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Question
Paper
Strategic Financial Management
(MB361F): January 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.
The most commonly held view of capital structure is
that 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.
2.
Consider the following information relating to
Glenco Ltd :
|
EBIT |
|
= Rs.20
crore |
|
|
|
Depreciation |
|
= |
Rs.3 crore |
|
|
Interest on debt |
|
= |
Rs.3 crore |
|
|
Annual loan installment |
= |
Rs.2 crore |
|
|
|
Tax
rate |
|
= 35% |
|
|
|
The
fixed charges coverage ratio of the company is |
|
|||
|
(a) 2.50 |
(b) 3.33 |
|
(c) 3.78 |
(d)
10.00 (e) None of the above. |
3.
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.
4.
Low cost product strategy is used
by Nirma in detergents, Ruf & Tuf in denims and Akai in television. This
strategy of pricing low, falls under which of the following costing techniques?
(a) Life cycle costing (b) Target costing (c)
Quality costing
(d) Activity based costing (e) Value
chain analysis.
5.
If the dividend per share for the
year is Rs.2.00, growth rate of dividends is 12% and the present market price
of the stock is Rs.52.50, the required return on the stock will be
(a) 16.27% (b)
15.81% (c)
15.00% (d) 8.19% (e)
7.73%.
6.
Given total debt-equity ratio =
5:4; total assets = Rs.4,500; short-term debt = Rs.600 and total debt consists
only of long-term debt and short-term debt, the long-term debt is equal to
(a) Rs.1,567 (b) Rs.1,900 (c)
Rs.2,167 (d)
Rs.2,500 (e)
Rs.2,833.
7.
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.
8.
The average collection period of
a company is 40 days. If the average receivables balance is Rs.20 lakhs, the
sales of the company, assuming 360 days in a year, is
(a) Rs. 60 lakhs (b) Rs. 90 lakhs (c)
Rs.120 lakhs (d) Rs.180 lakhs (e) Rs.210
lakhs.
9.
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
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(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 .
10.
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.
11.
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.
12.
The current market price of the
shares of Tractor India Ltd. is Rs.60. The company recently paid a dividend of
Rs.3.00 per share that is expected to grow at a rate of 8 percent. If the
floatation cost will be 2 percent of the current market price, what will be the
cost of external equity to Tractor India?
(a) 13.00
percent
(b)
13.67 percent
(c)
14.34 percent
(d)
15.00 percent
(e) 15.67
percent.
13.
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.
14.
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.
15.
The equity capital and total debt
of Super Industries Ltd. amount to Rs.150 lakhs and Rs.300 lakhs respectively.
The earnings before interest and taxes of the company amount to Rs.90 lakhs.
The return on investment of the company is
(a) 10% (b) 12% (c) 15% (d) 20% (e) 30%.
16.
If the net profit margin is
12.50%, asset turnover ratio is 0.85 and return on networth is 24% then, the
debt-asset ratio is approximately
(a) 0.37 (b) 0.44 (c) 0.56 (d) 0.63 (e) 0.97.
17.
The debt-asset ratio of a company is 1:3. It
implies that for every
(a) 3 rupees
of assets there is 1 rupee of equity
(b)
4 rupees of assets there is 1
rupee of debt
(c)
3 rupees of assets there are 2
rupees of debt
(d)
2 rupees of equity there is 1
rupee of debt
(e) 3 rupees
of debt there is 1 rupee of equity.
18.
If the current ratio is 2.45 and
the ratio of inventories to current liabilities is 0.45, the ratio of
inventories to current assets is
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2
inventories to current assets is
(a) 0.184 (b) 0.225 (c) 0.500 (d) 0.900 (e)
2.000.
19.
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.50,000.
20.
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.
21.
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%.
22.
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.
23.
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.
24.
Which of the following factors is not considered by Alcar model?
(a) Operating
profit margin
(b)
Incremental investment in working
capital
(c)
Income tax rate
(d)
Dividend growth rate
(e) Cost of
capital.
25.
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.
26.
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.
27.
Which of the following is a non-financial measure
of performance?
(a) Return on
capital employed
(b) Residual
Income
(c) Employee
morale and attitude
(d) Net
Profit
3
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28.
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.
29. If the market price per share of Magnificent Ltd. is Rs.44, EPS is
Rs.3.75 and retention ratio is 60%, then the multiplier according to
Graham-Dodd Model of dividend policy is
(a) 14.2 (b) 14.9 (c) 15.8 (d) 16.0 (e) 16.4.
30.
The return on investment of a firm
is 14% and cost of equity capital is 12%. According to the Walter Model on
dividend policy, in order to maximize the value of the firm, it should
(a) Adopt
100% dividend pay-out policy
(b)
Not pay dividends at all
(c)
Be indifferent as to the dividend
policy
(d)
Plough back 50% of profits and
pay the rest as dividends
(e) Leave the
decision of dividend payment to the discretion of Board of Directors.
END OF SECTION A
<
Answer >
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Answer >
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Answer >
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4
Section B : Problems/ Caselets
(50 Marks)
• This
section consists of questions with serial number 1 – 6.
• 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.
Prime Products Ltd. (PPL) had issued 15-year
tax-free debentures on July 1, 2000 carrying a coupon rate of 10.5 percent
payable semiannually. The issue provisions provide for a call option on these
debentures after a term of 5 years at a price, which is 6 percent above the
nominal value of the debentures. The interest paid by the company on these
debentures for the period July 1, 2004 to December 31, 2004 amounted to
Rs.1,05,000. Because of a fall in the interest rates, the company is planning
to replace these debentures with effect from July 1, 2005, by new debentures
carrying a coupon rate of 8.5 percent payable semi-annually and having a
maturity period of 10 years. The company expects that the net amount realized
from the issue of the new debentures will be equal to the total nominal value
of the existing debentures and the issue costs will amount to 1 percent of the
net amount realized. It is assumed that the coupon rate and the terms of coupon
payment of the new issue reflect the prevailing effective annual rate of
interest on the debt securities of the companies similar to PPL.
You are required to find out the following:
(a) The
direct costs associated with the replacement decision.
(b) The
financial viability of the replacement decision being considered by the firm.
(3 + 6 = 9 marks)
< Answer >
2.
Penta Top Ltd. would like to segregate
its client profile into the superior class and inferior class on the basis of
the current ratio and net profit margin. Given below is the information
relating to 12 accounts consisting of an equal number of superior and inferior
clients:
|
|
Superior clients |
|
Inferior clients |
||
|
Client |
Current
ratio |
Net Profit Margin |
Client |
Current |
Net Profit Margin |
|
(%) |
|
ratio |
(%) |
||
|
|
|
|
|||
|
A |
1.95 |
25 |
G |
0.85 |
22 |
|
B |
1.75 |
17 |
H |
0.62 |
10 |
|
C |
1.58 |
16 |
I |
0.44 |
3 |
|
D |
1.32 |
20 |
J |
0.58 |
9 |
|
E |
1.80 |
13 |
K |
0.62 |
5 |
|
F |
1.78 |
16 |
L |
0.65 |
8 |
From the above information, you are required
to estimate the discriminant function that discriminates between superior and
inferior clients.
(12 marks)
< Answer >
Caselet 1
Read the following caselet carefully and answer the
following questions:
3.
For evaluating business
performance both in financial and non-financial terms there is a necessity for
the investors to look beyond the ubiquitous information furnished by the media.
There is a tendency among the investors to overlook critically important
indicators that would otherwise have enabled them to better discern the firm’s
potential for wealth creation. Do you agree? Justify your opinion.
(8 marks)
< Answer >
4.
There are different groups of
people who read the financial statements, each looking for different types of
information. Earnings might be the most important area for investors, but other
areas of information are also of extreme significance. In this backdrop,
explain how notes to accounts and Management Discussion and Analysis provide
insights to the investors.
(6 marks)
< Answer >
5
Because there are literally
hundreds of things about a company to examine when analyzing its stock, it is
tough to know where to start. Most investors are good at evaluating earnings,
growth rates, revenue, and the P/E ratio, but they also tend to overlook other
aspects that can be just as important.
One of the items which the average investor tends to ignore is cashflow.
This represents the constant flow of money in and out of a company. All
companies provide separate cash flow statements as part of their financial
statements, but cash flow can also be estimated as net income plus depreciation
and other non-cash items. The second aspect which is also generally overlooked
by the typical investor is the management. This is one aspect of a company that
can make a world of difference. Think of management in terms of sports: Michael
Jordan might not have been the "whole show" during his reign at the
Chicago Bulls, but he was undoubtedly a huge contributing factor to their success.
The same is true for the management of a business.
Further, receivables and the finished goods inventory are two items in
the balance sheet on which the average investor does not place enough emphasis.
Receivables represent the sales for which the company has yet to collect the
money. Sales drive accounts receivable, so when sales are growing, accounts
receivable will grow at a similar rate. Inventory of the finished goods
available for sale ties in closely with accounts receivable.
Two other items which the investors tend to lose sight of, in the maze
of details that are present in any annual report are the notes to accounts and
the Management Discussion and Analysis(MD &A). These are the items which
contain vital information which can not be expressed in very objective terms or
quantifiable in the financial statements.
The technique of looking at the overall company and its outlook is
sometimes referred to "qualitative analysis," and it is a perspective
that is often forgotten. Peter Lynch once stated that he found his best
investments by looking at the trends his children follow.
Assessing a company from the fundamental/qualitative standpoint is one
of the most effective strategies for evaluating a potential investment, and it
is as important as looking at sales and earnings. These overlooked areas are by
no means the only things investors need to evaluate, but looking at more than
just the obvious will give you that extra advantage over other investors.
Earnings are important, but earnings are also the most widely published
financial figure for any company, so why base an investment decision solely on
what other people already know? The moral here is always to dig deeper by doing
solid research so that you can aim to be a step ahead of the crowd.
Caselet 2
Read the caselet carefully and answer the following
questions:
5.
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 >
6.
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 to 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 6
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 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.
END OF SECTION B
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Section C : Applied Theory (20
Marks)
• This
section consists of questions with serial number 7 - 8.
• Answer all questions.
• Marks are
indicated against each question.
• Do not
spend more than 25 -30 minutes on section C.
7.
Reorganization of a firm in
financial distress is often a more sensible solution than liquidation as the
firm will be more likely to repay its debts, when it is alive and operating
than when it is liquidated. Explain the steps involved in the reorganization of
a financially distressed firm.
(10 marks)
< Answer >
8.
Corporate decisions are affected
by a large number of variables. Many-a-times, 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 >
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management
(MB361F): January 2005
Section A : Basic Concepts
1. Answer : (b) < TOP >
7
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Reason :
According to the traditional approach to capital structure, as debt is added to
the capital structure the cost of capital declines initially because of lower
post-tax cost of debt. But as leverage is increased, the increased financial
risk overweighs the benefits of low cost debt and so the cost of capital starts
increasing. Hence the correct answer is (b).
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2. |
Answer
: (c) |
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EBIT + D |
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20+3 |
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LR |
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3 + |
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(1− T) = |
(1 |
− 0.35) = 3.78 |
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Reason
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3.
Answer : (c)
Reason : The marginal cost rate breaks down under a
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.
4.
Answer : (e)
Reason : Low cost strategy is one of the two
strategies followed under value chain analysis. The other strategy being
differentiation strategy.
5.
Answer : (a)
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D1 |
+ g |
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D0 (1+ g) |
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P0 |
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Reason
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Required rate of return on the stock = |
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+ g = |
52.50 + 0.12 |
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6. |
Answer
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Total
debt |
5 |
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Equity |
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Reason
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= 4 Adding 1 to both sides of the equation we
get: |
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Total
debt |
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5 |
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Total debt + equity |
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5 + 4 |
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Total asset |
9 |
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Equity |
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Equity |
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Equity |
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+ 1 = |
4 + 1
or |
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4 or |
= 4 |
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Total asset × 4 |
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4500× 4 |
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From
above, Equity = |
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9 |
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= |
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9 |
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=
Rs.2,000 |
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Now,
total assets |
= |
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Total
debt + equity |
= |
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Rs.4,500 |
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or |
Total debt + 2000 |
= |
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4500 |
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or |
Total
debt |
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= |
4500 –
2000 = Rs.2,500 |
||||||||||||||
Long term
debt = Total debt – Short term debt = 2500 – 600 = Rs.1,900.
7.
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.
8.
Answer : (d)
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Re
ceivables balance |
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Reason
: Average collection period |
= |
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Averagedaily
sales |
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Sales |
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Average
daily sales |
= |
360 |
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Re ceivablesbalance |
x 360 |
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∴ Average collection period |
= |
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sales |
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Average
collection period |
= |
40 days
(given) |
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Receivables
balance |
= |
Rs.20
lakhs |
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20 |
x 360 |
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∴ 40 |
= |
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Sales |
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<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
8
or Sales = 40 = Rs.180
lakhs.
9.
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
values.
10. Answer :
(e)
Reason : According to this theory the first and
most popular is retained earnings as it has no associated floatation cost.
11. 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.
12. Answer :
(b)
Reason
: The cost of equity for Tractor India
is:
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D1 |
+ g = |
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Do (1 + g) |
+ g |
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Ke = Po |
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P0 |
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3×1.08 |
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+ 0.08 |
= 0.1340 = 13.40 |
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60 |
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||
= 0.1340
= 13.40%
0.134
Hence, the cost of external equity will be = 0.98 = 0.1367 = 13.67 percent
13. 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).
14. 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.
15. Answer :
(d)
|
Reason
: Return on investment (ROI) |
= |
EBIT /
Total assets |
|||||||||
|
Total
assets |
= |
Debt + Equity = 300 + 150 =
Rs. 450 lakhs |
|||||||||
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EBIT |
= |
Rs. 90 lakhs (given) |
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∴ ROI |
= |
90 / 450 = 20% |
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16. Answer : (c) |
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Net profit |
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Reason
: Return on net worth (RONW) |
= |
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Net worth |
= 0.24 (given) |
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Net profit |
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Net
profit margin |
= |
Net sales |
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= |
0.125
(given) |
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Net
sales |
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Asset
turnover ratio |
= |
Total
assets |
= |
0.85
(given) |
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9 |
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<
TOP >
<
TOP >
<
TOP >
<TOP>
<
TOP >
<
TOP >
<
TOP >
<
TOP >
17. Answer :
(d)
Reason : Debt-Asset ratio of 1:3 implies that for
every 3 rupees of total assets there is one rupee of debt and two rupees of equity.
Hence, for every 2 rupees of equity there is one rupee of debt. Hence (d) is
true.
∴In this
case, for every 3 rupees of assets there are 2 rupees of equity. Hence (a) is
not true. Again for every 3 rupees of assets there is 1 rupee of debt. Therefore
both (b) and (c) are not true. For every one rupee of debt there are two rupees
of equity; hence (e) is not true.
18. Answer :
(a)
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Current
assets |
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Reason
: CR
= |
Current liabilities = 2.45 |
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Inventories |
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Current liabilities |
= |
0.45 |
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Inventories |
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Current liabilities |
× |
Inventories |
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Current Assets = |
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Current
Assets |
Current liabilities |
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1 |
× |
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Inventories |
0.45 |
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CR |
Current liabilities |
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= |
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= |
2.45 = 0.184. |
|||||||||
19. Answer :
(c)
Reason : According to Miller and Orr Model the
Upper limit, UL = 3RP – 2LL Where RP means return point and LL means lower
limit.
|
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UL + 2LL |
|
60,000 + 2×15,000 |
|
|
⇒RP= |
3 |
= |
3 |
= Rs. 30,000. |
<TOP>
<TOP>
<TOP>
10
20. 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.
21. Answer :
(c)
Reason : The increase in the nominal rate of
interest must be higher than the increase in the rate of inflation, if the
interest income is subject to tax. This is necessary for maintaining the real
state of interest. The increase in nominal rate is given by
(Inflation
rate after increase- Inflation rate before increase)
∆r = (1− tr )
∆r = (6 – 4) / (1– .35)
∆r = 2 / .65 = 3.076% or 3.1%.
22. Answer :
(e)
Reason : In stock split par value decreases and as
a result market price per share decreases immediately after a stock split.
23. 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.
24. 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).
25. 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
26. 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.
27. Answer :
(c)
Reason : ROCE, Residual Income, Net Profit and
Return on Net worth are all financial measures of performance. However,
employee morale & attitude is a non-financial measure of performance.
28. Answer :
(b)
Reason : BCG matrix classifies the products into
four broad categories. All others are the models for predicting sickness of a
firm.
29. Answer :
(d)
Reason
: Market price as per Graham – Dodd
Model is given by
|
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E |
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D + |
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3 |
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Po = m |
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11
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
<
TOP >
Given : Po = 44, E
= 3.75, D = 3.75 (1 – 0.6) = 1.5
44
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+ |
3.75 |
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1.5 |
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⇒ m = |
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3=16 |
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30. Answer : (b) |
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<TOP> |
||
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Reason
: As per Walter Model |
||||||||
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D + (E − D)r / k |
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|||||
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P0 = |
|
k |
||||||
Where,
the notations are in their standard use.
As the given return on investment (r) > cost of equity (k) the
company will maximize the value of share if no dividends are paid.
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12
|
PVIFA
(4.25%, 20) = (1.0425)20 (0.0425) =
13.294 |
|
∴NPV = (19,150 × 13.294) – 1,40,000 =
Rs.1,14,580 (Approx.) Since the NPV is positive the decision is viable. |
Section B : Problems
1.
a. Direct cost of the replacement decision =
Floatation costs + Call premium Call premium (total) = Total nominal value × 0.06
|
1, 05,
000 |
= |
||||
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0.105 |
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||||
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2 |
Rs.20,00,000 |
||||
|
Total
nominal value = |
|
||||
∴ Call
premium (total) = 20,00,000
× 0.06 = Rs.1,20,000
=
20,00,000 × 0.01
=
Rs.20,000
∴ Direct
cost of the replacement decision = 1,20,000 + 20,000 = Rs.1,40,000
b.
NPV of the replacement decision : Considering
in terms of half year : Interest savings after the new issue =
Total
interest on new debentures – Total interest on old debentures
0.085
Total interest on new debentures = (20,00,000 +
20,000) 2
|
|
=
Rs.85,850 |
|
Total
interest on old debentures |
= Rs.1,05,000 |
|
|
Coupon rate on new debentures |
|
|
Discount
rate = |
2 |
= 4.25% |
(Because the coupon rate and terms of coupon payment on the new debentures
reflect the prevailing effective rate of interest on the similar debt
instruments)
|
2. Let the discriminant function be Zi = aXi + bYi |
|
|
|
|
<TOP> |
|||||||
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|
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|
|||||||
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|
where |
Zi = Discriminant score for the
ith account |
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Xi =
Current ratio for the ith account |
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Yi = Net profit Margin for the ith account. |
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CustomerAccount |
Xi |
Yi |
(Xi – |
|
(Yi –Ym) |
(Xi – Xm)2 |
(Yi – Ym)2 |
(Xi – Xm) |
|
||
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Xm) |
|
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|
(Yi – Ym) |
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|
|
Gr. I A |
1.95 |
25.00 |
0.79 |
|
11.33 |
0.6241 |
128.3689 |
8.9507 |
|
|
|
|
|
B |
1.75 |
17.00 |
0.59 |
|
3.33 |
0.3481 |
11.0889 |
1.9647 |
|
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|
|
C |
1.58 |
16.00 |
0.42 |
|
2.33 |
0.1764 |
5.4289 |
0.9786 |
|
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|
|
|
D |
1.32 |
20.00 |
0.16 |
|
6.33 |
0.0256 |
40.0689 |
1.0128 |
|
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|
|
E |
1.80 |
13.00 |
0.64 |
|
-0.67 |
0.4096 |
0.4489 |
-0.4288 |
|
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|
F |
1.78 |
16.00 |
0.62 |
|
2.33 |
0.3844 |
5.4289 |
1.4446 |
|
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|
|
|
Gr. II G |
0.85 |
22.00 |
-0.31 |
|
8.33 |
0.0961 |
69.3889 |
-2.5823 |
|
|
|
|
|
H |
0.62 |
10.00 |
-0.54 |
|
-3.67 |
0.2916 |
13.4689 |
1.9818 |
|
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|
|
|
I |
0.44 |
3.00 |
-0.72 |
|
-10.67 |
0.5184 |
113.8489 |
7.6824 |
|
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|
|
J |
0.58 |
9.00 |
-0.58 |
|
-4.67 |
0.3364 |
21.8089 |
2.7086 |
|
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|
|
|
K |
0.62 |
5.00 |
-0.54 |
|
-8.67 |
0.2916 |
75.1689 |
4.6818 |
|
|
|
|
|
L |
0.65 |
8.00 |
-0.51 |
|
-5.67 |
0.2601 |
32.1489 |
2.8917 |
|
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|
|
Total |
13.94 |
164.00 |
0.02 |
|
-0.04 |
3.76 |
516.67 |
31.29 |
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Average |
1.16 |
13.67 |
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13 |
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Xm1 = Sum of
Xi for Gr. I/6 = 10.18/6 = 1.70
Xm2 = Sum of Xi for Gr. II/6 = 3.76/6 = 0.63
Ym = 164/12 = 13.67
Ym1 = Sum of Yi for Gr. I/6 = 107/6 = 17.83
Ym2 = Sum of Yi for Gr. II/6 = 57/6 = 9.5
σx2 =
(1/n-1) Σ(X - Xm)2 = (1/11)
x 3.76 = 0.342
σy2 =
(1/n-1) Σ(Y - Ym)2 = (1/11)
x 516.67 = 46.97
σxy = (1/n-1) Σ(X - Xm) (Y - Ym) = (1/11) x 31.29 = 2.84
dx = Xm1 – Xm2 = 1.70 – 0.63 = 1.07
dy = Ym1 – Ym2 = 17.83 – 9.5 = 8.33
a = (σy2 dx - σxy dy)/ (σx2σy2 - σxy2)
= (46.97 x
1.07 – 2.84 x 8.33)/(0.342 x 46.97 – 2.84 x 2.84)
= 26.60 /
7.998 = 3.32
b = (σx2 dy - σxy dx)/ (σx2σy2 - σxy2)
= (0.342 x
8.33 – 2.84 x 1.07)/(0.342 x 46.97 – 2.84 x 2.84)
= – 0.1899
/ 7.998 = – 0.024
Hence,
the required discriminant function is Zi = 3.32Xi – 0.024Yi
<TOP>
Caselet 1
3.
Figures reported in annual
reports mean exactly what the company designs them to appear -neither more nor
less. So investors looking at fundamentals must discern on a company-by-company
basis what the earnings whisper. Thus, investors ought to use different
parameters that make earnings evaluation easier, clearer, and more meaningful.
Some of the commonly overlooked indicators are: cashflow, management of the
company and composition of current assets in terms of inventory of finished
goods and receivables.
Proper cash flow levels vary from industry to industry, but a company
not generating the same amount of cash as competitors is bound to lose out. A
company without available cash to pay bills is in real trouble, even if the
company is profitable. By using the cash flow-to-debt ratio, which compares the
amount of cash generated to the amount of outstanding debt, you can judge the health of cash flow. This comparison reflects the
company's ability to service their loan and interest payments.
Good management doesn't do everything, but it certainly is an integral
part of the company. Sam Walton (of Wal-mart) and Jack Welch (of General
Electric) are examples of people who led their firms through thick and thin,
recessions and booms. The responsibility of the management has been greatly
enhanced in the wake of financial turmoils and scandals that have shaken the
investor confidence. The large-scale disasters of the likes of Enron and
Worldcom have served the purpose of highlighting the importance of good
corporate governance which can only be ensured by a prudent management.
Normally receivables grow in tandem with sales. So when sales are
growing receivables should also grow at a similar rate. Problems arise from
receivables which are increasing faster than sales, which indicates that the
company is not receiving payment for its sales and thus leaving itself short
for handling the expense of producing those sales. Finished goods inventory
also tends to respond to sales in a similar way to receivables. High inventory
is bad for several reasons. Firstly, there is a cost associated with storing the
extra inventory: increases in inventory cause higher storage costs. Secondly, a
growing inventory can indicate that the company is producing more than it can
sell.
In addition to the above the vital information and crucial insights
furnished by the footnotes to the financial statements, the directors’ report
on board responsibility and corporate governance, MD & A etc. tend to be
overlooked or side stepped by the common investors prior to making decisions.
It has been seen in the past that
the traditional measures and the GAAP-based reported earnings, leaves companies
with plenty of room for creative accounting and manipulation. Operating
earnings, which leaves out one-time gains and expenses from the bottom
line, is meant to make the numbers comparable across
companies. Unfortunately, many analysts now have their own criteria for what
should be excluded, so analyzing and comparing companies using operating
earnings can be difficult for the investors. While it is probably impossible to
develop a standard that can handle every contingency, good and honest reporting
is essential to assessing company fundamentals and value.
14
4.
As a preface to the annual report, a company's
management typically spends a few pages talking about the recent year (or
quarter) and gives a background of the company. While this is not the guts of
the financial statements, it does give investors a clearer picture of what the
company does. It also points out some key areas where the company has performed
well. The management's analysis is provided at their discretion, so take it for
what it's worth. Issues that analysts might look for in this portion are how
candid and accurate are the managers' comments, does the manager discuss
significant financial trends over past couple years, how clear are the managers
comments and do they mention potential risks or uncertainties moving forward?
If a company gives an adequate amount of information in the MD&A, it's
likely that management is being honest. It should raise a red flag if the
MD&A portion of the financial statement ignores serious problems that the
company has been facing. A good example would be a company that is known to
have large portions of outstanding debt but fails to mention anything about it
in the MD&A. Withholding important information not only deceives those who
read the financial statements, but in extreme cases also makes the company
liable for lack of disclosure.
Similarly, the notes to the financial statements (sometimes called
footnotes) are also an integral part of the overall picture. If the income
statement, balance sheet, and statement of cash flow are the heart of the
financial statements, then the footnotes are the arteries that keep everything
connected. If the analyst does not read the footnotes he may be missing out on
a lot of information.
The footnotes list important information that could not be included in
the actual ledgers. The notes list relevant things like outstanding leases, the
maturity dates of outstanding debt, and even details on where the revenue
actually came from. Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the
major accounting policies of the business. This portion of the footnotes tells
about the nature of the company's business, when its fiscal year starts and
ends, how inventory costs are determined, and any other significant accounting
policies that the company feels that you should be aware of. This is especially
important if a company has changed accounting policies. It may be that a firm
is changing policies only to take advantage of current conditions to hide poor
performance.
Disclosure - The second type of footnote provides additional disclosure
that simply could not be put in the financial statements. The financial
statements in an annual report are supposed to be clean and
easy to follow. To maintain this cleanliness, other calculations are left for
the footnotes. For example, details of long-term debt such as maturity dates and the interest rates at which debt was issued, can give you a better
idea of how borrowing costs are laid out. Other areas of disclosure include
everything from pension plan liabilities for existing employees to details
about ominous legal proceedings the company is involved in.
The majority of investors and analysts read the balance sheet, income
statement, and cash flow statement. But for whatever reason, the footnotes are
often ignored. What sets informed investors apart is digging deeper and looking
for information that others typically wouldn't.
<
TOP >
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Caselet 2
5.
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
15
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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.
<TOP>
6.
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-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 >
Section C
7.
Reorganization
The steps
involved in reorganization of a firm are
•
Techno- economic viability study
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•
Formulation and execution of the reorganization
plan
•
Monitoring the activities of the firm
Techno-economic Viability Study
A reorganization plan is worked out on the basis of a techno-economic
viability study of the firm. This study sets out to identify the strengths and
weaknesses of the firm, the causes of failure, the viability of future
operations and the course of action to be taken to bring about a turnaround.
The techno-economic viability study is undertaken by the operating agencies
assigned to the firm. These operating agencies are generally financial
institutions and banks such as IDBI , IFCI, ICICI, IRBI, SBI, PNB, etc.
The techno-economic viability study covers all the functional areas of a
firm: management, finance, production and marketing.
Management: The effectiveness and ability of the management is one of the most
important factors that determines the success or failure of a firm. A detailed
study is done in terms of the objectives of the firm, both short-term and
long-term, the corporate strategy, the corporate culture, the management-labor
relations, the organizational hierarchy, the decision- making process, etc. The
study tries to determine the effectiveness of management and its integrity. The
areas of mismanagement are also determined.
Finance: Finance it the main functional areas of business. It is a measurable
indicator of the firm’s health and performance. A though analysis of the firm’s
Balance Sheet and Profit/Loss statement is made.
These statements when properly analyzed give the financial stability and
liquidity of the firm; profitability and uses of funds. The analysis also
identifies the capital structure and the sources of unds. The analysis gives
insight into working capital management and management of earnings.
Production and Technology: Production and Technology function assumes
immense importance in the viability study. The various areas that are looked
into are, the firm’s equipment and machinery, the maintenance of the equipment,
the technology used in production, the production capacity and utilization, the
products being offered by the firm, the quality control system, production
planning and inventory control.
Marketing: A number of firms have failed because of lack of good marketing
management. The various areas of marketing that are studied are, the product
mix of the firm, the past sales of the product in terms of quantity and value,
the market share of the firm, the demand for the product range, the study of
the customer profile, the price of the products, the distribution channels
being used, the kind of promotion-mix being used and the most important of all
is the marketing team. This study is done in comparison with the competitors.
Formulation and Execution of the Plan
The viability study serves as the basis for formulation of a
rehabilitation plan. A thorough study of the various functional areas of the
firm reveals the strengths, weaknesses, opportunities and threats of the firm.
It gives a comprehensive idea about the status of the firm, the viability of
the firm both technically and economically and the additional funds required
for rehabilitation.
The
formulation plan involves the changes and action to be taken regarding the
various functions of the firm. It may decide to make changes in the management,
if it is not found competent. Some of the labour may be retrenched/recruited
depending on the situation. The amount of financial assistance to be given is
determined and arrangements are made to secure the loan. Various steps are
taken to improve the production function in terms of new machinery and new
technology. The viable level of operations are determined and steps are taken
to achieve this production level. The product-mix, the pricing, the quality of
the products, distribution channels and the promotion-mix are to be changed to
suit the needs of the customers, to achieve the desired sales levels. Once the
plan is formulated, the plan is carefully executed. All the necessary changes
prescribed by the plan are made. The funds are disbursed in a phased manner as
and when required. The necessary concessions and reliefs are provided. A close
watch is kept on the activities of the firm and a continuous evaluation is
done.
Monitoring
Monitoring is a very important part of a rehabilitation plan. It is done
to evaluate the execution of the plan. Regular meetings are held between the
firm, the bankers, the financial institutions and other concerned parties to
verify and evaluate the process of execution. Monitoring is one to ensure the
proper utilization of funds and adherence to the terms of rehabilitation plan.
It also ensures the proper working of the firm. Feedback is obtained and
remedial measures are taken as and when the situation demands. The impact of
rehabilitation becomes evident in a short period. Once the success of the firm
becomes evident, the role of agencies and banks is confined to constantly hold
meetings to assess and revies the process. This continues till the firm is
successful. In case the firm is found incapable of making a turnaround despite
the plan, then the steps to liquidate the firm are undertaken
<TOP>
8.
THE
MODELING PROCESS
17
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
• 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
18
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>
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