OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) Net Interest income is (i) (ii) (iii) (iv)

Interest earned on advances Interest earned on investments Total interest earned on advances and investment Difference be !een in ere" e#rne$ #n$ in ere" %#i$

Interest rate risk is a type of (i) (ii) (iii) (iv) Credit risk M#r&e ri"& Operational risk All the above

European opinion can be exercised on any day at the option of the buyer on or before the expiry of the option (i) (ii) True F#'"e

!hat is the beta factor for corporate finance under "tandardi#ed approach $ (i) (ii) (iii) (iv) %&' ()* %(' None of the above

A bank suffers loss due to adverse market movement of a security The security )as ho)ever held beyond the defeasance period !hat is the type of the risk that the bank has suffered $ (i) (ii) (iii) (iv) *arket +isk O%er# i+n#' Ri"& *arket ,i-uidation +isk Credit +isk

The .une %/// 0asle Committee on 0ankin1 "upervision issued proposals for reform of its %/22 Capital Accord (the 0asle II 3roposals) These proposals contained *AIN,4 (I) (II) (III) (I5) (5) (5I) (i) (ii) (iii) (iv) "ettlement risk mana1ement Capital re-uirements "upervisory revie) The handlin1 of hed1e funds Contin1ency plans *arket discipline

I6 III and 5I II6 I5 and 5 I6 I5 and 5 II, III #n$ VI

!hich of the follo)in1 is not a type of credit risk $ (i) (ii) (iii) (iv) 7efault risk Cre$i "%re#$ ri"& Intrinsic risk 0asis risk

2' 8overnment of India security is -uoted at +" %(9:; The current yield on the security6 )ill be;;;; (i) (ii) (iii) (iv) %(' / <' -./* 2'

+isk of a portfolio )ith over exposure in steel sector )ill be (i) (ii) (iii) (iv) M+re 0#n "1" e2# ic ri"& E-ual to intrinsic risk ,ess than intrinsic risk None of these

A company declares +" (:; dividend on the e-uity share of face value of +" &:; The share is -uoted in the market at +" 29:; the dividend yield )ill be;;;; (i) (ii) (iii) (9' =' =9'

(iv)

3.4*

>o) many accounts have suffered ratin1 mi1ration in the follo)in1 table +atin1 *i1ration of %99 A +ated Accounts *i1ration bet)een ?% 9? 9< and ?% 9? 9@ L#" R# in5 A N+. +f Acc+6n " %99 (i) (ii) (iii) (iv) 3 %/ (% (& A77 % A7 % A @/ Pre"en R# in5 B7 B %9 = C ? Def#6' (

The risk that arises due to )orsenin1 of credit -uality is (i) (ii) (iii) (iv) Intrinsic +isk Cre$i "%re#$ Ri"& 3ortfolio risk Counterparty risk

A debenture of face value of As %99 carries a coupon of %&' If the current yield is %( &' !hat is the current market price $ (i) (ii) (iii) (iv) +s %99 R".(38 +s %&9 +s %(&

In order to develop an capability to actively mana1e an credit portfolio one must have in place the follo)in1A (a) Credit +atin1 *odel (or models for different cate1ories of loans and advances) (b) 7evelop and maintain necessary data on defaults of borro)ers ratin1 cate1ory )ise6 i e 6 B+atin1 *i1rationC (i) (ii) (iii) (iv) B+ 0 ( #n$ 3 #re re96ire$ Only % is re-uired Only ( is re-uired None of the above

An increase in cash reserve ratio )ill cause yield curve to (i) (ii) (iii) (iv) "hift do)n)ard +emain unchan1ed 0ecome steeper Bec+2e f'# er

The model that combines five financial ratios usin1 reported accountin1 information and e-uity values to produce on obDective measure of borro)erCs financial health is (i) (ii) (iii) (iv) A' 2#n:" 3 "c+re BCredit *etricsC Credit +isk E None of the above

A bank holds a security that is rated AE The ratin1 of the security mi1rates to A !hat is the risk that the bank has faced $ (i) (ii) (iii) (iv) *arket risk Operational risk *arket li-uidation risk Cre$i ri"&

!hen interest rates 1o up6 prices of fixed interest bonds F (i) (ii) (iii) 8o up ;+ $+!n +emain unchan1ed

5a+ is not enou1h to assess market risk of a portfolio "tress testin1 is desirable because (i) (ii) (iii) (iv) It helps in calibratin1 5a+ module It helps as an additional risk measure I 0e'%" in #""e""in5 ri"& $6e + #bn+r2#' 2+ve2en +f 2#r&e %#r#2e er" It is used as 5a+ measure is not accurate enou1h

STUDY T<E FOLLO=IN; STATEMENTS AND ANS=ER

=

(COVERS ALL MODULES) (a) 0ond )ith B000C ratin1 )ill carry lo)er interest rate than one )ith BAAC ratin1 i. F#'"e ii True iii 7ifficult to say (b) Gall in interest rate cause the rate causes the bond prices also to fall i. F#'"e ii True iii 7ifficult to say A normal yield curve is slopin1 up)ard i Galse ii. Tr6e iii 7ifficult to say (d) "tamp duty on transfer of dematted shares is lo)er i. F#'"e ii True iii 7ifficult to say (e) ,ar1e 8overnment borro)in1 can cause yield curve to shift up)ard i Galse ii. Tr6e iii 7ifficult to say (f) 8ro)th Gunds assure 1ro)th in return i. F#'"e ii True iii 7ifficult to say (1) If short term interest rates remain hi1her than the lon1 term interest rates6 the yield curve )ill be inverted i Galse ii. Tr6e iii 7ifficult to say

(c)

&

(h)

Credit ratin1 a1encies determine interest rates on debt securities i. F#'"e ii True iii 7ifficult to say

(i)

The shares of soft)are companies carry hi1h 3:E ratio i Galse ii. Tr6e iii 7ifficult to say

(D)

Closed end mutual funds are tradin1 at discount to NA5 i Galse ii. Tr6e iii 7ifficult to say

(k)

In a risin1 interest rate phase Hero coupon bond )ill be traded at a premium i. F#'"e ii True iii 7ifficult to say

(l)

A sharp decline in short term interest rates )ill cause yield curve to be steeper i Galse ii. Tr6e iii 7ifficult to say

(m)

A fall in interest rates reduces the demand for bonds in the secondary market i ii. iii Galse Tr6e 7ifficult to say

(n)

Increase in the cash reserve ratio can cause the yield curve 1oin1 temporarily inverted i ii. iii Galse Tr6e 7ifficult to say

<

(o)

7emateriali#ation of stocks has increased turnover on the stock market i ii. iii Galse Tr6e 7ifficult to say

(p)

Ti1ht money and credit policy )ill cause bond prices to fall i ii. iii Galse Tr6e 7ifficult to say

(-)

Increasin1 8overnment borro)in1 )ill raise interest rates i ii. iii Galse Tr6e 7ifficult to say

(r)

0ond carryin1 BAAC ratin1 )ill carry hi1hest interest rate than one carryin1 B000C ratin1 i. ii iii F#'"e True 7ifficult to say

(s)

*utual fund redemption brin1 bearish influence on the stock market i ii. iii Galse Tr6e 7ifficult to say

(t)

7ecline in the interest rates on lon1 dated 8ovt bonds )ill cause yield curve to be steeper i. ii iii F#'"e True 7ifficult to say

(u)

7emat shares carry lo)er stamp duty on transfer than physical shares i. ii iii F#'"e True 7ifficult to say

(v)

Increase in interest rates )ill cause bond prices to fall

i ii. iii ())

Galse Tr6e 7ifficult to say

8ro)th fund is a mutual fund that invests primarily in e-uity shares i ii. iii Galse Tr6e 7ifficult to say

(x)

"tamp duty on transfer of demated shares is lo)est i. ii iii F#'"e True 7ifficult to say

(y)

,ar1e 8overnment borro)in1 in the market can make the yield curve shift up)ard i ii. iii Galse Tr6e 7ifficult to say

(#)

0ond )ith BAC ratin1 )ill carry hi1her interest rate than one carryin1 B000C ratin1 i. ii iii F#'"e True 7ifficult to say

OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) !hen the interest rates fall6 the market price of a fixed rate bond (i) (ii) (iii) falls ri"e" does not chan1e

A transaction )here financial securities are issued a1ainst the cash flo) 1enerated from a pool of assets is called (i) (ii) (iii) (iv) Sec6ri i># i+n Credit 7efault ")aps Credit ,inked Notes Total +eturn ")aps

8ro)th Gund is a mutual fund that (i) (ii) (iii) (iv) assures 1ro)th in income invests in fixed income securities 1ives fixed return inve" " %ri2#ri'1 in e96i ie"

Operational +isk arises from %) () ?) =) Inade-uate or failed internal processes 3eople and systems External Events 7efaults

!hich of the follo)in1 is true $ (i) (ii) (iii) (iv) All of them None of them (#) , (b) #n$ (c) (a) 6 (b) and (e)

A decline in cash reserve ratio )ill cause the yield curve to (i) (ii) (iii) (iv) shift up)ard "0if $+!n!#r$ become flatter remain unchan1ed

The third consultative paper recommended for (a) Cause based classification (b) Effect based classification (c) Event based classification Gor operational risk !hich of the follo)in1 is true (i) (ii) (a) None of them

(iii) (iv)

(c) (b)

%(' 8overnment of India security is -uoted at +s %(9 If interest rates 1o do)n by %'6 the market price of the security )ill be (i) (ii) (iii) (iv) +s %(9 R".(??.? +s %9/ +s %=9

0enefits of inte1rated risk frame )ork areA (a) To relate capital and reserves more effectively to their actual level of risk exposure (b) To evaluate pricin1 decisions and product profitability (c) In makin1 risk transfer decisions !hich of the follo)in1 is true $ (i) (ii) (iii) (iv) A'' +f 0e2 None of them (a) and (b) (b) and (c)

+e)ards of proper mana1ement of operational risks are (a) ,esser risk capital (b) Cost reductions in operations (c) Competitive ed1e !hich of the follo)in1 is true $ (i) (ii) (iii) (iv) All of them None of them (a) 6 (b) and (c) (#) #n$ (b)

A fall in lon1 term interest rates on 8overnment securities )ill make the yield curve become (i) (ii) (iii) f'# er steeper shift do)n)ard

%9

A bank expects fall in price of a security if it sells it in the market !hat is the risk that the bank is facin1 $ (i) (ii) (iii) (iv) (i) *arket risk Operational risk A""e Li96i$# i+n ri"& *arket li-uidity risk An 2;year 2' semi;annual bond has a 035 of +s %(& The yield on the bond has

%%' 8overnment of India security is -uoted at +s %%96 the yield )ill be F (i) (ii) (iii) (iv) %%' (8* /' None of these

% day 5a+ of a portfolio is +s &996999 )ith /&' confidence level In a period of six months (%(& )orkin1 days) ho) many times the loss on the portfolio may exceed +s &996999 $ (i) (ii) (iii) (iv) = days & days - $#1" @ days

A fall in interest rates )ill make prices of 8overnment "ecurities ; (ii) (iii) (iv) (v) 8o do)n ;+ 6% +emain unchan1ed None of these

"ystemic risk the risk of (i) (ii) (iii) (iv) Gailure of a bank6 )hich is not adherin1 to re1ulations Gailure of t)o banks simultaneously due to bankruptcy of one bank !here a 1roup of banks fail due to conta1ion effect F#i'6re +f en ire b#n&in5 "1" e2

If the yield on lon1 dated 8ovt securities falls6 then the yield curve )ill becameA; (i) (ii) "teeper F'# er

%%

(iii)

"hift do)n)ard

%%' 8ovt of India security is -uoted at +s %%9 If the interest rates 1o do)n by %' the market price of the security )ill be (i) (ii) (iii) (iv) +s %%9 +s %9/ R".(33.3 +s %?9

0alanced fund is a mutual fund that (i) (ii) (iii) (iv) Assures income Invests in debt and e-uity A""6re 5r+! 0 8ives fixed returns

0ack testin1 is done to (i) (ii) (iii) (iv) Test a model C+2%#re 2+$e' re"6' " #n$ #c 6#' %erf+r2#nce +ecord performance None of the above

Inder 0asel II6 Capital re-uirement under the accord is (i) (ii) (iii) (iv) The maximum Capital that is re-uired to be maintained The minimum Capital that is re-uired to be maintained T0e c#%i #' #" "%ecifie$ b1 0e re56'# +r1 #6 0+ri 1 i" re96ire$ + be 2#in #ine$ None of the above

STUDY T<E FOLLO=IN; STATEMENTS AND ANS=ER (COVERS ALL MODULES) (aa) Gall in interest rates cause the prices of 8ovt securities to 1o up i ii. iii Galse Tr6e 7ifficult to say

%(

(bb)

"teeper yield curve means lon1 term interest rates are much lo)er than short term interest rates i. ii iii F#'"e True 7ifficult to say

(cc)

*utual fund mobili#ation has bearish influence on the stock market i. ii iii F#'"e True 7ifficult to say

(dd)

Convertible debentures carry an element of e-uity shares i ii. iii Galse Tr6e 7ifficult to say

(ee)

Credit +atin1 a1encies fix interest rates on bonds or debentures issued by companies i. ii iii F#'"e True 7ifficult to say

(ff)

*utual Gunds invest only in e-uity shares i. ii iii F#'"e True 7ifficult to say

(11)

Gavorable monsoon bri1htens the prospects for stock market i ii. iii Galse Tr6e 7ifficult to say

(hh)

,ar1e 8overnment borro)in1s cause debt securities prices to rise i. ii iii F#'"e True 7ifficult to say

%?

(ii)

Gallin1 interest rates have benefited investors in debt securities mutual funds i ii. iii Galse Tr6e 7ifficult to say

(DD)

,ar1e 1overnment borro)in1 )ould cause interest rates to 1o do)n i. ii iii F#'"e True 7ifficult to say

(kk)

Gallin1 interest rates cause NA5s of debt mutual fund to 1o do)n i. ii iii F#'"e True 7ifficult to say

(ll)

0ond )ith B000C ratin1 )ill carry lo)er interest rates than one )ith BAC ratin1 i. ii iii F#'"e True 7ifficult to say

(mm) *oney market mutual funds do not invest in e-uity shares i ii. iii (nn) Galse Tr6e 7ifficult to say

"E0I 1ives credit ratin1 to securities issued in the capital market i. ii iii F#'"e True 7ifficult to say

(oo)

*utual funds can offer 1uaranteed returns i. ii iii F#'"e True 7ifficult to say

(pp)

,ar1e 1overnment borro)in1s )ill cause interest rates to 1o up

%=

i ii. iii (--)

Galse Tr6e 7ifficult to say

A mutual fund schemeJ )ith a entry load )ill have its sale price hi1her than its NA5 i ii. iii Galse Tr6e 7ifficult to say

(rr)

"ecurity )ith A ratin1 )ill carry hi1her interest rate than one )ith 00 ratin1 i. ii iii F#'"e True 7ifficult to say

OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) A fall in the interest rates causes 8ovt "ecurities to (i) (ii) (iii) +emain stable Gall Ri"e

Capital char1e for credit risk re-uires input for 376 ,876 EA7 and * Inder advanced I+0 approach6 )ho provide the input for ,87 (i) (ii) (iii) (iv) B#n& "upervisor Gunction provided by 0C0" None of the above

A debenture of +s %99 carryin1 %&' coupon rate is -uoted in the market at +s %?&:; The current yield on this debenture )ill be (i) (ii) (iii) (iv) %? &' %&' ((.((* %9'

Investment in 3ost Office time deposit is

%&

(i) (ii) (iii) (iv)

@er+ ri"& inve" 2en ,o) risk investment *edium risk investment >i1h risk investment

If the short term interest rates are temporarily hi1her than the lon1 term interest rates6 the yield curve )ill be (i) (ii) (iii) (iv) "lopin1 up)ard Inver e$ Hi1#a1 >ori#ontal

3remature payment of a term loan )ill result in interest rate risk of type (i) 0asis risk (ii) 4ield curve risk (iii) E2be$$e$ +% i+n ri"& (iv) *ismatch risk A company )ith e-uity capital of +s &9 crores (Gace 5alue of +s %9:; per share) makes 1ross profit of +s @9 crores and net profit after tax of +s (& crores If the market price of its e-uity share is +s &96 the 3E ratio )ill be (i) (ii) (iii) (iv) &9 & (8 (9

7aily volatility of a stock is %' !hat is its %9 days volatility approximately $ (i) (ii) (iii) (iv) ?* %9' %' ='

If call money rates are temporarily hi1her than the lon1 term interest rates6 the yield curve )ill be (i) (ii) (iii) (iv) "loppin1 up)ards Hi1#a1 Inver e$ >ori#ontal

Capital char1e component of pricin1 accounts for %) Cost of capital

%<

() Internal 1eneration of capital ?) ,oss provision !hich of the follo)in1 is true $ (i) (ii) (iii) (iv) All the statements are correct S # e2en " ( #n$ 3 #re c+rrec "tatements ( and ? are correct "tatements ? and % are correct

E-uity oriented mutual funds (i) (ii) (iii) (iv) Assure income Assure 1ro)th Invest in debentures Inve" in "0#re"

A bank funds its assets from a pool of composite liabilities Apart from credit and operational risks6 it faces (i) (ii) (iii) (iv) B#"i" ri"& *ismatch risk *arket risk ,i-uidity risk

A branch sanctions +s % core loan to a borro)er6 )hich of the follo)in1 risks the branch is takin1 %) () ?) =) &) (i) (ii) (iii) (iv) ,i-uidity risk Interest rate risk *arket risk Credit risk Operational risk

All of them %6( and ? only %6= and & only (,3,A #n$ 4 +n'1

A rise in 8overnment securities prices )ill make yield curve F (i) (ii) (iii) (iv) "lope up)ard S0if $+!n!#r$ +emain stable "hift up)ard

%@

+isk miti1ation measures result in %) +educin1 do)nside variability () +educin1 upside potential )hich of the follo)in1 is true (i) B+ 0 0e " # e2en " #re c+rrec (ii) 0oth the statements are not correct (iii) "tatement % is correct (iv) "tatement ( is correct /' 8overnment of India security is -uoted at +s %(9 The current yield on the security )ill be F (i) (ii) (iii) (iv) %(' /' /.4* %? ?'

Ginancial +isk is defined as (i) (ii) (iii) (iv) Uncer #in ie" re"6( in5 in #$ver"e v#ri# i+n +f %r+fi #bi'i 1 +r +6 ri50 '+""e" Incertainties that result in outri1ht losses Incertainties in cash flo) 5ariations in net cash flo)s

"trate1ic +isk is a type of (i) (ii) (iii) (iv) Interest +ate +isk Operation +isk ,i-uidity +isk N+ne +f 0e #b+ve

ObDective of li-uidity mana1ement is toA (i) (ii) (iii) (iv) Ensure profitability Ensure li-uidity Either of t)o B+ 0

%2

A mutual fund char1es %' entry load and no exit load Its NA5 is +s %<J its sale and repurchase price )ill ;;;;; (i) (ii) (iii) (iv) +s %< and +s %& 29 +s %< %< and +s %& 2= +s %& 2= and +s %< R".(-.(- #n$ R".(-

0anks need li-uidity toA (i) (ii) (iii) (iv) *eet deposit )ithdra)al Gund loan demands B+ 0 +f 0e2 None of them OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) A fall in interest rate of lon1 dated 1overnment securities )ith the short term interest rates remainin1 unchan1ed )ill make the yield curve (i) (ii) (iii) (iv) "teeper "lop do)n)ard "hift do)n)ard F'# er

Ade-uacy of bankCs li-uidity position depends uponA (i) (ii) (iii) (iv) "ources of funds Anticipated future fundin1 needs 3resent and future earnin1s capacity A'' +f 0e #b+ve

Current yield on a 1overnment security is &' If the market price of the bond is +s %<96 the coupon rate on the bond )ill ;;;; (i) (ii) (iii) (iv) <' &' )* %9'

Assets represent source of funds )here as liabilities denote the use of funds in a balance sheet (i) True

%/

(ii) (iii)

F#'"e 7ifficult to say

7ere1ulated environment has narro)ed spreads of the banks (i) (ii) (iii) Tr6e Galse 7ifficult to say

Asset ,iability mana1ement is only mana1ement of maturity mismatch and has no bearin1 on profit au1mentation (i) (ii) (iii) True F#'"e 7ifficult to say

A rise in the short term interest rates )ith the lon1 term interest rates remainin1 unchan1ed )ill make the yield curve ;;;;; (i) (ii) (iii) (iv) "teeper "hift up)ard F'# er "lope up)ard

Net Interest *ar1in is also kno)n as B"preadC (i) (ii) (iii) Tr6e Galse 7ifficult to say

A scheme of mutual fund has units )ith face value of +s %9 and NA5 of +s ?@ The Gund declares a dividend of ?&' in the scheme The ex;dividend NA5 )ill be ;;;;;;; per unit (i) (ii) (iii) (iv) +s ?@ +s ( R".??.48 +s ?& &

@ &' coupon interest 8overnment "ecurity is -uoted at +s %(9 Its current yield )ill be ;;;;;;;;;;

(9

(i) (ii) (iii) (iv)

2 &&' -.34* @ @&' @'

A company )ith e-uity capital of +s %& crores makes 30I7T of +s %& crores and 3AT of +s %9 crores The face value of its share is +s & and 3E is %96 the market price )ill be ;;;;;;;;; (i) (ii) (iii) (iv) +s &9 +s << R".?? +s %99

CASE STUDIES (COVERS ALL MODULES) % A company )ith e-uity of +s %9 crore6 earns 30I7T of +s ?9 crore It incurs interest cost of +s ?& crore depreciation of +s & crore and pays +s %9 crore as tax It has reserve of +s ?9 crore (excludin1 current yearCs profits) and lon1 terms debt of +s ?& crore It pays &9' dividends and transfer remainin1 profit to reserves Its share of +s %9 face value is -uoted at +s %&9:; Gind the follo)in1;;;; (i) Earnin1 per share 3AT K ;;;;;;;;;;;;;;;;; x %9 E-uity K (ii) ?9 F (& E & E %9) ;;;;;;;;;;;;;;;;;;;; x %9 K %9 %9 ;;;;;;; x %9 K +s %9 %9

0ook value of share K E-uity E +eserves K %9 E ?9 E & K +s =&

(iii)

+eturn on Net )orth

(%

3AT K ;;;;;;;;;;;;;;;; N! %9 K ;;;;;;;;;;;;;; x %99 =& K (( (' (iv) 7ebt;e-uity ratio K ?&A =& K @A/ (v) 3:E ratio 3E K *3 : E3" (vi) 3ayout ratio 7ividend K ;;;;;;;;;;; 3AT ( x %99 K & ;;;;;;;; x %99 K &9' %9 K %&9 : %9 K %&

A company )ith e-uity of +s %9 crore earns 30I7T of +s =9 crore It incurs interest of +s & crore6 depreciation of +s & crore and pays tax of +s %9 crore It has reserves of +s ?9 crore (Excludin1 current years profits) and lon1 term debt of +s &9 crore It pays %99' dividend and transfers remainin1 profit to reserves Its share of +s %9 face value is -uoted at price of +s (99 Gind the follo)in1 A (i) 0ook value of share after current yearLs profit transferred to reserves 0ook 5alue K E-uity E +eserves E Current yearCs (3AT F 7iv) K %9 E ?9 E ((9 F %9) K +s &9 (ii) Earnin1 per share E3" K 3AT : E-uity (9 ;;; x %9 =9 F ( &E&E%9) K ;;;;;;;;;;;;;;;;;; x %9 %9

K +s (9

((

(iii)

%9 +eturn on net )orth =9' +eturn on net )orth K 3AT x %99 ;;;;;;;;;;;; N! &9 ;;;;;; K &9 (9 K ;;;;;;; x %99 K =9' &9

(iv)

7ebt;e-uity ratio %A% 7ebt e-uity ratio K %A%

(v)

3:E ratio %9 * 3 K E3s x 3E (99 K (9 x 3E 3E K %9

(vi)

3ayout ratio &9' 7ividend ;;;;;;;;;;; 3AT %9 K ;;;; K &9' (9

IMPORTANT BEY =ORDS FOR PRACTICE A%%reci# i+nC An increase in the market value of an asset Arbi r#5eC (i) 7ealin1 bet)een t)o centres to take advanta1e in the rate due to a temporary difference in the rates bet)een t)o places (ii) The simultaneous tradin1 (purchase:sale O+ sale:purchase) of assets to take advan; ta1e of price differentials A""e cre# i+nC Ac-uisition of assets: investments B#'#nce "0ee C

(?

A Ginancial "tatement that indicates the type and amount of assets6 liabilities and Capital of a firm as on a particular date B#"e c6rrenc1C The currency a1ainst )hich another currency is -uoted ME1 IN+ ?/ =229:I"7F)herein IN+ is -uoted currency and I"7 is base currencyN B RC 0ankerCs +eceipt This is a receipt issued by the 0ond: security sellin1 bank )hen the ori1inal scrip: 0ond is not immediately deliverable for settlement Bi$C The price -uoted by someone to buy the asset or borro) funds Br+&erC Intermediaries )ho match buyers and sellers Or borro)ers and lenders and receive a commission (brokera1e) for such intermediation

C+nc6rren #6$i +rC A professional6 1enerally an external 1uy (not a staff)6 )ho checks: audits the day to day transactions and reports >is main task is to check )hether the laid do)n systems:procedures:policy has been complied )ith6 in each transaction and report the discrepancies to the *ana1ement C+verC To take out for)ard contracts to protect a1ainst exchan1e fluctuation bet)een todayCs date and due payment date De#'C A transaction undertaken by the 7ealer in the domestic market or Gorei1n Exchan1e market bindin1 the 0ank De#' c+nfir2# i+nC
(=

!ritten advice from one counterparty in a deal to the other in )hich the main terms and conditions of the deal are confirmed FiDe$ r# e c6rrenc1C Currency havin1 a fixed rate of exchan1e )ithin narro) limits versus another reference currency6 usually the dollar F'+# in5 r# e c6rrenc1C Currency havin1 its exchan1e rate determined by market forces includin1 Central 0ank intervention F+reDC Gorei1n Exchan1e F+r!#r$ c+n r#c C Any contract for settlement later than spot date F+r!#r$EF+r!#r$ $e#'C "imultaneous purchase and sale of one currency for different for)ard value dates F6n$in5 +f #""e "C 0orro)in1 done6 )hen assets are more than the ,iabilities of the bank <e$5eC Action taken by the 0ank to reduce or eliminate a risky exposure In r# $#1 %+"i i+nC Open position run by a dealer )ithin the day This is 1enerally reduced to s-uare or nearly so before close of business Bee%in5 #r2" 'en5 0C Not to influence:interfere or 1et influenced:interfered Li96i$i 1 ri"&C

(&

The variation in net income and market value of bank e-uity caused by the bankCs difficulty in obtainin1 immediate funds6 either by borro)in1 or sellin1 assets LIBORC ,ondon Interbank Offered +ateOthe rate at )hich maDor 0anks in ,ondon offer to lend in the interbank market N+" r+ #cc+6n C A 0ankCs account )ith a forei1n 0ank NSEC National "tock Exchan1e NSE er2in#'"C Computer nodes throu1h )hich screen driven tradin1 can be conducted in the N"E

OfferC +ate at )hich the 0ank:dealer sells or lends O%en %+"i i+nC 7ifference bet)een total purchases and total sales in a 1iven currency on )hich an exchan1e risk is run Pre2i62C 7ifference bet)een spot price and price for for)ard settlement Pr+#c iveC One )ho acts in advance before others react6 anticipatin1 the market move Re"erve"C Pualifyin1 assets to meet the statutory reserve re-uirements Se 'e2en +f $e#'"C

(<

5erification of the deal terms:calculations6 obtention of 7eal confirmation from the counterparty6 0rokers contract6 documentation of the transaction and arran1in1 the delivery of the documents S;L #cc+6n C "ubsidiary 8eneral ,ed1er Account maintained )ith +0I for 8ovt transactions S%+ $e#'C A deal for currency for delivery t)o business days from today S%+ neD C A deal from the spot date until the next day6 either as a deposit or a s)ap S%re#$C 7ifference bet)een the cost of funds and return from the funds "ecurities

V+'# i'e 2#r&e C *arket )herein the prices:rates are fluctuatin1 in a )ide band: ran1e V+" r+ #cc+6n C A forei1n 0ankCs account )ith a local 0ank =ire #5enc1C Ne)s reporters6 )hich are transmittin1 the information:ne)s instantaneously throu1h tele;net )ork Re"erve"A Assets -ualifyin1 to meet statutory re-uirements CRRA Cash +eserve +atio SLRA
(@

"tatutory ,i-uidity +atio A""e Li#bi'i 1 M# 6ri 1 Mi"2# c0e"C Case )hen either 1ross Ginancial Assets out1ro)s Capital Q ,iabilities or vice versa De2#n$ #n$ Ti2e Li#bi'i ie" (DTL)C "um of 7emand 7eposits and Gixed deposits includin1 inter bank deposits ;+vern2en S +c&FL+#nFSec6ri ie"F;i' "C ,oans raised by 8overnment to meet its fiscal deficits These are issued in the form of tradable bonds NDTL f+r SLRC 8ross 7T, less Inter 0ank 7eposits NDTL f+r CRRC N7T, for ",+ less exempted cate1ories of liabilities De'iver1 ver"6" P#12en (DVP) S1" e2A "ystem )here the securities are delivered a1ainst simultaneous payment As both the le1s of BdeliveryC and BpaymentC are simultaneous "ettlement +isk is avoided S;L Tr#n"fer F+r2C +0I prescribed format printed on semi security paper for effectin1 security transactions in the "8, account of the bank A6 0+ri>e$ Si5n# +rie"C Officials (1enerally back office staff) )ho are authori#ed to execute: si1n "8, Transfer Gorms and other documents and )hose specimen si1natures are lod1ed )ith +0I and other counterparts in the market B#n& R# eC

(2

Interest rate at )hich +0I lends to "ch Comm 0anks +efinance +ates and penalty on default of C++ are pe11ed to 0ank +ate +0I is usin1 0ank +ate as a tool to send interest rate si1nals to the market L+c#' B#n& Acc+6n C Account )ith "0I and:or such other 0ank6 )hich is mana1in1 the Clearin1 house6 throu1h )hich the Clearin1 net proceeds are and )here the 0ank is maintainin1 a current account for passin1 the Clearin1 inflo)s and outflo)s C#"0 S6r%'6" Br#nc0C 0ranch )hich collectin1 and holdin1 cash more than its stipulated limit: normal payment re-uirement P6rc0#"e$ F6n$"C Gunds sourced at the at market determined rates (different from rates offered to the public) Re%+#b'e Sec6ri ie"C "ecurities )hich are approved for +epo transactions Di"cre i+n#r1 Li#bi'i ie"C ,iabilities:resources raised at the discretion of the borro)er B61er" M#r&e C *arket )here the demand is less and supply is more 0uyer has better choice for selection:ne1otiation since sellers (supply) outnumbers the buyers (demand) CARC Capital Ade-uacy +atio DVP S1" e2C B7elivery versus 3aymentC (753) system is the "ettlement system )herein delivery of the "tock:security and 3ayment of consideration are made simultaneous In case if one side of the transaction doesnCt 1o throu1h (say6 for )ant of 1ood delivery)6 the +0I holds

(/

back the other side of the transaction (payment of consideration) 0y this6 settlement risk is totally hed1ed Deriv# ive U"#nce Pr+2i""+r1 N+ e (DUPN)C Isance 3romissory note dra)n by the discountin1 0ank a1ainst the underlyin1 0ills !hile rediscountin1 the 0ills6 actual endorsement and delivery of these 0ills are not necessary Instead this 3romissory Note is delivered "ince this Note derives its value from the underlyin1 0ills6 this is called 7erivative Isance 3romissory Note M#Di2i># i+n +f S%re#$"C 7ifference bet)een the Total cost of funds and total return from it 1ives the spread "preads can be maximi#ed either by reducin1 the cost and:or increasin1 the return from it M#Di2i># i+n +f Ne !+r 0C Increasin1 the profits of the business so that maximum profits can be plou1hed back to +eserves This maximi#es the Net )orth of the Company and thereby increases the "hareholders value

;APC It is the difference bet)een the +ate "ensitive Assets (+"A) and +ate "ensitive ,iabilities (+",) 8A3 is said to be positive )hen +"A R +", D6r# i+n ;APC 7ifference bet)een the a11re1ate duration of Assets and a11re1ate duration of ,iabilities is 7uration 8ap M#r&e In ere" R# eC The interest rate6 or discount rate6 or yield to maturity is an interest rate )hich chan1es constantly6 dependin1 on various factors like demand:supply of the Ginancial asset6 future economic outlook6 etc F#ce V#'6eC
?9

The principal value or the *aturity value of the 0ond6 )hich is printed on the bond and )hich is fixed throu1hout the bondCs life C+6%+n R# eC The fixed rate of interest )hich is printed on the 0ond certificate is called Coupon rate Coupon rates are contractual rates that cannot be chan1ed after the bond is issued Ti2e V#'6e +f M+ne1C In order to understand this concept6 it is important that )e are familiar )ith discounted cash flo) analysis It is kno)n thatA a b c 3eople have a positive time preference for moneyJ A rupee today is )orth more than a rupee received in the futureJ 3eople postpone their current consumption and save only if their future consumption opportunities )ill be more because of their savin1sJ d "ince money earns interest6 it takes more future rupees to e-ual the value of a rupee today The above sho) that money has a time value F6 6re V#'6eC The process of 1oin1 from todayCs value or 3resent 5alue (35) to Guture 5alue (G5) is called compoundin1 To understand this6 consider the case )here an investor put +s %99 in the 0ank at %9 per cent p a This means that +s %99 today is e-uivalent to its Guture value of +s %99 x (% E 9 %9) K +s %%9 one year from no) Guture 5alue at the end of second year is +s%%9 x (% E 9 %) K +s %(% This can be expressed by the formulaA G5 K 35 (%Ei) n

?%

!hereA i K interest rate and n is number of years Pre"en V#'6eC The process of calculation from Guture 5alue to todayCs value (3resent 5alue) is called discountin1 In the above -uoted example the 3resent value of +s %(% to be received from the 0ank at an interest rate of %9 per cent is +s %99 99 The process of discountin1 is simply the inverse process of compoundin1 Accordin1ly6 the 3resent 5alue (35) can be found out as follo)sA 35 K G5 : (%Ei) n Ne Pre"en V#'6eC "uppose an investment of +s %99 1enerates a net cash flo) of +s %%& from one year from no) and if the cost of funds for the 0ank is %9 per cent6 the investment is )orth doin1 To find out ho) much )ealth does the investment creates for the capital6 the future value of +s %%& is discounted at the cost of capital6 i e 6%9 per cent %%& 35 of +s %%& K OOOOOOOOO K +s %9= && (% E 9 %) "ince the initial cost of investment is only +s %996 the Net 3resent 5alue6 i e 6 the )ealth created for the shareholders6 is found out as N35 K 35 of the future revenue F initial cost K %9= && F%99 K +s = && The net present value (N35) approach can be extended to more complex situations Isin1 the same lo1ic as above6 to find the N35 of an asset )ith an initial investment of cost of C and net cash flo)s at subse-uent dates from year % to year BnC isA
cash flo) % (%Er)% cash flo) ( E (%Er)( cash flo) n OOOOOOOO (%Er) n

N35 K (F) C E OOOOOOO EOOOOOOO E

B+n$ V#'6# i+nC 0ond is a contractual obli1ation to payA

?(

i ii iii

Coupon:interest specified on the 0ondJ at fixed intervalsJ 3rincipal amount )ith or )ithout premium6 if specified any6 at maturity

The 3resent value or price of the 0ond is thereforeA i 35 of the future stream of cash flo)s (interest payments and 3rincipal) discounted at prevailin1 market interest ratesJ ii At the time of ne) issue6 coupon interest and market interest are ideally the same and expressed as follo)sA
C% 0ond 5alue (50) KOOOOOO C( E OOOOOO OOOOOOO (%Ei) (%Ei)( (%Ei)? (%Ei)n C? E OOOOOO E OOOOOOO (Cn E *) E

n K t K%

C OOOO (%Ei)t

* OOOOOO (%Ei) n

!hereA C% Cn K i K n K * K period coupon payment from year % to n market interest rates6 prevailin1 period to maturity 3rincipal )ith : )ithout redemption premium

The value of the 0ond )ill chan1e if there is a chan1e in the market interest rate (i) If market interest rate 1oes up beyond the coupon rate6 the value of the bond )ill fall so that the ne) investor (buyer) )ould earn market interest rate despite the fact that the coupon of the 0ond )ould continue to 1ive fixed lo)er income ,ike)ise if market interest rate declines belo) the coupon rate6 the value of the bond )ill appreciate so that the ne) investor (buyer) earn only lo)er market interest rate despite the fact that the coupon of the 0ond )ould continue to 1ive fixed hi1her income "uch e-uilibratin1 adDustment in bond price: value is kno)s as bond dynamics
??

!e learnt that the value of the 0ond depends on the coupon rate vis;S;vis prevailin1 market interest rates !e can summari#e the above as follo)sA i !henever the market interest rate rise above the coupon rate of the bond6 the price of the bond )ill fallJ ii if the market interest rate falls belo) the coupon rate of bond6 the price of bond )ill appreciateJ iii if there is no chan1e in the market interest rate from bond coupon rate6 the price of bond )ill remain the same

Ann6i 1C This is a series of e-ual payments made at fixed intervals for a specified number of periods If the payments are made at the end of the period6 it is kno)n as ordinary annuity or deferred annuity If payments are made at be1innin1 of period6 then it is an annuity due Gormula for Guture value of an ordinary :deferred annuity isA G5An K A (%Er) E A (%Er) E !here G5An K AK rK nK YIELDC 4ield is defined as an overall return to an investor on his investment !ith respect to yield on 0onds:8OI securities6 three types of yields are discussedA N+2in#' 1ie'$C EA Guture value of an annuity )ith BnC periods Constant:re1ular cash flo) Interest rate 7uration of the annuity

?=

This is the annual interest rate specified on the 0onds6 irrespective of its price (i e 6 )hether -uoted at a premium or at a discount) This is also kno)n as Coupon of the 0ond C6rren 1ie'$C This is the effective yield an investor earns keepin1 in mind the current market price of the 0ond This is 1iven by the formulaA Nominal yield or Coupon Current 4ield K OOOOOOOOOOOOOOO Current market 3rice x %99

Yie'$ + 2# 6ri 1C This term popularly kno)n as 4T* connotes redemption yield and is very useful for Treasury *ana1ers )hose investment hori#on is lon1 term 4T* can be interpreted as the bondCs avera1e compounded rate of return if the bond is bou1ht at the current asked price and held until it matures and the face value is repaid That is6 4T* can be defined as the discount rate that e-uates present value of all cash flo)s to the present market price of the 0ond Guture cash flo)s includes interest and capital 1ain:loss This can be al1ebraically expressed as follo)sA ,et the 0ond )ith a face value of BAC of coupon BCC )ith a term to maturity of BnC years is -uoted:traded at a market price of 36 then

C 3 K OOOOE (%Ey)%

C OOOO (%Ey)( E

C (%Ey)?

(C E A) (%Ey)n

OOOOE OOOOE OOOO

?&

!here ByC is the discount rate (to be found by trial Q error method ) at )hich the cash flo)s are discounted so that the ri1ht hand side of the above e-uation tallies:e-uates )ith the 3rice 3 (left hand side) of the 0ond The LyL so derived )ould be the 4ield to maturity (4T*) of the bond It implies that6 if the 0ond is held till maturity and the Coupons:Cash flo)s received are reinvested at the LyL rate itself6 the overall yield on the 0ond )ill be LyL6 )hich is its 4T* An example )ould further help to understand the mechanics of the 4T* "uppose the market value of +s %99 (face value) bond carryin1 coupon of %? per cent p a maturin1 after @ years is -uoted +s %9/ =& in the market The 4T* of the bond is found by discountin1 the yearly coupon flo)s of +s %? in the next < years and +s %%? (3rincipal of +s %99 E coupon of +s %?) at the end of @ year at a rate (to be found by trial Q error method)6 say BrC so that the 3resent value of such cash flo)s sums to +s %9/ =& +s %? (35IGA) E +s %99 (35IG) K +s %9/ =& 35IGA bein1 the 3rice 5alue Interest Gactor for the @ year Annuity and 35IG the 3rice 5alue Interest Gactor for @ years to be taken from the 35IGA table and 35IG table (available in all standard Ginance Text 0ooks) for a @ year term6 by trial and error method Accordin1ly for @ years (35IGA) at %%' and for @ years (35IG) at %%' K K = @%( 9 =2(

Then ,>" of the e-uation becomes %? x (= @%() E %99 x (9 =2() K +s %9/ =& Then %% per cent is said to be the 4T* of the bond6 also described as the Internal +ate of +eturn6 (I++) In other )ords6 in the above example6 if the above bond is held by the buyer till maturity the overall return from the 0ond )ill be %% per cent >o)ever as the above process )ill be time consumin16 4T* can be found by approximation as follo)s C E (A F 3):n 4T* K OOOOOOOOO T %99 (A E 3) :( !here C A K coupon K Gace 5alue:maturity 5alue

?<

3 n

K 3rice paid for the 0ond K term to maturity

Applyin1 this in the above example6 %? E (%99 F%9/ =&): @ 4T* K OOOOOOOOOOOOO K (%99 E %9/ =&): ( %? F % ?& K OOOOOO T %99 K %% %(' %9= @(& >o)ever underlyin1 assumption in the 4T* concept is that the coupons:cash flo)s received durin1 the tenure of the bond is reinvested at 4T* rate6 )hich may not be true since the market interest rates )ill al)ays be chan1in1 from time to time %? E (F / =&:@) OOOOOOOOO %9= @(&

<+'$in5 Peri+$FRe#'i>e$ Yie'$C !hen the holder:investor is 1oin1 to disinvest the 0ond before its maturity6 the overall yield earned by him from the 0ond is kno)n as >oldin1 3eriod 4ield or +eali#ed 4ield ,et us understand this )ith the help of an exampleA "uppose you are holdin1 a %9 year 0ond )ith a Gace value of +s %99 and coupon 2 per cent After ? years6 )hen the interest rates move up to %9 per cent for @ years term6 you )ant to sell this 0ond As the interest rates have moved up6 naturally you may have to sell the 0ond at a discount The sellin1 price for the 0ond by usin1 the 0ond 5aluation Gormula as follo)sA

2 (% %9)(

2 (% %9)?

%92 E OOOOOO K (% %9)@ /9 (&

OOOOO E OOOOOO E OOOOOO E OOOOOO (% %9)

?@

This sho)s that the 0ond have to be sold at a belo) par value of +s /9 (&6 thereby incurrin1 a capital loss of (%99 F /9 (&) K +s / @& No) to find the +eali#ed yield on the 2 per cent bond for the period of ? years held and )ith a redemption value of +s /9 (& (as the sale proceeds of the 0ond)6 the 4T* formula is used as follo)sA 2 OOOOOO E E OOOOOO K %99 (%Er) % (%Er) ( (%Er) ? 2 (2 E /9 (&)

!here BrC is the +eali#ed or >oldin1 3eriod 4ield Accordin1ly6 )e 1et the +eali#ed yield BrC K = / per cent >o)ever as it is much lo)er than the promised yield of 2 per cent6 the seller incurs a loss of (2 F = /) K ? % per cent returns on his 0ond

Yie'$ S%re#$"C 4ield spreads are the differences bet)een the yields of any pair of bondsOusually a #ero risk bond and another risky bondOof same maturity U4ield on risky bondVF U4ield on #ero risk bondsV K Uyield spreadV 4ield spreads are also called Brisk;premiumsC because they measure the additional yield that risky bonds pay to induce investors to buy more;risky bonds rather than less risky bonds Yie'$ +n Di"c+6n e$ in" r62en "C The issue price of a discounted instrument is calculated as follo)sA G 7 K OOOOOOOOOOOOOOO

?2

% E U( r x n):?<&99V )here6 7 G r n K K K K 7iscounted value of the instrument *aturity 5alue Effective rate of interest per annum Tenure of the instrument ( in days)

Conversely to find out the yield from a discounted instrument6 the follo)in1 formula can be derived from the above one6 (G F7) r K OOOOOO 7 )here6 7 G r n K K K K 7iscounted value of the instrument *aturity 5alue Effective rate of interest per annum Tenure of the instrument ( in days) ?<& T OOOOOOO T n %99

REPO Tr#n"#c i+n"Gc#'c6'# i+n"C Assume 0ank BAC borro)s from 0ank B0C an amount of +s %9 crores for a period of %= days from %9 %9 (99& to (= %9 (99&6 at an interest rate of 2 per cent a1ainst its holdin1 of %% &9 per cent 8OI (99@ (Interest 3ayment dates of this stock are &th April and &th October of the year) belo)A =+r&in5 (N+ eC !hile calculatin1 interest accrued on 8overnment securities6 ?<9 days are As already stated earlier6 the transaction involves ( le1sOGirst le1:+eady le1 and "econd le1:Gor)ard le1 The calculation for both le1s are explained

considered for an year )

?/

GI+"T ,E8:+EA74 ,E8 on %9 %9 (99&A 0ank 0)

(0ank A sold %% &9 per cent 8OI (99@ to

Calculation for first le1 is as if 0ank A is sellin1 the security (%% & per cent 8OI (99@) outri1ht to 0ank 0 at the market price of +s %99 This is as follo)sA 3rincipal (+s %9 crs W %99 99) Accrued int on the stock K (%9 crs x %% &' x &:?<9) Girst:+eady le1 settlement amount (%) K K +s %6&/6@(( (( +s %969%6&/6@(( (( K +s %96996996999 99

(It may be understood from the above transaction6 that 0ank A borro)ed +s %969%6&/6@(( (( from 0ank 0)

GO+!A+7:"ECON7 ,E8 on (= %9 (99&A (0ank A bou1ht back the stock from 0ank 0) Thou1h the second le1 transaction is to be calculated as if 0ank A is buyin1 outri1ht the security from 0ank 06 to arrive at the buyin1 rate:price6 the calculation has to be done on the reverse )ay6 as follo)sA % Calculate the settlement amount 0ank A has to pay 0ank 0 )hich is K Amount borro)ed E interest W 2' for %= days (+epo rate) K +s %969%6&/6@(( (( E +s ?69@6??/ =( "ettlement amount K +s %969=6<@69<% <= ( Grom this subtract accrued interest on the stock till date Accrued interest on the stock K %96996996999 x %% &' x %/ ;;;;;;;;; ?<9 K +s <69<6/== ==

=9

"ettlement amt F Accrued interest K %969=6<@69<% <= <69<6/== == +s /6/26<96%%@ (9 ? +esultin1 amount of +s /6/26<96%%@ (9 is the principal amount for the +s %9 crore value stock >ence to 1et rate of repurchase6 divide this value by nominal value ie /6/26<96%%@ (9 ;;;;;;;;;;;;;;;;;; %96996996999 No) based on this rate6 the accountin1 is done as follo)sA 3rincipal (+s %9 crs W// 2<9%%@) K +s /6/26<96%%@ (9 K // 2<9%%@

Accrued int on the stock K (%9 crs x %% &' x%/:?<9) Gor)ard:second le1 settlement amt
= (1) + int @ 8% for 14 days = (2) = Rs 10,04,67,061.64

+s <69<6/== ==

"TI74 *ATE+IA,A; GINANCIA, *ANA8E*ENT 5E+4 ">O+T PIE"TION" ( % *A+X) % 7efine Ginancial *ana1ement Ans financial mana1ement is that speciali#ed activity )hich is responsible for obtainin1 and affectively utili#in1 the funds for the efficient functionin1 of the business and6 therefore6 it includes financial plannin16 financial administration and financial control ( "tate the primary obDective of Ginancial mana1ement Ans To maximi#e the shareholders )ealth ? "tate the decisions involved in Ginancial mana1ement Ans a) Investment decision b) Ginancin1 decision c) 7ividend decision = !hat is meant by Ginancial 3lannin1$ Ans Ginancial plannin1 means decidin1 in advance6 the financial activities to

=%

be carried on to achieve the basic obDective of the firm The basic obDective of the firm is to 1et maximum profits out of minimum efforts & !hat are the obDectives of financial plannin1$ Ans a) to ensure availability of fund )henever re-uired b) to see that the firm does not raise funds unnecessarily < !hat is !orkin1 Capital $ Ans The capital re-uired for day to day operations of the business is called !orkin1 capital @ "tate the difference bet)een 1ross )orkin1 capital and net )orkin1 capital Ans 8ross )orkin1 capital is the sum: a11re1ate of the current assets6 )hereas Net )orkin1 capital K Current assets F current liabilities 2 !hat is meant by capital bud1etin1 decision$ Ans A lon1 term Investment decision is called capital bud1etin1 decision / !hen is financial levera1e considered favorable$ Ans) Ginancial levera1e is considered favorable )hen return on investment is hi1her than the cost of debt %9 >o) does production cycle effect )orkin1 capital$ Ans) )orkin1 capital re-uirement is hi1her )ith lon1er production cycle %% !hat do you mean by floatation cost$ Ans) Cost incurred for raisin1 funds %( !hat is capital structure of a company$ Ans Capital structure is the relative proportion of different sources of lon1 term finance In other )ords Capital structure of a company refers to the make up of its capitali#ation ">O+T AN"!E+ PIE"TION" (? : = *X") % Are the share holders of a company likely to 1ain )ith a debt component in the capital employed $ Explain )ith the help of an example$ Ans) The shareholders of a company are very likely to 1ain )ith debt component in the capital employed by )ay of tradin1 On e-uity as it increases the earnin1 per share(E3") of the share holders ( 7efine current assets and 8ive four examples Ans Current assets also called as floatin1 assets or fluctuatin1 assets are short term assets )hose value fluctuates in the short period These assets are re-uired to pay off the current liabilities Gor e 1 cash in hand:0ank6 Inventory6 7ebtors 0ills receivable6 *arketable securities etc ? YTo avoid the problem of shorta1e and surplus of funds6 )hat is re-uired in Ginancial mana1ement$ Name the concept and explain four points of importance Ans Ginancial 3lannin1 is re-uired to avoid shorta1e or surplus of finance Importance of financial plannin1 isA a) 0y plannin1 utili#ation of finance6 it reduces )aste 6duplication of efforts and 1aps in the plannin1 b) It helps in coordinatin1 the various business activities such as sales6

=(

purchases6 production6 finance etc c) It is a techni-ue of control It helps in settin1 up standard and compare )ith the actual performance The deviations6 if any are then analysed Causes found out and corrective measures are taken (d)It helps in avoidin1 shocks and surprises as proper provision re1ardin1 "horta1e or surplus is made in advance by anticipatin1 future receipts and 3ayments = Explain the role of BOperational efficiencyC in the determination of )orkin1 capital re-uirement Ans The firm )ith a better operational efficiency has to invest less in )orkin1 capital because; a) they convert ra) materials -uickly into finished 1oods6 and sell them at their earliest i e converts stock into sales -uickly b) 3romptly collects debts from debtors and bills receivable & 7iscuss ho) !orkin1 capital affects both the li-uidity and profitability of a business Ans "hort term Investment decisions are concerned )ith the decisions about the level of cash6 inventory and debtors etc ()orkin1 capital) Efficient cash mana1ement6 Inventory mana1ement and receivable mana1ement are essential in1redients of sound )orkin1 capital mana1ement The )orkin1 capital should be neither more or less than re-uired 0oth the situations are harmful If the amount of )orkin1 capital is more than re-uired6 it )ill no doubt increase the li-uidity but decrease the profitability "imilarly if there is a shorta1e of )orkin1 capital6 it )ill face the problem of meetin1 day to day re-uirements Thus optimum amount of current assets and current liabilities should be determined so that the profitability of the business remains intact and there is no fall in the li-uidity < >o) does BInterest covera1e ratioC affects the capital structure Ans The interest covera1e ratio refers to the number of times earnin1s before interest and taxes of a company covers the interest obli1ations Interest covera1e ratio K E0IT:Interest >i1her the ratio6 better is the position of the firm to pay its interest obli1ations6 so it should issue debt On the other hand if it is lo)6 the firm should avoid usin1 debt as interest is to be paid irrespective of profits @ !hy Capital bud1etin1 decisions are more important$ Ans The lon1 term Investment decision is called capital bud1etin1 It is more important due to the follo)in1 reasons; a) ,on1 term 1ro)th and affects A As capital bud1etin1 decisions involve investment in lon1 term fixed assets6 it affects the lon1 term 1ro)th b) ,ar1e amount of funds involved A As hu1e amount of fund is blocked for a lon1 period6 the decision should be taken rationally c) +isk involved A As such a decision affects the returns of the firm as a )hole6 it

=?

involves more risk d) Irreversible decisions A These lon1 term decisions taken once cannot be reversed back6 )ithout incurrin1 heavy losses It )ill lead to )aste of fund6 if reversed Thus capital bud1etin1 decisions should be taken after careful study and deep analysis 2 !hat is Ginancial risk$ >o) does it arise$ Ans It refers to the risk of the company not bein1 able to cover its fixed financial cost Gixed financial cost includes payment of interest that is to be paid irrespective of profit The hi1her level of risk are attached to hi1her de1rees of financial levera1e If E0IT(Earnin1s before interest and tax) decreases6 financial risk increases as the firm is not in a position to pay its interest obli1ations Thus the risk of default is called Ginancial risk The firm should overcome the situation accordin1ly or )ill be forced to)ards li-uidation ,ON8 PIE"TION" ( &:< *X") % !hat are the determinant of capital structure of a company$ O+ B7etermination of capital structure of a company is influenced by a number of factorsC explain six such factors Ans Capital structure refers to the relative proportion of different sources of lon1 term finance Gollo)in1 factors are to be considered before determinin1 capital structure a) Cash flo) positionA The cash available )ith the company should be enou1h to meet the fixed interest liabilities Interest on debt is to paid irrespective of profits A company has to meet )orkin1 capital re-uirements6 invest in fixed assets and also pay the interest and principal amount of debt after a particular stipulated period If cash position is sound6 debt van be raised6 and if not sound debt should be avoided b) Interest covera1e ratio A it is the ratio that expresses the number of times the Net profit before interest and tax covers the interest liabilities >i1her the ratio6 better is the position of the firm to raise debt c) Control A Issue of E-uity shares dilutes the control of the existin1 shareholders 6 )hereas issue of debt does not as the debenture holders do not participate in the mana1ement decisions as they are not the o)ners of the fir Thus if control is to be retained6 e-uity should be avoided d) "tock market conditions A If the stock market is bullish6 the investors are adventurous and are ready to invest in risky securities6 e-uity can be issued even at a premium )hereas in the 0earish phase6 )hen the investors become cautious6 debt should be issued as there is a demand for fixed cost security e) +e1ulatory frame)ork A 0efore determinin1 the capital structure of a company 6 the 1uidelines of "E0I and concerned re1ulatory authority is to be considered Gor e 1 companies Act6 0ankin1 re1ulation Act etc are to considered f) Tax rate A As interest on debt is treated as an expense6 it is tax deductable 7ividend on e-uity is the distribution of profit so is not tax deductable Thus

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if the tax rates are hi1h6 issue of debt is an attractive means as it is economical in nature ( Explain briefly five factors determinin1 the amount of fixed capital Ans Gixed capital refers to the capital )hich is used for the purchase of fixed assets6 such as land6 buildin16 machinery etc Gollo)in1 factors are to be considered before determinin1 its re-uirement a) Nature of 0usinessA If a firm is a manufacturin1 fir6 it re-uires to purchase fixed assets for the production process It needs investment in fixed assets6 so re-uire more fixed capital "imilarly if it is a Tradin1 firm )here the finished 1oods are only traded i e purchased and sold6 it needs less fixed capital b) "cale of operations lar1er the si#e and scale of operations lar1er is the re-uirement of the fixed capital and vice versa c) Choice of techni-ueA The *anufacturin1 firm usin1 the modern6 latest technolo1y machines has to invest more funds in the fixed assets6 so they re-uire more fixed capital On the other hand6 firms usin1 the traditional method of production )here the task is performed manually by the labourers6 it re-uires less fixed capital d) 7iversification A There are fe) firms and or1ani#ations )ho deal in a sin1le product These investment in fixed assets is lo)6 )hereas the firms dealin1 in number of products ( 7iversification) re-uires more investment in purchasin1 different fixed assets6 it re-uires more fixed capital e) Ginancin1 alternativesA If the manufacturin1 firm actually buys the assets and blocks hu1e funds in the fixed assets6 it re-uires more fixed capital The companies )ho ac-uire the fixed asset and use them by obtainin1 leasin1 facilities6 it re-uires less fixed capital ,easin1 is suitable in hi1h risk lines of business )here hu1e funds should not be blocked in the fixed assets ? !hat is meant by !orkin1 capital$ >o) is it calculated$ Explain the determinants of )orkin1 capital re-uirements Ans !orkin1 capital is the capital re-uired for meetin1 day to day re-uirements:operations of the business Net )orkin1 capitalK current assets F current liabilities Gollo)in1 factors are to be considered before determinin1 the re-uirement of )orkin1 capital a) "cale of operationsA There is a direct link bet)een the scale of business and )orkin1 capital ,ar1er business needs more )orkin1 capital as compared to the small or1ani#ations b) Nature of 0usinessA The manufacturin1 or1ani#ations are re-uired to purchase ra) materials6 convert them into finished 1oods6 maintain the stock of ra) materials6 semi finished 1oods and finished 1oods before they are offered for sale They have to block their capital for labour cost6 material cost etc6 so they need more )orkin1 capital In the tradin1 firm processin1 is not performed "ales are affected immediately after receivin1 1oods for sale Thus they do not block their capital and so needs less )orkin1 capital c) Credit allo)edA If the inventory is sold only for cash6 it re-uires less )orkin1 capital as money is not blocked in debtors and bills receivable 0ut due to increased competition6 credit is usually allo)ed A liberal credit policy results

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in hi1her amount of debtors6 so needs more )orkin1 capital d) Credit availedA If 1oods are purchased only for cash6 it re-uires more )orkin1 capital "imilarly if credit is received from the creditors6 the re-uirement of )orkin1 capital decreases e) Availability of +a) materialsA If the ra) materials are easily available in the market and there is no shorta1e6 hu1e amount need not be blocked in inventories6 so it needs less )orkin1 capital 0ut if there is shorta1e of materials6 hu1e inventory is to be maintained leadin1 to lar1er amount of )orkin1 capital "imilarly if the lead time is hi1her6 hi1her amount of )orkin1 capital is re-uired = BEvery *ana1er has to take three maDor decisions )hile performin1 the finance functionC briefly explain them Ans The three important decisions taken by the finance mana1er are as follo)s F %) Investment decisionA It refers to the selection of the assets in )hich investment is to be made by the company Investment can be made in ,on1 term fixed assets and short term current assets Thus Investment decision is divided in t)o parts A (a) ,on1 term Investment decisionsA "uch decisions are also called Capital 0ud1etin1 decisions It relates to the investment in lon1 term fixed assets As such decisions affects the 1ro)th of the firm6 it involves hu1e fund to be blocked for a lon1 period6 and such decisions are irreversible in nature6 they should be taken carefully after makin1 a comparative study of various alternatives available (b) "hort term Investment decision (!orkin1 capital decision)A It refers to investment in short term assets such as cash6 inventory6 debtors etc Ginance mana1er has to ensure that enou1h )orkin1 capital is available to meet the day to day re-uirements It should also ensure that unnecessarily hi1h reserve of )orkin1 capital should not be retains as it decreases the profitability Thus profitability and ,i-uidity are to be compared and appropriate amount kept as )orkin1 capital ( Ginancin1 decisionA There are various sources of obtainin1 lon1 term finance such as E-uity shares6 preference shares6 term loans6 7ebentures etc Gor takin1 financin1 decision and decidin1 the capital structure various factors are to be considered and an analysis of cost and benefit is made ? 7ividend decisionA It refers to the decision related to the distribution of profit The finance mana1er has to decide as to ho) much amount of profit is to be distributed as 7ividend and ho) much to be retained in the business If too much retained earnin1s are maintained6 it dissatisfies the shareholders as they receive less dividend "imilarly if a liberal dividend policy is follo)ed6 thou1h the shareholders are satisfies6 but the firm does not have enou1h reserve for future 1ro)th6 expression6 meetin1 contin1ency etc & !hat is meant by BGinancial mana1ementC Explain its importance Ans Ginancial mana1ement refers to that part of the mana1ement )hich is concerned )ith the efficient plannin1 and controllin1 the financial affairs of the enterprise Ginancial mana1ement plays the follo)in1 role ; a) 7etermination of fixed assets A Gixed assets have an important contribution in

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increasin1 the earnin1 capacity of the business ,on1 term investment decisions also called capital bud1etin1 decision raise the si#e of fixed assets b) 7etermination of current assets A Current assets are needed to meet the day to day transactions of the business The total investment in current assets is to be determined and the split up into its elements is re-uired Gor e 1 if it is decided to maintain current assets of +s %9 lakh6 further decision is to be made as to ho) much cash is re-uired6 ho) much amount to be invested in debtors6 stock etc c) 7etermination of lon1 term and short term financeA Inder this a Ginance mana1er has to maintain a proper ratio of short term and lon1 term sources of finance after estimatin1 its re-uirement d) 7etermination of Capital "tructureA A balanced decision related to capital structure is to be made The proportion of debt and e-uity is to be determined e) 7etermination of various items in the 3rofit and loss account;The financial decisions affect the various items to appear in the profit and loss account Gor e 1 depreciation on fixed assets6 interest on debt etc "TI74 *ATE+IA,A; CA"> G,O! "TATE*ENT PusA% !hy is the cash flo) statement not a suitable Dud1e of profitability $ AnsA Cash Glo) statement is prepared on cash basis of accountin1 but profit is calculated on accrual basis "o cash flo) statement is not a Dud1e of profitability PusA( Inder )hich accountin1 standard 6 cash flo) statement is prepared $ AnsA Inder accountin1 standard;?(+evised) PusA? !hy do )e add back non cash items to net profit )hile calculatin1 cash flo) from operatin1 activities AnsA Non cash items reduce the net profit )ithout reducin1 the cash balance PusA= >o) )ill you classify loans 1iven by >7GC )hile preparin1 cash flo) statement AnsA As Operatin1 Activities PusA& >o) )ill you classify deposits by customers in "0I )hile preparin1 cash flo) statement AnsA Operatin1 Activities PusA< !here )ill you sho) purchase of furniture in cash flo) statement $ AnsA As Outflo) under Investin1 Activities PusA@ 8ive examples of non cash transactions AnsA 8ive any t)o examples; (i) Ac-uisition of fixed asset by issue of debentures or shares (ii) Conversion of debentures into shares PusA2 A company receives a dividend of +s & ,akhs on its investment in other companyCs share )ill it be Cash inflo) from operatin1 or investin1 activities in case of a (i) Ginance Company

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(ii) Non;Ginance Company AnsA It )ill be operatin1 activities in case of a finance company and investin1 activities in case of non;Ginancin1 Company PusA/ 8ive four example of movement bet)een cash and cash e-uivalents AnsA Cash deposited into bank6 Cash )ithdra)n from bank for office use6 purchase of short term marketable securities6 6 sale of short term marketable securities PusA%9 >o) are various activities classified as per A";? (+evised) $ AnsA (i) Operatin1 Activities (ii)Investin1 Activities (iii)Ginancin1 Activities PusA%% 8ive one example each of an extra ordinary item under operatin16 investin1 and financin1 activity AnsA Examples of extraordinary items underA; (a) Operatin1 activity F claim received from insurance company a1ainst loss of stock (b) Investin1 activity F amount of compensation received a1ainst ac-uisition of land belon1in1 to the enterprise (c) Ginancin1 activity F payment for buy;back of e-uity shares of the company PusA%% Cash flo) from operatin1 Activities E Cash flo) from Investin1 Activities E Cash flo) from Ginancin1 Activities KZZZZZZZ AnsA ZK Net Increase :7ecrease in cash and Cash E-uivalents PusA%( !hat are the t)o methods )hich can be employed to calculate net cash flo) from operatin1 activities $ AnsA 7irect *ethod and Indirect *ethod PusA%? *odern Toys ,td 3urchased a machinery of +s (96996999 for manufacturin1 toys "tate 1ivin1 reason !hether the cash flo) due to the purchase of machinery )ill be cash flo) from operatin1 activities6 Investin1 activities or Ginancin1 activities $ AnsA Investin1 Activities 0ecause ZZZZZ PusA%= *:s ,akshmi Electrical Appliances furnish the follo)in1 information ; Calculate net cash flo) from financin1 activitiesA; 3articulars ?% %( (99@ ?% %( (992 E-uity share capital (6996999 =6&96999 %9' debentures %6996999 ; <' preference shares ; ?6996999 Additional information F (a) Interest paid on debentures +s &6999:; (b) 7ividend paid on e-uity shares +s =96999:; (c) 0onus shares )ere issued to existin1 shareholders in the

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ratio of =A% durin1 the year Ans A CA,CI,ATION OG NET CA"> G,O! G+O* GINANCIN8 ACTI5ITIE" 3articulars +s Cash proceeds from issue of ?6996999 3ref "hares E e-uity shares (6&96999 +edemption of %9' debentures (%6996999) Interest paid (&6999) 7ividend paid on e-uity shares (=96999) Net cash flo) from financin1 activity =69&6999 PusA%& A company had the follo)in1 balance ; 3articulars +s Investment at the be1innin1 of the period ?6=96999 Investment at the end of the period (6296999 7urin1 the year6 the company sold =9' of investments at the be1innin1 at a profit of 2=6999 Calculate cash fro6 investin1 activities F 3articulars +s Inflo) from sale of investment Cost of investment 8old (6(96999 (=9' of +s ?=9999) K %?<999 Add profit on sale K 2=999 Out flo) on purchase of investment (@<6999) Net cash flo) from investin1 activities %6==6999 Investment A:c To balance b:d ?6=96999 0y Cash sale of investment (6(96999 To profit on sale 2=6999 To bank a:c (purchase) @<6999 0y balance c:d (6296999 &6996999 &6996999 3ractice numericalA PusA%< Grom the follo)in1 profit or loss account find out the flo) of cash from operatin1 activities of *ohan ,td 3rofit and ,oss Account 7r Cr 3articulars Amount 3articulars Amount To +ent 3aid %=6999 ,essA 3repaid (6999 To "alaries To 7epreciation

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To ,oss on sale of Gurniture To 8ood)ill )ritten Off To 0ad 7ebts To Office Expenses To 7iscount allo)ed To 3roposed 7ividend To 3rovision for Tax To Net 3rofit (+s) %(6999 (&6999 %&6999 %96999 26999 ?6999 %26999 @6999 ?96999 ((6999 &(6299 (69(6299 0y 8ross 3rofit 0y 3rofit on "ale of *achine 0y Tax +efund 0y +ent received =6999 AddA +ent accrued %6999 (+s) %62(6999 %(6999 ?6299 &6999 (69(6299 NoteA There )as increase in Closin1 stock by +s (&6999 AnsA Cash from Operatin1 Activities +s %69?6299 PusA%@ 3repare Cash flo) "tatement from the follo)in1 information of ,O47 35T ,T7 Gor the year ended *arch ?%6(99= 0A,ANCE ">EET" OG ,O47 35T ,T7 A" ON *A+C> ?%6(99= ,iabilities (99? (99= Assets (99? (99= "hare capital 3rofit Q ,oss Account

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8eneral +eserve Tax 3rovision Creditors 0ill 3ayables 7epreciation 3rovision (+s) ?6996999 %6(96999 <96999 @96999 &96999 ?96999 (&6999 <6&&6999 (+s) =6996999 (6<96999 /&6999 296999 /96999 %96999 =96999 /6@&6999 8ood)ill *achinery %(' Investments "tock 7ebtors Cash at 0ank "hort term Investment (+s) @96999 ?6996999 %6&96999 ?&6999 &96999 ?96999 (96999 <6&&6999

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(+s) ?96999 ?6(96999 ?6996999 %62&6999 @96999 =96999 ?96999 /6@&6999 Additional Information A % Investment costin1 +s &96999 )ere sold for +s =26999 durin1 the year ( Tax paid durin1 the year +s @96999 ? Interest received on Investment +s %(6999 AnsA (i) Cash Inflo) Grom Operatin1 Activities +s 296 999 (ii)Cash Outflo) on Investin1 Activities +s %6 <96999 (iii) Cash Inflo) from Ginancin1 Activities +s %6 996999

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