Financial Management (MB211) – October 2005

 Financial Management (MB211) – October 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.
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1.
Which of the following is related to the control function of the financial manager?
(a) Interaction with the bankers for arranging a short-term loan
(b) Comparing the costs and benefits of different sources of finance
(c) Analysis of variance between the targeted costs and actual costs incurred and reporting on the same
(d) Assessing the costs and benefits of a project under consideration
(e) Deciding the optimum quantity of raw materials to be ordered for procurement.
2.
If the beta of a stock is 1.63 and the standard deviation of the return on the market is 16.25%, then thecovariance of returns of the stock and market is
(a) 99.39%2 (b) 162.00%2 (c) 250.02%2
(d) 430.42%2 (e) 701.59%2.
3.
The current price of a share of ABC Ltd. is Rs.50. The company issues one rights share for every fourshares held at Rs.45 per share. The ex-rights price of the share would be
(a) Rs.45 (b) Rs.48 (c) Rs.49 (d) Rs.50 (e) Rs.51.
4.
Which of the following is not a relevant factor in cash management?
(a) Prompt billing and mailing the same to the customers
(b) Branchwise collection of receivables
(c) Centralised purchases and payment to the suppliers
(d) Availing term loans to the maximum possible limit
(e) Prompt depositing of the cheques received from customers in bank.
5.
Which of the following assumption(s) underlie the definition of cost of capital under capital expendituredecisions?
I. The risk characterizing the new project under consideration is significantly lower than the risk characterizing the existing investments of the firm
II. The firm will continue to adopt the same debt to equity ratio
III. The management of the firm will remain the same.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (II) above (d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
6.
An ageing schedule gives particulars about
(a) Profit and present value
(b) Accounts receivable and proportion of sales
(c) Employees and age of their service
(d) Age-wise distribution of accounts receivable
(e) Current ratio and the corresponding year.
7.
The economic exposure of a firm can be managed by
(a) Forward contracts (b) Futures contracts (c) Option contracts
(d) Money markets operations (e) Pricing strategy.
8.
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.
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9.
You have the following information:
One year Swiss interest rate is 5% (compounded quarterly)
One year Singaporean interest rate is 6% (compounded quarterly)
The 6-month forward exchange rate is Singapore Dollar 1.20 per Swiss Franc.
According to interest rate parity, the spot exchange rate is
(a) 1.1941 (b) 1.2059 (c) 1.2160 (d) 1.2210 (e) 1.2260.
10.
An exporter has covered his dollar receivable by purchasing put options on dollar at Rs.44 by paying apremium of 75 paise. If on the date of realization of his receivable spot price turned out as Rs.44.05 / $,then net rupee amount realized per dollar is
(a) 43.25 (b) 43.30 (c) 44.05 (d) 44.75 (e) 44.80.
11.
If Rs./₤ exchange rate is 75.25/30 and Rs./Euro is 48.00/02, then implied ₤/Euro rate would be
(a) 0.6380/0.6384 (b) 0.6377/0.6379
(c) 1.5677/1.5681 (d) 1.5671/1.5688
(e) 0.6375/0.6381
12.
Consider the following:
$ / ₤ Spot : 1.5620/25
1-m : 15/10
2-m : 10/15
3-m : 20/25
Which of the following statements is correct?
(a) 1-month forward bid rate is 1.5635 (b) 2-months forward ask rate is 1.5610
(c) 2-months forward bid rate is 1.5610 (d) 3-months forward bid rate is 1.5640
(e) 3-months forward ask rate is 1.5600
13.
If the risk-free interest rate is 6% p.a. and the cost of storage is 1% p.a., a $295 per ounce one yearfutures price of gold implies a current spot price of
(a) $292.08 (b) $280.95 (c) $278.30 (d) $275.70 (e) $273.15
14.
An American exporter sold 5 Euro futures contracts at $0.8926. The initial margin requirement is 15%.If the contract size is Euro125,000, the initial margin amount is
(a) Euro 18,750 (b) $ 31,640 (c) $ 50,000
(d) $ 83,682 (e) Euro 93,750
15.
Which of the following appraisal methods is preferred for comparing mutually exclusive projectsproviding similar service but have unequal life spans?
(a) Annual capital charge (b) IRR (c) NPV
(d) Accounting rate of return (e) Pay-back period.
16.
Which of the following is not a feature of a commercial paper (CP)?
(a) It is an unsecured instrument
(b) It is issued in multiples of Rs.5 lakhs
(c) Buy-back facilities are not available for CPs
(d) It is negotiable by endorsement and delivery
(e) Maturity varies between 15 days to a year.
17.
If the yield to maturity (YTM) of bond X is greater than the yield to maturity of bond Y, with the same coupon rate and maturity, then which of the following is/are true?
I. The price of bond X will change more than the price of Bond Y for a given change in YTM.
II. The market price of bond Y is more than that of X.
III. The current yield of both the bonds would be same.
(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.
18.
As per the ‘rule of 69’, if the amount deposited today doubles in four years and seven months, theeffective interest rate per annum is
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(a) 15.1 percent (b) 15.5 percent (c) 15.8 percent
(d) 16.0 percent (e) 16.3 percent.
19.
The return on investment of a firm is 14% and cost of equity capital is 12%. In order to maximize thevalue of the firm according to Walter Model, the firm should
(a) Adopt 100% dividend pay-out policy
(b) Not pay dividends at all
(c) Be indifferent as to the dividend policy
(d) Plough back 50% of profits and pay the rest as dividends
(e) Leave the decision of dividend payment to the discretion of Board of Directors.
20.
Net working capital is equal to
(a) Current assets minus current liabilities (b) Fixed assets minus current assets
(c) Current Assets minus cash (d) Long term loans minus short term loans
(e) Current liabilities minus provisions.
21.
Which of the following is not a source of long term finance?
(a) Reserves and surplus (b) Equity capital
(c) Cash credit (d) Deferred credit (e) Debenture capital.
22.
Which of the following is not the logical consequence of liberalizing credit standards?
(a) Sales tend to increase
(b) Investment in receivables tend to increase
(c) Bad debt losses tend to increase
(d) Requirement of finance for working capital tends to decrease
(e) Collection costs tend to increase.
23.
The economic order quantity is the order quantity which
(a) Minimizes ordering costs
(b) Minimizes carrying costs
(c) Maximizes ordering costs
(d) Maximizes carrying costs
(e) Minimizes the total of ordering and carrying costs.
24.
The quote is said to be an ‘European quote’ where the exchange is expressed
(a) In terms of US dollars per unit of any other currency
(b) In terms of number of units of any other currency per US dollar
(c) In terms of British pound per US dollar
(d) In terms of euro per unit of any other currency
(e) Both (a) and (d) above.
25.
If the slope of the Security Market Line is zero then, which of the following is true?
(a) Beta is equal to zero
(b) Risk free return = Market return = Expected return of the given security
(c) The returns on the given security are not correlated with the returns on the market
(d) Risk free rate of return ≠ Market return
(e) Market return ≠ Expected return of the given security.
26.
Which of the following is not a feature of an optimal capital structure?
(a) Profitability (b) Liquidity (c) Flexibility
(d) Control (e) Solvency.
27.
In which of the following arrangements with the bank, a company does not directly assume the risk of default by its customers?
(a) Cash credit (b) Overdraft (c) Letter of credit
(d) Pledge (e) Hypothecation.
28.
When the net float is positive
(a) The firm’s balance in the books of the bank is higher than the bank balance in the books of the firm
(b) The firm’s balance in the books of the bank is less than the bank balance in the books of the firm
(c) The current assets are more than current liabilities
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(d) The current assets are less than current liabilities
(e) The receivables are more than current liabilities.
29.
Which of the following is not a valid reason for maintaining inventories?
(a) Avoidance of lost sales
(b) Obtaining quantity discounts
(c) Reduction in ordering cost
(d) Elimination of carrying cost
(e) Reducing the chance of stoppage of production.
30.
Which of the following is not an advantage of private placement of securities?
(a) Easy access for any reputed company
(b) Fewer procedural difficulties
(c) Lower issue cost
(d) Access to funds is faster
(e) Complete certainty of availability of funds.
END OF SECTION A
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Section B : Caselets/Problems (50 Marks)
This section consists of questions with serial number 1 – 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
Caselet 1
Read the caselet carefully and answer the following questions:
1. The caselet says that “Maruti Udyog Limited is unique of its kind, not only maintaining its growth both in terms of production and supply despite all the hiccups, but also increasing its market share in the automobile sector over a period of years”. List out the various strategic factors which helped Maruti Udyog Limited to establish itself as a market leader in the automobile industry during such a short course of time.
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The last few years have seen rapid development in the automobile industry in India. The passenger car market has come a long way and a greater choice is available to prospective owners. In comparison with the kind of cars available in developed countries, India’s passenger cars may appear primitive even today, when a much wider choice is available than in earlier years. Until Maruti Udyog Limited (MUL) came out with 800 cc car, the only cars visible on the Indian roads were Premiers, Ambassadors and few Standard Gazelles. Once MUL launched its three-cylinder car, there was a rush to book it, and it was considered distinctly prestigious to own once.
There is no doubt that the passenger car market in this country has come a long way since the time when there were long waiting lists for even the antiquated Premiers and Ambassadors. There is much greater choice available to prospective owners, manufacturers are striving for greater driving and seating comfort and fuel efficiency. The pre-1984 cocks of the walk, the Birla group company –Hindustan Motors (HM) and Premier Automobiles (PAL), have been overtaken by the state-owned MUL which has blitzed the market. In a short span of seven years, the erstwhile two-member oligopoly has been shattered, and MUL has become the un-disputed No.1. In fact, the recent statistics says that, three out of every four cars produced in India emerge from Maruti’s factory in Gurgaon, near Delhi.
In all fairness, one should add the name of Tata Engineering (TE) to the list of passenger car makers, for the the dieselized two-ton Tatamobile that the company launched in 1989, though technically a LCV, is being increasingly used as a passenger car. Apart from this TE rolled out number of passenger cars and LCV on the roads of Indian market. Other players in the market are Fork Ikon, Santro, Octavia to name a few.
Maruti Udyog Limited is unique of its kind, not only maintaining its growth both in terms of production and supply despite all the hiccups, but also increasing its market share in the automobile sector over a period of years, Palio from PAL, Production figures of the manufacturers over the last five years are revealing. While MUL’s production has been increasing by leaps and bounds, the competitors of MUL’s have also been steadily increasing the number of cars produced in the country. While the share of MUL in the total installedcapacity is 44 per cent, it contributed more than 70 per cent in terms of production and sales for the last five years, the other players in the market shared the remaining. It is an amazing statistic that 71 per cent of all cars sold in India last year were Marutis, while MUL sells 98 per cent of whatever it produces within two months of production and still has a waiting list for some of its vehicles, the other manufacturers take longer to sell.
For a long time, owning a personal four-wheeler was considered a luxury in India, and a limited road network with poor road surface did not help matters much. Production showed only a very gradual upward curve from the 1950s until the early 1980s before Maruti came into the scene.
The 1980s brought a sea change in the industry. With the government following a policy of liberalization, several foreign manufacturers got a toehold in the country, signing collaboration agreements to bring their products into India. With Maruti literally flooding the market with passenger cars, the other manufacturers had also to try and keep pace by introducing new and attractive models.
Caselet 2
Read the caselet carefully and answer the following questions:
2. Discuss the issues that need to be addressed while evaluating projects that claim attractive IRR.
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May be finance managers just enjoy living on the edge. What else would explain their weakness for using the internal
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rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects.
So why do finance pros continue to do what they know they shouldn't? IRR does have its allure, offering what seems to be a straightforward comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances.
Admittedly, some of the measure's deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations—and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards.
Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project's annual return on investment only when the project generates no interim cash flows—or when those interim cash flows really can be invested at the actual IRR. IRR's assumptions about reinvestment can lead to major capital budget distortions.
Even if the interim cash flows really could be reinvested at the IRR, very few practitioners would argue that the value of future investments should be commingled with the valueof the project being evaluated. Most practitioners would agree that a company's cost of capital—by definition, the return available elsewhere to its shareholders on a similarly risky investment—is a clearer and more logical rate to assume for reinvestments of interim project cash flows
When the cost of capital is used, a project's true annual equivalent yield can fall significantly—again, especially so with projects that posted high initial IRRs. Of course, when executives review projects with IRRs that are close to a company's cost of capital, the IRR is less distorted by the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10 percent or more above their company's cost of capital, these may well be significantly distorted.
An analysis conducted by Mckinsey, with the reinvestment rate adjusted to the company's cost of capital, indicated that the order of the most attractive projects changed considerably when this adjustment was done. The top-ranked project based on IRR dropped to the tenth-most-attractive project. Most striking, the company's highest-rated projects—showing IRRs of 800, 150, and 130 percent—dropped to just 15, 23, and 22 percent, respectively, once a realistic reinvestment rate was considered . Unfortunately, these investment decisions had already been made. Of course, IRRs of this extreme are somewhat unusual. Yet even if a project's IRR drops from 25 percent to 15 percent, the impact is considerable.
3. Mr. Anand Suman is considering investment in the sharesof ATCO Ltd. He has the following expectations of return on the stock and the market:
Return (%)
Probability
ATCO
Market
0.35
30
25
0.30
25
20
0.15
40
30
0.20
20
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The yield on 182 days T-bills is 10% p.a.
You are required to
a. Calculate the expected return and risk for ATCO.
b. Calculate the expected return and risk for the market.
c. Find out the beta coefficient of the ATCO shares.
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4. An investment manager is studying two alternatives of investments as given below:
Alternative I: This is a bond of Leather Products (India) Ltd., which has a maturity period of 5 years and a coupon rate of 12%. The market price of this bond is Rs.480 and the current yield on it is 12.5%. The bond will be redeemed at par on maturity.
Alternative II: This is an equity share of Western Drugs & Pharmaceuticals Ltd. The company has recently paid a dividend of Rs.3.20 per share. It has been studied that dividends have been growing at an approximate rate of 8%
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p.a. over a sufficiently long period of time. The market price of the share is Rs.48.
The investment manager requires a rate of return of 14%.
You are required to find out
a. The intrinsic value of the bond.
b. The intrinsic value of the share.
c. The alternative in which investment should be made so that the investment manager earns at least his required rate of return.
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5. Mehta Steel Products 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).
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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. In a large manufacturing concern, the finance function interfaces with the production and marketing functions as well as the top management. Briefly explain these interfaces.
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7. Diversification of investments in securities leads to risk reduction.However, the risk cannot be eliminated altogether, notwithstanding the extent of diversification. Briefly describe the diversifiable and non-diversifiable risks.
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8. The operations in a manufacturing firm pass through several stages that are interdependent on each other. This gives rise to interdependence among the various components of working capital. Briefly explain the interdependence among the different components of working capital in the context of a manufacturing concern.
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END OF SECTION C
END OF QUESTION PAPER
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Suggested Answers Financial Management (MB211) – October 2005
Section A : Basic Concepts
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1.
Answer : (c)
Reason : Alternative (a) is a part of the ‘mobilization of funds’ / ‘financing’ function of the finance manager. Alternative (b) involves partly the ‘funds mobilization function and partly the ‘risk- return tradeoff’ function. Alternative (c) is the control function. Alternative (d) is a part of the ‘deployment of funds’ function. Alternative (e) is also related with the ‘deployment of funds’ function.
2.
Answer : (d)
Reason : β = 2m)m,i(Covσor Cov(i,m) = β. 2mσ
= 1.63 (16.25)2 = 430.42%2
3.
Answer : (c)
Reason : Ex-rights price of a share = 1NSNP0++
= 1445)50(4++ = Rs.49.
4.
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.
5.
Answer : (b)
Reason : It is assumed that the risk characterizing the new project under consideration is almost same as the risk characterizing the existing investment of the firm. Therefore, statement (I) is not correct. It is assumed that the firm will continue to pursue the same financing policy, i.e. the debt-equity mix in the capital structure. Hence, (II) is correct.
Further, no assumption is made regarding the management of firm to remain same.
6.
Answer : (d)
Reason : Comparison of ageing schedule at periodic intervals helps to identify changes in the payment behaviour of customers.
7.
Answer : (e)
Reason : The economic exposure of a firm can be managed by pricing strategy. Forwards, futures, options, money markets are external hedging techniques for hedging foreign currency receivables or payables.
8.
Answer : (a)
Reason : The traders in a futures exchange, who tend to carry positions for longer periods are known as ‘position traders’. They are floor traders who add to the liquidity of the markets.
9.
Answer : (a)
Reason : 2406.01

+20.1405.01S12+×=
S = 1.1941
10.
Answer : (b)
Reason : Put option is not exercised (spot market – premium) = (44.05 – 0.75)
Net amount realized per dollar is Rs.43.30.
11.
Answer : (e)
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Reason : £ / Euro bid rate = 48.0075.30 = 0.6375
£ / Euro ask rate = 48.0275.25 0.6381
£ / Euro quote: 0.6375/0.6381
12.
Answer : (d)
Reason : Premium is to be added to bid / ask rates and discount is to be deducted from bid / ask rates to calculate the forward rates. Options in (a), (b), (c) and (e) are not correct. Option (d) is correct. 3 month premium added to the spot bid rate is 1.5620 + 0.0020 = 1.5640.
13.
Answer : (d)
Reason : Spot price 70.275$01.006.01295=++=
14.
Answer : (d)
Reason : Initial margin 15.058926.0000,125×××=
= $83,682 25.681,83$=
15.
Answer : (a)
Reason : For two mutually exclusive projects providing similar service but have unequal life spans one can compare only with respect to what is the equivalent annual expenditure.
16.
Answer : (c)
Reason : CPs normally have a buy-back facility, the issuer or dealers can buyback the CPs if needed. Hence (c) is incorrect.
17.
Answer : (b)
Reason : If the YTM of bond X is greater than the YTM of bond Y, other things remaining the same, then the market price of bond X is less than the market price of bond Y. So II is true. I is true according to the bond value theorem, “A change in YTMaffects the bonds with a higher YTM more than it does bonds with a lower YTM”.
Hence alternative (b) is correct.
18.
Answer : (e)
Reason : According to the rule of 69,
Doubling period (in years) = 0.35 + i69
∴4 + 127= 0.35 + i69
Solving the above equation we get i = 16.3%.
19.
Answer : (b)
Reason : As per Walter Model
P0 = kk/r)DE(D−+
Where, the notations are in their standard use.
As the given return on investment (r) > cost of equity (k) the company will maximize the value of share if no dividends are paid
20.
Answer : (a)
Reason : Current assets less current liabilities is equal to net working capital.
21.
Answer : (c)
Reason : Cash credit is not a source of long term finance. It is a type of short term bank finance. Alternative (a), (b), (d), and (e) represent sources of long term finance.
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22.
Answer : (d)
Reason : Alternatives (a), (b), (c) and (e) represent the logical consequences of liberalizing the credit standards because such an action leads to increase in credit sales and the aforesaid statements are the logical consequences.
Alternative (d) is not the logical consequence because the investment in receivables increases and the financing need for working capital also increases.
23.
Answer : (e)
Reason : The economic order quantity is the order size that minimizes the total of ordering and carrying costs.
24.
Answer : (b)
Reason : European quote is the number of units of any other currency expressed per US dollar.
25.
Answer : (b)
Reason : According to the SML equation:
kj = Rf + βj (km – Rf)
The slope is (km – Rf). When the slope is zero, kj = Rf + 0 = Rf
Further, km – Rf = 0 implies that km = Rf
∴Rf = km = kj
i.e. Risk free rate of return = Market return = Expected return of the given security.
26.
Answer : (b)
Reason : Liquidity is a feature of the investments made out of the funds raised. It is not a feature of the capital structure of the company.
27.
Answer : (c)
Reason : Under the letter of credit (L/C) arrangement the credit risk of customers is not borne by a company; it is borne by the bank issuing the L/C.
28.
Answer : (a)
Reason : When the net float is positive the balance in the books of bank is higher than the balance in the books of the firm.
29.
Answer : (d)
Reason : Inventories are not maintained to reduce carrying cost (carrying costs will always increase if inventories increase).
30.
Answer : (e)
Reason : Private placement of funds cannot ensure complete certainty of availability of funds; availability of funds is subject to the willingness of the parties to invest in the securities which are to be placed privately. All other alternatives are advantages of private placements.
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Section B : Problems
1. The following strategic factors that helped Maruti Udyog Limited to become a market leader within a very short span of time:
• To provide fuel efficient, low-cost vehicles, which were reliable and of high quality:
• Maruti has transformed the concept of after sales service in the Indian automobile industry. The company made sure that the relationship with the customer does not end with the purchase of a vehicle. It has built up an extensive network of showrooms, dealer workshops, and authorized service stations, to ensure that no matter where the customer is they are never far away from a Maruti Authorised Service Station
• Reducing the cost of manufacturing through superior practices, enhanced focus on quality and emphasis on 'doing it right first time' on the shop floor
• Reducing the cost of components through aggressive localization, value analysis and value engineering and better inventory management
– MUL has used IT to enhance efficiency of operations on the one hand and improve customer interface on the other. It provided benefits across the value chain. Major areas of IT implementation were as follows:
– Demand Planning and Management: By capturing and integrating various demand related information, this system will enable better consensus forecasts at various levels of product mix.
– Streamlining the warehouse and operations of the spare parts business.
– Extranet connecting all dealerships provided a competitive edge and support for New Business Initiatives.
– Customer Call centers should be added to the existing network so that customers and prospective customers are able to interact with the company through a toll free telephone number.
2. The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to be replaced easily. Executives should at the very least use a modified internal rate of return. While not perfect, MIRR at least allows users to set more realistic interim reinvestment rates and therefore to calculate a true annual equivalent yield. Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions. Executives who review projects claiming an attractive IRR should ask the following questions:
1. What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong. Particularly when sponsors sell their projects as "unique" or "the opportunity of a lifetime," another opportunity of similar attractiveness probably does not exist; thus interim flows won't be reinvested at sufficiently high rates. For this reason, the best assumption—and one used by a proper discounted cash-flow analysis—is that interim flows can be reinvested at the company's cost of capital.
2. Are interim cash flows biased toward the start or the end of the project?Unless the interim reinvestment rate is correct (in other words, a true reinvestment rate rather than the calculated IRR), the IRR distortion will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates.
3. a. Expected return for ATCO (ir) = 30 (0.35) + 25 (0.30) + 40 (0.15) + 20 (0.20)
= 28%
Risk for ATCO shares:
Variance of returns () = (30 – 28)2iσ2 (0.35)
+ (25 – 28)2 (0.30)
+ (40 – 28)2 (0.15)
+ (20 – 28)2 (0.20)
= 38.50 (%2)
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Standard deviation of returns (σ) = i50.38 = 6.20%
b. Expected return for the market (mr)
= 25 (0.35) + 20 (0.30) + 30 (0.15) + 10 (0.20)
= 21.25%
Risk for market:
Variance of returns () = (25 – 21.25)2mσ2 (0.35)
+ (20 – 21.25)2 (0.30)
+ (30 – 21.25)2 (0.15)
+ (10 – 21.25)2 (0.20)
= 42.2 (%2) approx.
Standard deviation of returns (σ) = m2.42 = 6.5% (approx.)
c. β = 2m)m,i(Covσ
Cov (i, m) = Σ (ri – ir) (rm –mr)p
= (30 – 28) (25 – 21.25) (0.35)
+ (25 – 28) (20 – 21.25) (0.30)
+ (40 – 28) (30 – 21.25) (0.15)
+ (20 – 28) (10 – 21.25) (0.20) = 37.5(%)2
σ = 42.2 (%2m2)
∴ β = 2.425.37 = 0.89
4. a. Given, n = 5 years
Coupon rate = 12%
Price (P) = Rs.480
Current yield = )P(icePr)C(paymentCoupon = 12.5%
∴ PC = 0.125
or C = 0.125P = 0.125 × 480 = Rs.60
∴ Par value or redemption value, F = rateCouponC = 12.060 = Rs.500
Required rate of return (k) = 14%
∴ Intrinsic value of the bond at a required return of 14%
= C . PVIFA(k, n) + F . PVIF(k, n)
= 60 PVIFA(14%, 5) + 500 PVIF(14%, 5)
= 60 (3.433) + 500 (0.519)
= Rs.465.48 ≈ Rs.465.50 (approx.)
b. Given, Current dividend, (D0) = 3.20
Growth rate, (g) = 8% p.a.
Market price (P) = Rs.48
Required rate of return, (ke) = 14%
Intrinsic value = gkDe1− = gk)g1(De0−+ = 08.014.0)08.1(20.3− = Rs.57.60
c. From above the following information is available:
Bond of Leather Products (India) Ltd.:
Intrinsic value at 14% required return = Rs.465.50
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Market price = Rs.480
Equity share of Western Drugs & Pharmaceuticals Ltd.:
Intrinsic value at 14% required return = Rs.57.60
Market price = Rs.48.00
∴ It can be seen that if investment is made in the bond at the current market price then the return earned will be less than the required return of 14%; and if the investment is made in the share at the current market price, the return will be more than the required return of 14%. Hence, alternative II, i.e. the equity shares must be selected for investment so that the minimum return of 14% is earned.
5. a. Economic Order Quantity = PCFU2
= 25.015625490018002×××
= 67.2 tonnes
b. Alternative 1:
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 = Rs.125 8.0
Δ = Change in profit π
∴ = UD + πΔ′−QU*QUF – −−′2PC*Q2C)DP(Q
= 4900 x 125 + −8049002.674900 x 1800 – ××−−225.0156252.67225.0)12515625(80
= 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.
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∴ The optimal order quantity = 80 tonnes.
Section C: Applied Theory
6. INTERFACE BETWEEN FINANCE AND OTHER FUNCTIONS
One common factor among all managers is that they use resources and since resources are obtained in exchange for money, they are in effect making the investment decision and, in the process of ensuring that the investment is effectively utilized they are also performing the control function. The interfaces between the finance and other functions, as well as the top management can be understood from the following:
Marketing-Finance Interface
There are many decisions which the Marketing Manager takes which have a significant impact on the profitability of the firm. For example, he should have a clear understanding of the impact of the credit extended to the customers on the profits of the company. Otherwise in his eagerness to meet the sales targets he is likely to extend liberal terms of credit which may put the profit plans out of gear. Similarly, he should weigh the benefits of keeping a large inventory of finished goods in anticipation of sales against thecosts of maintaining that inventory. Other key decisions of the Marketing Manager, which have financial implications are pricing, product promotion and advertisement, choice of product mix and distribution policy.
Production-Finance Interface
In any manufacturing firm, the Production Manager controls a major part of the investment in the form of equipment, materials and men. He should so organize his department that the equipments under his control are used most productively, the inventory of work-in-process or unfinished goods and stores and spares is optimized and the idle time and work stoppages are minimized. If the production manager can achieve this, he would be holding the cost of the output under control and thereby help in maximizing profits. He has to appreciate the fact that, whereas the price at which the output can be sold is largely determined by factors external to the firm like competition, government regulations, etc., the cost of production is more amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy or lease, etc. for which he has to evaluate the financial implications before arriving at a decision.
Top Management-Finance Interface
The top management, which is interested in ensuring that the firm’s long-term goals are met, finds it convenient to use the financial statements as a means for keeping itself informed of the overall effectiveness of the organization. We have so far briefly reviewed the interface of finance with the non-finance functional disciplines like production, marketing, etc. Besides these, the finance function also has a strong linkage with the functions of the top management. Strategic planning and management control are two important functions of the top management. Finance function provides the basic inputs needed for undertaking these activities.
7. Not withstanding the extent of diversification, the total risk of the portfolio cannot be reduced to zero. That part of total risk which can be eliminated by diversification is called diversifiable risk and the remaining risk which cannot be eliminated (nor reduced) is called non-diversifiable risk. Thus, the risk of any individual stock can be separated into two components: non-diversifiable and diversifiable risk.
Non-diversifiable risk is that part of total risk that arises from various sources like interest rate movements, inflation state of the economy etc. It is related to the general economy or the stock market as a whole and hence cannot be eliminated by diversification. Non-diversifiable risk is also referred to as market risk or systematic risk.
Diversifiable risk on the other hand, is that part of total risk that is specific to the company or industry to which the security belongs and hence can be eliminated by diversification. Diversifiable risk is also called unsystematic risk or specific risk.
Let us take a look at some of the factors that give rise to diversifiable and non-diversifiable risk.
Non-diversifiable or Market Risk Factors
• Major changes in tax rates
• War & other calamities
• An increase or decrease in inflation rates
• A change in economic policy
• Industrial recession
• An increase in international oil prices etc.
Diversifiable or Specific Risk Factors
• Company strike
• Bankruptcy of a major supplier/customer
• Death of a key company officer
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Unexpected entry of new competitor into the market etc.
8. Inter-dependence among components of working capital
Inter-dependence among the various components of working capital in the context of a manufacturing firm can be easily understood from the figure given below:
The figure depicts the inter-dependence among the components of working capital. A company starting with cash purchases raw materials, components etc., on a cash or credit basis. These materials will be converted into finished goods after undergoing the stage of work-in process. For this purpose the company has to make payments towards wages, salaries and other manufacturing costs. Payments to suppliers have to be made on purchase in the case of cash purchases and on the expiry of credit period in the case of credit purchases. Further, the company has to meet other operating costs such as selling and distribution costs, general, administrative costs and non-operating costs described as financial costs (interest on borrowed capital). In case the company sells its finished goods on a cash basis it will receive cash along with profit with least delay. When itsells goods on a credit basis, it will pass through one more stage, viz, accounts receivable and gets back cash along with profit on the expiry of credit period. Once again the cash will be used for the purchase of materials and/or payment to suppliers and the whole cycle termed as working capital or operating cycle repeats itself. This process indicates the dependence of each stage or component of working capital on its previous stage or component.
The dependence of one component of working capital on its previous stage/component is described above highlighting the inter-dependence among the components of working capital. However, there can be other kinds of inter-dependence which are not dictated by the usual sequence of manufacturing and selling operations. For example, in case the manufacturing process may require a raw material which is in short supply. Then the company may have to make advance payment in anticipation of the receipt of that raw material. This will cause immediate drain on cash resources unlike a situation where credit purchase of raw materials can be made. Similarly, if there is an excessive accumulation of finished goods inventory the company may have to provide more liberal credit period and/or relax its existing credit standards which will increase sundry debtors. In situations of greater need for cash even providing cash discount as part of credit-terms for sale which is likely to boost the cash resources, may have to be resorted to. In such cases the relative benefits and costs may have to be taken into consideration before taking decisions.