Mb361f July 05

Question Paper

Strategic Financial Management (MB361F) – July 2005 Section A : Basic Concepts (30 Marks) • • • •

1.

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.

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)

3.

It is given that the return on equity of company is decreasing while the net profit margin is increasing. If the asset level remains unchanged, which of the following can be inferred conclusively?

(b) Appraisal costs (e) Quality cost.

< Answer >

(c) Sales are falling < Answer >

(c) External failure costs

According to the Wilcox model, the best indicator of the financial health of an enterprise is (a) The profitability ratios (c) Net liquidation value of the firm (e) Share price of the firm.

6.

(b) Debt has increased (e) Both (a) and (c) above.

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

5.

< Answer >

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.

(a) Equity has increased (d) Sales are increasing 4.

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Which of the following is true in the context of stock split? (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.

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(b) The coverage ratios (d) Market capitalization of the firm

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

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(a) Market price (b) Marginal cost (c) Shadow price (d) Full cost pricing based on actual cost (e) Marginal cost + Lumpsum annual payment. 7.

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)

8.

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.

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

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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 1

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(e) 9.

Securities issued and traded in the market are infinitely divisible.

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

(b) Marketability risk (d) Financial risk

(e) Exchange risk.

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

(b) Growth

(c) Maturity

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(d) Saturation

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

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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.

12. 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

< Answer >

(e) Wilcox Model.

13. Which of the following statements most correctly describes the factors that influence capital structure decisions?

< Answer >

(a) The greater the business risk, the higher the optimal debt ratio will be (b) Large depreciation tax shields and tax-loss carry-forwards will make it more advantageous for firms to assume more debt (c) If a firm is run by a very aggressive manager, he/she may be more inclined to use debt to bolster profits, and hence raising the optimal debt level (d) The major reason firms limit the use of debt is that interest is tax-deductible, which raises the effective cost of debt (e) The higher the probability of future capital needs and the worse the consequences of a capital shortage, the stronger the balance sheet should be. 14. 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?

< Answer >

(a)

The weights based on the book values are difficult to estimate while calculating the weighted average cost of capital (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. 15. Which of the following models on dividend policy stresses on the investor’s preference for the current dividends? (a) Traditional Model (d) Miller and Modigliani Model 16.

(b) Walter Model (c) Gordon Model (e) Rational expectations model. < Answer >

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

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.

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

< Answer >

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. 2

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

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

19. Which of the following factors is not considered by Alcar model on value based management? (a) (b) (c) (d) (e)

< Answer >

Large amount of investment in the fixed assets Large amount of investment in the current assets Large amount of sales value in comparison to total assets Inefficient utilization of the assets High debt-equity ratio.

21. Which of the following conditions certainly indicates that short-term sources of funds have been used for financing long-term uses? (a) (b) (c) (d) (e)

(a) Realized Yield Approach (c) Earnings-Price Ratio Approach (e) Capital Asset Pricing Model.

(a) r = ke

(b) r < ke

(c) r > ke (d) g > ke

< Answer >

(e) g = k(e). < Answer >

24. Net working capital can be said to be financed by (a) Cash credit (d) Term loan only

< Answer >

(b) Bond Yield Plus Risk Premium Approach (d) Dividend Capitalization Approach

23. According to the Walter Model, if r is the internal rate of return, g is the growth rate and ke is the cost of capital, under which of the following conditions the optimal payout ratio is 100%?

(b) Overdraft (e) Long term sources of capital.

(c) Equity capital only

25. Which of the following will cause a decrease in the net operating cycle of a firm?

< Answer >

Increase in the average collection period Increase in the average payment period Increase in the finished goods storage period Increase in the raw materials storage period Increase in the work-in-progress period. < Answer >

26. The term agency costs in the context of capital structure means (a) (b) (c) (d) (e)

< Answer >

Current ratio is less than 1.00 Quick ratio is less than 1.00 Total debt to equity ratio is more than 1.00 Net working capital is positive Total asset turnover ratio is less than 1.

22. Which of the following approaches to compute the cost of equity capital assumes that actual returns to the equity shareholders have been in line with their expected returns?

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

< Answer >

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

20. High asset turnover ratio indicates (a) (b) (c) (d) (e)

< Answer >

The commission payable by a company to its purchasing agents The commission payable by a company to its selling agents The expenses incurred in distribution of the products of the company The cost on account of restrictive covenants imposed on a company by its lenders The dividends paid by a company to its shareholders.

27. Which of the following approaches to corporate risk management is also known as aggregation or diversification? (a) Risk avoidance (d) Separation

(b) Combination (e) Risk transfer. 3

(c) Loss control

< Answer >

28. According to which of the following techniques of strategic cost management, the cost of a product should be determined on the basis of a sales price necessary to capture a predetermined market share? (a) Activity based costing (d) Target costing

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

(c) Life cycle costing

29. Which of the following is considered to be an external factor leading to the bankruptcy of a firm? (a) Shortage in supply of raw materials (c) Labour unrest (e) Disputes among promoters.

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(b) Fraudulent practices by management (d) Technological obsolescence

30. Which of the following is not a source of long-term finance? (a) Retained earnings (c) Debenture capital

< Answer >

(b) Equity share capital (d) Trade credit (e) Term loan.

END OF SECTION A

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Section B : Problems/Caselets (50 Marks) This section consists of questions with serial number 1 – 7. Answer all questions. Marks are indicated against each question. Detailed workings/explanations should form part of your answer. Do not spend more than 110 - 120 minutes on Section B. 1.

Pioneer Enterprises Ltd. operates in the hospitality industry. The following details are available from its latest financial statements: EBIT

Rs.43 lakh

Effective tax rate

30%

Total debt

Rs.80 lakh

Cost of equity capital

16%

Net worth

Rs.80 lakh

Book value per share

Rs.20

The sources of financing used by the company are equity and debt. Total debt consists of current liabilities and long-term debt. The current liabilities amount to Rs.50 lakh and do not include any interest bearing liabilities. The long-term debt is perpetual in nature and carries an interest rate of 10%. The company do not expect any growth in its operations because the market is stable. So it pays out all its earnings as dividends. The company is planning to raise debt of Rs.70 lakh and use the same to buyback a portion of its outstanding equity shares. The new debt will carry an interest rate of 11%. It is assumed that the EBIT and the effective tax rate will remain unchanged in future. However, the cost of equity capital will rise to 18% after the buyback. It is also assumed that the company will continue to pursue its existing dividend policy in future. You are required to answer the following questions: a. Calculate the price for buying back the equity shares and the number of equity shares that can be bought. b. Suggest whether Pioneer Enterprises Ltd. should change its capital structure as per its plans. Justify your answer with necessary calculations. 2.

(4 + 4 = 8 marks) < Answer > The following information pertain to the operations of Agarwal Enterprises Ltd. at the end of a financial year : Net worth Current liabilities and provisions Cost of goods sold Gross profit margin Total asset turnover ratio Accounts receivable turnover ratio Total debt to equity ratio Current ratio Quick ratio

Rs.75 lakh Rs.90 lakh Rs.486 lakh 25% 3 12 1.88 1.5 0.70

You are required to complete the balance sheet of the company given below as at the end of the financial year: Balance sheet (Rs. in lakh) Net worth Term loan Current liabilities and provisions

Net fixed assets Inventories Receivables Cash and bank Total

Total 5

It is assumed that the revenues of the firm wholly consisted of sales and that the sales are entirely on credit basis. Assume 1 year = 360 days. (7 marks) < Answer > 3.

The finance manager of Murphy & Sons Ltd. intends to use a suitable model to manage the cash requirements of the company. An expert has suggested the Miller & Orr model. The company wants to maintain a minimum cash balance of Rs.3 lakh at all times. The company policy is to invest surplus cash in marketable securities. Presently the yield available on such securities is 6.3 percent. The transaction costs involved in buying and selling such securities is assumed to be a fixed amount of Rs.300 per transaction. The standard deviation of the daily changes in cash balances is Rs.3,000. Assume 1 year = 360 days. You are required to answer the following questions: a.

Determine the maximum amount of cash balance that can be accumulated at any time and the amount of cash that should be invested in marketable securities as the maximum cash balance is attained.

b.

What will be the change in the maximum cash balance and the required investment in marketable securities as the maximum cash balance is attained, if the daily inflows of cash increase by a constant amount of Rs.2000 and the daily out flows of cash increase by a constant amount of Rs.1500, due to increased business activity? It is assumed that the other factors influencing the cash balances will remain unchanged.

c. What will be the change in the required investment in marketable securities as the maximum cash balance is attained, if the minimum required cash balance is increased by Rs.1 lakh? It is assumed that the other factors influencing the cash balances will remain unchanged. (3 + 1 + 1 = 5 marks) < Answer >

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

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 >

5.

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 with 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 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 6

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.

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

Explain the various approaches to valuation of risky real assets. (10 marks) < Answer >

7.

Discuss the issues that need to be addressed while evaluating projects that claim attractive IRR. (5 marks) < Answer >

May be finance managers just enjoy living on the edge. What else would explain their weakness for using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects. So why do finance pros continue to do what they know they shouldn't? IRR does have its allure, offering what seems to be a straightforward comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances. Admittedly, some of the measure's deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations—and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards. Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project's annual return on investment only when the project generates no interim cash flows—or when those interim cash flows really can be invested at the actual IRR. IRR's assumptions about reinvestment can lead to major capital budget distortions. Even if the interim cash flows really could be reinvested at the IRR, very few practitioners would argue that the value of future investments should be commingled with the value of the project being evaluated. Most practitioners would agree that a company's cost of capital—by definition, the return available elsewhere to its shareholders on a similarly risky investment—is a clearer and more logical rate to assume for reinvestments of interim project cash flows When the cost of capital is used, a project's true annual equivalent yield can fall significantly—again, especially so with projects that posted high initial IRRs. Of course, when executives review projects with IRRs that are close to a company's cost of capital, the IRR is less distorted by the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10 percent or more above their company's cost of capital, these may well be significantly distorted. An analysis conducted by Mckinsey, with the reinvestment rate adjusted to the company's cost of capital, indicated that the order of the most attractive projects changed considerably when this adjustment was done. The top-ranked project based on IRR dropped to the tenth-most-attractive project. Most striking, the company's highest-rated projects— showing IRRs of 800, 150, and 130 percent—dropped to just 15, 23, and 22 percent, respectively, once a realistic reinvestment rate was considered . Unfortunately, these investment decisions had already been made. Of course, IRRs of this extreme are somewhat unusual. Yet even if a project's IRR drops from 25 percent to 15 percent, the impact is considerable.

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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.

Corporate decisions are affected by a large number of variables. Many-a-time, 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 >

9.

The dividend policy of a firm reflects the views and practices of the management with regard to the distribution of its earnings to the shareholders in the form of dividends. The dividend policy is arrived by the firm on the basis of some strategic determinants. Explain the strategic determinants of dividend policy.

(10 marks) < Answer > END OF SECTION C END OF QUESTION PAPER

Suggested Answers

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

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

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2.

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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3.

Answer : (a)

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S A S × A NW NW Reason : ROE = NPM × = NPM × At the same level of asset, the fall in sale will not normally give the same EBIT. Therefore, the increase in NPM indicates ,better asset use and better tax administration. Hence, for ROE to fall, equity component should rise.

4.

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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5.

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

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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. 6.

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.

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7.

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

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8.

Answer : (d) Reason : The assumptions of Modigliani Miller approach of capital structure are : 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.

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9.

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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10.

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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11.

Answer : (b) 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).

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12.

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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13.

Answer : (e) Reason : In times of financial and economic downturn, creditors will look to supply funds to companies that have stronger financial positions.

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14.

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

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values. 15.

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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16.

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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17.

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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18.

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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19.

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

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20.

Answer : (c) Reason : Asset turnover of a company is defined as the ratio between the sales value and total assets. High asset turnover is possible only when a company can generate a high sales volume in comparison to the amount invested in the fixed assets and current assets.

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21.

Answer : (a) Reason : When the current ratio is less than 1.00 (a), the current assets are less than current liabilities i.e. net working capital is negative. Such a situation indicates that short term funds have been used for long term purposes. Quick ratio (Quick assets / Current liabilities) may be less than 1.00 even when the current ratio is more than or equal to 1.00. Hence (b) is incorrect. Total debt to equity is greater than 1.00 does not imply that current ratio will be less than 1.00. Hence (c) is incorrect. A positive net working capital implies that some part of the long term sources of funds have been invested in short term uses (current assets).

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Hence (d) is incorrect < TOP >

22.

Answer : (a) Reason : The realized yield approach assumes that the actual returns to the equity shareholders have been in line with their expected returns.

23.

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

24.

Answer : (e) Reason : Net working capital is said to be financed by long term sources of capital.

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25.

Answer : (b) Reason : Increase in the average collection period, increase in the finished goods storage period, increase in the raw materials storage period and increase in the work-in process period all result in increasing the operating cycle of the firm. Only increase in the average payment period decreases the net operating cycle of the firm. Hence option (b) is correct.

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26.

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

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27.

Answer : (b) Reason : Combination is also known as aggregation or diversification.

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28.

Answer : (d) Reason : According to target costing the cost of a product should be determined on the basis of a sales price necessary to capture a predetermined market share.

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29.

Answer : (a) Reason : Shortage in supply of raw materials is an external factor, others are internal factors.

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30.

Answer : (d) Reason : Retained earnings (a), equity capital (b), debenture capital (c) and term loan (e) are all sources of long-term finance. However, trade credit is not a long-term source because it has a short span (less than 1 year).

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Section B : Problems 1.

a. (Rs. lakh) EBIT

43

Less: Interest

3

(80 – 50) × 0.10 Profit before tax

40

Less: Tax (40 × 0.30)

12

Profit after tax

28

No. of equity shares outstanding

Earnings per share

=

Rs.80 lakh = 4 lakh Rs.20

=

Rs.28 lakh = Rs.7.00 4 lakh EPS 7.00 = = Rs.43.75 ke 0.16

Intrinsic value of the share = The buyback price per share should be equal to the intrinsic value i.e. = Rs.43.75.

b.

Rs.70 lakh = 1, 60, 000. No. of equity shares that may bought back at the above price = Rs.43.75 Post buyback

(Rs. lakh) EBIT

43

Less: Interest 0.10 (80 – 50) + (70 × 0.11)

10.70

Profit before tax

32.30

Less: Tax (32.3 × 0.30)

9.69

Profit after tax

22.61

No. of outstanding equity shares Earnings per share

=

=

2261000 240000 =

400000 – 160000 =

240000

Rs.9.42

9.42 = Rs.52.33 0.18

Price per share = From above we can see that the price share is expected to increase from Rs.43.75 to Rs.52.33. So the company may change its capital structure by raising debt and buying back a portion of its shares. < TOP >

2.

Cost of goods sold 486 = = Rs. 648 lakh Sales = (1- Gross profit margin) 1 − 0.25 Sales 648 = = 3 Rs.216 lakh Total asset = Total assets turnover Inventories Current liabilities = Current ratio – Quick ratio

or Inventories = (1.50 – 0.70) × 90 = Rs.72 lakh 12

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

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

216 < TOP >

3

3.

a.

Return point (RP) = Given :

3bσ 2 4I + LL

b

= Rs.300

σ

= Rs.3,000

I

0.063 = 360 = 0.000175

LL = Rs.3,00,000

3 × 300 × 30002 13 ] ∴ RP = [ 4 × 0.000175 + 3,00,000 = Rs.3,22,618 Maximum amount of cash balance (UL) = 3RP – 2LL = (3 × 3,22,618) – (2 × 3,00,000) = Rs.3,67,854 The amount of cash that should be invested in marketable securities as the maximum cash balance is attained = UL – RP = 3,67,854 – 3,22,618 = Rs.45,236 b.

If the daily cash inflows increase by a constant amount of Rs.2,000 and the daily cash outflows increase by a constant amount of Rs.1,500, then the ‘changes’ in daily cash balances will increase by a constant amount of Rs.500 (i.e. Rs.2,000 – Rs.1,500). Since all the values (of changes) will increase by a constant value of Rs.500 their mean will also increase Rs.500. Because of this the deviations from mean will remain unchanged. Hence the standard deviation of the change in daily cash balances will also remain unchanged. Other factors influencing the cash balances will also remain unchanged. So there will be no change in the maximum cash balance and the required investment in marketable securities as the maximum balance is reached.

c.

If the minimum required cash balance is increased by Rs.1 lakh then, LL = 3 +1 = Rs.4 lakh. Required investment in marketable securities as the maximum cash balance is attained = UL – RP = (3RP – 2 LL) – RP = 2 RP – 2LL

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= 2 ( RP – LL) Since other factor remain unchanged the return point RP also increases by the same amount as LL i.e. Rs. 1 lakh. Hence the difference between RP and LL remains the same as before. So the required investment in marketable securities remains unchanged. < TOP >

4.

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 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 >

5.

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 risk14

management 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 >

6.

The various approaches that can be used for evaluation of risky assets are: i.

Risk Adjusted discount Rate method (RADR) One of the popular ways of estimating the present value of the future cash flows is by the use of the discount rate method. The rate at which the future cash flows are discounted is actually the project’s cost of capital. The method is generally used in case where there is a comparison firm or set of firms in the same line of business as the project. Calculation of the net present value of the future period’s cash flows using the risk adjusted discount rate can be using the following formula: PV = E (cf)/{1 + rf + beta (R - rf)} Where, E (cf) denotes expected future cash flows in the next period Beta denotes the beta of the return of the project rf denotes the risk-free return RT denotes the expected return of the tangency portfolio. < TOP >

ii.

The Certainty Equivalent Approach In contrast to the RADR approach that involves the adjustments made in the denominator of the NPV equation, this approach deals with adjusting the numerator of the equation. In other words, the CE cash flows are discounted at the risk-free interest rates rather than at risk adjusted discount rates that are done in the case of RADR approach. The certainty equivalent factor (CE) is actually the mount of cash that someone would require with certainty at a point of time which will make him indifferent between that certain amount and an amount expected to be received with risk at that same point of time. Here the risk-free rate and not the firm’s cost of capital are used as a discount rate for the estimation of the net present value. This is mainly done because the company’s cost of capital is a risky counting of the risk. It is to be kept in mind that the certainty equivalents range from 0 to 1.0 and the higher the factor the more certain is the expected cash flow. The CE can be computed in the following way: αt = (certain returns/risky returns) Further the net present value can be calculated as: NPV = NIVα(0) + Σ (NCFtαt)(1 + rf)t Where, α0 denotes the CE factor associated with the net initial investment t denotes economic life of the project αt denotes the CE factor associated with the net cash flows at each period of time t rf denotes the risk-free rate. Advantages of the Approach •

Each period’s cash flow can be adjusted separately to account for the specific risk of those cash flows.

•

The approach provides a clear basis for making decisions, because the decision makers can introduce their own risk preference directly into the analysis. 15

iii.

Scenario Analysis This is another technique that can be used to assess the risk of an investment project. This approach involves the simultaneous changes in the key variables, and their impact on the project. While using the approach, the various estimates of the project’s net present value is called for. This might involve both the optimistic as well as the most pessimistic estimates of the project’s value. The former may be defined in terms of the most optimistic values of each of the input variables whereas the pessimistic scenario can be explained as the pessimistic values of the inputs used in the project. Further, there will also be the existence of the probabilities of these different situations of the project. Advantages of the Risk-Free Scenario Method In the risk-free scenario, the investors expect the stocks to appreciate at the given risk-free rate. In a moderately pessimistic scenario, the manager finds it easier in estimating the future cash flows of the project than in estimating the expected value over all scenarios. < TOP >

7.

The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to be replaced easily. Executives should at the very least use a modified internal rate of return. While not perfect, MIRR at least allows users to set more realistic interim reinvestment rates and therefore to calculate a true annual equivalent yield. Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions. Executives who review projects claiming an attractive IRR should ask the following questions: 1. What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong. Particularly when sponsors sell their projects as "unique" or "the opportunity of a lifetime," another opportunity of similar attractiveness probably does not exist; thus interim flows won't be reinvested at sufficiently high rates. For this reason, the best assumption—and one used by a proper discounted cash-flow analysis—is that interim flows can be reinvested at the company's cost of capital. 2. Are interim cash flows biased toward the start or the end of the project? Unless the interim reinvestment rate is correct (in other words, a true reinvestment rate rather than the calculated IRR), the IRR distortion will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates. < TOP >

Section C: Applied Theory 8.

THE MODELING PROCESS 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 16

•

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 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 >

9.

STRATEGIC DETERMINANTS OF DIVIDEND POLICY Some of the key factors which influence dividend pay-out of a firm are delineated below. Liquidity: Traditional theories have postulated that a dividend decision is solely a function of the earnings of the firm. While earnings are an important determinant for the dividend decision, the role of liquidity cannot be ignored. Dividend pay-out entails cash outflow for the firm. Hence the quantum of dividends proposed to be distributed critically depends on the liquidity position of the firm. In practice, firms often face cash crunch in spite 17

of having good earnings. Such firms may not be in a position to declare dividends despite their profitability. Investment Opportunities: Another key determinant to the dividend decision is the requirement of capital by the firm. Normally firms tend to have low pay-out if profitable investment opportunities exist and conversely firms tend to resort to high pay-outs if profitable investment opportunities are lacking. Generally, firms operating in industries which are in the nascent and growth phases of the product life cycle are characterized by high dependence on retained earnings. On the other hand, firms operating in industries which are in the maturity and decline stages normally distribute a larger proportion of their earnings as dividends. Access to Finance: A company which has easy access to external sources of finance can afford to be more liberal in its dividend pay-out. The dividend policy of such firms is relatively independent of its financing decisions. Firms having little or no access to external financing have rather limited flexibility in their dividend decisions. Flotation Costs: Issue of securities to raise capital in lieu of retained earnings involves flotation costs. These costs include fees payable to the merchant bankers, underwriting commission, brokerage, listing fees, marketing expenses, etc. Moreover smaller the size of the issue, higher will be the 'flotation costs as a percentage of amount mobilized. Further there are indirect, flotation costs in the form of underpricing. Normally issue of shares are made at a discount to the, prevailing market price. The cost of external financing has an influence on' the dividend policy. Corporate Control: Further issue of shares (unless done through rights issue) results in dilution of the stake of the existing shareholders. On the other hand, reliance on retained earnings has no impact on the controlling interest. Hence companies vulnerable to hostile takeovers prefer retained earnings rather than fresh issue of securities. In practice, this strategy can be a double edged sword. The niggardly pay-out policy of the company may result in low market valuation of the company vis-a-vis its intrinsic value. Consequently the company becomes a more attractive target and is in the danger of being acquired. Investor Preferences: The preference of the shareholders has a strong influence on the dividend policy of the firm. A firm tends to have a high pay-out ratio if the shareholders have a strong preference towards current dividends. On the other hand, a firm resorts to retained earnings if the shareholders exhibit a clear tilt towards capital gains. Restrictive Covenants: The protective covenants in bond indentures or loan agreements often include restrictions pertaining to distribution of earnings. These conditions are incorporated to preserve the ability of the issuer/borrower to service the debt. These covenants limit the flexibility of the company in determining its dividend policy. Taxes: The incidence of taxation on the firm and the shareholders has a bearing on the dividend policy. India levies a 10% tax on the amount of distributed profits. This tax is a strong fiscal disincentive on dividend distribution. These dividends are totally tax-tree in the hands of the shareholders. The capital gains (long-term) are taxed at 20%. Dividend Stability: The earnings of a firm may fluctuate wildly between various time periods. Most firms do not like to have an erratic dividend pay-out in line with their varying earnings. They try to maintain stability in their dividend policy. Stability does not mean that the dividends do not vary over a period of time. It only indicates that the previous dividends have a positive correlation with the current dividends. In the long am, the dividends have to be invariably adjusted to synchronize with the earnings. However, the short-term volatility in earnings need not be fully reflected in dividends. < TOP >

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