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Question
Paper
Strategic
Financial Management (MB361F) – July 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 is true in the context
of stock split?
(a)
The par
value of the equity share increases
(b)
Reserves
are capitalized
(c)
Shareholders
proportional ownership changes
(d)
Book
value of equity capital increases
(e)
Market
price of the equity share decreases after a stock split.
2.
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.
3.
It is
given that the return on equity of company is decreasing while the net profit
margin is increasing. If the asset level remains unchanged, which of the
following can be inferred conclusively?
(a)
Equity has increased (b)
Debt has increased (c)
Sales are falling
(d) Sales
are increasing (e)
Both (a) and (c) above.
4.
In the
context of quality costing, costs associated with materials and products that
fail to meet quality standards and result in manufacturing losses are called
(a)
Prevention costs (b)
Appraisal costs (c)
External failure costs
(d)
Internal failure costs (e)
Quality cost.
5.
According
to the Wilcox model, the best
indicator of the financial health of an enterprise is
(a) The profitability ratios (b) The coverage ratios
(c) Net liquidation value of the firm (d) Market capitalization of the firm
(e)
Share
price of the firm.
6.
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.
7.
For a
firm, if the current ratio remains constant and the quick ratio decreases
during the same period, then, which of the following is indicated?
(a)
The
proportion of total debt relative to total assets is decreasing
(b)
The
proportion of total debt relative to net worth is decreasing
(c)
The
proportion of net worth relative to total assets is increasing
(d)
The
liquidity is decreasing
(e)
The
profitability is increasing.
8.
Which of
the following is not an assumption
of Modigliani - Miller approach to capital structure?
(a)
Information
is freely available to investors
(b)
The
capital market 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
1
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(e)
Securities
issued and traded in the market are infinitely divisible.
9.
The risk
that arises out of the assets of a firm being not readily marketable is called
(a)
Market risk (b)
Marketability risk
(c)
Business risk (d) Financial risk (e) Exchange risk.
10. During which of the following stages of the product
life cycle the profit margins from a product reach the peak?
(a) Introduction (b)
Growth (c) Maturity (d) Saturation
(e)
Decline.
11. According to the traditional approach to capital
structure, the weighted average cost of capital
(a)
Declines
steadily as more debt is used
(b)
First
declines with moderate application 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.
12. 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.
13. Which of the following statements most correctly describes the factors that
influence capital structure decisions?
(a)
The
greater the business risk, the higher the optimal debt ratio will be
(b)
Large
depreciation tax shields and tax-loss carry-forwards will make it more
advantageous for firms to assume more debt
(c)
If a firm
is run by a very aggressive manager, he/she may be more inclined to use debt to
bolster profits, and hence raising the optimal debt level
(d)
The major
reason firms limit the use of debt is that interest is tax-deductible, which
raises the effective cost of debt
(e)
The higher
the probability of future capital needs and the worse the consequences of a
capital shortage, the stronger the balance sheet should be.
14. In the calculation of the weighted average cost of
capital, why are the weights based on the market values preferred to weights
based on book values?
(a)
The
weights based on the book values are difficult to estimate while calculating
the weighted average cost of capital
(b)
Weights
based on the market values are fairly constant in nature
(c)
Weights
based on the book values have a high degree of volatility
(d)
Book
values are historical in nature and may not reflect the true economic values as
compared to market values
(e)
Data on
market values are always available whereas data on book values are not always
available.
15. Which of the following models on dividend policy
stresses on the investor’s preference for the current dividends?
(a)
Traditional Model (b)
Walter Model (c)
Gordon Model
(d)
Miller and Modigliani Model (e)
Rational expectations model.
16.
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.
17. In the presence of floatation costs, the cost of
external equity is
(a)
More than
the cost of existing equity capital
(b)
Less than
the cost of existing equity capital
(c)
Equal to
the cost of existing equity capital
(d)
Equal to
the cost of long-term debt
(e)
Equal to
the cost of short-term debt.
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18. 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.
19. Which of the following factors is not considered by Alcar model on value
based management?
(a)
Operating
profit margin
(b)
Incremental
investment in working capital
(c)
Income
tax rate
(d)
Dividend
growth rate
(e)
Cost of
capital.
20. 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.
21. Which of the following conditions certainly
indicates that short-term sources of funds have been used for financing
long-term uses?
(a)
Current
ratio is less than 1.00
(b)
Quick
ratio is less than 1.00
(c)
Total debt
to equity ratio is more than 1.00
(d)
Net
working capital is positive
(e)
Total
asset turnover ratio is less than 1.
22. Which of the following approaches to compute the
cost of equity capital assumes that actual returns to the equity shareholders
have been in line with their expected returns?
(a)
Realized Yield Approach (b)
Bond Yield Plus Risk Premium Approach
(c)
Earnings-Price Ratio Approach (d)
Dividend Capitalization Approach
(e)
Capital
Asset Pricing Model.
23. According to the Walter Model, if r is the internal rate of return, g is the growth rate and ke is the cost of capital, under which of the
following conditions the optimal payout ratio is 100%?
(a) r = ke (b) r < ke (c) r > ke (d) g >
ke (e) g = k(e).
24. Net working capital can be said to be financed by
(a) Cash
credit (b) Overdraft (c)
Equity capital only
(d) Term
loan only (e) Long term sources of
capital.
25. Which of the following will cause a decrease in the
net operating cycle of a firm?
(a)
Increase
in the average collection period
(b)
Increase
in the average payment period
(c)
Increase
in the finished goods storage period
(d)
Increase
in the raw materials storage period
(e)
Increase
in the work-in-progress period.
26. The term agency costs in the context of capital
structure means
(a)
The
commission payable by a company to its purchasing agents
(b)
The
commission payable by a company to its selling agents
(c)
The
expenses incurred in distribution of the products of the company
(d)
The cost
on account of restrictive covenants imposed on a company by its lenders
(e)
The
dividends paid by a company to its shareholders.
27. Which of the following approaches to corporate risk
management is also known as aggregation or diversification?
(a) Risk
avoidance (b)
Combination (c) Loss
control
(d)
Separation (e)
Risk transfer.
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28. According to which of the following techniques of
strategic cost management, the cost of a product should be determined on the
basis of a sales price necessary to capture a predetermined market share?
(a)
Activity based costing (b)
Quality costing (c)
Life cycle costing
(d)
Target costing (e)
Value chain analysis.
29. Which of the following is considered to be an
external factor leading to the bankruptcy of a firm?
(a)
Shortage in supply of raw materials (b)
Fraudulent practices by management
(c)
Labour unrest (d)
Technological obsolescence
(e)
Disputes
among promoters.
30. Which of the following is not a source of long-term finance?
(a) Retained
earnings (b)
Equity share capital
(c)
Debenture capital (d)
Trade credit (e) Term loan.
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.
Pioneer
Enterprises Ltd. operates in the hospitality industry. The following details
are available from its latest financial statements:
|
EBIT |
Rs.43 lakh |
|
Effective tax rate |
30% |
|
Total debt |
Rs.80 lakh |
|
Cost of equity capital |
16% |
|
Net worth |
Rs.80 lakh |
|
Book value per share |
Rs.20 |
|
|
|
The sources of financing used by
the company are equity and debt. Total debt consists of current liabilities and
long-term debt. The current liabilities amount to Rs.50 lakh and do not include
any interest bearing liabilities. The long-term debt is perpetual in nature and
carries an interest rate of 10%. The company do not expect any growth in its
operations because the market is stable. So it pays out all its earnings as
dividends.
The company is planning to raise
debt of Rs.70 lakh and use the same to buyback a portion of its outstanding
equity shares. The new debt will carry an interest rate of 11%. It is assumed
that the EBIT and the effective tax rate will remain unchanged in future.
However, the cost of equity capital will rise to 18% after the buyback. It is
also assumed that the company will continue to pursue its existing dividend
policy in future.
You are required
to answer the following questions:
a.
Calculate
the price for buying back the equity shares and the number of equity shares
that can be bought.
b.
Suggest
whether Pioneer Enterprises Ltd. should change its capital structure as per its
plans. Justify your answer with necessary calculations.
(4 + 4 =
8 marks) < Answer >
2.
The
following information pertain to the operations of Agarwal 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
Term loan
Current liabilities and provisions
Total
Net fixed assets
Inventories
Receivables
Cash and bank
Total
5
It is assumed that the revenues
of the firm wholly consisted of sales and that the sales are entirely on credit
basis.
Assume 1 year = 360 days.
(7 marks) < Answer >
3.
The
finance manager of Murphy & Sons Ltd. intends to use a suitable model to
manage the cash requirements of the company. An expert has suggested the Miller
& Orr model. The company wants to maintain a minimum cash balance of Rs.3
lakh at all times. The company policy is to invest surplus cash in marketable
securities. Presently the yield available on such securities is 6.3 percent.
The transaction costs involved in buying and selling such securities is assumed
to be a fixed amount of Rs.300 per transaction. The standard deviation of the
daily changes in cash balances is Rs.3,000. Assume 1 year = 360 days.
You are required
to answer the following questions:
a.
Determine
the maximum amount of cash balance that can be accumulated at any time and the
amount of cash that should be invested in marketable securities as the maximum
cash balance is attained.
b.
What will
be the change in the maximum cash balance and the required investment in
marketable securities as the maximum cash balance is attained, if the daily
inflows of cash increase by a constant amount of Rs.2000 and the daily out flows
of cash increase by a constant amount of Rs.1500, due to increased business
activity? It is assumed that the other factors influencing the cash balances
will remain unchanged.
c.
What will
be the change in the required investment in marketable securities as the
maximum cash balance is attained, if the minimum required cash balance is
increased by Rs.1 lakh? It is assumed that the other factors influencing the
cash balances will remain unchanged.
(3 + 1 +
1 = 5 marks) < Answer >
Caselet 1
Read the caselet carefully and
answer the following questions:
4.
In a
dynamic environment the companies can operate in the best interests of their
shareholders only if they effectively manage the risks they face. What are the
necessary steps that the companies should take for establishing effective risk
management processes?
(9 marks) < Answer >
5.
A
company, which wants to establish an effective risk management system, should
ideally create a highly effective risk management group. How can a company
create a highly effective risk management group in order to establish an
effective risk management system?
(6 marks) < Answer >
Risk is a fact of business life. Taking and
managing risks is part of what companies must do to create profits and
shareholder value. But the corporate meltdowns of recent years suggest that
many companies neither manage risk well nor fully understand the risks they are
taking. Such events are thus a reality that managements must deal with rather
than an unlikely "tail event." The directors’ unfamiliarity with risk
management is often mirrored by senior managers, who traditionally focus on
relatively simple performance measures, such as net income, earnings per share,
or growth expectations of the market. Risk-adjusted performance seldom figures
in these managers’ targets. Improving risk management thus entails both the
effective overseeing by the board and the integration of risk management into
day-to-day decision making. Companies that fail to improve their
risk-management processes face a different kind of risk: unexpected and
sometimes severe financial losses that make their cash flows and stock prices
volatile and harm their reputation with customers, employees, and investors.
Companies might also be tempted to adopt a more
risk -averse model of business in an attempt to protect themselves and their
share prices. However, being risk–averse may not help the company in creating
or maintainigng shareholder value. The CEO of one Fortune 500 company, when
asked to explain his company’s declining performance, replied that it was due
to the lack of a culture of risk taking; he explained that its absence meant
that the company was unable to create innovative and successful products. By
contrast, a senior partner of a leading investment bank with excellent risk-management
capabilities remarked, "Our operations have created a series of controls
that enable us to take more risk with more entrepreneurialism and, in the end,
make more profits."
In order to manage risk effectively the companies must first understand
what risks they are taking. They should clearly articulate the major risks they
are taking. The companies also need to know the potential impact on their
fortunes, of the risks they face and they should be transparent about it. The
CEOs of the companies should then define, with the help of the board, their
companys’ risk strategy. But more often than not, it is determined
inadvertently, every day, by dozens of business and financial decisions. One
executive, for instance, might be more willing to take risks than another or
have a different view of a project’s level of risk. The result may be a risk
profile that makes the company uncomfortable or can’t be managed effectively. A
shared understanding of the strategy is therefore vital. The companies must then
6
create a high performing risk management group
whose task will be to identify, measure, and assess risk consistently in every
business unit and then to provide an integrated, corporate-wide view of these
risks, ensuring that their sum is a risk profile consistent with the company’s
risk strategy. Next the companies should create a risk culture in order to cope
with the dynamic nature of the businesses and to minimise undue risk taking by
its managers. Lastly the board of directors of the companies should understand
and oversee the major risks it takes and ensure that its executives have a
robust risk-management capability in place.
Even world -class risk management won’t eliminate
unforeseen risks, but companies that successfully put the elements of effective
risk management in place are likely to encounter fewer and smaller unwelcome
surprises. Moreover, such companies will be better equipped to run the risks
needed to enhance the returns and growth of their businesses.
Without adequate risk-management processes,
companies may inadvertently take on levels of risk that will leave them exposed
to the next risk-management disaster. Alternatively, they may pursue
"extremely conservative" strategies, foregoing attractive
opportunities that their competitors can take. Either approach will surely be
penalized by the investors.
Caselet 2
Read the caselet carefully and
answer the following questions:
6.
Explain
the various approaches to valuation of risky real assets.
(10
marks) < Answer >
7.
Discuss
the issues that need to be addressed while evaluating projects that claim
attractive IRR.
(5 marks) < Answer >
May be finance managers just enjoy living on the
edge. What else would explain their weakness for using the internal rate of
return (IRR) to assess capital projects? For decades, finance textbooks and
academics have warned that typical IRR calculations build in reinvestment
assumptions that make bad projects look better and good ones look great. Yet as
recently as 1999, academic research found that three-quarters of CFOs always or
almost always use IRR when evaluating capital projects.
So why do finance pros continue to do what they
know they shouldn't? IRR does have its allure, offering what seems to be a
straightforward comparison of, say, the 30 percent annual return of a specific
project with the 8 or 18 percent rate that most people pay on their car loans
or credit cards. That ease of comparison seems to outweigh what most managers
view as largely technical deficiencies that create immaterial distortions in
relatively isolated circumstances.
Admittedly, some of the measure's deficiencies are
technical, even arcane, but the most dangerous problems with IRR are neither
isolated nor immaterial, and they can have serious implications for capital
budget managers. When managers decide to finance only the projects with the
highest IRRs, they may be looking at the most distorted calculations—and
thereby destroying shareholder value by selecting the wrong projects
altogether. Companies also risk creating unrealistic expectations for
themselves and for shareholders, potentially confusing investor communications
and inflating managerial rewards.
Practitioners often interpret internal rate of
return as the annual equivalent return on a given investment; this easy analogy
is the source of its intuitive appeal. But in fact, IRR is a true indication of
a project's annual return on investment only when the project generates no
interim cash flows—or when those interim cash flows really can be invested at
the actual IRR. IRR's assumptions about reinvestment can lead to major capital
budget distortions.
Even if the interim cash flows really could be
reinvested at the IRR, very few practitioners would argue that the value of
future investments should be commingled with the value of the project being
evaluated. Most practitioners would agree that a company's cost of capital—by
definition, the return available elsewhere to its shareholders on a similarly
risky investment—is a clearer and more logical rate to assume for reinvestments
of interim project cash flows
When the cost of capital is used, a project's true
annual equivalent yield can fall significantly—again, especially so with
projects that posted high initial IRRs. Of course, when executives review
projects with IRRs that are close to a company's cost of capital, the IRR is
less distorted by the reinvestment-rate assumption. But when they evaluate
projects that claim IRRs of 10 percent or more above their company's cost of
capital, these may well be significantly distorted.
An analysis conducted by Mckinsey, with the
reinvestment rate adjusted to the company's cost of capital, indicated that the
order of the most attractive projects changed considerably when this adjustment
was done. The top-ranked project based on IRR dropped to the
tenth-most-attractive project. Most striking, the company's highest-rated
projects— showing IRRs of 800, 150, and 130 percent—dropped to just 15, 23, and
22 percent, respectively, once a realistic reinvestment rate was considered .
Unfortunately, these investment decisions had already been made. Of course,
IRRs of this extreme are somewhat unusual. Yet even if a project's IRR drops
from 25 percent to 15 percent, the impact is considerable.
7
END OF
SECTION B
Section C : Applied Theory (20 Marks)
This section consists of questions with serial
number 8 - 9.
Answer all
questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.
8.
Corporate
decisions are affected by a large number of variables. Many-a-time, the inter
linkages between these variables, and their resultant effect on the decision is
extremely complex. Decision support models are used as a tool to spell-out the
relationships clearly in order to help the management to arrive at the optimal
decisions. Discuss the major steps involved in the process of building decision
support models.
(10
marks) < Answer >
9.
The
dividend policy of a firm reflects the views and practices of the management
with regard to the distribution of its earnings to the shareholders in the form
of dividends. The dividend policy is arrived by the firm on the basis of some
strategic determinants. Explain the strategic determinants of dividend policy.
(10
marks) < Answer >
END OF
SECTION C
END OF
QUESTION PAPER
Suggested Answers
Strategic Financial Management
(MB361F) – July 2005
Section A : Basic Concepts
1.
Answer :
(e)
Reason : In stock split par value
decreases and as a result market price per share decreases immediately after a
stock split.
2.
Answer :
(e)
Reason : According to this theory
the first and most popular is retained earnings, as it has no associated
floatation cost.
3.
Answer :
(a)
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S |
× |
A |
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S |
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Reason :
ROE = NPM × A |
NW |
= NPM× NW |
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At the same level of asset, the
fall in sale will not normally give the same EBIT. Therefore, the increase in
NPM indicates ,better asset use and better tax administration. Hence, for ROE
to fall, equity component should rise.
4.
Answer :
(d)
Reason : Costs that arise due to
materials and products that fail to meet quality standards and result in
manufacturing losses are called internal failure costs
5.
Answer :
(c)
Reason
: As per the Wilcox model, the net
liquidation value of a firm is the best indicator of its financial health. The
net liquidation value is the excess
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of the
liquidation value of the firm’s assets over the liquidation value of the firm’s
liabilities. Liquidation value is the market value of the assets and
liabilities at the time of dissolution.
6.
Answer :
(c)
Reason : The marginal cost rate
breaks down under capacity constraints of transferor division. The accounting
price arrival using mathematical programming method is appropriate for transfer
pricing. This type of price is also called shadow price.
7.
Answer :
(d)
Reason : Current ratio is defined
as the ratio between the current assets and current liabilities. While Quick
Ratio is calculated by dividing current assets minus inventories by current
liabilities. Now, among the components of the current assets, inventories are
the least liquid instruments. So, a decreasing quick ratio and same value of
the current ratio implies the increasing volume of inventory, thereby
indicating the decreasing level of liquidity.
8.
Answer :
(d)
Reason : The
assumptions of Modigliani Miller approach of capital structure are
:
1)
Information
is freely available to investors
2)
Transactions
are cost-free
3)
Investors
have homogeneous expectations about future earnings of a company
4)
Securities
issued and traded in the market are infinitely divisible.
However, option (d) is not an
assumption of MM approach as MM approach considers that growth of a firm is
financed by a mixture of debt, equity and retained earnings.
9.
Answer :
(b)
Reason : When assets, which are
not readily marketable, is required to be sold for need of funds, the
non-marketability may lead to liquidity risk. Thus the assets not being readily
marketable give rise to marketability risk.
10.
Answer :
(b)
Reason : Profit margins peak
during the growth stage due to experience curve effect which lower the unit
costs and promotion costs are spread over a large volume.
11.
Answer :
(b)
Reason : According to the
traditional approach to capital structure, as debt is added to the capital
structure the cost of capital declines initially because of lower post-tax cost
of debt. But as leverage is increased, the increased financial risk overweighs
the benefits of low cost debt and so the cost of capital starts increasing.
Hence the correct answer is (b).
12.
Answer :
(b)
Reason : BCG matrix classifies
the products into four broad categories. All others are the models for
predicting sickness of a firm.
13.
Answer :
(e)
Reason : In times of financial
and economic downturn, creditors will look to supply funds to companies that
have stronger financial positions.
14.
Answer :
(d)
Reason
: The weights based on the book values
are historical in nature and hence these do not reflect the cost of capital
owing to the changes in the business and financial risk of the company. The
reasons mentioned in the other options do not correctly reflect the advantages
of choosing the weights based on the book values in comparison to the market
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15.
Answer :
(c)
Reason : Gordon argued that the
investors would prefer the income that they earn currently to that income in
future that may or may not be available. Hence, they prefer to pay a higher
price for the stocks which earn them current dividend income and would discount
those stocks, which either reduce or postpone the current income. For that
reason, this model emphasizes the entire weight on the dividends, while other
models consider the dividend payment and the retained earnings. Hence, the
option (c) is correct.
16.
Answer :
(c)
Reason : Holding cash balance to
meet contingencies is a manifestation of precautionary motive. Transaction
motive (a) is manifested when cash balance is held to meet the requirements in
the normal course of business. Speculative motive (b) is manifested when cash
balance is held for gaining from speculative activities. Further holding cash
balance is a normal practice for all types of firms, large or small (d) and
(e).
17.
Answer :
(a)
Reason : In the presence of
floatation costs, the cost of external equity will always be more than the cost
of existing equity capital (a). It has got no logical connection with cost of
long-term or short-term debt. Hence (b), (c), (d) and (e) are all incorrect.
18.
Answer :
(d)
Reason : Working capital/Total
assets ratio is a balance sheet ratio. In the L C Gupta model, balance sheet
ratios are only the (Net Worth/Total Debt) and (All outside
liabilities/Tangible assets) ratios. All the other key ratios found suitable in
predicting failure are profitability ratios.
19.
Answer :
(d)
Reason : According to the Alcar
model, there are seven value drivers that affect a firm’s value. These are:
The rate of growth of sales. Operating profit
margin. Income tax rate.
Incremental investment in working capital.
Incremental investment in fixed assets. Value growth duration.
Cost of capital
Obviously, dividend growth rate is a factor not
considered in this model. So the correct answer is (d).
20.
Answer :
(c)
Reason : Asset turnover of a
company is defined as the ratio between the sales value and total assets. High
asset turnover is possible only when a company can generate a high sales volume
in comparison to the amount invested in the fixed assets and current assets.
21.
Answer :
(a)
Reason
: When the current ratio is less than
1.00 (a), the current assets are less than current liabilities i.e. net working
capital is negative. Such a situation indicates that short term funds have been
used for long term purposes. Quick ratio (Quick assets / Current liabilities)
may be less than 1.00 even when the current ratio is more than or equal to
1.00. Hence (b) is incorrect. Total debt to equity is greater than 1.00 does
not imply that current ratio will be less than 1.00. Hence (c) is incorrect. A positive
net working capital implies that some part of the long term sources of funds
have been invested in short term uses (current assets).
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10
22.
Answer :
(a)
Reason : The realized yield
approach assumes that the actual returns to the equity shareholders have been
in line with their expected returns.
23.
Answer :
(b)
Reason : According to Walter
model on dividend policy, if the internal rate of return is less then the cost
of capital then the optimal payout ratio is 100%.
24.
Answer :
(e)
Reason : Net working capital is said to be financed
by long term sources of capital.
25.
Answer :
(b)
Reason : Increase in the average
collection period, increase in the finished goods storage period, increase in
the raw materials storage period and increase in the work-in process period all
result in increasing the operating cycle of the firm. Only increase in the
average payment period decreases the net operating cycle of the firm. Hence
option (b) is correct.
26.
Answer :
(d)
Reason : Agency cost are cost on account of
restriction imposed by creditors on the firm in the form of some protective
covenants. Commission payable by the company to its purchasing and selling
agents , the expenses incurred in distribution of the products of the company,
or the dividends paid by the company does not come under the agency cost.
27.
Answer :
(b)
Reason :
Combination is also known as aggregation or diversification.
28.
Answer :
(d)
Reason : According to target
costing the cost of a product should be determined on the basis of a sales
price necessary to capture a predetermined market share.
29.
Answer :
(a)
Reason : Shortage in supply of raw materials is an
external factor, others are internal factors.
30.
Answer :
(d)
Reason : Retained earnings (a),
equity capital (b), debenture capital (c) and term loan (e) are all sources of
long-term finance. However, trade credit is not a long-term source because it
has a short span (less than 1 year).
11
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Section B : Problems |
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1. a. |
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|
(Rs.
lakh) |
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|
|
|
|
EBIT |
|
43 |
|
|
|
|
|
Less: Interest |
|
3 |
|
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(80 – 50) × 0.10 |
|
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Profit before tax |
|
40 |
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Less: Tax (40 × 0.30) |
|
12 |
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Profit after tax |
|
28 |
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Rs.80 lakh |
= 4 lakh |
|
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||
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No. of equity shares outstanding |
= |
|
Rs.20 |
||
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Rs.28 lakh |
|
Earnings per share = |
4 lakh |
|
|
|
|
Intrinsic value of the share |
= |
= Rs.7.00
EPS = 7.00 = Rs.43.75
k e 0.16
The buyback price per share should be equal to the
intrinsic value i.e. = Rs.43.75.
|
|
|
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|
Rs.70 lakh |
= 1, 60, 000. |
|
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No. of equity shares that may bought back at the
above price = |
Rs.43.75 |
||||
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b. Post buyback |
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(Rs. lakh) |
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EBIT |
|
43 |
|
|
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|
|
Less: Interest |
|
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0.10 (80 – 50) + (70 × 0.11) |
|
10.70 |
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Profit before tax |
|
32.30 |
|
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Less: Tax (32.3 × 0.30) |
|
9.69 |
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Profit after tax |
|
22.61 |
|
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|
No. of outstanding equity shares |
= |
400000 – 160000
= |
240000 |
|
|
Earnings
per share =
Price per
share =
2261000
240000 = Rs.9.42
9.42 = Rs.52.33
0.18
From above we can see that the price share is
expected to increase from Rs.43.75 to Rs.52.33. So the company may change its
capital structure by raising debt and buying back a portion of its shares.
<TOP>
|
|
Cost of goods sold |
= |
|
|
486 |
|
= Rs. 648 lakh |
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2. 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
12
|
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|
Sales |
= |
648 |
|
|
|
Receivables = Re ceivables turnover ratio |
12 = Rs.54 lakh |
|||||
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Current assets = Current liabilities × current ratio |
||||||
|
=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 |
|
81 |
|
Term loan |
51 |
Inventories |
|
72 |
|
Current liabilities & provisions |
90 |
Receivables |
|
54 |
|
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Cash
and Bank |
|
9 |
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|
216 |
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|
216 |
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<TOP>
3 3bσ2
3. a.
Return point (RP) =
4I
+ LL
Given :
b
= Rs.300
σ
=
Rs.3,000
0.063
I
= 360 =
0.000175 LL = Rs.3,00,000
|
|
3 × 300 × 30002 |
|
1 |
|
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|
] 3 |
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∴ RP = [ 4 × 0.000175 |
+ 3,00,000 = Rs.3,22,618 |
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Maximum amount of cash balance (UL) = 3RP – 2LL
= (3 ×
3,22,618) – (2 × 3,00,000)
= Rs.3,67,854
The amount of cash that should be invested in
marketable securities as the maximum cash balance is attained
=
UL – RP =
3,67,854 – 3,22,618 = Rs.45,236
b.
If the
daily cash inflows increase by a constant amount of Rs.2,000 and the daily cash
outflows increase by a constant amount of Rs.1,500, then the ‘changes’ in daily
cash balances will increase by a constant amount of Rs.500 (i.e. Rs.2,000 –
Rs.1,500). Since all the values (of changes) will increase by a constant value
of Rs.500 their mean will also increase Rs.500. Because of this the deviations
from mean will remain unchanged. Hence the standard deviation of the change in
daily cash balances will also remain unchanged. Other factors influencing the
cash balances will also remain unchanged. So there will be no change in the
maximum cash balance and the required investment in marketable securities as
the maximum balance is reached.
c.
If the
minimum required cash balance is increased by Rs.1 lakh then, LL = 3 +1 = Rs.4
lakh. Required investment in marketable securities as the maximum cash balance
is attained = UL – RP
= (3RP – 2 LL) – RP
= 2RP–2LL
13
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Since other factor remain unchanged the return
point RP also increases by the same amount as LL i.e. Rs. 1 lakh.
Hence the difference between RP and LL remains the
same as before. So the required investment in marketable securities remains
unchanged.
<TOP>
4.
The
necessary steps that the companies should take for establishing effective risk
management processes are as follows:
Understanding
the risks that they are taking
To manage risks properly,
companies must first understand what risks they are taking. In order to do so,
they need to make all of their major risks transparent and to define the types
and amounts of risk they are willing to take. Although these steps will go a
long way toward improving corporate risk management, companies must also go
beyond formal controls to develop a culture in which all managers automatically
look at both risks and returns. Rewards should be based on an individual’s
risk-adjusted—not simply financial—performance.
Achieving
transparency
Every company must not only understand the types of
risk it bears but also clearly know the amount of money at stake. It needs to
be transparent about the potential impact of these risks on its fortunes. Less
obviously, it should understand how the risks that different business units
take, might be linked and what is the effect on its overall level of risk. In
other words, companies need an integrated view. The over-all risk position
should be reviewed frequently (perhaps monthly) by the top-management team and
periodically (for instance, quarterly) by the board to help them decide whether
the current level of risk can be tolerated and whether the company has
attractive opportunities to take on more risk and earn commensurately larger
returns.
Deciding
on a strategy
High concentrations of risk aren’t necessarily bad.
Everything depends on the company’s appetite for it. Unfortunately, many
companies never articulate a risk strategy. The CEO, with the help of the
board, should define the company’s risk strategy. Formulating such a strategy
is one of the most important activities a company can undertake, affecting all
of its investment decisions. A good strategy makes clear the types of risks the
company can assume to its own advantage or is willing to assume, the magnitude
of the risks it can bear, and the returns it demands for bearing them. Defining
these elements provides clarity and direction for business-unit managers who
are trying to align their strategies with the overall corporate strategy while
making risk-return trade-offs.
Creating
a high-performing risk-management group
The task of the risk management group is to
identify, measure, and assess risk consistently in every business unit and then
to provide an integrated, corporate-wide view of these risks, ensuring that
their sum is a risk profile consistent with the company’s risk strategy. The
structure of the organization will vary according to the type of company it
serves. In a complex and diverse conglomerate, such as GE, each business might
need its own risk-management function with specialized knowledge. More
integrated companies might keep more of the function under the corporate wing.
Encouraging
a risk culture
The above steps will go a long way toward improving
risk management but are unlikely to prevent all undue risk taking. Companies
might thus impose formal controls—for instance, trading limits. Yet since
today’s businesses are so dynamic, it is impossible to create processes that
cover every decision involving risk. To cope with it, companies need to nurture
a risk culture. The goal is not just to spot immediately the managers who take
big risks but also to ensure that managers instinctively look at both risks and
returns when making decisions.
Overseeing
of the risk management processes by the board
A company’s board of directors should understand
and oversee the major risks it takes and ensure that its executives have a
robust risk-management capability in place. In order to do this, the board must
decide on the committee on which the responsibility of overseeing the risk
management should be vested. It should then ensure that appropriate reporting
to the board and its committees is done. It should also conduct regular
training programs for its existing and new members, and review the
effectiveness of the risk management processes periodically.
<
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5.
A
company, which wants to establish an effective risk management system, can
create a highly effective risk management group by following the steps given
below:
Appointing
top-notch talent
Risk executives at both the corporate and the
business-unit level must have the intellectual power to advise managers in a
credible way and to insist that they integrate risk-return considerations into
their business decisions. Risk management should be seen as an upward career
move. A key ingredient of many successful risk-
14
management
organizations is the appointment of a strong chief risk officer who reports
directly to the CEO or the CFO and has enough stature to be seen as a peer by
business-unit heads.
Segregation
of duties
Companies must separate employees
who set risk policy and monitor compliance with it from those who originate and
manage risk. Salespeople, for instance, are transaction driven—not the best
choice for defining a company’s appetite for risk and determining which
customers should receive credit.
Clear
individual responsibilities
Risk-management functions call
for clear job descriptions, such as setting, identifying, and controlling
policy. Linkages and divisions of responsibility also need to be defined,
particularly between the corporate risk-management function and the business
units. Should the corporate center have the right to review their risk-return
decisions, for example? Should corporate risk-management policies define
specific mandatory standards, such as reporting formats, for the business units?
Risk
ownership
The existence of a corporate risk
organization doesn’t absolve business units of the need to assume full
ownership of, and accountability for, the risks they assume. Business units
understand their risks best and are a company’s first line of defense against
undue risk taking.
<TOP>
6.
The
various approaches that can be used for evaluation of risky assets are:
i.
Risk Adjusted discount Rate method (RADR)
One of the popular ways of
estimating the present value of the future cash flows is by the use of the
discount rate method. The rate at which the future cash flows are discounted is
actually the project’s cost of capital. The method is generally used in case
where there is a comparison firm or set of firms in the same line of business
as the project. Calculation of the net present value of the future period’s
cash flows using the risk adjusted discount rate can be using the following
formula:
PV = E (cf)/{1 + rf + beta
(R - rf)} Where,
E (cf) denotes expected future cash flows in the
next period Beta denotes the beta of the return of the project
rf denotes the risk-free return
RT denotes the expected return of the tangency
portfolio.
<
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ii.
The Certainty Equivalent Approach
In contrast to the RADR approach
that involves the adjustments made in the denominator of the NPV equation, this
approach deals with adjusting the numerator of the equation. In other words,
the CE cash flows are discounted at the risk-free interest rates rather than at
risk adjusted discount rates that are done in the case of RADR approach. The
certainty equivalent factor (CE) is actually the mount of cash that someone
would require with certainty at a point of time which will make him indifferent
between that certain amount and an amount expected to be received with risk at
that same point of time. Here the risk-free rate and not the firm’s cost of
capital are used as a discount rate for the estimation of the net present
value. This is mainly done because the company’s cost of capital is a risky
counting of the risk. It is to be kept in mind that the certainty equivalents
range from 0 to 1.0 and the higher the factor the more certain is the expected
cash flow. The CE can be computed in the following way:
αt = (certain returns/risky returns)
Further the net present value can be calculated as:
NPV = NIVα(0) + Σ (NCFtαt)(1 + rf)t
Where, α0 denotes the CE factor associated with the net
initial investment t denotes economic life of the project
αt denotes
the CE factor associated with the net cash flows at each period of time t rf denotes
the risk-free rate.
Advantages
of the Approach
•
Each
period’s cash flow can be adjusted separately to account for the specific risk
of those cash flows.
•
The
approach provides a clear basis for making decisions, because the decision
makers can introduce their own risk preference directly into the analysis.
15
This is another technique that
can be used to assess the risk of an investment project. This approach involves
the simultaneous changes in the key variables, and their impact on the project.
While using the approach, the various estimates of the project’s net present
value is called for. This might involve both the optimistic as well as the most
pessimistic estimates of the project’s value. The former may be defined in terms
of the most optimistic values of each of the input variables whereas the
pessimistic scenario can be explained as the pessimistic values of the inputs
used in the project. Further, there will also be the existence of the
probabilities of these different situations of the project.
Advantages
of the Risk-Free Scenario Method
In the risk-free scenario, the
investors expect the stocks to appreciate at the given risk-free rate. In a
moderately pessimistic scenario, the manager finds it easier in estimating the
future cash flows of the project than in estimating the expected value over all
scenarios.
<
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7. The most straightforward way to avoid problems with
IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to
be replaced easily. Executives should at the very least use a modified internal
rate of return. While not perfect, MIRR at least allows users to set more
realistic interim reinvestment rates and therefore to calculate a true annual
equivalent yield. Despite flaws that can lead to poor investment decisions, IRR
will likely continue to be used widely during capital-budgeting discussions
because of its strong intuitive appeal. Executives should at least cast a
skeptical eye at IRR measures before making investment decisions. Executives
who review projects claiming an attractive IRR should ask the following
questions:
1.
What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that
interim flows can be reinvested at high rates is at best overoptimistic and at
worst flat wrong. Particularly when sponsors sell their projects as
"unique" or "the opportunity of a lifetime," another
opportunity of similar attractiveness probably does not exist; thus interim
flows won't be reinvested at sufficiently high rates. For this reason, the best
assumption—and one used by a proper discounted cash-flow analysis—is that
interim flows can be reinvested at the company's cost of capital.
2.
Are interim cash flows biased toward the start or
the end of the project? Unless
the interim reinvestment rate is correct (in other words, a true reinvestment
rate rather than the calculated IRR), the IRR distortion will be greater when
interim cash flows occur sooner. This concept may seem counterintuitive, since
typically we would prefer to have cash sooner rather than later. The simple
reason for the problem is that the gap between the actual reinvestment rate and
the assumed IRR exists for a longer period of time, so the impact of the
distortion accumulates.
< TOP >
Section C: Applied Theory
8.
THE MODELING PROCESS
The following are the major steps in the process of
using a model to arrive at the optimal decision:
•
Feasibility
study
•
Model
construction
•
Compatibility
of the model with the tools used
•
Model
validation
•
Implementation
•
Model
revision
•
Documentation
Feasibility Study
The foremost step in developing a model is to
ascertain the feasibility of a model assisting the decision making process. The
various points that are required to be considered are
Whether the decision under consideration is a
one-time process, or is required to be taken as a routing measure
•
The
suitability of the area in which the decision is required to be made, to be
supported by a model
•
The
possibility of all the relevant variable being unambiguously identified
•
The
possibility of all the variables being built-in into a single model
•
The
expected effectiveness of the model
•
The
acceptability of a model replacing human judgment to the management
•
The
possibility of obtaining the required date on an ongoing basis
16
•
The
possibility of integrating the model with the normal decision-making process
•
The costs
involved with setting up and running the model, and its comparision with the
expected benefits.
If it is feasible to construct an efficient and
effective model for the decision process under consideration, and if the model
can be easily integrated with the process, the firm can proceed to the next
step of constructing the model.
Model
Construction
•
The
construction of the model depends on a number of factors. Some of these are
•
The
decision to be made using the model
•
The
issues that are relevant for making the decision
•
The way
in which these issues and factors affect the decision
•
The
external factors that restrict the decision making process.
Depending on these factors, the
input requirement for the model is identified and the numerical and theoretical
relationship between variable are specified. This is followed by development of
the structure of the model.
Model
Compatibility
Once the model is in place, it
needs to be made compatible to the tools to be used to implement it. For
example, if a particular model is to be solved using computers, the model needs
to be programmed and converted to a language that the computer understands.
Model
Validation
A number of test runs are
conducted on the model to check whether it produces reasonable accurate
results. The test runs may use actual past data of the input variables, and the
results generated by the model compared to the actual results. Alternatively,
the model may be tested by using results. Alternatively, the model may be
tested probability distributions. Test running a model checks the effectiveness
of the structure of the model, as well as its predictive ability.
Implementation
The implementation of a model
includes integrating it with the normal decision -making process. Further ,it
needs to be ensured that the results generated by the model are relevant enough
for the decision-making to take them into consideration while making a
decision.
Mode
Revision
No model remains useful for an
indefinite period. The relationship between different variables that forms a
basis for the model may change over a period of time. External factors
affecting a model may also change. Use of the model over a period may provide
an insight into its drawbacks. It is necessary that such changes are noted and
the model periodically revised to accommodate them. Unless a model is
continuously updated, it may lose its relevance.
Documentation
Documentation is way of institutionalization
of the knowledge created during the process of developing and installing a
model. It involves making detailed, systematic notes at all the stages of the
process. The records should be maintained right for the stage when the need for
the model was felt, detailing the factors that gave rise to the need. The
various ideas considered at different stages needs to be documented along with
the reasons for their acceptance of rejection. The various problems faced
during the development and implementation of the model, together with their
solution should also form a part of the records. Documentation also helps in
proper communication between the members of the team working on the development
of the model. In addition, it makes the process of revision the model less
tedious.
While developing the implementing
models, certain issues need to be kept in mind. It is not just necessary to
specify the objectives of the model, it is also necessary to build the relative
importance of the different objectives into model. For example, the objective
may be to maximize the profits of the firm, while restricting the debt taken by
it to a certain percentage of the total assets. The model should specify the
objective(maximum profits or limited debt) that would be held supreme, if there
were a clash between the two. Another important point to be remembered is that
the model should preferable focus on some key aspects, rather than be a
collection of all relevant and irrelevant data. A focused model is more likely
to generate effective decision.
<TOP>
9.
STRATEGIC DETERMINANTS OF DIVIDEND POLICY
Some of the key factors which influence dividend
pay-out of a firm are delineated below.
Liquidity: Traditional theories have postulated that a
dividend decision is solely a function of the earnings of the firm. While
earnings are an important determinant for the dividend decision, the role of
liquidity cannot be ignored. Dividend pay-out entails cash outflow for the
firm. Hence the quantum of dividends proposed to be distributed critically
depends on the liquidity position of the firm. In practice, firms often face
cash crunch in spite
17
of having good earnings. Such
firms may not be in a position to declare dividends despite their
profitability.
Investment
Opportunities: Another
key determinant to the dividend decision is the requirement of capital by the
firm. Normally firms tend to have low pay- out if profitable investment
opportunities exist and conversely firms tend to resort to high pay-outs if
profitable investment opportunities are lacking. Generally, firms operating in
industries which are in the nascent and growth phases of the product life cycle
are characterized by high dependence on retained earnings. On the other hand,
firms operating in industries which are in the maturity and decline stages
normally distribute a larger proportion of their earnings as dividends.
Access to
Finance: A
company which has easy access to external sources of finance can afford to be
more liberal in its dividend pay-out. The dividend policy of such firms is
relatively independent of its financing decisions. Firms having little or no
access to external financing have rather limited flexibility in their dividend
decisions.
Flotation
Costs: Issue of securities to raise
capital in lieu of retained earnings involves flotation costs. These costs
include fees payable to the merchant bankers, underwriting commission,
brokerage, listing fees, marketing expenses, etc. Moreover smaller the size of
the issue, higher will be the 'flotation costs as a percentage of amount
mobilized. Further there are indirect, flotation costs in the form of
underpricing. Normally issue of shares are made at a discount to the,
prevailing market price. The cost of external financing has an influence on'
the dividend policy.
Corporate
Control: Further
issue of shares (unless done through rights issue) results in dilution of the
stake of the existing shareholders. On the other hand, reliance on retained
earnings has no impact on the controlling interest. Hence companies vulnerable
to hostile takeovers prefer retained earnings rather than fresh issue of
securities. In practice, this strategy can be a double edged sword. The
niggardly pay-out policy of the company may result in low market valuation of
the company vis-a-vis its intrinsic value. Consequently the company becomes a
more attractive target and is in the danger of being acquired.
Investor
Preferences: The
preference of the shareholders has a strong influence on the dividend policy of
the firm. A firm tends to have a high pay-out ratio if the shareholders have a
strong preference towards current dividends. On the other hand, a firm resorts
to retained earnings if the shareholders exhibit a clear tilt towards capital
gains.
Restrictive
Covenants: The
protective covenants in bond indentures or loan agreements often include
restrictions pertaining to distribution of earnings. These conditions are
incorporated to preserve the ability of the issuer/borrower to service the
debt. These covenants limit the flexibility of the company in determining its
dividend policy.
Taxes: The incidence of taxation on the firm and the
shareholders has a bearing on the dividend policy. India levies a 10% tax on the
amount of distributed profits. This tax is a strong fiscal disincentive on
dividend distribution. These dividends are totally tax-tree in the hands of the
shareholders. The capital gains (long-term) are taxed at 20%.
Dividend
Stability: The
earnings of a firm may fluctuate wildly between various time periods. Most
firms do not like to have an erratic dividend pay-out in line with their
varying earnings. They try to maintain stability in their dividend policy.
Stability does not mean that the dividends do not vary over a period of time.
It only indicates that the previous dividends have a positive correlation with
the current dividends. In the long am, the dividends have to be invariably
adjusted to synchronize with the earnings. However, the short-term volatility
in earnings need not be fully reflected in dividends.
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