Mb361f April 07

Question Paper Strategic Financial Management (MB361F) : April 2007 Section A : Basic Concepts (30 Marks) • • • •

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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.

< Answer > Which of the following statements is/are true with respect to survival strategies? I. A company might pursue a non-growth strategy if its non-economic objectives are more important than its economic objectives. II. A non-growth strategy is bound to be a corrective strategy. III. A company can adopt a negative strategy in pursuit of withdrawing from less profitable areas of business. IV. A corrective strategy cannot be used in conjunction with, or as one component of, a growth strategy. (a) Only (III) above (b) Both (I) and (II) above (c) Both (II) and (III) above (d) (I), (II) and (III) above (e) All (I), (II), (III) and (IV) above. < Answer > Which of the following is not a part of the internal governance groups of a firm? (a) Shareholders (b) The Board of Directors (c) Media (d) Managerial hierarchy (e) Internal capital markets. Which of the following factors does not figure in when assessing the present value of an investment by the risk< Answer > adjusted discount rate method? (a) Projected future cash flows from the investment (b) Beta of the investment in question (c) Expected return from the tangency portfolio (d) Expected return from the equity shares of the firm (e) Risk free return. Which of the following is used by the ratio comparison approach to the valuation of projects or commercial real< Answer > estate? (a) Ratio of total debt to equity (b) Ratio of total debt to total assets (c) Ratio of price to earnings (d) Ratio of net income to revenues (e) Ratio of revenues to total assets.

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< Answer > Which of the following statements with respect to the real options are not true? I. Investment timing option allows the firm to delay the project until at a later point of time when more information is available. II Growth options allow the firm to alter operations depending on how the conditions change during the life of the project. III. Abandonment options give the firms an option to abandon a project if not profitable. IV. Flexibility options allow a company to increase its capacity of operation if the market conditions are better than expected. (a) Both (I) and (II) above (b) Both (I) and (III) above (c) Both (II) and (III) above (d) Both (II) and (IV) above (e) (I), (II) and (IV) above. According to the trade-off theory of capital structure, the firm attempts to arrive at a trade-off between which of the< Answer > following? (a) Between agency cost and bankruptcy cost (b) Between agency cost and financial cost (c) Between bankruptcy cost and financial cost (d) Between size of the tax shield and bankruptcy costs (e) Between size of the tax shield and agency cost. < Answer > Consider the following data relating to a company: Degree of leverage Overall capitalization rate 0.50 10.00% 0.75 9.25% 1.00 8.75% 1.25 8.25% 1.50 8.00% 1.75 8.25% 2.00 8.75% 2.25 9.25% Which approach to capital structure defines the above pattern? (a) Net income approach (b) Net operating income approach (c) Traditional approach (d) M & M approach (e) Walter approach. < Answer > The term agency costs in the context of capital structure means (a) The commission payable by a company to its purchasing agents (b) The commission payable by a company to its selling agents (c) The expenses incurred in distribution of the products of the company (d) The cost on account of restrictive covenants imposed on a company by its lenders (e) The dividends paid by a company to its shareholders. For a firm, if the current ratio remains constant and the quick ratio decreases during the same period, then, which of< Answer > the following is indicated for the firm (a) The proportion of total debt relative to total assets is decreasing (b) The proportion of total debt relative to net worth is decreasing (c) The proportion of net worth relative to total assets is increasing (d) The liquidity is decreasing (e) The profitability is increasing.

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Which of the following statements is/are false with respect to different model for maximizing shareholders’ value? < Answer > I. According to Marakon model, a firm’s value is measured by the ratio of its book value to the economic value. II. According to Alcar model, for ascertaining the value generating capability of a strategy, the value of firm’s equity without the strategy is compared to the value of the firm’s equity if the strategy is implemented. III. McKinsey model focuses on the identification of key value drivers at various levels of the organization. (a) Only (I) above (b) Only (II) above (c) Both (I) and (II) above (d) Both (II) and (III) above (e) All (I), (II) and (III) above. Kohinoor Steel earns 10% on the equity and the growth rate of dividends and earnings is 5%. The book value per< Answer > share is Rs.80. If the market price of the shares of Kohinoor Steel is Rs.70, according to the Marakon model, the cost of equity is approximately (a) 9.67% (b) 10.71% (c) 12.45% (d) 13.78% (e) 14.67%. < Answer > Which of the following is a ‘value driver’ that affects the value of a firm according to Alcar Model? (a) Dividend payout (b) Value growth duration (c) Sales (d) Growth rate of dividends (e) Book value of the firm. < Answer > Which of the following is/are the assumptions of multiple discriminant analysis? I. There are two discrete groups to be analyzed. II. The independent variables can be combined in a linear manner for discriminating between the two groups. III. The values of the variables are distributed lognormally. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) All (I), (II) and (III) above. Which of the following statements is false with respect to Dutch Auction Tender Offer for share repurchases?

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(a) The firm does not fix any predetermined price (b) The firm may indicate a price band, consisting of floor price and a ceiling price, for the tender offer (c) The tender offer is open for all the shareholders of the firm (d) It is a financial hybrid combining some features of open market and fixed price tender offer (e) Dutch auction is more risky to the management than fixed price premium offers. There are two firms, A Ltd. and B Ltd. They are similar in all respects except that A Ltd. is unlevered, while B Ltd.< Answer > has Rs.4 crore of 11% debentures outstanding. Both companies have a net operating income of Rs.1 crore each. The tax rate applicable to both the companies is 35%. The discount rate for both the companies is 10% p.a. The value of firm B, considering Modigliani-Miller position on leverage holds good is (a) Rs.1 crore (b) Rs.3.5 crore (c) Rs.6.5 crore (d) Rs.7.90 crore (e) Rs.8.30 crore.

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Rohan Industries Ltd.(RIL) follows a strict residual dividend policy. The company has a capital budget of< Answer > Rs.80,00,000 and it wants to maintain the present D/E ratio even after the capital budget proposal. RIL forecasts that its net income will be Rs.30,00,000. If it has the dividend pay out ratio of 20%, what will be the targeted D/E ratio of the company? (a) 2.33 (b) 3.00 (c) 3.33 (d) 3.56 (e) 4.67. < Answer > Which of the following is true regarding the effect on return on equity, others things remaining constant? (a) Greater the amount of sales, lower the return on equity (b) Lower the equity multiplier, lower the return on equity (c) Higher the assets turnover, lower the return on equity (d) Lower the debt-assets ratio, higher the return on equity (e) Higher the return on assets, lower the return on equity. < Answer > Consider the following information of ABC Ltd.: Dividend per share Dividend cover Number of outstanding shares Net profit margin Total assets

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Rs.4 5 10,000 10% Rs.10,00,000

The asset turnover ratio for the company is (a) 1.25 (b) 1.50 (c) 2.00 (d) 2.50 (e) 4.00. Aditya Industries Ltd. is targeting at an EPS of Rs.3 per share for next year. The firm has 1,00,000 shares< Answer > outstanding. It is expected to have the sales revenue of Rs.12,00,000 for the next year. Its estimated fixed costs are Rs.1,50,000 and it’s target D/E ratio is 2:1. It pays 12% interest on debt and it falls under the tax bracket of 30%. It has total assets of Rs.15,00,000. What should be the percentage of its variable cost to sales to achieve its targeted EPS? (a) 35.56% (b) 38.58% (c) 41.79% (d) 45.77% (e) 49.67%. Which of the following models is based on numerical assessment of the firms’ weakness which is classified as< Answer > defects, mistakes and symptoms? (a) Beaver Model (b) The Wilcox Model (c) Blum Marc’s Failing Company Model (d) Altman’s Z score Model (e) Argenti Score Board. < Answer > High asset turnover ratio indicates (a) Large amount of investment in the fixed assets (b) Large amount of investment in the current assets (c) Large amount of sales value in comparison to total assets (d) Inefficient utilization of the assets (e) High debt-equity ratio.

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Which of the following is/are not assumption(s) of the Baumol model? I. The cash requirement for the period under consideration is constant and known. II. Cash expenses are incurred evenly over the period under consideration. III. There are no transaction costs involved in the conversion of securities into cash. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (II) and (III) above.

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Jyothi Industries Ltd. has annual sales of Rs.3,65,00,000 (Rs.1,00,000 a day on a 365-day basis). On average, the< Answer > company has Rs.1,20,00,000 in inventory and Rs.80,00,000 in accounts receivable. The company is looking for ways to shorten its net operating cycle, which is calculated on a 365-day basis. Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable. The company anticipates that these policies will also reduce sales by 10%. Accounts payable will remain unchanged. What effect would these policies have on the company’s net operating cycle? (Round off to the nearest whole day) (a) –40 days (b) –32 days (c) –27 days (d) –22 days (e) –18 days. < Answer > Which of the following is not a determinant of the capital structure of a company? (a) Type of asset financed (b) Product life cycle (c) Current capital structure (d) Credit rating (e) Type of raw material used. < Answer > Which of the following statements is/are not true with respect to the certainty equivalent approach? I. It restricts decision makers from introducing their own risk preference directly into the analysis. II. It is preferable to use this approach whenever forward prices are available for estimating future cash flows. III. Under this method, each period’s cash flow can be adjusted separately to account for the specific risk of those cash flows. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (I) and (III) above. < Answer > 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.

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M/S Swapna Enterprises Ltd., an Indian company has a subsidiary in Germany and is exposed to the risk of euro< Answer > weakening and the value of its assets, liabilities, and profit contributions declining in rupee terms in its consolidated financial statements. The company is exposed to which of the following risks? (a) Transaction risk (b) Translation risk (c) Economic risk (d) Interest rate risk (e) Market risk. < Answer > Which of the following are the tasks to be performed by the risk managers while managing environmental risks? I. Minimize the probability of occurrence of an adverse event such as an accident. II. Cut the cost when an accident occurs. III. Shift responsibility to other parties to the extent possible, when the event occurs. IV. Obtain more information to make risk assessment methodology as robust as possible. (a) Both (I) and (II) above (b) Both (III) and (IV) above (c) (I), (II) and (IV) above (d) (II), (III) and (IV) above (e) All (I), (II), (III), and (IV) above. According to the Walter Model, if r is the internal rate of return, g is the growth rate and ke is the cost of capital,< Answer > under which of the following conditions the optimal payout ratio is 100%? (a) r = ke (b) r < ke (c) r > ke (d) g > ke (e) g = ke. < Answer > Which of the following statements regarding bankruptcy models is/are true? I. According to Wilcox model, the net liquidation value of the firm is the best indicator of the financial health of the firm. II. Blum Marc’s failing company model is based on liquidity ratios only. III. According to the Beaver model, the ratio of cash flow to total debt is the single best predictor of corporate failure. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) All (I), (II) and (III) above.

END OF SECTION A

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

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.

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The information pertaining to the Hitech Industries Ltd.(HIL) for the year ending on 31st March, 2007 is as follows: Sales Net profit Net worth Dividend per share Share capital (face value Rs.10 per share). Cost of equity

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Rs.924.54 million Rs.384.84 million Rs.1593.25 million Re.1 Rs.587.5 million 21.5%

For the financial year 2007-2008, the earnings per share and the dividend per share are anticipated to be consistent with the sustainable growth rate. Current market price of the company is consistent with P/E ratio derived from fundamentals. You are required to a. Calculate the price of share as on 31st March 2007, assuming that perpetual dividend growth model holds good. b. Determine the post-issue share price, if during financial year 2007-08, the firm plans to shift to the policy of 100 percent dividend payout and decides to issue required shares for financing the increase in dividend expenses. The pre-issue capital appreciation for the year 2007-08 is to the extent of current growth rate. Dividend payment and new issue take place on 31st March 2008. Assume that M & M hypothesis on dividend policy holds good. c. Determine the growth rate that is consistent with the P/E ratio of the company’s post issue price as on 31st March 2008 derived in part (b), if perpetual dividend growth model holds good. (4 + 6 + 2 = 12 marks) 2.

L.C. Gupta’s model was the first Indian model proposed to predict failure. From the following Income statement and Balance sheet of Moti Labs Ltd. for the year 2005-06 and 2006-07, calculate the profitability ratios and balance sheet ratios of the company for both years as per the L.C. Gupta model. Financial Statements of Moti Labs Ltd. Income Statement for the year ending on (Rs. in Millions) 31st March, 2007 Income Net Sales Other Income A. Operating Income Expenses Material Consumed Manufacturing Expenses Personnel Expenses Selling Expenses Administrative Expenses B. Cost Of Sales Operating Profit (A-B) Other Recurring Income PBDIT Interest Expenses Depreciation Other Write offs PBT Tax Charges Non Recurring gains

31st March, 2006

18421.85 808.44 19,230.29

14372.65 230.01 14,602.66

10,136.62 1,528.18 952.49 1,382.16 1,007.04 15,006.49 4,223.80 218.23 4,442.03 134.75 402.84 0.99 3,903.45 877.50 40.96

7,419.47 1,234.44 734.63 1,171.15 848.86 11,408.55 3,194.11 130.87 3,324.98 44.84 283.56 0.66 2,995.92 647.50 129.02

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Other Non Cash adjustments Reported PAT Appropriations: Equity Dividend Preference Dividend Retained Earnings

0.00 3,066.91

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899.58 0.00 1,941.07

599.72 0.00 1,800.88

Balance Sheet as on (Rs. in Millions) 31 March, 2007 31st March, 2006 st

SOURCES OF FUNDS Owner's Fund Equity Share Capital (Face Value Rs.10) Share Application Money Preference Share Capital Reserves & Surplus Loan Funds Secured Loans Unsecured Loans Total USES OF FUNDS Fixed Assets Gross Block Less : Revaluation Reserve Less: Accumulated Depreciation Net Block Capital Work-in-progress Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written off Total

599.72 0.02 0.00 11,938.95

599.72 0.00 0.00 9,997.88

305.99 1,799.85 14,644.53

288.86 658.97 11,545.43

7,407.91 101.83 1,932.30 5,373.78 560.11 1,803.69

5,169.83 103.19 1,459.35 3,607.29 288.35 1,265.94

14,362.30 7,455.35 6,906.95 0.00 14,644.53

12,910.99 6,528.13 6,382.86 0.99 11,545.43 (6 marks)

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Excel Products Ltd. is a manufacturer of household goods. Presently it is planning to manufacture an automatic dishwasher. The investment required for manufacturing and marketing the new product is Rs.250 lakh. The investment-planning horizon is five years at the end of which it is estimated that the project will have a salvage value of Rs.20 lakh. The projected unlevered operating cash flows from the project are: Rs.200 lakh at the end of each of the first and second years respectively, and Rs.300 lakh at the end of each of the third, fourth and fifth years respectively. However these operating cash flows as well as the salvage value are uncertain and the actual unlevered cash flows may be less than the projections, especially in the later years. The uncertainty of the cash flows is to be factored in by the certainty equivalent method and the certainty equivalent factors for the various years are as follows: Year 0

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The project enhances the debt capacity of the firm in the first year as well as the second year by Rs.75 lakh, and in the third, fourth and fifth years by Rs.50 lakh. The interest rate on the borrowings of the company is expected to be 8% and the tax rate applicable is 36% for the entire investment horizon. The interest rate on risk free securities is 6%. It is assumed that the company will utilize all its tax shields with certainty.

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You are required to calculate the NPV of the investment.

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(7 marks)

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

The caselet says that the target costing can yield important benefits to the success of the new product/service development efforts. Explain the benefits of target costing.

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(7 marks) 5.

As mentioned in the caselet, after the determination of target cost, the achievement of the same is central to the success of new products and services. In this context, explain the various steps involved in the process of achieving the target cost.

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(7 marks) Target costing is different from a simple spending control mechanism, in so far as you determine market-based prices for envelopes of features based upon market and competitive conditions, in which price/volume relationships are examined, then subtract the required margin to determine the product or service level target cost. Such aggregate level target costs can be useful in designing your value delivery processes and determining the relative cost contribution of people, process and technology elements in such a manner to achieve your target cost before costs are incurred. Managing target costs can be viewed at a unit level and from the framework of product life-cycle costs, as well as from a portfolio perspective. It is this central algorithm (market price minus margin = target cost), which contributes to the definition of target costing as a profit and cost planning system. In this regard, cost becomes a dependent variable. Target costing can yield important benefits to the success of new product/service development efforts. Target costing also provides a way for your company to target cost reductions in its major cost categories by focusing on major "design drivers" that influence costs and on the cost of support processes. Frequently the benefits of such efforts can be applied across product lines. The most robust target costing processes seamlessly integrate strategic business and profit planning, competitive research and analysis, market research and customer requirements, research and development, technology advances and product development. These processes establish product and service strategies, which help to determine market niches, market share objectives and market volumes. Product portfolio and profit plans developed in business planning cycle can provide strategic summary schedules for product development, introduction and replacement, and capital investments. The target costing process is a logical outgrowth of determining the causes of cost and seeking ways to reduce or eliminate those costs before production costs were incurred, while simultaneously looking to improve quality and customer satisfaction. The target costing process is based upon systems theory and can be integrated into your New Product Development (NPD) process. It is an important contributor to NPD success. Determining the product or service concept and the relevant market niche is the first phase of the process. Key determinants of the concept include the business focus of the enterprise (strategy articulation), understanding the competitive conditions (competitive research), understanding customers' preferences as well as economic conditions in relevant markets (market research). After determining the target cost, achieving target cost is central to the success of new products and services. Key to the process is creating development plans which interact with the multi-year product and service, profit and cost plans. Design teams focus on the concurrent design of products or services and processes. Frequent checks of the parameters of the plan based upon anticipated, simulated and/or actual results are applied during the development process. Design reviews which focus on quality, cost and profitability are included in the check cycle. In conclusion, it can be said that although target costing in its simplest form is merely a calculation i.e., market price minus margin; today's competitive environment can make target costing an indispensable, strategic management technique. It can be successfully integrated into your current NPD and portfolio management processes to provide your firm with economic and strategic benefits. A key element to consider is the benefit of abandoning projects, which will not be economically viable in today’s competitive markets, and focusing typically limited resources on those opportunities, which will provide adequate returns to the company.

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

What is Enterprise Risk Management (ERM)? What does it aim to achieve?

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(6 marks) 7.

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What are the attributes involved in the discipline of managing risk? (5 marks)

A major reason the managers are frustrated with their progress on Enterprise Risk Management (ERM) is because they believe they don’t have adequate tools. This is particularly the case when it comes to risk modeling, developing probability distributions of outcomes that represent the uncertainty associated with specific risk factors. Illustration to explain the linkages between risk, risk management, risk capital and ERM consider the classic statistical example of a cookie jar full of white and black marbles. If there is a penalty for drawing a black marble from the jar, the draw of a black marble is risk. Risk management seeks to understand the full penalty for drawing the black marble as well as the likelihood that such a draw will occur. Risk capital calculations assure that if you draw a black marble or perhaps several in a row, you will survive the events. ERM finds the best way to put your hand into the cookie jar, so to speak. ERM, taking the pillars of a Basel II approach, then looks at the interaction of business lines, through dynamic, forward-looking scenarios and seeks to structure a firm in a manner to maximize its performance relative to its risk appetite. Achieving this requires both an understanding of how business lines operate as well as how they interact with each other and their competitive space. ERM would analyze the likely impact on both revenues and capital to determine if the merger made sense. This would then lead to an analysis of what the optimal combination of the three businesses might be going forward, if any and allocating risk-taking authority (risk capital) in such a fashion as to maximize the firm's anticipated risk-adjusted performance. It is quite conceivable that the three entities would produce a better risk-adjusted return for the merged entity if their sizes towards going forward were quite different. In other words, ERM helps to not only determine if a merger makes sense, but where the combined capital of the three entities is best deployed. This is exactly the same analysis that is done at any business with multiple existing business lines. Again, the goals of ERM are no different than those of existing managerial sciences, but are a vast improvement because of the emphasis on improving the understanding of one's own business through modeling, discipline and education.

END OF SECTION B

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

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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.

A corporate body can face risks arising out of a variety of sources in the dynamic business environment. In order to achieve its objective of maximizing the wealth of the shareholders every corporate body must effectively manage the risks it faces. Explain the various approaches to risk management that may be adopted by a corporate body.

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(10 marks) 9

Though the use of real options had brought in significant advantages in creating a project, still there exist some pitfalls in their usage. Discuss. (10 marks)

END OF SECTION C

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END OF QUESTION PAPER

Suggested Answers Strategic Financial Management (MB361F) : April 2007 Section A : Basic Concepts 1.

Answer : (d) Reason : A company might pursue a non-growth strategy if its non-economic objectives are more important than its economic objectives. Statement (I) is true. A non-growth strategy is bound to be a corrective strategy. Statement (II) is true. A company can adopt a negative strategy in pursuit of withdrawing from less profitable areas of business. Statement (III) is true. A corrective strategy can be used in conjunction with, or as one component of, a growth strategy. Statement (IV) is not true. Hence (d) is the answer.

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Answer : (c) Reason : Media is part of external governance groups of a firm. Hence (c) is the answer.

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Answer : (d) Reason : Expected return from the equity shares of the firm does not figure out when assessing the present value of an investment by the risk adjusted discount rate method. Answer : (c) Reason : Ratio of price to earnings is used by the ratio comparison approach to the valuation of projects or commercial real estate. Answer : (d) Reason : Investment Timing Option allows the firm to delay the project until at a later point of time when more information is available. Growth options allow a company to increase its capacity of operation if the market conditions are better than expected. Abandonment Options give the firms an option to abandon a project if not profitable. Flexibility options allow the firm to alter operations depending on how the conditions change during the life of the project. Hence (d) is the answer.

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Answer : (d) Reason : According to the trade-off theory of capital structure the firm attempts to arrive at a trade-off between size of the tax shield and bankruptcy costs.

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Answer : (c) Reason : The above trend shows that the overall capitalization rate first decreased and then increased. This is according to the traditional approach. According to net income approach, the overall capitalization rate steadily decreases and reaches a point – but does not increase while according to net operating income approach, it remains constant. Finally, according to MM approach, the overall capitalization rate is independent of the degree of leverage.

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Answer : (d) Reason : Agency cost are cost on account of restriction imposed by creditors on the firm in the form of some protective covenants. Commission payable by the company to its purchasing and selling agents , the expenses incurred in distribution of the products of the company, or the dividends paid by the company does not come under the agency cost.

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Answer : (d) Reason : Current ratio is defined as the ratio between the current assets and current liabilities. While Quick Ratio is calculated by dividing current assets minus inventories by current liabilities. Now, among the components of the current assets, inventories are the least liquid instruments. So, a decreasing quick ratio and same value of the current ratio implies the increasing volume of inventory, thereby indicating the decreasing level of liquidity.

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Answer : (a) Reason : Statement I is not correct. According to Marakon model, a firm’s value is measured by the ratio of its market value to the book value. Other both statements are correct with respect to different models of maximizing value of shareholders. Hence the correct answer is (a). Answer : (b)

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Reason : P0 =

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B(r − g) K −g

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80 ( 0.1 − 0.05 ) ( 0.01x − 0.05 )

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0.7 x – 3.5 = 4 10.71%.

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. Answer : (d) Reason : The assumptions of multiple discriminant analysis are : (1) There are two discrete groups to be analysed (2) The independent variables can be analysed in a linear manner for discriminating between two groups. (3) The values of the variables are distributed normally. Hence statement III is not an assumption of multiple discriminant analysis. So the correct option is (d). Answer : (e) Reason: Dutch auction are less riskier to the management than fixed price premium offers. All the shares repurchased receive a uniform price may induce some shareholders to submit their offers at very low ask prices to ensure their accepteance in the auction. This would benefit the firm by reducing the final repurchase price. It eliminates those shareholders who assign relatively lower valuatoins to the stock. All other options are true with respect to Dutch option tender offer. Answer : (d) Reason:

O(1 − t) k Value of B Ltd. = +B×t

= = =

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1× 0.65 0.10 + 0.35 × 4

6.50 + 1.40 Rs.7.90 crores

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Answer : (a) Reason : Dividend pay out ratio Dividends = Rs.30,00,000 × 20% = Rs.6,00,000 Income retained = Rs.30,00,000 – Rs.6,00,000 = Rs.24,00,000 Capital budget = Rs.80,00,000 Capital budget proposal to be financed with debt = Rs.80,00,000 - Rs.24,00,000 = Rs.56,00,000 D/E ratio = Rs.56,00,000/ Rs.24,00,000 = 2.33

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17.

Answer : (b) Reason: Du Pont equation for return on equity is:

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Sales Average assets Return on Equity (ROE) = Net profit × × Sales Average assets Average equity

The third component of the equation is called equity multiplier. Thus, higher the assets turnover ratio, higher the equity multiplier, higher the debt-assets ratio, higher the return on assets, higher will be the return on equity. Hence, (c), (d) and (e) are not correct and (b) is correct. Return on equity does not depend on sales. Hence, (a) is also not true. 18.

Answer: (c) Reason: Dividend cover = EPS/DPS Therefore EPS = 20

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(20)(10,000)/0.10 = 2 10, 00, 000 Therefore, Option (c) is the correct answer.

Asset turnover ratio =

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Answer : (c) Reason : EPS = [(Sales – Variable costs – Fixed costs – Interest ) × (1 – tax rate)] / Number of shares outstanding. Step 1: Calculate interest expense. Amount of debt = 2/3 × 15,00,000 = Rs.10,00,000 Step 2:

Interest expense = 10,00,000 × 0.12 = Rs.1,20,000. Solve for EPS EPS = 3 = [(12,00,000 – Variable cost – 150,000 – 1,20,000) × (1 – 0.3)]/1,00,000 3 = [(6,51,000 – 0.7 Variable cost)]/1,00,000 3,00,000 = 6,51,000 – 0.7 Variable cost 3,51,000 = 0.7 Variable cost Variable cost = 3,51,000/0.7= Rs.5,01,428.57 % of Variable cost to Sales = (Rs.5,01,428.57/Rs.12,00,000) ×100 =41.79%.

20. 21.

Answer : Reason: Answer : Reason :

(e) Argenti Score Card is classified in three weakness namely defects, mistakes and symptoms. (c) Asset turnover of a company is defined as the ratio between the sales value and total assets. High asset turnover is possible only when a company can generate a high sales volume in comparison to the amount invested in the fixed assets and current assets.

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22.

Answer : (c) Reason : There are two costs involved - Holding costs and transaction costs. Holding costs are in the form of interest forregone on cash balance held, and trasaction costs are costs incurred in converting securities into cash. Hence, statement (III) is wrong as there are transaction costs involved in the converting securities into cash. Hence, option (c) is the correct answer.

23.

Answer : (d) Reason : Net operating cycle = Inventory conversion period + Receivables collection period – Payables deferral period For this problem, we are only interested in the change in the net operating cycle. We may therefore ignore the payables deferral period, since it is assumed to remain unchanged. Old operating cycle (ignore payables) = Rs.1,20,00,000/Rs.1,00,000 + Rs.80,00,000/Rs.1,00,000 = 120 + 80 = 200 days. New operating cycle = Rs.96,00,000/Rs.90,000 + Rs.64,00,000/Rs.90,000 = 106.67 + 71.11 = 177.78 days. Change in operating cycle = New operating cycle – Old operating cycle = 177.78 – 200 = -22.22 days. Round off to 22 days shorter.

24.

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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25.

Answer : (a) Reason : The certainty equivalent approach provides a clear basis for making decisions, because the decision maker can introduce their own risk preference directly into the analysis. Hence, statement (I) is false. Whenever there is the availability of the forward prices for estimating the future cash flows it is preferable to use the certainty equivalent method. Hence, statement (II) is true. Under this method, each period’s cash flow can be adjusted separately to account for the specific risk of those cash flows. Hence, statement (III) is true. Hence, option (a) is the correct answer.

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26.

Answer : (d)

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Reason : WCL

27.

28.

=

CA CA = NFA + CA + ∆CA TA + ∆CA

=

150 = 150 = 150 = 0.652 . 200 + 30 230 50 + 150 + 150 x 0.2

Answer : (b) Reason : The example given in the question is of translation risk. The risk arises from the translation of balance sheets and income statements in foreign currencies to the currency of the parent company for financial reporting purposes. Hence (b) is the answer. Answer : (e) Reason : All the four tasks have to be performed by the risk managers while managing environmental risks.

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29.

Answer : (b) Reason : According to Walter model on dividend policy, if the internal rate of return is less then the cost of capital then the optimal payout ratio is 100%.

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30.

Answer : (d) Reason : The Wilcox model considers the net liquidation value of the firm as the best indicator of a firm’s financial health. Blum Marc’s failing company model is based on a set of 12 ratios divided into liquidity, profitability and variability ratios. The Beaver model identifies the cash flow to total debt as the single best indicator of a firm’s financial health.

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Section B : Problems 1.

a.

Net Pr ofit m arg in = Re turn on equity = EPS =

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384.84 = 41.63% 924.54

384.84 = 24.15% 1593.25

384.84 = Rs. 6.55 58.75

1 = 15.27% 6.55 Retention ratio = 1-0.1527 = 0.8473 Dividend pay out ratio =

g = ROE × b = 0.2415 × 0.8473 = 20.46% P/E ratio of the company as on 31st March 2007 =

(1 − b )(1 + g ) Ke − g

=

0.1527 × 1.2046 = 17.68 0.215 − 0.2046

The estimated price of share as on 31 March 2007 = 17.68 × 6.55 = 115.8 As given, the firm will have to issue new shares to finance its growth if it switches to a cent percent payout policy. The growth rate of dividends tends to decline when the amount of retained earnings decreases every year. On the basis of the current dividend payout policy, the price of the stock for the subsequent year can be obtained by multiplying the growth rate of 20.46 percent with the intrinsic value of Rs.115.804, which gives Rs.139.50. At March 2008, if the number of original shares outstanding is taken to be n1, the market value of the company shall be Rs 139.50n1. As per the revised policy, new shares numbering n2 will be issued to compensate for the amount distributed out of retained earnings. This compensation will be equivalent to the Rs 6.69 (5.55 × 1.2046) per original share (the difference of Rs. 7.89 and Rs 1.2046), an aggregate loss of Rs 6.69n1. The quantity of the new shares being n2 and with P1 as the price of the share at 31st March 2008 under the revised policy n2P1 = 6.69n1…(1) At the same time, as the total value of the firm does not get changed, i.e 139.5n1 = P1(n1 + n2)…(2) These two equations are to be solved to give the value of P1. By substituting P1 = 6.69n1/n2 in the other equation, we get, 139.50n1 = 6.69n1/n2 (n1 + n2), 139.50n2 = 6.69(n1 + n2) = 6.69n1+ 6.69n2, 20.855n2 = n1 + n2, n1 = 19.85n2 When this relation between n1 and n2 is again substituted in n2P1 = 6.69n1, we get st

b.

c.

n2P1 = 6.69 x 19.85n2, ∴ P1 = Rs 132.80. P/E ratio of the company as on 31st March 2008 = 132.80 / 7.89 = 16.83 1(1 + g ) 0.215 − g

∴

16.83 =

∴

3.6185 – 16.83g = 1+g

∴ ∴

2.

17.83g = 2.6185 g = 14.69%.

Profitability ratios: i. EBDIT/ NET SALES = for the year 2006 = 3324.98/ 14372.65 = 0.231 for the year 2007 = 4,442.03/ 18421.85 =0.241 ii. OCF/ SALES = ( Net profit + depreciation + other write offs)/net sales for the year 2006 = ( 2,477.44 + 283.56 + 0.66)/ 14372.65 = 0.192 for the year 2007 = (3,066.91 + 402.84 +0.99)/ 18421.85 = .188 iii. EBDIT / (TOTAL ASSETS +ACCUMULATED DEPRECIATION) = for the year 2006 = 3324.98/ (18073.56+1,459.35) = 0.1702 for the year 2007 = 4,442.03 /( 22099.88+ 1932.30) =0.1848 iv. OCF/ TOTAL ASSETS = ( Net profit + depreciation + other write offs) / Total assets for the year 2006 = (2477.44 +283.56+.66) / 18073.56 = 0.152. for the year 2007 = 3,066.91 + 402.84 +0.99/22099.88 =0 .157 v. EBDIT / (INTEREST +0.25 DEBT) = for the year 2006 = 3324.98/ 281.80 = 11.80 for the year 2007 = 4442.03 / 661.21 = 6.71 Balance sheet ratios: i. NET WORTH / TOTAL DEBT for the year 2006 = 10597.6 /7475.96 = 1.42 for the year 2007 = 12538.69 / 9561.19 = 1.31 ii ALL OUTSIDE LIABILITIES/ TANGIBLE ASSETS for the year 2006 = 7475.96 / 18072.58 = 0.414

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for the year 2007 = 9561.19 / 22099.88 = 0.43. < TOP >

3. Year A.

Debt capacity (increase)

B.

Interest (@ 8%)

C.

1

2

3

4

5

75

75

50

50

50

6

6

4

4

4

Interest tax shield = B(1 – 0.36)

3.84

3.84

2.56

2.56

2.56

D.

Projected operating cash flows

200

200

300

300

300

E.

Certainty equivalent

0.90

0.80

0.70

0.60

0.50

F.

CE cash flows = D × E

180

160

210

180

150

G.

Total CE operating cash flows = C + F

183.84

163.84

212.56

182.56

152.56

H.

CE salvage value = 20 × 0.50

I.

Total CE cash flows = G + H

10 183.84

163.84

212.56

182.56

183.84 163.84 212.56 182.56 162.56 + + + + − 250 1.062 1.063 1.064 1.065 NPV = 1.06 = Rs.513.8 lakh.

162.56

As the NPV arrived at after adjusting for uncertainty and tax shields is positive the project can be accepted. 4.

1. 2.

3.

4.

5. 6. 5.

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. Target costing reduces the development cycle of a product. Costs can be targeted at the time when the product is being designed, by including the functional personnel from the manufacturing and finance departments to ensure that all avenues of cost reduction are explored and that the product is designed for manufacturability at an early stage of development. 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 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. This helps the company to achieve its target market share goals. 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.

•

Prepare Development Plan One of the first steps in developing new products or services is to develop a plan including such elements as identification of key customers and suppliers or partners, project management and organization, budgets, information and tooling required and any other required changes in infrastructure.

•

Check Feasibility Once these efforts are complete, initial cost, quality and cycle time estimates are prepared. Then the plan is reviewed to ensure the product or service is still viable. If not, plans are revised and checked again.

•

Design product, service and processes Target cost is achieved through the design of product or service elements and processes that satisfy quality, cost, and time targets. Target cost goals are achieved by evaluating the entire cost structure of the company or value chain. For manufacturing companies, this is accomplished by applying value engineering to influence design-related cost drivers and process improvement methods to influence the cost and quality of other processes in the company or value chain. Activity-Based Costing (ABC) can be used to better understand the true costs of processes. Outsourcing options may also be considered to reduce the total cost of products and services.

•

Establishing a market value for new product or service features, functions and quality levels is not easy. Conjoint analysis can be applied to understand perceived customer value and then translate these into an engineering view of the product or service. One of the ways that product or service level target cost can be decomposed to the elements of the product or service is through the proportional use of perceived value from customers.

•

Pre-production/delivery preparation This preparation process is important to identify and eliminate problems before they occur in the full-scale product production or service delivery. Production schedules and sales, distribution and service plans are finalized. Members of the value chain are trained in pertinent new processes, techniques and control methods. Tests may be conducted and processes checked to ensure that they satisfy requirements for quality, cost and cycle time.

•

Produce/deliver products or services This process provides the intended products or services to the market place. In the production phase of the product or service life cycle, target costing and its supporting tools can be applied to focus cost reduction efforts. Frequently this effort is also referred to as kaizen costing. This can be particularly valuable when such efforts may provide cost reductions across multiple models or services through new technology or new process

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approaches. •

Check results Production process results are monitored to control quality and cycle time. Market place results such as sales, unit cost, customer satisfaction, etc., are evaluated. If results do not match expectations, remedial efforts are examined and implemented.

6.

Businesses face a lot of risks. Risks range from those arising due to changes in interest rates and exchange rates to risks like terrorist attacks. ERM is a tool that allows organizations to examine all the risk they face, measure the potential impact of those risks on the long-term viability of the company, and take appropriate steps to manage or mitigate those risks. Managing all the risks the organization has to face in an integrated manner is the essence of enterprise risk management (ERM). In addition to the coherence in risk management for the organization as whole, ERM offers other advantages. It helps in identifying the risks that may offset each other and need not be hedged for individually in reducing the costs. To deal proactively with financial, operational and strategic risks, organizations can adopt ERM.

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The range of risks most business face include hazard risk, such as property damage and theft; financial risks, such as interest rate and foreign exchange fluctuations; operational risks, such as supply chain problems or cost overruns; and strategic risks, such as misaligned products. The ERM is trying to address all those risks in an integrated fashion. It greatly expands the company’s definition of risk to include anything that threatens the organization’s continuity. This approach also divides the concept of risk into those risks that can help a company to grow and those that will only lead to loss. 7.

Managing risk demands more intuitive inklings of uncertainty, threats and opportunities. Managing risk well requires 1. 2. 3. 4.

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Insight assessments of threatened losses and potential gains. Awareness of strategies for dealing with these threats and opportunities. Ability to choose and implement the most promising of these strategies. And objectivity in reviewing results and adapting to change.

These four qualities are attributes that most persons naturally possess to some degree. The discipline called risk management seeks to refine these qualities and to identify and enhance specific skills so that they can be taught and passed across continents and from one generation to the next.

Section C: Applied Theory 8.

Approaches to risk Management 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

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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 its 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 business 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 transfer 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 holdharmless 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 even be retained unconsciously when the presence of risk is not recognized. It is very important to distinguish between the risk 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. This technique is a combination of risk retention and risk transfer. Under this technique, a particulars 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 contra ct, 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. 9.

Drawbacks of using Real Option Analysis Though the use of real options had brought in considerable advantages in creating a project, still there exists some pitfalls in their usage.these pitfalls can broadly be categorized under the following: Using the real option analysis when one should not use them. Framing a wrong model for the purpose of valuation. Using incorrect data and biased judgments in the model. Miscalculation in the process of valuation. a. Using real option analysis when one should not Real option analysis takes into account a number of assumptions. One basic assumption of real option is that the relevant uncertainties are random walks and as a result are unforeseeable. Coupled with this, it also states that the consumer is the price taker, and decision taken by the consumer can change the future course of the random walk. Such assumptions are in fact violated if there exists a small number of leading competitors. In this case the decisions may not be random. Each player’s action can influence the price of all the players who will take decisions with full knowledge of what the possible counter moves will be for every other player. The other assumption the option theory makes is that the risks of an option can be hedged away. If hedging is feasible the option will be priced as if it had been hedged, in which case the risk is risk-free. If it is given that hedging is indeed possible it does not matter whether any one option is actually hedged or not. b. Using the wrong real option model It is easy to wrongly assume that the actual decisions pertaining to the project is “Like” a given real option model while in reality it is “Unlike” so. Thus picking up a wrong model can be disastrous. Say for example, if one has assumed that the interest rates are fixed, should it change the decisions to a large extent if the interest rates were truly variable. If one bases his assumption that the prices of oil and gas are independent of each other, how can it, in any way, influence the decision if they were linked by some economic mechanism. c. Miscalculation in the data inputs It is important to understand the drivers of the option value in any specific real option model. One needs to check the model for sensitivity to the associated variables, try to understand how the errors in the variables could result in based results. Say for example, the value of the call option is increased in the time to expiry and the volatility of the underlying asset is increased. As far as this is concerned it is important to note that one has over-estimated the length of the available time, or what could be the smallest possible estimate one could use for volatility? d. Getting both the models of the data right, but making mistakes in the solution It may sometimes happen, that while using the complete mathematical algorithm, one can easily miss an important variable. While calculating the option value, one may notice that the calculated option values are exploding towards plus or minus infinity, or are oscillating between the two. The results of option valuation are sometimes in conflict with common sense approach. Nevertheless, it is important to make as many logical checks as possible to ensure that these results are commensurate with the economic rationality. < TOP OF THE DOCUMENT >

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