Mb361f-jan 06

Question Paper Strategic Financial Management (MB361F) : January 2006 Section A : Basic Concepts (30 Marks) • • • •

1.

Instead of capital gains, if investors show a leaning towards current dividends, then (a) (b) (c) (d) (e)

2.

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The cost of equity shall remain unaffected by a change in dividend policy The cost of equity will decrease with an increase in the rate of retention The cost of equity will increase with a reduction in the pay-out ratio A change in dividend policy shall not affect the cost of capital of the firm The stock price can be maximized through the residual dividend model.

According to the Wilcox model, the best indicator of the financial health of an enterprise is/are (a) (b) (c) (d) (e)

3.

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.

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The profitability ratios The coverage ratios Net liquidation value of the firm Market capitalization of the firm Share price of the firm. < Answer >

Which of the following statements is/are true? (a) Financial risk can be reduced by replacing common equity with preferred stock (b) If Firm A has a higher degree of business risk than Firm B, Firm A can offset this risk by increasing its operating leverage (c) A firm exposed to a high business risk should take recourse to a higher-than-average financial leverage (d) A capital structure that minimizes the weighted average cost of capital, in general, does not necessarily maximize the earnings per share of the firm (e) Both (b) and (c) above.

4.

When there is a capacity constraint in the transferor division, the transfer pricing can be ideally done by (a) (b) (c) (d) (e)

5.

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Market price Marginal cost Shadow price Full cost pricing based on actual cost Marginal cost + Lumpsum annual payment. < Answer >

Which of the following statements is/are correct? (a) Hazard risk refers to natural hazards, accidents, fire etc. that can be insured (b) Strategic risk covers systems, processes and people and includes issues such as succession planning, human resources, information technology, control systems and compliance with regulations (c) Operational risk covers systems, processes and people and includes issues such as succession planning, human resources, information technology, control systems and compliance with regulations (d) Both (a) and (b) above (e) Both (a) and (c) above.

6.

Which of the following statements is/are not true with respect to the Baumol Model? I. Cash expenses are incurred evenly over the planning horizon. II. Cash inflows are random and hence the balance in cash movements are random. III. Neither the amount of conversion nor the timing of conversion of securities into cash and vice versa is fixed. (a) Only (I) above

(b) Only (II) above 1

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(c) Only (III) above (e) Both (II) and (III) above. 7.

(d) Both (I) and (III) above < Answer >

White Squire strategy, as a defense against takeover threat involves (a) The target firm inviting another firm to make a counter offer to takeover (b) The repurchase of a block of shares from specific shareholder(s) at a substantial premium (c) The target company issuing a large block of shares or convertible preference shares to a friendly party (d) The payment of huge severance package to senior management cadres in case of takeover of the firm (e) The target firm making a tender offer on the raider as a response to the raider’s tender offer on the target.

8.

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Which of the following statements is/are false with respect to product liability? I. II.

Product liability arises when a defective product causes injury to persons or damages property. Class action suits ensure that many suppliers of the same product can be held liable according to their market share, if it is difficult to pinpoint the defect on one particular producer. III. In U.S., product liability judgements often favour plaintiffs and include substantial awards for economic and non-economic damages. (a) Only (I) above (c) Only (III) above (e) All (I), (II) and (III) above. 9.

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

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

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

10. For a firm, if the current ratio remains constant and the quick ratio decreases during the same period, then, which of the following is indicated? (a) (b) (c) (d) (e)

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Allows local control of local situations Leads to a competitive climate within a firm Accountability is clear Promotes specialization of labor Both (a) and (c) above.

12. Which of the following is/are considered to be a value driver as per the ‘Alcar’ approach to value based management? (a) Cash flow from operations (c) Incremental fixed capital investment (e) Both (c) and (d) above.

(a) Split-off

(b) Split-up

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(b) Long-term capital gains (d) Value growth duration < Answer >

13. Converting an existing division into a wholly owned subsidiary is called (c) Divestiture

(d) Equity carveout

14. Which of the following is not an assumption of Walter model on dividend policy? (a) (b) (c) (d) (e)

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The proportion of total debt relative to total assets is decreasing The proportion of total debt relative to net worth is decreasing The proportion of net worth relative to total assets is increasing The liquidity is decreasing The profitability is increasing.

11. Which of these is/are not the stated advantage(s) of a divisional structure? (a) (b) (c) (d) (e)

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The firm is a going concern and has a perpetual life The only source of finance available to the firm is debt The cost of capital of the firm remains constant throughout the life of the firm The return on investment remains constant throughout the life of the firm Both (a) and (d) above.

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(e) Spin-off. < Answer >

15. Which of the following adjustments is recommended by Current Cost Accounting method to determine the current cost operating profit? (a) Tax-Shield adjustment (c) Equity value adjustment (e) Debt value Adjustment.

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(b) Cost adjustment (d) Monetary Working Capital adjustment

16. Which of the following statements regarding the adjusted book value approach to valuation of companies is/are true?

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(a) The expected future cash flows of the firm are discounted at the weighted average cost of capital (b) Current assets like deposits made are valued at book value (c) The ratio of share price to book value per share is applied to the book value of the assets to determine their market value (d) Long term debt is valued using the standard equity valuation model (e) Short term debt is valued using the standard bond valuation model . 17. Which of the following statements regarding the Current Purchasing Power (CPP) method of accounting for inflation is/are true?

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I.

It is aimed at measuring all items in the financial statements in a unit of measurement that represents the same amount of general purchasing power. II. It attempts to measure the gains or losses that arise from holding financial assets. III. The figures given on CPP basis are equivalent to the current replacement values. (a) Only (I) above (c) Only (III) above (e) Both (I) and (III) above

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

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

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Information is freely available to investors The capital market 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.

19. The strategy of inviting another friendly firm to make a counter offer to a hostile offer is called (a) Golden parachute (d) Poison pill

(b) Green mail (e) Blue Squire.

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(c) White Knight

20. As per SEBI guidelines on take over if the acquirer crosses a certain x1% of voting capital of target company it should inform the concerned stock exchange and at the same time it should offer to other shareholders of the target company through a public announcement, to acquire minimum of x2% of voting capital of the target company through an offer document.

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The x1 and x2 in above paragraph are (a) 5 and 10 respectively (c) 10 and 15 respectively (e) 15 and 20 respectively.

(b) 5 and 15 respectively (d) 10 and 20 respectively < Answer >

21. The risk that arises out of the assets of a firm being not readily marketable is called (a) Market risk (d) Financial risk

(b) Marketability risk (c) Business risk (e) Exchange risk.

22. During which of the following stages of the product life cycle the profit margins from a product reach the peak? (a) Introduction

(b) Growth

(c) Maturity

(d) Saturation

(e) Decline.

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

There are two discrete groups to be analyzed. 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 3

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

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

24. Which of the following is true in the context of stocksplit? (a) (b) (c) (d) (e)

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.

25. According to the traditional approach to capital structure, the weighted average cost of capital (a) (b) (c) (d) (e)

Declines steadily as more debt is used First declines with moderate application 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 >

26. Which of the following is a non-financial measure of performance? (a) Return on capital employed (c) Employee morale and attitude (e) Economic Value Added.

(b) Residual Income (d) Profit

27. Which of the following is/are true regarding valuation models for firms? (a) (b) (c) (d) (e)

II. III. (a) (c) (e)

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Market price adjustments for a firm that is on the verge of bankruptcy are not a significant cost to the investors. Value of the firm is given by the sum of the value of an all-equity finance firm, the present value of the tax shield less the present value of the costs of financial distress. Costs incurred by financially troubled firms as a result of differences between the concerns of shareholders and creditors are known as bankruptcy costs. Only (I) above (b) Only (II) above Only (III) above (d) Both (I) and (III) above Both (II) and (III) above.

29. Which of the following statements is true with respect to merger waves? (a) (b) (c) (d) (e)

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They give an accurate measure of firm value The valuation processes are entirely objective in nature The inputs used in the valuation model leave some room for subjective judgements Both (a) and (c) above All (a), (b) and (c) above.

28. Which of the following statements is/are true? I.

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Vertical integration was the salient feature of the first wave of merger Horizontal combination was the salient feature of the second wave of merger The third merger wave was characterized by conglomerate mergers The fourth merger wave was characterized by the emergence of a combination of forward and backward integration The fifth merger wave was characterized by the emergence of professional corporate raiders.

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

(b) BCG Matrix (d) Argenti Score Board 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. 4

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Do not spend more than 110 - 120 minutes on Section B. 1.

The following information pertain to the operations of Agarwal Enterprises Ltd. at the end of financial year March 31, 2005: Net worth Current liabilities and provisions Cost of goods sold Gross profit margin Total asset turnover ratio Total debt to equity ratio Current ratio Quick ratio

Rs.75 lakh Rs.90 lakh Rs.486 lakh 25% 3 1.88 1.5 0.70

You are required to complete the following balance sheet of the company as at the end of the financial year March 31, 2005: Balance sheet (Rs. in lakh)

5

FCF

7

4

1

–2

3

7

4

1

–2

3

7

In future the trend is expected to remain the same. The cost of capital of the firm is 15%. You are required to find the value of the firm as on April 01, 2005. (6 marks) < Answer >

Caselet 1 Read the caselet carefully and answer the following questions: 4. Forward-looking approach towards estimating cost of equity is often conceptually preferable. However it is often not a straightforward technique to apply. Discuss the various issues associated with the application of forwardlooking approach for estimating the cost of equity. 5.

(7 marks) < Answer > The caselet also talks about the historical approach towards the estimation of cost of equity. Explain the critical issues that are associated with the application of this approach towards the estimation of cost of equity.

(7 marks) < Answer > The concept of cost of equity is central to every decision at the core of corporate finance. However, there has never been a consensus on how to estimate the cost of equity and the equity risk premium associated with it. Conflicting approaches towards calculating risk have resulted in differing estimates of the equity risk premium ranging from 0 percent to 8 percent—although many of the practitioners use a narrower range of 3.5 percent to 6 percent. With expected returns from long-term government bonds being about 5 percent in the US and UK capital markets, the narrower range implies a cost of equity for the typical company of between 8.5 percent and 11.0 percent. This variation in cost of equity can lead to a variation in the estimated value of a company by more than 40 percent and have profound implications for financial decision making. Comprehensive discussions about the cost of equity often involve such debateable issues as where the stock market is heading and whether the stocks are over or undervalued. For instance, the run-up in stock prices in the late 1990s prompted two contradictory points of view. On the one hand, as prices soared ever higher, some investors expected a new era of higher equity returns driven by increased future productivity and economic growth. On the other hand, some analysts and academics suggested that the rising stock prices meant that the risk premium was declining. Pushed to the extreme, a few analysts even argued that the premium would fall to zero, that the Dow Jones industrial average would reach 36,000 and that stocks would earn the same returns as government bonds. While these views were at the extreme end of the spectrum, it is still easy to get carried away by complex explanations and the numbers. There are two broad approaches towards estimating the cost of equity and market risk premium. The first is historical, based on what equity investors have earned in the past. The second is forward-looking, based on projections implied by current stock prices relative to earnings, cash flows, and expected future growth. The latter approach is conceptually more appealing. After all, the cost of equity should reflect the return expected (required) by investors. But forward-looking estimates are fraught with various problems the most difficult of which is estimation of future dividends or earnings growth. Some theorists have attempted to tackle that difficulty by surveying equity analysts, but the objectivity of analysts projections is also questionable. Other researchers have constructed elaborate models of forward-looking returns, but such models are generally so complex that it is difficult to draw meaningful conclusions or come out with anything but highly unstable results. Depending on the assumptions underlying the models, recently published research suggests that market risk premiums can vary between 0 percent and 4 percent. Unfortunately, the historical approach is almost equally difficult to apply because of the subjectivity of the assumptions underlying it. For instance, over what time period should returns be measured—the previous 5, 10, 20, or 80 years or more? How should the average returns be calculated? How frequently should average returns be sampled? Depending on the answers to the above questions, the market risk premium based on historical returns can be estimated to be as high as 8 percent. It appears from this discussion that both historical and forward-looking approaches, as practiced, may not lead to clear cut conclusions.

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

According to caselet, all the countries may not reap the potential benefits of cross broder mergers and acquisitions. In your view, what are the issues to be considered before going for cross border mergers & acquisitions? 6

7.

(7 marks) < Answer > According to caselet, there may be commonalities as well as differences between domestic mergers and cross border mergers. However, the single factor for cross border mergers and acquisitions is to have access to new markets. Explain the other benefits of cross border mergers and acquisitions. (6 marks) < Answer >

The compulsions and competitions arising out of the effects of liberalization, privatization and globalization (popularly known as LPG) of economic polices around the globe have reoriented the thinking of the government and the corporate sector towards change for survival, without being left isolated. The beginning of the 21st century is an era for corporate mergers, takeovers, synergies, re-mergers, de-mergers, acquisitions etc. and these effects are not only taking place fast within the national boundaries, but are seen across borders as well. Some of the causes for this phenomenon are increasing global competition, integration of markets, and the compulsions of the WTO. While mergers and acquisitions within the country and across borders have common features, they may be different because of differences in national polices, exchange rates, national cultures, ethos and other factors. Whatever may be the commonalities and differences between the two transactions, yet the single factor for cross-border mergers and acquisitions is access to new markets. MNCs find growing markets with skilled labor and advanced technologies more attractive. If the crossborder gates are kept open, the expansion of the corporate businesses, stock markets and new sources for future and potential is possible. The surveys conducted by the UNCTAD during the first quarter of the year 2004 reveals an optimistic outlook. China, India and Poland are well-positioned to receive upswing of FDI inflows. In their analysis, it has been predicted that greenfield investment will dominate the FDI in the developing countries and cross-border M&As in the developed countries. The recovery sign as predicated, however, does not mean that all countries will reap the potential benefits of FDIs or M&A. The phenomenon is mostly driven by Transnational Corporations (TNCs) from developed countries, with increasing participation by firms of developing country. Also, the trends may vary from region to region with turnarounds in Africa, Asia and the Pacific. The next question that needs to be answered is that how FDI’s are going to be with M&As? This is important, as various sectors flow into the channels of investment. The question is, which is the prime sector? Again a probable answer that has been predicted is that the “service sector”, as compared to its counterpart the “manufacturing sector”, is going to catch up and be the order for M&As. Although, the service sector is less transnationalized, it may generate a value-addition to the employment potential of sale of services, due to the fact that the size of the service sector is larger than that of the manufacturing sector. The concerns and the potential of cross-border M&As is full of paradoxes. To benefit from a globalized environment, there is need for dependence on the other economy in order to strengthen one’s economy. The most important contributing factors are attracting capital in the form of FDIs, technology etc. and setting up a competitive service sector. Services have better trading and bargaining power compared to the manufacturing sector. The chain-supply relationship is much longer and stronger, and the increasing access to international markets is made easier and simpler. The hurdle for the service sector lies only in the reciprocity for recognition, which is addressed by GATT, and TRIPS of WTO. While the service sector becomes prominent in the process, some of the services relating to basic utilities and infrastructure are susceptible to abuse by the monopoly of the market power. In this, the countries have to strike a balance between economic efficiency and broader developmental objectives. END OF SECTION B

Section C : Applied Theory (20 Marks) 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.

8.

One of the important objectives of Enterprise Risk Management is to include risk management in the day-to-day practices of the organization. Moreover the right organization culture would encourage entrepreneurial risk taking and discourage gambling. In this context explain the role of the senior management of the organization. (10 marks) < Answer >

9.

Target costing has recently received considerable attention in the industries around the world as it gives competitive edge in launching new products. Explain, what is target costing? Also discuss the benefits of target costing. (10 marks) < Answer > 7

END OF SECTION C END OF QUESTION PAPER

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Suggested Answers Strategic Financial Management (MB361F) : January 2006 Section A : Basic Concepts 1.

Answer : (c) Reason : The preference shown by the investors for dividends to capital gains is because they view dividends in the hand to be less risky than potential capital gains. The cost of equity shall be inversely related to the dividend payout ratio if the investors are less certain of receiving income from capital gains than they are of receiving dividend payments.

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2.

Answer : (c) Reason : As per the Wilcox model, the net liquidation value of a firm is the best indicator of its financial health. The net liquidation value is the excess of the liquidation value of the firm’s assets over the liquidation value of the firm’s liabilities. Liquidation value is the market value of the assets and liabilities at the time of dissolution.

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3.

Answer : (d) Reason : A high degree of business risk implies that the firm has to use a lower amount of financial leverage to counter this risk. Preferred stock being a fixed-income security would also increase financial risk. Initially EPS rises with the increase in debt but beyond a point interest rates will rise fast enough to depress EPS despite the decrease in outstanding shares.

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4.

Answer : (c) Reason : The marginal cost rate breaks down under 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. Answer : (e) Reason : Hazard risk refers to natural hazards, accidents, fire etc. that can be insured. Operational risk covers systems, processes and people and includes issues such as succession planning, human resources, information technology, control systems and compliance with regulations. However, Strategic risk stems from an inability to adapt to changes in the environment such as change in customer priorities, competitive conditions and geographical developments. Hence, statement (b) is not correct. So, the correct option is (e). Answer : (e) Reason : Baumol model is a deterministic model of cash budgeting. It assumes that the cash inflows as well as outflows are incurred evenly over the planning horizon. Conversion of securities into cash takes place at regular intervals. So both statements (II) and (III) are incorrect. Hence the correct answer is (e). Answer : (c) Reason : White Square strategy as a defense against takeover threat involves the target company issuing a large block of shares or convertible preference shares to a friendly party.

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8.

Answer : (e) Reason : Product liability arises when a defective product causes injury to persons or damages property. Class action suits ensures that many suppliers of the same product can be held liable according to their market share, if it is difficult to pinpoint the defect on one particular producer.. In US, product liability judgements often favour plaintiffs and include substantial awards for economic and non-economic damages. Hence, all these statements are true.

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9.

Answer : (b) Reason : As per Pecking order theory of financings, the preferred order of finance for firms are as follows: internal equity, debt, preference capital and external equity.

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10. 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 9

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5.

6.

7.

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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. 11. Answer : (d) Reason : Divisional structure is a type of departmentalization in which positions are grouped according to similarity of products, services or markets. The Divisional structure does not promote specialization of labor. Whereas options (a), (b) and (c) i.e. it allows local control of local situations, leads to a competitive climate within a firm, accountability is clear are the advantages of the divisional structure. Answer : (e) 12. Reason : Shareholders’ return comprises capital gains and dividend income. Cash flow from operations is a valuation component but not a driver as per this approach. Incremental investment in fixed and working capital are value drivers from the investment decision angle. Value growth duration is an indicator of the management’s perception of competitive advantage. It represents the period over which the investments are expected to earn a return in excess of the cost of capital. Hence, statements (c) and (d) are correct. So the correct option is (e). Answer : (d) 13. Reason : In a split off, a new company is created to take over the operations of an existing division or unit and a portion of the shares of the parent company is exchanged for the shares of the new company. When a new legal entity is created to take over the operations of a particular division or unit of the company and the shares of the new unit is distributed pro-rata among the existing shareholders, it is known as Spin off. A Split up refers to the complete breakup of a company into two or more new companies and the shares of the new company is distributed among the existing shareholders of the firm. Divestiture involves outright sale of a portion of the firm to outsiders. Equity carve out involves conversion of an existing division or unit into a wholly-owned subsidiary. Hence, only option (d) is correct. Answer : (b) 14. Reason : According to the Walter’s model, the firm is a going concern and has a perpetual life span. The cost of capital and the return on investment remain constant throughout the life of the firm. The only source of finance available to the firm is retained earnings. Thus the statements given in (a), (c) and (d) are correct. However statement given in (b) which says that the only source of finance is debt is incorrect. Hence the correct answer is (b). 15. Answer : (d) Reason : CCA recommends that three different adjustment are to be made in the income statements to determine the current cost operating profit. These are: •

Depreciation adjustment.

•

Cost of sales adjustment.

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Monetary Working Capital Adjustment. • Hence the correct answer is (d). 16. Answer : (b) Reason : The statements (b) is correct regarding the adjusted book value approach. (a) is not correct as discounted cash flows are not used under adjusted book value approach. Similarly, (c), (d) and (e) is not correct.

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17. Answer : (d) Reason : The following are the basic factors which work under the CPP method of accounting for inflation i.e (i) It is aimed at measuring all items in the financial statements in a unit of measurement that represents the same amount of general purchasing power and (ii) it attempts to measure the gains or losses that arise from holding financial assets.Hence,the correct option is (d). Answer : (d) 18. Reason : The assumptions of Modifian Miller approach of capital structure are :

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19. Answer : Reason : 20. Answer : Reason : 21. Answer : Reason :

22. Answer : Reason : 23. Answer : Reason :

24. Answer : Reason : 25. Answer : Reason :

26. Answer : Reason : 27. Answer : Reason :

1) Information is freely available to investors 2) Transactions are cost-free 3) Investors have homogeneous expectations about future earnings of a company 4) Securities issued and traded in the market are infinitely divisible. However, option (d) is not an assumption of MM approach as MM approach considers that growth of a firm is financed by a mixture of debt, equity and retained earnings. (c) The strategy of inviting another friendly firm to make a counter offer to a hostile offer is called White Knight. (e) The requirement of offering for additional 20% share once the acquirer crosses 15% is as per SEBI guidelines on takeovers. (b) 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. (b) 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. (d) 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). (e) In stock split par value decreases. As a result market price per share decreases immediately after a stock split. (b) 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). (c) ROCE, Residual Income, Profit, EVA are all financial measures of performance. However, employee morale & attitude is a non-financial measure of performance. (c) It is a common misconception that valuation models give an exact estimate of value. It is not totally an objective exercise as the inputs used leave some room for subjective judgements. Hence, only statement (c) is true. So the correct option is (c).

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28. Answer : (b) Reason : Value of the firm is given by the sum of the value of an all-equity finance firm and the present value of the tax benefit of corporate debt. The value of the levered firm will be reduced by present value of bankruptcy and agency costs. Bankruptcy costs are always a significant cost to investors and stakeholders. Agency costs are the costs that govern the way in which principals and agents write and enforce contracts and organize the ownership of the firm. 29. Answer : (c) Reason : Vertical Integration was the feature of Second Merger Wave. Horizontal combination was the feature of First Merger Wave. The Third Merger Wave was characterized by conglomerate transactions. Hence, statement (c) is true. So the correct option is (c).

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30. Answer : (b)

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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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Section B : Problems Sales =

1.

Cost of goods sold 486 = = Rs.648lakh (1- Gross profit margin) 1 − 0.25

Total asset =

Sales 648 Rs.216 lakh = = Total assets turnover 3

Inventories = Current ratio – Quick ratio Current liabilities or Inventories = (1.50 – 0.70) × 90 = Rs.72 lakh Receivables =

Sales 648 = Rs.54 lakh = Re ceivables turnover ratio 12

Current assets = Current liabilities × current ratio = 90 × 1.5

= Rs.135 lakh

Cash and bank = Current assets – Receivables – Inventories = 135 – 54 – 72 = Rs.9 lakh Net fixed asset = Total assets – Current assets = 216 – 135 = Rs.81 lakh Total debt = Total debt to equity ratio × Net worth = 1.88 × 75 = Rs.141 lakh Term loan = Total debt – Current liabilities & provisions = 141 – 90 = Rs.51 lakh Balance Sheet (Rs. lakh) Net worth

75

Net fixed assets

81

Term loan

51

Inventories

72

Current liabilities & provisions

90

Receivables

54

Cash and Bank

9

216

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2.

a.

Average sales per day

=

36506.25 + 36225.28 2 × 360

=

Rs.101.02 Lac

416.84 + 441.47 2

=

Rs.429.16 Lac

331.79 + 262.58 2

=

Rs.297.18 Lac

Average stock Raw materials and stores = Average finished goods inventory = Average WIP inventory

=

253.89 + 214.79 2

=

Rs.234.34 Lac

Average accounts receivable

=

2016.76 + 1399.15 2

=

Rs.1707.96 Lac

=

Rs.1441.12 Lac

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

= =

=

15957.14 + 960.09 + 1655.39 360 Rs.51.59 Lac

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214.79 + 20088.33 + 408.67 − 253.89 360 20457.9 = = Rs.56.83 Lac 360 262.58 + 20457.9 + 9305.87 + 2425.29 − 331.79 Average cost of good sold per day = 360 32119.85 = = Rs.89.22 Lac 360 Durations of various stages of the operating cycle

Average cost of production per day =

Duration of raw material and stores stage (Drm) =

429.16 51.59

=

8.32 days

Duration of WIP stage (Dlwip)

=

234.34 56.83

=

4.12 days

Duration of finished goods stage (Dfg)

=

297.18 89.22

=

3.33 days

Duration of accounts receivable stage (Dar)

=

1707.96 101.02

=

16.91 days

Duration of accounts payable stage (Dap)

=

1441.12 51.59

=

27.93 days

=

0.51

Weights for various stages of the operating cycle Raw material and stores stage, Wrm

=

51.59 101.20

Work in process stage

=

51.59 + 0.5 + 5.24 101.02

Finished good stage, Wfg

=

89.22 101.02

=

0.88

Account receivable stage, War

=

101.02 101.02

=

1.00

Account accounts payable

=

51.59 101.02

=

= 0.57

0.51

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

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

Sales per day × Weighted operating cycle + Cash balance requirement

= =

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

12.19 days.

< TOP >

3.

Free cash flow scenario for next 5 years Rs.in crore 2006 2007 2008 2009 2010 4 1 –2 3 7 P.V of explicit free cash flow upto 2010 4 1 3 7 −2 = + + + + 1.15 (1.15 )2 (1.15 )3 (1.15 )4 (1.15 )5 = 3.48 + 0.75 – 1.32 + 1.72 + 3.48 = 8.12 P.V. of free cash flow of all period considering the cyclical nature of the cash flow = 8.12 + 8.12 PVIF (15%, 5 yrs) + 8.12 PVIF (15%, 10yrs) + 8.12 PVIF (15%, 15yrs) + . . . =

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

14

=

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

4.

The forward-looking approach is often fraught with difficulties, the most intractable of which is the difficulty of estimating future dividends or earnings growth. One possible way of tackling the difficulty could be by surveying equity analysts, but it has been generally seen at the aggregate level that analyst projections almost always overstate the long-term growth of earnings or dividends. So the objectivity of analyst projections is hardly beyond question. Forecasting earnings with any degree of accuracy for one, two, or even three years into the future is difficult. The gap between forecast and reported earnings can be very wide. It was observed in one of the research studies that the aggregate earnings forecast exceeded corporate profits by more than 13 percent. The degree of overestimation generally increases with the number of periods for which the projections are made. Moreover, forecast errors are typically larger in periods of declining economic growth and they tend to decline when economic growth accelerates. The phenomenon of overshooting of the forecasts is not only limited to companies or industries that are rapidly growing and thus more prone to excessive optimism on the part of analysts, but is also observed in case of companies and industries which are undergoing a slow growth phase. Others have constructed elaborate models of forward-looking returns, but such models are typically so complex that it is extremely difficult to draw meaningful conclusions or generate anything but highly unstable results. Forward-looking models typically link current stock prices to expected cash flows by discounting the cash flows at the cost of equity. The implied cost of equity thus becomes a function of known current share values and estimated future cash flows. The problem lies with the estimation of the future cash flows because it is difficult to objectively make such estimates without making simplifying assumptions. The appropriateness of the model and the estimate of cost of equity it yields critically depends on the appropriateness of the underlying assumptions. Another issue that needs to be addressed in this regard is how should the current stock price be measured. Further, most models use the current level of dividends as a starting point for projecting cash flows to equity. However, many corporates have changed their way of providing the returns to the equity shareholders. Traditionally the returns to the equity shareholders were given by paying cash dividends. In the recent times many companies have adopted the method of buying back shares and also various other ways to return cash to the equity shareholders. So estimates based on ordinary dividends will not be able to take into consideration a substantial portion of the cash flows paid out to the equity shareholders. Finally the cash flows in the future are subject to change and the there should be some basis for estimating the changed cash flows in future. If it is assumed that cash flows tend to either grow or decline with the passage of time then the question that arises is how should the rate of growth or decline be estimated. The answers to all these issues will determine the accuracy of the estimate of the cost of equity. < TOP >

5.

The historical approach towards the estimation of cost of equity is also not easy to apply. The first issue that needs to be addressed is the number of time periods over which the returns to the equity shareholders be measured. The more is the number of time periods covered the greater will be the need for data. And it is often difficult to obtain data for long periods of time into the past. Also if the the time period covered into the past is too long the data may not be available for all companies for all the periods. Further, the returns to the equity shareholders do change over time and the extent of change may be different in different time periods depending upon the situations persisting both inside the firm as well as the business environment in which it operates. The next question that arises is how should the returns be represented or measured for any firm. If some measure of central tendency be used then the question is whether it should be the arithmetic mean or the geometric mean of the past returns. It should then be decided how frequently should the average returns be sampled. The exercise involved will be more if the sampling is done too frequently. However if the sampling is done over longer intervals they may fail to capture any significant change in the average returns over time because the mechanism of averaging tends to pull down the higher values and pull up the lower values. Finally the estimation of cost of equity by the historical approach is based on the assumptions: (1) the past returns to the equity shareholders have been in conformity with their expected returns and (2) the expected returns of the equity shareholders in the past are similar to their past expecteations. There are many equity shareholders in a company and their expectations will be different or similar to each other depending upon their assessment of the cashflows from the company. It is not very realistic to assume that for all the equity shareholders all the past returns have been in conformity with their expected returns. Secondly the future is uncertain and the economic conditions such as the inflation rate and the interest rate structure prevailing in the economy may undergo change. Changes in the future inflation rate and the interest rate structure usually result in a change in the rate of return required by the investors. The estimate of the cost of equity by the models based on the historical approach will critically depend upon the methodology and the assumptions underlying them as discussed above. < TOP >

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6.

Following issues regarding cross border mergers and acquisitions should be considered before going for it: • Degree of Openness: Each and every country has its own entry restrictions on some type of services, though in this connection, it is the developed countries which opt for transformation, as compared to the developing countries. Services such as computer and related services, commercial services, medical diagnostics, architectural, engineering and financial services are poised for preference in the FDIs. • Weeding Out Domestic Firms: M&As have costs and benefits. While the host economy will largely reap the benefits of advanced technology, generate larger employment potential, yet in the process there is a danger that small industries and possibly the big domestic firms will have to face stiff competition. There is a possibility that domestic firms in the crowd and cloud of competitiveness will get weeded out, or meekly surrender to the processes of M&As. • Infrastructure Facilities: M&As also largely depend on layout of facilities for infrastructure, which in turn deserves and demands huge investments for plants, roads, transport, communications etc. This will become a burden on the economy, and the infrastructure sector will also tend to get privatized in the process. • Stay Element—A Risk: That M&As are a permanent stay for the host country is a question of serious thought and discussion. They cannot be considered as a permanent stay for benefits, and in the long-run it may be a drift as well. • Drain of National Resources: M&A in the process of reaping benefits may cost the nation its national resources, and whether they are socially responsible towards the nation at large needs to be examined. The ecological and biological environments are the heritage of certain nations, and preservation of these elements will be put at stake by allowing M&As. < TOP >

7.

Following are the benefits of cross border merger and acquisition: • Broad-based Capital Market: The capital market of a country is the reflection of the monetary position of the economy, and also are it should be vibrant and vigorous; it should attract large inflows of FDIs. With the global fall in interest rates, developed countries see that there is at least a marginal inflation and rate of return from investing in the upcoming markets. This is seen with a view that developed markets also diversify their investment, and thus risk and return linkages and lineages are established. • Better Synergies for Production: One of the most common motives for any M&A is expansion. An acquisition of a particular company may provide synergistic gains and benefits when lines of business activities complement one another. An acquisition may be part of a diversification program that allows the company to move into a completely different line of business, which again may be a part of a turnaround strategy. • Finance Factors: Most of the M&As are driven by finance factors. In this connection, valuation analysis by experts is important. This may enable one to find out that the particular firm’s value is neither undervalued nor overvalued, and value addresses the market realities. Also, professionals such as bankers, accountants, valuation experts, attorneys provide a host of services, which in turn get brand image and recognition arising out of M&A’s transactions. • Better Harmonization between the Laws and the Regulatory Framework: M&As require a better harmonization of inland laws and regulatory framework with globe laws. Firms prefer to lend their investments where there are little controls and procedures. • Opening the Gates of the Economy: A developing country with aspiration to reap maximum benefits for its own self-development needs to restructure its position, and pave the way for free flow of FDIs and M&As. This, in the long run, will solve many of the problems being faced by it for a long time. For example, the potential for savings, investments, employment generation and recognition of local skills and labor automatically gets realized. Many of its afflictions such as poverty are alleviated in this dual process and progress. < TOP >

Section C: Applied Theory 8.

Role of the senior management The board and the senior managers need to send strong signals that they consider risk management a priority. The board should play an active role in identifying the risks that may have a significant impact on the fulfillment of corporate objectives. It should review information on these significant risks from time to time. The board should come to a consensus regarding what risks are acceptable, the probability of their occurrence and the type of mechanisms and processes needed to reduce their impact. The board should realize that whatever be the sophistication of the control systems and processes, risks due to poor judgment, human error and unforeseen circumstances can never be completely eliminated. It should be emphasized that the role of the board is not to advocate complete elimination of risk. In a competitive market place, not taking risks could turn out to be a risk in itself. In fact, if effective risk management processes are in place, the board may decide that more risks have to be taken to exploit the opportunities available for the business to succeed in the long run. The board and the senior 16

management team should play an active role in the following areas: •

Understanding the Risk Profile: The board members should clearly understand the risks to which the company is exposed. The board should further decide which risks are acceptable and which must be eliminated through the use of hedging techniques.

•

Setting Policy: The board should prepare policy guidelines, including the corrective action to be taken when things go wrong. For example there should be guidelines on when and how to unwind an unprofitable position, if rates move unfavorably. The exit strategy should be based on the amount of money the company is willing to put to risk.

•

Establishing Controls: Steps should be taken to ensure effective implementation of policies. An independent risk management unit is desirable. Ideally, risk managers should not report to traders. It is a good practice to make risk managers report to people one level higher than those who execute and approve derivative transactions.

•

Setting up systems: The most expensive but integral part of a comprehensive risk management function is consolidation and integration of data from a number of different systems across the company’s operations.

•

Checking compliance: The risk manager should send reports regularly to the senior management and the board. These reports should check compliance with policies and procedures and make independent evaluations of the various derivatives positions. The reports should also indicate whether the positions are synchronous with the company’s accounting department and with the disclosures in the company’s financial reports.

•

Periodic Review: The board must make it clear to traders and treasury managers that any violation of policies, guidelines or controls will be punished. When limits are violated, the board should not hesitate to take immediate action and send clear signals that indiscipline will not be tolerated. < TOP >

9.

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

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