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Answer Paper

ADVANCED FINANCIAL MANAGEMENT Duration: 75

Details: Test 1 [CH-1, 3 and 8] Marks: 40

Instructions:

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 In case of multiple choice questions, mention option number only Working notes are
compulsory wherever required in support of your solution
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your performance.

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Ans 1 (a) Sensitivity to Sales Price: Let the sale price per unit be "S" so that the project
breaks even with an NPV of 0.

₹ 50,00,000 = [2,00,000 (S - ₹ 16.50) - ₹ 10,00,000+ x ,PVIAF- (12%, 5)

₹ 50,00,000 = [2,00,000S - ₹ 33,00,000 - ₹ 10,00,000+ x 3.605

₹ 50,00,000 = [2,00,000S - ₹ 43,00,000+ x 3.605

₹ 13,86,963 = 2,00,000S - ₹ 43,00,000

₹ 56,86,963 = 2,00,000S

S = ₹ 28.43

This represents a fall of (30 - 28.43) / 30 or 5.23% in NPV if the selling price per unit
decreases by 5%.

(b) Sensitivity to Sales Volume: Let "V" be the sales volume per year required to break even
with an NPV of 0.

₹ 50,00,000 = *V x (₹ 30 - ₹ 16.50) - ₹ 10,00,000+ x ,PVIAF- (12%, 5)

₹ 50,00,000 = *V x ₹ 13.50 - ₹ 10,00,000+ x ,PVIAF- (12%, 5)

₹ 50,00,000 = *₹ 13.50V - ₹ 10,00,000+ x 3.605

₹ 13,86,963 = ₹ 13.50V - ₹ 10,00,000

₹ 23,86,963 = ₹ 13.50V

V = ₹ 1,76,812

This represents a fall of (2,00,000 - 1,76,812) / 2,00,000 or 11.59% in NPV if the expected
sales volume decreases by 10%.

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(c) Sensitivity to Variable Costs: Let "VC" be the variable cost per unit required to break
even with an NPV of 0.

₹ 50,00,000 = *2,00,000 x (₹ 30 - VC) - ₹ 10,00,000+ x ,PVIAF- (12%, 5)

₹ 50,00,000 = *₹ 60,00,000 - 2,00,000VC - ₹ 10,00,000+ x ,PVIAF- (12%, 5)

₹ 50,00,000 = *₹ 50,00,000 - 2,00,000VC] x 3.605

₹ 13,86,963 = ₹ 50,00,000 - 2,00,000VC

₹ 36,13,037 = 2,00,000VC

VC = ₹ 18.07

This represents a fall of (18.07 - 16.50) / 16.50 or 9.51% in NPV if variable costs per unit
increase by 10%.

(d) Sensitivity with Economic States: To calculate the expected NPV considering economic
states, we first find the expected sales volume and then determine the NPV.

Expected Sales Volume: Expected Sales Volume = (1,75,000 x 0.30) + (2,00,000 x 0.60) +
(2,25,000 x 0.10)

= 1,95,000 units

Now, calculate the expected NPV: Expected NPV = *1,95,000 x ₹ 13.50 - ₹ 10,00,000+ x
{PVIAF} (12%, 5 = 3.605) - ₹ 50,00,000 = ₹ 8,85,163

Further NPV in the worst and best cases:

Worst Case: NPV (Worst Case = *1,75,000 x ₹ 13.50 - ₹ 10,00,000+ x ,PVIAF- (12%, 5= 3.605) -
₹ 50,00,000 = - ₹ 88,188

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Best Case: NPV (Best Case = *2,25,000 x ₹ 13.50 - ₹ 10,00,000+ x ,PVIAF- (12%, 5= 3.605) - ₹
50,00,000 = ₹ 23,45,188

Considering the 20% acceptable level of risk, since there are 30% chances of negative NPV
and 70% chances of positive NPV, the project should not be accepted.

Conclusion: In conclusion, while the project has a positive expected NPV under normal
conditions, the sensitivity analysis reveals that it is highly sensitive to changes in sales price,
sales volume, and variable costs. Additionally, considering the uncertainty in economic
states, the project's overall risk exceeds the company's acceptable level. Therefore, it is not
advisable for Vikram Enterprises Ltd. to proceed with this project.

(8 marks)

Ans 2 Strategic Financial Management vs. Traditional Financial Management: Strategic

financial management and traditional financial management diverge notably due to their
orientations and approaches within the context of a dynamic business landscape. While
traditional financial management primarily deals with historical data and financial reporting,
strategic financial management adopts a forward-looking stance that aligns financial
decisions with broader organizational strategies.

(1 mark)

Core Functions of Strategic Financial Management

1. Continuous Opportunity Search: Strategic financial management involves an incessant

quest for investment opportunities that offer optimal returns while accounting for the
inherent risks. This proactive search acknowledges that in a rapidly changing environment,
markets evolve, and new avenues emerge, demanding adaptability and agility.

(1 mark)

2. Risk-Adjusted Opportunity Selection: Unlike conventional financial management,

strategic financial management emphasizes not only selecting profitable opportunities but

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also evaluating them in relation to risk. Decision-makers must weigh potential returns
against risks, ensuring that chosen ventures align with the organization's risk appetite.

(1 mark)

3. Optimal Resource Allocation: A crucial facet is determining the optimal mix of equity and
debt financing for various opportunities. This function recognizes that amidst uncertainties,
the balance between internal and external funds significantly impacts an organization's
financial stability and growth prospects.

(1 mark)

Significance in Corporate Decision-Making: Strategic financial management's departure

from tradition and its core functions hold immense importance in corporate decisions. In a
volatile business environment, it ensures the organization's adaptability to changing
circumstances by proactively identifying and capitalizing on opportunities. By considering
risk alongside returns, it promotes prudent decision-making and safeguards against
potential setbacks. Moreover, by optimizing resource allocation, it enables efficient capital
utilization for sustainable growth.

(1 mark)

In essence, the shift towards strategic financial management represents a paradigm change,
enabling organizations to navigate uncertainties while pursuing growth opportunities. Its
core functions empower decision-makers to address complexities and capitalize on market
dynamics for long-term success.

Ans 3 (a) Total Income Available for Distribution:

- Income from April: ₹22.950 lakh (0.0765 Per unit)

- Add: Dividend equalization collected on issue: ₹0.459 lakh (0.0765 Per unit)

- Add: Income from May: ₹34.425 lakh

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- Add: Income from June: ₹45.450 lakh

- Less: Dividend equalization paid on repurchase: ₹0.567 lakh (0.1890 Per unit)

- Less: Dividend Paid: ₹71.9019 lakh (70% of 102.717)

Total Income After Distribution: ₹30.8151 lakh

(b): Issue Price at the end of April:

- Opening NAV: ₹18.75

- Add: Entry Load (2% of ₹18.75): ₹0.375

- Add: Dividend Equalization paid on Issue Price: ₹0.0765

Issue Price at the end of April: ₹19.2015

(c): Repurchase Price at the end of May:

- Opening NAV: ₹18.75

- Less: Exit Load (2% of ₹18.75): ₹0.375

- Add: Dividend Equalization paid on Issue Price: ₹0.1890

Repurchase Price at the end of May: ₹18.564

(d): Closing NAV as of June 30th:

- Opening Net Asset Value (₹18.75 multiplied by 300 Lakh units): ₹5625 Lakh

- Portfolio Value Appreciation: ₹425.47 lakh

- Issue of Fresh Units (6 Lakh units multiplied by ₹19.2015): ₹115.2090 lakh

- Income Received (₹22.950 lakh + ₹34.425 lakh + ₹45.450 lakh): ₹102.8250

- Less: Units repurchased (3 Lakh units multiplied by ₹18.564): -₹55.692 lakh

- Income Distributed: -₹71.9019 lakh

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Closing Net Asset Value: ₹6140.9101 Lakh

Closing Units (300 + 6 – 3 Lakh units): 303 Lakh units

Hence, the closing Net Asset Value (NAV) as of June 30th is ₹20.2670 per unit.

(6 marks)

Ans 4 (i) Calculation of NPV for Project X:

Year-end Cash Certainty Adjusted Cash Present Value Total

Flow (₹) Equivalent (CE) Flow (₹) Factor at 7% Present
Value (₹)
1 ₹3,50,000 0.9 ₹3,15,000 0.9346 ₹2,94,399
2 ₹4,00,000 0.85 ₹3,40,000 0.8734 ₹2,96,956
3 ₹4,50,000 0.8 ₹3,60,000 0.8163 ₹2,93,868

Initial Investment: -₹12,00,000

Net Present Value (NPV) of Project X = ₹(2,94,399 + 2,96,960 + 2,93,868 - 12,00,000) =

₹(3,14,773)

(ii) Calculation of NPV for Project Y:

Year-end Cash Flow (₹) Certainty Equivalent (CE) Adjusted Cash Flow (₹) Present Value
Factor at 7% Total Present Value (₹)

Year-end Cash Certainty Adjusted Cash Present Value Total

Flow (₹) Equivalent (CE) Flow (₹) Factor at 7% Present
Value (₹)
1 ₹3,00,000 0.95 ₹2,85,000 0.9346 ₹2,66,361
2 ₹4,20,000 0.88 ₹3,69,600 0.8734 ₹3,22,809

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3 ₹5,00,000 0.78 ₹3,90,000 0.8163 ₹3,18,357

Initial Investment: -₹11,50,000

Net Present Value (NPV) of Project Y = ₹(₹2,66,361+ ₹3,22,809+ ₹3,18,357- 11,50,000) =

₹(2,42,473)

(iii) RADR Calculation:

The RADR is calculated using the risk-free rate as a base, adjusted for the risk of the project.
Higher-risk projects will have a higher RADR.

- RADR for Project X = Risk-Free Rate + Risk Premium = 7% + 7% = 14%

For Project Y:

- RADR for Project Y = Risk-Free Rate + Risk Premium = 7% + 6% = 13%

Based on RADR, Project X has a higher rate (14%) compared to Project Y (13%), indicating
that Project X is less risky.

(iii) Decision:

- Using the Certainty Equivalent approach, Project X has an NPV of ₹(3,14,773), and Project Y
has an NPV of ₹(2,42,473)

- Based on NPV, IPL should accept Project Y as it has a higher NPV.

- With the RADR method, Project X is appraised with a higher rate (14%) compared to
Project Y (13%), indicating that Project X is less risky.

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Hence, the choice of the project may differ based on the approach used, but overall, Project
Y appears to be the better choice based on NPV.

(6 marks)

Ans 5 (a) Number of days for which each investment was held

Growth Plus: From 1st August 2020 to 31st March 2021 = 243 days

Wealth Rise: From 15th October 2020 to 31st March 2021 = 168 days

Value Plus: From 3rd December 2020 to 31st March 2021 = 119 days

(b) Annualised Scheme Returns

Growth Plus:

Investment = ₹5,00,000

NAV at purchase = ₹25

Units purchased = 5,00,000/25 = 20,000 units

NAV as on 31st March 2021 = ₹33

Value as on 31st March 2021 = 20,000 units x ₹33 = ₹6,60,000

Dividend received = ₹1,00,000

Total Gain = (6,60,000 + 1,00,000) - 5,00,000 = ₹2,60,000

Annualised Return = (Total Gain/Investment) x (365/No. of days)

= (2,60,000/5,00,000) x (365/243) = 78.11%

Wealth Rise Return

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Investment = ₹10,00,000

NAV at purchase = ₹20

Units purchased = 10,00,000/20 = 50,000 units

NAV as on 31st March 2021 = ₹22

Value as on 31st March 2021 = 50,000 units x ₹22 = ₹11,00,000

Dividend received = ₹40,000

Total Gain = (11,00,000 + 40,000) - 10,00,000 = ₹1,40,000

Annualised Return = (Total Gain/Investment) x (365/No. of days)

= (1,40,000/10,00,000) x (365/168) = 30.42%

Value Plus Return

Investment = ₹7,00,000

NAV at purchase = ₹18

Units purchased = 7,00,000/18 = 38,889 units

NAV as on 31st March 2021 = ₹24

Value as on 31st March 2021 = 38,889 units x ₹24 = ₹9,33,336

Total Gain = 9,33,336 - 7,00,000 = ₹2,33,336

Annualised Return = (Total Gain/Investment) x (365/No. of days)

= (2,33,336/7,00,000) x (365/119) = 102.24%

(c) Sharpe Ratio

Sharpe Ratio = (Scheme Return - Risk Free Rate)/Scheme Standard Deviation

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Growth Plus:

Scheme Return = 78.11%

Risk Free Rate = 5%

∴ Sharpe Ratio = (78.11% - 5%)/24= 3.05

Similarly, Sharpe Ratios for other schemes are:

Wealth Rise -

Scheme Return = 27.65%

Risk Free Rate = 5%

∴ Sharpe Ratio = (27.65% - 5%)/30 = 0.75

Value Plus - 1.12

Scheme Return = 102.24%

Risk Free Rate = 5%

∴ Sharpe Ratio = (102.24% - 5%)/40 = 2.431

(d) Treynor Ratio

Treynor Ratio = (Scheme Return - Risk Free Rate)/Scheme Beta

Using scheme returns, risk free rate and betas:

Growth Plus - (78.11% - 5%)/1.2 = 60.92

Wealth Rise - (27.65% - 5%)/1.5 = 15.1

Value Plus - (102.24% - 5%)/2.0 = 48.62

Therefore, the detailed solution covers all required aspects.

(6 marks)

CATESTSERIES.ORG
Ans 6 The key decisions falling within the scope of financial strategy are the following:

1. Financing decisions: These decisions deal with the mode of financing or mix of equity
capital and debt capital.

2. Investment decisions: These decisions involve the profitable utilization of firm's funds
especially in long-term projects (capital projects). Since the future benefits associated with
such projects are not known with certainty, investment decisions necessarily involve risk.
The projects are therefore evaluated in relation to their expected return and risk.

3. Dividend decisions: These decisions determine the division of earnings between

payments to shareholders and reinvestment in the company.

4. Portfolio decisions: These decisions involve evaluation of investments based on their

contribution to the aggregate performance of the entire corporation rather than on the
isolated characteristics of the investments themselves.

(4 marks)

MCQs

1. Answer: C. The expected monetary value (EMV) of the pilot project's success outweighs
the EMV of failure.

In the decision tree analysis, Rama Swamy evaluates different alternatives at decision nodes
and assigns probabilities and values to chance nodes to determine the expected monetary
value (EMV) associated with each alternative. In this case, Rama Swamy evaluates the
options at each decision point and determines the EMV at outcome points.

At Decision Point C, where the commercial launch succeeds, the EMV of investing ₹2 million
for a perpetual annual net after-tax cash income of ₹400,000 is calculated to be ₹10 million,
which is higher than not investing and receiving ₹0. Therefore, the preferred choice at this
decision point is to invest.

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At Decision Point D, where the commercial launch fails, the EMV of investing ₹1.2 million for
a perpetual annual net after-tax cash income of ₹100,000 is calculated to be a negative
value, indicating that not investing is the preferred choice.

At Outcome Point B, Rama Swamy evaluates the EMV based on the probability-weighted
outcomes of success and failure. The EMV of success is ₹10 million (0.50 probability), and
the EMV of failure is ₹0 (0.50 probability), resulting in an EMV of ₹10 million.

Since the EMV of success (₹10 million) outweighs the EMV of failure (₹0), the preferred
choice at the initial decision point (A) is to invest ₹240,000 in the pilot project.

Option A is incorrect because the decision tree analysis doesn't necessarily indicate a certain
positive outcome; it considers probabilities and values to determine the most favorable
option.

Option B is incorrect because the comparison between annual cash flows and the initial
investment is not the sole criterion for decision-making in the decision tree analysis.

Option D is incorrect because the discount rate affects the present value calculations but
isn't the sole reason for Rama Swamy's preference in this scenario. The EMV comparison of
outcomes is the primary factor influencing her decision.

2. Answer: C) 2.8%

The expense ratio is the percentage of the assets spent to run a mutual fund. In this case,
the expense ratio of Scheme B is 2.8%, as mentioned. Rahul is considering the impact of the
expense ratio on the performance of the mutual fund schemes, which is a crucial factor to
consider while making investment decisions.

3. Answer: B) The company will have to rely heavily on equity issuance to support its
growth, potentially diluting existing shareholders' ownership.

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Reason: The passage discusses the sustainable growth rate (SGR) as the maximum rate of
growth in sales that a firm can achieve while maintaining its financial ratios, profitability,
and asset utilization. If a company exceeds its SGR, it implies that its growth is outpacing its
sustainable financial capacity, and additional financing is required. "either additional equity
must be raised, or the borrower will have to reduce the rate of expansion." Option B
accurately reflects this implication by stating that the company will have to rely heavily on
equity issuance, potentially leading to dilution of existing shareholders' ownership. This
aligns with the concept of financing growth beyond the sustainable capacity through equity
issuance.

4. Answer: C) Thematic Fund

A Thematic Fund is a mutual fund scheme that focuses on broader themes, sectors, or
trends that are likely to result in out-performance by certain segments of the market. Unlike
sector funds that are highly concentrated in a single industry, thematic funds have a broader
outlook and allow investors like Sneha to capitalize on specific investment themes. Given
Sneha's experience and her desire to take advantage of potential market trends, a thematic
fund would align well with her investment preferences.

5. Answer: C) The actual net cash flow stream after deflating for inflation will be lower due
to reduced profitability.

Inflation impacts capital budgeting decisions in various ways. In this scenario, considering an
inflation rate of 8% per year, the nominal revenues and costs will increase over time.
However, the actual purchasing power of these cash flows will be lower due to inflation.
Specifically, nominal revenues and costs will increase, but the real value of the net cash
flows (after deflating for inflation) will decrease.

Let's break down the calculations:

- Initial outlay: ₹100,000

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- Annual revenues (nominal): Year 1 = ₹80,000, Year 2 = ₹80,000 (1 + 0.08) = ₹86,400, and
so on.

- Annual costs (nominal): Year 1 = ₹30,000, Year 2 = ₹30,000 (1 + 0.08) = ₹32,400, and so on.

- Depreciation remains the same since it's based on historical costs.

- Taxable profit changes due to inflation's impact on revenues and costs.

- Actual net cash flows (real) are calculated by subtracting the inflation rate from the
nominal cash flows.

As a result, the real net cash flows after deflating for inflation will be lower than the net
cash flows without considering inflation, leading to reduced profitability. This aligns with
option C.

(5 x 1 = 5 Marks)

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