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Question Paper
Strategic Financial Management (MB361F) : July
2006
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/are not true regarding the Activity Based Costing (ABC)?
I.It is more expensive than the traditional costing.
II.
Overheads
are applied to products using a single predetermined overhead rate based on a
single
activity measure.
III.
It is
based on historical costs.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Both (I)
and (II) above
(d)
Both (I)
and (III) above
(e)
Both (II)
and (III) above.
2. Which of the following statements is true?
(a)
A
non-growth strategy refers to that strategy where there is no turnover
(b)
A company
can pursue a non-growth strategy, if it rates its non-economic objectives
higher than its economic objectives
(c)
A
non-growth strategy need not always be a corrective strategy
(d)
A
corrective strategy cannot be used in conjunction with a growth strategy
(e)
The
long-term objectives of the company include only survival of the firm.
3. Which of the following ratios is not used by the 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.
4.
Which of the following is not the
possible procedure, that can be used in order to deal with real options?
(a)
Using the
Discounted Cash Flow valuation and ignoring any real options, with the
assumption that their values are negative
(b)
Using the
Discounted Cash Flow valuation and including a qualitative recognition of any
real option value
(c)
Using the
decision tree analysis
(d)
Using a
financial model for a financial option
(e)
Developing a unique, project specific model with
the help of techniques in financial engineering.
5. The operational structure of a firm consists of
(a)
Ownership
structure
(b)
Financial
leverage
(c)
State of
the economy
(d)
Capital
budgeting decisions
(e)
External
governance groups.
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< Answer >
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6. The current operating income of Aditya Pharma Ltd.
(APL) is Rs.60 lakhs. The company has no debt and has Rs.100 lakh as equity
capital with a face value of Rs.10 each. APL is planning to buy back some of
its shares, which is proposed to be financed through an issue of 10% debentures
worth of Rs.80 lakh. If the company falls under the tax bracket of 40% and wants
to maintain the current EPS without any change in the current operating income
even after the buy-back, the number of shares to be bought back is
(a)
0.33 lakh
(b)
1.0 lakh
(c)
1.33 lakh
(d)
1.63 lakh
(e)
2.0
lakhs.
7. Which of the following statements regarding Marakon
approach is/are not true?
I.
Value is
created only when return on equity is higher than cost of equity.
II.
The price
to book value ratio of the firm depends on the return on equity, growth rate of
dividends
and cost of equity.
III. Shareholder
wealth creation is measured by the difference between the book value of equity
and its
face value.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (III) above
(e)
Both (II)
and (III) above.
8. Which of the following statements is not true with respect to MM-model?
I.
Firm’s
cost of equity decreases with leverage.
II.
Higher
the leverage, lower the beta of the firm.
III.
Leverage
does not affect the WACC.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (II) above
(e)
Both (II)
and (III) above.
9. Which of the following conditions certainly
indicates that short-term sources of funds have been used for financing
long-term uses?
(a)
Quick
ratio is less than 1.00
(b)
Total
debt to equity ratio is more than 1.00
(c)
Net
working capital is positive
(d)
Total
asset turnover ratio is less than 1.00
(e)
Current
ratio is less than 1.00.
10. Which of the following statements regarding target
costing is/are not true?
(a)
Target
costing reduces the development cycle of the product wherein costs are targeted
at the time of product design
(b)
Target
costing has proved to be very efficient in the manufacture of complex products
that requires many sub-assemblies
(c)
Target
costing can be used to forecast costs to be incurred in the future and provides
motivation to meet future cost objectives
(d)
Target
cost is the excess of the sales price for the target market over the
pre-determined margin of profit
(e)
Target
costing can be used for measuring different cost scenarios to ensure that the
best ideas available incorporated into the product design.
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11. According to the Wilcox model, the best indicator
of the financial health of an enterprise is
(a)
Net
Profit Margin
(b)
Interest
coverage ratio
(c)
Net
liquidation value of the firm
(d)
Market
capitalization of the firm
(e)
Share
price of the firm.
12. Which of the following is not a type of real options?
(a)
Investment
timing option
(b)
Growth
option
(c)
Abandonment
option
(d)
Flexibility
option
(e)
Foreign
currency option.
13. Which of the following statements is true regarding agency costs in the context of capital structure?
(a)
It is the
commission payable by a company to its purchasing agents
(b)
It is the
commission payable by a company to its selling agents
(c)
It is the
expense incurred in distribution of the products of the company
(d)
It is the
cost on account of restrictive covenants imposed on a company by its lenders
(e)
It is the
dividend paid by a company to its shareholders.
14. Which of the following statement is/ are true?
I.
Open
market repurchases are not very effective signals for under valuation of
company’s stock as compared to tender offers.
II.
Dutch
auctions are less informative than fixed price offer as signals of under
valuation.
III.
In a
Dutch auction, outside shareholders do not play an active role in establishing
terms of trade.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (II) above
(e)
Both (II)
and (III) above.
15.
Care Corporation is planning an
investment of Rs.20 million. Its optimal capital structure is 40 percent equity
and 60 percent debt. Its earnings before interest and taxes (EBIT) were Rs.36
million for the year. The firm has Rs.180 million in assets, pays an average
interest of 10 percent on all its debt, and faces a marginal tax rate of 40
percent. If the firm maintains a residual dividend policy and will keep its optimal
capital structure intact, the amount of the dividends it will pay after
financing its capital budget is
(a)
Zero
(b)
Rs.5.42
million
(c)
Rs.7.12
million
(d)
Rs.12.02
million
(e)
Rs.15.12
million.
16. From the information given below, what is the upper
control limit as per Miller and Orr model? (Assume 360 days in a year.)
|
|
|
Lower limit of cash balance |
Rs.50,000 |
|
|
|
Annual yield on securities |
10% |
|
|
|
Fixed transaction cost |
Rs.1,600 |
|
|
|
Variance of change in daily
cash balance |
80,000 |
|
(a) |
Rs.70,560.21 |
|
|
|
(b) |
Rs.71,047.31 |
|
|
|
(c) |
Rs.72,560.31 |
|
|
|
(d) |
Rs.72,955.31 |
|
|
|
(e) |
Rs.73,260.31. |
|
|
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17. A firm has total assets of Rs.400 lakhs and a
debt/equity ratio of 0.60. Its sales are Rs.300 lakhs, and it has total fixed
costs of Rs.120 lakhs. If the firm's EBIT is Rs.60 lakhs, its tax rate is 40
percent, and the interest rate on all of its debt is 9 percent, the firm's ROE
is
(a)
6.98%
(b)
13.75%
(c)
5.25%
(d)
11.16%
(e)
11.25%.
18. Which of the following is an important tool for
assessing the financial strength of an organization within the industry?
(a)
Accounting
analysis
(b)
Time
series Analysis
(c)
Common
size statements
(d)
Comparative
analysis
(e)
Market
analysis.
19. The balance sheet (based on market values) of Amrut
Foods Ltd, which has 1,000 outstanding shares is as follows:
|
|
Balance Sheet Based
on Market Values |
|
|||
|
Liabilities |
|
Rs. |
Assets |
Rs. |
|
|
Equity |
1,20,000 |
Cash |
20,000 |
||
|
|
|
|
Other Assets |
|
1,00,000 |
|
|
1,20,000 |
|
|
1,20,000 |
|
The company has declared a dividend of Rs.6 per share.
If the company’s stock goes ex-dividend tomorrow and there are no taxes, the
ex-dividend price of the company’s stock is
(a)
Rs.108.00
(b)
Rs.112.00
(c)
Rs.114.00
(d)
Rs.118.80
(e)
Rs.126.00.
20. 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.
21. 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.
22. Hedging through forwards, futures, swaps, etc. is
an example of
(a)
Risk
avoidance
(b)
Loss
control
(c)
Risk
sharing
(d)
Risk
transfer
(e)
Separation.
< Answer >
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< Answer >
23. 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.
24. Calculate the price to book value ratio of a
company based on the following information:
|
Return on equity |
25% |
|
Cost of equity |
15% |
|
Growth rate of earnings and dividends |
5% |
(a)
1.00
(b)
1.27
(c)
1.89
(d)
2.00
(e)
2.30.
25. 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 for the firm?
(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.
26. Which of the following factors does not figure in when assessing the present value of an investment by the risk
adjusted discount rate method?
(a)
Projected
future cash flows from the investment
(b)
Beta of
the investment in question
(c)
Expected
return from the tangency portfolio
(d)
Expected
return from the equity shares of the firm
(e)
Risk free
return.
27. According to the Pecking order theory of financing,
the preferred order of finance for firms is
(a)
External
equity, debt, preference capital, internal equity
(b)
Internal
equity, debt, preference capital, external capital
(c)
Debt,
preference capital, internal equity, external equity
(d)
Internal
equity, external equity, debt, preference capital
(e)
External
equity, internal equity, debt, preference capital.
28. Which of the following statements is/are not true?
I.
Economic
risk is associated with losing competitive advantage due to exchange rate
movements.
II.
Transaction risk represents only the immediate
effect on cash flow after a change in exchange rate.
III.
Economic
risk does not take into account the long-term consequent of the change in
currency value.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (III) above
(e)
Both (II)
and (III) above.
< Answer >
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|
Which of the following statements is not true with respect to ERM? |
< Answer > |
|
|
|
I.
ERM can
be delegated to the treasury desk of the company.
II.
A
tactical orientation of ERM implies that the objectives are limited, and
involves hedging of explicit future commitments.
III.
A
strategic approach looks at the company only when a risk management process is
selected.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Both (I)
and (II) above
(d)
Both (II)
and (III) above
(e)
All (I),
(II) and (III) above.
|
30. Which of the following is a variable that
can be analyzed at the generic level as per the Mckinsey |
< Answer > |
|
|
|
||
|
approach? |
|
|
|
(a) |
Return on invested capital |
|
|
(b) |
Product mix and Product design |
|
|
(c) |
Customer mix and Customer
relationship |
|
|
(d) |
Level of capacity utilization |
|
|
(e) |
Cost of managing inventories. |
|
END OF SECTION A
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/explantions should form part of your answer.
•
Do not
spend more than 110 - 120 minutes on Section B.
1.
Ganesh
Automobiles Limited has estimated cash requirement of Rs.15,00,000 per month.
The company holds a portfolio of securities worth Rs.50 lakhs. The company had purchased
this portfolio 5 years ago at an average price of Rs.100 per share. The current
average market price of the securities in the portfolio is Rs.177. The company
is planning to sell some of the securities in order to meet its cash
requirements over the planning horizon. The fixed cost per conversion is
expected to be Rs.500.
Using the Baumol Model, you are required to determine the amount of securities the firm needs to convert per
order so as to minimize the total cost if the planning horizon of the firm is
three months.
(5
marks)
2.
Seven
Hills Computers Ltd., is currently engaged in manufacturing four products.
Details of the four products and relevant information are given below:
< Answer >
< Answer >
Particulars
Output in Units
Cost per unit:
Direct Material (Rs.)
Direct Labour (Rs.)
Machine Hours (per unit)
Stereo
headphones
120
40
28
4
|
Product |
|
||
|
External |
UPS |
||
|
Modem |
|||
|
|
|||
|
100 |
|
80 |
|
|
50 |
|
30 |
|
|
21 |
|
14 |
|
|
3 |
|
2 |
|
Foot pedals
120
60
21
3
All the four products are usually produced in
production runs of 20 units and sold in batches of 10 units each.
The production overhead is currently absorbed by
using machine hour rate, and the total of the production overhead for the
period has been analyzed as follows:
Particulars
Machine Department Cost (rent, business rates,
depreciation and supervision) Set-up cost
Stores consumables
Inspection / quality control
Materials handling and dispatch
Amount (Rs.)
10,430
5,250
3,600
2,100
4,620
26,000
You have
ascertained the following ‘Cost Drivers’ to be used for the overhead costs:
Cost
Setup costs
Stores & consumables
Inspection / quality control
Materials handled and dispatch
Cost Drivers
No. of production runs
Requisition raised
No. of production runs
Orders executed
The number of requisitions raised
on the stores was 20 for each product and the number of orders executed was 42,
each order being a batch of 10 units of a product.
You are required to find out:
|
|
a. |
The
total costs for each product if all overhead costs are absorbed on the basis
of machine |
|
|
|
|
hour. |
|
|
|
b. |
The
total costs for each product using Activity-Based Costing. |
|
|
|
|
(2 + 6
= 8 marks) |
|
|
3. |
The |
finance manager
of Kalidas Computers
Ltd is of
the opinion that
in the process of |
< Answer > |
|
|
discriminating the high-credit worthy accounts and
the low-credit worthy, the two key ratios that can be employed for
discrimination are the current ratio and the earning power where the former is
the ratio of current assets to current liabilities and the latter is the ratio
of the earnings before interest and tax to the total assets. High credit worthy
and low credit worthy information relating to fourteen accounts comprising an
equal number of the above mentioned accounts are given below:
High-credit worthy accounts
|
Client |
Current
ratio |
Earning |
|
number |
|
capacity (%) |
|
1 |
1.25 |
15 |
|
2 |
1.43 |
18 |
|
3 |
1.68 |
15 |
|
4 |
1.89 |
22 |
|
5 |
2.12 |
20 |
|
6 |
0.95 |
16 |
|
7 |
1.05 |
12 |
Low-credit worthy accounts
|
Client |
Current |
Earning |
|
number |
ratio |
capacity (%) |
|
8 |
0.86 |
10 |
|
9 |
0.66 |
8 |
|
10 |
0.49 |
6 |
|
11 |
0.52 |
9 |
|
12 |
0.72 |
–6 |
|
13 |
0.58 |
7 |
|
14 |
0.41 |
–3 |
You are required to establish the appropriate discriminant function
that best discriminates between the high-credit worthy accounts and the
low-credit worthy accounts.
(9
marks)
Caselet 1
Read the caselet carefully
and answer the following questions:
4.
For
evaluating business performance both in financial and non-financial terms there
is a necessity for the investors to look beyond the ubiquitous information
furnished by the media. There is a tendency among the investors to overlook
critically important indicators that would otherwise have enabled them to
better discern the firm’s potential for wealth creation. Do you agree? Justify
your opinion.
(7
marks)
5.
There are
different groups of people who read the financial statements, each looking for
different types of information. Earnings might be the most important area for
investors, but other areas of information are also of extreme significance. In
this backdrop, explain how notes to accounts and Management Discussion and
Analysis provide insights to the investors.
(8
marks)
< Answer >
< Answer >
Because there are literally hundreds of things
about a company to examine when analyzing its stock, it is tough to know where
to start. Most investors are good at evaluating earnings, growth rates,
revenue, and the P/E ratio, but they also tend to overlook other aspects that
can be just as important.
One of the items which the average investor tends
to ignore is cash flow. This represents the constant flow of money in and out
of a company. All companies provide separate cash flow statements as part of
their financial statements, but cash flow can also be estimated as net income
plus depreciation and other non-cash items. The second aspect, which is also
generally overlooked by the typical investor, is the management. This is one
aspect of a company that can make a world of difference. Think of management in
terms of sports: Michael Jordan might not have been the "whole show"
during his reign at the Chicago Bulls, but he was undoubtedly a huge
contributing factor to their success. The same is true for the management of a
business.
Further receivables and the finished goods
inventory are two items in the balance sheet on which the average investor does
not place enough emphasis. Receivables represent the sales for which the
company has yet to collect the money. Sales drive accounts receivable, so when
sales are growing, accounts receivable will grow at a similar rate. Inventory
of the finished goods available for sale ties in closely with accounts
receivable.
Two other items which the investors tend to lose
sight of, in the maze of details that are present in any annual report are the
notes to accounts and the Management Discussion and Analysis (MD&A). These
are the items, which contain vital information which cannot be expressed in
very objective terms or quantifiable in the financial statements.
The technique of looking at the overall company and
its outlook is sometimes referred to "qualitative analysis," and it
is a perspective that is often forgotten. Peter Lynch once stated that he found
his best investments by looking at the trends his children follow.
Assessing a company from the
fundamental/qualitative standpoint is one of the most effective strategies for
evaluating a potential investment, and it is as important as looking at sales
and earnings. These overlooked areas are by no means the only things investors
need to evaluate, but looking at more than just the obvious will give you that
extra advantage over other investors. Earnings are important, but earnings are
also the most widely published financial figure for any company, so why base an
investment decision solely on what other people already know? The moral here is
always to dig deeper by doing solid research so that you can aim to be a step
ahead of the crowd.
Caselet 1
Read the caselet carefully and answer the
following questions:
6.
No one
predict an industry’s cycle precisely and any single forecast of performance
may lead to enormous conclusions. Given this, suggest a methodology for
valuation of cyclical companies.
(8
marks)
7.
Discuss
how mangers can exploit the cyclical nature of their industry.
(5
marks)
< Answer >
< Answer >
Companies in industries prone to significant swings
in profitability present special difficulties for mangers and investors trying
to understand how they should be valued. In extreme cases, companies in these
so called cyclical industries-airline travel, chemicals, paper, and steel, for example
– challenge the fundamental principles of valuation, particularly when their
shares behave in ways that appear unrelated to the discounted value of their
underlying cash flows. The DCF values is far less volatile than the underlying
cash flows. Indeed, there is almost no volatility in the
DCF value because no single year’s performance
affects it significantly. In the real world, of course, the share prices of
cyclical companies are less stable.
On the assumption that the market values of
companies are linked to consensus earnings forecasts, when these consensus
earnings forecasts were examined for clues it was found that these forecasts
appeared to ignore cyclicality entirely by almost always showing an upward
trend, regardless of whether a company was at the peak or the trough of a
cycle. Earnings forecasts generally have a positive bias. Sometimes this is
attributed to the pressures faced by equity analysts at investment banks.
Analysts might fear that a company subjected to negative commentary would cut
off their access or that a pessimistic forecast about a company that is a
client of the bank they work for could damage relations between the two. In
light of these, it is reasonable to conclude that analysts as a group are
unable or unwilling to predict the business cycle for these companies. Business
cycles, and particularly their inflection points, are hard for any one to
predict. Given this, how the market ought to behave? Should it be able to
predict the cycle and thus avoid fluctuations in share prices? However, that
might be asking too much; at any point, a company or industry could break out
it its cycle and move to a new one that is higher or lower.
END OF
SECTION B
Section C : Applied Theory (20 Marks)
•
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.
With
growing levels of uncertainty and risk, firms have to face an indecisive and
non-deterministic future. Effective Risk Management is gaining prominence and
increasing attention in the corporate world. What are the various approaches
using which firms can manage their risks?
(10
marks)
9.
The
dividend policy of a firm reflects the views and practices of the management
with regard to the distribution of its earnings to the shareholders in the form
of dividends. The dividend policy is arrived by the firm on the basis of some
strategic determinants. Explain the strategic determinants of dividend policy.
(10
marks)
END OF SECTION C
END OF QUESTION PAPER
< Answer >
< Answer >
Suggested Answers
Strategic Financial Management (MB361F) : July
2006
Section A : Basic Concepts
Reason : ABC costing is more
expensive than the traditional costing. In many production processes, overheads
are applied to products using a single predetermined overhead rate based on a
single activity measure, but in ABC costing, multiple activities are identified
in the production process that are associated with costs. It is based on
historical costs. Therefore statements (I) and (III) are true and statement
(II) is not true. Hence (b) is the answer.
2.
Answer
: (b)
Reason : A non-growth strategy refer to that strategy
where there is no growth in earnings, but not necessarily turnover. Statement
(a) is not true.
A company can pursue a non-growth if it rates its
non-economic objectives higher than its economic objectives. Statement (b) is
true.
A non-growth strategy is bound to be a corrective
strategy. Statement (c) is not true.
A corrective strategy can be used in conjunction
with, or as one component of, a growth strategy. Statement (d) is not true.
The
long-term objectives of the
company include both survival
and growth of the firm.
Statement (e) is not true.
Hence (b) is the answer.
3.
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.
4.
Answer
: (a)
Reason : In option (a), the
assumption is that their values are zero. Other options are correct with
respect to the possible procedures that can be used in order to deal with the
real option.
5.
Answer
: (d)
Reason :The business environment
of the firm consisits of the state of the economy, resoruce availability,
external governance groups and internal governance groups.
The
operational structure of the firm consists of the capital structure decisions,
decision regarding the size of the company and the production function,
interanl audit, and decision regarding the financial sructure of the company.
The financial structure decisions
typically comprises o the ownership structure, financial leverage, dividend and
stock repurchase policies and the executive compensation plans. Hence (d) is
the answer.
6.
Answer :
(c) Reason :
(EBIT-I1 )(1-T)
= (60 − 0)(0.6)
= 3.6
No.of shares 10, 00,
000
3.6 = (EBIT-I2 )(1-T)
No.of shares
(60-8)(0.6)
3.6 =
x
X = 8.67 lakhs
Therefore 1.33 lakh (10 lakh – 8.67 lakh) shares
should be bought back.
∴Answer is (c).
7.
Answer
: (c)
Reason : While price to book
ratio depends upon the return on equity, growth rate of dividends and the cost
of equity under the Marakon approach, the value created for shareholders is
measured by the difference between the book value of equity B and the market
value of equity M, where M stands for how productively the firm has employed
its equity or capital contributed by the shareholders.
Therefore statement (III) is not
true and statements (I) and (II) are true. Hence (c) is the answer.
<TOP>
<TOP>
< TOP >
< TOP >
< TOP >
<TOP>
<TOP>
Reason : Firm’s cost of equity increases with
leverage. Statement (I) is wrong, higher the leverage, higher the beta of the
firm. Statement (II) is wrong. Therefore (d) is the answer.
9.
Answer
: (e)
Reason : When the current ratio
is less than 1.00 (a), the current assets are less than current liabilities
i.e. net working capital is negative. Such a situation indicates that short
term funds have been used for long term purposes. Quick ratio (Quick assets /
Current liabilities) may be less than 1.00 even when the current ratio is more
than or equal to 1.00. Hence (a) is incorrect. Total debt to equity is greater
than 1.00 does not imply that current ratio will be less than 1.00. Hence (b)
is incorrect. A positive net working capital implies that some part of the long
term sources of funds have been invested in short term uses (current assets).
Hence (e) is the correct answer.
10.
Answer
: (b)
Reason : Target costing is based on external
analysis of markets and competitors, and is a cost management tool that reduces
a product’s costs over its entire life cycle. But it is difficult to use in the
presence of complex products because on the one hand, analysis of costs needs
to be performed at various levels, while on the other, the activity of tracking
costs becomes more complicated and cumbersome. Hence statemetns (a), (c), (d)
and (e) are true and statement (b) is not true. Hence (b) is the answer.
11.
Answer
: (c)
Reason : As per the Wilcox model, the net
liquidation value of a firm is the best indicator of its financial health. The
net liquidation value is the excess of the liquidation value of the firm’s
assets over the liquidation value of the firm’s liabilities. Liquidation value
is the market value of the assets and liabilities at the time of dissolution.
Hence (c) is the answer.
12.
Answer
: (e)
Reason : The tracking portfolio approach seeks to
develop tracking portfolios for which the present value of the tracking error
is zero. Statement (I) is not true.
Tracking error is the difference between the cash
flows of the tracking portfolios and the cash flows of the projects. Statement
(II) is true.
Strategic planning models are normative strategies
that consider the firm as an organic entity that is more interested in
self-preservation. Statement (III) is true.
Hence (e) is the answer.
13.
Answer
: (d)
Reason : Agency costs are costs
on account of restriction imposed by creditors on the firm in the form of some
protective covenants. Commission payable by the company to its purchasing and
selling agents , the expenses incurred in distribution of the products of the
company, or the dividends paid by the company does not come under the agency
cost. Hence (d) is the answer.
14.
Answer
: (d)
Reason : Open market repurchases
are not very effective signals for under valuation of company’s stock as
compared to tender offers because open market repurchases are executed at the
prevailing market prices and do not have any premium content. Dutch auctions
are also very less informative than fixed price offer as signals of under
valuation. In Dutch auction outside shareholders play an active role in
establishing terms of trade. Hence option (d) is the answer.
15.
Answer
: (c)
Reason :
Interest cost:
Total assets = Rs.180M; debt = 60% × Rs.180M
= Rs.108 million in debt.
Interest cost = Rs.108M × 0.10 =
Rs.10.8 million.
Net income (in millions):
EBIT Rs.36.0
|
less: Interest |
– 10.8 |
|
|
|
|
|
EBT Rs.25.2
less:
Taxes (@40%) – 10.08
< TOP >
< TOP >
<TOP>
< TOP >
< TOP >
<TOP>
<TOP>
<TOP>
|
Rs.15.12 |
The portion of project financed with retained
earnings:
Retained earnings portion: 20M x 0.40 = Rs.8.0
million
Debt portion = Rs.20M x 0.60 = Rs.12.0 million
The residual available for dividends = Rs.15.12M –
Rs.8.0M = Rs.7.12 million in dividends
16.
Answer
: (b)
3 3bσ2 + LL
|
Reason :
RP = |
4I |
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|
10 |
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|
I |
= |
360 |
= 0.0278% |
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3 |
|
3×1, 600×80, 000 |
+ 50,
000 |
|||
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RP |
= |
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4×
0.000278 |
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||
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||
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|
= |
57,015.77 |
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UL |
= |
3RP – 2LL |
||||||
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|
= |
3(57,015.77) – (2 ×
50,000) |
||||||
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|
= |
71,047.31 |
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|
17.Answer : |
(d) |
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Reason : |
Rs.40,000,000 |
= |
Total equity + Total debt. |
||||||
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|
Total debt |
= |
0.60(Total equity) |
||||||
|
|
40,000,000 |
= |
Total equity + 0.60(Total
equity) |
||||||
|
|
Total equity |
= |
400,00,000/1.60 =
Rs.2,50,00,000. |
||||||
|
|
Total debt |
= |
Rs.4,00,00,000 – Rs.2,50,00,000
= Rs.1,50,00,000. |
||||||
|
|
Debt
interest |
= |
|
|
|
1,50,00,000(0.09) = Rs.13,50,000 |
|||
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|
Net income |
= |
|
|
(EBIT – I)(1 – T) |
||||
|
|
|
|
= |
60,00,000 – 13,50,000) 0.60 =
Rs.2,790,000. |
|||||
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|
ROE |
|
= |
2,790,000/2,50,00,000 = 11.16%. |
|||||
Hence (d) is the answer.
18. Answer
: (d)
Reason : Comparative analysis is an important tool for
assessing the financial strength of an organization within the industry.
|
19.Answer : |
(c) |
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Rs.1,
20, 000 |
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||
|
Reason : |
Since the balance sheet shows
market values, the stock is worth |
1, 000 |
=
Rs.120 |
||
|
|
per share today (cum dividend).
The ex-dividend price will be (Rs.120 – Rs.6) = Rs.114. |
||||
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|
Once the dividend is paid, the
company has Rs.6,000 less cash, so total equity is worth |
||||
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Rs.1,14, 000 |
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Rs.1,14,000 or |
1, 000 |
= Rs.114
per share. |
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20.
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.
<TOP>
<TOP>
< TOP >
< TOP >
<TOP>
Obviously, dividend growth rate is a factor not
considered in this model. So the correct answer is (d).
21.
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.
22.
Answer
: (d)
Reason : Risk avoidance is an
extreme way of managing risk by not undertaking the activity that entails risk.
Loss control refers to the attempt to reduce either possibility of or the
quantum of loss. Risk is transferred when the firm originally exposed to a risk
transfers it to another party which is willing to bear the risk. Derivative
instruments are used to transfer the risk. Risk is retained when nothing is
done to avoid. The combinations of risk retention and risk transfer is known as
risk sharing. Separation is the technique of reducing risk through separating
parts of businesses or assets or liabilities.
23.
Answer
: (a)
Reason :
Shortage in supply of raw materials is an external factor, others are
internal factors.s
24.
Answer
: (d)
Reason : P/B = (r – g)/(k – g)
=
(25 –
5)/(15 – 5) = 2.00.
25.
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
26.
Answer
: (d)
Reason : Expected return from the
equity shares of the firm does not figure out when assessing the present value
of an investment by the risk adjusted discount rate method.
27.
Answer
: (b)
Reason : As per Pecking order theory of financings,
the preferred order of finance for firms are as follows: internal equity, debt,
preference capital and external equity.
28.
Answer
: (c)
Reason : Economic risk takes into
account the long-term consequences of the change in currency value.
29.
Answer
: (e)
Reason : ERM speaks about some advanced areas of
risk management, such as technology risk, anti-trust risk, environment risk,
political risk etc., and all the statements are true.
30.
Answer
: (a)
Reason : At generic level, the variables that
reflect the achievement or non-achievement of the objective of value
maximization most directly are identified.
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
< TOP >
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students, get latest Solved assignments
and case studies by professionals.
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Section B : Problems/Caselets
1. The total cash required over the planning period =
Rs. 15,00,000 x 3 = Rs. 45,00,000 The average annual yield on the securities
can be determined as follows:
100 (1+ r) 5 = 177
=> r = 12.09 %
Therefore, the yield for three month period = 3%
Fixed conversion cost = Rs. 500 per conversion.
According to Baumol model, the total cost is
minimized when conversion size (C ) is given by
C= 
2bT I where b= Fixed cost per
conversion
T = Total cash required during the planning horizon
I = Yield on marketable securitiesover the planning
horizon
Substituting the given values, we get
2 × 500 × 45, 00, 000
0.03
= Rs.3,87298.33
Therefore, the company needs to convert Rs.387298
worth of securities per conversion in order to minimize the total cost.
<TOP>
2. a.Calculations showing overheads assigned on an
Machine Hour Rate Basis
|
Total
overheads |
= |
Machine |
Department Cost
+ Set-up |
costs
+ Stores consumables
+ |
|||
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|
Inspection/quality control +
Materials handling and dispatch |
||||
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= |
10430 +
5250 + 3600 + 2100 + 4620 |
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= |
26,000 |
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Machine Hours = (output in units) × (Machine Hours per unit) |
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||||
|
Product Stereo headphones |
= |
120×4 |
= |
480 |
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|
Product External Modem |
= |
100×3 |
= |
300 |
|
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Product UPS |
|
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= |
80×2 |
= |
160 |
|
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Product Foot Pedals |
|
= |
120×3 |
= |
360 |
|
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Total Machine Hours |
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1,300 |
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Total
Overheads
Total Machine Hours
Machine Hour Rate =
Rs 26, 000
=
1,300
=
Rs 20/-
per MHR
Statement showing cost per unit per product
(Rs.)
|
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Products |
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Particulars |
Stereo |
External Modem |
UPS |
Foot Pedals |
Total |
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headphones |
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|
Direct Material Direct Labour Overheads absorbed
(Machine Hour Rate × Machine Hour per unit)
Cost per unit
|
40 |
50 |
30 |
60 |
|
28 |
21 |
14 |
21 |
|
80 |
60 |
40 |
60 |
148 131 84 141
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180
84
240
504
|
17760 |
13100 |
6720 |
16920 |
54500 |
(Cost per unit × Output
in
units)
b.
Calculations
showing overheads assigned on ABC Basis
Application rate of cost driver for overheads
i.
Machine
Department
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Machine Dept. cos t |
= |
10430 |
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Total machine Hrs |
1300 |
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= |
Rs.8.0231
per machine hour rate |
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Total Setup cost |
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ii. |
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Setup costs |
= |
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No. of production runs |
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Total number
of output units of all products |
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420 |
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No.of requisition raised for each product |
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No. of Production runs |
= |
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= |
20 |
= 21 |
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5250 |
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Setup costs
= |
21 |
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= |
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Rs.250 per production run |
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Total stores + Com mod ity cos t |
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3600 |
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iii. |
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Stores & Consumables |
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No.of requisitions raised |
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= |
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20×4 = |
Rs.45 per requisition |
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Inspection / QC cos t |
2100 |
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No.of production runs = |
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iv. |
Inspection/QC |
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= |
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21 |
|
= Rs.100
per production run |
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Material handling & dispatch cost |
4620 |
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No. of
orders executed |
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v. |
Materials handling and
dispatch |
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= |
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= |
42 |
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= Rs.110 orders executed.
Particulars
Number of Production Runs
Number of stores requisition
No. of Sales order (deduced from
information)
Stereo
headphones
6
20
12
Products
External
Modem
5
20
10
UPS
4
20
8
Foot
Pedals
6
20
12
Total
21
80
42
Calculations
of the cost per unit and the total costs of each product (Rs.)
Products
Particulars
Direct Material
Direct Labour
Overheads:
i.
Machine
Department (MHR)
ii.
Setup
costs
iii.
Stores
receiving
iv.
Inspection
/ QC
v.
Materials
handling and dispatch Total overheads
Cost per unit
Total cost per product
|
Stereo |
External |
UPS |
Foot |
|
headphones |
Modem |
|
Pedals |
|
40.00 |
50.00 |
30.00 |
60.00 |
|
28.00 |
21.00 |
14.00 |
21.00 |
|
32.09 |
24.07 |
16.05 |
24.07 |
|
12.50 |
12.50 |
12.50 |
12.50 |
|
7.50 |
9.00 |
11.25 |
7.50 |
|
5.00 |
5.00 |
5.00 |
5.00 |
|
11.00 |
11.00 |
11.00 |
11.00 |
|
68.09 |
61.57 |
55.80 |
60.07 |
|
136.09 |
132.57 |
99.80 |
141.07 |
|
16,331.08 |
13,256.92 |
7983.69 |
16928.31 |
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|
<TOP>
3. Let the discriminant function be Zi = aXi + bYi
where Zi = Discriminant score for the ith account
Xi =
Current assets/Current liabilities for the ith account
Yi = EBIT/Total assets for the ith account.
Account X
number i
Gr. I
1
1.25
2
1.43
3
1.68
4
1.89
5
2.12
6
0.95
7
1.05
Gr. II
8
0.86
9
0.66
10
0.49
11
0.52
12
0.72
13
0.58
14
0.41
Xm = 14.61/14 = 1.04
Yi
15
18
15
22
20
16
12
10
8
6
9
-6
7
-3
(Xi –Xm)
0.21
0.39
0.64
0.85
1.08
–0.09
0.01
-0.18
-0.38
-0.55
-0.52
-0.32
-0.46
-0.63
(Yi –Ym)
4.36
7.36
4.36
11.36
9.36
5.36
1.36
-0.64
-2.64
-4.64
-1.64
-16.64
-3.64
-13.64
(Xi – Xm)2
0.0441
0.1521
0.4096
0.7225
1.1664
0.0081
0.0001
0.0324
0.1444
0.3025
0.2704
0.1024
0.2116
0.3969
(Yi – Ym)2
19.0096
54.1696
19.0096
129.0496
87.6096
28.7296
1.8496
0.4096
6.9696
21.5296
2.6896
276.8896
13.2496
186.0496
(Xi – Xm)
(Yi – Ym)
0.9156
2.8704
2.7904
9.656
10.1088
– 0.4824
0.0136
0.1152
1.0032
2.552
0.8528
5.3248
1.6744
8.5932
Xm1 = Sum of Xi for Gr. I/7 = 10.37/7 = 1.48
Xm2 = Sum of Xi for Gr. II/7 = 4.24/7 = 0.61
Ym = 149/14 = 10.64
Ym1 = Sum of Yi for Gr. I/7 = 118/7 = 16.86
Ym2 = Sum of Yi for Gr. II/7 = 31/7 = 4.43
σx2 = (1/n-1) Σ(X - Xm)2 = (1/13) x 3.9635 = 0.305
σy2 = (1/n-1) Σ(Y - Ym)2 = (1/13) x 847.2144 = 65.17
σxy = (1/n-1) Σ(X - Xm) (Y - Ym) = (1/13) x 45.99 = 3.54
dx = Xm1 – Xm2 = 1.48 – 0.61 = 0.87
dy = Ym1 – Ym2 = 16.86 – 4.43 = 12.43
a
= (σy2 dx - σxy dy)/ (σx2σy2 - σxy2)
= (65.17 x 0.87 – 3.54 x 12.43)/(0.305 x 65.17 – 3.54
x 3.54)
= 12.6957 / 7.3453 = 1.728
b
= (σx2 dy - σxy dx)/ (σx2σy2 - σxy2)
= (0.305 x 12.43 – 3.54 x 0.87)/(0.305 x 65.17 – 3.54
x 3.54)
Hence, the required discriminant function is Zi = 1.728Xi + 0.097Yi
<TOP>
4. Figures reported in annual reports mean exactly
what the company designs them to appear -neither more nor less. So investors
looking at fundamentals must discern on a company-by-company basis what the
earnings whisper. Thus, investors ought to use different parameters that make
earnings evaluation easier, clearer, and more meaningful. Some of the commonly
overlooked indicators are: cashflow, management of the company and composition
of current assets in terms of inventory of finished goods and receivables.
Proper
cash flow levels vary from industry to industry, but a company not generating
the same amount of cash as competitors is bound to lose out. A company without
available cash to pay bills is in real trouble, even if the company is
profitable. By using the cash flow-to-debt ratio, which compares the amount of
cash generated to the amount of outstanding debt, you can
judge the health of cash flow. This comparison reflects the company's ability
to service their loan and interest payments.
Good
management doesn't do everything, but it certainly is an integral part of the
company. Sam Walton (of 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.
<TOP>
5. As a preface to the annual report, a company's
management typically spends a few pages talking about the recent year (or
quarter) and gives a background of the company. While this is not the guts of
the financial statements, it does give investors a clearer picture of what the
company does. It also points out some key areas where the company has performed
well. The management's analysis is provided at their discretion, so take it for
what it's worth. Issues that analysts might look for in this portion are how
candid and accurate are the managers' comments, does the manager discuss
significant financial trends over past couple years, how clear are the managers
comments and do they mention potential risks or uncertainties moving forward?
If a company gives an adequate amount of information in the MD&A, it's
likely that management is being honest. It should raise a red flag if the
MD&A portion of the financial statement ignores serious problems that the
company has been facing. A good example would be a company that is known to
have large portions of outstanding debt but fails to mention anything about it
in the MD&A. Withholding important information not only deceives those who
read the financial statements, but in extreme cases also makes the company
liable for lack of disclosure.
Similarly,
the notes to the financial statements (sometimes called footnotes) are also an
integral part of the overall picture. If the income statement, balance sheet,
and statement of cash flow are the heart of the financial statements, then the
footnotes are the arteries that keep everything connected. If the analyst does
not read the footnotes he may be missing out on a lot of information.
The
footnotes list important information that could not be included in the actual
ledgers. The notes list relevant things like outstanding leases, the maturity
dates of outstanding debt, and even details on where the revenue actually came
from. Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote
identifies and explains the major accounting policies of the business.
This
portion of the footnotes tells about the nature of the company's business, when
its fiscal year starts and ends, how inventory costs are determined, and any
other significant accounting policies that the company feels that you should be
aware of. This is especially important if a company has changed accounting
policies. It may be that a firm is changing policies only to take advantage of
current conditions to hide poor performance.
Disclosure
- The second type of footnote provides additional disclosure that simply could
not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To
maintain this cleanliness, other calculations are left for the footnotes. For
example, details of long-term debt such as maturity dates and the interest rates at which debt was issued, can give you a better
idea of how borrowing costs are laid out. Other areas of disclosure include
everything from pension plan liabilities for existing employees to details
about ominous legal proceedings the company is involved in.
The
majority of investors and analysts read the balance sheet, income statement,
and cash flow statement. But for whatever reason, the footnotes are often
ignored. What sets informed investors apart is digging deeper and looking for
information that others typically wouldn't.
<TOP>
6. No one can predict an industry’s life cycle
precisely, and any single forecast of performance has to be wrong. But managers
and investors can benefits by explicitly following the probabilistic approach
to valuing cyclical companies. This approach avoids the traps of a single
forecast and makes it possible to explore a wider range of outcomes and their
implications.
The
following method of valuing cyclical companies involves creating two scenarios.
This approach provides an estimated of a company’s value and scenarios an
estimate that puts boundaries on the valuations. Managers can use the
boundaries to think about how they should modify their strategies and possible
ways of responding to signals that one scenario was more likely to materialize
than another.
Step 1
Construct
and value the “normal-cycle” scenario using information about past cycles.
Using information about past earnings cycle pay particular attention to the
long term line of operating profits, cash flow, and return on invested capital
because this will affect the valuation. Make sure the continuous value is base
on a “normalized” level of profit- that is, on the company’s long term flow
trend line
Step 2
Construct
and value a “new trend – line scenario” based on recent performance. Again,
focus most on the long-term trend line because it will have the greatest impact
on value.
Step 3
Develop
an economic rationale for each scenario, considering factors such as growth in
demand, technological changes that will affect the balance of supply and
demand, and the entry or exit of companies into the industry.
Step 4
Assign
probabilities to the scenarios and calculate then weighted value, basing it on
your analysis of the likelihood of the events leading to each of them.
<TOP>
7. Managers have detailed information about their markets
and might thus be expected to do a better job than the stock market at
predicting the cycle and reacting appropriately. However, managers do exactly
the opposite and exacerbate the problem. Cyclical companies often commit
themselves to big capital spending projects just when prices are high and the
cycle is hitting its peak. They then proceed to retrench when prices are low.
Some develop forecasts that are quite similar to those issuing form equity
analysts: upward sloping, regardless of where in the cycle the company is. In
doing so, these companies send wrong signals to the stock market.
Rather
than spreading confusion, managers should learn to expoit their superior
knowledge. They could first improve the timing of capital expenditures and then
follow up with a strategy of issuing shares at the peak of the cycle and
repurchasing them at the trough. The most aggressive managers could take this
one step further and adopt a trading approach for acquiring assets at the
bottom of the cycle and selling them at the top. In this way, a typical
cyclical industry could more than double its returns.
<TOP>
Section C: Applied Theory
8. The following are the different approaches to
managing risks:
•
Risk
avoidance
•
Loss
control
•
Separation
•
Risk
transfer
•
Risk
retention
•
Risk
sharing.
Risk Avoidance
An extreme way of managing risk
is to avoid it altogether. This can be done by not undertaking the activity
that entails risk. For example, a corporate may decide not to invest in a
particular industry because the risk involved exceeds its risk bearing
capacity. Though this approach is relevant under certain circumstances, it is
more of an exception rather than a rule. It is neither prudent, nor possible to
use it for managing all kinds of risks. The use of risk avoidance for managing
all risks would result in no activity taking place, as all activities involve
risk, while the level may vary.
Loss Control
Loss control refers to the
attempt to reduce either the possibility of a loss or the quantum of loss. This
is done by making adjustments in the day-to-day business activities. For
example, a firm having floating rate liabilities may decide to invest in
floating rate assets to limit its exposure to interest rate risk. Or a firm may
decide to keep a certain percentage of its funds in readily marketable assets.
Another example would be a firm invoicing its raw material purchases in the
same currency in it which invoices the sales of its finished goods, in order to
reduce its exchange risk.
Combination
Combination refers to the
technique of combining more than one business activities in order to reduce the
overall risk of the firm. It is also referred to as aggregation or
diversification. It entails entering into more than one business, with the
different businesses having the least possible correlation with each other. The
absence of a positive correlation results in at least some of the businesses
generating profits at any given time. Thus, it reduces the possibility of the
firm facing losses.
Separation
Separation is the technique of
reducing risk through separating parts of businesses or assets or liabilities.
For example, a firm having two highly risky businesses with a positive
correlation may spin-off one of them as a separate entity in order to reduce its
exposure to risk. Or, a company may locate its inventory at a number of places
instead of storing all of it at one place, in order to reduce the risk of
destruction by fire. Another example may be a firm sourcing its raw materials
from a number of suppliers instead of from a single supplier, so as to avoid
the risk of loss arising from the single supplier going out of business.
Risk Transfer
Risk is transferred when the firm
originally exposed to a risk transfers it to another party which is willing to
bear the risk. This may be done in three ways. The first is to transfer the
asset itself. For example, a firm into a number of businesses may sell-off one
of them to another party, and thereby transfer the risk involved in it. There
is a subtle difference between risk avoidance and risk transfer through
transfer of the title of the asset. The former is about not making the
investment in the first place, while the latter is about disinvesting an
existing investment.
The second way is to transfer the
risk without transferring the title of the asset or liability. This may be done
by hedging through various derivative instruments like forwards, futures, swaps
and options.
The third way is through
arranging for a third party to pay for losses if they occur, without
transferring the risk itself. This is referred to as risk financing. This may
be achieved by buying insurance. A firm may insure itself against certain risks
like risk of loss due to fire or earthquake, risk of loss due to theft, etc.
Alternatively, it may be done by entering into hold- harmless agreements. A
hold-harmless agreement is one where one party agrees to bear another party’s
loss, should it occur. For example, a manufacturer may enter into a
hold-harmless agreement with the vendor, under which it may agree to bear any
loss to the vendor arising out of stocking the goods.
Risk Retention
Risk is retained when nothing is
done to avoid, reduce, or transfer it. Risk may be retained consciously because
the other techniques of managing risk are too costly or because it is not
possible to employ other techniques. Risk may even be retained unconsciously
when the presence of risk is not recognized. It is very important to
distinguish between the risks that a firm is ready to retain and the ones it wants
to offload using risk management techniques. This decision is essentially
dependent upon the firm’s capacity to bear the loss.
Risk Sharing
This
technique is a combination of risk retention and risk transfer. Under this
technique, a particular risk is managed by retaining a part of it and
transferring the rest to a party willing to bear it. For example, a firm and
its supplier may enter into an agreement, whereby if the market price of the
commodity exceeds a certain price in the future, the seller foregoes a part of
the benefit in favor of the firm, and if the future market price is lower than
a predetermined price, the firm passes on a part of the benefit to the seller.
Another example is a range forward, an instrument used for sharing currency risk.
Under this contract, two parties agree to buy/sell a currency at a future date.
While the buyer is assured a maximum price, the seller is assured a minimum
price. The actual rate for executing the transaction is based on the spot rate
on the date of maturity and these two prices. The buyer takes the loss if the
spot rate falls below the minimum price. The seller takes the loss if the spot
rate rises above the maximum price. If the spot rate lies between these two
rates, the transaction is executed at the spot rate.
<TOP>
9. Strategic Determinants of Divivdend Policy:
Some of the key factors which influence dividend
pay-out of a firm are delineated below.
Liquidity: Traditional theories have postulated that a dividend decision is solely
a function of the earnings of the firm. While earnings are an important
determinant for the dividend decision, the role of liquidity cannot be ignored.
Dividend pay-out entails cash outflow for the firm. Hence the quantum of
dividends proposed to be distributed critically depends on the liquidity
position of the firm. In practice, firms often face cash crunch in spite of
having good earnings. Such firms may not be in a position to declare dividends
despite their profitability.
Investment Opportunities: Another key determinant to the dividend decision
is the requirement of capital by the firm. Normally firms tend to have low
pay-out if profitable investment opportunities exist and conversely firms tend
to resort to high pay-outs if profitable investment opportunities are lacking.
Generally, firms operating in industries which are in the nascent and growth
phases of the product life cycle are characterized by high dependence on
retained earnings. On the other hand, firms operating in industries which are
in the maturity and decline stages normally distribute a larger proportion of
their earnings as dividends.
Access to Finance: A company which has easy access to external sources of finance can
afford to be more liberal in its dividend pay-out. The dividend policy of such
firms is relatively independent of its financing decisions. Firms having little
or no access to external financing have rather limited flexibility in their
dividend decisions.
Flotation Costs: Issue of securities to raise capital in lieu of retained earnings involves
flotation costs. These costs include fees payable to the merchant bankers,
underwriting commission, brokerage, listing fees, marketing expenses, etc.
Moreover smaller the size of the issue, higher will be the 'flotation costs as
a percentage of amount mobilized. Further there are indirect, flotation costs
in the form of underpricing. Normally issue of shares are made at a discount to
the, prevailing market price. The cost of external financing has an influence
on' the dividend policy.
Corporate Control: Further issue of shares (unless done through
rights issue) results in dilution of the stake of the existing shareholders. On
the other hand, reliance on retained earnings has no impact on the controlling
interest. Hence companies vulnerable to hostile takeovers prefer retained
earnings rather than fresh issue of securities. In practice, this strategy can
be a double edged sword. The niggardly pay-out policy of the company may result
in low market valuation of the company vis-a-vis its intrinsic value. Consequently
the company becomes a more attractive target and is in the danger of being
acquired.
Investor
Preferences: The preference of the shareholders has a strong
influence on the dividend policy of the firm.
A firm tends to have a high pay-out ratio if the
shareholders have a strong preference towards current dividends.
On the other hand, a firm resorts to retained
earnings if the shareholders exhibit a clear tilt towards capital gains.
Restrictive Covenants: The protective covenants in bond indentures or
loan agreements often include restrictions pertaining to distribution of
earnings. These conditions are incorporated to preserve the ability of the
issuer/borrower to service the debt. These covenants limit the flexibility of
the company in determining its dividend policy.
Taxes: The
incidence of taxation on the firm and the shareholders has a bearing on the
dividend policy. India levies a 10% tax on the amount of distributed profits.
This tax is a strong fiscal disincentive on dividend distribution. These
dividends are totally tax-tree in the hands of the shareholders. The capital
gains (long-term) are taxed at 20%.
Dividend Stability: The earnings of a firm may fluctuate wildly
between various time periods. Most firms do not like to have an erratic
dividend pay-out in line with their varying earnings. They try to maintain
stability in their dividend policy. Stability does not mean that the dividends
do not vary over a period of time. It only indicates that the previous
dividends have a positive correlation with the current dividends. In the long
am, the dividends have to be invariably adjusted to synchronize with the
earnings. However, the short-term volatility in earnings need not be fully
reflected in dividends.
<TOP>
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