Fixed rate 10.00% Libor + 0.50%
The quality spread is
(a) 0.25 %
(b) 0.50 %
(c) 0.75 %
(d) 1.00 %
(e) 1.50 %.
< Answer >
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29. Which of the following is not a feature of futures contract?
(a) Standard volume
(b) Liquidity
(c) Customized maturity
(d) Counterparty guarantee
(e) Intermediate cash flows.
< Answer >
30. An Indian exporter bought put option on dollar at Rs.46.50 by paying a premium of Rs.0.30. On the
date of delivery if spot rate is Rs.46.75, then the net amount realized per dollar will be (ignore time
value of money)
(a) Rs.46.20
(b) Rs.46.45
(c) Rs.46.50
(d) Rs.46.75
(e) Rs.47.05.
< 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 Specialty Foods 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:
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%
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.
c. Estimate the beta co-efficient for the equity shares of the company and state its implication.
(5 + 4 + 3 = 12 marks)
< Answer >
2 Tuff Steel Ltd. (TSL) is engaged in the manufacture of steel based products. It has planned to produce
6,000 ingots during the year 2005-06 which will be sold at a price of Rs.10,000 per ingot. The estimated
costs per ingot are given below:
Particulars Amount (Rs.)
Raw materials cost 5000
Manufacturing expenses 2000
Selling, administration and financial expenses 1000
Total 8000
< Answer >
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Assessment of the last year’s operations indicates the following durations at the various stages of the
operating cycle:
Raw material stage = 2 months
Work-in-process stage = 1 month
Finished goods stage = 1 month
Debtors stage = 3 months
It is assumed that production and sales will continue uniformly throughout the year. TSL needs 10% of its
gross current assets as cash.
You are required to answer the following questions:
a. Calculate the investment required in various current assets.
b. Estimate the gross working capital requirement.
(9 + 1 = 10 marks)
3 Zenith Industries Ltd. has an earnings per share of Rs.8.00 in the recently concluded financial year. The
cost of capital for the company is 12 percent. It is assumed that the Walter’s model of dividend policy
holds true for the company.
You are required to
a. Find out the price of the company’s share at dividend payout ratios of 50 percent and 75 percent
respectively, if the internal rate of return of the company is 15 percent.
b. Find out the price of the company’s share at dividend payout ratios of 50 percent and 75 percent
respectively, if the internal rate of return of the company is 10 per cent.
c. Give your inference about the model on the basis of your solutions to the aforementioned questions.
(4 + 4 + 2 = 10 marks)
< Answer >
4 Northern Transports Ltd. is presently using a truck that has a book value of Rs.6.50 lakhs. It is being
depreciated on a straight line basis and it will be written off over the next six years. Presently the salvage
value of the truck is Rs.3,00,000 and the salvage value after six years will be Rs.50,000. The company is
planning to replace the old truck with a new one which is improvised and more efficient. The new truck
costs Rs.14 lakhs. It will be depreciated on a straight line basis over the period of next six years and will
be fully written off at the end of the six year period. The new truck will have a salvage value of
Rs.350,000 at the end of the six year period. The general manager of the company has collected the
following additional information:
The
savings in annual operating and maintenance costs will be Rs.150,000.
The
income from the operations will increase by Rs.250,000 per year.
The cost of capital for the company is 12% and the tax rate applicable to it is 30%.
You are required to
a. Project the cash flows related with the replacement decision.
b. Appraise the capital expenditure proposal using the NPV technique and advise the general manager
of the company accordingly.
(8 + 2 = 10 marks)
< Answer >
5 Modern Suppliers Ltd. currently allows a credit period of 30 days without any cash discount. All the sales
are on credit basis and the average collection period is 32 days. Currently, it sells 600,000 units at an
average price of Rs.80 per unit and the variable cost to sales ratio is 70%. In order to expand sales, the
management of the company is considering to change the existing credit terms to 1/10, net 30. Due to the
change in credit policy, sales are expected to go up by 12%. 30% of the customers are expected to avail of
the discount and pay on the tenth day. The average collection period for the new policy is expected to be
24 days. The cost of capital of the company is 15%.
You are required to find out the impact of the change in credit policy on the profit of the company. Ignore
taxes.
(8 marks)
< Answer >
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END OF SECTION B
Section C : Applied Theory (20 Marks)
· This section consists of questions with serial number 6 - 7.
· Answer all questions.
· Marks are indicated against each question.
· Do not spend more than 25 -30 minutes on section C.
6 A company should plan its capital structure in such a manner that will minimize the cost of capital.
Briefly describe the factors influencing the capital structure and the features of an optimal capital
structure.
(10 marks)
< Answer >
7 Describe the role of the finance manager in the mobilization and deployment of funds for an
organization.
(10 marks)
< Answer >
END OF SECTION C
END OF QUESTION PAPER
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Suggested Answers
Financial Management (MB211) : July 2006
Section A : Basic Concepts
1. Answer : (e)
Reason : When the market value of the firm increases, the wealth of its owners increases. The ultimate
objective of financial management is to maximize the wealth of the owners. All the other
alternatives may not necessarily maximize the wealth of the owners.
Hence option (e) is the answer.
< TOP >
2. Answer : (d)
Reason : 60
365
P
100 -P ´
= 0.115
P
100 - P
= 365
0.115 ´60
P
100 - P
= 0.0189
or, 1.0189 P = 100 Þ P = 1.0189
100
or, P = Rs.98.14.
< TOP >
3. Answer : (d)
Reason : As the return on a security lies below the security market line, the security is over priced as the
expected return is less than the required return. The statements as stated in the options (a), (b)
and (c) are not related to the security market line.
< TOP >
4. Answer : (b)
Reason : 12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.30%.
< TOP >
5. Answer : (c)
Reason : Rights issue involves the issue of securities to the existing shareholders at the price, which is
generally lower than the current market price and it involves lower issue cost. As statements
(II) and (III) are true, alternative (c) is answer.
< TOP >
6. Answer : (c)
Reason : As per traditional approach on capital structure theory, up to a certain amount of leverage the
cost of debt will decrease but there after as the default risk increases, cost of debt also
increases. So (c) would be the correct answer.
< TOP >
7. Answer : (b)
Reason : Capital recovery factor is the inverse of the PVIFA factor. It can be applied to find out the
amount that can be withdrawn periodically for a certain length of time, if a given amount is
invested today. Hence I is not true and III is true and the answer is (b). Hence option (b) is
the answer.
< TOP >
8. Answer : (b)
Reason : As the number of securities in a portfolio increases the portfolio variance decreases. Also
portfolio variance depends more on average covariance.
< TOP >
9. Answer : (c)
Reason : According to the Miller and Modigliani model on dividend policy, if the entire amount of profit
is disbursed among the shareholders in the form of dividends, it will have to raise additional
capital from the market. Therefore, the appreciation of the share prices due to the higher
dividend payment will be automatically dampened with the issue of the new equity shares.
Hence, it can be concluded that the dividend policy of the firm does not significantly influence
the share prices.
< TOP >
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10. Answer : (b)
Reason : Current yield =
Coupon amount
Marketprice
Coupon rate =
Coupon amount
Facevalue
\Current yield = Coupon rate implies that market price = face value. Further this means that
the bond is trading at its face value.
Hence both (I) and (II) are true.
< TOP >
11. Answer : (a)
Reason : Since interest on debt is tax deductible and there is no possibility of firms’ financial distress,
the value of the firm maximizes with more use of leverage. Hence, the correct answer is (a).
< TOP >
12. Answer : (b)
Reason : Total costs associated with inventory = Ordering cost + Carrying cost = 2
QPC
F
Q
U
´ +
Where
U is the annual usage
Q is the quantity ordered
F is fixed cost per unit
P is the purchase price per unit
C is the carrying cost expressed as a percentage of the purchase price.
Hence, 870 =
U 1,000 10 0.03
100
1,000 2
´ ´
´ +
Hence, U = 7,200 units.
< TOP >
13. Answer : (b)
Reason : Statement (I) is not true because in an aggressive financing policy for current assets the
financing mix is tilted more towards short term sources of financing.
Statement (II) is true because risk of technical insolvency is high in aggressive current asset
financing policy, as the debt servicing obligations are high in the short run.
Statement (III) is not true because cost of financing is usually low in aggressive current asset
financing policy, as short term financing is less expensive than long term financing.
< TOP >
14. Answer : (d)
Reason : Cost of trade credit
= (Discount Rate/ 1- Discount Rate) × [360 /(Credit Period – Discount Period)]
By careful observation of the above formula, it can interpreted that, there is a positive
relationship between discount rate and cost of trade credit and negative relationship between
the spread between credit period and discount period and cost of trade credit. As statements (I)
and (III) are not true, alternative (d) is answer.
< TOP >
15. Answer : (b)
Reason : If the material is priced at the value that is realizable at the time of issue, such pricing method
is called replacement method. Answer is (b).
Under FIFO method, the pricing will be based on the cost of material that was obtained first.
Under LIFO method, the pricing will be based on the material that has been purchased recently.
Under statndard price method, the pricing is based on predetermined price.
Under weighted average cost method, pricing is based on weighted average basis.
< TOP >
16. Answer : (d)
Reason : Whether or not to avail of term loans and to what extent is related with the borrowing policy of
a firm; it is not related with cash management.
< TOP >
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17. Answer : (b)
Reason : The internal rate of return considers the timing of the cashflows from a project and provides a
straight forward decision-making criterion. It assumes that the firm is able to reinvest the
interm cash flows from a project at the internal rate of return. It is not a meaningful criterion, if
there are multiple internal rates of return due to the intermediate cash outflows. Hence, answer
is (b).
< TOP >
18. Answer : (e)
Reason : Net Cash Flow = Rs.60,000 (1 – 0.40) + Rs.30,000 = Rs.66,000.
< TOP >
19. Answer : (a)
Reason : In the presence of floatation costs, the cost of external equity will always be more than the cost
of existing equity capital (a). It has no logical connection with cost of long-term or short-term
debt. Hence (b), (c), (d) and (e) are incorrect.
< TOP >
20. Answer : (e)
Reason : All the above mentioned statements are the valid criticism of the Walter model on dividend
policy.
< TOP >
21. Answer : (b)
Reason : Overtrading means that the firm has disproportionately low level of working capital with
respect to the level of sales. To define it as a state in which the firm has disproportionately high
level of working capital with respect to sales or a disproportionately high level of receivables
with respect to total assets or a dis proportionately high level of cash with respect to total assets
or low turnover of working capital is incorrect. Hence, alternative (b) is answer.
< TOP >
22. Answer : (e)
Reason : Economic exposure refers to the impact on the value of firms operations due to unanticipated
changes in the exchange rates.
Transaction exposure arises out of day-to-day activities of a company.
Transaction exposure arises due to the need to translate the foreign currency values of assets
and liabilities into the domestic currency
Currency exposure refers to the currency which is to be received/or paid.
Correct answer is (e).
< TOP >
23. Answer : (d)
Reason : The rate to be quoted to the Importer is the ask rate
= (Rs./$) ask ´ ($/£) ask
= (Rs./$) ask ´(1/£/$) bid
= 43.79 ´ (1/0.5285) = Rs.82.86/£.
< TOP >
24. Answer : (c)
Reason : According to the Interest rate parity or the covered interest parity condition, the cost of
borrowing money or the rate of return on financial investments, when adjusted for the cost of
covering foreign exchange risk is equal across different currencies.
< TOP >
25. Answer : (c)
Reason : In a swap-out deal, the foreign currency is sold spot and bought forward. Options in (a), (b), (d)
and (e) are not correct.
< TOP >
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26. Answer : (d)
Reason : The exchange rates under floating exchange rate system are determined by the demand and
supply position for the currencies in the foreign exchange market.
(a) When a group of countries get together and agree to maintain the exchange rates between
the currencies within a certain band around fixed central exchange rates, then it is called a
target zone arrangement.
(b) A crawling peg system is a hybrid of fixed and flexible exchange rate system. Under this
system, while the value of a currency is fixed in terms of a reference currency, this peg
itself keeps changing in accordance with the underlying economic fundamentals.
(c) Under fixed exchange rate system, the value of a currency in terms of another is fixed and
it is determined by Governments or Central banks of the respective countries.
(e) Under a currency board system, a country fixes the rate of its domestic currency in terms
of a foreign currency and its exchange rate in terms of other currencies depends on the
exchange rates between the other currencies and the currency to which the domestic
currency is pegged.
< TOP >
27. Answer : (b)
Reason : The synthetic rates of US $/Euro are
(US $/Euro)bid = (US$/S$)bid ´ (S$/Euro)bid
=
bid
ask
1
(S$/Euro)
(S$/US$)
´
=
1
2.0118
1.7386
´
= 1.1571.
Similarly (US$/Euro)ask =
1
2.0121
1.7384
´
= 1.1574.
US$/Euro = 1.1571/74.
< TOP >
28. Answer : (c)
Reason : Quality spread is fixed market = 10.00 – 9.00 = 1.00%
In floating market = (LIBOR + 0.50) – (LIBOR + 0.25) = 0.25%
Difference in quality spreads = 1.00 – 0.250 = 0.75%.
< TOP >
29. Answer : (c)
Reason : Futures contract have standard maturity and hence customized maturity is not a feature of a
futures contract. All the others are the features of a futures contract.
< TOP >
30. Answer : (b)
Reason : If spot is Rs.46.75, put will not be exercised, and dollar will be sold at spot market.
\ Net amount realized per dollar = 46.75 – 0.30 = Rs.46.45.
< TOP >
Section B : Problems
1. a.
Scenario Optimistic Normal Pessimistic
Projected rate of return
=
1
P
D P
0
1 1 -
+ 1
96
110 + 4 -
= 0.1875
1
96
105 + 3 -
= 0.125
1
96
99 + 3 -
= 0.0625
i.e., 18.75% i.e., 12.5% 6.25%
Probability 0.30 0.40 0.30
Expected rate of return from the share = Spiki
= 18.75 (0.30) + 12.5 (0.40) + 6.25 (0.30) = 12.5% < TOP >
14
Risk for the share = [ 2 ]1/ 2
Spi (k i - k)
= [(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 = Spikm
= 15 (0.30) + 12 (0.40) + 8 (0.30) = 11.70%
Risk for the market, sm = [Spi (km - 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%.
c. b =
2
m
Cov (i,m)
s
Cov (i, m) = SPi (ki - ki ) (km - km )
= (0.30) (18.75 – 12.50) (15 – 11.70) + (0.40) (12.50 – 12.50) (12 – 11.70) +
(0.30) (6.25 – 12.50) (8 – 11.70)
= 13.125
2
sm = 7.41
\b = 7.41
13.125
= 1.77
Implication: A beta of 1.77 indicates that if market returns change by 1% then returns on the share
will change by 1.77% in the same direction.
2.
a. Monthly production and sales =
6000
12 = 500 ingots
The table below shows the investments in various current assets required to be made by TSL:
(Rs.’000)
Inputs Period
(months)
Raw
materials
Work-inprocess
Finished
goods
Debtors Total
1. Raw materials
In stock 2 5000
In WIP 1 2500
In finished goods 1 2500
In debtors 3 7500
17500
2. Manufacturing
costs
In WIP 1/2 500
In finished goods 1 1000
In debtors 3 3000
4500
3. Selling
administration
and financial
expenses
In finished goods 1 500
In debtors 3 1500
2000
4. Profit
In debtors 3 3000
3000
Total 5000 3000 4000 15000 27000 < TOP >
15
Note: The manufacturing costs are assumed to be incurred evenly throughout the month. Hence on
average the manufacturing expense component of WIP will be equal to half month’s
manufacturing expenses.
b. The amount of gross current assets (raw materials + WIP + finished goods + debtors + cash)
required by TSL will be
= 2,70,00,000 ´
100
90
= Rs.3,00,00,000 i.e., Rs.3 crores.
3. According to the Walter’s model on dividend policy the price per share is given by the formula:
P = k
k
D+(E -D) r
a. E = Rs.8.00 per share (given)
r = 15% = 0.15
k = 12% = 0.12
If dividend payout ratio is 50% ––
D = 8 (0.50) = Rs.4.00 per share
\ P = 0.12
0.12
4 +(8 - 4) 0.15
= 0.12
0.12
4 + 4´0.15
= Rs.75 per share
If dividend payout ratio is 75% ––
D = 8 (0.75) = Rs.6.00
P = 0.12
0.12
6+ (8 -6) 0.15
= 0.12
0.12
6+ 2´0.15
= Rs.70.83 per share.
b. E = Rs.8.00 per share (given)
r = 0.10
k = 0.12
If dividend payout ratio is 50% then –
D = 8 (0.50) = Rs.4.00 per share
P = 0.12
0.12
4 +(8 - 4) 0.10
= Rs.61.11
If dividend payout ratio is 75% then –
D = 8 x (0.75) = Rs.6.00
\ P = 0.12
0.12
6+ (8 -6) 0.10
= 0.12
0.12
2(0.10)
6+
= Rs.63.89 per share.
c. Inference:
When the internal rate of return of a firm is greater than its cost of capital (i.e. the firm is a growth
firm) the price per share increases as the dividend payout ratio decreases.
When the internal rate of return of a firm is less than its cost of capital (i.e., the firm is a declining
firm) the price per share increases as the dividend payout ratio increases. < TOP >
4. a. Cash flows associated with the replacement project:
Year 0 1 2 3 4 5 6
A Net investment in
new truck1 (11,00,000)
B Savings in costs 150,000 150,000 150,000 150,000 150,000 150,000
C Incremental Income 250,000 250,000 250,000 250,000 250,000 250,000
D Incremental 75,000 75,000 75,000 75,000 75,000 75,000 < TOP >
16
depreciation2
E Pre-tax profit
(E: B+C-D)
325,000 325,000 325,000 325,000 325,000 325,000
F Taxes 97,500 97,500 97,500 97,500 97,500 97,500
G Post-tax profit 227,500 227,500 227,500 227,500 227,500 227,500
H Initial flow (11,00,000)
I Operating flow:
G+D
302,500 302,500 302,500 302,500 302,500 302,500
J Terminal flow3 300,000
K Net cash flow:
H+I+J
(11,00,000) 302,500 302,500 302,500 302,500 302,500 602,500
Working Notes:
1. Net investment in new truck = 14 – 3 = Rs.11 lakhs
2. Existing depreciation (on old truck) per year over the next six years:
6
650,000 -50,000
= Rs.100,000
Depreciation on the new truck for each year over the next six years:
6
14,00,000 - 3,50,000
= Rs.1,75,000
\ Incremental depreciation in each year = 1,75,000 – 1,00,000 = Rs.75,000.
3. Terminal flow = Incremental salvage value
= 350,000 – 50,000
= Rs.300,000
b. NPV = S
I
(1 k)
CF
t
t -
+
= 302,500 PVIFA (12%, 5) + 602,500 PVIF (12%, 6) – 11,00,000
= 302,500 ´ 3.605 + 602,500 (0.507) – 11,00,000
= Rs.295,980.
The NPV is positive. So the investment in the new truck is justified.
5. The effect on profit ignoring taxes = DS (1 – V) + KDI – DDIS
where, DI = 360
S0
(ACP0 – ACPN) – 360
VDS
ACPN
and DDIS = Pn (S0 + DS)dn – P0 S0d0
DS = 600000 ´ 80 ´ 0.12 = 5760000
DI = 360
600000 ´80
(32 – 24) – 360
(0.70)(5760000 )
´ 24
= 360
600000 ´80´8- 96768000
= Rs.797867 (approx.)
DDIS = (0.30) (600000 ´ 80 ´ 1.12) (0.01) – (0) (600000 ´ 80) (0)
= Rs.1,61,280
DS(1–V) = 5760000 (1 – 0.70) = Rs.1728000
\ Effect on profit ignoring taxes = 1728000 + (0.15) (797867) – 161280
= Rs.1686400.05 (approx.)
Thus it can be seen that as a result of the new policy of allowing cash discount, the profit (ignoring
taxes) increases by Rs.16.86 lakh. < TOP >
Section C: Applied Theory
17
6. Factors influencing the capital structure:
Leverage - The use of fixed charges sources of funds such as preference shares, debentures and term
loans along with equity capital in the capital structure is described as financial leverage or trading on
equity. The term trading on equity is used because it is the equity that is used as a basis for raising
debt. Financial institutions while sanctioning long-term loans insist that companies should generally
have a debt-equity ratio of 2:1 for medium and large-scale industries and 3:1 for small-scale industries.
A debt-equity ratio of 2:1 indicates that for every 1 unit of equity the company has, it can raise 2 units
of debt.
Increased use of leverage increases the fixed commitments of the company in the form of interest and
repayments and thus increases the risk of the equity shareholders as their returns are affected.
The other factors that should be considered whenever a capital structure decision is taken are:
a. Cost of capital
b. Cash flow projections of the company
c. Size of the company
d. Dilution of control
e. Floatation costs.
Features of an Optimal Capital Structure
An optimal capital structure should have the following features:
· Profitability - The company should make maximum use of leverage at a minimum cost.
· Flexibility - The capital structure should be flexible to be able to meet the changing conditions.
The company should be able to raise funds whenever the need arises and also retire debts
whenever it becomes too costly to continue with that particular source.
· Control - The capital structure should involve minimum dilution of control of the company.
· Solvency - The use of excessive debt threatens the solvency of the company. In a high interest
rate environment, Indian companies are beginning to realize the advantage of low debt.
Companies are now launching public issues with the sole purpose of reducing debt.
< TOP >
7. Mobilization of Funds for the Firm
The Finance Manager has to plan for and mobilize the required funds from various sources when they
are required and at an acceptable cost. This decision is called the Financing Decision. For this purpose
he would be liaising with banks and financial institutions. He also deals with merchant banking
agencies for procuring funds from the public through issue of shares, debentures and inviting the
public to subscribe to its fixed deposits. In deciding how much to procure from various sources, he
would weigh many considerations like the cost of the funds in the form of interest/dividend and the
cost of public issue in the case of shares and debentures, the length of time for which funds would be
available, etc. Banks and other financial institutions which give short-term and long-term loans
generally lay down some conditions. These conditions are aimed at ensuring the safety of the loans
given by them and contain provisions restricting the freedom of the borrower to raise loans from other
sources. Therefore, the Finance Manager would try to balance the advantages of having funds
available with the costs and the loss of flexibility arising from the restrictive provisions of the loan
contract.
Deployment of Funds
There are always many competing needs for the allocation of funds. In consultation with the managers
of various departments such as production, marketing, personnel, R & D and the top management, the
Finance Manager decides on the manner of deployment of funds in various assets such as land,
buildings, machinery, materials, etc. Sometimes the managers of the various departments named above
constitute an ‘Investment Committee’ and appraise an investment proposal along the marketing,
technical and financial dimensions. The Finance Manager appraises the proposal along the financial
dimensions to determine its worthiness in relation to the investment involved. This decision called the
‘Investment Decision’ constitutes one of the core activities of the Finance Manager. < TOP >
< TOP OF THE DOCUMENT >