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Question Paper

Financial Management (MB-211) April 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. Maximu m time for answering Section A is 30 Minutes.

1. Which of the following is an example of systematic risk?

(a) Risk of non-availability of a major raw material to a company making aluminium bars(b) Death of the finance manager of a company providing financial services(c) Unexpected entry of a multi-national company in the tea industry

(d) Reduction of tax rate by the government(e) Sudden strike called by the workers of a jute manufacturing company demanding wage revision.

< Answer >

2. If a securitys return is plotted above the security market line, then

(a) The risk free rate is equal to the required rate of return on the security(b) The securitys rate of return is more than the return on the market portfolio(c) The securitys beta is less than one and hence a conservative security

(d) The security is said to be overvalued(e) The security is to be bought immediately.

< Answer >

3. Other things being equal, which of the following will cause an increase in the value of a bond?

(a) Decrease in the term to maturity(b) Increase in the required rate of return on maturity(c) Decrease in the discount on the bond on issue

(d) Increase in the premium on maturity of the bond(e) Decrease in the coupon rate of the bond.

< Answer >

4. The amount that can be realized by a company if it sells its business as an operating one is termed as

(a) Going concern value (b) Market value (c) Bookvalue

(d) Replacement value (e) Liquidation value.

< Answer >

5. Which of the following is true with regard to the degree of operating leverage (DOL) for a company?

(a) Irrespective of the level of output, DOL of a company remains same(b) DOL of a company is positive above the operating break-even point

(c) DOL of a company is positive below the operating break-even point(d) DOL of a company is negative above the operating break-even point(e) DOL is zero at the operating break-even point.

< Answer >

6. Which of the following is a liquidity ratio?

(a) Return on equity (b) Return on investment (c) Acid -test ratio(d) Debt-equity ratio (e) Debt-asset ratio.

< Answer >

7. The objective of financial management to increase the wealth of the shareholders means to

(a) Increase the physical assets owned by the firm(b) Increase the market value of the shares of the firm

(c) Increase the current assets of the firm(d) Increase the cash balance of the company(e) Increase the total number of outstanding shares of the company.

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8. Mr. Suresh deposited Rs.2,000 at the beginning of every month in a bank for five years. If the interestrate is 9% p.a. compounded monthly, the accumulated amount he w ill get after 5 years is

(a) Rs.89,910 (b) Rs.1,34,400 (c) Rs.1,43,340 (d) Rs.1,51,980 (e) Rs.1,62,000.

< Answer >

9. Which of the following players cannot act as a borrower in the call money market?

(a) Discount and Finance House of India(b) SBI Mutual Fund(c) State Bank of India(d) Securities Trading Corporation of India

(e) Reserve Bank of India.

< Answer >

10. Consider the following information regarding Satish Ltd. :

Annual cost of sales : Rs.36,00,000

Opening stock of finished goods : Rs.50,000Finished goods storage period : 5 days

Assuming 360 days in a year, the closing stock of finished goods is

(a) Rs.40,000 (b) Rs.50,000 (c) Rs.60,000(d) Rs.1,20,000 (e) Rs.1,80,000.

< Answer >

11. Which of the following approaches advocates that the overall capitalization rate remains constant for all

degrees of leverage and that there is no optimal capital structure?

(a) Traditional approach (b) Miller and Modigliani approach(c) Net operating income approach (d) Net income approach

(e) Both (b) and (c) above.

< Answer >

12. Which of the following assumption underlie(s) the definition of cost of capital under capital expendituredecisions?

I. The risk characterizing the new project under consideration is significantly lower than the riskcharacterizing 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.

< Answer >

13. Which of the following functions is/are served by the primary capital market of an economy?

(a) It allows the corporate houses to raise the long term capital by issuing new securities

(b) It offers a market to trade for the outstanding long term securities(c) It offers a market to trade for the outstanding short term securities(d) It offers an excellent exit route for the venture capital funding companies

(e) Both (c) and (d) above.

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14. Which of the following is not a marketable instrument?(a) Commercial Paper (b) Certificate of Deposit

(c) Inter Corporate Deposit (d) Preference Shares (e) Treasury Bills.

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15. Which of the following functions of the financial system channelises the savings from the savers to theproducers in the economy?

(a) Savings function (b) Liquidity function(c) Payment function (d) Risk function (e) Policy function.

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16. A company can increase its paid-up share capital without receiving any money from the shareholders

through a

(a) Public issue (b) Rights issue (c) Bonus issue

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(d) Private placement (e) Bought-out deal.

17. When a firm increases its net holding of currencies that are expected to rise in value and decreases its

net holding of currencies that are expected to fall in value, it is adopting the strategy of

(a) Bilateral netting (b) Multilateral netting(c) Balance sheet hedging (d) Leads and lags (e) Currency swap.

< Answer >

18. The following figures are projected by the production manager of Kajaria Iron:

Average Daily Usage (Units) Probability Lead Time (in days) Probability

300 0.25 6 0.30500 0.50 8 0.40700 0.25 10 0.30

What is the amount of normal consumption during the lead-time?

(a) 3000 units (b) 4000 units (c) 5000 units (d) 6000 units (e) 7000 units.

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19. Other things remaining the same, if the contribution margin for a one year project of a firm increases

from Rs.200 lakh to Rs.300 lakh, what will be its impact on the NPV of the project? (Assume, theapplicable tax rate is 35 percent and the cost of capital is 10 percent. Round off your answer to thenearest integer)

(a) Increase by Rs.59 lakh (b) Increase by Rs.65 lakh(c) Increase by Rs.70 lakh (d) Increase by Rs.75 lakh(e) Increase by Rs. 80 lakh.

< Answer >

20. If the terms of credit are 1/10 net 40, what will be the implicit cost of trade credit? (Assume 360 days ina year)

(a) 11.11 percent (b) 12.12 percent (c) 13.13 percent

(d) 14.14 percent (e) 15.15 percent.

< Answer >

21. Which of the following factors does not influence the working capital management policies of a firm?

(a) Excise duties on the capital equipments

(b) Sudden increase in the demand for the product of the company(c) Adoption of better technology leading to the reduction in production time

(d) Sudden stoppage of the supply of a major raw material(e) Increase in the short-term interest rate.

< Answer >

22. Which of the following statements is true with respect to float in the context of cash management?

(a) It is an instrument that may increase the cash inflows

(b) It represents the difference between the total cash inflows and total outflows during any givenperiod

(c) It is the difference between the actual bank balance and the bank balance in the cash book of the

company(d) It means the time required for the encashment of a cheque submitted to a bank(e) It implies the time lag between the public issue and the actual receipt of funds.

< Answer >

23. M/s Kothari Forge Ltd. has paid a dividend of Rs.3.5 per share on a face value of Rs.10 in the FinancialYear ended 31st March, 2004. The relevant data regarding the company and the market are as under:

Current market price of share = Rs.75

Growth rate of earnings and dividends = 7.5%Beta of share = 0.95Average market return = 12.5%

Risk free rate = 6%

The intrinsic value of the stock is

(a) Rs.60.00 (b) Rs.80.48 (c) Rs.89.00

(d) Rs.94.26 (e) Rs.104.25.

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24. When a firm is a target of hostile tender offer, the target firm invites other friendly bidder. This strategyof takeover defense is called

(a) Poison pills (b) Crown jewels (c) White knights(d) Golden parachute (e) Green mail.

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25. 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.

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26. The dollar is trading at CHF 1.6640. Interest rates prevailing in Switzerland and U.S.A. are 2% p.a. and3% p.a. respectively. What is the 3 months forward quote for CHF / $

(a) 1.6478 (b) 1.6599 (c) 1.6681 (d) 1.6803 (e) 1.6767.

< Answer >

27. If the cost of an investment is Rs.2000 and it pays Rs.175 in perpetuity at an interest rate of 8%, thebenefit cost ratio of the investment is

(a) 1.09 (b) 0.09 (c) 0.70 (d) 1.09 (e) 1.20.

< Answer >

28. The backwardation in a futures market refers to a situation

(a) When the futures prices are higher than cash prices

(b) When the futures prices are lower than cash prices(c) When the basis is positive(d) When the basis is zero

(e) Both (b) and (c) above.

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29. Which of the following is/are not true regarding capital structure theory as stated by Miller &Modigliani?

I. If the given assumptions hold, the total market value of the firm is independent of the degree ofleverage

II. In the presence of taxes, the market value of the firm is increased by the tax shield of debt

III. If bankruptcy costs are considered, the expected cost of bankruptcy decreases when the debt-equity ratio increases

(a) Only (I) above (b) Only (III) above(c) Both (I) and (III) above (d) Both (II) and (III) above(e) All (I), (II) and (III) above.

< Answer >

30. Which of the following statements is false?

(a) Capital expenditure benefits accrue over a long term(b) Net present value uses cost of capital as the discounting rate

(c) Internal rate of return considers the time value of money(d) If the benefit-cost ratio is equal to one, the equity shareholders can be said to have earned more

than expected return

(e) Pay-back period considers the cash flows up to a certain number of years.

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END OF SECTION A

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Section B : Problems/Caselets (50 Marks)

This section consists of questions with serial number 1 6. 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.

Caselet 1

Read the caselet carefully and answer the following question:

1. What are the advantages and disadvantages of having less debt in the capital structure?

(8 marks) < Answer

2. According to Modigliani-Miller hypothesis, is it better to have a lower debt in the presence of taxes? Justify.

(7 marks) < Answer

Theories suggest that one of the most important elements affecting leverage is corporate tax rate. Debt derives much of

its attractiveness from the tax deduction available on interest payments, a benefit not available on dividends.

Myth: Companies paying high rates of corporate tax would have high proportion of debt in their capital structure.

Reality: Corporate tax rates do not have an effect on the capital structure.

Tax factor

Tax (%) Leverage Interest coverage

Bajaj Auto 29.00 0.14 60.27

Colgate Palmolive 46.00 0.01 265.83Glaxo 30.00 0.18 17.59Reliance Industries 0.08 0.56 12.86

Telco 31.00 0.53 4.97Tisco 0.10 1.05 2.37

A study conducted on debt-equity ratios indicates a different picture. Glaxo which paid a tax of 30 per cent in fiscal 95had a low debt- equity ratio of 0.18 while Asea Brown Boveri, wh ich paid a tax of 37 per cent for the same year had a

similarly low debt-equity ratio of 0.18. The leverage of ICI India, another major tax payer has been declining over thelast three years and now stands at a low 0.17. Colgate-Palmolive, a virtually zero debt company has negligible leveragedespite paying a tax of 46 per cent.

This scenario is not restricted to multinational companies alone. A number of Indian players in the high tax bracket alsohave low leverages. Bajaj Auto paid a tax of 29 per cent in March 96. Over the last three years, its leverage has beenreducing and currently stands at a low 0.14. Telco, which paid a tax of 31 per cent in fiscal 96 had a low debt-equity

ratio of 0.13. Hindalco with a leverage of 0.27 paid a tax of more than 37 per cent in fiscal 96.

The set of high tax paying companies with relatively low leverage includes Hindalco, Indo-Gulf Fertilizers, MotorIndustries Corporation, Asea Brown Boveri, East India Hotels, ICI India, Smithkline Beecham Consumer Products,

Punjab Tractors, Ingersoll-Rand, and Britannia.

Though it would be risky to generalize, it has been observed that most high tax paying companies are well establishedand are major players in their respective industries. Their operations are focused and most of the fund requirements are

met through internal sources sparing the need for debt.

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Interest coverage ratio measures the margin of safety the firm enjoys with respect to its interest burden. A low interestcoverage may lead to financial embarrassment when earnings before interest and taxes decline. In this respect, firms

like Bajaj Auto, Glaxo and Reliance have comfortable interest coverage. In contrast, Tisco has a coverage of 2.37 whileTelco has a slightly higher coverage of 4.97.

The same assumption has not proved to be completely incorrect. There are companies like Indian Oil Corporation,

Grasim, Nocil, SKF Bearings, MRF, Siemens, Tata Chemicals, Crompton Greaves, and Nestle India which are in thehigh tax bracket and also have relatively high debt-equity ratios.

Caselet 2

Read the caselet carefully and answer the following question:

3. Describe the composition of current assets that is likely to be observed in the three divisions of the company.

(7 marks) < Answer

Unicorn Industries Ltd. has been in existence for quite sometime. The company initially started off with the

manufacture of processed agricultural products and has diversified into other lines of business over a period of time.Presently it is involved in the processing of agricultural products, retailing and travel management. Three separatedivisions of the company manage these three lines of business.

The agricultural processing division purchases raw agricultural produce from the farmers through its purchase agents.The raw materials for this division are pronouncedly seasonal in nature; hence their supply is not uniform over the year.However, the processing activity continues throughout the year. This division has well-established trade relationships

with its clients and its clientele mainly consists of hotels, restaurants, and consumer cooperatives. Sales are madethroughout the year on credit basis and the remittances from the clients come in a regular manner over the year.

The retailing division of the company operates a chain of retail stores spread out mostly in the northern part of the

country. This division purchases in bulk a large variety of finished products from different manufacturers, and sellsthem to retail customers, largely on a cash basis. The purchases as well as sales are spread out uniformly throughout theyear.

The travel management division of the company is mainly involved in the business of air-ticketing and conductingpackage tours. The sales of this division are largely on credit basis and major portion of the business of this divisioncomes from corporate clients. Moreover, the package tour business, which makes a significant contribution to the

revenues of this division, is seasonal in nature.

4. Mr. Ajoy Rathor is planning to purchase a house which costs Rs.8,00,000. He contacted two housing financecompanies viz, City Housing Finance Ltd. (CHFL) and Southern Finance Company Ltd. (SFCL). CHFL has

offered for 100% financing for a period of 7 years. Mr. Rathor has to repay the loan along with interest in equatedmonthly installments of Rs.18,500 each, payable at the end of every month over a period of 7 years.

SFCL has offered to provide 90% finance for a period of 8 years. Mr. Rathor has to bring in 10% of the cost of the

house at the time of purchase. He will borrow the amount of his contribution from one of his relatives and will paback his relative Rs.40,000 and Rs.50,000 (which include the amount borrowed and the interest) at the end of thefirst year and the second year respectively. The amount borrowed from SFCL has to be repaid along with interest

in equated monthly installments of Rs.12,800 each, payable at the end of every month over a period of 8 years .

You are required to find out the effective rates of interest for both the financing alternatives and advise Mr.Rathor accordingly.

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(10 marks) < Answer

5. Srujan Industries Ltd. has the following capital structure:

Equity share capital:

There are 100,00,000 equity shares of Rs.10 each fully paid up. Presently the shares have a market price of Rs.30per share. The company has recently paid dividends to its equity shareholders amounting to Rs.3 crore. The

dividends have been growing at the rate of 4% over the years and this growth rate is expected to continue in future.

Reserves and surplus:

The reserves and surplus amount to Rs.50 crore.

Debentures:

There are 14,00,000 debentures of Rs.100 each which are redeemable at a premium of 5% after five years. Thecoupon rate on these debentures is 12% and the current yield on these debentures is 14%. The net amount realized

per debenture is Rs.95.

Term loan:

The amount of term loan is Rs.58 crore and carries an interest rate of 14%. The market value of the term loan is

equal to its book value.

The tax rate applicable to the company is 50%.

You are required to find out the following:

a. The costs of the various sources of finance used by the company.

b. The weighted average cost of capital using market value weights.

(6 + 3 = 9 marks) < Answer

6. An investment advisor has been monitoring the equity share of Spicy Foods Ltd. (SFL) over the past one year. Onthe basis of his assessment of the fundamentals of the company and his expectations on the stock marketconditions during the next six months, he has provided the following projections:

Probability (%) Return from SFL share (%) Return on the market index (%)

10 10 1215 16 1620 20 1825 26 22

20 30 2410 36 30

You are required to calculate the following:a. The expected return and risk of the SFL share.

b. The expected return and risk of the market index.c. The beta coefficient of the SFL share.

(3 + 3 + 3 = 9 marks) < Answer

END OF SECTION B

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Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 7 - 9.

Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.

7. Briefly explain the different forms of business combinations.

(7 marks) < Answer

8. Many business organizations undertake business largely on a credit basis. Briefly explain the costs associated with

maintaining receivables arising out of credit sales .

(6 marks) < Answer

9. The managers in an enterprise are responsible for the proper utilization of the resources under their control. Since

the resources are acquired in exchange for money, the decisions of the managers will ultimately affect the financialcondition of the organization. In this sense it can be said that the finance function interfaces with other majorfunctions of the enterprise as well as the top management. Briefly explain the interfaces of the finance function

with the marketing and production functions, and the top management.

(7 marks) < Answer

END OF SECTION C

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Suggested Answers

Financial Management (MB211) April 2005

Section A : Basic Concepts

1. Answer: (d)

Reason: Reduction of tax rate by the government will affect all the companies in the market andso can be considered as a systematic risk. While the factors mentioned in the otheroptions will affect a particular company or the companies belonging to a particular

industry. Hence, these factors may be termed as non-systematic risk.

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2. Answer: (e)

Reason: If a securitys return plots above the security market line (SML) then the return on the

security is more than the required rate of return on the security according to the SML. Agreater return means a lesser price of the security than its intrinsic value that implies thesecurity is under priced and hence that should be bought immediately to book profit in

future as its price increases.

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3. Answer: (d)

Reason: Intrinsic value of bond = C x PVIFA(k,n) + Fx PVIF(k,n)

where, C is the coupon payment on the bond, F is the amount payable at maturity, k isthe discount rate or the required rate of return and n is the number of years of maturity tothe bond.

From the above expression of the intrinsic value of a bond, we can see that other thingsbeing equal if the amount payable at maturity (F) increases, the value of bond alsoincreases correspondingly. While decreasing the term to maturity and the coupon rate of

the bond as well as increasing the required rate of return on the bond will decrease theintrinsic value of the bond. The discount on the bond at the time of issue does not haveany role to play in this context. Hence, the alternative (d) is correct.

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4. Answer: (a)

Reason: The amount that a company can realize if it sells its business as an operating one iscalled going concern value. Replacement value indicates the value that a company

would be required to spend if it were to replace its existing assets in the presentsituation. Liquidation value is the amount that a company could realize by selling itsassets following the termination of its business. Market value of an asset is the current

market price at which it may be sold or bought in the market.

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5. Answer: (b)

Reason: The following statements are correct with respect to the degree of operating leverage(DOL) for the operations of a company:

Each level of output has a distinct DOL

DOL is always negative below the operating break even point DOL is always positive above the operating break even point DOL is undefined at the operating break even point.Hence, the option (b) is the answer.

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6. Answer: (c)

Reason: Debt-equity ratio and debt-asset ratio are leverage ratios for a company. Return onequity and return on investment represents the profitability ratios of a business entity.Acid test ratio indicates the liquidity status of a company.

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7. Answer: (b) < TOP >

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Reason: According to the objective of financial management to increase the wealth of theshareholders means to increase in the market value of the shares issued by the firm.

Increasing the physical assets or current assets of the company may not provideadequate returns to the shareholders, if it is done through incremental borrowing.Increasing cash balance imparts more liquidity to a company but decreases the returns

on investments. Increase in the total number of outstanding shares of the company does

not make any impact on the total value of the firm.8. Answer: (d)

Reason: FVIFA (annuity due) = FVIFA (1 + interest rate)

FVIFA (0.75%, 60) =

60(1.0075) 1

0.0075

(1.0075)

= 75.99

Amount receivable in future = 75.99 2000 = Rs.1,51,980

(Note that 9% compounded monthly means 0.75% interest for each month for 12 5

= 60 months).

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9. Answer: (b)

Reason: All the participants in the call money market are split into two categories. The firstcomprises of the entities who can borrow as well as lend in the market and the secondcomprises of only lenders i.e. the participants in the second category cannot borrow in

the call money market. RBI, DFHI, STCIL and commercial banks belong to the firstcategory and all the financial institutions and mutual funds belong to the second. Hence,(b) cannot borrow in the call money market

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10. Answer: (b)

Reason: Finished goods storage period = salesofcostdailyAverage

goodsfinishedofstockAverage

5 =

Averagestockoffinishedgoods

36,00,000

360

or Average stock of finished goods = 5 x10,000 = Rs. 50,000

Average stock = 2

stockClosingstockOpening +

or Closing stock = 2 Average stock Opening stock

= 2 50,000 50,000 = Rs.50,000.

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11. Answer: (e)

Reason: As per net operating income approach the cost of capital of the company reduces withthe increasing introduction of debt and becomes asymptotic to kd parallel to X-axis.

As per traditional approach cost of capital decreases upto a certain point, remains moreor less unchanged for moderate increases in leverage and rises beyond a certain point.This advocates an optimum capital structure for the firm.

Both, Net Operating Income approach and Miller and Modigliani approach advocate thatoverall capitalization rate remains constant for all degrees of leverage. Therefore, thereis no optimal capital structure.

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12. 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 financingpolicy, 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.

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13. Answer: (a)

Reason: Primary market allows the corporate houses to raise long term funds by issuing new

securities like, shares equity and preference as well as debentures. The venture capitalfunding companies generally dilute their stakes in a company by selling their holdings inany company to the investors through secondary capital market route.

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14. Answer: (c)

Reason: Inter Corporate deposits are not traded in the market. The instruments as mentioned inthe other options are traded in the re spective financial markets

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15. Answer: (a)

Reason: Savings function encourages the household sector to save money through the variouschannels in the financial system like, banks, insurance companies, capital markets, etc.

These funds are ultimately channelised to the productive sector that needs money. Theother functions do not play any role in this context

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16. Answer: (c)

Reason: In a bonus issue, the additional shares are issued to the existing shareholders on pro ratabasis without taking any money from them while an equivalent amount of reserves andsurpluses are transferred to the capital of the issuing company. In the other issues,

money is collected from the investors in order to issue the securities

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17. Answer: (d)

Reason: Leading involves advancing a payment. That is making a payment before it is due.

Lagging on the other hand refers to postponing a payment. A company can leadpayments required to be made in a currency that is likely to appreciate and lag thepayments that it needs to make in a currency that is likely to depreciate. This strategy is

called leading and lagging.

Netting means matching receivables with payables in the same currency to arrive at thenet amount. Correct answer is (d).

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18. Answer: (b)

Reason: Expected daily usage during the lead time is 300 0.25 + 500 0.50 + 700 0.25 = 500units while the expected lead time is 6 0.30 + 8 0.40 + 10 0.30 = 8 days. Hence,the normal consumption during the lead time = 500 8 = 4,000 units

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19. Answer: (a)

Reason: Contribution margin increases by Rs.100 lakh and hence the corresponding amount ofnet cash flow will also go up by Rs.100 lakh (1 - 0.35) = Rs.65 lakh.

Hence, the NPV of the project will also increase by

Rs.65

1.10 = Rs.59.09 lakh or Rs.59

lakh

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20. Answer: (b)

Reason: The cost of trade credit is defined as

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( )

Rateofdiscount Numberof daysinayear

1 Rateofdiscount CreditPeriod Discountperiod

=

0.01 360 .01 3600.1212

1 0.01 40 10 0.99 30 = =

= 12.12 percent

21. Answer: (a)

Reason: Excise duties on the capital equipments influence the initial cost of the machineries, notthe operating cycle for the operation of a company. Sudden increase in the demand forthe product of a company, adoption of better technology and the sudden stoppage of the

supply of a major raw material affect the finished goods storage period, work in processperiod and the raw material storage period respectively. While an increase in the shortterm interest rate will increase the interest expenses of the firm against the borrowings

for the current assets. So, the option (a) is correct.

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22. Answer: (c)

Reason: A float, in the context of cash management, arises when a bank does not credit its

customers account in its book despite a cheque was being deposited or does not debit itscustomers account against the issue of a cheque. This fact is mentioned in the option(c).

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23. Answer: (b)

Reason: Intrinsic Value, Po = gk

D1

Using CAPM

K = Rf+ (Rm Rf) = 6+ 0.95 (12.5 6)

= 12.175%

P =

3.5 1.075

0.12175 0.075

= 80.48

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24. Answer: (c)

Reason: When a company is the target of an un wanted bid or the threat of a bid from a potential

acquirer, it may seek the help of a white knight or another company which is moreacceptable suitor for target This method of takeover defense is called white knight.

Poison pills is a defense strategy which involves issuing new securities which would be

convertible into equity at low price in event of an hostile take over of the firm.

Crown jewels strategy involves creating mechanism to ensure that a raider, in event of ahostile takeover, is denied access to the jewels.

Golden parachutes are agreement that provides for payment of huge severance packagesto the senior management executives in case of takeover of the firm.

Green mail is a form of targeted share repurchase. It refers to the repurchase of a block

of shares from specific share holder(s), at a substantial premium, to prevent a hostiletender offer on the company.

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25. Answer: (e)

Reason: Economic exposure refers to the impact on the value of firms operations due to

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unanticipated changes in the exchange rates.

Transaction exposure arises out of day-to-day activities of a company.

Translation exposure arises due to the need to translate the foreign currency values ofassets and liabilities into the domestic currency

Currency exposure refers to the currency which is to be received/or paid.

Correct answer is (e).

26. Answer: (b)

Reason: 1.6640

++

4/03.01

4/02.01

= 1.6599.

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27. Answer: (d)

Reason: Present value of cost = Rs.2,000

Present value of benefit = 08.0

175

= 2187.5

BCR = 2000

5.2187

= 1.09

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28. Answer: (e)

Reason: The backwardation in a futures market refers to

(i) when the futures prices are lower than cash prices and

(ii) when the basis is positive. The difference between the cash price and futures priceof a commodity is referred to as basis.

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29. Answer: (b)

Reason: As per M&M approach, if bankruptcy costs are considered, the expected cost ofbankruptcy increases when the debt equity ratio increases.

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30. Answer: (d)

Reason: If the benefit cost ratio is equal to one, the present value of the cash flows at the cost ofcapital is equal to the initial investment. This implies all the stakeholders of the projecthave enjoyed the return expected. Hence the option (d) is false. However, the other

statements are correct with respect to the capital expenditure.

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Section B: Problems

1. The advantages of a low debt are:

The risk of the company will be low Funds can be raised at any point of time without difficulty because there is lot of reserve borrowing power There will not be any restrictive covenants on the use of funds by the company which are normally imposed

by lenders

The cost of funds can be low, if the company is in a position to raise equity at such a high premium that thecost of equity continues to be lower than the post tax cost of debt

The disadvantages are:

If the cost of equity is not low because of poor capital market conditions making it difficult to make premiumissues or for any other reason, using a less amount of debt results in losing an opportunity for earning more returnsfor the equity investors which is possible through the debt

If equity is issued instead of the debt to be raised, the floating stock in the market may reach saturation levelsand make it difficult to raise equity in future.

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2. According to the Modigliani-Miller hypothesis, adjusted for the presence of taxes, the value of a levered company is thesum of the present value of the operating earnings, discounted at the discount rate applicable for the firm considering itsoperating risk level, plus the present value of the tax saving on the infinite stream of interest payments. That is, the value

of a levered company is the sum of the value of an otherwise identical but unlevered company and the present value ofthe infinite stream of tax shields from the interest payments. Thus, the value of a levered firm, according to thehypothesis, will be higher than the value of a unlevered firm to the extent of the present value of the interest tax shields.

So, having a higher debt in the capital structure increases the value of the company and is hence desirable.

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3. The agricultural division faces a seasonal supply of raw materials. However the processing operations are continued

throughout the year. In order to continue its processing operations throughout the year it has to maintain the raw materialsinventory throughout the year. Thus a significant proportion of total current assets of this division will consist of rawmaterials inventory. Also there will some amount of finished goods inventory and its amount will be determined by the

size of orders received by the company on average. Moreover the stock of the major raw materials will be highest duringthe procurement season and gradually decrease as consumption takes place until the time the next season when they willbe replenished again. Further the sales of this division are made on credit basis to well-established clients and remittances

come regularly over the year. Hence there will some receivables and cash balance. The amount of receivables will dependupon the credit period allowed by this division to its clients. One of the factors that will determine the cash balancemaintained by this division is the time lag after which the payments are made by the clients (or the frequency of the

remittances over the year).

The retailing division purchases a large variety of finished products from different manufacturer. Hence it will have alarge inventory of finished goods or stock-in-trade, throughout the year. Moreover, the sales of this division are on cash

basis; hence there will be significant amount of cash in its current assets. The exact amount of cash balance maintainedwill be determined mainly by the frequency of cash outflows arising out of payments to be made to suppliers.

The travel management division of the company is largely seasonal in nature, though there will be some regular business

arising out of regular business travelers. Moreover the business is largely on a credit basis. Hence there will be asignificant amount of receivables and cash balance throughout the year. The amount of receivables will be highest duringthe tourist seasons and will decreases gradually as collections will be made later. The cash balance is expected to be

significantly maintained during the remaining part of the year (off-season) in order to meet the regular expenditure. (It isneedless to say that there will be no inventories of raw materials or finished goods because the business is agency type).

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4. Cost of house = Rs.8,00,000

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Financing by CHFL:

Let the interest rate per month be r

Number of months for which payments have to be made to CHFL = 7 12 = 84

Amount payable at the end of every month to CHFL = Rs.18,500

8,00,000 = 18,500 PVIFA(r, 84)

or PVIFA = 18500

800000

= 43.243

For, r = 1.7%, PVIFA =84

84

)017.1(017.0

1)017.1(

= 44.548

For, r = 1.8%, PVIFA =84

84

)018.1(018.0

1)018.1(

= 43.141

r = )548.44243.43()548.44141.43()7.18.1(

7.1

+ = 1.793%

Effective interest rate = (1 + r)12 1 = (1.01793)12 1 = 23.77% p.a. (approx.)

Financing by SFCL and relative of Mr. Rathor :

Let the interest rate be r.

Amount of finance from SFCL = 8,00,000 0.90 = Rs.7,20,000

Amount of finance from relative = Rs.80,000

Total amount of financing = Rs.7,20,000 + Rs.80,000 = Rs.8,00,000

Amount payable at the end of every month to SFCL = Rs.12,800

Number of months for which payments have to be made to SFCL = 8 12 = 96 monthsAmount payable to relative :

At the end of one year (i.e. 12 months) = Rs.40,000

At the end of two years (i.e. 24 months) = Rs.50,000

8,00,000 = 12,800 PVIFA (r, 96) +2412 )r1(

000,50

)r1(

000,40

++

+

Let r = 1.2%, RHS = 12800 241296

96

)012.1(

50000

)012.1(

40000

)012.1(012.0

1)012.1(++

= 12800 56.818 + 34665.2 + 37552.4= Rs.7,99,488

r = 1.1% RHS = 12800 241296

96

)011.1(

50000

)011.1(

40000

)011.1(011.0

1)011.1(++

= 12800 59.104 + 35078.9 + 38454.1 = Rs.830064.2

r = 1.1 + )2.830064799488()1.12.1(

(800000 830064.2) = 1.198%

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Effective interest rate per annum = (1 + r)12 1 = (1.01198)12 1 = 0.1536 i.e. 15.36%.

We find from above that if Mr. Rathor borrows 90% of the cost of the house from SFCL and borrows the remaining

amount from his relative he faces a lesser effective rate of interest (15.36% per annum ) than the effective rate of interest

(23.77% per annum)he faces if he borrows 100% of the cost of the house from CHFL. Hence he should borrow 90% ofthe cost of the house from SFCL and the remaining amount from his relative.

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5. a. Cost of equity capital (ke):

ke =g

P

D

0

1 +

D1 = D0 (1 + g)

D0 = Current dividend per share =

Rs.3crore

Rs.1crore = Rs3 (Number of equity shares = 100,00,000 = 1 crore)

ke =

3(1.04)0.04

30

+= 0.144 i.e., 14.4%.

Cost of retained earnings i.e., reserves and surplus (kr):

Kr = ke = 14.4%

Cost of debenture capital (kd):

2

PFn

PF)t1(I

kd +

+=

I = Rs.12 (given)

t = 0.50 (given)

F = 100 + 5 = Rs.105

P = Rs.95n = 5 years

kd =

(105 95)12(1 0.50)

5105 95

2

+

+=8%

Cost of term loan (kt):

14(1 0.50) 7%= =t

k

b. Computation of market values:

(Rs. in crores)

Equity share capital: Rs.30 1 crore 30

Debenture capital :debenturesofNumberx

yieldCurrent

amountCoupon

=

121400000

0.14x

= Rs.120000000 i.e., 12

Term loan 58

Reserve and surplus 50

Total market value 150

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Computation of weights:

Weight for equity by capital (we) =

30

150 0.20

Weight for debenture capital (wd) =12150

0.08

Weight for term loan (wt) =

58

150 0.39

Weight for retained earning(Wr) =

50

150 0.33

1.00

Weighted average cost of capital

= we ke + wd kd + wt kt

= (0.2) (14.4) + (0.08) (8) + (0.39) (7)+(0.33)(14.4)= 11% (approximately)

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6. a. SFL share:

Expected rate of return = (10 0.10) + (16 0.15) + (20 0.20) + (26 0.25) + (30 0.20) + (36 0.10)

= 23.5%

Risk= i( ) ( ) ( ) ( ) ( ) ( )

12 2 2 2 2 2 210 23.5 0.10 16 23.5 0.15 20 23.5 0.20 26 23.5 0.25 30 23.5 0.20 36 23.5 0.10 + + + + +

= ( ) ( ) ( )

1

2

182.25 0.10 56.25 0.15 12.25 0.20 (6.25 0.25) (42.25 0.20) (156.25 0.10) + + + + +

= 7.399 7.4%

b. b. Market index:Expected return = ( 12 0.10) + (16 0.15) + (18 0.20) + (22 0.25) + (24 0.20) + (30 0.10) = 20.5%

Risk = m

=( ) ( ) ( ) ( ) ( ) ( )

12 2 2 2 2 2 212 20.5 0.10 16 20.5 0.15 18 20.5 0.20 22 20.5 0.25 24 20.5 0.20 30 20.5 0.10 + + + + +

= ( ) ( ) ( ) ( ) ( ) ( )1

272.25 0.10 20.25 0.15 6.25 0.20 2.25 0.25 12.25 0.20 90.25 0.10 + + + + + = 4.85%

c. c. Beta coefficient of SFL share :

Beta =2

m

Cov(i,m)

Cov (i,m) = (10 23.5) (12 20.5)0.10 + (16 23.5)(16 20.5)0.15 + (20 23.5)(18 20.5)0.20 +(26 23.5)(22 20.5) 0.25 + (30 23.5)(24 20.5) 0.20 + (36 23.5)(30 20.5)0.10

= ( 13.5 8.5 0.10 ) + ( 7.5 4.5 0.15) + ( 3.5 2.5 0.20) + (2.5 1.5 0.25 ) + ( 6.5 3.5 0.20) + ( 12.5 9.5 0.10)

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= 11.475 + 5.0625 + 1.75 + 0.9375 + 4.55 + 11.875

= 35.65

Beta =

35.651.514 1.51

23.55=

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Section C: Applied Theory

7. Forms of Business Combinations

Consolidation: It is a form of business combination caused by the fusion of two or more firms, resulting in the

formation of anew firm. In this combination, all the firms involved loose their individual identity. A new firm which was

hitherto not in existense, comes into being. For example, the combination of two Swiss firms Sandoz and Ciba Geigyresulted in the formation of Novartis. This form is generally applied in combinations of firms of equal size. In India,consolidation are generally referred to as amalgamations.

Merger: The terms merger is often abused, by being loosely applied to refer to any form of business combinations. It

has however got a specific connotation. A merger refers to a business combination of two or more firms in which only

one firm survives and the other firms go out of existense. In a merger, the surviving firm acquires the assets and liabilitiesof the other firm(s) . For example, the recent marger of HDFC Bank and Times Bank. After the merger, Times Bank willgo out of existense and expanded HDFC Bank the firms involved in the combination are of unequal size. The

larger/stronger firm continues to exist because of its stronger bargaining power and the smaller/ weaker firms go out ofexistense. Another form of merger is the subsidiary merger. In a subsidiary merger, the target firm becomes a subsidiaryor is merged with subsidiary of the acquirer. A variation of the subsidiary merger is the reverse subsidiary merger. In a

reverse subsidiary merger, a subsidiary firm of the acquirer is merged into the target firm of the acquirer is merged intothe target firm. In India, mergers are generally referred to as absorptions.

Takeovers: Takeovers refers to the process of acquiring control over the management of a firm by acquiring a substantial

portion of its equity. After a takeover, the individual firms continue to exist but under a new management. For example,the acquisition of the leading American investment bank First Boston by the Credit Suisse group of Switzerland. CS First

Boston continues to be a separate legal entity but under the management control of the Credit Suisse group . A takeovermay be a prelude to full fledged merger or consolidation. The topic of takeover is dealt in detail in a subsequent section.

Asset Purchases : This is the simplest form of business combination from the legal point of view. In this case, the

acquirer buys out a division or an asset of the firm. Both the firms continue to exist but there is a transfer of the businessor the asset. For example, the recent acquisition of the cement division of Tata Steel by Laffarge of France. Laffarge

acquired only the 1.7 million tonnne coment plant and its releated assets form Tata Steel. The asset being purchased may

be intangible in nature. For example, Coca-cole paid Rs.170 crore to Parle to acquire its soft drinks brands like ThumpsUp. Limca, Gold Spot etc.

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8. The costs involved in maintaining the accounts receivables by an organization are:

Additional fund requirement for the company

When a firm maintains receivables, some of the firms resources remain blocked in them because there is a time lagbetween the credit sales to customers and receipt of cash from them as payment. To the extent that the firms resourcesare blocked in its receivables, it has to arrange for additional finance to meet its own obligations towards its creditors and

employees, like payments for purchases, salaries and other production and administrative expenses. Whether thisadditional finance is met fro m its own resources or from outside, it involves a cost to the firm in terms of interest (iffinanced from outside) or opportunity costs (if internal resources which could have been put to some other use are taken).

Administrative costs

When a company maintains receivables, it has to incur additional administrative expenses in the form of salaries to clerkswho maintain records of debtors, expenses on investigating the creditworthiness of debtors etc.

Collection costs

These are costs which the firm has to incur for collection of the amounts at the appropriate time from the customers.

Defaulting costs

When customers make default in payments, not only is the collection effort to be increased but the firm may also have toincur losses from bad debts.

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9. One common factor among all managers is that they use resources and since resources are obtained in exchange formoney, they are in effect making the investment decision and in the process of ensuring that the investment is effectivelyutilized they are also performing the control function. The interfaces between the finance function and the marketing and

production functions, as well as the top management are given below:

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 the credit extended to the customers on the profitsof the company. Otherwise in his eagerness to meet the sales targets he is likely to extend liberal terms of credit whichmay 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 the costs of maintaining that inventory. Other key decisions of the MarketingManager which have financial implications are pricing, product promotion and advertisement, choice of product mix anddistribution 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 theoutput 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 orbuy, 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 firms long-term goals are met, finds it convenient to usethe 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 planningand management control are two important functions of the top management. Finance function provides the basic inputs

needed for undertaking these activities.

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