Symbiosis College of Arts and Commerce,

(An Autonomous College under SPPU)

Title of the examination S.Y. B.Com ( Accounting and Finance)

Title of paper Advanced Financial Accounting.

Semester IV

Subject code

Date of examination

Paper set number Set 1

Name of the paper setter Monica Parikh

Section A:

1. A – 20.39
2. B - Business risk is assumed to be constant as the capital structure changes.
3. C - $85,479
4. A – Translation
5. C - $5.40
6. C – II and IV
7. D – 103 days
8. D- 3 times
9. D- maximisation of market share
10. D – I, III and IV
11. D- $218.75
12. D -$400 benefit
13. B - $4,981
14. D - $1.92
15. A-31%

Section B:

16. (a) B- 65 days

(b) A – 52 days
(c) B- 84 days
(d) D- 112 days
(e) C- both I and II

17. (a) B- 474,608CC

(b) C- Interest rate parity
(c ) D - 479,874 CC
(d) C- Both I and II
(e ) A – 14%

18. (a) C- $391,0000

(b) 8.9 %
(c ) C- 44%
(d) D – neither I nor II
(e ) D- neither I nor II
19. Delta :
c) Capital rationing can be divided into hard capital rationing, which is externally imposed, or soft
capital rationing, which is internally imposed.

Soft capital rationing:

Investment capital may be limited internally because a company does not want to take on a
commitment to increased fixed interest payments, for example, if it expects future profitability to be
poor. A company may wish to avoid diluting existing earnings per share or changing existing patterns
of ownership and control by issuing new equity. A company may limit investment funds because it
wishes to pursue controlled growth rather than rapid growth. Given the uncertainty associated with
forecasting future cash flows, a company may limit investment funds in order to create an internal
market where investment projects compete for finance, with only the best investment projects being
granted approval.

Hard capital rationing

External reasons for capital rationing can be related to risk and to availability of finance. Providers of
finance may see a company as too risky to invest in, perhaps because it is highly geared or because it
has a poor record or poor prospects in terms of profitability or cash flow. Long-term finance for capital
investment may have limited availability because of the poor economic state of the economy, or
because there is a banking crisis.

(d) The risk of an investment project could be assessed by using probability analysis or by using the
capital asset pricing model (CAPM).

Probability analysis

Project risk can be assessed or quantified by attaching probabilities to expected investment project
outcomes. At an overall level, this could be as simple as attaching probabilities to two or more
expected scenarios, for example, associated with different economic states. Key project variables
might then take different values depending on the economic state.

At the level of individual project variables, probability distributions of values could be found through
expert analysis, and the probability distributions and relationships between variables then built into a
simulation model. This model could then be used to generate a probability distribution of expected
project outcomes in terms of net present values. Project risk could then be measured by the standard
deviation of the expected net present value.

CAPM

The systematic business risk of an investment project can be assessed by identifying a proxy
company in a similar line of business. The equity beta of the proxy company can then be ungeared to
give the asset beta of the company, which reflects systematic business risk alone as the effect of the
systematic financial risk of the proxy company is removed by the ungearing process. The asset beta
can then be regeared to reflect the systematic financial risk of the investing company, giving an equity
beta which reflects the systematic risk of the investment project.

20. Gamma

b) Since the investment project is different to business operations, its business risk is different to that
of existing operations. A cost of equity for appraising it can be therefore be found using the capital
asset pricing model.

Ungearing proxy company equity beta

Asset beta = 1.2 × 54/(54 + (12 × 0.8)) = 1.2 × 54/63.6 = 1.019

Regearing asset beta

Market value of debt = $15m (calculated in part (a))

Regeared asset beta = 1.019 × (75 + (15 × 0.8))/75 = 1.019 × 87/75 = 1.182

Using the CAPM Equity or market risk premium = 11 – 4 = 7%

Cost of equity = 4 + (1.182 × 7) = 4 + 8.3 = 12.3%

(c) Portfolio theory suggests that the total risk of a portfolio of investments can be reduced by
diversifying the investments held in the portfolio, e.g. by investing capital in a number of different
shares rather than buying shares in only one or two companies.

Even when a portfolio has been well-diversified over a number of different investments, there is a
limit to the risk-reduction effect, so that there is a level of risk which cannot be diversified away. This
undiversifiable risk is the risk of the financial system as a whole, and so is referred to as systematic
risk or market risk. Diversifiable risk, which is the element of total risk which can be reduced or
minimised by portfolio diversification, is referred to as unsystematic risk or specific risk, since it relates
to individual or specific companies rather than to the financial system as a whole.

Portfolio theory is concerned with total risk, which is the sum of systematic risk and unsystematic risk.
The capital asset pricing model assumes that investors hold diversified portfolios, and so is concerned
with systematic risk alone.

d) Capital market efficiency is concerned with pricing efficiency when weak form, semistrong form and
strong form efficiency are being discussed.

In relation to pricing efficiency, the efficient markets hypothesis (EMH) suggests that share prices
fully and fairly reflect all relevant and available information. Relevant and available information can be
divided into past information, public information and private information.

Significance of EMH to financial managers

If the EMH is correct and share prices are fair, there is no point in financial managers seeking to
mislead the capital market, because such attempts will be unsuccessful. Window-dressing financial
statements, for example, in order to show a company’s performance and position in a favourable light,
will be seen through by financial analysts as the capital market digests the financial statement
information in pricing the company’s shares.

Another consequence of the EMH for financial managers is that there is no particular time which is
best for issuing new shares, as share prices on the stock market are always fair.

Because share prices are always fair, there are no bargains to be found on the stock market, i.e.
companies whose shares are undervalued. An acquisition strategy which seeks to identify and exploit
such stock market bargains is pointless if the EMH is correct.

It should be noted, however, that if real-world capital markets are semi-strong form efficient rather
than strong form efficient, insider information may undermine the strength of the points made above.
For example, a company which is valued fairly by the stock market may be undervalued or overvalued
if private or insider information is taken into account.