8/3/2019 0607_FM-I_(MB211)

1/17

1

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 risk 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 5percent. What is the market risk premium?

(a) 1.30%(b) 6.30%

(c) 6.50%

(d) 7.25%

(e) 15.00%.

< Answer >

8/3/2019 0607_FM-I_(MB211)

2/17

2

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 atan 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 Millers 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 aspecified 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 lessthan 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 ofdividend payout ratio increases

(e) The optimal dividend pay out ratio should be 100% to ma ximize the value of the firm.

< Answer >

8/3/2019 0607_FM-I_(MB211)

3/17

3

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 lessthan 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 firms 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.870Quantity per order 1,000 units

Carrying cost as a percentage of the purchase price 3%Fixed cost per order Rs.100Purchase 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 >

8/3/2019 0607_FM-I_(MB211)

4/17

4

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 creditwill be higher.

II. If the spread between credit period and cash discount period is lower, the cost of trade credit willbe 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 projects

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 >

8/3/2019 0607_FM-I_(MB211)

5/17

5

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 ofsales

(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 firmsoperations 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 >

8/3/2019 0607_FM-I_(MB211)

6/17

6

24. If interest rate parity holds and the transaction costs are zero, covered foreign financing will result inan 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 thecurrencies 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 >

8/3/2019 0607_FM-I_(MB211)

7/17

7

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 thedate 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 thefollowing 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 toa. 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 produce6,000 ingots during the year 2005-06 which will be sold at a price of Rs.10,000 per ingot. The estimatedcosts per ingot are given below:

Particulars Amount (Rs.)

Raw materials cost 5000

Manufacturing expenses 2000

Selling, administration and financial expenses 1000

Total 8000

< Answer >

8/3/2019 0607_FM-I_(MB211)

8/17

8/3/2019 0607_FM-I_(MB211)

9/17

8/3/2019 0607_FM-I_(MB211)

10/17

10

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 ultimateobjective of financial management is to maximize the wealth of the owners. All the otheralternatives may not necessarily maximize the wealth of the owners.

Hence option (e) is the answer.

< TOP >

2. Answer : (d)

Reason : 60

365

P

P100

= 0.115

P

P100

= 365

60115.0

P

P100

= 0.0189

or, 1.0189 P = 100 P = 0189.1

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 theexpected 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)1.15RPM = 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 thecost of debt will decrease but there after as the default risk increases, cost of debt alsoincreases. 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 theamount 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) isthe answer.

< TOP >

8. Answer : (b)

Reason : As the number of securities in a portfolio increases the portfolio variance decreases. Alsoportfolio 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 profitis disbursed among the shareholders in the form of dividends, it will have to raise additionalcapital 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 influencethe share prices.

< TOP >

8/3/2019 0607_FM-I_(MB211)

11/17

11

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 thatthe 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

QPCF

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 0.03100

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 thefinancing mix is tilted more towards short term sources of financing.

Statement (II) is true because risk of technical insolvency is high in aggressive current assetfinancing 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 positiverelationship 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 methodis 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 ofa firm; it is not related with cash management.

< TOP >

8/3/2019 0607_FM-I_(MB211)

12/17

12

17. Answer : (b)

Reason : The internal rate of return considers the timing of the cashflows from a project and provides astraight 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, ifthere are multiple internal rates of return due to the intermediate cash outflows. Hence, answeris (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 costof existing equity capital (a). It has no logical connection with cost of long-term or short-termdebt. 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 dividendpolicy.

< 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 highlevel of working capital with respect to sales or a disproportionately high level of receivableswith respect to total assets or a dis proportionately high level of cash with respect to total assetsor 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 unanticipatedchanges 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 assetsand 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 ofcovering 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 >

8/3/2019 0607_FM-I_(MB211)

13/17

13

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 betweenthe 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 thissystem, 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 andit 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 termsof a foreign currency and its exchange rate in terms of other currencies depends on theexchange 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$/US$)

=

12.0118

1.7386

= 1.1571.

Similarly (US$/Euro)ask =

12.0121

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 afutures 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

PD

0

11 +

196

4110

+

= 0.18751

96

3105

+

= 0.1251

96

399

+

= 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 = piki= 18.75 (0.30) + 12.5 (0.40) + 6.25 (0.30) = 12.5% < TOP >

8/3/2019 0607_FM-I_(MB211)

14/17

14

Risk for the share = [ ]2/12

ii )kk(p

= [(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 = pikm

= 15 (0.30) + 12 (0.40) + 8 (0.30) = 11.70%

Risk for the market, m = [pi (km - mk )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. =2m

)m,i(Cov

Cov (i, m) = Pi (ki - ik ) (km - mk )

= (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

2m = 7.41

= 41.7

125.13

= 1.77

Implication: A beta of 1.77 indicates that if market returns change by 1% then returns on the sharewill 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)

InputsPeriod

(months)Raw

materialsWork-in-process

Finishedgoods

Debtors Total

1. Raw materials

In stock 2 5000

In WIP 1 2500

In finished goods 1 2500

In debtors 3 7500

17500

2. Manufacturingcosts

In WIP 1/2 500In 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 30003000

Total 5000 3000 4000 15000 27000 < TOP >

8/3/2019 0607_FM-I_(MB211)

15/17

15

Note: The manufacturing costs are assumed to be incurred evenly throughout the month. Hence onaverage the manufacturing expense component of WIP will be equal to half months

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 Walters model on dividend policy the price per share is given by the formula:

P = k

k

r)DE(D +

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 = 12.0

12.0

15.0)48(4 +

= 12.0

12.0

15.044

+

= Rs.75 per share

If dividend payout ratio is 75%

D = 8 (0.75) = Rs.6.00

P = 12.0

12.0

15.0)68(6 +

= 12.0

12.0

15.026

+

= Rs.70.83 per share.

b. E = Rs.8.00 per share (given)

r = 0.10k = 0.12

If dividend payout ratio is 50% then

D = 8 (0.50) = Rs.4.00 per share

P = 12.0

12.0

10.0)48(4 +

= Rs.61.11

If dividend payout ratio is 75% then

D = 8 x (0.75) = Rs.6.00

P = 12.012.0

10.0)68(6 +

= 12.012.0

)10.0(26+

= 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 growthfirm) 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

ANet investment innew truck1

(11,00,000)

B Savings in costs 150,000 150,000 150,000 150,000 150,000 150,000C 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 >

8/3/2019 0607_FM-I_(MB211)

16/17

16

depreciation2

EPre-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)

IOperating flow:

G+D302,500 302,500 302,500 302,500 302,500 302,500

J Terminal flow3 300,000

KNet 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

000,50000,650

= Rs.100,000

Depreciation on the new truck for each year over the next six years:

6000,50,3000,00,14

= 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 =

I)k1(

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 = S (1 V) + KI DIS

where, I = 360

S0

(ACP0 ACPN) 360

SV

ACPN

and DIS = Pn (S0 + S)dn P0 S0d0

S = 600000 80 0.12 = 5760000

I = 360

80600000

(32 24) 360

)5760000)(70.0(

24

= 360

96768000880600000

= Rs.797867 (approx.)

DIS = (0.30) (600000 80 1.12) (0.01) (0) (600000 80) (0)

= Rs.1,61,280

S(1V) = 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 (ignoringtaxes) increases by Rs.16.86 lakh. < TOP >

Section C: Applied Theory

8/3/2019 0607_FM-I_(MB211)

17/17

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 onequity. The term trading on equity is used because it is the equity that is used as a basis for raisingdebt. 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 andrepayments 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 purposehe would be liaising with banks and financial institutions. He also deals with merchant bankingagencies 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, hewould weigh many considerations like the cost of the funds in the form of interest/dividend and thecost 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 loansgenerally lay down some conditions. These conditions are aimed at ensuring the safety of the loansgiven 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 fundsavailable 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 managersof 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 aboveconsti tute an Investment Committee and appraise an investment proposal along the marketing,

technical and financial dimensions. The Finance Manager appraises the proposal along the financialdimensions to determine its worthiness in relation to the investment involved. This decision called theInvestment Decision constitutes one of the core activities of the Finance Manager. < TOP >

< TOP OF THE DOCUMENT >