Mb361f-jan 05

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

The most commonly held view of capital structure is that the weighted average cost of capital (a) (b) (c) (d) (e)

2.

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 >

Declines steadily as more debt is used First declines with moderate amounts of leverage and then increases Increases proportionately with increases in leverage Is unaffected by the level of debt used Is minimized at a balanced capital structure of 50% equity and 50% debt. < Answer >

Consider the following information relating to Glenco Ltd : EBIT Depreciation Interest on debt Annual loan installment Tax rate

= = = = =

Rs.20 crore Rs.3 crore Rs.3 crore Rs.2 crore 35%

The fixed charges coverage ratio of the company is (a) 2.50 3.

(b) 3.33

(c) 3.78

(d) 10.00 (e) None of the above.

When there is a capacity constraint in the transferor division, the transfer pricing can be ideally done by

< Answer >

(a) Market price (b) Marginal cost (c) Shadow price (d) Full cost pricing based on actual cost (e) Marginal cost + Lumpsum annual payment. 4.

Low cost product strategy is used by Nirma in detergents, Ruf & Tuf in denims and Akai in television. This strategy of pricing low, falls under which of the following costing techniques? (a) Life cycle costing (b) Target costing (d) Activity based costing

5.

6.

(d) 8.19%

(b) Rs.1,900

(c) Rs.2,167

(d) Rs.2,500

(e) 7.73%. < Answer >

(e) Rs.2,833.

The average collection period of a company is 40 days. If the average receivables balance is Rs.20 lakhs, the sales of the company, assuming 360 days in a year, is (b) Rs. 90 lakhs

(c) Rs.120 lakhs

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The weights based on the book values are difficult to estimate while calculating the weighted average cost of capital 1

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(d) Rs.180 lakhs (e) Rs.210 lakhs.

In the calculation of the weighted average cost of capital, why are the weights based on the market values preferred to weights based on book values? (a)

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Market risk Marketability risk Business risk Financial risk Exchange risk.

(a) Rs. 60 lakhs 9.

(c) 15.00%

The risk that arises out of the assets of a firm being not readily marketable is called (a) (b) (c) (d) (e)

8.

(b) 15.81%

Given total debt-equity ratio = 5:4; total assets = Rs.4,500; short-term debt = Rs.600 and total debt consists only of long-term debt and short-term debt, the long-term debt is equal to (a) Rs.1,567

7.

(c) Quality costing (e) Value chain analysis.

If the dividend per share for the year is Rs.2.00, growth rate of dividends is 12% and the present market price of the stock is Rs.52.50, the required return on the stock will be (a) 16.27%

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(b) Weights based on the market values are fairly constant in nature (c) Weights based on the book values have a high degree of volatility (d) Book values are historical in nature and may not reflect the true economic values as compared to market values (e) Data on market values are always available whereas data on book values are not always available . 10. According to Pecking Order Theory of financing, which of the following orders of financing is most preferable for a firm? (a) (b) (c) (d) (e)

Debenture, preference capital, fresh equity, retained earnings Fresh equity, preference capital, debenture, retained earnings Retained earnings, fresh equity, debenture, preference capital Fresh equity, retained earnings, preference capital, debenture Retained earnings, debenture, preference capital, fresh equity.

11. Which of the following models on dividend policy stresses on the investor’s preference for the current dividends? (a) (b) (c) (d) (e)

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A manifestation of the transaction motive A manifestation of the speculative motive A manifestation of the precautionary motive A characteristic of large firms only A characteristic of small firms only. < Answer >

14. In the presence of floatation costs, the cost of external equity is (a) (b) (c) (d) (e)

More than the cost of existing equity capital Less than the cost of existing equity capital Equal to the cost of existing equity capital Equal to the cost of long-term debt Equal to the cost of short-term debt.

15. The equity capital and total debt of Super Industries Ltd. amount to Rs.150 lakhs and Rs.300 lakhs respectively. The earnings before interest and taxes of the company amount to Rs.90 lakhs. The return on investment of the company is (a) 10%

(b) 12%

(c) 15%

(d) 20%

(a) 0.37

(b) 0.44

(c) 0.56

(d) 0.63

< Answer >

(e) 30%.

16. If the net profit margin is 12.50%, asset turnover ratio is 0.85 and return on networth is 24% then, the debt-asset ratio is approximately

< Answer >

(e) 0.97.

17. The debt-asset ratio of a company is 1:3. It implies that for every (a) (b) (c) (d) (e)

< Answer >

13.00 percent 13.67 percent 14.34 percent 15.00 percent 15.67 percent.

13. Holding cash balance to meet contingencies is (a) (b) (c) (d) (e)

< Answer >

Traditional Model Walter Model Gordon Model Miller and Modigliani Model Rational expectations model.

12. The current market price of the shares of Tractor India Ltd. is Rs.60. The company recently paid a dividend of Rs.3.00 per share that is expected to grow at a rate of 8 percent. If the floatation cost will be 2 percent of the current market price, what will be the cost of external equity to Tractor India? (a) (b) (c) (d) (e)

< Answer >

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3 rupees of assets there is 1 rupee of equity 4 rupees of assets there is 1 rupee of debt 3 rupees of assets there are 2 rupees of debt 2 rupees of equity there is 1 rupee of debt 3 rupees of debt there is 1 rupee of equity.

18. If the current ratio is 2.45 and the ratio of inventories to current liabilities is 0.45, the ratio of inventories to current assets is 2

< Answer >

inventories to current assets is (a) 0.184

(b) 0.225

(c) 0.500

(d) 0.900

(e) 2.000.

19. If the upper limit and lower limit of cash balances are Rs.60,000 and Rs.15,000 respectively, then return point according to Miller and Orr Model is (a) (b) (c) (d) (e)

Rs.20,000 Rs.25,000 Rs.30,000 Rs.45,000 Rs.50,000.

20. Which of the following ratios is not applied in LC Gupta model for prediction of bankruptcy? (a) (b) (c) (d) (e)

< Answer >

The par value of the equity share increases Reserves are capitalized Shareholders proportional ownership changes Book value of equity capital increases Market price of the equity share decreases after a stock split.

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

< Answer >

Operating profit margin Incremental investment in working capital Income tax rate Dividend growth rate Cost of capital.

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 (d) Internal failure costs

(b) Appraisal costs (e) Quality cost.

(a) Introduction

(b) Growth

(c) Maturity

27. Which of the following is a non-financial measure of performance? Return on capital employed Residual Income Employee morale and attitude Net Profit 3

< Answer >

(c) External failure costs

26. During which of the following stages of the product life cycle, the profit margins from a product reach the peak?

(a) (b) (c) (d)

< 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.

24. Which of the following factors is not considered by Alcar model? (a) (b) (c) (d) (e)

< Answer >

1.3% 2.0% 3.1% 3.4% 6.2%.

22. Which of the following is true in the context of stock split? (a) (b) (c) (d) (e)

< Answer >

EBDIT/Net sales Operating cash flow/Total assets Net worth/Total debt Working capital/Total assets Operating cash flow/Sales.

21. If the expected inflation rate increases from 4% to 6%, and if the tax rate applicable to the lender is 35%, the nominal interest rate shall rise by (a) (b) (c) (d) (e)

< Answer >

(d) Saturation

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(e) Decline. < Answer >

(e)

Return on net worth.

28. Which of the following is not a model for predicting sickness of a firm? (a) Beaver Model (c) Altman’s Z Score Model

(b) BCG Matrix (d) Argenti Score Board

(e) Wilcox Model.

29. If the market price per share of Magnificent 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 (b) 14.9 (c) 15.8 (d) 16.0 (e) 16.4. 30. The return on investment of a firm is 14% and cost of equity capital is 12%. According to the Walter Model on dividend policy, in order to maximize the value of the firm, it should (a) (b) (c) (d) (e)

Adopt 100% dividend pay-out policy Not pay dividends at all Be indifferent as to the dividend policy Plough back 50% of profits and pay the rest as dividends Leave the decision of dividend payment to the discretion of Board of Directors. END OF SECTION A

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

2.

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

Prime Products Ltd. (PPL) had issued 15-year tax-free debentures on July 1, 2000 carrying a coupon rate of 10.5 percent payable semiannually. The issue provisions provide for a call option on these debentures after a term of 5 years at a price, which is 6 percent above the nominal value of the debentures. The interest paid by the company on these debentures for the period July 1, 2004 to December 31, 2004 amounted to Rs.1,05,000. Because of a fall in the interest rates, the company is planning to replace these debentures with effect from July 1, 2005, by new debentures carrying a coupon rate of 8.5 percent payable semi-annually and having a maturity period of 10 years. The company expects that the net amount realized from the issue of the new debentures will be equal to the total nominal value of the existing debentures and the issue costs will amount to 1 percent of the net amount realized. It is assumed that the coupon rate and the terms of coupon payment of the new issue reflect the prevailing effective annual rate of interest on the debt securities of the companies similar to PPL. You are required to find out the following: (a) The direct costs associated with the replacement decision. (b) The financial viability of the replacement decision being considered by the firm. (3 + 6 = 9 marks) < Answer > Penta Top Ltd. would like to segregate its client profile into the superior class and inferior class on the basis of the current ratio and net profit margin. Given below is the information relating to 12 accounts consisting of an equal number of superior and inferior clients: Superior clients Inferior clients Client

Current ratio

A B C D E F

1.95 1.75 1.58 1.32 1.80 1.78

Net Profit Margin (%) 25 17 16 20 13 16

Client G H I J K L

Current ratio 0.85 0.62 0.44 0.58 0.62 0.65

Net Profit Margin (%) 22 10 3 9 5 8

From the above information, you are required to estimate the discriminant function that discriminates between superior and inferior clients. (12 marks) < Answer >

Caselet 1 Read the following caselet carefully and answer the following questions: 3.

For evaluating business performance both in financial and non-financial terms there is a necessity for the investors to look beyond the ubiquitous information furnished by the media. There is a tendency among the investors to overlook critically important indicators that would otherwise have enabled them to better discern the firm’s potential for wealth creation. Do you agree? Justify your opinion. (8 marks) < Answer >

4.

There are different groups of people who read the financial statements, each looking for different types of information. Earnings might be the most important area for investors, but other areas of information are also of extreme significance. In this backdrop, explain how notes to accounts and Management Discussion and Analysis provide insights to the investors. (6 marks) < Answer >

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Because there are literally hundreds of things about a company to examine when analyzing its stock, it is tough to know where to start. Most investors are good at evaluating earnings, growth rates, revenue, and the P/E ratio, but they also tend to overlook other aspects that can be just as important. One of the items which the average investor tends to ignore is cashflow. This represents the constant flow of money in and out of a company. All companies provide separate cash flow statements as part of their financial statements, but cash flow can also be estimated as net income plus depreciation and other non-cash items. The second aspect which is also generally overlooked by the typical investor is the management. This is one aspect of a company that can make a world of difference. Think of management in terms of sports: Michael Jordan might not have been the "whole show" during his reign at the Chicago Bulls, but he was undoubtedly a huge contributing factor to their success. The same is true for the management of a business. Further, receivables and the finished goods inventory are two items in the balance sheet on which the average investor does not place enough emphasis. Receivables represent the sales for which the company has yet to collect the money. Sales drive accounts receivable, so when sales are growing, accounts receivable will grow at a similar rate. Inventory of the finished goods available for sale ties in closely with accounts receivable. Two other items which the investors tend to lose sight of, in the maze of details that are present in any annual report are the notes to accounts and the Management Discussion and Analysis(MD &A). These are the items which contain vital information which can not be expressed in very objective terms or quantifiable in the financial statements. The technique of looking at the overall company and its outlook is sometimes referred to "qualitative analysis," and it is a perspective that is often forgotten. Peter Lynch once stated that he found his best investments by looking at the trends his children follow. Assessing a company from the fundamental/qualitative standpoint is one of the most effective strategies for evaluating a potential investment, and it is as important as looking at sales and earnings. These overlooked areas are by no means the only things investors need to evaluate, but looking at more than just the obvious will give you that extra advantage over other investors. Earnings are important, but earnings are also the most widely published financial figure for any company, so why base an investment decision solely on what other people already know? The moral here is always to dig deeper by doing solid research so that you can aim to be a step ahead of the crowd.

Caselet 2 Read the caselet carefully and answer the following questions: 5.

In a dynamic environment the companies can operate in the best interests of their shareholders only if they effectively manage the risks they face. What are the necessary steps that the companies should take for establishing effective risk management processes? (9 marks) < Answer >

6.

A company, which wants to establish an effective risk management system, should ideally create a highly effective risk management group. How can a company create a highly effective risk management group in order to establish an effective risk management system? (6 marks) < Answer >

Risk is a fact of business life. Taking and managing risks is part of what companies must do to create profits and shareholder value. But the corporate meltdowns of recent years suggest that many companies neither manage risk well nor fully understand the risks they are taking. Such events are thus a reality that managements must deal with rather than an unlikely "tail event." The directors’ unfamiliarity with risk management is often mirrored by senior managers, who traditionally focus on relatively simple performance measures, such as net income, earnings per share, or growth expectations of the market. Risk-adjusted performance seldom figures in these managers’ targets. Improving risk management thus entails both the effective overseeing by the Board and the integration of risk management into day-today decision making. Companies that fail to improve their risk-management processes face a different kind of risk: unexpected and sometimes severe financial losses that make their cash flows and stock prices volatile and harm their reputation to customers, employees, and investors. Companies might also be tempted to adopt a more risk-averse model of business in an attempt to protect themselves and their share prices. However, being risk-averse may not help the company in creating or maintainigng shareholder value. The CEO of one Fortune 500 company, when asked to explain his company’s declining performance, replied that it was due to the lack of a culture of risk- taking; he explained that its absence meant that the company was unable to create innovative and successful products. By contrast, a senior partner of a leading investment bank with excellent risk-management capabilities remarked, "Our operations have created a series of controls that enable us to take more risk with more entrepreneurialism and, in the end, make more profits." In order to manage risk effectively the companies must first understand what risks they are taking. They should clearly 6

articulate the major risks they are taking. The companies also need to know the potential impact on their fortunes, of the risks they face and they should be transparent about it. The CEOs of the companies should then define, with the help of the board, their companys’ risk strategy. But more often than not, it is determined inadvertently, every day, by dozens of business and financial decisions. One executive, for instance, might be more willing to take risks than another or have a different view of a project’s level of risk. The result may be a risk profile that makes the company uncomfortable or can’t be managed effectively. A shared understanding of the strategy is therefore vital. The companies must then create a high performing risk management group whose task will be to identify, measure, and assess risk consistently in every business unit and then to provide an integrated, corporate-wide view of these risks, ensuring that their sum is a risk profile consistent with the company’s risk strategy. Next the companies should create a risk culture in order to cope with the dynamic nature of the businesses and to minimise undue risk taking by its managers. Lastly the board of directors of the companies should understand and oversee the major risks it takes and ensure that its executives have a robust risk-management capability in place. Even world-class risk management won’t eliminate unforeseen risks, but companies that successfully put the elements of effective risk management in place are likely to encounter fewer and smaller unwelcome surprises. Moreover, such companies will be better equipped to run the risks needed to enhance the returns and growth of their businesses. Without adequate risk-management processes, companies may inadvertently take on levels of risk that will leave them exposed to the next risk-management disaster. Alternatively, they may pursue "extremely conservative" strategies, foregoing attractive opportunities that their competitors can take. Either approach will surely be penalized by the investors.

END OF SECTION B

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

7.

This section consists of questions with serial number 7 - 8. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.

Reorganization of a firm in financial distress is often a more sensible solution than liquidation as the firm will be more likely to repay its debts, when it is alive and operating than when it is liquidated. Explain the steps involved in the reorganization of a financially distressed firm. (10 marks) < Answer >

8.

Corporate decisions are affected by a large number of variables. Many-a-times, the inter linkages between these variables, and their resultant effect on the decision is extremely complex. Decision support models are used as a tool to spell-out the relationships clearly in order to help the management to arrive at the optimal decisions. Discuss the major steps involved in the process of building decision support models. (10 marks) < Answer > END OF SECTION C END OF QUESTION PAPER

Suggested Answers Strategic Financial Management (MB361F): January 2005 Section A : Basic Concepts 1.

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Answer : (b) 7

Reason : According to the traditional approach to capital structure, as debt is added to the capital structure the cost of capital declines initially because of lower post-tax cost of debt. But as leverage is increased, the increased financial risk overweighs the benefits of low cost debt and so the cost of capital starts increasing. Hence the correct answer is (b). 2.

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Answer : (c) EBIT + D 20 + 3 LR 2 I+ 3+ (1 − T) = (1 − 0.35) = 3.78 Reason : Fixed charges coverage ratio =

3.

Answer : (c) Reason : The marginal cost rate breaks down under a capacity constraints of transferor division. The accounting price arrival using mathematical programming method is appropriate for transfer pricing. This type of price is also called shadow price.

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4.

Answer : (e) Reason : Low cost strategy is one of the two strategies followed under value chain analysis. The other strategy being differentiation strategy.

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5.

Answer : (a)

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D1 +g Reason : Required rate of return on the stock = P0 = = 6.

D 0 (1 + g ) 2(1.12) P0 + g = 52.50 + 0.12 0.1627 i.e. 16.27% < TOP >

Answer : (b)

Reason :

Total debt 5 Equity = 4 Adding 1 to both sides of the equation we get: Total debt + equity Total asset Total debt 5 5+ 4 9 Equity + 1 = 4 + 1 or Equity Equity = 4 or = 4 Total asset × 4 4500 × 4 9 9 From above, Equity = = = Rs.2,000

Now, total assets

= or or

Total debt + equity = Rs.4,500 Total debt + 2000 = 4500 Total debt = 4500 – 2000 = Rs.2,500

Long term debt = Total debt – Short term debt = 2500 – 600 = Rs.1,900. 7.

Answer : (b) Reason : When assets, which are not readily marketable, is required to be sold for need of funds, the non-marketability may lead to liquidity risk. Thus the assets not being readily marketable give rise to marketability risk.

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8.

Answer : (d)

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=

Re ceivables balance Average daily sales

=

Sales 360

∴ Average collection period

=

Re ceivables balance x 360 sales

Average collection period

=

40 days (given)

Receivables balance

=

Rs.20 lakhs

=

20 x 360 Sales

Reason : Average collection period

Average daily sales

∴ 40

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or Sales

=

20 x 360 40 = Rs.180 lakhs.

9.

Answer : (d) Reason : The weights based on the book values are historical in nature and hence these do not reflect the cost of capital owing to the changes in the business and financial risk of the company. The reasons mentioned in the other options do not correctly reflect the advantages of choosing the weights based on the book values in comparison to the market values.

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10.

Answer : (e) Reason : According to this theory the first and most popular is retained earnings as it has no associated floatation cost.

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11.

Answer : (c) Reason : Gordon argued that the investors would prefer the income that they earn currently to that income in future that may or may not be available. Hence, they prefer to pay a higher price for the stocks which earn them current dividend income and would discount those stocks, which either reduce or postpone the current income. For that reason, this model emphasizes the entire weight on the dividends, while other models consider the dividend payment and the retained earnings. Hence, the option (c) is correct.

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12.

Answer : (b) Reason : The cost of equity for Tractor India is:

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Do (1 + g ) D1 +g = +g P P0 Ke = o 3 × 1.08 + 0.08 = 0.1340 = 13.40 60 = 0.1340 = 13.40% 0.134 Hence, the cost of external equity will be = 0.98 = 0.1367 = 13.67 percent

13.

Answer : (c) Reason : Holding cash balance to meet contingencies is a manifestation of precautionary motive. Transaction motive (a) is manifested when cash balance is held to meet the requirements in the normal course of business. Speculative motive (b) is manifested when cash balance is held for gaining from speculative activities. Further holding cash balance is a normal practice for all types of firms, large or small (d) and (e).

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14.

Answer : (a) Reason : In the presence of floatation costs, the cost of external equity will always be more than the cost of existing equity capital (a). It has got no logical connection with cost of long-term or short-term debt. Hence (b), (c), (d) and (e) are all incorrect.

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15.

Answer : (d) Reason : Return on investment (ROI) = EBIT / Total assets Total assets = Debt + Equity = 300 + 150 = Rs. 450 lakhs EBIT = Rs. 90 lakhs (given)

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∴ ROI 16.

=

90 / 450 = 20% < TOP >

Answer : (c)

Reason : Return on net worth (RONW) =

Net profit margin

=

Asset turnover ratio =

Net profit Net worth

=

0.24 (given)

Net profit Net sales

=

0.125 (given)

Net sales Total assets

=

0.85 (given)

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Return on networth Net profit margin × Asset turnover ratio ∴

or

0.24 0.125 × 0.85

=

=

Net profit Net worth Net profit Net sales × Net sales Total assets

Total assets Net worth Total assets Net worth

or 2.2588 = Subtracting 1 from both sides we get Total assets − Net worth Net worth ∴

or

Debt Net worth

=

=

2.2588 – 1 = 1.2588

1.2588.

Net worth 1 Debt 1.2588 ∴ = Adding 1 to both sides we get Net worth + Debt Debt Total assets Debt =

2.2588 1.2588

Debt ∴ Total assets =

1.2588 2.2588

or

17.

=

1+ 1.2588 1.2588

=

0.56.

Answer : (d) Reason : Debt-Asset ratio of 1:3 implies that for every 3 rupees of total assets there is one rupee of debt and two rupees of equity. Hence, for every 2 rupees of equity there is one rupee of debt. Hence (d) is true.

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∴ In this case, for every 3 rupees of assets there are 2 rupees of equity. Hence (a) is not true. Again for every 3 rupees of assets there is 1 rupee of debt. Therefore both (b) and (c) are not true. For every one rupee of debt there are two rupees of equity; hence (e) is not true. 18.

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Answer : (a)

Reason : CR =

Current assets Current liabilities = 2.45

Inventories Current liabilities

=

Inventories Current Assets =

Current liabilities Inventories × Current Assets Current liabilities

= 19.

0.45

1 Inventories × CR Current liabilities

=

0.45 2.45 = 0.184.

Answer : (c) Reason : According to Miller and Orr Model the Upper limit, UL = 3RP – 2LL Where RP means return point and LL means lower limit. UL + 2LL 60,000 + 2 × 15,000 3 3 = = Rs. 30,000. ⇒ RP =

10

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20.

Answer : (d) Reason : Working capital/Total assets ratio is a balance sheet ratio. In the L C Gupta model, balance sheet ratios are only the (Net Worth/Total Debt) and (All outside liabilities/Tangible assets) ratios. All the other key ratios found suitable in predicting failure are profitability ratios.

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21.

Answer : (c) Reason : The increase in the nominal rate of interest must be higher than the increase in the rate of inflation, if the interest income is subject to tax. This is necessary for maintaining the real state of interest. The increase in nominal rate is given by

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∆r =

( Inflation rate after increase- Inflation rate before increase ) (1 − t r )

∆r = (6 – 4) / (1– .35) ∆r = 2 / .65 = 3.076% or 3.1%. 22.

Answer : (e) Reason : In stock split par value decreases and as a result market price per share decreases immediately after a stock split.

23.

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.

24.

Answer : (d) Reason : According to the Alcar model, there are seven value drivers that affect a firm’s value. These are:

• • • • • • •

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The rate of growth of sales. Operating profit margin. Income tax rate. Incremental investment in working capital. Incremental investment in fixed assets. Value growth duration.

Cost of capital Obviously, dividend growth rate is a factor not considered in this model. So the correct answer is (d). 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 : Profit margins peak during the growth stage due to experience curve effect which lower the unit costs and promotion costs are spread over a large volume.

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27.

Answer : (c) Reason : ROCE, Residual Income, Net Profit and Return on Net worth are all financial measures of performance. However, employee morale & attitude is a non-financial measure of performance.

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28.

Answer : (b) Reason : BCG matrix classifies the products into four broad categories. All others are the models for predicting sickness of a firm.

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29.

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

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E  D +  3 Po = m 

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Given : Po = 44, E = 3.75, D = 3.75 (1 – 0.6) = 1.5

44 3.75    1.5 + 3  = 16 ⇒m=  30.

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Answer : (b) Reason : As per Walter Model D + ( E − D) r / k k P0 = Where, the notations are in their standard use. As the given return on investment (r) > cost of equity (k) the company will maximize the value of share if no dividends are paid.

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Section B : Problems 1.

a.

b.

Direct cost of the replacement decision = Floatation costs + Call premium Call premium (total) = Total nominal value × 0.06

1, 05, 000 =  0.105    Total nominal value =  2  Rs.20,00,000 ∴ Call premium (total) = 20,00,000 × 0.06 = Rs.1,20,000 Floatation cost of new debentures = Net amount realized from the new debentures × 0.01 = 20,00,000 × 0.01 = Rs.20,000 ∴ Direct cost of the replacement decision = 1,20,000 + 20,000 = Rs.1,40,000 NPV of the replacement decision : Considering in terms of half year : Interest savings after the new issue = Total interest on new debentures – Total interest on old debentures 0.085 Total interest on new debentures = (20,00,000 + 20,000) 2 = Rs.85,850 Total interest on old debentures = Rs.1,05,000 Interest savings every half year = 1,05,000 – 85,850 = Rs.19,150 Number of half yearly periods up to maturity = 10 × 2 = 20 Coupon rate on new debentures 2 = 4.25% Discount rate = (Because the coupon rate and terms of coupon payment on the new debentures reflect the prevailing effective rate of interest on the similar debt instruments) ∴NPV = 19150 PVIFA (4.25%,20) – 1,40,000 (1.0425) 20 − 1 20 PVIFA (4.25%, 20) = (1.0425) (0.0425) = 13.294 ∴NPV = (19,150 × 13.294) – 1,40,000 = Rs.1,14,580 (Approx.) Since the NPV is positive the decision is viable. < TOP >

2.

Let the discriminant function be Zi = aXi + bYi where Zi = Discriminant score for the ith account Xi = Current ratio for the ith account Yi = Net profit Margin for the ith account. (Xi – CustomerAccount Yi Xi (Yi –Ym) Xm) Gr. I A 1.95 25.00 0.79 11.33 B 1.75 17.00 0.59 3.33 C 1.58 16.00 0.42 2.33 D 1.32 20.00 0.16 6.33 E 1.80 13.00 0.64 -0.67 F 1.78 16.00 0.62 2.33 Gr. II G 0.85 22.00 -0.31 8.33 H 0.62 10.00 -0.54 -3.67 I 0.44 3.00 -0.72 -10.67 J 0.58 9.00 -0.58 -4.67 K 0.62 5.00 -0.54 -8.67 L 0.65 8.00 -0.51 -5.67 Total 13.94 164.00 0.02 -0.04 Average

1.16

13.67

13

0.6241 0.3481 0.1764 0.0256 0.4096 0.3844 0.0961 0.2916 0.5184 0.3364 0.2916 0.2601

128.3689 11.0889 5.4289 40.0689 0.4489 5.4289 69.3889 13.4689 113.8489 21.8089 75.1689 32.1489

(Xi – Xm) (Yi – Ym) 8.9507 1.9647 0.9786 1.0128 -0.4288 1.4446 -2.5823 1.9818 7.6824 2.7086 4.6818 2.8917

3.76

516.67

31.29

(Xi – Xm)2

(Yi – Ym)2

Xm = 13.94/12 = 1.16 Xm1 = Sum of Xi for Gr. I/6 = 10.18/6 = 1.70 Xm2 = Sum of Xi for Gr. II/6 = 3.76/6 = 0.63 Ym = 164/12 = 13.67 Ym1 = Sum of Yi for Gr. I/6 = 107/6 = 17.83 Ym2 = Sum of Yi for Gr. II/6 = 57/6 = 9.5 σx2 = (1/n-1) Σ(X - Xm)2 = (1/11) x 3.76 = 0.342 σy2 = (1/n-1) Σ(Y - Ym)2 = (1/11) x 516.67 = 46.97 σxy = (1/n-1) Σ(X - Xm) (Y - Ym) = (1/11) x 31.29 = 2.84 dx = Xm1 – Xm2 = 1.70 – 0.63 = 1.07 dy = Ym1 – Ym2 = 17.83 – 9.5 = 8.33 a = (σy2 dx - σxy dy)/ (σx2σy2 - σxy2) = (46.97 x 1.07 – 2.84 x 8.33)/(0.342 x 46.97 – 2.84 x 2.84) = 26.60 / 7.998 = 3.32 b = (σx2 dy - σxy dx)/ (σx2σy2 - σxy2) = (0.342 x 8.33 – 2.84 x 1.07)/(0.342 x 46.97 – 2.84 x 2.84) = – 0.1899 / 7.998 = – 0.024 Hence, the required discriminant function is Zi = 3.32Xi – 0.024Yi < TOP >

Caselet 1 3.

Figures reported in annual reports mean exactly what the company designs them to appear -neither more nor less. So investors looking at fundamentals must discern on a company-by-company basis what the earnings whisper. Thus, investors ought to use different parameters that make earnings evaluation easier, clearer, and more meaningful. Some of the commonly overlooked indicators are: cashflow, management of the company and composition of current assets in terms of inventory of finished goods and receivables. Proper cash flow levels vary from industry to industry, but a company not generating the same amount of cash as competitors is bound to lose out. A company without available cash to pay bills is in real trouble, even if the company is profitable. By using the cash flow-to-debt ratio, which compares the amount of cash generated to the amount of outstanding debt, you can judge the health of cash flow. This comparison reflects the company's ability to service their loan and interest payments. Good management doesn't do everything, but it certainly is an integral part of the company. Sam Walton (of Walmart) and Jack Welch (of General Electric) are examples of people who led their firms through thick and thin, recessions and booms. The responsibility of the management has been greatly enhanced in the wake of financial turmoils and scandals that have shaken the investor confidence. The large-scale disasters of the likes of Enron and Worldcom have served the purpose of highlighting the importance of good corporate governance which can only be ensured by a prudent management. Normally receivables grow in tandem with sales. So when sales are growing receivables should also grow at a similar rate. Problems arise from receivables which are increasing faster than sales, which indicates that the company is not receiving payment for its sales and thus leaving itself short for handling the expense of producing those sales. Finished goods inventory also tends to respond to sales in a similar way to receivables. High inventory is bad for several reasons. Firstly, there is a cost associated with storing the extra inventory: increases in inventory cause higher storage costs. Secondly, a growing inventory can indicate that the company is producing more than it can sell. In addition to the above the vital information and crucial insights furnished by the footnotes to the financial statements, the directors’ report on board responsibility and corporate governance, MD & A etc. tend to be overlooked or side stepped by the common investors prior to making decisions. It has been seen in the past that the traditional measures and the GAAP-based reported earnings, leaves companies with plenty of room for creative accounting and manipulation. Operating earnings, which leaves out one-time gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately, many analysts now have their own criteria for what should be excluded, so analyzing and comparing companies using operating earnings can be difficult for the investors. While it is probably impossible to develop a standard that can handle every contingency, good and honest reporting is essential to assessing company fundamentals and value. 14

< TOP >

4.

As a preface to the annual report, a company's management typically spends a few pages talking about the recent year (or quarter) and gives a background of the company. While this is not the guts of the financial statements, it does give investors a clearer picture of what the company does. It also points out some key areas where the company has performed well. The management's analysis is provided at their discretion, so take it for what it's worth. Issues that analysts might look for in this portion are how candid and accurate are the managers' comments, does the manager discuss significant financial trends over past couple years, how clear are the managers comments and do they mention potential risks or uncertainties moving forward? If a company gives an adequate amount of information in the MD&A, it's likely that management is being honest. It should raise a red flag if the MD&A portion of the financial statement ignores serious problems that the company has been facing. A good example would be a company that is known to have large portions of outstanding debt but fails to mention anything about it in the MD&A. Withholding important information not only deceives those who read the financial statements, but in extreme cases also makes the company liable for lack of disclosure. Similarly, the notes to the financial statements (sometimes called footnotes) are also an integral part of the overall picture. If the income statement, balance sheet, and statement of cash flow are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. If the analyst does not read the footnotes he may be missing out on a lot of information. The footnotes list important information that could not be included in the actual ledgers. The notes list relevant things like outstanding leases, the maturity dates of outstanding debt, and even details on where the revenue actually came from. Generally speaking there are two types of footnotes: Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business. This portion of the footnotes tells about the nature of the company's business, when its fiscal year starts and ends, how inventory costs are determined, and any other significant accounting policies that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is changing policies only to take advantage of current conditions to hide poor performance. Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt such as maturity dates and the interest rates at which debt was issued, can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings the company is involved in. The majority of investors and analysts read the balance sheet, income statement, and cash flow statement. But for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn't. < TOP >

Caselet 2 5.

The necessary steps that the companies should take for establishing effective risk management processes are as follows: Understanding the risks that they are taking To manage risks properly, companies must first understand what risks they are taking. In order to do so, they need to make all of their major risks transparent and to define the types and amounts of risk they are willing to take. Although these steps will go a long way toward improving corporate risk management, companies must also go beyond formal controls to develop a culture in which all managers automatically look at both risks and returns. Rewards should be based on an individual’s risk-adjusted—not simply financial—performance. Achieving transparency Every company must not only understand the types of risk it bears but also clearly know the amount of money at stake. It needs to be transparent about the potential impact of these risks on its fortunes. Less obviously, it should understand how the risks that different business units take, might be linked and what is the effect on its overall level of risk. In other words, companies need an integrated view. The over-all risk position should be reviewed frequently (perhaps monthly) by the top-management team and periodically (for instance, quarterly) by the board to help them decide whether the current level of risk can be tolerated and whether the company has attractive opportunities to take on more risk and earn commensurately larger returns. Deciding on a strategy High concentrations of risk aren’t necessarily bad. Everything depends on the company’s appetite for it. Unfortunately, many companies never articulate a risk strategy. The CEO, with the help of the board, should define the company’s risk strategy. Formulating such a strategy is one of the most important activities a company 15

can undertake, affecting all of its investment decisions. A good strategy makes clear the types of risks the company can assume to its own advantage or is willing to assume, the magnitude of the risks it can bear, and the returns it demands for bearing them. Defining these elements provides clarity and direction for business-unit managers who are trying to align their strategies with the overall corporate strategy while making risk-return trade-offs. Creating a high-performing risk-management group The task of the risk management group is to identify, measure, and assess risk consistently in every business unit and then to provide an integrated, corporate-wide view of these risks, ensuring that their sum is a risk profile consistent with the company’s risk strategy. The structure of the organization will vary according to the type of company it serves. In a complex and diverse conglomerate, such as GE, each business might need its own riskmanagement function with specialized knowledge. More integrated companies might keep more of the function under the corporate wing. Encouraging a risk culture The above steps will go a long way toward improving risk management but are unlikely to prevent all undue risk taking. Companies might thus impose formal controls—for instance, trading limits. Yet since today’s businesses are so dynamic, it is impossible to create processes that cover every decision involving risk. To cope with it, companies need to nurture a risk culture. The goal is not just to spot immediately the managers who take big risks but also to ensure that managers instinctively look at both risks and returns when making decisions. Overseeing of the risk management processes by the board A company’s board of directors should understand and oversee the major risks it takes and ensure that its executives have a robust risk-management capability in place. In order to do this, the board must decide on the committee on which the responsibility of overseeing the risk management should be vested. It should then ensure that appropriate reporting to the board and its committees is done. It should also conduct regular training programs for its existing and new members, and review the effectiveness of the risk management processes periodically. < TOP >

6.

A company, which wants to establish an effective risk management system, can create a highly effective risk management group by following the steps given below: Appointing top-notch talent Risk executives at both the corporate and the business-unit level must have the intellectual power to advise managers in a credible way and to insist that they integrate risk-return considerations into their business decisions. Risk management should be seen as an upward career move. A key ingredient of many successful riskmanagement organizations is the appointment of a strong chief risk officer who reports directly to the CEO or the CFO and has enough stature to be seen as a peer by business-unit heads. Segregation of duties Companies must separate employees who set risk policy and monitor compliance with it from those who originate and manage risk. Salespeople, for instance, are transaction driven—not the best choice for defining a company’s appetite for risk and determining which customers should receive credit. Clear individual responsibilities Risk-management functions call for clear job descriptions, such as setting, identifying, and controlling policy. Linkages and divisions of responsibility also need to be defined, particularly between the corporate riskmanagement function and the business units. Should the corporate center have the right to review their risk-return decisions, for example? Should corporate risk-management policies define specific mandatory standards, such as reporting formats, for the business units? Risk ownership The existence of a corporate risk organization doesn’t absolve business units of the need to assume full ownership of, and accountability for, the risks they assume. Business units understand their risks best and are a company’s first line of defense against undue risk taking. < TOP >

Section C 7.

Reorganization The steps involved in reorganization of a firm are •

Techno- economic viability study 16

•

Formulation and execution of the reorganization plan

•

Monitoring the activities of the firm

Techno-economic Viability Study A reorganization plan is worked out on the basis of a techno-economic viability study of the firm. This study sets out to identify the strengths and weaknesses of the firm, the causes of failure, the viability of future operations and the course of action to be taken to bring about a turnaround. The techno-economic viability study is undertaken by the operating agencies assigned to the firm. These operating agencies are generally financial institutions and banks such as IDBI , IFCI, ICICI, IRBI, SBI, PNB, etc. The techno-economic viability study covers all the functional areas of a firm: management, finance, production and marketing. Management: The effectiveness and ability of the management is one of the most important factors that determines the success or failure of a firm. A detailed study is done in terms of the objectives of the firm, both short-term and long-term, the corporate strategy, the corporate culture, the management-labor relations, the organizational hierarchy, the decision-making process, etc. The study tries to determine the effectiveness of management and its integrity. The areas of mismanagement are also determined. Finance: Finance it the main functional areas of business. It is a measurable indicator of the firm’s health and performance. A though analysis of the firm’s Balance Sheet and Profit/Loss statement is made. These statements when properly analyzed give the financial stability and liquidity of the firm; profitability and uses of funds. The analysis also identifies the capital structure and the sources of unds. The analysis gives insight into working capital management and management of earnings. Production and Technology: Production and Technology function assumes immense importance in the viability study. The various areas that are looked into are, the firm’s equipment and machinery, the maintenance of the equipment, the technology used in production, the production capacity and utilization, the products being offered by the firm, the quality control system, production planning and inventory control. Marketing: A number of firms have failed because of lack of good marketing management. The various areas of marketing that are studied are, the product mix of the firm, the past sales of the product in terms of quantity and value, the market share of the firm, the demand for the product range, the study of the customer profile, the price of the products, the distribution channels being used, the kind of promotion-mix being used and the most important of all is the marketing team. This study is done in comparison with the competitors. Formulation and Execution of the Plan The viability study serves as the basis for formulation of a rehabilitation plan. A thorough study of the various functional areas of the firm reveals the strengths, weaknesses, opportunities and threats of the firm. It gives a comprehensive idea about the status of the firm, the viability of the firm both technically and economically and the additional funds required for rehabilitation. The formulation plan involves the changes and action to be taken regarding the various functions of the firm. It may decide to make changes in the management, if it is not found competent. Some of the labour may be retrenched/recruited depending on the situation. The amount of financial assistance to be given is determined and arrangements are made to secure the loan. Various steps are taken to improve the production function in terms of new machinery and new technology. The viable level of operations are determined and steps are taken to achieve this production level. The product-mix, the pricing, the quality of the products, distribution channels and the promotion-mix are to be changed to suit the needs of the customers, to achieve the desired sales levels. Once the plan is formulated, the plan is carefully executed. All the necessary changes prescribed by the plan are made. The funds are disbursed in a phased manner as and when required. The necessary concessions and reliefs are provided. A close watch is kept on the activities of the firm and a continuous evaluation is done. Monitoring Monitoring is a very important part of a rehabilitation plan. It is done to evaluate the execution of the plan. Regular meetings are held between the firm, the bankers, the financial institutions and other concerned parties to verify and evaluate the process of execution. Monitoring is one to ensure the proper utilization of funds and adherence to the terms of rehabilitation plan. It also ensures the proper working of the firm. Feedback is obtained and remedial measures are taken as and when the situation demands. The impact of rehabilitation becomes evident in a short period. Once the success of the firm becomes evident, the role of agencies and banks is confined to constantly hold meetings to assess and revies the process. This continues till the firm is successful. In case the firm is found incapable of making a turnaround despite the plan, then the steps to liquidate the firm are undertaken < TOP >

8.

THE MODELING PROCESS 17

The following are the major steps in the process of using a model to arrive at the optimal decision: •

Feasibility study

•

Model construction

•

Compatibility of the model with the tools used

•

Model validation

•

Implementation

•

Model revision

• Documentation Feasibility Study The foremost step in developing a model is to ascertain the feasibility of a model assisting the decision making process. The various points that are required to be considered are Whether the decision under consideration is a one-time process, or is required to be taken as a routing measure •

The suitability of the area in which the decision is required to be made, to be supported by a model

•

The possibility of all the relevant variable being unambiguously identified

•

The possibility of all the variables being built-in into a single model

•

The expected effectiveness of the model

•

The acceptability of a model replacing human judgment to the management

•

The possibility of obtaining the required date on an ongoing basis

•

The possibility of integrating the model with the normal decision-making process

• The costs involved with setting up and running the model, and its comparision with the expected benefits. If it is feasible to construct an efficient and effective model for the decision process under consideration, and if the model can be easily integrated with the process, the firm can proceed to the next step of constructing the model. Model Construction •

The construction of the model depends on a number of factors. Some of these are

•

The decision to be made using the model

•

The issues that are relevant for making the decision

•

The way in which these issues and factors affect the decision

• The external factors that restrict the decision making process. Depending on these factors, the input requirement for the model is identified and the numerical and theoretical relationship between variable are specified. This is followed by development of the structure of the model. Model Compatibility Once the model is in place, it needs to be made compatible to the tools to be used to implement it. For example, if a particular model is to be solved using computers, the model needs to be programmed and converted to a language that the computer understands. Model Validation A number of test runs are conducted on the model to check whether it produces reasonable accurate results. The test runs may use actual past data of the input variables, and the results generated by the model compared to the actual results. Alternatively, the model may be tested by using results. Alternatively, the model may be tested probability distributions. Test running a model checks the effectiveness of the structure of the model, as well as its predictive ability. Implementation The implementation of a model includes integrating it with the normal decision-making process. Further ,it needs to be ensured that the results generated by the model are relevant enough for the decision-making to take them into consideration while making a decision. Mode Revision No model remains useful for an indefinite period. The relationship between different variables that forms a basis for the model may change over a period of time. External factors affecting a model may also change. Use of the model over a period may provide an insight into its drawbacks. It is necessary that such changes are noted and the model periodically revised to accommodate them. Unless a model is continuously updated, it may lose its relevance. Documentation Documentation is way of institutionalization of the knowledge created during the process of developing and 18

installing a model. It involves making detailed, systematic notes at all the stages of the process. The records should be maintained right for the stage when the need for the model was felt, detailing the factors that gave rise to the need. The various ideas considered at different stages needs to be documented along with the reasons for their acceptance of rejection. The various problems faced during the development and implementation of the model, together with their solution should also form a part of the records. Documentation also helps in proper communication between the members of the team working on the development of the model. In addition, it makes the process of revision the model less tedious. While developing the implementing models, certain issues need to be kept in mind. It is not just necessary to specify the objectives of the model, it is also necessary to build the relative importance of the different objectives into model. For example, the objective may be to maximize the profits of the firm, while restricting the debt taken by it to a certain percentage of the total assets. The model should specify the objective(maximum profits or limited debt) that would be held supreme, if there were a clash between the two. Another important point to be remembered is that the model should preferable focus on some key aspects, rather than be a collection of all relevant and irrelevant data. A focused model is more likely to generate effective decision. < TOP >

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