Mb361f July 06

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

1.

This section consists of questions with serial number 1 - 30. Answer all questions. Each question carries one mark. Maximum time for answering Section A is 30 Minutes.

Which of the following is/are not true regarding the Activity Based Costing (ABC)?

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I. II.

It is more expensive than the traditional costing. Overheads are applied to products using a single predetermined overhead rate based on a single activity measure. III. It is based on historical costs. (a) (b) (c) (d) (e)

2.

Which of the following statements is true? (a) (b) (c) (d) (e)

3.

(b) (c) (d) (e) 5.

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Using the Discounted Cash Flow valuation and ignoring any real options, with the assumption that their values are negative Using the Discounted Cash Flow valuation and including a qualitative recognition of any real option value Using the decision tree analysis Using a financial model for a financial option Developing a unique, project specific model with the help of techniques in financial engineering.

The operational structure of a firm consists of (a) (b) (c) (d) (e)

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

Which of the following is not the possible procedure, that can be used in order to deal with real options? (a)

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A non-growth strategy refers to that strategy where there is no turnover A company can pursue a non-growth strategy, if it rates its non-economic objectives higher than its economic objectives A non-growth strategy need not always be a corrective strategy A corrective strategy cannot be used in conjunction with a growth strategy The long-term objectives of the company include only survival of the firm.

Which of the following ratios is not used by the LC Gupta model for prediction of bankruptcy? (a) (b) (c) (d) (e)

4.

Only (I) above Only (II) above Both (I) and (II) above Both (I) and (III) above Both (II) and (III) above.

Ownership structure Financial leverage State of the economy Capital budgeting decisions External governance groups.

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(e) 6.

The current operating income of Aditya Pharma Ltd. (APL) is Rs.60 lakhs. The company has no debt < Answer > and has Rs.100 lakh as equity capital with a face value of Rs.10 each. APL is planning to buy back some of its shares, which is proposed to be financed through an issue of 10% debentures worth of Rs.80 lakh. If the company falls under the tax bracket of 40% and wants to maintain the current EPS without any change in the current operating income even after the buy-back, the number of shares to be bought back is (a) (b) (c) (d) (e)

7.

III. (a) (b) (c) (d) (e)

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

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Value is created only when return on equity is higher than cost of equity. The price to book value ratio of the firm depends on the return on equity, growth rate of dividends and cost of equity. Shareholder wealth creation is measured by the difference between the book value of equity and its face value. Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above.

Which of the following statements is not true with respect to MM-model? I. II. III.

9.

0.33 lakh 1.0 lakh 1.33 lakh 1.63 lakh 2.0 lakhs.

Which of the following statements regarding Marakon approach is/are not true? I. II.

8.

External governance groups.

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Firm’s cost of equity decreases with leverage. Higher the leverage, lower the beta of the firm. Leverage does not affect the WACC. Only (I) above Only (II) above Only (III) above Both (I) and (II) above Both (II) and (III) above.

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

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 1.00 Current ratio is less than 1.00.

10. Which of the following statements regarding target costing is/are not true? (a) (b) (c) (d) (e)

Target costing reduces the development cycle of the product wherein costs are targeted at the time of product design Target costing has proved to be very efficient in the manufacture of complex products that requires many sub-assemblies Target costing can be used to forecast costs to be incurred in the future and provides motivation to meet future cost objectives Target cost is the excess of the sales price for the target market over the pre-determined margin of profit Target costing can be used for measuring different cost scenarios to ensure that the best ideas available incorporated into the product design.

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available incorporated into the product design. 11. According to the Wilcox model, the best indicator of the financial health of an enterprise is (a) (b) (c) (d) (e)

Net Profit Margin Interest coverage ratio Net liquidation value of the firm Market capitalization of the firm Share price of the firm. < Answer >

12. Which of the following is not a type of real options? (a) (b) (c) (d) (e)

Investment timing option Growth option Abandonment option Flexibility option Foreign currency option.

13. Which of the following statements is true regarding agency costs in the context of capital structure? (a) (b) (c) (d) (e)

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

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It is the commission payable by a company to its purchasing agents It is the commission payable by a company to its selling agents It is the expense incurred in distribution of the products of the company It is the cost on account of restrictive covenants imposed on a company by its lenders It is the dividend paid by a company to its shareholders. < Answer >

14. Which of the following statement is/ are true? I.

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Open market repurchases are not very effective signals for under valuation of company’s stock as compared to tender offers. Dutch auctions are less informative than fixed price offer as signals of under valuation. In a Dutch auction, outside shareholders do not play an active role in establishing terms of trade. Only (I) above Only (II) above Only (III) above Both (I) and (II) above Both (II) and (III) above.

15. Care Corporation is planning an investment of Rs.20 million. Its optimal capital structure is 40 percent < Answer > equity and 60 percent debt. Its earnings before interest and taxes (EBIT) were Rs.36 million for the year. The firm has Rs.180 million in assets, pays an average interest of 10 percent on all its debt, and faces a marginal tax rate of 40 percent. If the firm maintains a residual dividend policy and will keep its optimal capital structure intact, the amount of the dividends it will pay after financing its capital budget is (a) (b) (c) (d) (e)

Zero Rs.5.42 million Rs.7.12 million Rs.12.02 million Rs.15.12 million.

16. From the information given below, what is the upper control limit as per Miller and Orr model? (Assume < Answer > 360 days in a year.)

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

Lower limit of cash balance Annual yield on securities Fixed transaction cost Variance of change in daily cash balance Rs.70,560.21 Rs.71,047.31 Rs.72,560.31 Rs.72,955.31 Rs.73,260.31.

Rs.50,000 10% Rs.1,600 80,000

(e)

Rs.73,260.31.

17. A firm has total assets of Rs.400 lakhs and a debt/equity ratio of 0.60. Its sales are Rs.300 lakhs, and it < Answer > has total fixed costs of Rs.120 lakhs. If the firm's EBIT is Rs.60 lakhs, its tax rate is 40 percent, and the interest rate on all of its debt is 9 percent, the firm's ROE is (a) (b) (c) (d) (e)

6.98% 13.75% 5.25% 11.16% 11.25%.

18. Which of the following is an important tool for assessing the financial strength of an organization within < Answer > the industry? (a) (b) (c) (d) (e)

Accounting analysis Time series Analysis Common size statements Comparative analysis Market analysis.

19. The balance sheet (based on market values) of Amrut Foods Ltd, which has 1,000 outstanding shares is < Answer > as follows: Liabilities Equity

Balance Sheet Based on Market Values Rs. Assets Rs. 1,20,000 Cash 20,000 Other Assets 1,00,000 1,20,000 1,20,000

The company has declared a dividend of Rs.6 per share. If the company’s stock goes ex-dividend tomorrow and there are no taxes, the ex-dividend price of the company’s stock is (a) (b) (c) (d) (e)

Rs.108.00 Rs.112.00 Rs.114.00 Rs.118.80 Rs.126.00.

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

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

21. Which of the following will cause a decrease in the net operating cycle of a firm? (a) (b) (c) (d) (e)

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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.

22. Hedging through forwards, futures, swaps, etc. is an example of (a) (b) (c) (d) (e)

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Risk avoidance Loss control Risk sharing Risk transfer Separation.

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(e)

Separation.

23. Which of the following is considered to be an external factor leading to the bankruptcy of a firm? (a) (b) (c) (d) (e)

Shortage in supply of raw materials Fraudulent practices by management Labour unrest Technological obsolescence Disputes among promoters.

24. Calculate the price to book value ratio of a company based on the following information: Return on equity Cost of equity Growth rate of earnings and dividends (a) (b) (c) (d) (e)

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25% 15% 5%

1.00 1.27 1.89 2.00 2.30.

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

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.

26. Which of the following factors does not figure in when assessing the present value of an investment by < Answer > the risk adjusted discount rate method? (a) (b) (c) (d) (e)

Projected future cash flows from the investment Beta of the investment in question Expected return from the tangency portfolio Expected return from the equity shares of the firm Risk free return.

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

28. Which of the following statements is/are not true? I. II. III. (a) (b) (c) (d) (e)

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Economic risk is associated with losing competitive advantage due to exchange rate movements. Transaction risk represents only the immediate effect on cash flow after a change in exchange rate. Economic risk does not take into account the long-term consequent of the change in currency value. Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above.

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29. Which of the following statements is not true with respect to ERM? I. II. III. (a) (b) (c) (d) (e)

ERM can be delegated to the treasury desk of the company. A tactical orientation of ERM implies that the objectives are limited, and involves hedging of explicit future commitments. A strategic approach looks at the company only when a risk management process is selected. Only (I) above Only (II) above Both (I) and (II) above Both (II) and (III) above All (I), (II) and (III) above.

30. Which of the following is a variable that can be analyzed at the generic level as per the Mckinsey < Answer > approach? (a) (b) (c) (d) (e)

Return on invested capital Product mix and Product design Customer mix and Customer relationship Level of capacity utilization Cost of managing inventories.

END OF SECTION A

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

1.

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

Ganesh Automobiles Limited has estimated cash requirement of Rs.15,00,000 per month. The company holds a portfolio of securities worth Rs.50 lakhs. The company had purchased this portfolio 5 years ago at an average price of Rs.100 per share. The current average market price of the securities in the portfolio is Rs.177. The company is planning to sell some of the securities in order to meet its cash requirements over the planning horizon. The fixed cost per conversion is expected to be Rs.500.

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Using the Baumol Model, you are required to determine the amount of securities the firm needs to convert per order so as to minimize the total cost if the planning horizon of the firm is three months. (5 marks) 2.

Seven Hills Computers Ltd., is currently engaged in manufacturing four products. Details of the four products and relevant information are given below: Particulars Output in Units Cost per unit: Direct Material (Rs.) Direct Labour (Rs.) Machine Hours (per unit)

Stereo headphones 120 40 28 4

Product External Modem 100 50 21 3

UPS

Foot pedals

80

120

30 14 2

60 21 3

All the four products are usually produced in production runs of 20 units and sold in batches of 10

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All the four products are usually produced in production runs of 20 units and sold in batches of 10 units each. The production overhead is currently absorbed by using machine hour rate, and the total of the production overhead for the period has been analyzed as follows: Particulars Machine Department Cost (rent, depreciation and supervision) Set-up cost Stores consumables Inspection / quality control Materials handling and dispatch

business rates,

Amount (Rs.) 10,430 5,250 3,600 2,100 4,620 26,000

You have ascertained the following ‘Cost Drivers’ to be used for the overhead costs: Cost

Cost Drivers

Setup costs

No. of production runs

Stores & consumables

Requisition raised

Inspection / quality control

No. of production runs

Materials handled and dispatch

Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being a batch of 10 units of a product. You are required to find out: a.

The total costs for each product if all overhead costs are absorbed on the basis of machine hour.

b.

The total costs for each product using Activity-Based Costing. (2 + 6 = 8 marks)

3.

The finance manager of Kalidas Computers Ltd is of the opinion that in the process of discriminating the high-credit worthy accounts and the low-credit worthy, the two key ratios that can be employed for discrimination are the current ratio and the earning power where the former is the ratio of current assets to current liabilities and the latter is the ratio of the earnings before interest and tax to the total assets. High credit worthy and low credit worthy information relating to fourteen accounts comprising an equal number of the above mentioned accounts are given below: High-credit worthy accounts Client Current ratio Earning number capacity (%) 1 1.25 15 2 1.43 18 3 1.68 15 4 1.89 22 5 2.12 20 6 0.95 16 7 1.05 12

Low-credit worthy accounts Client Current Earning number ratio capacity (%) 8 0.86 10 9 0.66 8 10 0.49 6 11 0.52 9 12 0.72 –6 13 0.58 7 14 0.41 –3

You are required to establish the appropriate discriminant function that best discriminates between the high-credit worthy accounts and the low-credit worthy accounts. (9 marks)

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

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4.

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

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(7 marks) 5.

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

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

Caselet 1 Read the caselet carefully and answer the following questions: 6.

No one predict an industry’s cycle precisely and any single forecast of performance may lead to enormous conclusions. Given this, suggest a methodology for valuation of cyclical companies.

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(8 marks) 7.

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Discuss how mangers can exploit the cyclical nature of their industry. (5 marks)

Companies in industries prone to significant swings in profitability present special difficulties for mangers and investors trying to understand how they should be valued. In extreme cases, companies in these so called cyclical industries-airline travel, chemicals, paper, and steel, for example – challenge the fundamental principles of valuation, particularly when their shares behave in ways that appear unrelated to the discounted value of their underlying cash flows. The DCF values is far less volatile than the underlying cash flows. Indeed, there is almost no volatility in the

flows. The DCF values is far less volatile than the underlying cash flows. Indeed, there is almost no volatility in the DCF value because no single year’s performance affects it significantly. In the real world, of course, the share prices of cyclical companies are less stable. On the assumption that the market values of companies are linked to consensus earnings forecasts, when these consensus earnings forecasts were examined for clues it was found that these forecasts appeared to ignore cyclicality entirely by almost always showing an upward trend, regardless of whether a company was at the peak or the trough of a cycle. Earnings forecasts generally have a positive bias. Sometimes this is attributed to the pressures faced by equity analysts at investment banks. Analysts might fear that a company subjected to negative commentary would cut off their access or that a pessimistic forecast about a company that is a client of the bank they work for could damage relations between the two. In light of these, it is reasonable to conclude that analysts as a group are unable or unwilling to predict the business cycle for these companies. Business cycles, and particularly their inflection points, are hard for any one to predict. Given this, how the market ought to behave? Should it be able to predict the cycle and thus avoid fluctuations in share prices? However, that might be asking too much; at any point, a company or industry could break out it its cycle and move to a new one that is higher or lower.

END OF SECTION B

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

8.

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

With growing levels of uncertainty and risk, firms have to face an indecisive and nondeterministic future. Effective Risk Management is gaining prominence and increasing attention in the corporate world. What are the various approaches using which firms can manage their risks?

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(10 marks) 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) END OF SECTION C END OF QUESTION PAPER

Suggested Answers Strategic Financial Management (MB361F) : July 2006 Section A : Basic Concepts

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1.

2.

3.

4.

5.

6.

Answer : (b) Reason : ABC costing is more expensive than the traditional costing. In many production processes, overheads are applied to products using a single predetermined overhead rate based on a single activity measure, but in ABC costing, multiple activities are identified in the production process that are associated with costs. It is based on historical costs. Therefore statements (I) and (III) are true and statement (II) is not true. Hence (b) is the answer. Answer : (b) Reason : A non-growth strategy refer to that strategy where there is no growth in earnings, but not necessarily turnover. Statement (a) is not true. A company can pursue a non-growth if it rates its non-economic objectives higher than its economic objectives. Statement (b) is true. A non-growth strategy is bound to be a corrective strategy. Statement (c) is not true. A corrective strategy can be used in conjunction with, or as one component of, a growth strategy. Statement (d) is not true. The long-term objectives of the company include both survival and growth of the firm. Statement (e) is not true. Hence (b) is the answer.

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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. Answer : (a) Reason : In option (a), the assumption is that their values are zero. Other options are correct with respect to the possible procedures that can be used in order to deal with the real option.

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Answer : (d) Reason : The business environment of the firm consisits of the state of the economy, resoruce availability, external governance groups and internal governance groups. The operational structure of the firm consists of the capital structure decisions, decision regarding the size of the company and the production function, interanl audit, and decision regarding the financial sructure of the company. The financial structure decisions typically comprises o the ownership structure, financial leverage, dividend and stock repurchase policies and the executive compensation plans. Hence (d) is the answer. Answer : (c) Reason : (EBIT-I1 )(1-T) (60 − 0)(0.6) = = 3.6 No.of shares 10, 00, 000

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3.6 =

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(EBIT-I 2 )(1-T)

No.of shares

(60-8)(0.6) x X = 8.67 lakhs Therefore 1.33 lakh (10 lakh – 8.67 lakh) shares should be bought back. ∴Answer is (c). Answer : (c) Reason : While price to book ratio depends upon the return on equity, growth rate of dividends and the cost of equity under the Marakon approach, the value created for shareholders is measured by the difference between the book value of equity B and the market value of equity M, where M stands for how productively the firm has employed its equity or capital contributed by the shareholders. Therefore statement (III) is not true and statements (I) and (II) are true. Hence (c) is the answer. 3.6 =

7.

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answer. Answer : (d) Reason : Firm’s cost of equity increases with leverage. Statement (I) is wrong, higher the leverage, higher the beta of the firm. Statement (II) is wrong. Therefore (d) is the answer.

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Answer : (e) 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 (a) is incorrect. Total debt to equity is greater than 1.00 does not imply that current ratio will be less than 1.00. Hence (b) 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). Hence (e) is the correct answer. Answer : (b) Reason : Target costing is based on external analysis of markets and competitors, and is a cost management tool that reduces a product’s costs over its entire life cycle. But it is difficult to use in the presence of complex products because on the one hand, analysis of costs needs to be performed at various levels, while on the other, the activity of tracking costs becomes more complicated and cumbersome. Hence statemetns (a), (c), (d) and (e) are true and statement (b) is not true. Hence (b) is the answer. 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. Hence (c) is the answer. Answer : (e) Reason : The tracking portfolio approach seeks to develop tracking portfolios for which the present value of the tracking error is zero. Statement (I) is not true. Tracking error is the difference between the cash flows of the tracking portfolios and the cash flows of the projects. Statement (II) is true. Strategic planning models are normative strategies that consider the firm as an organic entity that is more interested in self-preservation. Statement (III) is true. Hence (e) is the answer. Answer : (d) Reason : Agency costs are costs 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. Hence (d) is the answer. Answer : (d) Reason : Open market repurchases are not very effective signals for under valuation of company’s stock as compared to tender offers because open market repurchases are executed at the prevailing market prices and do not have any premium content. Dutch auctions are also very less informative than fixed price offer as signals of under valuation. In Dutch auction outside shareholders play an active role in establishing terms of trade. Hence option (d) is the answer.

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Answer : (c) Reason : Interest cost:

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Total assets = Rs.180M; debt = 60% × Rs.180M = Rs.108 million in debt. Interest cost = Rs.108M × 0.10 = Rs.10.8 million. Net income (in millions): EBIT Rs.36.0 less: Interest – 10.8 EBT Rs.25.2 less: Taxes (@40%) – 10.08

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16.

Net income Rs.15.12 The portion of project financed with retained earnings: Retained earnings portion: 20M x 0.40 = Rs.8.0 million Debt portion = Rs.20M x 0.60 = Rs.12.0 million The residual available for dividends = Rs.15.12M – Rs.8.0M = Rs.7.12 million in dividends Answer : (b) 3

Reason :

RP

=

I

=

3bσ2 + LL 4I 10 360 = 0.0278% 3

RP UL

17.

18.

19.

20.

=

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3×1, 600 × 80, 000 + 50, 000 4 × 0.000278

=

57,015.77

=

3RP – 2LL

=

3(57,015.77) – (2 × 50,000)

=

71,047.31

Answer : (d) Reason : Rs.40,000,000 = Total equity + Total debt. Total debt = 0.60(Total equity) 40,000,000 = Total equity + 0.60(Total equity) Total equity = 400,00,000/1.60 = Rs.2,50,00,000. Total debt = Rs.4,00,00,000 – Rs.2,50,00,000 = Rs.1,50,00,000. Debt interest = 1,50,00,000(0.09) = Rs.13,50,000 Net income = (EBIT – I)(1 – T) = 60,00,000 – 13,50,000) 0.60 = Rs.2,790,000. ROE = 2,790,000/2,50,00,000 = 11.16%. Hence (d) is the answer. Answer : (d) Reason : Comparative analysis is an important tool for assessing the financial strength of an organization within the industry. Answer : (c)  Rs.1, 20, 000    1, 000  = Rs.120 Reason : Since the balance sheet shows market values, the stock is worth  per share today (cum dividend). The ex-dividend price will be (Rs.120 – Rs.6) = Rs.114. Once the dividend is paid, the company has Rs.6,000 less cash, so total equity is worth  Rs.1,14, 000    1, 000  = Rs.114 per share. Rs.1,14,000 or  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.

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• Cost of capital Obviously, dividend growth rate is a factor not considered in this model. So the correct answer is (d). 21.

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29.

30.

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. Answer : (d) Reason : Risk avoidance is an extreme way of managing risk by not undertaking the activity that entails risk. Loss control refers to the attempt to reduce either possibility of or the quantum of loss. Risk is transferred when the firm originally exposed to a risk transfers it to another party which is willing to bear the risk. Derivative instruments are used to transfer the risk. Risk is retained when nothing is done to avoid. The combinations of risk retention and risk transfer is known as risk sharing. Separation is the technique of reducing risk through separating parts of businesses or assets or liabilities. Answer : (a) Reason : Shortage in supply of raw materials is an external factor, others are internal factors.s Answer : (d) Reason : P/B = (r – g)/(k – g) = (25 – 5)/(15 – 5) = 2.00. 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 Answer : (d) Reason : Expected return from the equity shares of the firm does not figure out when assessing the present value of an investment by the risk adjusted discount rate method. Answer : (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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Answer : (c) Reason : Economic risk takes into account the long-term consequences of the change in currency value. Answer : (e) Reason : ERM speaks about some advanced areas of risk management, such as technology risk, antitrust risk, environment risk, political risk etc., and all the statements are true. Answer : (a) Reason : At generic level, the variables that reflect the achievement or non-achievement of the objective of value maximization most directly are identified.

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Section B : Problems/Caselets 1.

The total cash required over the planning period = Rs. 15,00,000 x 3 = Rs. 45,00,000 The average annual yield on the securities can be determined as follows: 100 (1+ r) 5 = 177 => r = 12.09 % Therefore, the yield for three month period = 3% Fixed conversion cost = Rs. 500 per conversion. According to Baumol model, the total cost is minimized when conversion size (C ) is given by C=

2bT I

where b= Fixed cost per conversion T = Total cash required during the planning horizon I = Yield on marketable securitiesover the planning horizon Substituting the given values, we get 2 × 500 × 45, 00, 000 0.03

= Rs.3,87298.33 Therefore, the company needs to convert Rs.387298 worth of securities per conversion in order to minimize the total cost. < TOP >

2.

a.

Calculations showing overheads assigned on an Machine Hour Rate Basis Total overheads = Machine Department Cost + Set-up costs + Stores consumables + Inspection/quality control + Materials handling and dispatch = 10430 + 5250 + 3600 + 2100 + 4620 = 26,000

Machine Hours = (output in units) × (Machine Hours per unit) Product Stereo headphones

=

120 × 4

=

Product External Modem

=

100 × 3

=

300

Product UPS

=

80 × 2

=

160

Product Foot Pedals

=

120 × 3

=

360 1,300

Total Machine Hours

Machine Hour Rate =

480

Total Overheads Total Machine Hours

Rs 26, 000 1,300

= = Rs 20/- per MHR Statement showing cost per unit per product (Rs.) Products Particulars

Stereo headphones

External Modem

UPS

Foot Pedals

Total

Direct Material

40

50

30

60

180

Direct Labour

28

21

14

21

84

Overheads absorbed

80

60

40

60

240

148

131

84

141

504

17760

13100

6720

16920

54500

(Machine Hour Rate × Machine Hour per unit)

Cost per unit Total cost per product

Total cost per product (Cost per unit × Output in units) b.

17760

13100

6720

16920

54500

Calculations showing overheads assigned on ABC Basis Application rate of cost driver for overheads i. Machine Department

Machine Dept. cos t 10430 = Total machine Hrs 1300

ii.

Setup costs

=

=

Total Setup cost No.of production runs

No. of Production runs Setup costs

iii.

iv.

v.

Rs.8.0231 per machine hour rate

5250 21 =

Stores & Consumables

Inspection/QC

=

Number of Production Runs Number of stores requisition No. of Sales order (deduced from information)

Totalstores + Com mod ity cos t No.of requisitions raised Inspection / QC cos t No.of production runs

=

=

=

3600 20 × 4

= Rs.45 per requisition

2100 = 21 = Rs.100 per production run

Material handling & dispatch cost No.of orders executed

4620 = 42 = Rs.110 orders executed.

Stereo headphones 6 20 12

Products External Modem 5 20 10

UPS 4 20 8

Direct Material Direct Labour Overheads: i. Machine Department (MHR) ii. Setup costs iii. Stores receiving iv. Inspection / QC v. Materials handling and dispatch Total overheads Cost per unit Total cost per product

Stereo headphones 40.00 28.00

Products External Modem 50.00 21.00

32.09 12.50 7.50 5.00 11.00 68.09 136.09 16,331.08

24.07 12.50 9.00 5.00 11.00 61.57 132.57 13,256.92

Total

Foot Pedals 6 20 12

21 80 42 (Rs.)

Calculations of the cost per unit and the total costs of each product Particulars

420 = 20 = 21

= Rs.250 per production run

Materials handling and dispatch

Particulars

Total number of output units of all products No.of requisition raised for each product

UPS

30.00 14.00

Foot Pedals 60.00 21.00

16.05 12.50 11.25 5.00 11.00 55.80 99.80 7983.69

24.07 12.50 7.50 5.00 11.00 60.07 141.07 16928.31 < TOP >

3.

Let the discriminant function be Zi = aXi + bYi

where Zi = Discriminant score for the ith account Xi = Current assets/Current liabilities for the ith account Yi = EBIT/Total assets for the ith account. Account number

Xi

Yi

(Xi –Xm)

(Yi –Ym)

(Xi – Xm)2

(Yi – Ym)2

(Xi – Xm) (Yi – Ym)

Gr. I 1 2 3 4 5 6 7

1.25 1.43 1.68 1.89 2.12 0.95 1.05

15 18 15 22 20 16 12

0.21 0.39 0.64 0.85 1.08 –0.09 0.01

4.36 7.36 4.36 11.36 9.36 5.36 1.36

0.0441 0.1521 0.4096 0.7225 1.1664 0.0081 0.0001

19.0096 54.1696 19.0096 129.0496 87.6096 28.7296 1.8496

0.9156 2.8704 2.7904 9.656 10.1088 – 0.4824 0.0136

Gr. II 8 9 10 11 12 13 14

0.86 0.66 0.49 0.52 0.72 0.58 0.41

10 8 6 9 -6 7 -3

-0.18 -0.38 -0.55 -0.52 -0.32 -0.46 -0.63

-0.64 -2.64 -4.64 -1.64 -16.64 -3.64 -13.64

0.0324 0.1444 0.3025 0.2704 0.1024 0.2116 0.3969

0.4096 6.9696 21.5296 2.6896 276.8896 13.2496 186.0496

0.1152 1.0032 2.552 0.8528 5.3248 1.6744 8.5932

Xm = 14.61/14 = 1.04 Xm1 = Sum of Xi for Gr. I/7 = 10.37/7 = 1.48 Xm2 = Sum of Xi for Gr. II/7 = 4.24/7 = 0.61

Ym = 149/14 = 10.64 Ym1 = Sum of Yi for Gr. I/7 = 118/7 = 16.86 Ym2 = Sum of Yi for Gr. II/7 = 31/7 = 4.43 σx2 = (1/n-1) Σ(X - Xm)2 = (1/13) x 3.9635 = 0.305 σy2 = (1/n-1) Σ(Y - Ym)2 = (1/13) x 847.2144 = 65.17 σxy = (1/n-1) Σ(X - Xm) (Y - Ym) = (1/13) x 45.99 = 3.54

dx = Xm1 – Xm2 = 1.48 – 0.61 = 0.87 dy = Ym1 – Ym2 = 16.86 – 4.43 = 12.43 a

= (σy2 dx - σxy dy)/ (σx2σy2 - σxy2) = (65.17 x 0.87 – 3.54 x 12.43)/(0.305 x 65.17 – 3.54 x 3.54) = 12.6957 / 7.3453 = 1.728

b

= (σx2 dy - σxy dx)/ (σx2σy2 - σxy2) = (0.305 x 12.43 – 3.54 x 0.87)/(0.305 x 65.17 – 3.54 x 3.54)

= 0.7114 / 7.3453 = 0.097 Hence, the required discriminant function is Zi = 1.728Xi + 0.097Yi < TOP >

4.

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

5.

As a preface to the annual report, a company's management typically spends a few pages talking about the recent year (or quarter) and gives a background of the company. While this is not the guts of the financial statements, it does give investors a clearer picture of what the company does. It also points out some key areas where the company has performed well. The management's analysis is provided at their discretion, so take it for what it's worth. Issues that analysts might look for in this portion are how candid and accurate are the managers' comments, does the manager discuss significant financial trends over past couple years, how clear are the managers comments and do they mention potential risks or uncertainties moving forward? If a company gives an adequate amount of information in the MD&A, it's likely that management is being honest. It should raise a red flag if the MD&A portion of the financial statement ignores serious problems that the company has been facing. A good example would be a company that is known to have large portions of outstanding debt but fails to mention anything about it in the MD&A. Withholding important information not only deceives those who read the financial statements, but in extreme cases also makes the company liable for lack of disclosure. Similarly, the notes to the financial statements (sometimes called footnotes) are also an integral part of the overall picture. If the income statement, balance sheet, and statement of cash flow are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. If the analyst does not read the footnotes he may be missing out on a lot of information. The footnotes list important information that could not be included in the actual ledgers. The notes list relevant things like outstanding leases, the maturity dates of outstanding debt, and even details on where the revenue actually came from. Generally speaking there are two types of footnotes: Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business.

This portion of the footnotes tells about the nature of the company's business, when its fiscal year starts and ends, how inventory costs are determined, and any other significant accounting policies that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is changing policies only to take advantage of current conditions to hide poor performance. Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt such as maturity dates and the interest rates at which debt was issued, can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings the company is involved in. The majority of investors and analysts read the balance sheet, income statement, and cash flow statement. But for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn't. < TOP >

6.

No one can predict an industry’s life cycle precisely, and any single forecast of performance has to be wrong. But managers and investors can benefits by explicitly following the probabilistic approach to valuing cyclical companies. This approach avoids the traps of a single forecast and makes it possible to explore a wider range of outcomes and their implications. The following method of valuing cyclical companies involves creating two scenarios. This approach provides an estimated of a company’s value and scenarios an estimate that puts boundaries on the valuations. Managers can use the boundaries to think about how they should modify their strategies and possible ways of responding to signals that one scenario was more likely to materialize than another. Step 1 Construct and value the “normal-cycle” scenario using information about past cycles. Using information about past earnings cycle pay particular attention to the long term line of operating profits, cash flow, and return on invested capital because this will affect the valuation. Make sure the continuous value is base on a “normalized” level of profit- that is, on the company’s long term flow trend line Step 2 Construct and value a “new trend – line scenario” based on recent performance. Again, focus most on the longterm trend line because it will have the greatest impact on value. Step 3 Develop an economic rationale for each scenario, considering factors such as growth in demand, technological changes that will affect the balance of supply and demand, and the entry or exit of companies into the industry. Step 4 Assign probabilities to the scenarios and calculate then weighted value, basing it on your analysis of the likelihood of the events leading to each of them. < TOP >

7.

Managers have detailed information about their markets and might thus be expected to do a better job than the stock market at predicting the cycle and reacting appropriately. However, managers do exactly the opposite and exacerbate the problem. Cyclical companies often commit themselves to big capital spending projects just when prices are high and the cycle is hitting its peak. They then proceed to retrench when prices are low. Some develop forecasts that are quite similar to those issuing form equity analysts: upward sloping, regardless of where in the cycle the company is. In doing so, these companies send wrong signals to the stock market. Rather than spreading confusion, managers should learn to expoit their superior knowledge. They could first improve the timing of capital expenditures and then follow up with a strategy of issuing shares at the peak of the cycle and repurchasing them at the trough. The most aggressive managers could take this one step further and adopt a trading approach for acquiring assets at the bottom of the cycle and selling them at the top. In this way, a typical cyclical industry could more than double its returns. < TOP >

Section C: Applied Theory 8.

The following are the different approaches to managing risks: • •

Risk avoidance Loss control

• Combination • Separation • Risk transfer • Risk retention • Risk sharing. Risk Avoidance

An extreme way of managing risk is to avoid it altogether. This can be done by not undertaking the activity that entails risk. For example, a corporate may decide not to invest in a particular industry because the risk involved exceeds its risk bearing capacity. Though this approach is relevant under certain circumstances, it is more of an exception rather than a rule. It is neither prudent, nor possible to use it for managing all kinds of risks. The use of risk avoidance for managing all risks would result in no activity taking place, as all activities involve risk, while the level may vary. Loss Control

Loss control refers to the attempt to reduce either the possibility of a loss or the quantum of loss. This is done by making adjustments in the day-to-day business activities. For example, a firm having floating rate liabilities may decide to invest in floating rate assets to limit its exposure to interest rate risk. Or a firm may decide to keep a certain percentage of its funds in readily marketable assets. Another example would be a firm invoicing its raw material purchases in the same currency in it which invoices the sales of its finished goods, in order to reduce its exchange risk. Combination

Combination refers to the technique of combining more than one business activities in order to reduce the overall risk of the firm. It is also referred to as aggregation or diversification. It entails entering into more than one business, with the different businesses having the least possible correlation with each other. The absence of a positive correlation results in at least some of the businesses generating profits at any given time. Thus, it reduces the possibility of the firm facing losses. Separation

Separation is the technique of reducing risk through separating parts of businesses or assets or liabilities. For example, a firm having two highly risky businesses with a positive correlation may spin-off one of them as a separate entity in order to reduce its exposure to risk. Or, a company may locate its inventory at a number of places instead of storing all of it at one place, in order to reduce the risk of destruction by fire. Another example may be a firm sourcing its raw materials from a number of suppliers instead of from a single supplier, so as to avoid the risk of loss arising from the single supplier going out of business. Risk Transfer

Risk is transferred when the firm originally exposed to a risk transfers it to another party which is willing to bear the risk. This may be done in three ways. The first is to transfer the asset itself. For example, a firm into a number of businesses may sell-off one of them to another party, and thereby transfer the risk involved in it. There is a subtle difference between risk avoidance and risk transfer through transfer of the title of the asset. The former is about not making the investment in the first place, while the latter is about disinvesting an existing investment. The second way is to transfer the risk without transferring the title of the asset or liability. This may be done by hedging through various derivative instruments like forwards, futures, swaps and options. The third way is through arranging for a third party to pay for losses if they occur, without transferring the risk itself. This is referred to as risk financing. This may be achieved by buying insurance. A firm may insure itself against certain risks like risk of loss due to fire or earthquake, risk of loss due to theft, etc. Alternatively, it may be done by entering into hold- harmless agreements. A hold-harmless agreement is one where one party agrees to bear another party’s loss, should it occur. For example, a manufacturer may enter into a hold-harmless agreement with the vendor, under which it may agree to bear any loss to the vendor arising out of stocking the goods. Risk Retention

Risk is retained when nothing is done to avoid, reduce, or transfer it. Risk may be retained consciously because the other techniques of managing risk are too costly or because it is not possible to employ other techniques. Risk may even be retained unconsciously when the presence of risk is not recognized. It is very important to distinguish between the risks that a firm is ready to retain and the ones it wants to offload using risk management techniques. This decision is essentially dependent upon the firm’s capacity to bear the loss. Risk Sharing

This technique is a combination of risk retention and risk transfer. Under this technique, a particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it. For example, a firm and its supplier may enter into an agreement, whereby if the market price of the commodity exceeds a certain price in the future, the seller foregoes a part of the benefit in favor of the firm, and if the future market price is lower than a predetermined price, the firm passes on a part of the benefit to the seller. Another example is a range forward, an instrument used for sharing currency risk. Under this contract, two parties agree to buy/sell a currency at a future date. While the buyer is assured a maximum price, the seller is assured a minimum price. The actual rate for executing the transaction is based on the spot rate on the date of maturity and these two prices. The buyer takes the loss if the spot rate falls below the minimum price. The seller takes the loss if the spot rate rises above the maximum price. If the spot rate lies between these two rates, the transaction is executed at the spot rate. < TOP >

9.

Strategic Determinants of Divivdend 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 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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