Mb361f April 05

Question Paper

Strategic Financial Management (MB361F) : April 2005 Section A : Basic Concepts (30 Marks) • • • • 1.

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.

According to proposition II of Modigliani and Miller, if the overall capitalization rate of a firm is 12%, cost of debt is 10% and debt-equity ratio is 0.5, the expected yield on the equity of the firm should be (a) 12%

2.

(b) 13%

(c) 14%

(d) 22%

< Answer >

(e) 24%. < Answer >

Which of the following statements regarding estimation of continuing value is/are true? I. The output of the value driver method and the growing free cash flow method is the same. II. The replacement cost method ignores the value of intangible assets of the company. III. The P/E ratio method is based on the assumption that prices of shares are determined by earnings. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) All of (I), (II) and (III) above.

3.

I. II. III.

Shareholder wealth creation is measured by the difference between the book value of equity and it’s face value. The price to book value ratio of the firm depends on the return on equity, growth rate of dividends and cost of equity. Value is created only when return on equity is higher than cost of equity.

(a) Only (I) above (c) Only (III) above (e) Both (II) and (III) above. 4.

(b) Only (II) above (d) Both (I) and (III) above

If the market price of share of Exogenous Ltd. is Rs.44, EPS is Rs.3.75 and retention ratio is 60%, then the multiplier according to Graham-Dodd Model of dividend policy is (a) 14.2

5.

< Answer >

Which of the following statements regarding Marakon approach is/are true?

(b) 14.9

(c) 15.8

(d) 16.0

< Answer >

(e) 16.4. < Answer >

Which of the following is/are the differences between stock splits and bonus issues? I. II. III.

Stock splits result in an increase in the number of shares while bonus issues do not Stock splits result in reduction in the face value of the shares while bonus issues do not Stock splits require the conversion of the reserves and surpluses into equity while bonus issues do not. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (II) and (III) above.

6.

(a) Risk transfer (c) Risk avoidance 7.

< Answer >

Managing risk by not undertaking the activities that entail risk is called (b) Risk retention (d) Loss control

(e) Separation. < Answer >

Consider the following data regarding Midtech Company: Period Ending

EPS

DPS

December, 2002

4.5

2.0

December, 2001

4.0

1.8

If the target pay out rate of the firm is 0.5, then as per John Lintner the firm is (a) Aggressive (d) Unpredictable

(b) Defensive (e) Investor Friendly. 1

(c) Neutral

8.

I. II. III.

If the EBIT – EPS indifference point is higher than the expected EBIT, raising equity is better At the EBIT – EPS indifference point, a firm is indifferent between debt and equity If the EBIT – EPS indifference point is lower than expected EBIT, raising equity is better.

(a) Only (I) above (c) Only (III) above (e) Both (II) and (III) above. 9.

< Answer >

Which of the following statements is/are true?

(b) Only (II) above (d) Both (I) and (II) above < Answer >

Consider the following data regarding Punjab Tractors: Investment base Rs.1,000 crore Cost of capital 10% Investment turnover 2 Residual income 20 crore The return on investment (ROI) of Punjab Tractors is (a) 10%

(b) 11%

(c) 12%

(d) 13%

(e) 14%. < Answer >

10. The following information is available about Kun United & Co.: Rs. in crore Gross Fixed Assets = 75 Accumulated Depreciation = 25 Total current assets = 150 Current liability = 50 EBIT = 30 Working Capital Leverage (WCL) for 20% increase in current assets will be (a) 0.238 (b) 0.313 (c) 0.588 (d) 0.652

(e) 0.885.

11. According to RBI, which of the following conditions have to be satisfied by a SSI unit to be classified as sick unit? I. II. III. IV. (a) (c) (e)

The Principal or interest in respect of any of its borrowal accounts has to remain overdue for periods exceeding 2½ years. The Principal or interest in respect of any of its borrowal accounts has to remain overdue for periods exceeding 2 years. There should be erosion in networth due to accumulated cash losses to the extent of 50 percent or more of its peak networth during the preceding 2 accounting years. There should be erosion in networth due to accumulated cash losses to the extent of 50 percent or more of its peak networth during the preceding 3 accounting years. Only (I) above (b) Both (I) and (III) above Both (II) and (III) above (d) Both (I) and (IV) above Both (II) and (IV) above.

12. Which of the following is not an assumption of Modigliani Miller Approach of capital structure? (a) (b) (c) (d) (e)

III.

< Answer >

Information is freely available to investors Transactions are cost free Investors have homogeneous expectations about future earnings of a company Growth of a firm is entirely financed through retained earnings Securities issued and traded in the market are infinitely divisible.

13. Which of the following is/are assumptions of multiple discriminant analysis? I. II.

< Answer >

< Answer >

There are two discrete groups to be analyzed. The independent variables can be analyzed in a linear manner for discriminating between the two groups. The values of the variables are distributed lognormally.

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

(b) Only (II) above (d) Both (I) and (II) above

14. In the year 2003, B had an inventory turnover ratio and gross sales of 3 and Rs 1.2 crores respectively. In 2004, because of the implementation of the JIT system, the level of inventory declined and the inventory turnover ratio increased to 7.5. If the level of sales remained the same in both 2003 and 2004, what is the increase in cash reserves as an effect of this transition? 2

< Answer >

what is the increase in cash reserves as an effect of this transition? (a) Rs.30 lakhs (d) Rs.24 lakhs

(b) Rs.20 lakhs (e) Rs.16 lakhs.

(c) Rs.120 lakhs < Answer >

15. Which of the following can be the consequences of heavy borrowing? (a) (b) (c) (d) (e)

Interest rate risk, default risk and financial risk Default risk, financial risk and liquidity risk Interest rate risk, liquidity risk and financial risk Only interest rate risk and financial risk Interest rate risk, default risk, liquidity risk and financial risk.

16. The common stock outstanding and net income of KP Ltd. are 10,00,000 shares and Rs.80,00,000 respectively. KP Ltd. intends to re-purchase 15% of its shares, and this is not expected to affect its net income or P/E ratio. If the current stock price is Rs.30, the price after the re-purchase will be (a) Rs.33.64

(b) Rs.36.92

(c) Rs.35.29

(d) Rs.37.55

(e) Rs.31.43.

17. In a cash acquisition an acquiring company has offered Rs.40 per share to acquire the target. The share price of the acquiring company is Rs.60. The combined earnings of the two companies including estimated synergies are Rs.1,60,000. If the acquired company has 20,000 shares and the target has 10,000 shares, the postmerger EPS of the combined firm is approximately (a) Rs.4.57

(b) Rs.5.33

(c) Rs.6.00

(d) Rs.6.86

< Answer >

(e) Rs.7.00. < Answer >

18. Which of the following is not a determinant of the capital structure of a company? (a) (b) (c) (d) (e)

< Answer >

Type of asset financed Product life cycle Current capital structure Credit rating Type of raw material used.

19. Venus Industries follows a strict residual dividend policy. The company has a capital budget of Rs.4,000,000. It has a target capital structure which consists of 40 percent debt and 60 percent equity. Venus forecasts that its net income will be Rs.3,000,000. What will be the company’s expected dividend payout ratio this year? (a) 20%

(b) 30%

(c) 35%

(d) 40%

< Answer >

(e) 45%.

20. Which of the following statements regarding target-costing is/are not true?

< Answer >

(a)

Target costing reduces the development cycle of the product wherein costs are targeted at the time of product design (b) Target costing has proved to be very efficient in the manufacture of complex products that requires many sub-assemblies (c) Target costing can be used to forecast costs to be incurred in the future and provides motivation to meet future cost objectives (d) Target cost is the excess of the sales price for the target market over the pre-determined margin of profit (e) Both (b) and (d) above. 21. The stock of C Ltd. trades at Rs.100 per share. A stock split as such is not expected to have any effect on the market value of the equity of C Ltd. What is the stock split proportion being contemplated if the stock price of the company after the stock split is Rs.75? (a) (b) (c) (d) (e)

1-for-4 4-for-1 4-for-3 3-for-4 2-for-3.

22. The required rate of return is the return shareholders demand (a) (b) (c)

< Answer >

For the value of common stock by looking at its current dividend and making assumptions about any future dividends that it may pay For the valuation of stock on the assumption that dividends are received at the end of the period To compensate for the time value of money tied up in their investments and the certainty of the future cash flows from these investments 3

< Answer >

(d) To compensate the time value of money tied up in their investment and the uncertainty of the future cash flows from these investments (e) Both (a) and (c) above. < Answer >

23. Which of the following statements is/are true? I. II. III. (a) (c) (e)

According to Beaver Model, corporate failure is defined as the inability of a firm to pay its financial obligations as they mature. As per Wilcox Model, the best indicator of the financial health of a firm is considered to be the net liquidation value. Blum Marc’s Failing Company Model is based on multiple discriminant analysis. Only (I) above (b) Only (II) above Only (III) above (d) Both (I) and (II) above All (I), (II) and (III) above.

24. Which of the following statements is/are not true with respect to the Baumol Model?

< Answer >

I. II. III.

Cash expenses are incurred evenly over the planning horizon. Cash inflows are random and hence the balance in cash movements are random. Neither the amount of conversion nor the timing of conversion of securities into cash and vice versa is fixed. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) Both (II) and (III) above.

25. In the context of quality costing, costs associated with materials and products that fail to meet quality standards and result in manufacturing losses are called (a) Prevention costs (c) External failure costs (e) Quality cost.

(b) Appraisal costs (d) Internal failure costs

26. According to the Pecking order theory of financing, the preferred order of finance for firms is (a) (b) (c) (d) (e)

< Answer >

< Answer >

External equity, debt, preference capital, internal equity Internal equity, debt, preference capital, external equity Debt, preference capital, internal equity, external equity Internal equity, external equity, debt, preference capital External equity, internal equity, debt, preference capital.

27. The risk that arises out of the assets of a firm being not readily marketable is called (a) Market risk (c) Business risk (e) Exchange risk.

(b) Marketability risk (d) Financial risk

28. Which of the following is most likely when a firm’s managers have surplus cash at their disposal? (a) Liquidity crunch (c) Enterprise risk (e) Agency conflicts.

< Answer >

(b) Value growth duration (d) Growth rate in dividends

30. Converting an existing division into a wholly owned subsidiary is called (a) Split-off (d) Equity carveout

< Answer >

(b) Bankruptcy costs (d) Higher profitability

29. Which of the following is a ‘value driver’ that affect the value of a firm according to Alcar Model? (a) Dividend payout (c) Net profit margin (e) Book value of the firm.

< Answer >

(b) Split-up (e) Demerger.

END OF SECTION A

4

(c) Divestiture

< Answer >

Section B : Problems/Caselets (50 Marks) • • • • • 1.

This section consists of questions with serial number 1 – 7. 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.

The following information is available regarding Singhvi Polyester Limited: (All figures in Rs. lakhs) I. II.

III.

IV. V.

Particulars Sales Expenditures: i. Manufacturing costs a. Raw material b. Consumable stores c. Packing material d. Power and fuel ii. Excise duty iii. Salaries and wages iv. Admin.& Selling Expenses Inventories i. Raw Material ii. Finished Goods iii. Stocks in process Accounts Receivables Accounts Payables

31.3.2004

15079.77 971.77 1620.11 2416.68

31.3.2003

16834.50 948.41 1690.66 2190.33

31.3.2004 36506.25

31.3.2003 36225.28

20088.33 9305.87 408.67 2425.29

21663.90 8826.70 477.22 2057.88

416.84 331.79 253.89 2016.76 1558.21

441.47 262.58 214.79 1399.15 1324.04

You are required to find out the duration of the weighted operating cycle for the year 2003-04. (10 marks) < Answer > 2.

Bond Cements Ltd. have experienced cyclical free cash flow over last decade. The free cash flow repeats over a period of 5 years as under: Rs.in crore Year Ending March 31st FCF

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

7

4

1

–2

3

7

4

1

–2

3

7

In future the trend is expected to remain the same. The cost of capital of the firm is 15%. You are required to find the value of the firm as on April 01, 2004. (6 marks) < Answer > 3.

Vipin Industries Ltd. is contemplating to invest in a new project which requires an initial investment of Rs.70 crores. The project is expected to generate earnings before interest and taxes of Rs.20 crores every year. The firm is evaluating alternative sources of financing to fund this project. It plans to raise the funds in the form of equity or debt. Its present capital structure is given below: Equity

Rs.10,00,00,000

[1,00,00,000 shares of Rs.10 each]

Debt

Rs. 6,00,00,000

[at 14% interest]

Current annual earnings before interest and taxes stand at Rs.7 crores. Additional debt can be issued at 16% p.a. and equity at Rs.35 per share. At present, the firm pays a dividend of Rs.3.50 on each equity share and wishes to maintain the same level of dividends. The firm is in the tax bracket of 35%. You are required to a.

Determine the change in the pay-out ratio if any, if the firm wishes to maintain the current level of dividend per share and the company earns an EBIT at which it is indifferent between equity and debt. 5

b.

Determine the EBIT at which the firm is indifferent between a debt-equity ratio of 2:1 and 1:1.

(5 + 5 = 10 marks) < Answer >

Caselet 1 Read the caselet carefully and answer the following questions: 4.

Traditionally, the free cash flow method is considered to be a reliable measure of business valuation. Discuss in brief about the features of this method. Why it is significant for the shareholders? (6 marks) < Answer >

5.

The Securities and Exchange Commission (USA) has repeatedly pronounced in the course of financial statements filed by enterprises that the EBITDA doesn’t mean net income, doesn’t measure liquidity and isn’t part of the Generally Accepted Accounting Principles. EBITDA has been alleged to only create an appearance of stronger interest coverage and lower financial leverage. In this context, state the limitations of using EBITDA as a measure of determining the cash flows in an organization. (6 marks) < Answer >

EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, has been used by analysts and investors as a tool to measure the fiscal health of the many high tech, media and other asset-heavy firms that do not generate earnings, but instead incur plenty of depreciation, amortization, and other charges. In the 1980s through the 1990s, many analysts and others believed that peeling away these expenses, which generally were not directly incurred in operations, would enable them to more accurately analyze and compare the core operations of companies. In fact, many treated EBITDA as a modified cash flow statement, sometimes mistakenly referring to it as free cash flow. It should be noted, though, that while a cash flow statement reconciles a company’s net income or loss for a period to the company’s cash position as of the end of that period, EBITDA does not. EBITDA is also different from a free cash flow statement, which is basically EBITDA reduced by capital expenditures (purchases of generally long-lived assets like machinery, equipment or other items that show up on the balance sheet instead of the income statement). And of course, because EBITDA excludes so many expenses, it does not measure net income. In light of this, some people have questioned its usefulness. In the 1980s people started to use EBITDA to find good candidates for LBOs as EBITDA was thought to be a good indicator of a company s ability to meet debt payments. They would project growing EBITDA in the future and say that the company could handle much more debt. Using an EBITDA-based analysis, LBOs would then put huge amounts of debt in companies and then later find that there was not sufficient cash to service the debt. John Percival, an adjunct finance professor at Wharton, is one who never quite accepted EBITDA as a valid tool. In some of my classes, I call it EBIT Duh, he says. It is the lazy analyst’s cash flow and it is dangerous. But EBITDA has its takers too. That was clearly demonstrated in the case of WorldCom, which saw its stock go into a free-fall and was recently delisted after the company reported that it had inflated its EBITDA by $3.8 billion over a five-quarter period by simply, and improperly, classifying routine operating costs as long-term capital costs.

Caselet 2 Read the caselet carefully and answer the following questions: 6.

In what way is corporate culture important for those inside the company and those outside the company? Discuss. (6 marks) < Answer >

7.

The caselet mentions that the internal culture of the organisation does eventually influence how the customer sees it — and therefore the `equity' of the corporate brand. Do you agree? Discuss. (6 marks) < Answer >

Even the sceptics in the corporate world are beginning to admit the possible existence of something called the corporate culture, although to the hard-headed accountants and engineers the words seem currently in favour, mainly amongst the thinking types and academics. What is distinctive about a company, almost amounting to a flavour of its ways of working (Sumantra Ghoshal calls the `smell of the place'), could constitute a business advantage, which will gain in significance in the future. This flavour, like good wine, matures and evolves over time. And the older any organisation (not even necessarily a business) gets, the less easy it is for any one person or group to change its content dramatically. True, the Ford Motor Company today is not what it was under Henry Ford in the early years, but all inside and outside would agree that there is yet a discernible Ford way of doing business, method of managing the process of building cars and of selling them, which can be seen anywhere in the world. What is more, this extends to ways of relating to employees, customers, 6

which can be seen anywhere in the world. What is more, this extends to ways of relating to employees, customers, suppliers and dealers. Although the connection might seem far-fetched to some people on the face of it, the internal culture of the organisation does eventually influence how the customer sees it — and therefore the `equity' of the corporate brand. The more explicitly one articulates the elements of a culture or `the way', the easier it is to ensure a degree of standardisation in execution of major policies. It is also easier to inculcate it in new entrants and draw the line of negotiability. To know what is debatable and negotiable and what is not saves a lot of time and energy. One can avoid needless stress otherwise demanded by having to explicate the essence to others in a crisis situation. A written code of conduct, of course, is one form of such expression but it cannot anticipate all possible eventualities nor be as flexible as guidelines. It has been found even written codes need to be supported by visible behaviour or `walking the talk', especially by the senior managers. This is only all the more important when considering Indian companies going global and wanting to establish companies elsewhere in Asia or further beyond. As a well-integrated and ingrained culture becomes more and more internalised, it would create the space for managerial initiative. It would make for more effective working and behaviour in what would be already a stressful situation, working against unfamiliar competition in an unfamiliar market. Establishing the minimal bases for sound action is also very essential also for another external reason - maintaining the character of the company everywhere. Sony, Toyota, and McDonald's are often cited as splendid examples of this. Wherever you go in the world, you can expect the same quality and level of service — or so the expectation goes. END OF SECTION B

Section C : Applied Theory (20 Marks) • • • • 8.

This section consists of questions with serial number 8 - 9. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.

With growing levels of uncertainty and risk, firms are having to face an indecisive and non-deterministic future. Effective Risk Management is gaining prominence and increasing attention in the corporate world. What are the various approaches using which firms can manage their risks? (10 marks) < Answer >

9.

Target costing has recently received considerable attention in the industries around the world as it gives competitive edge in launching new products. Explain, what is target costing? Also discuss the benefits of target costing.

(10 marks) < Answer >

END OF SECTION C END OF QUESTION PAPER

Suggested Answers

Strategic Financial Management (MB361F) : April 2005 Section A : Basic Concepts 1.

Answer : (b) Reason : According to the second proposition of MM theory of capital structure, ke = ku + (ku – kd) D/E. Therefore, ke

=

0.12 + (0.12 – 0.10) 0.5

=

0.13 or 13%. 7

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2.

Answer : (e) Reason : The assumption that the share prices are determined by earnings forms the basis of the P/E ratio. The replacement cost takes into account only the tangible asset of the company, and not its intangible assets. In estimating the continuing value of the firm, the two cash flow methods used are the growing free cash flow perpetuity method and the value driver method.

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3.

Answer : (e) Reason : While price to book ratio depends upon the return on equity, growth rate of dividends and the cost of equity under the Marakon approach, the value created for shareholders is measured by the difference between the book value of equity B and the market value of equity M, where M stands for how productively the firm has employed its equity or capital contributed by the shareholders.

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4.

Answer : (d) Reason : Market price as per Graham – Dodd Model is given by

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E  D +  3  Po = m Given: Po = 44, E = 3.75, D = 3.75 (1 – 0.6) = 1.5 44 3.75   1.5 +  3  = 16. ⇒m=  5.

Answer : (b) Reason : Bonus issues require conversion of reserves and surpluses into equity, not stock splits. Both bonus issues and stock splits result in an increase in the number of shares. Only stock splits result in reduction of face value

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6.

Answer : (c) Reason : An extreme way of managing risk is to avoid it altogether. This can be done by not undertaking the activity that entail risk. So, the correct answer is ‘c’.

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7.

Answer : (b) Reason : Dt =

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cr EPS t + (1 – c) Dt – 1 ⇒

2.0 = c × 0.5 × 4.5 + (1 – c) 1.8

⇒

c (2.25 – 1.8) = 2.0 – 1.8 = 0.2

⇒ c = 0.44 i.e., Relatively more weightage is attached to past dividend than to current earnings hence firm is a defensive firm. 8.

Answer : (d) Reason : If the expected EBIT is lower than the EBIT – EPS indifference point, raising equity is better alternative as it will give higher EPS

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9.

Answer : (c)

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Net income Reason : ROI = Investment Net income = RI + k × Investment = 20 + 0.1 × 1000 = 120 crore. 120 ⇒ ROI = 1000 = 0.12 i.e. 12% 10.

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Answer : (d)

Reason : WCL

CA CA TA + ∆ CA NFA + CA + ∆CA = = 150 150 150 = = 0.652 50 + 150 + 150 x 0 . 2 200 + 30 230 = = . 8

11.

Answer : (b) Reason : According the RBI, the following conditions have to be satisfied by a SSI unit to be classified as sick unit: (i) The principal or interest in respect of any of its borrowal accounts has to remain overdue for periods exceeding 2 ½ years and (ii) their should be erosion in networth during the preceding 2 accounting years.

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12.

Answer : (d) Reason : (a), (b), (c) and (e) are the assumptions of Modigliani Miller Approach of capital structure. Regarding growth no assumption have been made in the M-M approach. Hence (d) is not correct.

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13.

Answer : (d) Reason : The technique of multiple discriminant analysis is based on the assumptions that:

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14.

•

There are two discrete groups to be analyzed

•

The independent variables can be analyzed in a linear manner for discriminating between the two groups

•

The values of the variables are distributed normally, not lognormally, as given in the question. < TOP >

Answer : (d) Reason : Inventory turnover ratio = Sales volume/Inventory ∴Inventory = Sales volume/ Inventory turnover ratio For the year 2003, inventory = Rs.1,20,00,000/3 = Rs.40,00,000 For the year 2004, inventory = Rs.1,20,00,000/7.5 = Rs.16,00,000 The effect of this on the freeing up of cash is given by their difference of Rs 24,00,000, which is Rs.40,00,000 – Rs.16,00,000.

15.

Answer : (c) Reason : Default risk is the risk arising due to default with respect to obligations by outsiders to the enterprise. This risk cannot be the consequence of any borrowing resorted to by the firm. The other risks, interest rate risk, liquidity risk and financial risk are directly the effect of a high degree of financial leverage employed by the firm in its capital structure.

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16.

Answer : (c) Reason : Number of shares re-purchased = 0.15 x 10,00,000 = 1,50,000 EPS 0 = NI/No. of shares = Rs.80,00,000/10,00,000 = Rs.8 Current P/E = P0/EPS 0 = Rs.30/Rs 8 = 3.75 EPS1 = Rs.80,00,000/(10,00,000 – 1,50,000) = Rs.9.41 The price after re-purchase = P 1 = EPS1 x P/E = Rs.9.41 x 3.75 = Rs.35.29

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17.

Answer : (c)

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Reason :

Post merger EPS =

Post merger earnings Post merger number of o/sshares 1,60,000 =

 40  20,000 + 10,000    60 

=

1,60,000 26,667 = 5.99 or 6 app.

18.

Answer : (e) Reason : Type of asset financed, product life cycle, current capital structure and credit rating are all direct determinants of capital structure of a company while the type of raw material used does not have any direct relationship with it.

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19.

Answer : (a) Reason : Step 1 Find equity required to maintain capital budget:

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Capital budget

Rs.4,000,000 9

Percent of budget financed with equity

x 0.60 Rs.2,400,000

Step 2 Calculate dividend: Earnings

Rs.3,000,000

Less equity retained

2,400,000

Dividend

Rs.600,000

Step 3 Find payout ratio: Dividend/Earnings = Rs.600,000/Rs.3,000,000 = 0.2000 = 20%. 20.

Answer : (b) Reason : Target costing is based on external analysis of markets and competitors, and is a cost management tool that reduces a product’s costs over its entire life cycle. But it is difficult to use in the presence of complex products because on the one hand, analysis of costs needs to be performed at various levels, while on the other, the activity of tracking costs becomes more complicated and cumbersome.

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21.

Answer : (c) Reason : P0 is given as Rs.100, and P1 is given as Rs.75 Split ratio is given by dividing P1 by P 0, i.e Rs.100/Rs.75, which as per convention is known as the 4-for-3 stock split.

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22.

Answer : (d) Reason : The required rate of return is the return shareholders demand to compensate them for the time value of money tied up in their investment and the uncertainty of the future cash flows from these investments.

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23.

Answer : (d) Reason : Statements I and II are true. Altman’s z-score model is based on multiple discriminant analysis. Blum Marc’s failing company model is not based on it, therefore, statement III is not correct.

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24.

Answer : (e) Reason : Baumol model is a deterministic model of cash budgeting. It assumes that the cash inflows as well as outflows are incurred evenly over the planning horizon. Conversion of securities into cash takes place at regular intervals. So both statements (II) and (III) are incorrect. Hence the correct answer is (e).

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25.

Answer : (d) Reason : Costs that arise due to materials and products that fail to meet quality standards and result in manufacturing losses are called internal failure costs

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26.

Answer : (b) Reason : As per Pecking order theory of financings, the preferred order of finance for firms are as follows: internal equity, debt, preference capital and external equity. Answer : (b) Reason : When assets, which are not readily marketable, is required to be sold for need of funds, the nonmarketability may lead to liquidity risk. Thus the assets not being readily marketable give rise to marketability risk.

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28.

Answer : (e) Reason : Managers with limited free cash flow are less prone to make wasteful expenditures. Agency conflicts are particularly likely, when too much cash is available with the managers. This happens to be an important reason for why firms reduce excess cash flow in a variety of ways.

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29.

Answer : (b) Reason : Of the given factors, value growth duration only is a value driver as per Alcar Model all other are financial factor determining firm’s value as per Marakon Model.

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30.

Answer : (d) Reason : Converting an existing division into a wholly owned subsidiary is called equity Carve-out.

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27.

10

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11

Section B : Problems

1.

a.

36506.25 + 36225.28 2 × 360

=

Rs.101.02 lakhs

416.84 + 441.47 2

=

Rs.429.16 lakhs

331.79 + 262.58 2

=

Rs.297.18 lakhs

=

253.89 + 214.79 2

=

Rs.234.34 lakhs

=

2016.76 + 1399.15 2

=

Rs.1707.96 lakhs

=

Rs.1441.12 lakhs

Average sales per day = Average stock Raw materials and stores = Average finished goods inventory = Average WIP inventory Average accounts receivable

1558.21 + 1324.02 2 Average accounts payable = Average raw material and stores consumed per day = =

15957.14 + 960.09 + 1655.39 360 Rs.51.59 lakhs

Average cost of production per day

Average cost of good sold per day

=

214.79 + 20088.33 + 408.67 − 253.89 360

=

20457.9 360 =

=

262.58 + 20457.9 + 9305.87 + 2425.29 − 331.79 360

Rs.56.83 lakhs

32119.85 360 = = Rs.89.22 lakhs Durations of various stages of the operating cycle 429.16 51.59 = 8.32 days Duration of raw material and stores stage (Drm) = Duration of WIP stage (Dl wip)

=

234.34 56.83

=

4.12 days

Duration of finished goods stage (Dfg)

=

297.18 89.22

=

3.33 days

=

1707.96 101.02

=

16.91 days

=

1441.12 51.59

=

27.93 days

=

51.59 101.20

=

0.51

=

51.59 + 0.5 + 5.24 101.02

Duration of accounts receivable stage (Dar) Duration of accounts payable stage (Dap) Weights for various stages of the operating cycle Raw material and stores stage, Wrm Work in process stage

12

=

0.57

Finished good stage, Wfg

=

89.22 101.02

Account receivable stage, War

=

101.02 101.02

51.59 101.02

Account accounts payable = = Duration of weighted operating cycle Dwoc = Wrm . Drm + Wwip. Dwip + Wfg . Dfg + War . Dar – Wap . Dap b.

=

0.88

=

1.00

0.51

= 0.51 × 8.32 + 0.57 × 4.12 + 0.88 × 3.33 + 1 × 16.91 – 0.51 × 27.93 = Working capital requirement =

Sales per day × Weighted operating cycle + Cash balance requirement

= =

(101.02 × 1.10) × 12.19 + 150 Rs.1504.58 lakhs.

12.19 days.

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2.

Free cash flow scenario for next 5 years Rs.in crore 2005 2006 2007 2008 2009 4 1 –2 3 7 P.V of explicit free cash flow upto 2009 −2 4 1 3 7 + + + + 1.15 (1.15 )2 (1.15 )3 (1.15 )4 (1.15 )5 = = 3.48 + 0.75 – 1.32 + 1.72 + 3.48 = 8.12 P.V. of free cash flow of all period considering the cyclical nature of the cash flow = 8.12 + 8.12 PVIF (15%, 5 yrs) + 8.12 PVIF (15%, 10yrs) + 8.12 PVIF (15%, 15yrs) + . . . =

1 + 0.497 + (0.497 )2 + (0.497 )3 + ...  8.12 

=

8.12 1 8.12 × 1 − r = 1 − 0.497 = Rs.16.14 crores. < TOP >

3.

a.

(EBIT − I t )(1 − t ) n1 (EBIT − 6(0.14)) (0.65) 1+ 2 (EBIT − 0.84) (0.65) 3 0.65 EBIT – 0.546 –0.546 + 1.638 + 21.84 1.3 EBIT

=

(EBIT − I 2 )(1 − t ) n2

=

(EBIT − 6(0.14) − 70 (0.16)) (0.65) 1

= = = =

(EBIT − 0.84 − 11.2) (0.65) 1 1.95 EBIT – 1.638 – 21.84 (1.95 – 0.65) EBIT 22.932

22.932 = 17.64 crores EBIT = 1.3 At this level of EBIT the firm is indifferent as EPS is same under both the alternatives. If funds are raised through equity, EPS is given by EPS

= = =

(EBIT − 6(0.14) 0.65 3 (17.64 − 0.84) 0.65 3 3.64

13

Current EPS Current pay-out ratio

b.

=

(7 − 0.84) 0.65 1 = 4.004

=

3.5 4.004 = 0.87 = 87%

3 .5 3 To maintain the same dividend per share, the new pay-out ratio should be .64 = 96%. DER is 2 : 1 : Let equity be x and Debt will be (70 – x) 6 + (70 − x ) 10 + x = 2 Then, 6 + 70 – x = 20 + 2x 76 – 20 = 3x 56 3 = x = Rs.18.67 crores Additional equity = Rs.18.67 crores and additional debt = Rs.51.33 crores. Hence, total equity = 18.67 + 10 = 28.67 and Total debt = 51.33 + 6 = Rs.57.33 crores DER is 1 : 1 : Let equity be x and Debt be (70 – x)

6 + (70 − x) 10 + x = 1 Then, 6 + 70 – x = 10 + x 76 – 10 = 2x 66 2 = 33 x = Additional equity = 33 and Additional debt = 37 Hence, Total equity = 33 + 10 = Rs.43 crores and Total debt = 37 + 6 Indifference EBIT is the value of EBIT in the following:

= Rs.43 crores.

(EBIT − 6 × 0.14 − 51.33 × 0.16) × 0.65 (EBIT − 6 × 0.14 − 37 × 0.16)0.65 18.67 33 1+ 1+ 35 35 =

EBIT − 9.053 1.533 = 1.943 EBIT – 17.59 0.41 EBIT EBIT EBIT

(EBIT − 6.76) 1.943 = = = =

1.533 EBIT – 10.363 17.54 – 10.363 7.227/0.41 Rs.17.63 crores. < TOP >

4.

Companies generate revenue by selling their products and services to another party. In the process company generates revenues and incurs expenses in the form of salaries, cost of goods sold, selling and general administrative expenses and research and development. The difference between operating revenue and operating expense is depicted in terms of Operating Income or Net Operating Profit. To produce revenue a firm has to not only incur operating expenses, but it also must invest money in other avenues like real estate, buildings and equipment, and in working capital so that the usual business activities are continued at with ease. Apart from the above, companies incur expenses in the form of income taxes. The amount of cash that’s left over after the payment of these expenses from operating income by the company is known as Free Cash Flow (FCF). The FCF method is an important measure to analyze a company’s effectiveness. The simple equation used to calculate FCF is: FCF = Net Operating Profit – Taxes – Net Investment – Net Change in Working Capital. This measure is useful from the point of view of the shareholder also because FCF is the cash that is available to pay the company's various claim holders, especially equity holders. Free cash flow method is an in depth analysis of the cash flow schedule of any company. Proper analysis of this method provides a better understanding of the revenue generation and operating aspect of the companies that are very critical from the points of view of the 14

revenue generation and operating aspect of the companies that are very critical from the points of view of the shareholder. < TOP >

5.

While cash flow, which is the amount of cash left after money comes into and goes out of an organization during a certain time period, can’t be easily distorted or subject to imprecision, EBITDA is easy to manipulate by using creative accounting techniques for revenue, expenses and asset write-downs. Earnings are not cash but merely reflect the difference between revenues and expenses, which are accounting constructs. EBITDA is inappropriate for many industries because it ignores their unique attributes. It's a poor measure of cash flow for companies undergoing a great deal of technological change or for firms that have short-lived assets (those lasting, say, three to five years) and need to keep upgrading their equipment to stay up-to-date. Several are the accepted limitations of EBITDA as a principal determinant of cash flows. EBITDA ignores changes in working capital and overstates cash flow in periods of working capital growth. It ignores distinctions in the quality of cash flow resulting from differing accounting policies, as not all revenues are cash equivalents. Apart from being a misleading measure of liquidity (quick access to cash), it says nothing about the quality of earnings. It is neither a common denominator for cross-border accounting conventions nor can be an adequate stand-alone measure for a company’s acquisition multiples. It doesn’t consider the amount of required reinvestments, especially for companies with short-lived assets, whether it’s cable equipment or trucks. When used in bond indentures created by the bondholders for protecting their interests and agency related conflicts, the measure does not offer the required level of protection. In simple words, EBITDA as a measure can drift from the realm of reality. < TOP >

6.

To define culture is both easy and difficult at the same time. It is a set of widely accepted guidelines that influence company employees' behavior, a set of underlying values, a way of life all rolled into one. It is something indefinably real, which can be felt, like the wind on your face — but not held in the palm of your hand or put under a microscope. Put in a mundane way, it tacitly dictates the `done things' and the `not done things' inside a company. It is partly dependent on history, origins, and the type of business and the leadership but not on any one of them singly. A little depth of observation will show that the internal benefits of culture are far from being just intangible or conceptual. It can result in greater effectiveness in implementation and value-driven behavior, including decisionmaking throughout the organization. Indeed, contrary to what one might think, it can also contribute to speed and efficiency of decision-making. Consider the following: If the values, beliefs and ways were explicit, widely shared and unambiguous, any educated person could make almost any decision given the same information; and the result is unlikely to be far different from what it would be if the senior-most person handled the situation. This is one of the truly unsung benefits of a culture of standards and guidelines rather than bureaucratic procedures. As a result, the area manager working a thousand miles away from headquarters and facing an unfamiliar situation cropping up need not feel paranoid about inviting a tonne of bricks on his head when he returns to base. He can tackle the problem (say, with a customer or a Government officer), confident that what he decided would be acceptable, and indeed much the same as what his Managing Director might have done in his place. The global consumer is a major reason for the concern for culture. The global outlook and the marketplace that engenders it demands as a minimum that a Body Shop outlet or a Marks & Spencer store everywhere in the world will look and feel familiar to the customer coming there, hoping to get the shopping ambience and experience she has been accustomed to `at home'. This applies to the airport brands from whisky to cheese and chocolates that vast numbers of travellers — backpackers just as much as business travellers — rush into for the last-minute gift buying before departure. The customer takes it for granted that the truly global brands will be there and will feel and taste the same no matter where in the world they are made. < TOP >

7.

There is definitely a link between internal culture of an organization and its effect on potential customer. The link is more readily apparent in hotels, banks and airlines because of the very nature of the service. Think back to the best interaction that you had with airline counter staff, a bank teller or the front office or room service staff of a hotel. And you will conclude that you can never disconnect in your mind the brand experience from your impression of the individual. Therefore, what the customer is paying for is largely for the experience at the `touch point' or the `moment of truth' when the employee, trained in the ways of doing business according to the culture and traditions of the company, enters into a direct relationship with the customer. Today, the consumers have a wide variety of brands available to choose from. They are ready to pay a little more price but they want an excellent service to be provided. We can see that banks like ICICI or HDFC have become so strong brands within such a short period of time only because of the service they provide. LIC has been rated as the number one brand in insurance sector because of the same reason. The same goes true with all brands irrespective of the industry. All else is mere talk, compared to what one gets as direct experience. The experience that a customer gets in turn depend upon what the culture of the organization is and to what extent it has been ingrained into the employees 15

depend upon what the culture of the organization is and to what extent it has been ingrained into the employees delivering the product or service. Hence culture plays an important role in creating the brand equity. < TOP >

Section C: Applied Theory 8.

The following are the different approaches to managing risks: • Risk avoidance • Loss control • Combination • Separation • Risk transfer • Risk retention • Risk sharing. Risk Avoidance An extreme way of managing risk is to avoid it altogether. This can be done by not undertaking the activity that entails risk. For example, a corporate may decide not to invest in a particular industry because the risk involved exceeds its risk bearing capacity. Though this approach is relevant under certain circumstances, it is more of an exception rather than a rule. It is neither prudent, nor possible to use it for managing all kinds of risks. The use of risk avoidance for managing all risks would result in no activity taking place, as all activities involve risk, while the level may vary. Loss Control Loss control refers to the attempt to reduce either the possibility of a loss or the quantum of loss. This is done by making adjustments in the day-to-day business activities. For example, a firm having floating rate liabilities may decide to invest in floating rate assets to limit its exposure to interest rate risk. Or a firm may decide to keep a certain percentage of its funds in readily marketable assets. Another example would be a firm invoicing its raw material purchases in the same currency in it which invoices the sales of its finished goods, in order to reduce its exchange risk. Combination Combination refers to the technique of combining more than one business activities in order to reduce the overall risk of the firm. It is also referred to as aggregation or diversification. It entails entering into more than one business, with the different businesses having the least possible correlation with each other. The absence of a positive correlation results in at least some of the businesses generating profits at any given time. Thus, it reduces the possibility of the firm facing losses. Separation Separation is the technique of reducing risk through separating parts of businesses or assets or liabilities. For example, a firm having two highly risky businesses with a positive correlation may spin-off one of them as a separate entity in order to reduce its exposure to risk. Or, a company may locate its inventory at a number of places instead of storing all of it at one place, in order to reduce the risk of destruction by fire. Another example may be a firm sourcing its raw materials from a number of suppliers instead of from a single supplier, so as to avoid the risk of loss arising from the single supplier going out of business. Risk Transfer Risk is transferred when the firm originally exposed to a risk transfers it to another party which is willing to bear the risk. This may be done in three ways. The first is to transfer the asset itself. For example, a firm into a number of businesses may sell-off one of them to another party, and thereby transfer the risk involved in it. There is a subtle difference between risk avoidance and risk transfer through transfer of the title of the asset. The former is about not making the investment in the first place, while the latter is about disinvesting an existing investment. The second way is to transfer the risk without transferring the title of the asset or liability. This may be done by hedging through various derivative instruments like forwards, futures, swaps and options. The third way is through arranging for a third party to pay for losses if they occur, without transferring the risk itself. This is referred to as risk financing. This may be achieved by buying insurance. A firm may insure itself against certain risks like risk of loss due to fire or earthquake, risk of loss due to theft, etc. Alternatively, it may be done by entering into hold- harmless agreements. A hold-harmless agreement is one where one party agrees to bear another party’s loss, should it occur. For example, a manufacturer may enter into a hold-harmless agreement with the vendor, under which it may agree to bear any loss to the vendor arising out of stocking the goods. Risk Retention Risk is retained when nothing is done to avoid, reduce, or transfer it. Risk may be retained consciously because the other techniques of managing risk are too costly or because it is not possible to employ other techniques. Risk may 16

other techniques of managing risk are too costly or because it is not possible to employ other techniques. Risk may even be retained unconsciously when the presence of risk is not recognized. It is very important to distinguish between the risks that a firm is ready to retain and the ones it wants to offload using risk management techniques. This decision is essentially dependent upon the firm’s capacity to bear the loss. Risk Sharing This technique is a combination of risk retention and risk transfer. Under this technique, a particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it. For example, a firm and its supplier may enter into an agreement, whereby if the market price of the commodity exceeds a certain price in the future, the seller foregoes a part of the benefit in favor of the firm, and if the future market price is lower than a predetermined price, the firm passes on a part of the benefit to the seller. Another example is a range forward, an instrument used for sharing currency risk. Under this contract, two parties agree to buy/sell a currency at a future date. While the buyer is assured a maximum price, the seller is assured a minimum price. The actual rate for executing the transaction is based on the spot rate on the date of maturity and these two prices. The buyer takes the loss if the spot rate falls below the minimum price. The seller takes the loss if the spot rate rises above the maximum price. If the spot rate lies between these two rates, the transaction is executed at the spot rate. < TOP >

9.

Target costing has recently received considerable attention. It is defined as under: Target cost = Sales price (for the target market share) – Desired profit Sony walkman is an excellent example of it. In fact Japanese cost management is known to be guided by the concept of target cost. In it management decides, before the product is designed, what a product should cost, based on marketing (rather than manufacturing) factors. There are several phases in the methodology. Conception (Planning) Phase Based upon its strategic business plans, a company must first identify the type of product it wishes to manufacture. Several steps must be taken in order to establish a reasonable target cost. 1. Market research should be done to determine several factors. First, the products of competitors’ should be analyzed with regard to price, quality, service and support, delivery, and technology. After a preliminary test of competitor’s product, it is necessary to establish the features consumers value in this type of product, and the important features that are lacking. 2. After preliminary testing, a company should be able to pinpoint a market niche it believes is undersupplied, and in which it believes it might have some competitive advantage. Only then can a company set a target cost close to competitors’ products of similar functions and value. The target cost is bound to change in the development and design stages. However, the new target costs should only be allowed to decrease, unless the company can provide added features that add value to the product. Development Phase The company must find ways to attain the target cost. This involves a number of steps. 1. First, an in-depth study of the most competitive product on the market must be conducted. This study will show materials used and features provided, and it will give an indication of the manufacturing process needed to complete the product. 2. After identifying the cost structure of the competitor, the company should develop estimates for the internal cost structure of its own products. 3. After preliminary analysis of the cost structures of both the competition and itself, the company should further define these cost structures in terms of cost drivers. Focusing on cost drivers can help reduce waste, improve quality, minimize non-value-added activities, and identify ineffective product design. Production Phase In these stages, target costing becomes a tool for reducing costs of existing products. It is highly unlikely that the design, manufacturing, and engineering groups will develop the optimal, cost-efficient process at the beginning of production. The search for better, less expensive products should continue in the framework of continuous improvement. BENEFITS OF TARGET COSTING 1. The process of target costing provides detailed information on the costs involved in producing a new product, as well as a better way of testing different cost scenarios through the use of ABC. 2. Target costing reduces the development cycle of a product. 3. The internal costing model, using ABC, can provide an excellent understanding of the dynamics of production costs and can detail ways to eliminate waste, reduce non-value-added activities, improve quality, simplify the process, and attack the root causes of costs (cost drivers). It can also be used for measuring 17

4.

5. 6. 7.

simplify the process, and attack the root causes of costs (cost drivers). It can also be used for measuring different cost scenarios to ensure that the best ideas available are incorporated from the outset into the production design. The profitability of new products is increased by target costing through promoting reduction in costs while maintaining or improving quality. It also helps in promoting the requirements of consumers, which leads to products that better reflect consumer needs and find better acceptance than existing products. Target costing is also used to forecast future costs and to provide motivation to meet future cost goals. Target costing is very attractive because it is used to control costs before the company even incurs any production costs, which save a great deal of time and money. There is one major drawback to target costing. It is difficult to use with complex products that require many subassemblies, such as automobiles. This is because tracking costs becomes too complicated and tedious, and cost analysis must be performed at so many levels. < TOP >

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