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Birla Institute of Technology & Science, Pilani Hyderabad Campus

II Semester 2018-19
Comprehensive Examination (Closed Book)
Course No.: ECON F315 Marks: 40. Date: 01-05-2019
Course Title: Financial Management Duration: 3 Hrs.
Instructions: Write all parts of an answer at one place and in sequence

Q:1/ Stockholders can transfer wealth from bondholders through a variety of actions. How
would the following actions by stockholders transfer wealth from bondholders?

a. An increase in dividends
b. A leveraged buyout
c. Acquiring a risky business

How would bondholders protect themselves against these actions? [3.00]


Answer:
(a) An increase in dividends: Make existing debt riskier and reduce its value. Bondholders can
protect themselves by constraining dividend policy.
(b) A leveraged buyout: If the existing debt is not refinanced at the “new” interest rate, existing
bondholders will find the value of their holdings are lower after the LBO. Bondholders can
protect themselves by inserting protective puts into their debt, allowing them to put the bonds
back to the firm and receive face value.
(c) Acquiring a risky business: If a risky business is acquired, existing bondholders may find
themselves worse off since the underlying debt is now riskier. Bondholders can protect
themselves by restricting investment policy.

Q:2/ How can credit scores be considered as alternative to bond ratings? [3.00]

Answer:

Bond ratings are a tool that we use to measure default risk and arrive at a cost of debt.
Lenders (such as banks) have historically used credit scores as a measure of default risk,
especially when lending to individuals and private businesses. A credit score is derived
by measuring how a borrower scores on a variety of measures, which over time have
been correlated with default risk.

Q:3/ Provide an answer to the following question:


If high-dividend stocks offer a higher expected (and required) return than low-dividend
stocks due to higher personal taxes levied on the former, why don’t corporations simply
reduce dividend payments and thus lower their cost of capital?” [3.00]

Answer:

If the cause and effect were this simple – and this was the only factor – then firms could
reduce dividend payments to lower their cost of capital. In reality, the relationship is
more complex. First, using return on equity x retention ratio as an approximation of
growth, lower dividend pay-outs means higher retention and higher growth. A higher
growth means a higher, not a lower cost of capital. If firms reduced their dividend they
would need positive net present value projects to invest in to satisfy investors. If they
took the reduced dividend and invested in treasury securities (negative net present
value investment for the corporation), then shareholders would sell their shares and
invest in a value-maximizing firm.

Q:4/ Explain the determinants of Dividends versus Stock Buybacks. [3.00]

ANSWER:
In a general framework, firms will consider the following in deciding how to return cash to
stockholders.

1. how much of a signal they want to send with their decision; dividends tend to send a stronger
signal because they imply a commitment for future periods.

2. how much the firm values flexibility; the greater the value of flexibility to a firm, the more
inclined it will be to buy back stock.

3. how much of a tax burden dividends will create for stockholders; this will depend upon the
type of stockholders that the firm, and how they are taxed on dividends and capital gains.

Q:5/ Given below is the summary table for calculation of operating cycle for ABC Limited. (A year
is assumed to have 360 days).

Rs. In Lakhs
Data for the Previous Year
Opening Balance of
A Raw Materials, Stores and Spares etc. 4223
B Work-in-Process 63
C Finished Goods 700
D Accounts Receivable 986
E Accounts Payable 3625
Closing Balance of
A Raw Materials, Stores and Spares etc. 5598
B Work-in-Process 95
C Finished Goods 1265
D Accounts Receivable 1458
E Accounts Payable 3698
Purchase of Raw Material, stores, spares etc. 15896
Manufacturing Expenses 1300
Depreciation 365
Customs and Excise Duty on sales 45896
Selling, Administration and Financial 5647
Expenses
Sales 62354

Estimate the working capital requirements based on operating cycle. Consider other
details such as the firm sells 1, 75,00,000 units every year at the price of Rs 356.31.
Monthly sales equal 14, 58,333 units. Assuming 50% of manufacturing expenses incurred
in W-I-P. In the absence of information in respect of categorization of sales into cash and
credit components all sales are assumed to have been made on a credit basis.
[8.00]
Solution:
Solution:
Data for Previous Year Rs. In Lakhs

Opening Balance of Stage


A Raw Materials, Stores 4223
and Spares etc Raw Material Raw Material Storage Period
B Work-in-Process 63 Avg Stock of Raw Material 4,910.50
C Finished Goods 700 Annual consumption of RM 14,521.00
D Accounts Receivable 986 Avg daily consimp of RM 40.34
E Accounts Payable 3625 RM Storage Period 122.00

Closing Balance of
A Raw Materials, Stores 5598
and Spares etc WIP Average Conversion of WIP
B Work-in-Process 95 Avg stock of WIP 79.00
C Finished Goods 1265 Annual Cost of Prod 16,154.00
D Accounts Receivable 1458 Avg daily cost of prod 44.87
E Accounts Payable 3698 Avg conversion period 2.00

Purchase of Raw Material, 15896


stores, spares etc.
Finished Goods Finished Goods storage Period
Manufacturing Expenses 1300 Avg stock of finished goods 982.50
Annual cost of finished goods 67,132.00
Depreciation 365 Avg daily cost of finished goods 186.48
Finished Goods storage Period 5.00
Customs and Excise Duty 45896
Debtors ACP
Selling, Administration and 5647
Financial Expenses Average book debts 1,222.00
Annual sales 62,354.00
Sales 62354 Average daily sales 173.21
ACP 7.00
yearly monthly price/unit
Units sold 1,75,00,000.00 14,58,333.33 356.31 Creditors APP
Average bal of trade creditors 3,661.50
Annual purchases 15,896.00
Cost Schedule (Rs.) Annual Cost Monthly Cost Unit Cost Daily Purchases 44.16
APP 83.00
Raw Material 1,45,21,00,000.00 12,10,08,333.33 82.98
Manufacturing Expenses 16,33,00,000.00 1,36,08,333.33 9.33 Operating Cycle 53.00
Selling Admin and
Financial
expenses 5,15,43,00,000.00 42,95,25,000.00 294.53

Total Cost Rs. 386.84


Selling Price Rs. 356.31 800 400.00
Margin Rs. -30.53 per unit 80.00
120.00
Based on the above, investment in various current assets can be calculated:

Input Period (in months) RM WIP Finished Goods Debtors Total

Raw Material

In Stock 4.50 54,45,37,500.00


In WIP 0.07 80,67,222.22
In Finished Goods 0.17 2,01,68,055.56
In Debtors 0.23 2,82,35,277.78
60,10,08,055.56

Manufacturing Expenses
In WIP 0.03 4,53,611.11
In Finished Goods 0.17 22,68,055.56
In Debtors 0.23 31,75,277.78
58,96,944.44
Selling, Admin and Fin Exp
In Finished Goods 0.17 7,15,87,500.00
In Debtors 0.23 10,02,22,500.00
17,18,10,000.00
Profit
In Debtors 0.23 -1,03,89,166.67
-1,03,89,166.67

Total 54,45,37,500.00 85,20,833.33 9,40,23,611.11 12,12,43,888.89 76,83,25,833.33

76,83,25,833.33 0.00
Q:6/ You have been hired by Surya Corporation, a mid-size company which manufactures
luggage to assess their capital structure. You have been provided with the most recent
income statement and balance sheet for the company –
Income Statement (in Rs. million)
Revenue 100
(-)Cost of Goods Sold(Includes Depreciation of 10) 60
=EBIT 40
(-)Interest Expense 6
=Taxable Income 34
(-)Taxes 13.6
=Net Income 20.4

Balance Sheet (in Rs. million)


Assets Liabilities
Fixed Assets 100 Current Liabilities 20
Current Assets 40 Debt 60
Equity 60

The company had 10 million shares outstanding trading at Rs. 24 per share. Nearly 40%
of the outstanding stock is held by the founding family. You are also provided with the
following additional information –
▪ A regression of returns on the stock against a market index over the last 5 years
yields a beta of 0.90, but Surya had no debt for the first four out of the five years.
Its debt ratio in the fifth year was similar to its current debt ratio.
▪ The debt is 10-year bank debt; however, based on its interest coverage ratio the
firm would be rated AA and carry a market interest rate of 10%. The Treasury
bond rate is 8% and the market risk premium is 5.5%. The tax rate is 40%.
Answer the following questions based on the above information.
A. Estimate the current cost of equity for Surya Corporation. Assume the average
debt ratio of the period for unlevering the beta.
B. Estimate the current weighted average cost of capital for Surya Corporation
C. Assume now that Surya Corporation plans to double its debt ratio. The bond
rating is expected to drop to BBB, with a market interest rate of 11.5%. Estimate
the new cost of capital.
D. If Surya does decide to double its debt capacity immediately by buying back
stock, estimate the rupee debt it would need to borrow.
E. If Surya decides to double its debt ratio over the next 3 years, and plans to use the
new debt to finance new projects, estimate the total rupee debt that the firm will
have to issue over the next 3 years. (Surya pays no dividends)
F. Based upon the most recent financial data, would you suggest that Surya take
projects with the debt or return cash to stockholders. Explain. (You can assume
that the book value of equity was Rs.40 million at the beginning of the year, while
the book value of debt was Rs. 60 million)
[1+2+2+1+2+1=9.00]

Answer:
A. Unlevered Beta for Samson = 0.90/(1+(1-0.4)(.05)) = 0.873786408 !
Used the average debt/equity ratio over period)
New Levered Beta = 0.87(1+(1-.4)(.25)) = 1.0005

New Cost of Equity = 8% + 1(5.5%) = 13.50%


B. Cost of Capital = 13.50%(.8) + 10%(1-.4)(.2) = 12.00%

C. The debt ratio currently is 20%. Doubling the debt ratio will increase it to 40%.

New Levered Beta = 0.87(1+(1-.4)(40/60)) = 1.218

New Cost of Equity = 8% + 1.22(5.5%) = 14.71%

New Cost of Capital = 14.71%(0.6)+11.5%(1-.4)(0.4) = 11.59%

D. Value of Firm today = 240+60 = 300

Dollar Debt at 40% debt ratio = 0.4*300 = 120

Additional Debt needed = 120 - 60 = 60

E. Value of Equity in 3 years = 240(1.135)^3 = $351


This is probably understated. The beta will rise over time.
Dollar Debt in 3 years = (0.4/0.6) ($ 351) = $234.00

F. Return on Capital in most recent year = 40(1-.4)/100 = 24.00%

Note: use of D:E ratio will also be considered.


I used the book value at the beginning. If you decide to use averages, specify it here… The
firm is making a return on capital that is higher than the cost of capital. If it can continue
to do so, I would suggest it take projects
Q:7/ Samsung is currently operating at the 65% capacity utilization level with its sales pegged at
Rs 950 lakhs. As per its current credit policy the firm is offering a credit period of 20 days.
The average collection period for Samsung is 30 days. In view of increased competition that
has of late started to erode its bottom-line the firm's management has been contemplating
relaxing its credit terms. As per management's projections such a liberalization of firm's
credit policy is likely to boost its sales by 30%. However, since the proposed change is
likely to increase the average credit period for the firm by 30 days, one section of company
management is opposed to such a change proposed in the credit policy and is advocating a
status quo. The variable costs for the firm are 75% of the sales. Are you in favour of such a
change proposed in the firm's credit policy? Assume the opportunity cost of capital for
Samsung is 12%. [4.00]
Q:8/ You are in a world where there are only two assets, gold and stocks. You are interested
in investing your money in one, the other or both assets. Consequently, you collect the
following data on the returns on the two assets over the last six years.
Gold Stock
Market Average return 8% 20%
Standard deviation 25% 22%
Correlation -.4
A. If you were constrained to pick just one, which one would you choose and why?
B. A friend argues that this is wrong. He says that you are ignoring the big payoffs that
you can get on gold. How would you go about alleviating his concern?
C. How would a portfolio composed of equal proportions in gold and stocks do in
terms of mean and variance?
D. You now learn that GPEC (a cartel of gold-producing countries) is going to vary
the amount of gold it produces with stock prices in the US. (GPEC will produce less gold
when stock markets are up and more when it is down.) What effect will this
have on your portfolios? Explain. [4.00]

Answer:
a. You’d pick the stock market portfolio, since it dominates gold on both average return (with
a higher average) and standard deviation ( a lower value).
b. The higher possible returns on gold are balanced by the lower possible returns at other
times. Note that the average return on gold is much less than that on the stock market. Not
that your friend may be making a point (albeit in an indirect way about the dangers of the
mean variance framework and arguing that investors like big positive payoffs (skewness).

c. The expected return on this portfolio would be (8+20)/2 = 14%.


The variance would equal (0.5)2(25)2 + (0.5)2(22)2 + 2(0.5)(0.5)(25)(22)(-0.4) = 167.25;
the standard deviation equals 12.93%

d. If the supply of gold is negatively correlated with the level of the market, and the
price of gold is inversely related to the supply of gold, we have a positive correlation
between the return on the market and the return on gold. This would make gold less
desirable to diversified investors, since it does not help as much in reducing
portfolio variance. The optimal amount to invest in gold would drop.

Q:9/ You have just run a regression of monthly returns of American Airlines (AMR) against
the S&P 500 over the past five years. You have misplaced some of the output and
are trying to derive it from what you have.
A. You know the R2 of the regression is 0.36, and that your stock has a
variance of 67 percent. The market variance is 12 percent. What is the beta of
AMR?
B. You also remember that AMR was not a very good investment during the period
of the regression and that it did worse than expected (after adjusting for risk) by
0.39 percent a month for the five years of the regression. During this period, the
average risk-free rate was 4.84 percent. What was the intercept on the
regression?
C. You are comparing AMR to another firm that also has an R2 of 0.48. Will the two
firms have the same beta? If not, why not? [3.00]
Answer:
a. (b 2)(Var. of mkt)/Var. of stock = R2; hence the = 1.41
b. Intercept – (1- b)R f = 0.0039; the monthly riskfree rate is
computed as (1.0484)1/12 – 1 = 0.0039465 or 0.39465%.
Intercept = 0.0039 – (1-1.141)(.0039465) = .45%
c. The two firms need not have the same beta, if the extents to which their
relative stock price movements covariance with the market are different. If
AMR has a higher beta, then it will also have correspondingly a lower amount
of diversifiable firm-specific risk.