Fundamentals Level – Skills Module

Time allowed
Reading and planning: 15 minutes
Writing: 3 hours
ALL FOUR questions are compulsory and MUST be attempted.
Formulae Sheet, Present Value and Annuity Tables are on
pages 6, 7 and 8.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
P
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p
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F
9
Financial
Management
Thursday 6 December 2007
The Association of Chartered Certified Accountants
ALL FOUR questions are compulsory and MUST be attempted
1 (a) Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the same
business sector. Financial information on Danoca Co, which is shortly to pay its annual dividend, is as follows:
Number of ordinary shares 5 million
Ordinary share price (ex div basis) $3·30
Earnings per share 40·0c
Proposed payout ratio 60%
Dividend per share one year ago 23·3c
Dividend per share two years ago 22·0c
Equity beta 1·4
Other relevant financial information
Average sector price/earnings ratio 10
Risk-free rate of return 4·6%
Return on the market 10·6%
Required:
Calculate the value of Danoca Co using the following methods:
(i) price/earnings ratio method;
(ii) dividend growth model;
and discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the current
market value of Danoca Co. (11 marks)
(b) Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time.
Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current
ordinary share price of Phobis Co is $4·45 and this is expected to grow at a rate of 6·5% per year for the
foreseeable future. Phobis Co has a cost of debt of 7% per year.
Required:
Calculate the following current values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium. (6 marks)
(c) Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss the
significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong
form efficient. (8 marks)
(25 marks)
2
2 Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’, which is
used in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg of
Quago per year, could be bought for $800,000, payable immediately. The scrap value of the machine after four years
would be $30,000. Forecast demand and production of Quago over the next four years is as follows:
Year 1 2 3 4
Demand (kg) 1·4 million 1·5 million 1·6 million 1·7 million
Existing production capacity for Quago is limited to one million kilograms per year and the new machine would only
be used for demand additional to this.
The current selling price of Quago is $8·00 per kilogram and the variable cost of materials is $5·00 per kilogram.
Other variable costs of production are $1·90 per kilogram. Fixed costs of production associated with the new machine
would be $240,000 in the first year of production, increasing by $20,000 per year in each subsequent year of
operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable
depreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It has a cost of equity
of 11% and a before-tax cost of debt of 8·6%. The long-term finance of the company, on a market-value basis,
consists of 80% equity and 20% debt.
Required:
(a) Calculate the net present value of buying the new machine and advise on the acceptability of the proposed
purchase (work to the nearest $1,000). (13 marks)
(b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of the
proposed purchase (work to the nearest $1,000). (4 marks)
(c) Explain the difference between risk and uncertainty in the context of investment appraisal, and describe how
sensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisal
process. (8 marks)
(25 marks)
3 [P.T.O.
3 The following financial information relates to Echo Co:
Income statement information for the last year
$m
Profit before interest and tax 12
Interest 3
–––
Profit before tax 9
Income tax expense 3
–––
Profit for the period 6
Dividends 2
–––
Retained profit for the period 4
–––
Balance sheet information as at the end of the last year
$m $m
Ordinary shares, par value 50c 5
Retained earnings 15
–––
Total equity 20
8% loan notes, redeemable in three years’ time 30
–––
Total equity and non-current liabilities 50
–––
Average data on companies similar to Echo Co:
Interest coverage ratio 8 times
Long-term debt/equity (book value basis) 80%
The board of Echo Co is considering several proposals that have been made by its finance director. Each proposal is
independent of any other proposal.
Proposal A
The current dividend per share should be increased by 20% in order to make the company more attractive to equity
investors.
Proposal B
A bond issue should be made in order to raise $15 million of new debt capital. Although there are no investment
opportunities currently available, the cash raised would be invested on a short-term basis until a suitable investment
opportunity arose. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ time
at par.
Proposal C
A 1 for 4 rights issue should be made at a 20% discount to the current share price of $2·30 per share in order to
reduce gearing and the financial risk of the company.
Required:
(a) Analyse and discuss Proposal A. (5 marks)
(b) Evaluate and discuss Proposal B. (7 marks)
(c) Calculate the theoretical ex rights price per share and the amount of finance that would be raised under
Proposal C. Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk.
(7 marks)
(d) Discuss the attractions of operating leasing as a source of finance. (6 marks)
(25 marks)
4
4 PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of
PKA Co has been investigating the working capital management of the company and has gathered the following
information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet
production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250,
while the cost of holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant during
the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year
and that demand is constant throughout the year.
Accounts receivable management
Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average
accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts
as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.
Accounts payable management
PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. The
financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the
currency risk of this account payable. The following information has been provided by the company’s bank:
Spot rate ($ per €): 1·998 ± 0·002
Six months forward rate ($ per €): 1·979 ± 0·004
Money market rates available to PKA Co:
Borrowing Deposit
One year euro interest rates: 6·1% 5·4%
One year dollar interest rates: 4·0% 3·5%
Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.
Required:
(a) Identify the objectives of working capital management and discuss the conflict that may arise between them.
(3 marks)
(b) Calculate the cost of the current ordering policy and determine the saving that could be made by using the
economic order quantity model. (7 marks)
(c) Discuss ways in which PKA Co could improve the management of domestic accounts receivable.
(7 marks)
(d) Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge
the foreign account payable. (8 marks)
(25 marks)
5 [P.T.O.
6
Formulae Sheet
Economic order quantity
Miller – Orr Model
The Capital Asset Pricing Model
The asset beta formula
The Growth Model
Gordon’s growth approximation
The weighted average cost of capital
The Fisher formula
Purchasing power parity and interest rate parity
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7 [P.T.O.
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Present value cf 1 i.e. (1 + U)
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Where r ~ cisccunt rate
n ~ number cf periccs until payment
'LVFRXQW UDWH U
3HULRGV
(n) 1º 2º 3º 4º 5º 6º 7º 8º 9º 10º
1 0ă990 0ă980 0ă971 0ă962 0ă952 0ă943 0ă935 0ă926 0ă917 0ă909 1
2 0ă980 0ă961 0ă943 0ă925 0ă907 0ă890 0ă873 0ă857 0ă842 0ă826 2
3 0ă971 0ă942 0ă915 0ă889 0ă864 0ă840 0ă816 0ă794 0ă772 0ă751 3
4 0ă961 0ă924 0ă888 0ă855 0ă823 0ă792 0ă763 0ă735 0ă708 0ă683 4
5 0ă951 0ă906 0ă863 0ă822 0ă784 0ă747 0ă713 0ă681 0ă650 0ă621 5
6 0ă942 0ă888 0ă837 0ă790 0ă746 0ă705 0ă666 0ă630 0ă596 0ă564 6
7 0ă933 0ă871 0ă813 0ă760 0ă711 0ă665 0ă623 0ă583 0ă547 0ă513 7
8 0ă923 0ă853 0ă789 0ă731 0ă677 0ă627 0ă582 0ă540 0ă502 0ă467 8
9 0ă914 0ă837 0ă766 0ă703 0ă645 0ă592 0ă544 0ă500 0ă460 0ă424 9
10 0ă905 0ă820 0ă744 0ă676 0ă614 0ă558 0ă508 0ă463 0ă422 0ă386 10
11 0ă896 0ă804 0ă722 0ă650 0ă585 0ă527 0ă475 0ă429 0ă388 0ă350 11
12 0ă887 0ă788 0ă701 0ă625 0ă557 0ă497 0ă444 0ă397 0ă356 0ă319 12
13 0ă879 0ă773 0ă681 0ă601 0ă530 0ă469 0ă415 0ă368 0ă326 0ă290 13
14 0ă870 0ă758 0ă661 0ă577 0ă505 0ă442 0ă388 0ă340 0ă299 0ă263 14
15 0ă861 0ă743 0ă642 0ă555 0ă481 0ă417 0ă362 0ă315 0ă275 0ă239 15
(n) 11º 12º 13º 14º 15º 16º 17º 18º 19º 20º
1 0ă901 0ă893 0ă885 0ă877 0ă870 0ă862 0ă855 0ă847 0ă840 0ă833 1
2 0ă812 0ă797 0ă783 0ă769 0ă756 0ă743 0ă731 0ă718 0ă706 0ă694 2
3 0ă731 0ă712 0ă693 0ă675 0ă658 0ă641 0ă624 0ă609 0ă593 0ă579 3
4 0ă659 0ă636 0ă613 0ă592 0ă572 0ă552 0ă534 0ă516 0ă499 0ă482 4
5 0ă593 0ă567 0ă543 0ă519 0ă497 0ă476 0ă456 0ă437 0ă419 0ă402 5
6 0ă535 0ă507 0ă480 0ă456 0ă432 0ă410 0ă390 0ă370 0ă352 0ă335 6
7 0ă482 0ă452 0ă425 0ă400 0ă376 0ă354 0ă333 0ă314 0ă296 0ă279 7
8 0ă434 0ă404 0ă376 0ă351 0ă327 0ă305 0ă285 0ă266 0ă249 0ă233 8
9 0ă391 0ă361 0ă333 0ă308 0ă284 0ă263 0ă243 0ă225 0ă209 0ă194 9
10 0ă352 0ă322 0ă295 0ă270 0ă247 0ă227 0ă208 0ă191 0ă176 0ă162 10
11 0ă317 0ă287 0ă261 0ă237 0ă215 0ă195 0ă178 0ă162 0ă148 0ă135 11
12 0ă286 0ă257 0ă231 0ă208 0ă187 0ă168 0ă152 0ă137 0ă124 0ă112 12
13 0ă258 0ă229 0ă204 0ă182 0ă163 0ă145 0ă130 0ă116 0ă104 0ă093 13
14 0ă232 0ă205 0ă181 0ă160 0ă141 0ă125 0ă111 0ă099 0ă088 0ă078 14
15 0ă209 0ă183 0ă160 0ă140 0ă123 0ă108 0ă095 0ă084 0ă074 0ă065 15
8
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Where r ~ cisccunt rate
n ~ number cf periccs
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3HULRGV
(n) 1º 2º 3º 4º 5º 6º 7º 8º 9º 10º
1 0ă990 0ă980 0ă971 0ă962 0ă952 0ă943 0ă935 0ă926 0ă917 0ă909 1
2 1ă970 1ă942 1ă913 1ă886 1ă859 1ă833 1ă808 1ă783 1ă759 1ă736 2
3 2ă941 2ă884 2ă829 2ă775 2ă723 2ă673 2ă624 2ă577 2ă531 2ă487 3
4 3ă902 3ă808 3ă717 3ă630 3ă546 3ă465 3ă387 3ă312 3ă240 3ă170 4
5 4ă853 4ă713 4ă580 4ă452 4ă329 4ă212 4ă100 3ă993 3ă890 3ă791 5
6 5ă795 5ă601 5ă417 5ă242 5ă076 4ă917 4ă767 4ă623 4ă486 4ă355 6
7 6ă728 6ă472 6ă230 6ă002 5ă786 5ă582 5ă389 5ă206 5ă033 4ă868 7
8 7ă652 7ă325 7ă020 6ă733 6ă463 6ă210 5ă971 5ă747 5ă535 5ă335 8
9 8ă566 8ă162 7ă786 7ă435 7ă108 6ă802 6ă515 6ă247 5ă995 5ă759 9
10 9ă471 8ă983 8ă530 8ă111 7ă722 7ă360 7ă024 6ă710 6ă418 6ă145 10
11 10ă37 9ă787 9ă253 8ă760 8ă306 7ă887 7ă499 7ă139 6ă805 6ă495 11
12 11ă26 10ă58 9ă954 9ă385 8ă863 8ă384 7ă943 7ă536 7ă161 6ă814 12
13 12ă13 11ă35 10ă63 9ă986 9ă394 8ă853 8ă358 7ă904 7ă487 7ă103 13
14 13ă00 12ă11 11ă30 10ă56 9ă899 9ă295 8ă745 8ă244 7ă786 7ă367 14
15 13ă87 12ă85 11ă94 11ă12 10ă38 9ă712 9ă108 8ă559 8ă061 7ă606 15
(n) 11º 12º 13º 14º 15º 16º 17º 18º 19º 20º
1 0ă901 0ă893 0ă885 0ă877 0ă870 0ă862 0ă855 0ă847 0ă840 0ă833 1
2 1ă713 1ă690 1ă668 1ă647 1ă626 1ă605 1ă585 1ă566 1ă547 1ă528 2
3 2ă444 2ă402 2ă361 2ă322 2ă283 2ă246 2ă210 2ă174 2ă140 2ă106 3
4 3ă102 3ă037 2ă974 2ă914 2ă855 2ă798 2ă743 2ă690 2ă639 2ă589 4
5 3ă696 3ă605 3ă517 3ă433 3ă352 3ă274 3ă199 3ă127 3ă058 2ă991 5
6 4ă231 4ă111 3ă998 3ă889 3ă784 3ă685 3ă589 3ă498 3ă410 3ă326 6
7 4ă712 4ă564 4ă423 4ă288 4ă160 4ă039 3ă922 3ă812 3ă706 3ă605 7
8 5ă146 4ă968 4ă799 4ă639 4ă487 4ă344 4ă207 4ă078 3ă954 3ă837 8
9 5ă537 5ă328 5ă132 4ă946 4ă772 4ă607 4ă451 4ă303 4ă163 4ă031 9
10 5ă889 5ă650 5ă426 5ă216 5ă019 4ă833 4ă659 4ă494 4ă339 4ă192 10
11 6ă207 5ă938 5ă687 5ă453 5ă234 5ă029 4ă836 4ă656 4ă486 4ă327 11
12 6ă492 6ă194 5ă918 5ă660 5ă421 5ă197 4ă988 4ă793 4ă611 4ă439 12
13 6ă750 6ă424 6ă122 5ă842 5ă583 5ă342 5ă118 4ă910 4ă715 4ă533 13
14 6ă982 6ă628 6ă302 6ă002 5ă724 5ă468 5ă229 5ă008 4ă802 4ă611 14
15 7ă191 6ă811 6ă462 6ă142 5ă847 5ă575 5ă324 5ă092 4ă876 4ă675 15
1 (1 ÷ U)
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End of Question Paper

(11 marks) (b) Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time. The current ordinary share price of Phobis Co is $4·45 and this is expected to grow at a rate of 6·5% per year for the foreseeable future. to Phobis Co. in comparison to the current market value of Danoca Co. which is shortly to pay its annual dividend. (iii) conversion premium. Both companies are stock-market listed and are in the same business sector. of the values you have calculated. 5 million $3·30 40·0c 60% 23·3c 22·0c 1·4 10 4·6% 10·6% (6 marks) (c) Distinguish between weak form. (ii) dividend growth model.ALL FOUR questions are compulsory and MUST be attempted 1 (a) Phobis Co is considering a bid for Danoca Co. (ii) floor value. semi-strong form and strong form stock market efficiency. and discuss the significance. Financial information on Danoca Co. is as follows: Number of ordinary shares Ordinary share price (ex div basis) Earnings per share Proposed payout ratio Dividend per share one year ago Dividend per share two years ago Equity beta Other relevant financial information Average sector price/earnings ratio Risk-free rate of return Return on the market Required: Calculate the value of Danoca Co using the following methods: (i) price/earnings ratio method. (8 marks) (25 marks) 2 . Phobis Co has a cost of debt of 7% per year. Required: Calculate the following current values for each $100 convertible bond: (i) market value. and discuss the significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong form efficient. Alternatively. each bond may be converted on that date into 20 ordinary shares of the company.

and describe how sensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisal (8 marks) process. The scrap value of the machine after four years would be $30.000 kg of Quago per year.000 per year in each subsequent year of operation. (25 marks) 3 [P. Forecast demand and production of Quago over the next four years is as follows: Year Demand (kg) 1 1·4 million 2 1·5 million 3 1·6 million 4 1·7 million Existing production capacity for Quago is limited to one million kilograms per year and the new machine would only be used for demand additional to this. consists of 80% equity and 20% debt. It has a cost of equity of 11% and a before-tax cost of debt of 8·6%. Other variable costs of production are $1·90 per kilogram.000. Required: (a) Calculate the net present value of buying the new machine and advise on the acceptability of the proposed purchase (work to the nearest $1. on a market-value basis. The long-term finance of the company.T. increasing by $20. . The current selling price of Quago is $8·00 per kilogram and the variable cost of materials is $5·00 per kilogram. (13 marks) (b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of the (4 marks) proposed purchase (work to the nearest $1. (c) Explain the difference between risk and uncertainty in the context of investment appraisal.000 in the first year of production. A new machine. could be bought for $800. with a useful life of four years and a maximum output of 600.000). A balancing allowance is claimed in the final year of operation. Duo Co uses its after-tax weighted average cost of capital when appraising investment projects.O. which is used in food processing.000. Fixed costs of production associated with the new machine would be $240. Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable depreciation) on a 25% reducing balance basis.2 Duo Co needs to increase production capacity to meet increasing demand for an existing product. payable immediately.000). ‘Quago’.

redeemable in three years’ time Total equity and non-current liabilities Average data on companies similar to Echo Co: Interest coverage ratio Long-term debt/equity (book value basis) 20 30 ––– 50 ––– 8 times 80% The board of Echo Co is considering several proposals that have been made by its finance director. (b) Evaluate and discuss Proposal B. (6 marks) (25 marks) 4 . Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk.3 The following financial information relates to Echo Co: Income statement information for the last year Profit before interest and tax Interest Profit before tax Income tax expense Profit for the period Dividends Retained profit for the period $m 12 3 ––– 9 3 ––– 6 2 ––– 4 ––– $m Balance sheet information as at the end of the last year $m Ordinary shares. Although there are no investment opportunities currently available. Proposal C A 1 for 4 rights issue should be made at a 20% discount to the current share price of $2·30 per share in order to reduce gearing and the financial risk of the company. Required: (a) Analyse and discuss Proposal A. Each proposal is independent of any other proposal. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ time at par. Proposal A The current dividend per share should be increased by 20% in order to make the company more attractive to equity investors. (5 marks) (7 marks) (c) Calculate the theoretical ex rights price per share and the amount of finance that would be raised under Proposal C. Proposal B A bond issue should be made in order to raise $15 million of new debt capital. the cash raised would be invested on a short-term basis until a suitable investment opportunity arose. par value 50c 5 Retained earnings 15 ––– Total equity 8% loan notes. (7 marks) (d) Discuss the attractions of operating leasing as a source of finance.

The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information: Inventory management The current policy is to order 100. The following information has been provided by the company’s bank: Spot rate ($ per €): Six months forward rate ($ per €): Money market rates available to PKA Co: One year euro interest rates: One year dollar interest rates: Borrowing 6·1% 4·0% Deposit 5·4% 3·5% 1·998 ± 0·002 1·979 ± 0·004 Assume that it is now 1 December and that PKA Co has no surplus cash at the present time. Accounts receivable management Domestic customers are allowed 30 days’ credit. Accounts payable management PKA Co has used a foreign supplier for the first time and must pay $250. Orders are received two weeks after being placed with the supplier.4 PKA Co is a European company that sells goods solely within Europe.000 units. The cost of placing and processing an order is €250. (3 marks) (b) Calculate the cost of the current ordering policy and determine the saving that could be made by using the (7 marks) economic order quantity model. . increased in the last financial year from 5% to 8%. Forecast demand to meet production requirements during the next year is 625. You should assume a 50-week year and that demand is constant throughout the year. (7 marks) (d) Evaluate whether a money market hedge.O.T. (25 marks) 5 [P. while the cost of holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant during the next year. a forward market hedge or a lead payment should be used to hedge (8 marks) the foreign account payable.000 units when the inventory level falls to 35. The financial manager also noted that bad debts as a percentage of sales.000 units. which are all on credit. but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. (c) Discuss ways in which PKA Co could improve the management of domestic accounts receivable.000 to the supplier in six months’ time. The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the currency risk of this account payable. Required: (a) Identify the objectives of working capital management and discuss the conflict that may arise between them.

Formulae Sheet Economic order quantity 2CoD n CH = Miller – Orr Model Return point = Lower limit + ( 1 × spread) 3 1 ⎡ 3 × transaction cost × variance of cash flows ⎤ 3 ⎥ Spread = 3 ⎢ 4 ⎢ ⎥ interest rate ⎣ ⎦ The Capital Asset Pricing Model E ri = Rf + βi E rm – Rf () (( ) ) ( The asset beta formula ⎡ ⎤ ⎡ ⎤ Vd 1 – T Ve ⎢ ⎥+⎢ βa = βe βd ⎥ ⎢ ⎥ ⎢ ⎥ Ve + Vd 1 – T Ve + Vd 1 – T ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ ( ( )) ( ( ) )) The Growth Model D0 1 + g Po = (r ( e –g ) ) Gordon’s growth approximation g = bre The weighted average cost of capital ⎡ V ⎤ ⎡ V ⎤ e d ⎥ ke + ⎢ ⎥k 1 – T WACC = ⎢ ⎢ Ve + Vd ⎥ ⎢ Ve + Vd ⎥ d ⎣ ⎦ ⎣ ⎦ ( ) The Fisher formula (1 + i) = (1 + r ) (1 + h) Purchasing power parity and interest rate parity S1 = S0 × (1 + h ) (1 + h ) c b F0 = S0 × (1 + i ) (1 + i ) c b 6 .

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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         End of Question Paper 8 .

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