Question Paper Financial Management (MB211) : July 2006

Section A : Basic Concepts (30 Marks)
• • • • This section consists of questions with serial number 1 - 30. Answer all questions. Each question carries one mark. Maximum time for answering Section A is 30 Minutes.

1.

The objective of financial management is to (a) (b) (c) (d) (e) Maximize the revenues Minimize the expenses Maximize the return on investment Minimize the risk Maximize the wealth of the owners by increasing the value of the firm.

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2.

Mr. Sharma wishes to purchase a 91 day T-bill of face value Rs.100, maturing after 60 days. If, on maturity, he wishes to earn a yield of 11.5%, the purchase price of T-bill for Mr. Sharma should be (a) (b) (c) (d) (e) Rs.88.50 Rs.92.21 Rs.97.22 Rs.98.14 Rs.99.03.

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3.

If the return on a security lies below the security market line, (a) (b) (c) (d) (e) The security is conservative security The security is aggressive security The ris k free rate of return is more than the expected return from that security The security is over priced The security is under priced.

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4.

A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5 percent. What is the market risk premium? (a) (b) (c) (d) (e) 1.30% 6.30% 6.50% 7.25% 15.00%.

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1

the share price decreases. < Answer > 9. It can be applied to find out the amount to be invested periodically to liquidate a loan over a specified period at a given rate of interest. It is the inverse of the PVIF factor. (II). IV. (a) (b) (c) (d) (e) Only (I) above Only (III) above Both (II) and (III) above Both (II) and (IV) above All (I). As the number of securities in a portfolio increases. (III) and (IV) above. < Answer > 7. It generally entails lower cost of issue.5. 2 < Answer > . It involves the issue of securities to the existing shareholders at a price. It represents the amount that has to be invested at the end of every year for a period of ‘n’ years at the rate of interest ‘k’ in order to accumulate Re. It is generally made to high networth individuals. III. Which of the following statements is/are true regarding the capital recovery factor? I. if the rate of return is less than the cost of capital The dividend policy of the firm does not influence its value Irrespective of the rate of return and cost of capital the share price increases. (II) and (III) above. This proposition is based on (a) (b) (c) (d) (e) Net income approach on capital structure Net operating income approach on capital structure Traditional approach on capital structure Modigliani and Miller approach Merton Miller’s argument. which is generally lower than the current market price. The cost of debt remains more or less constant up to a certain degree of leverage but rises there after at an increasing rate. II. < Answer > 8. the share price decreases. II. (a) Only (II) above (b) (c) (d) (e) Only (III) above Both (II) and (III) above Both (I) and (III) above All (I). It involves the issue of securities to the existing shareholders and to the public simultaneously.1 at the end of the period. as the amount of dividend payout ratio increases The optimal dividend pay out ratio should be 100% to ma ximize the value of the firm. if the rate of return is greater than the cost of capital As the dividend payout ratio decreases. < Answer > 6. Which of the following can be inferred from the Miller and Modigliani model on dividend policy? (a) (b) (c) (d) (e) As the dividend payout ratio increases. (a) (b) (c) (d) (e) The portfolio variance increases The portfolio variance depends more on average covariance The portfolio variance depends more on average expected value The portfolio variance depends more on average variance The portfolio variance does not change. III. Which of following statements is/are true with respect to rights issue? I.

10 < Answer > 13. Current yield is equal to the coupon rate. < Answer > 11. Which of the following statements is/are true? I. II.000 units 3% Rs. the value of the firm will be maximized. The financing mix will be tilted towards equity.900 units 9. when (a) (b) (c) (d) (e) Pure debt is used Pure equity is used Debt and equity are used in equal proportion Debt-equity ratio is 2:1 Debt-equity ratio is 3:2. Risk of technical insolvency will be high. (a) (b) (c) (d) (e) Only (I) above Both (I) and (II) above Both (I) and (III) above Both (II) and (III) above All (I).000 units 9. the value of the bond is less than its par value. III.200 units 8. III. When the required rate of return (kd ) is greater than the coupon rate.10. The cost of financing will be high. Rs. Current yield is equal to the interest paid divided by the face value of the bond. (II) and (III) above. (a) (b) (c) (d) (e) Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above. < Answer > 3 . II. < Answer > 12. if the market price is equal to the face value of the bond.000 units 7.950 units.100 Rs. Consider the following data regarding a product: Total cost of ordering and carrying inventory Quantity per order Carrying cost as a percentage of the purchase price Fixed cost per order Purchase price The annual usage of the material is (a) (b) (c) (d) (e) 3. Which of the following statements is/are true regarding aggressive financing policy for current assets? I.870 1. In a world with corporate taxes but no possibility of firm’s financial distress.

Which of the following is not a relevant factor in cash management? (a) (b) (c) (d) (e) Prompt billing and mailing the same to the customers Branch wise collection of receivables Centralized purchases and payments to the suppliers Availing of term loans to the maximum possible limit Prompt depositing of the cheques received from customers in the bank.000 per year. III. II.66. < Answer > 17.48. II. Annual depreciation from the project is Rs. the cost of trade credit will be higher.40. It fails to provide a straightforward decision-making criterion.14.36. If the spread between credit period and cash discount period is greater.54. Which of the following statements is/are not true? I. If the material is priced at the value that is realizable at the time of issue. III.000 Rs. The weakness/es of the internal rate of return approach is/are that I.60.000 Rs. It cannot be a meaningful criterion for the projects with multiple internal rates of return. It does not directly consider the timing of the cash flows from a project. such pricing method is referred to as (a) (b) (c) (d) (e) Standard price method Replacement method LIFO method Weighted average cost method FIFO method. < Answer > 4 .000 and the firms’ tax rate is 40 percent.000 Rs. < Answer > 18. < Answer > 15. whose cash inflows and outflows are interspersed. If the spread between credit period and cash discount period is lower.30. < Answer > 16. An investment project is expected to generate earnings before taxes (EBT) of Rs. (a) (b) (c) (d) (e) Only (I) above Only (II) above Only (III) above Both (I) and (III) above Both (II) and (III) above. If the discount rate increases. the cost of trade credit decreases. the cost of trade credit will be higher.000.000 Rs. (a) (b) (c) (d) (e) Only (I) above Only (III) above Only (II) above Both (II) and (III) above Both (I) and (III) above. The project’s annual net cash flows are (a) (b) (c) (d) (e) Rs.

The business risk of the firm has a direct impact on the value of the firm. < Answer > 20. the cost of external equity is (a) (b) (c) (d) (e) More than the cost of existing equity capital Less than the cost of existing equity capital Equal to the cost of existing equity capital Equal to the cost of long-term debt Equal to the cost of short-term debt.82. < Answer > 23.84/£.82. < Answer > 5 . (a) (b) (c) (d) (e) Only (I) above Only (II) above Both (I) and (II) above Both (II) and (III) above All (I). Which of the following foreign exchange exposures refers to the impact on t e value of firms h operations due to unanticipated changes in the exchange rates? (a) (b) (c) (d) (e) Transformation exposure Transaction exposure Translation exposure Currency exposure Economic exposure. thus cost of equity capital cannot be constant.82.82/£ Rs. II./$ Spot 43. Exclusive financing by retained earnings makes the model suitable only for all equity firms.79/£ Rs. < Answer > 22. In case of high investments the return on investment will not be constant.86/£ Rs.82. Which of the following is/are the limitation(s) of Walter model on dividend policy? I.5285 /86 If an Indian importer requires pounds. Overtrading means (a) (b) (c) (d) (e) The firm has disproportionately high amount of working capital with respect to the level of sales The firm has disproportionately low amount of working capital with respect to the level of sales The firm has disproportionately high level of receivables with respect to total assets The firm has disproportionately high level of cash with respect to total assets The firm has been experiencing low turnover of working capital.19.78 / 79 £/$ 0. < Answer > 21. III. The rates available in the market are: Rs. (II) and (III) above. the rate quoted to him is (a) (b) (c) (d) (e) Rs. In the presence of floatation costs.72/£ Rs.82.

25% Libor + 0.7384/86 < Answer > The synthetic rates of US $/Euro are 1. < Answer > 25. covered foreign financing will result in an effective borrowing rate that is (a) (b) (c) (d) (e) Less than domestic interest rate Greater than domestic interest rate Equal to domestic interest rate Less than domestic interest rate if forward rate is in discount Negative.50% 6 .50 %.75 % 1. In a swap-out deal.00% 10. < Answer > 28. Following information is available for two firms: Firm Objective Sealine Floating rate Desert Fixed rate The quality spread is (a) (b) (c) (d) (e) 0.24.25 % 0. Fixed interest 9. The following are the exchange rates quoted in Singapore market: S$/Euro S$/US$ (a) (b) (c) (d) (e) : 2. If interest rate parity holds and the transaction costs are zero. the foreign currency is (a) (b) (c) (d) (e) Bought both spot and forward Sold both spot and forward Sold spot and bought forward Sold forward with different maturities Bought forward with different maturities.8639/42 3.0118/21 : 1.1571/74 0.8640/41 0.00% Floating interst Libor + 0. < Answer > 26.4977/79.1572/73 1.50 % 0. The system under which the exchange rates are determined by the demand and supply position for the currencies in the foreign exchange market is known as (a) (b) (c) (d) (e) Target zone arrangement system Crawling peg system Fixed exchange rate system Floating exchange rate system Currency board system. < Answer > 27.00 % 1.

96 per share.46. Marks are indicated against each question.) 5000 2000 1000 8000 < Answer > . < Answer > 30.00 Rs. A security analyst has projected the following information for the next year: Scenario Probability Projected share price Projected Dividend Projected market return You are required to a.20 Rs. The estimated costs per ingot are given below: Particulars Raw materials cost Manufacturing expenses Selling.46. Estimate the beta co-efficient for the equity shares of the company and state its implication.99.120 minutes on Section B.0. Which of the following is not a feature of futures contract? (a) (b) (c) (d) (e) Standard volume Liquidity Customized maturity Counterparty guarantee Intermediate cash flows. administration and financial expenses Total 7 Amount (Rs. An Indian exporter bought put option on dollar at Rs.50 by paying a premium of Rs.00 Rs. b. The company has recently paid a dividend of Rs. < Answer > END OF SECTION A Section B : Problems (50 Marks) • • • • • 1 This section consists of questions with serial number 1 – 5.10.. are presently trading at Rs. (TSL) is engaged in the manufacture of steel based products.3.05. Answer all questions.3.45 Rs.29.3.46.000 ingots during the year 2005-06 which will be sold at a price of Rs. It has planned to produce 6.46.110. a food processing company.75 Rs.00 15% Normal 40% Rs. (5 + 4 + 3 = 12 marks) Optimistic 30% Rs.50 Rs. Detailed workings should form part of your answer.00 12% Pessimistic 30% Rs.000 per ingot.105.4. < Answer > The equity shares of Specialty Foods Ltd.30. On the date of delivery if spot rate is Rs. c.46.47.00 Rs.00 per share. Find out the expected return and risk for the equity shares of the company. then the net amount realized per dollar will be (ignore time value of money) (a) (b) (c) (d) (e) Rs. Do not spend more than 110 .00 8% 2 Tuff Steel Ltd.46.75. Find out the expected return and risk for the market.

Project the cash flows related with the replacement decision.000 and the salvage value after six years will be Rs. the management of the company is considering to change the existing credit terms to 1/10. it sells 600. You are required to answer the following questions: a.Assessment of the last year’s operations indicates the following durations at the various stages of the operating cycle: Raw material stage Work-in-process stage Finished goods stage Debtors stage = = = = 2 1 1 3 months month month months It is assumed that production and sales will continue uniformly throughout the year. You are required to a.000. (4 + 4 + 2 = 10 marks) 4 Northern Transports Ltd.14 lakhs. (8 marks) 8 . TSL needs 10% of its gross current assets as cash.80 per unit and the variable cost to sales ratio is 70%. c. if the internal rate of return of the company is 15 percent. is presently using a truck that has a book value of Rs.6. You are required to find out the impact of the change in credit policy on the profit of the company. It is being depreciated on a straight line basis and it will be written off over the next six years.00.350. b.250.00 in the recently concluded financial year. The average collection period for the new policy is expected to be 24 days. The company is planning to replace the old truck with a new one which is improvised and more efficient. In order to expand sales. (8 + 2 = 10 marks) 5 Modern Suppliers Ltd. Estimate the gross working capital requirement.8.000 units at an average price of Rs. You are required to a. The general manager of the company has collected the following additional information: The savings in annual operating and maintenance costs will be Rs. Calculate the investment required in various current assets. The cost of capital of the company is 15%.000. sales are expected to go up by 12%. Presently the salvage value of the truck is Rs. has an earnings per share of Rs. (9 + 1 = 10 marks) 3 Zenith Industries Ltd. Appraise the capital expenditure proposal using the NPV technique and advise the general manager of the company accordingly. b.000 at the end of the six year period. Currently. It will be depreciated on a straight line basis over the period of next six years and will be fully written off at the end of the six year period. The new truck costs Rs. < Answer > < Answer > The cost of capital for the company is 12% and the tax rate applicable to it is 30%. net 30. All the sales < Answer > are on credit basis and the average collection period is 32 days. It is assumed that the Walter’s model of dividend policy holds true for the company.000 per year. The cost of capital for the company is 12 percent. if the internal rate of return of the company is 10 per cent. Find out the price of the company’s share at dividend payout ratios of 50 percent and 75 percent respectively.50. Give your inference about the model on the basis of your solutions to the aforementioned questions. The income from the operations will increase by Rs. The new truck will have a salvage value of Rs.50 lakhs. b. Find out the price of the company’s share at dividend payout ratios of 50 percent and 75 percent respectively. 30% of the customers are expected to avail of the discount and pay on the tenth day.3.150. Due to the change in credit policy. currently allows a credit period of 30 days without any cash discount. Ignore taxes.

7. < Answer > A company should plan its capital structure in such a manner that will minimize the cost of capital. (10 marks) END OF SECTION C END OF QUESTION PAPER < Answer > 9 .END OF SECTION B Section C : Applied Theory (20 Marks) • • • • 6 This section consists of questions with serial number 6 . Answer all questions. Marks are indicated against each question. (10 marks) 7 Describe the role of the finance manager in the mobilization and deployment of funds for an organization. Do not spend more than 25 -30 minutes on section C. Briefly describe the factors influencing the capital structure and the features of an optimal capital structure.

It can be applied to find out the amount that can be withdrawn periodically for a certain length of time.0189 P = 100 ⇒ P = 3.0189 or. Therefore. < TOP > .25% = (RPM )1. < TOP > 6.115 Reason : 0.0189 100 1. All the other alternatives may not necessarily maximize the wealth of the owners. Hence I is not true and III is true and the answer is (b). cost of debt also increases. Answer : (d) Reason : As the return on a security lies below the security market line. 2.25% = 5% + (RPM)1. Hence. alternative (c) is answer. 7.15 RPM = 6. 4. Answer : (c) Reason : According to the Miller and Modigliani model on dividend policy. the security is over priced as the expected return is less than the required return. Hence option (e) is the answer. So (c) would be the correct answer. P = Rs. Answer : (c) Reason : As per traditional approach on capital structure theory. if a given amount is invested today. Hence option (b) is the answer. 115 × 60 100 − P 365 P = 100 − P P = 0.30%. it will have to raise additional capital from the market. Also portfolio variance depends more on average covariance. Answer : (b) Reason : Capital recovery factor is the inverse of the PVIFA factor. if the entire amount of profit is disbursed among the shareholders in the form of dividends. Answer : (d) < TOP > 100 − P 365 × P 60 = 0. 9. 1. up to a certain amount of leverage the cost of debt will decrease but there after as the default risk increases. < TOP > 8.98. (b) and (c) are not related to the security market line. Answer : (b) Reason : 12. < TOP > Answer : (e) Reason : When the market value of the firm increases. Answer : (c) Reason : Rights issue involves the issue of securities to the existing shareholders at the price. Answer : (b) Reason : As the number of securities in a portfolio increases the portfolio variance decreases. As statements (II) and (III) are true.14.Suggested Answers Financial Management (MB211) : July 2006 Section A : Basic Concepts 1. it can be concluded that the dividend policy of the firm does not significantly influence the share prices. 5. which is generally lower than the current market price and it involves lower issue cost. the wealth of its owners increases.15 7. the appreciation of the share prices due to the higher dividend payment will be automatically dampened with the issue of the new equity shares. The statements as stated in the options (a). The ultimate objective of financial management is to maximize the wealth of the owners. 10 < TOP > < TOP > < TOP > < TOP > or.

Answer : (b) Reason : Statement (I) is not true because in an aggressive financing policy for current assets the financing mix is tilted more towards short term sources of financing. pricing is based on weighted average basis. alternative (d) is answer. As statements (I) and (III) are not true. 14.000 × 10 × 0.Discount Rate) × [360 /(Credit Period – Discount Period)] By careful observation of the above formula. it can interpreted that.03 ×100 + 1. 16. Hence. Under FIFO method. Statement (III) is not true because cost of financing is usually low in aggressive current asset financing policy. Answer : (a) Reason : Since interest on debt is tax deductible and there is no possibility of firms’ financial distress.000 2 Hence. the pricing will be based on the cost of material that was obtained first. such pricing method is called replacement method. there is a positive relationship between discount rate and cost of trade credit and negative relationship between the spread between credit period and discount period and cost of trade credit. Under LIFO method. the pricing is based on predetermined price. Hence both (I) and (II) are true. Under statndard price method. Statement (II) is true because risk of technical insolvency is high in aggressive current asset financing policy. 870 = Hence. as the debt servicing obligations are high in the short run. the value of the firm maximizes with more use of leverage. Answer : (d) Reason : Whether or not to avail of term loans and to what extent is related with the borrowing policy of a firm. 12. as short term financing is less expensive than long term financing. the pricing will be based on the material that has been purchased recently. Answer : (b) < TOP > Coupon amount Reason : Current yield = Marketprice Coupon amount Coupon rate = Facevalue ∴Current yield = Coupon rate implies that market price = face value. Answer : (b) Reason : If the material is priced at the value that is realizable at the time of issue. 11. Further this means that the bond is trading at its face value. Answer is (b). Under weighted average cost method. < TOP > 13. U 1. Answer : (b) < TOP > < TOP > U QPC × F+ 2 Reason : Total costs associated with inventory = Ordering cost + Carrying cost = Q Where U is the annual usage Q is the quantity ordered F is fixed cost per unit P is the purchase price per unit C is the carrying cost expressed as a percentage of the purchase price. U = 7. < TOP > < TOP > < TOP > 11 . 15. the correct answer is (a). Answer : (d) Reason : Cost of trade credit = (Discount Rate/ 1.200 units.10. it is not related with cash management.

79 × (1/0. Answer : (d) Reason : The rate to be quoted to the Importer is the ask rate = = = (Rs . Answer : (a) Reason : In the presence of floatation costs.86/£. Answer : (b) Reason : Overtrading means that the firm has disproportionately low level of working capital with respect to the level of sales.66. 23. It assumes that the firm is able to reinvest the interm cash flows from a project at the internal rate of return. 22. Correct answer is (e). 19.000. < TOP > 12 . if there are multiple internal rates of return due to the intermediate cash outflows. Answer : (e) Reason : Net Cash Flow = Rs. It has no logical connection with cost of long-term or short-term debt. 25. Answer : (e) Reason : All the above mentioned statements are the valid criticism of the Walter model on dividend policy. It is not a meaningful criterion. (d) and (e) are not correct. Answer : (c) Reason : According to the Interest rate parity or the covered interest parity condition. answer is (b). the cost of external equity will always be more than the cost of existing equity capital (a). when adjusted for the cost of covering foreign exchange risk is equal across different currencies. (b). the cost of borrowing m oney or the rate of return on financial investments.000 (1 – 0. Answer : (e) Reason : Economic exposure refers to the impact on the value of firms operations due to unanticipated changes in the exchange rates. < TOP > < TOP > < TOP > < TOP > 21.< TOP > 17.60.30. 18. alternative (b) is answer. Options in (a). To define it as a state in which the firm has disproportionately high level of working capital with respect to sales or a disproportionately high level of receivables with respect to total assets or a dis proportionately high level of cash with respect to total assets or low turnover of working capital is incorrect. (d) and (e) are incorrect.5285) = Rs./$) ask × ($/£) ask (Rs. Hence.82. (c). Transaction exposure arises out of day-to-day activities of a company. Hence (b). Answer : (b) Reason : The internal rate of return considers the timing of the cashflows from a project and provides a straight forward decision-making criterion./$) ask ×(1/£/$) bid 43. Hence. Transaction exposure arises due to the need to translate the foreign currency values of assets and liabilities into the domestic currency Currency exposure refers to the currency which is to be received/or paid.40) + Rs. the foreign currency is sold spot and bought forward. Answer : (c) Reason : In a swap-out deal. 20. < TOP > < TOP > < TOP > 24.000 = Rs.

= 1 × (S$/Euro) bid (S$/US$)ask 1 × 2.00 – 9.1571. 18.7384 = 1.30 Expected rate of return from the share = Σp i ki = 18.250 = 0.75.25% 0. this peg itself keeps changing in accordance with the underlying economic fundamentals. < TOP > < TOP > Section B : Problems 1.00 = 1.75%.5% 0. (c) Under fixed exchange rate system.e.0121 1. the value of a currency in terms of another is fixed and it is determined by Governments or Central banks of the respective countries. while the value of a currency is fixed in terms of a reference currency. a country fixes the rate of its domestic currency in terms of a foreign currency and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged.75 (0.0118 1.< TOP > 26.5 (0. put will not be exercised.00% In floating market = (LIBOR + 0. (a) When a group of countries get together and agree to maintain the exchange rates between the currencies within a certain band around fixed central exchange rates.125 i. Under this system.40) + 6. then it is called a target zone arrangement.45. 12. Scenario Projected rate of return Optimistic Normal Pessimistic D1 + P1 −1 P0 = 110 + 4 105 + 3 −1 −1 96 96 = 0.50) – (LIBOR + 0. Answer : (c) Reason : Quality spread is fixed market = 10. Answer : (b) Reason : If spot is Rs.40 99 + 3 −1 96 = 0. (e) Under a currency board system. Answer : (c) Reason : Futures contract have standard maturity and hence customized maturity is not a feature of a futures contract..0625 6.. (b) A crawling peg system is a hybrid of fixed and flexible exchange rate system.5% 13 .46. Answer : (d) Reason : The exchange rates under floating exchange rate system are determined by the demand and supply position for the currencies in the foreign exchange market.1875 = 0. 30.25) = 0.30) + 12. and dollar will be sold at spot market. Answer : (b) Reason : The synthetic rates of US $/Euro are (US $/Euro)bid = (US$/S$)bid × (S$/Euro)bid = = Similarly (US$/Euro)ask US$/Euro = 1.1574. 29.30 = Rs. 1 × 2.e.46. a.75% i.30 < TOP > Probability 0.7386 = 1.1571/74.25 (0. All the others are the features of a futures contract.30) = 12. < TOP > 28.25% Difference in quality spreads = 1. ∴ Net amount realized per dollar = 46.00 – 0. < TOP > 27.75 – 0.

Selling administration and financial expenses In finished goods In debtors Profit In debtors Total 1/2 1 3 500 1000 3000 4500 Period (months) 2 1 1 3 Raw materials 5000 2500 2500 7500 17500 2.50)2 (0.41 = 1.107]1/2 = (7.41 13 .2 Risk for the share = Σpi (k i − k) = [(18. Work-inprocess Finished goods Debtors Total 1 3 500 1500 2000 4.30) (18. a.125 σ2 = m ∴β = 7.50) (12 – 11.719]1/2 = 4.70% Risk for the market.77 indicates that if market returns change by 1% then returns on the share will change by 1.70)2 (0.41)1/2 = 2.50) (8 – 11.77 Implication: A beta of 1.’000) Inputs 1. Cov (i.70) + (0.50 – 12.50 – 12.77% in the same direction.k i ) (km .40) + (8 – 11.30) + (12 – 11.k m )2 ]1/2 = = [(15 – 11. [11. 2. β= σ2 m = ΣPi (ki . m) = (0.k m ) Cov (i.75 – 12.70)2 (0. σm = [Σp i (k m .40) + (6.719 + 0 + 11. m ) c.30) (6.25 – 12.50) (15 – 11.70)2 (0.75 – 12.84% Expected return from the market = Σp i k m = 15 (0.70) = 13.40) (12.30) + 12 (0.30) + (12.30) = 11.50)2 (0.25 – 12.30)]1/2 [3.267 + 0.50)2 (0.70) + (0.125 7. Raw materials In stock In WIP In finished goods In debtors Manufacturing costs In WIP In finished goods In debtors 3.72%. 6000 Monthly production and sales = 12 = 500 ingots The table below shows the investments in various current assets required to be made by TSL: (Rs.30)]1/2 [ ] 1/ 2 = b. 3 5000 14 3000 4000 3000 15000 3000 27000 < TOP > .40) + 8 (0.036 + 4.

12 0.6.12 = 6+ 0. Hence on average the manufacturing expense component of WIP will be equal to half month’s manufacturing expenses.000 150.10 k = 0.000 15 < TOP > .000 75.4.12 2 × 0. 15 0.15 0.12 2( 0.75) = Rs.11 0.3 crores.000) new truck1 Savings in costs Incremental Income Incremental 1 2 3 4 5 6 A B C D 150.000 i.00.00.00 per share (given) 15% = 0.000 150.e.000 75. The manufacturing costs are assumed to be incurred evenly throughout the month.00 per share (given) r = 0.000 250. Cash flows associated with the replacement project: Year 0 Net investment in (11.00 6 + (8 − 6) ∴P = Inference: 0. Rs.00. The amount of gross current assets (raw materials + WIP + finished goods + debtors + cash) required by TSL will be = = 100 2.00.12 If dividend payout ratio is 75% then – D = 8 x (0.12 = 4+ 0.00 per share 4 + (8 − 4) ∴P = 0.15 0.61.50) = Rs. the firm is a growth firm) the price per share increases as the dividend payout ratio decreases.12 = 6+ 0.70.000 250. 12 = Rs. When the internal rate of return of a firm is less than its cost of capital (i.000 75.000 150.3. According to the Walter’s model on dividend policy the price per share is given by the formula: D + ( E − D) P a.50) = Rs.89 per share.000 75.10 0.12 If dividend payout ratio is 50% –– D = 8 (0. Rs.12 0..15 k = 12% = 0.00 per share 4 + (8 − 4) P = 0.Note: b.8.10) 0. 12 = Rs.15 0.12 If dividend payout ratio is 50% then – D = 8 (0. c.12 = Rs. the firm is a declining firm) the price per share increases as the dividend payout ratio increases. a.000 150.e.12 0.000 250..70.83 per share. < TOP > 4.000 75.75 per share If dividend payout ratio is 75% –– D = 8 (0.000 250. E = = 0.000 250.10 0.00 6 + (8 − 6) P b.12 = Rs.63.4. 3. E r = = = r k k Rs.75) = Rs.000 75.000 150.e.000 × 90 Rs.000 250. When the internal rate of return of a firm is greater than its cost of capital (i.6.12 4 × 0.8.

500 97. and ∆S = ∆I = = = ∆DIS V∆ S ∆I = 360 (ACP0 – ACPN ) – 360 ACPN ∆DIS = Pn (S0 + ∆S)d n – P0 S0 d 0 600000 × 80 × 0. 6) – 11.500 302.500 97.000 97.000 – 50.000) 302.500 302.500 602.1.70) = Rs.500 302.000 CFt b.000 325.000 ∴ Incremental depreciation in each year = 1.16.500 302.00.500 300.12 = 5760000 S0 600000 × 80 (0. Terminal flow = Incremental salvage value = = 350.100.500 227.1728000 = 1728000 + (0.500 302.00.15) (797867) – 161280 ∆S(1– V) = ∴ Effect on profit ignoring taxes = Rs.500 227.00.300.500 302. 5.000 6 = Rs. 5) + 602. 000 − 50 .) Thus it can be seen that as a result of the new policy of allowing cash discount. < TOP > Section C: Applied Theory 16 .75.500 227. The NPV is positive. So the investment in the new truck is justified.295.000 – 1.05 (approx. 00.000 325.605 + 602.797867 (approx.000.000 Rs.1686400.500 97.500 227.500 PVIF (12%.000 325.280 5760000 (1 – 0.000 325.500 97.75.507) – 11.000 325.980.500 PVIFA (12%.500 (0.000 Depreciation on the new truck for each year over the next six years: 14.00.01) – (0) (600000 × 80) (0) Rs.000 − 3.000) 302.00.500 227.11 lakhs 2.000 = Rs.500 Working Notes: 1.500 227. 3.000 Rs.500 97.50. Existing depreciation (on old truck) per year over the next six years: 650. NPV = = = = t Σ (1 + k) −I 302.500 302.) = = (0.E F G H I J K depreciation2 Pre-tax profit (E: B+C-D) Taxes Post-tax profit Initial flow Operating flow: G+D Terminal flow3 Net cash flow: H+I+J 325.000 6 = Rs. The effect on profit ignoring taxes = ∆S (1 – V) + K∆I – ∆DIS where.500 × 3.500 302.12) (0.86 lakh.75. Net investment in new truck = 14 – 3 = Rs.000 302.500 302.000 (11.61.70 )(5760000 ) 360 360 (32 – 24) – × 24 600000 × 80 × 8 − 96768000 360 Rs.500 (11.30) (600000 × 80 × 1. the profit (ignoring taxes) increases by Rs.1.

The term trading on equity is used because it is the equity that is used as a basis for raising debt. The Finance Manager appraises the proposal along the financial dimensions to determine its worthiness in relation to the investment involved.The company should make maximum use of leverage at a minimum cost. In deciding how much to procure from various sources. Therefore. Financial institutions while sanctioning long-term loans insist that companies should generally have a debt-equity ratio of 2:1 for medium and large-scale industries and 3:1 for small-scale industries. The other factors that should be considered whenever a capital structure decision is taken are: a. etc. This decision is called the Financing Decision. machinery. • Flexibility . b. Factors influencing the capital structure: Leverage . R & D and the top management. < TOP > 7. • Control . Companies are now launching public issues with the sole purpose of reducing debt. it can raise 2 units of debt. debentures and term loans along with equity capital in the capital structure is described as financial leverage or trading on equity. he would weigh many considerations like the cost of the funds in the form of interest/dividend and the cost of public issue in the case of shares and debentures. buildings. • Solvency . Banks and other financial institutions which give short-term and long-term loans generally lay down some conditions. c. Floatation costs.6.The use of excessive debt threatens the solvency of the company. In a high interest rate environment. Sometimes the managers of the various departments named above constitute an ‘ nvestment Committee’ and appraise an investment proposal along the marketing. marketing. the Finance Manager would try to balance the advantages of having funds available with the costs and the loss of flexibility arising from the restrictive provisions of the loan contract. The company should be able to raise funds whenever the need arises and also retire debts whenever it becomes too costly to continue with that particular source. Features of an Optimal Capital Structure An optimal capital structure should have the following features: • Profitability . Dilution of control e. I technical and financial dimensions. Cost of capital Cash flow projections of the company Size of the company d.The capital structure should involve minimum dilution of control of the company. In consultation with the managers of various departments such as production. debentures and inviting the public to subscribe to its fixed deposits. For this purpose he would be liaising with banks and financial institutions. Mobilization of Funds for the Firm The Finance Manager has to plan for and mobilize the required funds from various sources when they are required and at an acceptable cost. Increased use of leverage increases the fixed commitments of the company in the form of interest and repayments and thus increases the risk of the equity shareholders as their returns are affected. etc. This decision called the ‘Investment Decision’ constitutes one of the core activities of the Finance Manager. A debt-equity ratio of 2:1 indicates that for every 1 unit of equity the company has. the Finance Manager decides on the manner of deployment of funds in various assets such as land. Indian companies are beginning to realize the advantage of low debt.The capital structure should be flexible to be able to meet the changing conditions.The use of fixed charges sources of funds such as preference shares. These conditions are aimed at ensuring the safety of the loans given by them and contain provisions restricting the freedom of the borrower to raise loans from other sources. materials. the length of time for which funds would be available. personnel. He also deals with merchant banking agencies for procuring funds from the public through issue of shares. Deployment of Funds There are always many competing needs for the allocation of funds. < TOP OF THE DOCUMENT > < TOP > 17 .