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Question
Paper
Strategic
Financial Management (MB361F) – October 2005
Section A : Basic Concepts (30 Marks)
•
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.
1.
Which of
the following statement is/ are true?
I.
Open market
repurchases are not very effective signals for under valuation of company’s
stock as compared to tender offers.
II.
Dutch
auctions are less informative than fixed price offer as signals of under
valuation.
III. In a Dutch auction, outside shareholders do not
play an active role in establishing terms of trade.
(a) Only
(I) above (b)
Only (II) above (c)
Only (III) above
(d) Both
(I) and (II) above (e)
Both (II) and (III) above.
2.
Which of
the following is not an assumption
of Modigliani Miller approach to capital structure?
(a)
Information
is freely available to investors
(b)
Transactions
are cost free
(c)
Investors
have homogeneous expectations about future earnings of a company
(d)
Growth of
a firm is entirely financed through retained earnings
(e)
Securities
issued and traded in the market are infinitely divisible.
3.
Which of
the following is not a financial determinant of value according to Marakon
Model?
(a) Cost
of goods sold (b)
Return on equity
(c) Cost
of equity (d)
Growth rate of dividends (e)
Retention ratio.
4.
A costing
technique based on sales price of a product necessary to capture a
predetermined market share is known as
(a)
Activity based costing (b)
Absorption costing
(c)
Quality costing (d)
Target costing (e)
Life cycle costing.
5.
Which of
the following is not a model for
predicting sickness of a firm?
(a)
Beaver Model (b)
BCG Matrix
(c)
Altman’s Z Score Model (d)
Argenti Score Board
(e)
Wilcox
Model.
6.
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% (b) 30% (c) 35% (d) 40% (e) 45%.
7.
The most
commonly held view of capital structure is - the weighted average cost of
capital
(a)
Declines
steadily as more debt is used
(b)
First
declines with moderate amounts of leverage and then increases
(c)
Increases
proportionately with increases in leverage
(d)
Is
unaffected by the level of debt used
(e)
Is
minimized at a balanced capital structure of 50% equity and 50% debt.
8.
High
asset turnover ratio indicates
(a)
Large
amount of investment in the fixed assets
(b)
Large
amount of investment in the current assets
(c)
Large
amount of sales value in comparison to total assets
(d)
Inefficient
utilization of the assets
(e)
High
debt-equity ratio.
1
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9.
Which of
the following ratios is not applied in LC Gupta model for prediction of
bankruptcy?
(a)
EBDIT/Net
sales
(b)
Operating
cash flow/Total assets
(c)
Net
worth/Total debt
(d)
Working
capital/Total assets
(e)
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% (e) 6.2%.
11. Holding cash balance to meet contingencies is
(a)
A
manifestation of the transaction motive
(b)
A
manifestation of the speculative motive
(c)
A
manifestation of the precautionary motive
(d)
A
characteristic of large firms only
(e)
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
(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)
The cost
of debt remains constant while cost of equity and overall capitalization rate
decrease
(b)
The cost
of debt increases while cost of equity and over-all capitalization rate remain
constant
(c)
The cost
of debt and overall capitalization rate increase while cost of equity remains
constant
(d)
The
overall capitalization rate decreases while cost of equity and cost of debt
remain constant
(e)
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% (e) 33%.
15. Which of the following statements regarding
estimation of continuing value is/are true?
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 (b)
Only (II) above
(c) Only
(III) above (d)
Both (I) and (II) above
(e)
All (I),
(II) and (III) 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 (b)
Retained earnings / Total assets
(c) EBIT
/ Total assets (e)
Sales / Total assets
(e)
Networth/Total
Debt.
18. Which of the following is the correct representation of residual income?
(a)
Residual
income = Profit after tax – dividend paid
(b)
Residual
income = Profit after tax – dividend paid + interest on debt
(c)
Residual
income = Profit after tax – dividend paid + minimum charge on investment
(d)
Residual
income = EBIT – Imputed interest on investment
(e)
Residual
income = Income – taxes paid – dividend paid.
19. Which of the following types of costing provide the
benefit of accurate product cost?
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(a) Activity
based costing (b)
Life cycle costing (c) Target costing
(d)
Quality Costing (e)
Both (a) and (c) above.
20. Free cash flow of a firm is defined by
(a)
NOPLAT (1
– t) + Depreciation + Non cash charges – Gross Investment
(b)
EBIT (1 –
t) + Depreciation + Non cash charges
(c)
EBIT (1 –
t) + Depreciation + Non cash charges + Non operating cash flow
(d)
NOPLAT +
Depreciation + Non cash charges – Gross Investment
(e)
EBIT (1 –
t) + Depreciation + Non-cash charges – Net investment.
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.
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.
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)
Debenture,
preference capital, fresh equity, retained earnings
(b)
Fresh
equity, preference capital, debenture, retained earnings
(c)
Retained
earnings, fresh equity, debenture, preference capital
(d)
Fresh
equity, retained earnings, preference capital, debenture
(e)
Retained
earnings, debenture, preference capital, fresh equity.
26. A standard normal distribution has a
(a) Mean
of one (b)
Mean of zero
(c) Mean
of the distribution (d)
Mean equal to the standard deviation
(e)
Mean
equal to the variance.
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 (b)
Separation (c) Transfer
(d) Loss
control (e)
Combination.
3
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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 (b)
Common size analysis
(c) Time
series analysis (d)
Index analysis
(e)
Comparative
analysis.
29. Which of the following is not an internal device for containing agency cost?
(a)
Separation
of management and control
(b)
Linking
managerial compensation to share holder returns
(c)
Development
of a market for corporate control
(d)
Establishment
of system for performance monitoring
(e)
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.
Assets of
the bankrupt firm can be sold at their economic value.
II.
Legal and
administrative expenses are not present.
III. No cost is associated with bankruptcy.
IV. 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. |
|
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END OF SECTION A |
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4
Section B : Problems/Caselets (50
Marks)
•
This
section consists of questions with serial number 1 – 7.
•
Answer all questions.
•
Marks are
indicated against each question.
•
Detailed
workings/explanations should form part of your answer.
•
Do not
spend more than 110 - 120 minutes on Section B.
1.
The
following information pertain to the operations of R.P Enterprises Ltd. at the
end of a financial year :
|
Net worth |
Rs.75 lakh |
|
Current liabilities and provisions |
Rs.90 lakh |
|
Cost of goods sold |
Rs.486 lakh |
|
Gross profit margin |
25% |
|
Total asset turnover ratio |
3 |
|
Accounts receivable turnover ratio |
12 |
|
Total debt to equity ratio |
1.88 |
|
Current ratio |
1.5 |
|
Quick ratio |
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 |
? |
Net fixed assets |
? |
|
Term loan |
? |
Inventories |
? |
|
Current liabilities and provisions |
? |
Receivables |
? |
|
|
? |
Cash and bank |
? |
|
Total |
? |
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 out-standing 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.
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 >
5.
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
well-governed 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.4 Moreover, the reward for good
corporate governance is large.5 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%.6 Thus, improving corporate governance could be a strategy for
leapfrogging competitors in financial markets.
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
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)
•
This
section consists of questions with serial number 8 - 9.
•
Answer all questions.
•
Marks are
indicated against each question.
•
Do not
spend more than 25 -30 minutes on section C.
8.
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
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8
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.
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.
3.
Answer :
(a)
Reason : As
per Marakon model,
|
|
Po |
r − g |
|
|
||
|
|
|
|
|
|
||
|
|
B |
= k − 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.
5.
Answer :
(b)
Reason : BCG matrix classifies
the products into four broad categories. All others are the models for
predicting sickness of a firm.
6.
Answer :
(a)
Reason :
Step 1) Find equity required to maintain capital budget:
|
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
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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) < TOP >
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.
9. Answer
: (d) < TOP >
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.
10. Answer
: (c) < TOP >
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
(Inflation
rate after increase- Inflation rate before increase)
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∆r = |
(1 − tr ) |
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∆r = (6 – 4) / (1– .35) |
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∆r = 2 / .65 = 3.076% or 3.1%. |
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11.
Answer : (c) |
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<TOP> |
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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) |
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<TOP> |
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Reason :
The marginal cost rate breaks down under capacity constraints of
transferor division. The |
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accounting price arrival using mathematical
programming method is appropriate for |
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transfer pricing. This type of price is also
called shadow price. |
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13. |
Answer : (d) |
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<TOP> |
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Reason : According to the net income approach, the
cost of debt (kd) and
the cost of equity (ke) |
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remain unchanged when the
degree of leverage varies. The average cost of capital declines |
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as the proportion of debt
increases. This happens because as B/S (the degree of leverage) |
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increases, kd which is
lower than ke receives a higher weight in the calculation
of the |
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average cost of capital. |
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14. |
Answer : (b) |
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<TOP> |
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Reason : According to the second proposition of MM
theory of capital structure, ke = ku + (ku – kd) |
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D/E. |
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Therefore, ke |
= |
0.12 + (0.12 – 0.10) 0.5 |
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= |
0.13 or 13%. |
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15. |
Answer : (e) |
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<TOP> |
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Reason : The assumption that the share prices are
determined by earnings forms the basis of the P/E |
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ratio. The replacement cost
takes into account only the tangible asset of the company, and |
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not its intangible assets. In
estimating the continuing value of the firm, the two cash flow |
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methods used are the growing
free cash flow perpetuity method and the value driver |
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method. |
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16. |
Answer : (c) |
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<TOP> |
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Reason :
According to Miller and Orr Model the Upper limit, UL = 3RP – 2LL |
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UL + 2LL |
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60,000 + 2 ×15,000 |
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⇒ RP= |
3 |
= |
3 |
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= Rs.30,000 |
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17. |
Answer : (c) |
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<TOP> |
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EBIT |
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Reason : The coefficient of X3 i.e. Total assets |
is highest of the coefficients of all other
ratios used |
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10
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.
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.
20.
Answer :
(d)
Reason :
Free cash flow
=
Gross
cash flow – Gross investment
= NOPLAT + Depreciation + Non Cash Charges + Non
operating cash flow – Gross Investment
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.
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.
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.
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
25.
Answer : (e)
Reason : According to this theory
the first and most popular is retained earnings, as it has no associated
floatation cost.
26.
Answer :
(b)
Reason : A
standard normal distribution has a mean of zero.
27.
Answer :
(d)
11
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<TOP>
<TOP>
<
TOP >
<
TOP >
<
TOP >
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
inter-relationships 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.
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.
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).
<
TOP >
<
TOP >
<
TOP >
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Dear students, get latest Solved assignments and case studies by
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12
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Cost of goods sold |
= |
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486 |
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= Rs. 648 lakh |
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1. Sales = (1-
Gross profit margin) |
1− 0.25 |
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Sales |
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= |
648 |
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= |
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Total asset = Total
assets turnover |
3 |
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Rs.216 lakh |
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Inventories
Current liabilities = Current ratio – Quick ratio or Inventories = (1.50 – 0.70) × 90 =
Rs.72 lakh
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Sales |
= |
648 |
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Receivables = Re ceivables turnover ratio |
12 = Rs.54 lakh |
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Current assets = Current liabilities × current ratio |
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=90×1.5 |
= Rs.135 lakh |
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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
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(Rs. lakh) |
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Net worth |
75 |
Net
fixed assets |
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81 |
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Term loan |
51 |
Inventories |
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72 |
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Current liabilities & provisions |
90 |
Receivables |
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54 |
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Cash and Bank |
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9 |
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216 |
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216 |
2.
a.
Expected earnings per share in 2010 = 5 × (1.20)5
× 1.05 = Rs.13.06368 Expected
dividends per share in 2010 = Rs. 13.06368 × 0.65 =
Rs.8.491392
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
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8.49 |
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Therefore, the expected price at the end of 2009
= 0.1160 − 0.05 =
Rs.128.6363. |
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b. |
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Year |
EPS (in
Rs.) |
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DPS (in
Rs.) |
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2005 |
6 |
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0.72 |
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2006 |
7.2 |
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0.864 |
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2007 |
8.64 |
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1.0368 |
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2008 |
10.368 |
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1.24416 |
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2009 |
12.4416 |
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1.4929 |
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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,
4) + 1.4929
× PVIF (13, 5) + 128.6363 × PVIF (13, 5) = Rs.73.4242. 13
<TOP>
PVIF (13, 3) + 1.24416
<TOP>
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
In(S/X)+[(r-q)+σ2/2]t
d1 = σ t
= 0.33290 + [(.09-.05)+ .03/2)] 12/ (.03x12) 1/2 = 1.6548
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d2 |
= d1- σ t |
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= (1.6548 -0.6)= 1.0548 |
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Hence |
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d1 |
= 1.6548 |
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From the table |
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When d1 |
= 1.65, N(d1) = 0.9505 |
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When d1 |
= 1.66, N(d2) = 0.9515 |
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Through interpolation |
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1.6548-1.65 |
×(0.001) |
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= 0.9505 + 1.66 −1.65 |
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= 0.9510 |
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N(d1) = 0.9510.
Similarly N(d2) can be calculated.
d2 = 1.0548 N(d2) =
0.8542.
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 non-executive
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 inter-corporate 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
|
<TOP> |
|
17 |
•
Using
incorrect data and biased judgments in the model
•
Miscalculation
in the process of valuation.
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
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