Mb361f-oct 05

Question Paper

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

1.

II. III. (a) (d)

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 (b) Only (II) above (c) Only (III) above Both (I) and (II) above (e) Both (II) and (III) above.

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

3.

Which of the following is not a financial determinant of value according to Marakon Model?

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(b) BCG Matrix (d) Argenti Score Board

(c) 35%

(d) 40%

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

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

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(e) 45%.

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

8.

(b) 30%

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(e) Life cycle costing.

Dutta Industries follows a strict residual dividend policy. The company has a capital budget of Rs.4,000,000. It has a target capital structure which consists of 40 percent debt and 60 percent equity. Dutta Industries forecasts that its net income will be Rs.3,000,000. What will be the company’s expected dividend payout ratio this year? (Assuming that there will be no fresh issue of equity). (a) 20%

7.

(b) Absorption costing (d) Target costing

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(e) Retention ratio.

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

6.

(b) Return on equity (d) Growth rate of dividends

A costing technique based on sales price of a product necessary to capture a predetermined market share is known as (a) Activity based costing (c) Quality costing

5.

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Information is freely available to investors Transactions are cost free Investors have homogeneous expectations about future earnings of a company Growth of a firm is entirely financed through retained earnings Securities issued and traded in the market are infinitely divisible.

(a) Cost of goods sold (c) Cost of equity 4.

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

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.

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. 1

9.

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.

10. If the expected inflation rate increases from 4% to 6%, and if the tax rate applicable to the lender is 35%, the nominal interest rate shall rise by (a) 1.3%

(b) 2.0%

(c) 3.1%

(d) 3.4%

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(e) 6.2%. < Answer >

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

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

12. 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. 13. According to the net income approach to the capital structure, the implications of increase in leverage are (a) (b) (c) (d) (e)

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The cost of debt remains constant while cost of equity and overall capitalization rate decrease The cost of debt increases while cost of equity and over-all capitalization rate remain constant The cost of debt and overall capitalization rate increase while cost of equity remains constant The overall capitalization rate decreases while cost of equity and cost of debt remain constant The overall capitalization rate increases while cost of equity and cost of debt remain constant.

14. According to proposition II of Modigliani and Miller, if the overall capitalization rate of a firm is 12%, cost of debt is 10% and debt-equity ratio is 0.5, the expected yield on the equity of the firm should be (a) 12%

(b) 13%

(c) 14%

(d) 22%

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(e) 33%.

15. Which of the following statements regarding estimation of continuing value is/are true?

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I. The output of the value driver method and the growing free cash flow method is the same. II. The replacement cost method ignores the value of intangible assets of the company. III. The P/E ratio method is based on the assumption that prices of shares are determined by earnings. (a) Only (I) above (c) Only (III) above (e) All (I), (II) and (III) above.

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

16. If the upper limit and lower limit of cash balances are Rs.60,000 and Rs.15,000 respectively, then return point according to Miller and Orr Model is (a) Rs.20,000

(b) Rs.25,000

(c) Rs.30,000

(d) Rs.45,000

(e) Rs.55,000.

17. According to Altman’s Z-score model, which of the following ratios has the highest significance in predicting corporate failure? (a) Working capital / Total assets (c) EBIT / Total assets (e) Networth/Total Debt.

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(b) Retained earnings / Total assets (e) Sales / Total assets

18. Which of the following is the correct representation of residual income? (a) (b) (c) (d) (e)

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Residual income = Profit after tax – dividend paid Residual income = Profit after tax – dividend paid + interest on debt Residual income = Profit after tax – dividend paid + minimum charge on investment Residual income = EBIT – Imputed interest on investment Residual income = Income – taxes paid – dividend paid.

19. Which of the following types of costing provide the benefit of accurate product cost? 2

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(a) Activity based costing (d) Quality Costing

(b) Life cycle costing (c) Target costing (e) Both (a) and (c) above. < Answer >

20. Free cash flow of a firm is defined by (a) (b) (c) (d) (e)

NOPLAT (1 – t) + Depreciation + Non cash charges – Gross Investment EBIT (1 – t) + Depreciation + Non cash charges EBIT (1 – t) + Depreciation + Non cash charges + Non operating cash flow NOPLAT + Depreciation + Non cash charges – Gross Investment EBIT (1 – t) + Depreciation + Non-cash charges – Net investment. < Answer >

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

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22. Which of the following statements is not true? (a) Accruals are financially free in the sense that no interest must be paid on these short term funds (b) The strategy of matching asset and liability maturities is considered desirable because it tends to minimize default risk (c) The effect of compensating balances is to decrease the effective interest rate on a loan (d) Commercial paper in general trade practice is not sold to individual investors (e) Short term borrowing is cheaper than long term borrowing if the yield curve is upward sloping.

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23. Which of the following statements is/are true? (a)

A key disadvantage of the pure residual dividend policy is that it usually results in a variable dividend payout, which is unattractive to investors (b) Stock splits tend to reduce the number of shares outstanding (c) An increase in the capital gains tax rate should work to discourage corporations from repurchasing their shares (d) The bird-in-hand theory of dividends suggests that firms that decreasing their dividend payout should expect to realize a higher share price and a lower cost of equity capital (e) Both (a) and (c) above. 24. In year 2004, B had an inventory turnover ratio and gross sales of 3 and Rs 1.2 crore respectively. In 2005, because of the implementation of the JIT system, the level of inventory declined and the inventory turnover ratio increased to 7.5. If the level of sales remained the same in both 2004 and 2005, what is the increase in cash reserves as an effect of this transition? (a) Rs.30 lakh

(b) Rs.20 lakh

(c) Rs.120 lakh

(d) Rs.24 lakh

(e) Rs.16 lakh.

25. 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)

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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. < Answer >

26. A standard normal distribution has a (a) Mean of one (c) Mean of the distribution (e) Mean equal to the variance.

(b) Mean of zero (d) Mean equal to the standard deviation

27. Raising funds through floating interest rate bearing instruments reduces the losses due to interest rate risk. This is an example of managing the risk by which of the following approaches? (a) Avoidance (d) Loss control

(b) Separation (e) Combination.

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(c) Transfer

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28. A system of financial statement analysis, which highlights the inter-relationships in the contents of financial statements is called (a) Du Pont analysis (c) Time series analysis (e) Comparative analysis.

(b) Common size analysis (d) Index analysis

29. Which of the following is not an internal device for containing agency cost? (a) (b) (c) (d) (e)

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Separation of management and control Linking managerial compensation to share holder returns Development of a market for corporate control Establishment of system for performance monitoring Establishment of system for responsibility accounting.

30. Which of the following statements is/are true with respect to bankruptcy cost, when capital market is perfect? I. II. III. IV.

Assets of the bankrupt firm can be sold at their economic value. Legal and administrative expenses are not present. No cost is associated with bankruptcy. An impending bankruptcy entails significant costs in the form of sharply impaired operational efficiency. (a) Only (I) above (b) Both (I) and (II) above (c) Both (I) and (III) above (d) (I), (II) and (III) above (e) All (I), (II), (III) and (IV) above. END OF SECTION A

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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/explanations should form part of your answer. Do not spend more than 110 - 120 minutes on Section B.

The following information pertain to the operations of R.P 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 Total

? ? ? ? ?

Net fixed assets Inventories Receivables Cash and bank Total

? ? ? ? ?

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. (10 marks) < Answer > 2.

Dimple Corporation, a construction company, reported earnings per share of Rs.5 in 2004, on which it paid dividends per share of Rs.0.60. Earnings are expected to grow 20% a year from 2005 to 2009, during which period the dividend payout ratio is expected to remain unchanged. After 2009, the earnings growth rate is expected to drop to a stable 5%, and the payout ratio is expected to increase to 65% of earnings. The firm has a beta of 1.45 currently, and it is expected to have a beta of 1.20 after 2009. The risk-free rate is 5 % and the market price of risk is 5.5%. You are required to determine (a)

The expected price of the stock at the end of 2009.

(b) The present value of the stock. (6 marks) < Answer > 3.

An oil company was the target of a takeover in early 2004 at Rs.70 per share (It had 165.30 million shares outstanding and total debt of Rs.9.9 billion). It had estimated reserves of 3,038 million barrels of oil and the total cost of developing these reserves at that time was estimated to be Rs.30.38 billion (the development lag is approximately two years). The average relinquishment life of the reserves is 12 years. The price of oil was Rs.22.38 per barrel, and the production costs, taxes, and royalties were estimated at Rs.7 per barrel. The Government bond rate at the time of the analysis was 9.00%. If the oil company were to choose to develop these reserves, it was expected to have cash flows next year of approximately 5% of the value of the developed reserves. The variance in oil prices is 0.03. You are required to find out the value of undeveloped reserves of the oil company by using Black-Scholes model. (5 + 5 = 10 marks) < Answer >

Caselet 1 5

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

5.

The caselet suggest that good corporate governance practices increase the market value of a company. The analysis of the survey in the caselet points out towards the practices which are rated high on the scorecard. On this basis develop a code for good corporate governance for Indian corporates. (6 marks) < Answer > Many factors contribute to good governance, some of which are difficult to quantify. Nevertheless, several useful indications of a well-governed company are available to a shareholder. Assume yourself as a shareholder and state which factors would you consider. (6 marks) < Answer >

Does good governance pay? In theory, it should increase the market valuation of companies by improving their financial performance, reducing the risk that boards will make self-serving decisions, and generally raising investor confidence. Indeed, surveys suggest that institutional investors will pay as much as 28% more for the shares of wellgoverned companies in emerging markets. Do such investors practice what they preach? To find out we looked at 188 companies from six emerging markets—India, Malaysia, Mexico, South Korea, Taiwan, and Turkey—and tested the link between the market valuation and the corporate governance practices of these companies in 2001. We rated the performance of each company against some key components of corporate governance and used explicit, objective criteria for every component to ensure consistent ratings. The information on which we based the ratings came from public and proprietary sources as well as annual reports. If, for example, half of the members of the board of a company were truly independent—that is, if they had no business connections to it—the company rated a top mark of 2 on our scorecard. By contrast, companies with fewer independent directors scored either a 1 or a 0. After we aggregated the ratings for each company into a single metric of governance, we tested the relationship of this score with the market valuation of the company as measured by its price-to-book ratio on the local stock exchange at the end of its 1999 fiscal year. To account for systematic differences in corporate valuations and governance among nations, we expressed the price-to-book ratio and corporate governance score of each company as the percentage by which they differed from its national and industry averages. Even after allowing for the effect of characteristics such as financial performance (measured by returns on equity) and size on valuations, we found that companies with better corporate governance did have higher price-to-book ratios, indicating that investors will pay a premium for shares in a well-governed company. Moreover, the reward for good corporate governance is large. By moving from worst to best in corporate governance, companies in our sample could expect, on average, to experience roughly a 10% to 12% increase in their market valuation—a result underscoring the importance investors attach to these attributes. The market value of a Mexican food processor, for example, stood at $158 mn on December 31, 1999. Onerous anti-takeover rules gave the company the lowest score on one measure of governance. If the company adopted less onerous defenses, our model predicts that capital markets would raise its valuation by close to 12%. Thus, improving corporate governance could be a strategy for leapfrogging competitors in financial markets. 4

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Average scores on various components of corporate governance diverged among countries—a fact suggesting that companies in different tones should focus on different components. For example, Malaysian, South Korean, and Taiwanese companies, reflecting the concerted effort to improve their corporate governance after the 1997 Asian crisis, had the highest average scores for board oversight and shareholder rights. In many ways, South Korea led the governance-reform efforts. Among other things, the country’s government required major banks and conglomerates to appoint a majority of outside directors, to define transparent board responsibilities, and to establish committees ensuring the independent oversight of board activities. It also removed ceilings on foreign ownership, thus intensifying competition, and lowered the size threshold for any group of shareholders seeking to sue a board they believe has failed to protect their interests. A South Korean organization, People’s Solidarity for Participatory Democracy, subsequently challenged major companies, such as Samsung Electronics and SK Telecom. Although Mexican companies had generally poor scores on board responsibilities and shareholder rights, they had among the highest average scores on transparency, which includes accounting standards, disclosure, and auditing. In our sample, Mexican companies were the most likely to be cross-listed on US exchanges and thus obliged to comply with tough US Securities and Exchange Commission regulations on financial reporting—a standard that most other companies in emerging markets have yet to meet. Moreover, recent reforms in Mexican capital-markets legislation will likely promote higher standards of corporate governance in precisely those areas in which Mexico had previously lagged behind. Companies in emerging markets often claim that Western corporate-governance standards don’t apply to them. Our results, however, show that investors the world over are looking for high standards of good governance and will pay a premium for shares in companies that meet them. Enron’s collapse is a worrisome sign that some US companies too fail to meet those standards. But high standards of corporate governance are crucial to the value of companies, especially in emerging markets. 6

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

What is the logical rationale behind the indifference of the classical theory between buybacks and dividends? Explain. (6 marks) < Answer >

7.

How are buybacks more flexible than dividends? Explain. (6 marks) < Answer >

On November 8, 2001. Royal & Sun Alliance announced that it would cut the dividend to be paid to shareholders. Contrary to popular view that cutting dividend is a sign of weakness, the company is projecting excellent growth opportunities with rising insurance premiums worldwide especially after the World Trade Center tragedy. The company is of the view that the attractive outlook for 2002 justified the action of retaining earnings than distributing them as dividends. Stock markets approved this, and moved the share price up by five percent after the news, as analysts considered it as a positive move. This shows how corporate Europe is changing its attitude towards dividends. CFO Europe conducted a survey in November that looked into the changing ways of distributing cash to shareholders by 127 companies over the past few years – paying regular dividends as income to shareholders or buying back shares that would result in capital gain. The survey revealed that more and more companies are now choosing buybacks as against regular dividends. The results of the survey also revealed that the classic finance theory that there is no difference between buybacks and dividends is no more applicable. Buybacks have out performed dividends. One reason for this is that many countries allowed buybacks only in 1990s by changing the company law. Another reason for the shift could be the flexibility that comes with buybacks, as dividends assume the shape of a contract and once paid, becomes difficult to cut. Also in countries where the capital gains tax is lower than the income tax the investors would prefer repurchases to dividends. However, dropping dividends totally in favor of buybacks would not be appreciated by the markets as a conventional investor might consider this as the failure of the company. The belief is that dividends indicate the health of the company and a dividend cut indicates lower profits. However, with increase in transparency and adherence to corporate governance, investors are undoubtedly in a position to understand the performance of the company in the light of a dividend cut or raise. The survey also revealed an interesting insight that although there was high correlation between share price and dividend during 1990s, this was relatively low in 2000. The strongest argument for dividends is the ‘bird in hand’ theory that considers dividends safer than capital gains. The another situation in which this classical theory does not hold good is when companies do not repay excess cash at all, either through dividends or buybacks and instead invest them in value destroying acquisitions. Repurchasing is a good strategy even during times when the stock markets are falling, but if the stock is over priced a company should never go for a buy back. However, this trend may reverse once the economy turns.

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.

Creating value for the shareholders is perhaps the single most important objectives for the management. Measurement of values created by companies is as diverse as the objectives themselves. One such approach is Alcar approach, which stresses upon the comparison of the pre-implementation and post-implementation firm values of various strategies before they are implemented. In this context, explain the various value drivers that affect the value of a firm. (10 marks) < Answer >

9.

Though the use of real options has brought in considerable advantages in creating a project, still there exist some pitfalls in their usage. Discuss the various drawbacks in the usage of real options. 7

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

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Suggested Answers

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

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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2.

Answer : (d) Reason : (a), (b), (c) and (e) are the assumptions of Modigliani Miller Approach of capital structure. Regarding growth no assumption have been made in the M-M approach. Hence (d) is not correct.

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3.

Answer : (a) Reason : As per Marakon model,

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r −g Po k B = −g

where,

Po

–

Present market value

B

–

Book value

r

–

Return on equity

g

–

Growth rate in earnings and dividends that depends on retention ratio.

k

–

Cost of equity.

Clearly, cost of goods sold is not a financial determinant of firm’s value. 4.

Answer : (d) Reason : Target cost = Sale Price (for target market share) – Desired Profit This is the approach used by SONY to launch Walkman. Subsequently, it has become popular for launch of new product and for competitive advantage.

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5.

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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6.

Answer : (a) Reason : Step 1) Find equity required to maintain capital budget:

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Capital budget

Rs.4,000,000

Percent of budget financed with equity

x 0.60 Rs.2,400,000

Step 2) Calculate dividend: Earnings

Rs.3,000,000

Less equity retained

2,400,000

Dividend

Rs.600,000

Step 3) Find payout ratio: Dividend/Earnings = Rs.600,000/Rs.3,000,000 = 0.2000 = 20%. 7.

Answer : (b) Reason : According to the traditional approach to capital structure, as debt is added to the capital 9

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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). 8.

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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9.

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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10.

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

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

∆r = ∆r = (6 – 4) / (1– .35) ∆r = 2 / .65 = 3.076% or 3.1%. 11.

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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12.

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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13.

Answer : (d) Reason : According to the net income approach, the cost of debt (kd) and the cost of equity (ke) remain unchanged when the degree of leverage varies. The average cost of capital declines as the proportion of debt increases. This happens because as B/S (the degree of leverage) increases, kd which is lower than ke receives a higher weight in the calculation of the average cost of capital.

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14.

Answer : (b) Reason : According to the second proposition of MM theory of capital structure, ke = ku + (ku – kd) D/E. Therefore, ke = 0.12 + (0.12 – 0.10) 0.5 = 0.13 or 13%.

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15.

Answer : (e) Reason : The assumption that the share prices are determined by earnings forms the basis of the P/E ratio. The replacement cost takes into account only the tangible asset of the company, and not its intangible assets. In estimating the continuing value of the firm, the two cash flow methods used are the growing free cash flow perpetuity method and the value driver method.

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16.

Answer : (c) Reason : According to Miller and Orr Model the Upper limit, UL = 3RP – 2LL

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⇒ 17.

UL + 2LL 60,000 + 2 × 15,000 3 3 RP = = = Rs.30,000

Answer : (c)

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EBIT Total assets is highest of the coefficients of all other ratios used Reason : The coefficient of X3 i.e.

10

to determine it. 18.

Answer : (d) Reason : Residual income is defined as the income, reduced by the minimum charge on investment(INV). RI = ROI × INV – K × INV, where ‘K’ is imputed interest on INV.

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19.

Answer : (a) Reason : In activity based costing multiple activities are identified in the process as well as the cost drivers that cause work (costs). Target costing is used to arrive at a market-based cost that is calculated using a sales price necessary to capture a predetermined market share. Life cycle costing provides a framework for managing the cost and performance of a product over the duration of its life. A Quality cost system monitors and accumulates the costs incurred by a firm in maintaining or improving product quality.

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20.

Answer : (d) Reason : Free cash flow = Gross cash flow – Gross investment = NOPLAT + Depreciation + Non Cash Charges + Non operating cash flow – Gross Investment

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21.

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

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22.

Answer : (c) Reason : Compensating balances increases the effective rate because the firm will be required by the bank to maintain excess balances that do not bear any interest benefit. Accruals are a spontaneous source of funds arising in the course of routine business, and thus no interest is paid. Matching of maturities minimizes the risk of the firm not being able to pay its maturing obligations. Commercial paper being unsecured debt of strong firms is sold primarily to companies and financial institutions. If the slope of the yield curve is positive, it implies that long-term rates are dearer than short-term rates.

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23.

Answer : (e) Reason : Statement (a) is true because a residual dividend policy results in unstable dividends. Statement (b) is false because stock splits increase the number of shares. Statement (c) is true because an increase in the capital gains tax rate decreases the after-tax proceeds of selling shares to the company. Thus, the company can distribute funds to shareholders via share repurchases less easily. The bird-in-the-hand theory favors dividends, thus a firm that lowers its dividend payout should expect a lower share price and a higher cost of capital. Thus, answers (a) and (c) are both correct and answer e is the most correct answer.

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24.

Answer : (d) Reason : Inventory turnover ratio = Sales /Inventory ∴Inventory = Sales / Inventory turnover ratio For the year 2004, inventory = Rs 1,20,00,000/3 = Rs 40,00,000 For the year 2005, inventory = Rs 1,20,00,000/7.5 = Rs 16,00,000 The effect of this on the freeing up of cash is given by their difference of Rs 24,00,000, which is Rs 40,00,000 - Rs 16,00,000 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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26.

Answer : (b) Reason : A standard normal distribution has a mean of zero.

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27.

Answer : (d)

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25.

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Reason : Loss control measures are used in respect of risks which cannot be avoided. These risks might have been assumed either voluntarily or because they could be avoided. The objective of these measures is either to prevent a loss or to reduce the probability of loss. Insurance, for example, is a loss control measure. Introduction to systems and procedures, internal or external audit help in controlling the losses. Raising funds through floating rate interest bearing instruments reduces the losses due to interest rate risk. 28.

Answer: (a) Reason: Analyzing return ratios is referred to as DuPont Analysis. This system highlights the interrelationships in the contents of financial statements. Hence, the answer is (a). The other alternatives compare the financial statements by taking the individual items of different financial statements and reviewing the changes that have occurred from year to year and over the years.

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29.

Answer: (c) Reason: Agency cost arises from the divergence between the goal of share holders and between debt and equity holders. A market for corporate control can not resolve the problem. All other alternatives mentioned in the question can resolve the problem.

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30.

Answer: (d) Reason: When capital market is perfect, no cost is associated with bankruptcy. Assets of a bankrupt firm can be sold at their economic value and legal and administrative expenses are not present. So, the answer would be (d).

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Section B : Problems 1.

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

or Inventories = (1.50 – 0.70) × 90 = Rs.72 lakh Sales 648 = R e 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 Term loan Current liabilities & provisions

75 51 90

Net fixed assets Inventories Receivables Cash and Bank

216

81 72 54 9 216 < TOP >

2.

a.

Expected earnings per share in 2010 = 5 × (1.20) × 1.05 = Rs.13.06368 Expected dividends per share in 2010 = Rs. 13.06368 × 0.65 = Rs.8.491392 5

Cost of Equity capital after 2010 = Rf + β (Rm – Rf) = 5 + 1.20x 5.5 = 11.60% According to Dividend Discount Model D1 Po = ke − g 8.49 0.1160 − 0.05 = Rs.128.6363. Therefore, the expected price at the end of 2009 =

b. Year 2005 2006 2007 2008 2009

EPS (in Rs.) 6 7.2 8.64 10.368

DPS (in Rs.) 0.72 0.864 1.0368 1.24416

12.4416

1.4929

Cost of equity = Rf + β (Rm – Rf) = 5 + 1.45 × 5.5 = 12.975 % ≈ 13% Present value of stock = 0.72 × PVIF (13, 1) + 0.864 × PVIF (13, 2) + 1.0368 × PVIF (13, 3) + 1.24416 × PVIF (13, 4) + 1.4929 × PVIF (13, 5) + 128.6363 × PVIF (13, 5) = Rs.73.4242. < TOP >

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3.

The value of undeveloped reserves can be thought of as a call option Value of underlying asset i.e. S= Value of estimated reserves discounted back for period of Development lag (S) =3,038 ×(Rs.22.38 - Rs.7)/1.052 = Rs.42, 380.44 Exercise price (X) = Estimated cost of developing reserves today = Rs.30,380 million Time to expiration (t) = Average length of relinquishment option = 12 years Variance in value of asset = Variance in oil prices = 0.03 Risk-less interest rate (rf) = 9% Dividend yield (q) = Net production revenue/ Value of developed reserves = 5% According to Black –Scholes model 2

In(S/X)+[(r-q)+σ /2]t d1 =

σ t

= 0.33290 + [(.09-.05)+ .03/2)] 12/ (.03x12) 1/2 = 1.6548 d2 = d1- σ t = (1.6548 -0.6)= 1.0548 Hence d1 = 1.6548 From the table When d1 = 1.65, N(d1) = 0.9505 When d1 = 1.66, N(d2) = 0.9515 Through interpolation 1.6548-1.65 × ( 0.001) = 0.9510 = 0.9505 + 1.66 − 1.65 N(d1) = 0.9510. Similarly N(d2) can be calculated. N(d2) = 0.8542. d2 = 1.0548 The call can be calculated using the following formulae

Call Value = S × exp(-dividend yield)(time to expiration) N (d1) – X × exp. (-dividend yield)(time to expiration) N(d2) Call value = 42,380.44 exp(-.05)(12)(0.951 0) - 30,380 exp(-0.09)(12)(0.8542) = Rs.13,306 million. < TOP >

4.

Corporate Governance is no longer alien to Indian Inc. The developments in the Indian and global markets have established that Indian companies can no longer ignore better governance practices. There is a global consensus about the objective of ‘good’ corporate governance: Maximizing long-term shareholder value. A code for corporate governance in India must include the following: • A single board can maximize the long-term shareholder value if it performs well. The board should meet a minimum of six times a year, preferably at an interval of two months and each of these meetings must have agenda items that require at least half a day of discussion. • Any listed company with a turnover of Rs. 100 cr and above should have professionally competent and acclaimed non-executive directors, who should constitute at least 30% of the board if the chairman is a nonexecutive director, or 50% if the chairman and managing director is the same person. • No single person should hold directorships in more than 10 companies that excludes directorships in subsidiaries and associate companies. • For non-executive directors to play an important role they need to become active participants and must have clearly defined responsibilities. • To secure better efforts from non-executive directors, companies should pay a commission over and above the sitting fees for the use of the professional inputs. • While re-appointing members of the board, companies should give the attendance record of the concerned directors. If a director has not been present for 50% or more meetings, this should be explicitly stated in the resolution that is put to vote. One should not re-appoint a non-executive director who has not attended even one-half of the meetings. • The key information that must be placed before the board include annual operating plans and budgets, capital and overhead budgets, internal audit reports, defaults in payment of interest or principal amounts, details of 14

•

• • • • • • • • •

any joint venture, and transactions that involve substantial payment for goodwill or brand equity. Listed companies with either a turnover of over Rs. 100 cr or a paid-up capital of Rs. 20 cr whichever is less should set up Audit Committees. The committee should consist of at least three members, drawn from a company’s non-executive directors, having adequate knowledge of finance, accounts and basic elements of company law. Under “Additional Shareholder’s Information”, listed public companies should give data on high and low monthly averages of share prices, statement on value added, and greater detail on business segments or divisions. Consolidation of Group Accounts should be optional and subject to the FIs allowing companies to leverage on the basis of the group’s assets, and the Income Tax Department using the group concept in assessing corporate income tax. Major Indian stock exchanges should gradually insist upon a compliance certificate signed by the CEO and the CFO, which states that the management is responsible for the preparation, integrity and fair presentation of the financial statements and other information in the annual report. For all companies with paid-up capital of Rs. 20 cr or more, the quality and quantity of disclosure that accompanies a GDR issue should be the norm for any domestic issue. Government must allow for greater funding to the corporate sector against the security of shares and other paper. It would be desirable for FIs to re-write their covenants to eliminate having nominee directors except in the event of serious and systematic debt default. If any company goes to more than one credit rating agency, then it must divulge in the prospectus and issue document the rating of all the agencies that did such an exercise. Companies that default on fixed deposits should not be permitted to accept further deposits and make intercorporate loans or investments or declare dividends until the default is made good. FIs should take a policy decision to withdraw from boards of companies where they have little or no debt exposure and where their individual shareholding is 5% or less, or total FI holding is under 10%. < TOP >

5.

Many factors contribute to good governance; some (such as the relationship between the CEO and the chair) are difficult to quantify. Nevertheless, several useful indicators of a well-governed company are available to shareholders. Ten widely recognized principles are summarized here. i. Accountability a. Transparent ownership: Identify major shareholders, director and management shareholdings, and cross-holdings. b. Board size: Establish an appropriate number of board seats; studies suggest that optimal number is 5 to 9. c. Board accountability: Define board’s role and responsibilities in published guideline, and make them basis for board compensation. d. Ownership neutrality: Eschew anti-takeover defenses that shield management from accountability. Notify shareholders at least 28 days before shareholder meetings and allow them to participate online. ii. Independence a. Dispersed ownership: Deny any single shareholders or group privileged access to or excessive influence over decision-making. b. Independent audits and oversight: Perform annual audit using independent and reputable auditor. Insist that independent committees oversee auditing, internal controls, and top-management compensation and development. c. Independent directors: Allow no more than half of directors to be executives of company; at least half of non-executive directors should have no other ties to company. iii. Disclosure and Transparency a. Broad, timely, and accurate disclosure: Fully disclose information on financial and operating performance, competitive position, and relevant details (such as board member backgrounds) in timely manner. Offer multiple channels of access to information and full access to shareholders. b. Accounting standards: Use internationally recognized accounting standards’ for both annual and quarterly reporting. iv. Shareholder Equality One share, one vote: Assign all shares equal voting rights and equal rights to distributed profit. < TOP >

6.

Dividends are increasingly losing their status as the primary vehicle of earnings distribution. Firms are often adopting a strategy of share repurchases as a method to reward shareholders The buy-back provides liquidity to the scrips and also presents an exit opportunity (often at a premium to the prevailing market price) to the investors who wish to offload their holdings. According to classical theory, the wealth of the investors that is vested in the 15

company comes down in the case of both buybacks and dividends. And, the extent of diminution of the wealth of the investors is to the extent of the money spent on buybacks/dividends. Similarly, the loss on the opportunity of investing the money again is the same for both as these are offered to all the shareholders. Thus, there is no real difference between payment of dividend and stock buyback. < TOP > 7.

The advantages of buybacks in comparison to dividends are as follows: • While resorting to buybacks, the company may buyback the shares when there are profits and may not do so when there are no profits. But, with dividends, it becomes necessary to maintain a steady or rising trend. Reduction in the dividends may give the impression that there are no profits/cash flows and bring down the share price. •

The buyback gives the investor a choice on whether they should sell their stock or not. In contrast, a dividend payment is something that comes automatically to all the shareholders. Thus, a buyback gives some flexibility to the investors too. However, it can be argued that investor may buy the stock with the amount they receive on account of the dividends, but that would involve transaction costs. < TOP >

Section C: Applied Theory 8.

The Alcar model uses the discounted cash flow analysis to identify value-adding strategies. According to this 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. Value growth duration refers to the time period for which a strategy is expected to result in a higher than normal growth rate for the firm. The first six factors affect the value of the strategy for the firm by determining the cash flows generated by a strategy. The last term, i.e. the cost of capital affects the value of the strategy by determining the present value of these cash flows. The following figure represents the Alcar approach. According to the model, a strategy should be implemented if it generates additional value for a firm. For ascertaining the value generating capability of a strategy, the value of the firm's equity without the strategy is compared to the value of the firm's equity if the strategy is implemented. The strategy is implemented if the latter is higher than the former. The following steps are undertaken for making the comparison. Calculate the value of the firm's equity without the strategy: The present value of the expected cash flows of the firm is calculated using the cost of capital. The cash flows should take the firm's normal growth rate and its effect on operating flows and additional investment in fixed assets and working capital into consideration. The cost of capital would be the weighted average cost of the various sources of finance, with their market values as the weights. The value of the equity is arrived at by deducting the market value of the firm's debt from this present value. Calculate the value of the firm if the strategy is implemented: The firm's cash flows are calculated over the value growth duration, taking into consideration the growth rate generated by the strategy and the required additional investments in fixed assets and current assets. These cash flows are discounted using the post-strategy cost of capital. The post-strategy cost of capital may be different from the pre-strategy cost of capital due to the financing pattern of the additional funds requirement, or due to a higher cost of raising finance. The PV of the residual value of the strategy is added to the present value of these cash flows to arrive at the value of the firm. The residual value is the value of the steady perpetual cash flows generated by the strategy, as at the end of the value growth duration. The value of the post-strategy market value of debt is then deducted from the value of the firm to arrive at the post-strategy value of equity. The value of the strategy is given by the difference between the post-strategy value of the firm's equity and the pre-strategy value of the firm's equity. A strategy should be accepted if it generates a positive value. < TOP >

9.

Though the use of real options had brought in considerable advantages in creating a project, still there exists some pitfalls in their usage. These pitfalls can be broadly categorized under the following: •

Using the real option analysis when one should not use them

•

Framing a wrong model for the purpose of valuation 16

•

Using incorrect data and biased judgments in the model

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

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