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Question Paper

Strategic Financial Management - I (MSF3L1) : July 2007


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. Which of the following statements is/are true according to the BCG matrix?
I. Business units having low growth rate and high market share are termed as Cash Cows.
II. Business units having low growth rate and low market share are termed as Question Marks.
III. Business units having high growth rate and low market share are termed as Dogs.
IV. Business units having high growth rate and high market share are termed as Stars.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (I) and (IV) above.
2.
Which of the following ratios is not applied under L. C. Gupta model for prediction of bankruptcy?
(a) EBDIT/Net Sales
(b) Operating Cash Flow/Sales
(c) Operating Cash Flow/Total Assets
(d) Total Sales/Average Total Assets
(e) Net Worth/Total Debt.
3. Which of the following statements is not an assumption as per Baumol Model?
(a) There are two costs involved holding cost and transactions cost
(b) Cash inflows and outflows over a period are random
(c) Securities for a particular sum are converted into cash at a regular frequency
(d) The cash requirement for the period under consideration is known in advance
(e) Cash expenses occur evenly over the planning period.
4. The following data is available for Mark Ltd.
Annual yield on securities = 7%
Fixed transaction cost = Rs. 650
Standard deviation of change in daily cash balance = Rs. 450
Assuming a year consists of 360 days, the spread between upper limit (UL) and lower limit (LL) is
(a) Rs. 1,720.02
(b) Rs. 2,540.13
(c) Rs. 3,781.11
(d) Rs. 4,497.19
(e) Rs. 5,160.04.
5. Which of the following is not the primary reason for a company to go for non-growth strategy?
(a) Pressure from public opinion
(b) Development of new facilities
(c) Lack of additional staff with sufficient expertise and loyalty
(d) Maintaining an acceptable quality of life
(e) Diseconomies of scale of the particular production set-up.
6. The current earning per share of Marion Ltd. is Rs. 9.50. The dividend per share for the current year is Rs. 6.45. The
weightage given to the current earnings is 0.35. If the dividend per share in previous year is Rs. 6.55, the target
payout ratio for Marion Ltd. as per Linter Model is
(a) 0.18
(b) 0.42
(c) 0.51
(d) 0.66
(e) 0.77.
7. Prashant Ltd. has the following details:
Cost of machine = Rs. 2.50 lakh
Cost of installation = Rs. 0.55 lakh
Estimated life of the asset = 5 years
If the inflation factor is 8.5% and the firm follows straight line method of depreciation, the amount of backlog
depreciation under current cost accounting method (CCA) is,
(a) Rs. 0.25 lakh
(b) Rs. 0.48 lakh
(c) Rs. 0.66 lakh
(d) Rs. 0.71 lakh
(e) Rs. 0.85 lakh.
8. Which of the following statements is/are false with regard to Zero Based Budgeting (ZBB)?
I. In Zero Based Budgeting no previous experience is assumed and every proposed activity is justified
newly.
II. Zero based budgeting is a forced periodic justification of any expenditure program in which each
department calculates its resource needs based on the next years priorities rather than on the last years budget
or expenditure patterns.
III. Zero based budgeting is not so attractive because it does not distinguish between high and low priority
areas and does not contain the pursuit of personal objectives by managers.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
9. According to value chain analysis, which of the following is a part of the support activities of a firm?
(a) Research and development
(b) Production
(c) Marketing and sales
(d) Human resource
(e) Service.
10. A leader who uses coercive power and manipulation to attain personal goals is called
(a) Phantom
(b) Catalyst
(c) Strategic Leader
(d) Machiavellianist
(e) Democratic Leader.
11. Incubating is one of the stages for a successful technology management. Incubating refers to
(a) Developing the initial insight about the market opportunity for a particular technical
development
(b) Nurturing the technology sufficiently to gauge whether it can be commercialized or not
(c) Building prototypes and getting feedback from potential investors and customers
(d) Persuading the market to adopt the innovation
(e) Ensuring that the product or process has a long life in the market.
12. An Indian company imports parts from Japan. The Indian company is exposed to the risk of the Yen strengthening
and, as a result, the rupee price of parts increases. Its an example of
I. Transaction risk.
II. Translation risk.
III. Economic risk.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
13. Which of the following statements is false with respect to change in interest rates?
(a) If interest rates are higher, a company which has a large surplus of cash and liquid
funds to invest might switch some of its short-term investments from equities to
interest bearing securities
(b) When interest rates are low, it might be beneficial to borrow more, preferably at a fixed
rate of interest, and so increase the companys gearing
(c) When interest rates are higher, a company might decide to reduce the amount of its
debt finance, and to substitute it with equity finance
(d) When interest rates are low, it is usually beneficial to borrow for longer periods rather
than short periods
(e) If interest rates fall, the share prices usually will fall.
14. A manufacturing company produces a product, which is selling at the price of Rs.11.50 per unit. The marginal cost
of producing each unit of the product is Rs.7.50. Annual fixed cost is Rs.45,000. Owing to the increase in the costs,
the marginal cost is expected to rise to Rs.8 per unit and fixed cost to Rs.53,000. However, selling price cannot be
increased due to the competition in the market. What should be the percentage increase in the number of units to be
sold after the increase in costs, if the company wants to maintain the same amount of profit at Rs.22,000 as before
increase in the costs?
(a) 15.68%
(b) 27.93%
(c) 31.42%
(d) 43.12%
(e) 52.16%.
15. Which of the following statements is/are false with respect to Dutch Auction Tender Offer method of share
repurchases?
I. Dutch auctions are more risky to the management than fixed price premium offers.
II. The firm does not fix any predetermined price but announces the number of shares it proposes to buy-
back.
III. The tender offer is open to all the shareholders of the firm.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
16. Which of the following controls helps check, systematically and continuously, whether or not the assumptions set
during the planning and implementation process are still valid?
(a) Premise control
(b) Implementation control
(c) Strategic surveillance
(d) Special alert control
(e) Operational control.
17. Which of the following statements is false for backward integration?
(a) Firms can have a regular and uninterrupted supply of raw materials, components and
other inputs
(b) Firms can enjoy economies of large-scale operations
(c) Quality control of raw material, components and parts are ensured
(d) Firms can have their own facilities for providing pre-sales and post-sales service
(e) There can be minimization on direct taxes payable on purchases of inputs.
18. Vertical scope is described by
(a) Extent to which firms compete with a co-ordinated strategy in a range of related
Industries
(b) Extent to which firms serve buyers by variety of products
(c) Extent to which activities are performed in-house
(d) Extent to which firms serve a particular segment
(e) A range of region, countries or group of countries in which a firm operates.
19. Which of the following statements is false regarding the assumptions of capital structure theories?
(a) The expected value of the subjective probability distributions of the anticipated future
earnings is identical to all investors
(b) The assets of a bankruptcy company can be sold at their economic value without
incurring any liquidating and legal expenses
(c) The impact of tax shield associated with the debt is abstracted
(d) The firm is not allowed to issue and repurchase any amount of debt or equity
(e) The securities are finitely divisible.
20. Which of the following statements is/are false with respect to internalization model as proposed by Johanson and
Mattsson?
I. Internalization model emphasizes on learning through experience and increasing commitment to foreign
markets.
II. Internalization model focuses on the relationships between companies involved in the production,
distribution and use of goods and services within an industry.
III. In Internalization model, a company moves sequentially from lower stages of internalization like exports
to higher forms of internalization like wholly owned subsidiaries.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
21. Which of the following is an interpersonal role of a manager?
(a) Spokesman role
(b) Monitor role
(c) Figurehead role
(d) Disseminator role
(e)
Entrepreneurial role.
22. Which of the following statements is false under Pecking Order Theory?
I. The market is chronically underinformed about the relative values of various projects that the firm brings
to the market.
II. The uninformed investors tend to break even on the securities they purchase.
III. The managers find the effective cost of external financing lower than that it should be.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
23. In which of the following tactics of using power and influence, the manager does not try to change the situation, but
argues that people will benefit by behaving in certain ways?
(a) Coercion
(b) Persuasion
(c) Obligation
(d) Inducement
(e) Legitimation.
24.
Poison Ltd., a wholly owned subsidiary of Halos Ltd., has a covariance with the market of 221(%)
2
. The market
return is 12.5%. The market variance is 170%
2
. The 91-day T-bill are issued at a discount of 1.5% to face value. The
expected value per share of Poison Ltd. after a year is Rs.38. According to risk adjusted discount rate method, the
companys present value of share, assuming no payment of dividend, is
(a) Rs.15.20
(b) Rs.28.45
(c) Rs.33.21
(d) Rs.41.53
(e) Rs.53.21.
25. Which of the following elements does not constitute the firms business architecture in an organization?
(a) Leverage
(b) Resources
(c) Size and capital intensity
(d) Internal legal structures
(e) Internal governance structures.
26. Which of the following is/are true regarding a company following a conservative working capital policy?
I. The company will finance its current assets more from long-term sources.
II. The technical insolvency of the company will be high.
III. The company will have a higher current ratio than the one following an aggressive working capital policy.
IV. The company will have a lower current assets turnover ratio than the one following an aggressive
working capital policy.
(a) Only (I) above
(b) Both (II) and (III) above
(c) Both (III) and (IV) above
(d) (I), (II) and (III) above
(e) (I), (III) and (IV) above.
27. The factors that do not make a firm, a desirable candidate for acquisition and vulnerable for a takeover is
(a) A low stock price compared to asset replacement cost
(b) A highly liquid balance sheet with large amount of excess cash
(c) Significantly used debt capacity
(d) Good cash flow relative to current stock prices
(e) Relatively small stock holdings under the control of incumbent management.
28. The face value of the equity share of Green Water Ltd. is Rs.145 and the current market price of the share is Rs.78.
The company is expected to declare a dividend of 25% during the current year. If the dividends are expected to
decline at the constant rate of 15% p.a., the expected rate of return on the share is
(a) 18.30%
(b) 24.50%
(c) 31.40%
(d) 40.00%
(e) 51.60%.
29. Which of the following statements is not a major drawback of establishing joint ventures?
(a) Loss of control to the other firm
(b) Difference of culture and customs between both the parties
(c) Excessive competitive pressures
(d) Foreign exchange regulations imposed by both governments
(e) Lack of proper coordination between both the partners.
30. Which of the following statements is/are false with respect to different modes of strategic decision making?
I. Problems associated with strategy are given secondary importance in entrepreneurial mode.
II. Entrepreneurial mode of decision making results in a fragmented strategy with incremental improvement.
III. Planning mode encompasses both a proactive search for opportunities and a reactive solution to existing
problems.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
END OF SECTION A
Section B : Problems (50 Marks)
This section consists of questions with serial number 1 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
Mahavir Automobiles Ltd. (MAL) is projecting its cash budget for the months of January and February. The sales
and other expenses of the company are as follows:
Sales
January February
Amount (Rs.) Probability Amount (Rs.) Probability
57,000 0.11 26,000 0.15
78,000 0.14 69,000 0.19
1,25,000 0.16 1,05,000 0.21
1,79,500 0.25 1,25,400 0.13
2,00,000 0.34 1,98,000 0.32
Other Expenses
January February
Amount (Rs.) Probability Amount (Rs.) Probability
55,000 0.39 48,000 0.31
69,000 0.29 81,000 0.28
1,00,000 0.32 1,06,000 0.41
Additional information:
Credit sales are expected to be 65% of total sales. Of the credit sales, 45% is expected to be realized in the
month of sale and the rest in the succeeding month.
Purchase of raw materials is likely to be 55% of total sales. They are paid entirely in the following month
of sale.
The opening cash balance in January is Rs. 35,000 and the receivables of the previous month to be
realized in January amount to Rs. 50,000.
The company wants to maintain a cash balance of Rs. 9,000 at the end of every month. Shortfall of cash is
brought in through short-term borrowings in multiples of Rs. 9,000. The interest on the borrowing if any may be
ignored.
The following random numbers may be used for simulation:
Months Sales Expenses
January 45 35
February 78 29
You are required to project the cash budget of MAL for the months of January and February using a single run
simulation technique.
(12 marks)
Maritime India Ltd. (MIL) has an expansion plan for its product, to cater the growing needs of the market. The
company has 40 lakh equity shares outstanding with a face value of Rs.10 each and outstanding debt of Rs. 42 lakh
at an interest rate of 12% p.a. MIL has free reserves of Rs. 12.50 lakh, which can be capitalized. The company is
planning a bonus issue to utilize the entire free reserves and later stock split, to make the face value of the shares
Rs.2.50.
After the bonus and stock split, the company plans to raise funds of Rs. 85 lakh. The required fund can be raised
either through issue of debt at an interest rate of 13% p.a. or by issue of equity, at the price of Rs. 2.50.
The company expects that the standard deviation of total EBIT, after the investment is made is Rs. 28.5 lakh. The
corporate tax rate applicable to the company is 35%.
From the point of view of EPS, you are required to calculate the minimum level of EBIT at which the debt issue is
better than the equity with 90% probability.
(11 marks)
The Profit and Loss account for the current year and Balance Sheet for the previous year of Rolta Ltd. are as
follows:
Balance sheet
Liabilities Rs. Assets Rs.
Share capital 60,000Plant and machinery 90,000
14% debentures 36,000Stock 14,400
Sundry creditors 21,600Debtors 7,200
Cash 6,000
1,17,600 1,17,600
Profit and Loss account
Particulars Rs. Particulars Rs.
To opening stock 14,400By sales 60,000
To purchases 27,600By closing stock 12,000
To gross profit 30,000
72,000 72,000
To operating expenses 4,800By gross profit 30,000
To interest on debentures 4,860
To depreciation 9,000
To net profit 11,340
30,000 30,000
Additional information:
There is no change in debtors and creditors during the year.
First in first out method is used for the valuation of stock.
Following indices are to be taken into consideration
On 1
st
January (current year)
200
Average of (current year) 240
On 31
st
December (current year)
300
You are required to prepare the final accounts for the current year after adjusting for price level changes under
Current Purchasing Power (CPP) method.
(10 marks)
The following information pertains to the operations of Moulin Bioinformatics Ltd. at the end of a financial year:
Equity Rs.1,50,000
Retained earnings Rs.2,50,000
Plant and machinery Rs.1,00,000
Gross profit margin 25%
Total asset turnover ratio 2
Inventory turnover ratio 2.5 times
Total debt to net worth ratio 0.75
Average collection period (360 days a year) 42 days
Acid test ratio 0.6
You are required to complete the balance sheet of the company given below as at the end of the financial year:
Balance sheet
Liabilities Rs. Assets Rs.
Equity Plant and machinery
Retained earnings Inventory
Accounts payable Accounts receivable
Cash
Total Total
(6 marks)
Avion Iron Ltd. manufactures several products of varying levels of designs and models. It uses a single overhead
recovery rate based on direct labour hours. The overheads incurred by the company in the first half of the year are
as follows:
Particulars Rs.
Machine operation expenses
15,18,750
Machine maintenance expenses 2,81,250
Salaries of technical staff 9,56,250
Wages and salaries of stores staff 3,93,750
During this period, the company introduced activity based costing system and the following significant activities
are identified:
Receiving materials and components
Set up of machines for production runs
Quality inspection
It is also determined that:
- The machine operation and machine maintenance expenses should be apportioned between stores and
production activity in the ratio of 1:4.
- The technical staff salaries should be apportioned between machine maintenance, set up and quality
inspection in the ratio of 3:4:3.
The consumption of activities during the period under review is as follows:
- Direct labour hours worked - 60,000
- Direct wage rate - Rs.9 per hour
- Production set-ups - 3,060
- Material and component consignments received from suppliers - 2,940
- Number of quality inspections carried out - 1,920
The data relating to two products manufactured by the company during the period are as follows:
Particulars
Products
Silver Gold
Direct material costs Rs.9,000 6,000
Direct labour hours 1,440 150
Direct material consignments received 72 78
Production runs 54 36
Number of quality inspections done 45 15
Quantity produced (units) 22,500 7,500
A potential customer has approached the company for the supply of 36,000 units of a component namely Nickel to
be delivered in lots of 4,500 units per quarter. The job will involve an initial design cost of Rs.90,000 and the
production will involve the following per quarter:
Direct material costs Rs.18,000
Direct labour hours 450
Production runs 9
Inspections 36
Number of consignment of direct materials to be received 30
The company desires a mark up of 37.5% on cost.
You are required to
a. Determine the cost of products for Silver and Gold using activity based costing system.
b. Compute the sale value per quarter of Nickel using activity based costing system.
(6 + 5 = 11 marks)
END OF SECTION B
Section C : Applied Theory (20 Marks)
This section consists of questions with serial number 6 - 7.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.
Corporate financial models are formal representations of a companys operations and processes in financial
terms. What are the major steps in the process of using a model to arrive at the optimal decision?
(10 marks)
< Ans
A process in management is defined as a perceptible flow of information through interrelated stages of
analysis directed towards the achievement of an aim. Discuss the various elements in the process of
strategic management.
(10 marks)
< Ans
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management - I (MSF3L1) : July 2007
Section A : Basic Concepts
1. Answer : (e)
Reason : According to the BCG matrix, the firms can be classified on the basis market growth rate and
market share as follows:
Question Marks: High Market growth rate and low market share.
Stars: High market growth rate and high market share.
Cash Cows: Low market growth rate and high market share.
Dogs: Low market growth rate and low market share.
Thus statements (I) and (IV) are correct and the correct answer is (e).
2. Answer : (d)
Reason: Total sales/average total asset is not considered by L C Gupta for measuring the bankruptcy of
a firm. Hence option (d) is the answer.
3. Answer : (b)
Reason: Cash inflows are random over a period of time is an assumption of Miller and Orr Model.
Hence option (b) is false.
4. Answer : (e)
Reason: Spread = UL LL
= 3RP 2LL LL
= 3RP 3LL
=
I = 7/360 = 0.0194

2
= (450)
2
= 202500
Spread =
= Rs. 5160.04
5. Answer : (b)
Reason: In general terms , the minimum period for a long term plan is that, which is necessary for
implementation of decisions on matters such as
Development of new facilities.
Development of new products or services.
Entry into a new field of marketing for existing products.
Hence option (b) is the answer. Other options are the primary reason for a company to go for non-growth
strategy.
6. Answer : (d)
Reason:
D
t
= dividend per share for the current year
c = weightage given to the current earnings of the firm
r = target payout ratio
EPS
t
= earnings per share for the current year
D
t-1
= dividend per share for the previous year
6.45 = 0.35r(9.50) + (1- 0.35)6.55
6.45 = 3.325r + 4.2575
2.1925 = 3.325r
r = 0.66
7. Answer : (c)
Reason:
(Rs. in lakh)
Year
Historical
cost
Replacement
cost
Depreciation
based on
historical
cost
Depreciation
based on
replacement
cost
Difference (CCA
adjustment)
1 3.05 3.31 0.61 0.66 0.05
2 3.05 3.59 0.61 0.72 0.11
3 3.05 3.90 0.61 0.78 0.17
4 3.05 4.23 0.61 0.85 0.24
5 3.05 4.59 0.61 0.92 0.31
Total 3.05 3.93 0.88
Backlog depreciation for 5 years
= 4.59 3.93
= Rs. 0.66 lakh.
8. Answer : (b)
Reason: Zero based budgeting is attractive because it distinguishes between high and low priority area
and contains the pursuit of personal objectives by managers. Hence option (b) is the answer.
9. Answer : (d)
Reason: Human resource is a part of the support activities of a firm, according to value chain analysis.
All other functions are primary activities.
10. Answer : (d)
Reason : Phantom is a board of directors having low degree of involvement in strategic management
where it never knows what to do. On the other hand a catalyst is a board having high involvement in
strategic management and takes a leading role in establishing and modifying the mission, objectives,
strategy and policies. Strategic leader is one who gives direction to his subordinates with a long term
vision which he shares with them. Democratic leader takes into consideration the suggestions by his
subordinates in arriving at any decision. He follows a participative style of management. A
machiavellianist is one who uses coercive power to achieve his personal goals.
11. Answer : (b)
Reason: Incubating is nurturing the technology sufficiently to gauge whether it can be commercialized.
Hence option (b) is the answer.
12. Answer : (a)
Reason: Transaction risk is associated with individual transaction denominated in foreign currencies,
imports, exports, foreign assets and loans. Hence option (a) is the answer.
13. Answer : (e)
Reason: If interest rates fall, shares become more attractive to buy. As demand for shares increases,
their share price too rise. Thus option (e) is incorrect. All other statements are correct with respect to
interest rates.
14. Answer : (b)
Reason: Before increase in costs:
Contribution = Selling Price Marginal Cost = Rs11.5 Rs.7.5 = Rs.4.
No. Units for target profit = [Rs. 45000 + Rs. 22000 ] / Rs.4 = 16, 750
After increase in costs:
Contribution = Selling Price Marginal Cost = Rs.11.5 Rs.8.0 = Rs.3.5
No. Units for target profit = [Rs. 53000 + Rs. 22000 ] / Rs.3.5 = 21429 (approx)
Therefore the % increase is [(21429 16750)/16750] = 27.93%.
15. Answer : (a)
Reason: Dutch auctions are less risky to the management than fixed price premium offers. Other
statements are true. Hence option (a) is the answer.
16. Answer : (a)
Reason: Premise means assumption. Premise control helps to check, systematically and continuously,
whether or not the assumptions set during the planning and implementation process are still valid.
17. Answer : (d)
Reason: Under forward integration firms can have their own facilities for providing pre-sales and post-
sales service. Hence option (d) is false.
18. Answer : (c)
Reason: Vertical scope is described by the extent to which activities were performed in house.
19. Answer : (d)
Reason: The firm is allowed to issue and repurchase any amount of debt or equity. Hence option (d) is
false.
20. Answer : (b)
Reason: Network approach of internalization model not internalization model focuses on the
relationships between companies involved in the production, distribution and use of goods and services
within an industry. Hence option (b) is the answer.
21. Answer : (c)
Reason: The three interpersonal roles are figurehead role, leadership role and liaison role. Hence option
(c) is the answer.
22. Answer : (b)
Reason: The market is chronically under informed about the relative values of various projects that the
firm brings to the market, as a result market tends to undervalue these projects. This in turn undervalues
the securities that are issued to finance them. These results to some sort of pooling equilibrium so that on
an average, the uninformed investors break even on the securities they purchase. This in turn puts the
mangers in such conditions that they find the effective cost of external financing higher than it should be.
Hence option (b) is the answer.
23. Answer : (b)
Reason: In persuasion the manager does not try to change the situation, but argues that people will
benefit by behaving in certain ways.
24. Answer : (c)
Reason: The beta for the company is 221/170 = 1.3
Now, 91-day T-bill is at discount of 1.5%. Therefore, the yield of t-bill is .
Now, Risk adjusted discount rate method
PV = E(cf)/{1 + r
f
+ beta (R
M
R
f
)}
= 38/{1 + 0.0611 + 1.3(0.125 0.0611)
= 38/1.1442
= Rs.33.21
Hence the correct answer is (c).
25. Answer : (a)
Reason: The structure of organizational architecture is divided into business architecture and financial
architecture.
Leverage comes under financial architecture. Hence option (a) is the answer.
26. Answer : (e)
Reason: Under a conservative working capital policy, the financing mix will consist of a higher
proportion of long-term sources of finance like equity and to some extent debentures also.
Hence statement (I) is correct.
As a conservative working capital policy involves financing of current assets more from long-term
sources, the company will have a lower debt-servicing cost compared to an aggressive policy and
consequently a lower degree of the risk of technical insolvency.
Hence statement (II) is incorrect.
A company following a conservative working capital policy will invest more in current assets than a
company following an aggressive working capital policy. Hence, it will have a higher current ratio than
the one following an aggressive working capital policy. So statement (III) is correct.
Under a conservative worming capital policy, a firm invests more in current assets than a firm following
an aggressive policy. Therefore the current assets turnover ratio computed as Sales Current assets will
be lower incase of a conservative working capital policy. So statement (IV) is also correct.
Hence option (e) is the correct choice as statements (I), (III) and (IV) are correct.
27. Answer : (c)
Reason: Significantly unused debt capacity makes a firm a desirable candidate for acquisition and
vulnerable to a takeover. Hence option (c) is the answer.
28. Answer : (b)
Reason: We know, P
0
=
Where,
P
0
= Current market price
k
e
= Expected rate of return
g = Growth rate in dividends
D
1
= Dividend at the end of one year.
The above equation can be rewritten as:
k
e
=
Putting the values for the variables we get:
k
e
= =
= 24.50%.
Hence, option (b) is the answer.
29. Answer : (c)
Reason: An excessive competitive pressure is a reason for adopting retrenchment strategies, and not a
drawback to establish a joint venture. Hence option (c) is the answer.
30. Answer : (b)
Reason: In adaptive mode decision making results in a fragmented strategy with incremental
improvement. Hence option (b) is the answer.
Section B : Problems
The random number ranges for sales are as follows:
Sales
January
Amount
(Rs.)
Probability Cumulative
Probability
Range
57,000 0.11 0.11 0 -10
78,000 0.14 0.25 11 -24
1,25,000 0.16 0.41 25 -40
1,79,500 0.25 0.66 41 -65
2,00,000 0.34 1 66 -99
Sales
February
Amount
(Rs.)
Probability Cumulative
Probability
Range
26,000 0.15 0.15 0 -14
69,000 0.19 0.34 15 -33
105000 0.21 0.55 34 -54
125400 0.13 0.68 55 -67
198000 0.32 1 68 -99
The random number ranges for expenses are as follows:
Expenses
January
Amount
(Rs.)
Probability Cumulative
Probability
Range
55,000 0.39 0.39 0 -38
69,000 0.29 0.68 39 -67
100000 0.32 1 68 -99
Expenses
February
Amount
(Rs.)
Probability Cumulative
Probability
Range
48,000 0.31 0.31 0 -30
81,000 0.28 0.59 31 -58
106000 0.41 1 59 -99
On running the simulation the following values are obtained:
Sales
(Rs.)
Expenses (Rs.)
January 1,79,500 55,000
February 1,98,000 48,000
Cash budget
Particulars January
(Rs.)
February
(Rs.)
Sales 179500 198000
Cash sales 62825 69300
Realization from credit sales:
Current month 52504 57915
Previous month 50000 64171
Total inflows 165329 191386
Payment for purchases 76923 98725
Other expenses 55,000 48000
Total outflows 131923 146725
Surplus/Deficit 33406 44661
Opening Balance 35000 68406
Closing Balance 68406 113067
Workings for payment of purchase
January
Receivables of December to be realised in January = Rs. 50000
(it is equal to 55% of december credit sales)
Total credit sales in December = 50000/0.55 = Rs. 90909
Total sales in December = 90909/0.65 = Rs. 139860
Purchases in December to be paid in January = 139860 0.55= Rs. 76923
February
Purchases in January to be paid in February = 179500 0.55 = 98725
Number of shares after bonus issue
= 41.25 lakh
Number of shares after stock split = 41.25 (10/2.5) = 165 lakh
The expression for EPS, if funds are raised through equity is as follows:
= =
The expression for EPS, if funds are raised through debt is as follows:
= =
Let the total EBIT be x. The EBIT EPS indifference point can be calculated as follows :
=
=
= 165x 541.20 = 199x 2081.54
= 34x = 1540.34
x = 45.30
Hence indifference EBIT = Rs. 45.30 lakh
The minimum level of EBIT that is expected at which debt is better than equity by 90% is
= = 1.29
= 82.065
Hence the expected EBIT = Rs. 82.065 lakh.
Income statement restated as per CPP method for the current year
Particulars
Historical
(Rs.)
Conversion
Factor
CPP
(Rs.)
Sales 60000 1.25 75000
Opening stock 14400 1.5 21600
Purchases 27600 1.25 34500
Cost of goods available for
sale
42000 56100
Less: closing stock (FIFO) 12000 1.25 15000
Cost of goods sold 30000 41100
Gross profit on sale 30000 33900
Operating expenses 4800 1.25 6000
Depreciation 9000 1.5 13500
Interest on debentures 4860 4860
Total 18660 24360
Profit before adjustment 11340 9540
Price level gain - 15300
Retained earnings 11340 24840
Balance sheet as at the end of the current year
Liabilities
Historical
(Rs.)
Conversion
Factor
CPP
(Rs.)
Share capital 60000 1.5 90000
Debentures 36000 1.0 36000
Sundry creditors 21600 1.0 21600
Retained earnings 11340 24840
Total 172440
Assets
Cash 28740 1.0 28740
Debtors 7200 1.0 7200
Stock 12000 1.25 15000
Plant and machinery 90000 1.5 135000
Less: depreciation 9000 1.5 13500
Total 172440
Workings
(Rs.)
Creditors 57600 1.5 (i) 86400
Balance remained (ii) 57600
A ( i ii) 28800
Cash and debtors 13200 1.5 (iii) 19800
Purchases = 27600 1.25 (iv) 34500
(iii + iv) 54300
But stayed at (13200 + 27600) 40800
B 13500
Total gain on monetary assets (A B) 15300
Determination of closing cash balance
(Rs.)
Closing balance 6000
Sales 60000
Total (i) 66000
Less: Purchases 27600
Operating expenses 4800
Interest on debentures 4860
Total (ii) 37260
Total (i ii) 28740
Debt to net worth ratio = = Rs. 3,00,000
Total asset turnover ratio = = = Rs. 14,00,000
Sales = Rs. 14,00,000
Gross profit margin = = = Rs. 350000
Cost of goods sold = sales - gross profit = 14,00,000 3,50,000 = 10,50,000
Accounts receivable turnover ratio = 360 days/average accounts receivable or credit sales/average debtors
= 360/42 = 8.57
8.57 = 1400000/average debtors
= Rs. 163361
Inventory turnover ratio = cost of goods sold/ inventory
= 1050000/2.5 = Rs. 420000
Acid test ratio = liquid assets/current liabilities
= 300000 0.6 = 180000
Cash = 180000 - 163361
= Rs. 16639
Balance Sheet
(Rs.)
Equity 150000 Plant and machinery 100000
Retained earnings 250000 Inventory 420000
Accounts payable 300000 Accounts receivable 163361
Cash 16639
700000 700000
i. Overhead rate per labour hour
=
ii. Apportionment of technical staff salaries:
Machine maintenance = 9,56,250 3/10 = Rs.2,86,875
Set up = 9,56,250 4/10 = Rs.3,82,500
Quality Inspection = 9,56,250 3/10 = Rs.2,86,875
iii. Statement showing apportionment of Machine operation and Machine maintenance between stores
and production activity (set up) in ratio 1:4
Particulars Total expenses Stores/receiving Set up/production run
Machine operation 15,18,750 3,03,750 12,15,000
Machine maintenance 568125 1,13,625 454500
(Rs. 2,81,250 + Rs.2,86,875)
Wages and salaries of stores staff 3,93,750 3,93,750 -
Component of set-up cost 3,82,500 - 3,82,500
Total 28,63,125 8,11,125 20,52,000
iv. Rate per activity cost driver
Particulars Stores/receiving Set-up/ production run Quality inspection
Total overheads (Rs.) 8,11,125 20,52,000 2,86,875
Units of activities carried out 2,940 3,060 1,920
Rate per activity cost driver (Rs. 275.89 670.59 149.41
a. Statement showing computaion of cost of products Silver and Gold (using activity based costing system)
Particulars Product
Silver Gold
Units 22,500 7,500
Direct materials cost Rs.9,000 Rs.6,000
Direct labour cost Rs.12,960 Rs.1,350
Receiving / Stores cost (72 275.89) Rs.19,864.08
(78
275.89)
Rs.21,519.42
Production runs/Set ups cost (54 670.59) Rs.36,211.86
(36
670.59)
Rs.24,141.24
Inspection cost (45 149.41) 6,723.45
(15
149.41)
2241.15
Total cost of products Rs.84,759.39 Rs.55,251.81
Cost per unit Rs.3.77 Rs.7.37
b. Computation of sales value per quarter of component Nickel (using activity based costing system)
Units of component Nickel to be delivered per quarter 4,500
Components of initial design cost per quarter (Rs. 90,000 /8 quarters) Rs.11,250
Direct material costs Rs.18,000
Direct labour cost (450 hours Rs.9) Rs.4050.00
Receiving cost (30 Rs.275.89) Rs. 8,276.70
Production runs cost (9 Rs.670.59) Rs.6,035.31
Inspection cost (36 Rs.149.41) Rs.5,378.76
Total cost Rs.52,990.77
Add: Mark up (37.5% of cost) Rs.19,871.54
Sales value Rs.72,862.31
Selling price per unit of Nickel (Rs.72,862.31 / 4,500 units) Rs.16.19
Section C: Applied Theory
6 The following are the major steps in the process of using a model to arrive at he optimal decision:
Feasibility report
Model construction
Compatibility of the model with the tools used
Model validation
Implementation
Model revision
Documentation
Feasibility Report The foremost step in developing a model is to ascertain the feasibility of a model assisting
the decision making process. The various points that are required to be considered are:
Whether the decision under consideration is a one-time process, or is required to be taken as a routine measure.
The suitability of the area in which the decisions is required to be made, to be supported by a model.
The possibly of all the relevant variables being unambiguously identified.
The possibility of all the variables being built-in into a single model.
The expected effectiveness of the model.
The acceptability of a model replacing human judgment to the management.
The possibility of obtaining the required data on an ongoing basis.
The possibility of integrating the model with the normal decision-making process.
The costs involved with setting up and running the model, and its comparison with the expected
benefits.
If it is feasible to construct an efficient and effective model for the decision process under consideration, and if
the model can be easily integrated with the process, the firm can proceed to the next step of constructing the
model.
Model Construction The construction of the model depends on a number of factors. Some of these are:
The decision to be made using the model.
The issues that are relevant for making the decision.
The way in which these issues and factors affect the decision.
The external factors that restrict the decision making process.
Depending on these factors, the inputs requirement for the model is identified and the numeric and theoretical
relationships between variable are specified. This is followed by development of the structure of the model.
Model Compatibility One of the model is inactive, it needs to be made compatible to the tools to be used to
implement it. For example, if a particular model is to be solved using computers, the model needs to be
programmed and converted to a language that the computer understands.
Model Validation A number of test runs are conducted on the model to check whether it produces reasonably
accurate results. The test runs may use actual last data of the input variables, and the results generated by the
model compared to the actual results. Alternatively, the model may be tested by using probability distribution.
Test running a middle checks the effectiveness of the structure of the model, as well as its predictive ability.
Implementation The implementation of a model includes integrating it with the normal distribution process.
Further, it needs to be ensured that the results generated by the model are relevant enough for the decision
maker to take them into consideration while making a decision.
Model Revision No model remains useful for an indefinite period. The relationships between variables that
form a basis for the model may change over a period of time. External factors affecting a model may also
change. Use of the model over a period may provide an insight into its drawbacks. It is necessary that such
changes are noted and the mode periodically revised to accommodate them. Unless a model is continuously
updated, it may lose its relevance.
Documentation Documentation is a way of institutionalization of the knowledge created drug the process of
developing ad installing a model. It involves making detailed, systematic notes at all the stages of the process.
The records should be maintained right from the stage when the need for the model was fell, detailing the
factors that gave rise to the need. The various ideas considered at different stages need to be documented along
with the reasons for their acceptance or rejection. The various problems faced during the development and
implementation of the model, together with their solutions should also form a part of the records.
Documentation also helps in proper communication between the members of the team working on the
<
development of the model. In addition, it makes the process of revising the model less tedious.
While developing and implementing models, certain issues need to in kept in mind. It is not just necessary to
specify the objectives of the model, it is also necessary to build the relative importance of the different
objectives of the model. For example, the objective may be to maximize the profits of the firm, while restricting
the debt taken by it to a certain percentage of the total assets. The model should specify the objective
(maximum profits or limited debt) that would be held supreme, if there were a clash between to the two.
Another important point to be remembered is that the model should preferably focus on some keys aspects,
rather than to be collection of all relevant and irrelevant data. A focused model is more likely to generate
effective decisions.
7 There are four basic elements in the process of strategic management:
Environmental scanning
Strategy formulation
Strategy implementation
Evaluation and control
Environmental scanning Environmental scanning involves monitoring the environment, and evaluating and
disseminating information obtained form the internal and external environment. The aim of environmental
scanning is to identify the strategic factors that may determine the future of the firm. An organization can
determine several benefits from environmental scanning including the development of a common perception,
identification of strengths and weaknesses, understanding of trends and conditions, and the optimum utilization
of internal and external information. Tools such as surveys, questionnaires, focus groups and open forums can
be employed in environmental scanning. SWOT analysis is the most commonly used technique for
environmental scanning. SWOT is an acronym for the strengths, weaknesses, opportunities and threats faced by
a firm. Strengths and weaknesses are within the control of the top management in the long run. Opportunities
and threats are external factors that are outside the control of the organization. The key strengths of the firm
become the core competencies that the organization can use to gin competitive advantage.
Strategy formulation strategy formulation refers to the development of long term plans for managing
opportunities and threat to the external environment, and for utilizing the strengths ad overcoming the
weaknesses within the organization. A strategist has taken into consideration the components of strategic
management such as company mission, company profile, external environment, strategic analysis and choice
long term objectives, annual objective, grand strategy while formulating a strategy.
Strategy formulation hips an organization to :
Capitalize on available resources.
Address the challenges faced by the organization.
Provide leadership that understands and masters change.
Incorporate in-depth planning model that involves the community.
Strategy implementation The process by which strategies are put into action is called strategy
implementation. Programs, budgets and procedures are developed for this purpose. This process may call for
changes in overall culture, organizational structure, and/or the management system. The implementation of
strategy is typically handled by middle and lower level managers except when drastic company-wide changes
are needed. However, implementation is reviewed by the top management for time to time.
Evaluation and control Evaluation and control refers to the process in which corporate activities and
performance results are compared with the desired performance. This information is used to take corrective
action and resolve problems. It also pinpoints the weaknesses of strategic plans implemented earlier. Thus this
exercise provides a valuable opportunity for organizational learning.
For effective evaluation and control, the management must obtain clear, prompt and unbiased information from
the people who actually execute the strategies. Unbiased information is essential as this information is used for
corrective action and to minimize the mistakes the organization might commit in the future.
Feedback is a very important part of the evaluation process as it provides an opportunity to revise or correct
decisions made in the earlier stages. Poor performance indicates that something has gone wrong with either
strategy formulation or implementation. It could also mean that variable was ignored in the environmental
analysis.
<
< TOP OF THE DOCUMENT >
Question Paper
Strategic Financial Management - I (MSF3L1) : October 2007
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 following are the most typical beliefs that shape organizational culture except
(a) A belief that customers should reign supreme
(b) A belief in inspiring people to do their best, whatever their ability
(c) A belief that growth and profits are essential to a companys healthy financial position
(d) A belief in the importance of formal communication
(e) A belief in superior quality and service.
< Answ
2. Which of the following statements is false?
(a) In reality, risk management aims at ensuring that risk remains at the desired and
acceptable level
(b) In risk management, primary risks are those that arise out of the business activities but
are not integrally related to them
(c) Complete elimination of risk can take place only when no business activity is
undertaken
(d) Risk may be retained consciously because other techniques of managing risk are too
costly or not possible to employ
(e) The significance of a particular risk depends upon the size of the loss that it may result
in and the probability of the occurrence of such loss.
< Answ
3. Which of the following statements related to product life cycle is true?
(a) The products have infinite lives and pass through different phases in their life
(b) Product cost, revenue and profit patterns tend to follow unpredictable courses through
the product life cycle
(c) Profits of the product first appear during the maturity phase and decline thereafter
(d) Profit per unit varies as products move through their life cycles
(e) Each phase of the product life cycle except maturity phase poses different threats and
opportunities that give rise to different strategic actions.
< Answ
4. The return point of cash balances of Rosi Ltd. is Rs.4,250 and the summation of upper control limit and lower control limit
is equal to 2.2 times of return point. The annual yield on securities is 10% and the fixed conversion cost is Rs.500.
Assuming a year consists of 365 days, the variance of daily changes in the expected cash balance according to Miller and
Orr Model, is
(a) Rs.252.41
(b) Rs.336.54
(c) Rs.448.72
(d) Rs.311.55
(e) Rs.112.18.
< Answ
5. A decrease in a firm's willingness to pay dividends is likely to result from an increase in its
(a) Earnings stability
(b) Access to capital markets
(c) Profitable investment opportunities
(d) Collection of accounts receivable
(e) Stock price.
< Answ
6. Sankar Ltd. desires to maintain its capital structure at debt-equity ratio of 3:7. The company forecasts that its net income
for this year will be Rs.10,00,000. The company follows a residual dividend policy and anticipates a dividend payout ratio
of 40%. The amount of the companys capital budget is
(a) Rs. 6,00,000
(b) Rs. 8,57,143
(c) Rs.10,00,000
(d) Rs.14,28,571
(e) Rs.20,00,000.
< Answ
7. Which of the following statements related to industry analysis is false?
(a) A firm in a competitive industry should maintain less debt capacity as a matter of
competitive strategy
(b) The executive compensation contracts should reflect the firms industry relative
< Answ
performance as well as absolute performance, depending upon the level of competition
in an industry
(c) Co-operative relationship among firms like joint ventures and strategic alliances are
becoming means to compete effectively in industry
(d) Leverage can be used to create a barrier to the entry of rival firms in an industry
(e) A firms leverage should be set to balance the managerial agency costs with the costs
associated with competition in terms of product marketing strategy.
8. Which of the following statements is/are false with respect to different modes of strategic decision making?
I. Entrepreneurial mode is characterized by reactive solutions to existing problems.
II. Adaptive mode of decision making results in a fragmented strategy with incremental improvement.
III. In planning mode, appropriate information for situational analysis is gathered systematically.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answ
9. Acquisition of a distress firm can create value due to the following reasons except
(a) The combination may result in increased economies of scale
(b) The combination may create a different set of compensation system for the diverse set
of business activities
(c) The combination may increase the product market power
(d) The acquiring firm may be able to enhance the trouble firms operations through
superior management techniques
(e) The acquiring firm may be able to contribute badly needed capital to the trouble firms
for internal cash generation and useful access to external capital market.
< Answ
10. XXL Ltd. has made a profit of Rs.2,50,000 during the last year. The invested capital of the company for the last year was
Rs.26,00,000. The company has purchased a machinery for Rs.5,00,000, that has, by estimate increased the income by
10%. If the residual income of the company decreases by Rs.42,000, the cost of capital of the company would be
(a) 15.20%
(b) 14.25%
(c) 13.40%
(d) 12.20%
(e) 12.76%.
< Answ
11. Organization change means any substantive modification to some part of the organization. Change frequently disrupts
normality whilst the organization may be facing strong external pressure. Which of the following steps is not related to the
change process?
(a) Create consensus
(b) Building awareness of need to change
(c) Incompatibility with cherished values
(d) Foster debate
(e) Assign responsibility.
< Answ
12. If a company adheres strictly to the residual dividend policy, a sale of new equity by the company would suggest that
(a) The dividend payout ratio has remained constant
(b) The dividend payout ratio is increasing
(c) The dividend payout ratio is decreasing
(d) No dividends were paid for the year
(e) The amount of investments has decreased.
< Answ
13. Hindusthan Traders Ltd. has furnished the following information pertaining to its capital structure:
Particulars Rs. in crore
Equity capital (100 lakh equity shares of Rs.10 each) 10
Reserves 2
14% Debentures of Rs.100 each 3
For the year ended, the company has paid equity dividend at the rate of 20%. As the company is a market leader with good
future, dividend is likely to grow by 5% every year. The equity shares are now traded at Rs.80 per share in the stock
exchange. Income tax rate applicable to the company is 35%. The current weighted cost of capital of the company is
(a) 7.92%
(b) 7.50%
(c) 9.13%
(d) 8.34%
(e) 8.87%.
< Answ
14. A-1 Ltd. has provided the following information pertaining to its operation for a period:
< Answ
Units produced and sold 15,000
Sale price per unit Rs.200
Variable cost per unit Rs.172
Total fixed cost Rs.2,10,000
If the units (produced and sold) increase by 12%, the percentage change in EBIT will be
(a) 10.25%
(b) 11.80%
(c) 12.80%
(d) 18.50%
(e) 24.00%.
15. Which of the following statements best describes the theories of investors preferences for dividends?
(a) Modigliani and Miller argue that investors prefer dividends to capital gains
(b) The bird-in-hand theory suggests that a company can reduce its cost of equity capital by reducing its
dividend payout ratio
(c) The tax preference theory suggests that a company can increase its stock price by
increasing its dividend payout ratio
(d) One key advantage of a residual distribution policy (with all distributions as dividends)
is that it enables a company to follow a stable dividend policy
(e) The clientele effect suggests that companies should follow a stable dividend policy.
< Answ
16. Which of the following statements is false with respect to BCG matrix?
(a) Cash cows hold a large market share in a mature and slow-growing industry
(b) Question marks have a small market share in a high growth market
(c) Question marks need significant investment because their cash needs are high
(d) Dogs have low market share in an intensely competitive mature industry characterized
by low profits
(e) Stars have a strong business position and negligible investment requirement and hence
the returns from these businesses are often more than their investment requirements.
< Answ
17. The collection of beliefs, expectations and values learned and shared by a corporation's members and transmitted from one
generation of employees to another is known as
(a) Cultural Integration
(b) Corporate Culture
(c) Corporate Intensity
(d) Corporate Integration
(e) Corporate Identity.
< Answ
18. Which of the following controls helps to check, systematically and continuously, whether or not the assumptions set during
the planning and implementation process are still valid?
(a) Operational control
(b) Premise control
(c) Strategic surveillance control
(d) Special alert control
(e) Implementation control.
< Answ
19. If the inflation rate is expected to rise from 6% to 8%, nominal return before rise in inflation is 15%, and tax rate is 35%,
then nominal return after rise in level of inflation will be
(a) 17.23%
(b) 16.74%
(c) 12.15%
(d) 18.08%
(e) 20.71%.
< Answ
20. Which of the following assumptions is false with respect to Baumol Model?
(a) Cash expenses are incurred evenly over the planning period
(b) Securities for a particular sum are converted into cash at a regular frequency
(c) The cash requirement for the period under consideration is known in advance
(d) There are two costs involved i.e. holding costs and conversion costs
(e) All cash surplus is initially parked in short-term securities.
< Answ
21. Following information is related to two companies - AB Ltd. and MN Ltd.:
Particulars AB Ltd. MN Ltd.
Asset Beta 0.85 0.76
Network asset / Total asset 0.50 0.40
Non-network asset / Total asset 0.50 0.60
Assuming the networks for both the companies are comparable, the network beta is
(a) 1.215
< Answ
(b) 1.150
(c) 1.165
(d) 1.135
(e) 1.300.
22. There are two firms, P Ltd. and Q Ltd. They are similar in all respects except that P Ltd. is unlevered, while Q Ltd. has
Rs.6 crore of 14% Debentures outstanding. Both companies have a net operating income of Rs.1.2 crore each. The tax rate
applicable to both the companies is 35%. The discount rate for both the companies is 12% p.a. The value of firm Q Ltd.,
considering Modigliani-Miller position on leverage holds good is
(a) Rs.9.32 crore
(b) Rs.6.82 crore
(c) Rs.7.52 crore
(d) Rs.8.60 crore
(e) Rs.5.22 crore.
< Answ
23. If a portion of the firm is sold to outsiders through an equity offering, giving them ownership of that portion of the
previously existing firm, it is referred to as
(a) Spin-off
(b) Split-off
(c) Split-up
(d) Equity carve-out
(e) Divestiture.
< Answ
24. Which of the following is not a decision role of a manager?
(a) Entrepreneur role
(b) Resource allocator role
(c) Negotiator role
(d) Disseminator role
(e) Disturbance handler role.
< Answ
25. Which of the following is not the possible procedure that can be used in order to deal with real options?
(a) Using the decision tree analysis
(b) Using a standard model for a financial option
(c) Using the Discounted Cash Flow valuation and including a qualitative recognition of
any real option value
(d) Developing a unique, project specific model with the help of techniques in financial
engineering
(e) Using the Discounted Cash Flow valuation and ignoring any real options, with the
assumption that their values are negative.
< Answ
26. Omol Ltd. is acquiring Komol Ltd. for Rs. 7,00,000. The financial information pertaining to Komol Ltd. is as follows:
Cash sales Rs.8,00,000 per year for the indefinite future
Cash costs 80% of sales
Cost of levered equity 16%
Interest rate 12%
Target debt to equity ratio 1/3
Tax rate 34%
The net present value of the acquisition for Omol Ltd., using weighted average cost of capital is
(a) Rs.44,943
(b) Rs.59,836
(c) Rs.58,620
(d) Rs.55,365
(e) Rs.65,600.
< Answ
27. Which of the following is not a value driver that affects the value of a firm according to Alcar Model?
(a) Operating profit margin
(b) Income tax rate
(c) Cost of capital
(d) Growth rate of sales
(e) Book value of the firm.
< Answ
28. Which of the following statements most correctly describes the factor that influences capital structure decisions?
(a) The higher the probability of future capital needs and the worse the consequences of a
capital shortage, the stronger the balance sheet should be
(b) The greater the business risk, the higher the optimal debt ratio will be
(c) Large depreciation tax shields and tax-loss carry-forwards will make it more
advantageous for firms to assume more debt
(d) The major reason for firms to limit the use of debt is that interest is tax-deductible,
which raises the effective cost of debt
(e) If a firm is run by a very conservative manager, he/she may be more inclined to use
debt to bolster profits.
< Answ
29. Which of the following is not the assumption of the theories of capital structure?
(a) The impact of tax shields associated with debt is abstracted
(b) The firm is allowed to issue and repurchase any amount of debt or equity
(c) The composition of capital can be changed without any transaction costs
(d) The firm consistently follows the policy of 100% dividend pay out
(e) The operating earnings of the firm are expected to grow at a constant rate for all future periods.
< Answ
30. The covariance between the returns on the stock of Vinayak Ltd., a wholly owned subsidiary of Shiva Ltd., and the returns
on the market is 300%
2
. The market return is 13%. The risk associated with market returns is 200%
2
. The 364-day T-bills
are issued at a discount of 6% to face value. The expected value per share of Vinayak Ltd. after a year hence is Rs.30.
According to risk adjusted discount rate method, the companys present value of share, assuming no payment of dividend,
is
(a) Rs.21.83
(b) Rs.25.80
(c) Rs.23.20
(d) Rs.22.73
(e) Rs.24.52.
< Answ
END OF SECTION A
Section B : Problems (50 Marks)
This section consists of questions with serial number 1 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
XLNT Ltd. has a capital of Rs.10,00,000 in equity shares of Rs.100 each. The shares are currently quoted at par. The
company proposes to declare a dividend of Rs.10 per share. The capitalization rate for the risk class to which the company
belongs is 12%.
Required:
a. According to MM Dividend Model, what will be the market price of the share at the end of the year, if (i) no
dividend is declared? and (ii) 10% dividend is declared?
b. Assuming that the company has net profits of Rs.5,00,000 and makes new investments of Rs.10,00,000 during the
period, using MM Dividend Model, how many new shares the company will issue in the case (i) dividend is paid? and
(ii) dividend is not paid? Also verify the MM Dividend Irrelevancy Theory.
(2 + 6 = 8 marks)
<
Asian Cables Ltd. is manufacturing a special type of cable used by electricity undertakings. The company has furnished the
following information pertaining to its capital structure:
Particulars Rs. in lakh
Equity shares of Rs.100 each 20
Retained earnings 10
9% Preference shares 12
7% Debentures 8
Total 50
The company earns a return of 12% on capital employed. Owing to the increasing demand of the product in the market, the
company has made an expansion programme. The company requires a sum of Rs.25 lakh to finance its expansion programme
for which the following plans are available:
Plans Particulars
1 Issue of 20,000 equity shares at a premium of Rs.25 per share entirely.
2 Issue of equity shares at a premium of Rs.25 per share and 8% debentures in the ratio of 2:3
respectively.
3 Issue of 8% debentures entirely.
It is estimated that the P/E ratios of the aforementioned three alternative financing plans would be 21.4, 17.0 and 15.7
respectively. The income-tax rate of the company is 33%.
Required:
a. Which of the three financing plans would you recommend and why?
b. Compute the indifference level of EBIT between plan (1) and plan (3) above.
<
(9 + 2 = 11 marks)
Piston Manufacturing Ltd. has estimated its annual budget. The company has provided the following relevant details
pertaining to its estimation for the next year:
Sales (25% cash sales and balance on credit sales) Rs.46.80 lakh for 78,000 units
Raw material costs 60% of sales value
Labour costs Rs.6 per unit
Variable overhead costs Re.1 per unit
Fixed overhead costs including Rs.1,10,000
as depreciation Rs.5 lakh
Budgeted stock levels:
Raw materials
Work-in-progress
Finished goods
3 weeks
1 week (material 100%, labour
and overheads 50% completed)
2 weeks
Debtors period 4 weeks
Creditors period 4 weeks
Cash in hand required Rs.50,000
Lag in payment of overhead costs 2 weeks
Lag in payment of wages 2 weeks
You are required to calculate net requirement of working capital budget for the next year of the company, making whatever
assumptions that you may find necessary.
(11 marks)
<
Gemini Ltd. has furnished the following information pertaining to its accounting information and functional ratios for the
year ended March 31, 2007:
i. Accounting information:
Gross profit 15% of sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months usage
Stock of finished goods 6% of works cost
Debtors collection period 60 days
ii. Ratios:
Fixed assets to sales 1 : 3
Fixed assets to current assets 13 : 11
Current ratio 2
Long term loan to current liabilities 2
Capital to reserves and surplus 1 : 4
The value of fixed assets as on March 31, 2007 amounted to Rs.26 lakh. All sales are made on credit.
You are required to prepare a summarized profit and loss account of the company for the year ended March 31, 2007 and
balance sheet as at March 31, 2007.
(9 marks)
<
Deba Ltd. commenced its business on 1
st
April 2006. The company issued 2,00,000 equity shares of Rs.10 each at par and
12.5% Debentures of the aggregate value of Rs.2,00,000. The company has utilized the proceeds as follows:
Particulars Rs.
Fixtures and equipment (estimated life 10 years, no scrap value) 16,00,000
Goods purchased for resale at Rs.200 per unit 6,00,000
The company has furnished the following information pertaining to its business at the end of the financial year March 31,
2007:
The goods were entirely sold by 31
st
January, 2007 at a profit of 40% on selling price. The outstanding balance of debtors at
the year end amounted to Rs.60,000 and goods sold were replaced at a cost of Rs.7,20,000, the number of units purchased
being the same as before. A payment of Rs.40,000 to a supplier was outstanding as on the last day of the year. The replaced
goods remained entirely in stock on March 31, 2007. The market rate per unit of stock on that date was Rs.280.
The replacement cost of fixtures and equipments (depreciation on straight line basis) was Rs.20,00,000 as on March 31, 2007.
You are required to prepare Profit and Loss Accounts and Balance Sheets on historical cost basis and on replacement cost
(entry value) basis for the year ended March 31, 2007.
(11 marks)
<
END OF SECTION B
Section C : Applied Theory (20 Marks)
This section consists of questions with serial number 6 - 7.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.
Value-Based Management (VBM) is an approach to management whereby the companys overall aspiration, analytical
techniques and management process are all aligned to maximize the value of a company by focusing management decision-
making on the key drivers of value. In this context, explain the various steps involved in maximizing the value of the
company.
(10 marks)
<
Crisis management handles certain risks and uncertainties that arise over a period of time due to unanticipated and unwanted
events, which may result in huge losses in terms of money, reputation, etc. In this context, define the crisis management and
steps involved in managing the crisis.
(10 marks)
<
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management - I (MSF3L1) : October 2007
Section A : Basic Concepts
Answer : (d)
Reason : A belief in the importance of formal communication is not correct, it should be informal communication.
Other options mentioned in (a), (b), (c) and (e) are correct. Hence, the answer is (d).
Answer : (b)
Reason : In reality, risk management aims at ensuring that risk remains at the desired and acceptable level this
statement (a) is true.
In risk management, primary risks are those that arise out of the business activities but are not integrally
related to them this statement (b) is not true because this is secondary risk, not primary risk.
Complete elimination of risk can take place only when no business activity is undertaken this statement (c)
is true.
Risk may be retained consciously because other techniques of managing risk are too costly or not possible to
employ this statement (d) is true.
The significance of a particular risk depends upon the size of the loss that it may result in and the probability
of the occurrence of such loss this statement (e) is true.
Hence, the answer is (b).
Answer : (d)
Reason : The products have infinite lives and pass through different phases in their life (a) this is not true because
products have finite life.
Product cost, revenue and profit patterns tend to follow unpredictable courses through the product life cycle
(b) this is not true because these follow predictable courses through the product life cycle.
Profit of the product first appear during the maturity phase and after stabilizing during the growth phase (c)
this is not true because profit first appear during the growth phase.
Each phase of the product life cycle except maturity phase poses different threats and opportunities that give
rise to different strategic actions (e) this is not true because maturity phase also poses threars and opportunities.
Profit per unit varies as products move through their life cycles (d) this is true. Therefore, answer is (d)
Answer : (c)
Reason : UL + LL = 2.2 RP = 2.2 Rs. 4,250 = Rs.9,350
UL = 3RP 2LL
(UL + LL) + LL = 3RP
Rs.9,350 + LL = 3 Rs. 4,250 = Rs.12,750
LL = Rs.12,750 Rs.9,350 = Rs.3,400
UL = Rs.9,350 Rs.3,400 = Rs.5,950
I = 10% 365 = 0.0274%
Rs.4,250 = + Rs.3,400
(Rs.4,250 - Rs.3,400)
3
=
= Rs.448.72.
Answer : (c)
Reason : A decrease in a firm's willingness to pay dividends is likely to result from an increase in its profitable
investment opportunities, but not increase in earnings stability, access to capital markets, collection of accounts
receivable and stock price. Hence the answer is (c).
Answer : (b)
Reason : Dividend payout = Rs.10,00,000 0.4 = Rs.4,00,000
Retained earning = Rs.10,00,000 0.6 = Rs.6,00,000 available for capital investment
Given that the firm will finance new investment with 70% equity and 30% debt,
Rs.6,00,000 must represent 70% of the companys capital budget,
that is Rs.6,00,000 = Capital budget 0.7,
Capital budget = Rs.6,00,000 0.7 = Rs.8,57,143.
Answer : (a)
Reason : A firm in a competitive industry should maintain less debt capacity as a matter of competitive strategy this
statement is not correct because competitive industry should maintain excess debt capacity. Other options are correct.
Hence, the answer is (a).
Answer : (a)
Reason : Adaptive mode is characterized by reactive solutions to existing problems, not entrepreneurial mode. All
other statements are correct. Therefore, the answer is (a).
Answer : (b)
Reason : The combination may create a different set of compensation system for the diverse set of business activities
this statement (b) is not the reason for acquisition, this is one of the important internal legal structure of a firm. Other
options are the reasons for creating value for acquisition. Therefore, the answer is (b).
. Answer : (c)
Reason : Residual income is the income in excess of the cost of capital. Let, the cost of capital = X
The current residual income = [Rs.2,50,000 (Rs.26,00,000 X)]
If the equipment is purchased, the residual income
= [( Rs.2,50,000 + Rs.25,000) (Rs.26,00,000 + Rs.5,00,000) X)]
Residual income decreases by = Rs.42,000.
Therefore,
[(Rs.2,50,000 + Rs.25,000) (Rs.26,00,000 + Rs.5,00,000) X] (Rs.2,50,000 Rs.26,00,000 X) = - Rs.42,000
Rs.2,75,000 31,00,000X 2,50,000 + 26,00,000X = - Rs.42,000
Rs.25,000 5,00,000X = - Rs.42,000
5,00,000X = Rs.67,000
X = Rs.67,000 5,00,000 = 0.134 or 13.40%
. Answer : (c)
Reason : Incompatibility with cherished values is the reason for resistance to change, this is not the step in the
changing process. Other options (a), (b), (d) and (e) are the steps in the changing process. Hence, the correct answer is
(c).
. Answer : (d)
Reason : The residual dividend policy (with all distributions in the form of dividends) implies that dividends should be
paid only out of leftover earnings. The sale of equity implies that the company has already used all retained earnings.
Therefore, no dividends would have been paid. Hence the answer is (d).
. Answer : (a)
Reason : Cost of debt capital = 14% (1 - 0.35) = 9.1%
Cost of equity capital = [2(1.05) 80] + 0.05 = 0.07625 or 7.625%
Current weighted cost of capital = [(3 0.091 + (12 0.07625)] 15 = 0.0792 or 7.92%
. Answer : (e)
Reason : EBIT at 15,000 units = 15,000 (Rs.200 Rs.172) Rs.2,10,000 = Rs.2,10,000
EBIT at 15,000 1.12 = 16,800 units = 16,800 (Rs.200 Rs.172) Rs.2,10,000 = Rs.2,60,400.
% increase = (Rs.2,60,400 Rs.2,10,000) Rs.2,10,000 = 0.24 or 24%
. Answer : (e)
Reason : Statement (e) is true; the others are false. MM developed the dividend irrelevance theory. Reducing the
payout would have the effect of increasing the cost of equity if the bird-in-the-hand theory holds. The tax preference
theory suggests that a company can increase its stock price by reducing its payout ratio. The residual distribution policy
(with all distributions in the form of dividends) should be followed to determine the long-run target payout ratio. If
followed year to year, dividends would fluctuate.
. Answer : (e)
Reason: Cash cows have a strong business position and negligible investment requirement and hence the returns from
these businesses are often more than their investment requirements. All other statements are correct with respect to BCG
matrix.
. Answer : (b)
Reason : The collection of beliefs, expectations, and values learned and shared by a corporation's members and
transmitted from one generation of employees to another is known as the corporate culture.
. Answer : (b)
Reason: Premise means assumption. Premise control helps to check, systematically and continuously, whether or not
the assumptions set during the planning and implementation process are still valid.
. Answer : (d)
Reason : We have, r
1
= r +
Where, r
1
= Nominal rate after considering inflation factor.
r = Nominal rate prior to the increase in rate of inflation.
a
1
= Expected inflation rate after increase
a = Expected inflation rate before increase
f = Tax rate
r
1
= 15 + = 15 + = 18.08%.
. Answer : (d)
Reason : There are two costs involved i.e. holding costs and transaction costs. Conversion cost is the assumption of
Miller and Orr Model. Other assumption is true with respect to Baumol model. Hence, the answer is (d).
. Answer : (e)
Reason : AB : 0.85 = (0.5) + (0.5) .(1)
MN : 0.76 = (0.4) + (0.6) .(2)
Multiplying both the sides of the first equation by 6 and second equation by 5 and then subtracting equation (2) from
equation (1), and solving for ,
Therefore, 1.3 = 1
Therefore, = 1.3
. Answer : (d)
Reason : Value of Q Ltd.= + B t = + 0.35 6
= Rs.6.50 + Rs.2.10 = Rs.8.60 crore.
. Answer: (d)
Reason: If a portion of the firm is sold to outsiders through an equity offering, giving them ownership of that portion
of the previously existing firm, it is referred to as equity carve out. Therefore the answer is (d).
. Answer : (d)
Reason : Entrepreneur role, Resource allocator role, Negotiator role, and Disturbance handler role fall under decision
role of a manager. Disseminator role comes under information role. Therefore, the answer is (d).
. Answer : (e)
Reason : In option (e), the assumption is that their values are zero. Other options are correct with respect to the
possible procedures that can be used in order to deal with the real option.
. Answer : (d)
Reason : Weighted Average cost of capital (r
wacc
) = (3/4) 0.16 + (1/4) 0.12 (0.66) = 13.98%.
Cash inflows Rs. 8,00,000
Cash costs Rs. 6,40,000
Operating income Rs. 1,60,000
Corporate tax (34 %) Rs. 54,400
Unlevered cash flow Rs. 1,05,600
Present value = 1,05,600 0.1398 = Rs. 7,55,365
Net present value = Rs.7,55,365 Rs.7,00,000 = Rs. 55,365.
. Answer : (e)
Reason : Amongst the given alternatives, book value of the firm is not a value driver as per the Alcar model. Hence,
alternative (e) is answer.
. Answer : (a)
Reason : In times of financial and economic downturn, creditors will look to supply funds to companies that have
stronger financial positions. Therefore, the higher the probability of future capital needs and the worse the consequences
of a capital shortage, the stronger the balance sheet should be.
. Answer : (e)
Reason : The operating earnings of the firm are expected to remain constant for all future periods, not to grow at a
constant rate. All other statements are correct. Hence, alternative (e) is answer.
. Answer : (b)
Reason : The beta for the company is 300 200 = 1.5
Now, 364-day T-bill is at discount of 6%. Therefore, the yield of T-bill is .
Now, Risk adjusted discount rate method
PV = E(cf)/{1 + r
f
+ beta (R
T
R
f
)}
= 30 {1 + 0.064 + 1.5(0.13 0.064)} = 30 1.163 = Rs.25.80
Hence the correct answer is (b).
Section B : Problems
a. Modigliani and Miller Dividend Irrelevancy Model:
, Where,
P
0
= Existing market price per share i.e. Rs.100
P
1
= Market price of share at the year end (to be determined)
D
1
= Contemplated dividend per share i.e. Rs. 10
K
e
= Capitalisation rate for the risk class to which the company belongs i.e. 12% or 0.12
i. Calculation of share price when no dividend is declared:
, or
P
1
= 100 1.12 = Rs.112
ii. Calculation of share price when dividend is declared:
, or
P
1
+ 10 = 100 1.12; or P
1
= 112 10 = Rs.102
b. Calculation of number of shares to be issued according to MM Model:
Particulars If no dividend
declared (Rs.)
If dividend declared
(Rs.)
Net Income 5,00,000 5,00,000
Less: Dividend paid 1,00,000
Retained earnings 5,00,000 4,00,000
New investments 10,00,000 10,00,000
Amount to be raised by issue of new shares (i) 5,00,000 6,00,000
Market price per share (ii) 112 102
Number of new shares to be issued (i) (ii) 4,464 5,882
Verification of MM Dividend Irrelevancy Theory:
Particulars If dividend not
declared
If dividend
declared
Existing shares 10,000 10,000
New shares 4,464 5,882
Total number of shares at the year end (i) 14,464 15,882
Market price per share (ii) Rs.112 Rs.102
Total market value of shaers at the end of year (i) x (ii) Rs.16,20,000 16,20,000
Analysis: The market value of shares at the end of year will remain the same whether dividends are distributed or not declared.
a. An alternative which would ensure the highest market price per share should be recommended. Estimated earnings per share
(EPS) and market price per share (MPS) under the various financing plans are as follows:
Particulars At Present
Equity Shares
Plan (1)
Equity + 8%
Debenture
Plan (2)
Debentures
Plan
(3)
Earnings before interest and tax (EBIT)
at the rate of 12% on Rs.75 lakh (Rs.) 6,00,000 9,00,000 9,00,000 9,00,000
Less: Interest Old (Rs.) 56,000 56,000 56,000 56,000
New (Rs.) 1,20,000 2,00,000
Profit before tax (PBT) (Rs.) 5,44,000 8,44,000 7,24,000 6,44,000
Less: Tax @ 33% (Rs.) 1,79,520 2,78,520 2,38,920 2,12,520
Profit after tax (PAT) (Rs.) 3,64,480 5,65,480 4,85,080 4,31,480
Less: Preference dividend Old (Rs.) 1,08,000 1,08,000 1,08,000 1,08,000
Profit for equity shares (Rs.) 2,56,480 4,57,480 3,77,080 3,23,480
No. of equity shares (number) 20,000 40,000 28,000 20,000
EPS (Rs.) 12.82 11.44 13.47 16.17
P.E. Ratio 21.4 17.0 15.7
Market price per share (EPS P.E. Ratio)
(Rs.)
244.82 229.00 253.87
Recommendation: The objective of financial management is to maximize the wealth of the owners, which in the context of
companies means maximizing the market price of the companys equity shares. The above analysis shows that the market price per
share in debenture financing (plan 3) is Rs.253.87, which is maximum. EPS is higher in the case of debenture financing without
undue financial risk. Therefore, debenture financing alternative is recommended.
b. Indifference point on between alternative plans 1 and 3:
(EBIT Rs.56,000)(1 T) 40,000 = (EBIT Rs.2,56,000)(1 T) 20,000
EBIT Rs.56,000 = 2(EBIT Rs.2,56,000)
EBIT = Rs.5,12,000 Rs.56,000 = Rs.4,56,000.
Unit selling price and cost:
Particulars Rs.
Selling price per unit 60
Raw material costs 36
Labour costs 6
Variable overhead costs 1
Fixed overhead costs (excluding depreciation) 5
Total cost per unit 48
Statement of working capital requirement:
Current Assets: No. of weeks No. of units Cost per unit
(Rs.)
Total costs
(Rs.)
Raw material 3 4,500 36 1,62,000
Work-in-progress 1 1,500 42 63,000
Finished goods 2 3,000 48 1,44,000
Debtors 4 4,500 48 2,16,000
Cash in hand 50,000
Total current assets 6,35,000
Current liabilities: No. of weeks No. of units Cost per unit
(Rs.)
Total costs
(Rs.)
Creditors 4 6,000 36 2,16,000
Lag in wages 2 3,000
[2/52 78,000]
6 18,000
Lag in payment
of overheads
2 3,000
[2/52 78,000]
6 18,000
Total current liabilities 2,52,000
Net working capital required = Rs.6,35,000 Rs.2,52,000 = Rs.3,83,000.
Note: 1. Total sales for 4 weeks are 6,000 units. Excluding 25% cash sales, credit amounts to
4,500 units.
2. One year is assumed to be 52 weeks.
Profit and loss account for the year ended March 31, 2007
Particulars Rs.000 Particulars Rs.000
To Materials consumed 1,326By sales 7,800
To Direct wages 663
To Works overhead expenses (bal. fig.) 4,641
To gross profit c/d 1,170
7,800 7,800
To Admn. and selling & distribution expenses (bal.) 546By gross profit b/d 1,170
To Net profit 624
1,170 1,170
Balance Sheet as at March 31, 2007
Liabilities Rs.000 Assets Rs.000 Rs.000
Equity capital 300Fixed Assets: 2,600
Reserve & surplus 1,200Current assets:
Long term loan 2,200Raw material 331.5
Current liabilities 1,100Finished goods 397.8
Debtors 1,282.2
Cash (balancing) 188.5 2,200
4,800 4,800
Workings:
Works cost = Sales (1 gross profit margin) = Rs.78 lakh 0.85 = Rs.66.3 lakh
Sales = 3 Fixed assets = Rs.78 lakh
Current assets = Fixed assets 11/13 = Rs.22 lakh
As current ratio is 2, Current liabilities = (Current assets/2) = Rs.11 lakh
Average collection period = (Debtors 365/credit sales) = 60 (given)
Hence, Debtors = (Rs.78 60 days) 365 = Rs.12.822 lakh.
Profit and loss account for the year ended 31
st
March, 2007
Particulars Historical cost basis (Rs.) Replacement cost basis (Rs.)
Sales (6,00,000 100/60) 10,00,000 10,00,000
Less: Cost of sales 6,00,000 7,20,000
Gross profit 4,00,000 2,80,000
Less: Depreciation 1,60,000 1,80,000
(Average)
2,40,000 1,00,000
Less: Debentures interest 25,000 25,000
Net profit 2,15,000 75,000
Balance sheet as at 31
st
March 2007
Liabilities Historical
cost
Replacement cost Assets Historical cost Replacement cost
Equity share capital 20,00,000 20,00,000 Fixtures and equipments 14,40,000 18,00,000
Replacement reserve 6,20,000 Stock 7,20,000 8,40,000
Profit and loss a/c 2,15,000 75,000 Debtors 60,000 60,000
12.5% Debentures 2,00,000 2,00,000 Cash and Bank 2,35,000 2,35,000
Creditors 40,000 40,000
24,55,000 29,35,000 24,55,000 29,35,000
Working notes:
1. Replacement cost of sales has been taken on the basis of replacement cost at the date of sale Rs.7,20,000.
2. Depreciation has been calculated on the basis of average cost of equipment i.e., Rs.1,80,000.
3. Net current replacement cost of fixtures and equipment has been computed as follows:
Gross Replacement Cost 20,00,000
Less: Depreciation (10% of Rs.20,00,000) 2,00,000
18,00,000
4. Replacement Reserve = Realized Holding Gains + Unrealized Holding Gains
= Rs.1,40,000 + Rs.4,80,000 = Rs.6,20,000:
Particulars Realized Holding
Gains (Rs.)
Unrealized
Holding
Gains (Rs.)
Stocks:
Sold [replacement cost at the date of sale historical
cost = Rs.7,20,000 Rs.6,00,000]
1,20,000
Unsold [Closing Stock (Closing Rate Rate at the
date of purchase) = 3,000 (Rs.280 Rs.240)]
1,20,000
Fixtures and Equipments:
Depreciation (Rs.1,80,000 Rs.1,60,000) 20,000
Unrealized Holding Gain (Rs.18,00,000 Rs.14,40,000) 3,60,000
1,40,000 4,80000
5. Ascertainment of Cash and Bank Balance
Particulars Rs.
Collection from sales (Rs.10,00,000 Rs.60,000) 9,40,000
Less: Payment for purchases (Rs.7,20,000 Rs.40,000) 6,80,000
2,60,000
Less: Debenture interest 25,000
Cash and Bank Balance 2,35,000
Section C: Applied Theory
The McKinsey model, developed by leading management consultants McKinsey & Company, is a comprehensive approach
to value-based management It focuses on the identification of key value drivers at various levels of the organization, and
places emphasis on these value drivers in all the areas, i.e. in setting up of targets, in the various management processes, in
performance measurement, etc. According to Copeland, Koller and Murrin, value-based management is "an approach to
management whereby the company's overall aspirations, analytical techniques, and management processes are all aligned to
help the company maximize its value by focusing management decision-making on the key drivers of value". According to
this model, the key steps in maximizing the value of a firm are as follows:
Identification of value maximization as the supreme goal
Identification of the value drivers
Development of strategy
Setting of targets
Deciding upon the action plans
Setting up the performance measurement system
Implementation.
Value Maximization - The Supreme Goal
A firm may have many conflicting goals like maximization of PAT, maximization of market share, achieving consumer
satisfaction, etc. The first step in maximizing the value of a firm is to make it the most important goal for the organization. It
is generally reflected in maximized discounted cash flows. The other goals that a firm may have are generally consistent
with the goal of value maximization, but in case of a conflict, it should prevail over all other objectives.
Identification of the Value Drivers
The important factors that affect the value of a business are referred to as key value drivers. It is necessary to identify these
variables for value-based management. The value drivers need to be identified at various levels of an organization, so that
the personnel at all levels can ensure that their performance is in accordance with the overall objective. The other objectives
of a firm mentioned above may act as value drivers at some level of the organization. For example, degree of innovation in
products may be identified as the value driver for the design department. The three main levels at which the key value
drivers need to be identified are:
The generic level: At this level, the variables that reflect the achievement or non-achievement of the value
maximization objective most directly are identified. These may be the return on capital employed or operating margin
or the net profit margin, etc.
The department level: At this level, the variables that guide the department towards achieving the overall
objective are identified. For example, for the sales department, the key value drivers may be achieving the optimum
product mix, maximizing market share, etc.
The grass roots level: At the grass roots level, the variables that reflect the performance at the operational level
are identified. These may be the level of, capacity utilization, cost of managing inventory, etc.
Development of Strategy
The next step is to develop strategies at all levels of the organization, which are consistent with the goal of value
maximization, and lead to the achievement of the same. The strategies should be aimed at and give directions for the
achievement of the desired level of the key value drivers.
Setting of Targets
Development of strategies is followed by setting up of specific short-term and long-term targets. These should be specified
in terms of the desirable level of key value drivers. The short-term targets should be in tune with the long-term targets.
< TOP >
Similarly, the targets for the various levels of the organization should be in tune. They should be set both for financial as
well as non-financial variables.
Deciding upon the Action Plans
Once the strategy is in place and the targets have been determined, there is a need to specify the particular actions that are
required to be undertaken to achieve the targets in a manner that is consistent with the strategy. At this stage, the detai1
action plans are laid out.
Setting up the Performance Measurement System
The future performance of personnel is affected by the way their performance measured, to a large extent. Hence, it is
essential to set up a precise and unambiguous performance measurement system. A performance measure system should be
linked to the achievement of targets and should reflect the characteristics of each individual department.
Implementation
The first step in implementing value-based management is to identify the current position of the firm in term of the six
factors shown in the figure below:
Figure
Source: Copeland, Koller & Murrin, Valuation: Measuring and Managing the Value of Companies.
The next step is to use the action plans laid out to stretch the firm to the maximum possible extent in terms of each of these
factors. The outer limit of the hexagon reflects the maximum limit to which an organization can stretch itself. The aim of
value maximization is to make the firm reach these limits.
Crisis management addresses certain risks and uncertainties that arise over period of time. Crises can be of different types:
accidental (e.g. fires and computer failure) deliberate (e.g. poisoning scares contamination of food products). Wherever
possible, firms prepare contingency plans to mitigate the effect of these crises. Sometimes, strategic changes can also lead to
a crisis of confidence. For example rumors that a firm is going to be acquired by some other company might lead to falling
sales, reduction of profits, etc. Three decisions are important in ensuring that crisis strategy is effective:
Decisions concerning what can go wrong, the probability of it happening and the impact it will have if it does
happen.
Decisions about investing in preventive measures in order to reduce or minimize the risk.
Decisions on mechanisms for contingency management
Steps for Managing Crisis
The various steps in the process of crisis management arc:
Identification of the most obvious areas of risk
Establishment of policies and procedures to avoid chances of risks becoming cases.
Identification of trained crisis management team to take care of a crisis situation whenever it arises.
Stakeholder analysis is another crucial aspect of the process. It is important to identify which stakeholders are
most likely to be affected by a particular crisis and how. Where stakeholder perspectives and expectations differ, it may
be necessary to deal with each group on an individual basis.
Formulation of a clear communication strategy is essential. Sometimes ethical issues may be involved and the
company is expected to be cooperative, open, honest and consistent. The company should be in control but should not
attempt to cover up its failings.
Overall an effective information system is required for gathering and disseminating the salient facts. Therefore crisis
management is important from a strategic point of view. Failure to deal effectively with crises can lead to loss of confidence,
competitiveness, profits and market share.
< TOP >
< TOP OF THE DOCUMENT >

Question Paper
Strategic Financial Management (MB361F) : October 2007

Section A : Basic Concepts (30 Marks)

This section consists oI questions with serial number 1 - 30.
Answer all questions.
Each question carries one mark.
Maximum time Ior answering Section A is 30 Minutes.
1. Goal congruence can be achieved by
I. Paying bonuses to managers.
II. Rewarding managers with shares.
III. Monitoring managerial behavior.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
2. Which oI the Iollowing is/are the primary reason(s) responsible Ior adoption oI non-growth strategy?
I. Pressure Irom public opinion.
II. Maintaining an acceptable quality liIe.
III. OverIlow oI expert and loyal staII.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
3. Which oI the Iollowing comes under the Iinancial structure oI the Iirm?
(a) Executive compensation policies
(b) Capital budgeting decisions
(c) Decision regarding the size oI the Iirm
(d) Internal audit
(e) Decision regarding the production Iunction oI the company.
4. JK Tyres has a target capital structure oI 40 debt and 60 equity. The yield to maturity on the
company`s outstanding bond is 12, the company`s tax rate is 45. JK`s CFO has calculated
company`s average cost oI capital as 10. The company`s cost oI equity is
(a) 8.00
(b) 9.62
(c) 10.65
(d) 11.22
(e) 12.27.
5. A Iirm is considering Iollowing Iive proposals:
The project that will be ranked Iirst as per ProIitability Index method is
Project Initial investment (Rs.) NPV (Rs.)
1 1000 210
2 6000 1560
3 5000 850
4 2500 500
5 500 95
(a) Project 1
(b) Project 2
(c) Project 3
(d) Project 4
(e) Project 5.
6. Which oI the Iollowing statements is/are false about real options?
I. The underlying in case oI real option is a security like share/bond.
II. The underlying in case oI real option is a tangible asset.
III. The management has a control over the underlying asset on which real options are written.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
7. Which oI the Iollowing approach advocates that cost oI capital is dependent on the capital structure i.e.,
there is an optimal capital structure?
(a) Net Income approach
(b) Traditional approach
(c) Net operating Income approach
(d) MM approach
(e) Walter approach.
8. Which oI the Iollowing statements is/are true about the agency cost?
I. These costs arise as the creditors doubt about the credibility oI the management.
II. These are the legal and enIorcement costs.
III. These costs impair the operating eIIiciency.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
9. The level at which Earnings Per Share(EPS) oI the Iirm is same Ior two diIIerent capital structures is
known as
(a) Operating breakeven point
(b) Breakeven point
(c) IndiIIerence point
(d) Financial breakeven point
(e) Total breakeven point.
10. Birla Ltd. has 95,000 shares outstanding. The current market price oI the share is Rs.20. The company
expects a net proIit oI Rs.2,60,000 during the year and it belongs to a risk class Ior which appropriate
capitalization rate has been estimated to be 9. The company has declared a dividend oI Rs.5 per share
Ior the current year. Using Modigliani-Miller model the value oI the share is
(a) Rs.14.8
(b) Rs.16.8
(c) Rs.17.2
(d) Rs.19.8
(e) Rs.21.8.
11. Which oI the Iollowing is/are the diIIerence(s) between stock splits and bonus issues?
I. Stock splits result in an increase in the number oI shares while bonus issues do not.
II. Stock splits result in reduction in the Iace value oI the shares while bonus issues do not.
III. Stock splits require the conversion oI the reserves and surpluses into equity, while bonus issues do
not.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
12. The rate oI return oI CAT Ltd. is 12, earnings per share is Rs.15 and the cost oI capital is 10. The
dividend payout ratio oI the company is 20. The share price oI the company as per Gordon model is
(a) Rs.550
(b) Rs.650
(c) Rs.750
(d) Rs.850
(e) Rs.950.
13. Which oI the Iollowing schemes is/are not used by management to decrease the risk oI their personal
portIolios?
I. Lesser diversiIication.
II. Bias towards investment with near-term pay-oIIs.
III. Underemployment oI debt.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
14. Which oI the Iollowing reasons is/are considered responsible Ior the Iailure oI executive compensation
plan?
I. Correlation between the size oI the company and its payment structure.
II. Emphasis on short term perIormance oI the company.
III. Extra Iocus on the accounting measures while designing the compensation contracts.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
15. According to McKinsey model, which oI the Iollowing is the supreme goal oI the Iirm?
(a) ProIit maximization
(b) Value maximization
(c) Consumer satisIaction
(d) Optimum product mix
(e) Capacity utilization.
16. Which oI the Iollowing statements is/are true about Marakon Model oI maximization oI shareholder
value?
I. The Iirm`s value is measured by the ratio oI its market value to the book value.
II. A Iirm can maximize its value by understanding the Iinancial Iactors that determine the Iirm`s
value.
III. Firm`s value can be maximized by creating an internal structure to counter the divergence between
the shareholder`s goals and management`s goals.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
17. According to Porter`s Five Forces model oI industry analysis, a Iirm can take an advantage over its rival
Iirm by
I. Using constant price policy.
II. Improving the product diIIerentiation and distribution system.
III. Exploiting relationship with suppliers.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
18. Which oI the Iollowing is an important tool Ior assessing the strength oI an organization within its
industry?
(a) Ratio Analysis
(b) Comparative Analysis
(c) Technical Analysis
(d) Accounting Analysis
(e) Marketing Analysis.
19. Which oI the Iollowing is an internal Iactor oI bankruptcy?
(a) Technological obsolescence
(b) Scarcity oI raw materials
(c) Prolonged power cuts
(d) Inadequate Iunds
(e) Shrinking demand.
20. Which oI the Iollowing statements is/are true regarding Wilcox model oI bankruptcy prediction?
I. The net liquidation value oI the Iirm is best indicator oI its Iinancial health.
II. Liquidation value is the market value oI assets only, iI liquidated at the point oI study.
III. This model suggests that the Iinancial ratios are useIul in prediction oI Iailure at least 5 years
beIore their occurrence.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
21. Which oI the Iollowing is not an assumption oI Baumol Model oI cash management?
(a) There are two involved-holding costs and transaction costs
(b) The cash requirement Ior the period under consideration is known in advance
(c) Securities Ior a particular sum are converted into cash at a regular Irequency
(d) The conversion cost is variable
(e) Cash expenses are incurred evenly over the planning period.
22. Consider the Iollowing inIormation relating to Aircel Ltd.:
The Iixed charges coverage ratio oI the company is
EBIT Rs.20 crore
Depreciation Rs.3 crore
Interest on debt Rs.3 crore
Annual loan installment Rs.2 crore
Tax rate 35
(a) 2.50
(b) 3.03
(c) 3.78
(d) 4.04
(e) 4.59.
23. The Iollowing inIormation is available about Raj & Co.:
Rs. in crore

Working Capital Leverage (WCL) Ior 30 increase in current assets will be
Gross Fixed Assets 75
Accumulated Depreciation 25
Total current assets 150
Current liability 50
EBIT 30
(a) 0.238
(b) 0.313
(c) 0.588
(d) 0.612
(e) 0.885.
24. Which oI the Iollowing statements is/are false regarding Activity Based Costing (ABC)?
I. ABC is based on historical costs.
II. ABC makes diIIerence between variable and Iixed costs.
III. ABC is as accurate as the quality oI cost drivers.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

25. Which oI the Iollowing is not a cause oI relative cost advantage?
(a) EIIicient process technology
(b) Access to low cost distribution channels
(c) Product diIIerentiation
(d) Superior management
(e) Economies oI scale.
26. Which oI the Iollowing statements is/are true?
I. Corporate risk management is the process oI managing risk at an acceptable level.
II. The goal oI risk management is complete elimination oI risk.
III. To earn proIits, bearing some risk is must.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
27. Which oI the Iollowing statements with regard to Value at Risk (VaR) is/are true?
I. VaR is an estimate oI the level oI gain on a portIolio, which is expected to be equaled or exceeded
with a given small probability.
II. VaR is also used to identiIy risk arising out oI individual assets or individual liabilities, which can
be aggregated later Ior the whole Iirm.
III. A portIolio having a VaR oI Y at 95 conIidence level implies that, there is a 5 probability oI
the portIolio`s value Ialling by less than Y.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
28. A Iirm speciIic risk can be hedged by
(a) Futures
(b) Real options
(c) Insurance contracts
(d) Financial options
(e) Swaps.
29. Which oI the Iollowing Iactor(s) determine the economic risk?
I. Location oI production Iacilities.
II. Location oI competitors.
III. Determinants oI input prices.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
30. The table below shows Iollowing inIormation about a company:
The asset turnover ratio Ior the company is
Dividend per share Rs.5
Dividend cover 5
Number oI outstanding shares 10,000
Net proIit margin 10
Total assets Rs.10,00,000
(a) 1.25
(b) 1.50
(c) 2.00
(d) 2.50
(e) 4.00.

Section B : Problems/Caselet (50 Marks)
This section consists oI questions with serial number 1 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should Iorm part oI your answer.
Do not spend more than 110 - 120 minutes on Section B.

1. The Iollowing inIormation is given about the Kalyani Publishers Ltd.
You are required to calculate the optimal capital structure oI Kalyani Publishers.
(10 marks)
Proportion of
debt ()
Cost of debt
(after tax) ()
Cost of equity
()
0 0 16.0
10 8.0 15.5
20 8.5 15.0
30 9.0 14.5
40 9.5 14.0
50 10.0 13.5
60 10.5 13.0
2. Reliance Industries Ltd. expects some degree oI certainty to generate Iollowing net income and the
Iollowing capital expenditure during the next 5 years:
The company currently has 15,00,000 shares oI equity and pays dividend oI Rs.6 per share.
You are required to calculate
a. Dividends per share iI the dividend policy is treated as residual decision.
b. Amount oI external Iinancing that will be necessary iI the present dividend per share is
maintained.
c. Amount oI external Iinancing that will be necessary iI the dividend pay out ratio oI 40 is
maintained.
(4 + 4 + 4 12 marks)
Year

Net Income(NI)
(Rs.)
Capital expenditure (CE)
(Rs.)
1 60,00,000 20,00,000
2 50,00,000 25,00,000
3 26,00,000 32,00,000
4 21,00,000 4000,000
5 16,00,000 50,00,000
3. a. Aditya Industries Ltd. uses the Baumol model to estimate its optimal cash balance Ior the
period under consideration. The optimal cash balance under this method is Rs.20 Lakhs. Every
time the marketable securities are converted into liquid reserves, a cost oI Rs.500 is incurred. II
the opportunity cost oI Iunds applicable to the Iirm is 10 percent p.a., you are required to
estimate the weekly cash usage rate.
b. The company is planning to experiment with the Miller-Orr model Ior its cash reserve limits.
Under this method, the company will be subject to a daily interest rate oI 0.0333, a standard
deviation oI cash balance oI Rs.5,000 and has to incur a sum oI Rs.1600 as Iixed conversion
cost, the management oI company would like to maintain a minimum cash balance oI
Rs.50,000.
You are required to:
i. Estimate the return point and upper control limit oI Aditya Industries Ltd.
ii. Comment what measures a Iinancial manager should take iI the cash balance reaches the
upper control limit or lower control limit?
END OF SECTION B
(4 + 8 12 marks)
Caselet
Read the caselet carefully and answer the following questions:
4. Why are Iinance managers motivated to increase capital investment, iI perIormance is measured
based on EBIT? How is EBIT better over revenue earned or proIit earned?
(6 marks)
5. What are the major non-Iinancial measures oI perIormance?
(10 marks)
All the companies interviewed in France and Germany emphasized value creation in their communication with
Iinancial analysts and investors. This has become a must` in annual reports and can be seen as part oI a wider eIIort to
improve the quality oI inIormation provided to shareholders, including greater use oI international accounting
standards, the introduction oI quarterly reports, more willingness to provide a Iinancial breakdown oI key business
segments, more regular conIerence calls and more active market guidance.
However, those value indicators used in communication are Iar Irom being standardized and the range oI alternatives
varies widely Irom traditional earnings per share to the new` metrics, such as TSR (Total Shareholder Return) and
EVA (Economic Value Added).
Attempts to develop a common language are not encouraged by the Iinancial community itselI. Many analysts make
their own adjustments Irom the accounting IiguresoIten driven by the peculiarities oI a particular sector while others
are dismissive oI the new` metrics. There may be general enthusiasm Ior the concept oI shareholder value but there is
no clear guidance Irom the Iinancial markets on how best to implement it within the Iirm.
Quite a large number oI companies are clearly content to make vague and cosmetic reIerences to value creation while
leaving their internal management processes unaltered.
Others go deeper but merely to observe that there are many unsettled issues within the organization: how to compute
the cost oI capital Ior the diIIerent business units, wherein the company goodwill should be allocated, which rule should
be used Ior capitalizing R&D or advertising expenses. They take advantage oI the Iocus on shareholders` interests to
revisit their own indicators but reIrain Irom embarking on a global change.
Only a Iew Iirms interviewed in Europe are currently doing the latter or willing to contemplate radical change in Iuture.
As we shall see below, the main reason given by the respondents Ior embarking on wholesale change was the
recognition by top management, oIten a new CEO, that Iinancial perIormance had deteriorated in the recent past and
that a radical new approach needed to be introduced. Such a move was oIten opportunistic (in part at least) and
designed primarily to send an internal message throughout the company rather than to the outside world.
Determination of performance measures
Surprisingly perhaps, the most commonly used perIormance measure at the level oI the proIit center does not take
account oI capital employed. Many companies still rely on such measures as Operating ProIit or EBIT (Earnings BeIore
Interest and Tax). This clearly means that managers have a strong incentive to increase capital investment. Balance
sheet issues are likely to remain in the hands oI accounting and Iinance people at corporate HQ with the result that the
allocation oI capital employed may not be related to the economic structure oI each business.
The two perIormance measures that usually appear in the headlines in connection with the new metrics are CFROI
(Cash Flow Return on Investment) and EVA (Economic Value Added) which is a trademark oI the US consultancy
Iirm Stern Stewart). These measures can be seen as an outgrowth Irom more traditional ones: ROI (Return on
Investment) and Residual Income respectively.
END OF CASELET

Suggested Answers
Strategic Financial Management (MB361F) : October 2007
Section A : Basic Concepts
END OF SECTION C

END OF QUESTION PAPER

6. Target costing has recently received considerable attention in the industries around the world as it
gives competitive edge in launching new products. Explain, what is target costing? Also discuss the
beneIits oI target costing.
(10 marks)
7. With growing levels oI uncertainty and risk, Iirms are Iacing an indecisive and non-deterministic
Iuture. Explain various approaches a Iirm can use to manage the risk.
(10 marks)
1. Answer : (e)
Reason: Goal congruence can be achieved by paying bonuses, incentives, rewarding managers with shares etc
these measures may motivate the managers to take the decisions which are consistent with the object
oI shareholders. Alternative measures like the management audit to monitor the behavior oI the man
can also help in establishment oI goal congruence.
2. Answer : (d)
Reason : The primary reasons Ior adopting non-growth strategy may include:
Pressure Irom the public opinion;
Maintain an acceptable quality oI liIe
Lack oI enough additional staII with suIIicient expertize and loyalty;
Enable the owner-manager to retain the personal control over operations and
Diseconomies oI scale oI particular production.
3. Answer : (a)
Reason : The operational structure oI the Iirm consists oI
The capital budgeting decisions.
Decision regarding the size oI the company.
Decision regarding the production Iunction (capital/labor intensive operations ).
Decision regarding the Iinancial structure oI the company.
Internal audit consisting oI cost and quality audit.
The Iinancial structure oI the Iirm consists oI
Ownership structure.
Financial planning and leverage
Executive compensation policies.
Dividend and stock repurchase policies.
4. Answer : (e)
Reason :

(1 )
0.10 0.60 0.40 0.12(1 0.45)
0.10 0.0264 0.0736
0.122666 12.27
0.60 0.60
H H H G
H
H
:$&& Z N Z N W
N
N
= +
= +

= = =
5. Answer : (b)
Reason :
Project
(1)
Initial investment
(Rs.)
(2)
NPV
(Rs.)
(3)
Cash inflows
(PV)
(Rs.)
(4) (2)+(3)
PI
(5) (4)/(2) Rank
1 1000 210 1210 1.21 II
2 6000 1560 7560 1.26 I
3 5000 850 5850 1.17 V
4 2500 500 3000 1.20 III
5 500 95 595 1.19 IV
6.
Answer : (a)
Reason : The basic diIIerence that exists between a Iinancial option and a real option lies in its underlying.
underlying that exists in case oI the Iormer is security such as a share oI common stock or a b
whereas the underlying Ior the latter is a tangible asset like a business unit or a project. Financial opt
are most oI the times issued by independent agents instead oI the by the companies whose shares they
contingent, thus agents who issue them has no inIluence and control oI the company and the shares
case oI real options the management controls the underlying real assets on which the real options
written.
7.
Answer : (b)
Reason: The principal implication oI the Traditional approach is that the cost oI capital is dependent on t
capital structure and there is an optimal capital structure which minimizes the cost oI capital. Accordi
to Net income approach the cost oI equity capital and debt capital remain unchanged when the degree
leverage changes. In other words, average cost oI capital declines as B/S increases because cost de
which is lower than cost oI equity receives higher weight in calculation oI average cost. According t
Net operating income approach, the overall capitalization rate and the cost oI debt remains constant I
all degrees oI leverage, MM approach states the relationship between the leverage and the cost oI capi
as explained by the net operating approach in terms oI three basic propositions.
8. Answer : (e)
Reason: Whenever the creditors are approached by a Iirm to obtain debt capital, they impose certain restrict
on the Iirm in the Iorm oI protective covenants incorporated in the loan contract as the creditors do
about the credibility oI the management. These restrictions generally entail the legal and enIorcem
costs which also impair the operating eIIiciency oI the Iirm. All these costs are reIerred to as agency co
9. Answer : (c)
Reason : The level at which the EPS oI the Iirm is same Ior two diIIerent capital structures is known as
indiIIerence point.
10. Answer : (b)
Reason :

( )
( )
When the dividend is declared:
1
1 0 1
20 1 0.09 5
1
21.8 5 .16.8
1
= +
= +
= =
3 3 N '
H
3
3 5V
11. Answer : (b)
Reason : Bonus issues require conversion oI reserves and surpluses into equity, not stock splits. Both bonus is
and stock splits result in an increase in the number oI shares. Only stock splits result in reduction oI
value
12. Answer : (c)
Reason :

( )
( )
Gordan Model:
E 1-b
P
15 1-0.80
P .750
0.10 (0.80 0.12)

=

N EU
H
5V
13. Answer : (a)
Reason : Management may use any oI the Iollowing schemes to decrease the Iirm`s risk and thus the risk oI t
personal portIolios:
Excessive diversiIication like conglomerates to reduce the Iirm-speciIic risk and ultimately ris
losing job.
In case management compensation is tied to the Iirm`s earnings, management has an incentiv
bias their selection oI capital investment projects towards investments that pay-oII well in short perio
time.
To save their jobs management may choose lower level oI leverage than its optimal to reduce
probability oI bankruptcy.
14. Answer : (e)
Reason : The basic reasons Ior the Iailure oI executive compensation plan are:
Correlation between the size oI the company and its payment structure. Because oI the existenc
the strong correlation between the size oI the company based on its asset value and sales
payment structure, companies sometimes tend to strive Ior bigger size irrespective oI the Iact th
adds to the valu oI the concern
Emphasis on the short-term perIormance oI the company. It has been Irequently observed that
short-term perIormance indicators such as sales and growth in the earnings provide a gre
weightage in incentive compensation that is paid to the executive.
More Iocus on accounting measures is given while designing the compensation contracts. Som
the measures are earnings and the return on investments.
15. Answer : (b)
Reason :
As per McKinsey model a Iirm may have conIlicting goals like maximization oI proIit aIter
maximization oI market share, achieving consumer satisIaction etc. The Iirst step in maximizing the v
oI a Iirm is to make it most important goal Ior the organization. It is generally reIlected in maxim
discounted cash Ilows. The other goals that a Iirm may have are generally consistent with the goa
value maximization, but in case oI conIlict, it should prevail over other objectives.
16. Answer : (e)
Reason : According to Marakon Model, a Iirm`s value is measured by ratio oI market value to the book value
the model Iurther states that a Iirm can maximize its value by Iollowing these Iour steps:
Understand the Iinancial Iactors that determine the Iirm`s value.
Undestand the strategic Iorces that aIIect the value oI the Iirm
Formulate strategies that lead to higher value oI oI the Iirm
Create an internal structures to counter the divergence between the shareholders goals
management`s goals.
17. Answer : (e)
Reason : According to Five Forces model a Iirm can take an advantage over the rival Iirm by changing pr
raising or lowering prices to gain a temporarry advantage, improving product diIIerentiation, creati
use oI ditribution system and exploiting relationship with suppliers.
18. Answer : (b)
Reason : Comparative Analysis is an important tool Ior assessing the strength oI an organization within its indu
19. Answer : (a)
Reason : Technological obsolescence is the internal Iactor oI bankruptcy.
20. Answer : (a)
Reason : Wilcox Model proposed that net liquidation value oI a Iirm is best indicator oI it Iinancial health. The
liquidation value can be obtained by the diIIerence in liquidation value oI Iirm`s assets and liquida
value oI liabilities. Liquidation value is market value oI assets and liabilities, iI liquidated at that poin
study.
21. Answer : (d)
Reason : The assumptions oI Baumol Model are:
1. There are two costs involved-holding costs and transaction costs. Holding costs are in the Iorm
interest Iorgone on cash balance held and transaction costs are costs incurred in converting secur
into cash.
2. The cash requirement Ior the period under the consideration is known in advance.
3. Securities Ior a particular sum are converted into cash at regular Irequency.
4. Cash expenses are incurred evenly over planning period.
5. The conversion cost is a Iixed sum irrespective oI the amount oI securities converted.
22. Answer : (c)

Section B
Reason : Fixed charges coverage ratio 3.78

) T 1 (
LR
I
D EBIT

+
+
) 35 . 0 1 (
2
3
3 20

+
+
23. Answer : (d)
Reason :
WCL

.

CA TA
CA
+
CA
NFA CA CA + +
150
50 150 150 0.30 + +
150 150
0.612
200 45 245
= =
+
24. Answer : (b)
Reason : ABC does not partition variable and Iixed costs. This is considered as is considered as a shortcomin
many short run decisions need to identiIy variable costs.
25. Answer : (c)
Reason : Product diIIerentiation gives competitive advantage to a Iirm. It cannot help to reduce the cost.
26. Answer : (e)
Reason : Corporate risk management reIers to the process oI a company attempting to managing its risk a
acceptable level. In order to earn proIit bearing some risk is necessary as risk elimination may o
possible iI there is no business at all. It is a misconception that goal oI risk management is comp
elimination oI risk. Actually risk management aims at ensuring that the risk remains at desired level.
27. Answer
(b)
Reason : VAR is an estimate oI the level oI the loss and not the gain on a portIolio that is expected to be equ
or exceeded with a given small probability. A portIolio having a VAR oI Y at 95 conIidence l
implies that there is a 5 percent probability oI the portIolio`s value Ialling by more, and not less than
Though not usable in isolation to quantiIy risk, VAR is also used to identiIy risk arising out oI indivi
assets or individual liabilities that are summed up to compute the VAR Ior the organization as a whole
28. Answer : (c)
Reason : Firm-speciIic risk is generally diversiIiable but cannot be hedged with derivative contracts. It is poss
to, however, to hedge many sources oI Iirm-speciIic risk with insurance contracts. For example, a
insurance contract provides a good hedge against the losses incurred as a result oI a Iire.
29. Answer : (e)
Reason : The Iollowing are the Iactors that determine the economic risk:
DiIIerence between the location Iacilities and where the product is sold
Location oI competitors
Determinants oI input prices: are they determined in international markets or local markets.
30. Answer : (d)
Reason : Dividend cover EPS/DPS
ThereIore EPS 25
Asset turnover ratio 2.5

ThereIore, Option (d) is the correct answer.
(25)(10,000)/0.10
10, 00, 000
1.

Proportion

oI debt
(1)
cost oI
debt
(2)
Weighted
average
(3) (1)*
(2)
Proportion

oI equity
(4)
Cost oI
equity
(5)
Weighted
average
(6) (4)*
(5)
Weighted average

cost oI capital
(7) (3) (6)



0 0 0 1 0.160 0.160 0.160 16.0
0.1 0.080 0.008 0.9 0.155 0.139 0.147 14.7
0.2 0.085 0.017 0.8 0.150 0.120 0.137 13.7
Since weighted average cost oI capital is lowest at 60 debt and 40 equity thereIore it is the optimal
capital structure oI the Iirm.
0.3 0.090 0.027 0.7 0.145 0.101 0.128 12.8
0.4 0.095 0.038 0.6 0.140 0.084 0.122 12.2
0.5 0.100 0.050 0.5 0.135 0.067 0.117 11.7
0.6 0.105 0.063 0.4 0.130 0.052 0.115 11.5
2. a.
b. Total amount oI dividend per year 1500000 * 6 Rs.90,00,000
c.
Year
(1)
NI
(2)
CE
(3)
Balance
(4) (2)-(3)
DPS Balance/
No. oI shares
1 6000000 2000000 4000000 2.666667
2 5000000 2500000 2500000 1.666667
3 2600000 3200000 - -
4 2100000 4000000 - -
5 1600000 5000000 - -
NI
(1)
Dividends
(2)
CE
(3)
Ex. Financing
(4) (2) (3) (1)
6000000
5000000
2600000
2100000
1600000
9000000
9000000
9000000
9000000
9000000
2000000
2500000
3200000
4000000
5000000
5000000
6500000
9600000
10900000
12400000
Rs.4,50,00,000 Rs.4,44,00,000
NI
(1)
Dividends
(2)
CE
(3)
Ex. Financing
(4) (2) (3) (1)
6000000
5000000
2600000
2100000
1600000
2400000
2000000
1040000
840000
640000
2000000
2500000
3200000
4000000
5000000
0
0
1640000
2740000
4040000
Rs.69,20,000 Rs.84,20,000
3. a. As per the Baumol model Ior determining the optimal cash balance,
Optimal cash balance |(2 x Annual cash usage x Cost per sale oI securities)/Annual interest rate|
1/2


Annual cash usage Rs.40,00,00,000
Weekly cash usage rate 400000000 / 52 Rs.76,92,308.
b. i. The return point and the upper control limit Ior beta as per Miller and Orr model are as
Iollows:
RP

UL 3RP 2LL
RP Return Point
b Rs.1600
I 0.0333
2
2 2
2
2
(2000000) (0.10)
.40, 00, 00, 000
2 2 500
EW
RU &
,
VTXDULQJ ERWK VLGHV ZH JHW
EW
&
,
& ,
RU W 5V
E
=
=

= = =

2
3
3
LL
4
E
,

+
Section C
Rs. 5000

LL Rs. 50,000
UL Upper control Limit.
RP

UL 3 94,964 - 2 50,000

UL Rs. 1,84,892.
ii. II the cash balance reaches the upper control limit oI Rs.1,84,892, the Iinance manager
should buy marketable securities Ior Rs.89,982. On the other hand, iI the cash balance
touches the lower limit oI Rs.50,000, the Iinance manager should sell marketable securities
to restore the cash balance to the return point level oI Rs.94,964.

2
3
3(1600) (5000)
50, 000 .94, 964
4 0.00033
5V + =


4. Managers try to increase capital investment iI their perIormance is measured based on the EBIT. This is
because EBIT is an absolute measure oI earning and is calculated ignoring the Iinancing eIIects. That
is, it is the Iigure oI earnings Irom which both interest and dividend have not been reduced. So,
increasing the capital investment will help them to increase EBIT.
Revenue earned is worse than EBIT as it does not even reveal operational eIIiciency. ProIit earned is
better. Ideally perIormance should be measured by a ratio oI the proIits Iinally remaining compared to
the investment.
5. Emphasis oI Iinancial measures alone can result in the ignorance oI physical as well as the qualitative
measure oI perIormance, by the heads oI the responsibility centers. Moreover, all the elements oI output
turned out by a responsibility center (and also the inputs) do not lend themselves to a money
measurement.
A brieI description oI some non-Iinancial measures oI perIormance is presented below.
a. Employee Productivity: This can be measured by calculating output obtained per employee or
sales aIIected per employee or the value added per employee. In addition to the measurement oI
employee productivity it is possible to measure the output per unit oI the inputs consumed i.e. a
measure oI overall productivity.
b. Marketing Effectiveness: This would measure the success oI the marketing eIIorts put in by the
divisions. For this purpose, a report on market position must be obtained Irom the divisional
managers. The market position is represented by the percentage oI sales to total sales in the market
and also by the ability oI the division to meet the outside competition successIully. An appraisal
has to be made oI each oI the major products handled by the division including an analysis oI the
product market leadership, superior or inIerior oI Ieatures in the own product compared with
outsider's product.
c. Employee Morale and Attitude: This is a vital aspect oI perIormance. The divisional managers
sometimes ignore the impact oI their decisions on employees in an attempt to maximize
production and proIitability. It is, thereIore, necessary to evaluate whether during the last one-year
employee morale has decreased or increased. Absolute precision in measurement oI this element
oI perIormance is seldom possible and iI attempted, could be a time consuming process. Hence, a
judgment made by a team oI executives aIter a thread-bare discussion may be suIIicient Ior this
purpose.
d. Social Responsibility: Contribution oI social responsibility can also be considered as one oI the
measures oI perIormance. The managers can sometimes deliberately ignore this aspect oI
perIormance in their bid to show a high amount oI proIit or return on capital employed.
e. Qualitative Aspects of Performance: The qualitative aspects must also Iigure in the list oI
perIormance measures. These include the number oI complaints received Irom customers, the
errors and Irauds, timely submission oI daily, weekly and monthly reports to higher authorities,
regularity oI attendance in meetings, etc.
I. Management practices: Adherence to better corporate governance eg. Transparency in the
operations, investment handling oI investors, client`s grievances dealing with creditors, debtors
and development oI human resources etc. all reIlect the type oI management practices being
Iollowed.
6. Target costing has recently received considerable attention. It is deIined as under:
Target cost Sales price (Ior the target market share) Desired proIit
Sony walkman is an excellent example oI it. In Iact Japanese cost management is known to be guided
by the concept oI target cost. In it management decides, beIore the product is designed, what a product
should cost, based on marketing (rather than manuIacturing) Iactors.
There are several phases in the methodology.
Conception (Planning) Phase
Based upon its strategic business plans, a company must Iirst identiIy the type oI product it wishes to
manuIacture.
Several steps must be taken in order to establish a reasonable target cost.
1. Market research should be done to determine several Iactors. First, the products oI competitors`
should be analyzed with regard to price, quality, service and support, delivery, and technology.
AIter a preliminary test oI competitor`s product, it is necessary to establish the Ieatures consumers
value in this type oI product, and the important Ieatures that are lacking.
2. AIter preliminary testing, a company should be able to pinpoint a market niche it believes is
undersupplied, and in which it believes it might have some competitive advantage. Only then can
a company set a target cost close to competitors` products oI similar Iunctions and value. The
target cost is bound to change in the development and design stages. However, the new target
costs should only be allowed to decrease, unless the company can provide added Ieatures that add
value to the product.
Development Phase
The company must Iind ways to attain the target cost. This involves a number oI steps.
1. First, an in-depth study oI the most competitive product on the market must be conducted. This
study will show materials used and Ieatures provided, and it will give an indication oI the
manuIacturing process needed to complete the product.
2. AIter identiIying the cost structure oI the competitor, the company should develop estimates Ior
the internal cost structure oI its own products.
3. AIter preliminary analysis oI the cost structures oI both the competition and itselI, the company
should Iurther deIine these cost structures in terms oI cost drivers. Focusing on cost drivers can
help reduce waste, improve quality, minimize non-value-added activities, and identiIy ineIIective
product design.

Production Phase
In these stages, target costing becomes a tool Ior reducing costs oI existing products. It is highly
unlikely that the design, manuIacturing, and engineering groups will develop the optimal, cost-eIIicient
process at the beginning oI production. The search Ior better, less expensive products should continue
in the Iramework oI continuous improvement.
BENEFITS OF TARGET COSTING
1. The process oI target costing provides detailed inIormation on the costs involved in producing a
new product, as well as a better way oI testing diIIerent cost scenarios through the use oI ABC.
2. Target costing reduces the development cycle oI a product.
3. The internal costing model, using ABC, can provide an excellent understanding oI the dynamics
oI production costs and can detail ways to eliminate waste, reduce non-value-added activities,
improve quality, simpliIy the process, and attack the root causes oI costs (cost drivers). It can also
be used Ior measuring diIIerent cost scenarios to ensure that the best ideas available are
incorporated Irom the outset into the production design.
4. The proIitability oI new products is increased by target costing through promoting reduction in
costs while maintaining or improving quality. It also helps in promoting the requirements oI
consumers, which leads to products that better reIlect consumer needs and Iind better acceptance
than existing products.
5. Target costing is also used to Iorecast Iuture costs and to provide motivation to meet
Iuture cost goals.
6. Target costing is very attractive because it is used to control costs beIore the company even incurs
any production costs, which save a great deal oI time and money.
7. There is one major drawback to target costing. It is diIIicult to use with complex products that
require many subassemblies, such as automobiles. This is because tracking costs becomes too
complicated and tedious, and cost analysis must be perIormed at so many levels.
7.
The Iollowing are the diIIerent approaches to managing risks:
Risk avoidance
Loss control
Combination
Separation
Risk transIer
Risk retention
Risk sharing.
Risk Avoidance
An extreme way oI managing risk is to avoid it altogether. This can be done by not undertaking the
activity that entails risk. For example, a corporate may decide not to invest in a particular industry
because the risk involved exceeds its risk bearing capacity. Though this approach is relevant under
certain circumstances, it is more oI an exception rather than a rule. It is neither prudent, nor possible to
use it Ior managing all kinds oI risks. The use oI risk avoidance Ior managing all risks would result in
no activity taking place, as all activities involve risk, while the level may vary.
Loss Control
Loss control reIers to the attempt to reduce either the possibility oI a loss or the quantum oI loss. This is
done by making adjustments in the day-to-day business activities. For example, a Iirm having Iloating
rate liabilities may decide to invest in Iloating rate assets to limit its exposure to interest rate risk. Or a
Iirm may decide to keep a certain percentage oI its Iunds in readily marketable assets. Another example
would be a Iirm invoicing its raw material purchases in the same currency in it which invoices the sales
oI its Iinished goods, in order to reduce its exchange risk.
Combination
Combination reIers to the technique oI combining more than one business activities in order to reduce
the overall risk oI the Iirm. It is also reIerred to as aggregation or diversiIication. It entails entering into
more than one business, with the diIIerent businesses having the least possible correlation with each
other. The absence oI a positive correlation results in at least some oI the businesses generating proIits
at any given time. Thus, it reduces the possibility oI the Iirm Iacing losses.
Separation
Separation is the technique oI reducing risk through separating parts oI businesses or assets or
liabilities. For example, a Iirm having two highly risky businesses with a positive correlation may spin-
oII one oI them as a separate entity in order to reduce its exposure to risk. Or, a company may locate its
inventory at a number oI places instead oI storing all oI it at one place, in order to reduce the risk oI
destruction by Iire. Another example may be a Iirm sourcing its raw materials Irom a number oI
suppliers instead oI Irom a single supplier, so as to avoid the risk oI loss arising Irom the single supplier
going out oI business.
Risk Transfer
Risk is transIerred when the Iirm originally exposed to a risk transIers it to another party which is
willing to bear the risk. This may be done in three ways. The Iirst is to transIer the asset itselI. For
example, a Iirm into a number oI businesses may sell-oII one oI them to another party, and thereby
transIer the risk involved in it. There is a subtle diIIerence between risk avoidance and risk transIer
through transIer oI the title oI the asset. The Iormer is about not making the investment in the Iirst
place, while the latter is about disinvesting an existing investment.
The second way is to transIer the risk without transIerring the title oI the asset or liability. This may be
done by hedging through various derivative instruments like Iorwards, Iutures, swaps and options.
The third way is through arranging Ior a third party to pay Ior losses iI they occur, without transIerring
the risk itselI. This is reIerred to as risk Iinancing. This may be achieved by buying insurance. A Iirm
may insure itselI against certain risks like risk oI loss due to Iire or earthquake, risk oI loss due to theIt,
etc. Alternatively, it may be done by entering into hold- harmless agreements. A hold-harmless
agreement is one where one party agrees to bear another party`s loss, should it occur. For example, a
manuIacturer may enter into a hold-harmless agreement with the vendor, under which it may agree to
bear any loss to the vendor arising out oI stocking the goods.
Risk Retention
Risk is retained when nothing is done to avoid, reduce, or transIer it. Risk may be retained consciously
because the other techniques oI managing risk are too costly or because it is not possible to employ
other techniques. Risk may even be retained unconsciously when the presence oI risk is not recognized.
It is very important to distinguish between the risks that a Iirm is ready to retain and the ones it wants to
oIIload using risk management techniques. This decision is essentially dependent upon the Iirm`s
capacity to bear the loss.
Risk Sharing
This technique is a combination oI risk retention and risk transIer. Under this technique, a particular
risk is managed by retaining a part oI it and transIerring the rest to a party willing to bear it. For
example, a Iirm and its supplier may enter into an agreement, whereby iI the market price oI the
commodity exceeds a certain price in the Iuture, the seller Ioregoes a part oI the beneIit in Iavor oI the
Iirm, and iI the Iuture market price is lower than a predetermined price, the Iirm passes on a part oI the

7232)7+('2&80(17!
beneIit to the seller. Another example is a range Iorward, an instrument used Ior sharing currency risk.
Under this contract, two parties agree to buy/sell a currency at a Iuture date. While the buyer is assured
a maximum price, the seller is assured a minimum price. The actual rate Ior executing the transaction is
based on the spot rate on the date oI maturity and these two prices. The buyer takes the loss iI the spot
rate Ialls below the minimum price. The seller takes the loss iI the spot rate rises above the maximum
price. II the spot rate lies between these two rates, the transaction is executed at the spot rate.


1
Question Paper
Strategic Financial Management (MB361F) : 1anuary 2008
Section A : Basic Concepts (30 Marks)
This section consists oI questions with serial
number 1 - 30.
Answer all questions.
Each question carries one mark.
Maximum time Ior answering Section A is 30
Minutes.
1. Which oI the Iollowing is considered as the principal Iinancial objective oI the Iirm?
(a) Shareholder wealth maximization
(b) General welIare oI the employees
(c) WelIare oI the society
(d) WelIare oI management
(e) Leadership in research and development.
<Ar
2. Which oI the Iollowing is/are considered as Iundamental pillar(s) oI Iirm`s Iinancial structure?
I. Ownership structure.
II. Financial Planning and Leverage.
III. Executive compensation policies.
IV. Internal audit.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) (I), (II) and (III) above
(e) (I), (II) and (IV) above.
<Ar
3. Which oI the Iollowing is included in the internal governance structure oI a Iirm?
(a) Shareholders
(b) Governments
(c) Creditors
(d) Business analysts
(e) Media.
<Ar
4. Consider the Iollowing inIormation:
Dividend per share Rs.4
Dividend cover 5
Number oI outstanding shares 10,000
Net proIit margin 10
Total assets Rs.10,00,000
The asset turnover ratio Ior the company is
(a) 1.25
(b) 1.50
(c) 2.00
(d) 2.50
(e) 4.00.
<Ar
5. A Iirm paid a dividend oI Rs.3 per share last year and its reported earning per share Ior this year is Rs.7.50. The
target pay out ratio oI the Iirm is 0.60 and the value oI the Iirm`s speed oI adjustment coeIIicient is 0.30. The
Iirm`s DPS Ior this year as per Lintner`s Dividend Smoothing Model is
(a) Rs.2.15
(b) Rs.3.45
(c) Rs.4.15
(d) Rs.4.85
(e) Rs.5.50.
<Ar

2
6. Purvi Industries Limited Iollows Miller & Orr`s model Ior managing its cash. The Iollowing is the inIormation
pertaining to the company.
Fixed cost oI eIIecting a marketable securities transaction Rs. 980
Standard deviation oI change in daily cash balance Rs. 4,000
Minimum cash balance required Rs.14,500
Return point Rs.50,500
Annual yield on marketable securities is approximately
(a) 7.9
(b) 8.2
(c) 8.7
(d) 9.2
(e) 10.1.
<Ar
7. Which oI the Iollowing model states that the current dividend oI the Iirm depends on its current earnings and its
past dividends?
(a) Walter Model
(b) Linter Model
(c) Merton Miller Model
(d) Gordon Model
(e) Modigliani-Miller Model.
<Ar
8. Which oI the Iollowing is/are the strategic determinant(s) oI dividend policy?
I. Liquidity.
II. Investment opportunities.
III. Investment preIerences.
(a) Only (II) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
<Ar
9. Which oI the Iollowing assumptions oI ideal capital market states that the investors wealth or at least the wealth
that they are willing to bring to purchase the given Iirm`s securities is small, relative to the total value oI a given
Iirm`s securities?
(a) Frictionless markets
(b) Homogenous expectations
(c) Atomistic competition
(d) InIormation is Ireely available
(e) Fixed Iinancing oI Iirm.
<Ar
10. Conversion cost oI Aroma Ltd. is Rs.600 per batch oI the securities. The annual rate oI interest is 10.II the
company liquidates Rs.1,00,000 worth oI securities per batch, then the estimated cash requirement oI Aroma Ltd.
over a 6-month planning period according to Baumol model will be
(a) Rs.4,16,667
(b) Rs.5,16,667
(c) Rs.6,16,667
(d) Rs.8,16,667
(e) Rs.9,16,667.
<Ar
11. Which oI the Iollowing is not a determinant oI the capital structure oI a company?
(a) Type oI asset Iinanced
(b) Product liIe cycle
(c) Current capital structure
(d) Credit rating
(e) Type oI raw material used.
<Ar
12. Which oI the Iollowing statements is/are true?
I. II the EBIT EPS indiIIerence point is higher than the expected EBIT, raising equity is better.
II. At the EBIT EPS indiIIerence point, a Iirm is indiIIerent between debt and equity.
III. II the EBIT EPS indiIIerence point is lower than expected EBIT, raising equity is better.
<Ar


3
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
13. Which oI the Iollowing approach advocates that cost oI capital is dependent on the capital structure oI a Iirm?
(a) Net Income approach
(b) Traditional approach
(c) Net Operating Income approach
(d) Miller and Modigliani approach
(e) Walter approach.
<Ar
14. The required rate oI return is the return shareholders demand
I. For the value oI common stock by looking at its current dividend and making assumptions about any Iuture
dividends that it may pay.
II. For the valuation oI stock on the assumption that dividends are received at the end oI the period.
III. To compensate Ior the time value oI money tied up in their investment and the uncertainty oI the Iuture cash
Ilows Irom these investments.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
<Ar
15. In the context oI dividend policy, which oI the Iollowing propounds that the Iirms Iinance the equity portion oI
viable projects with proIits beIore paying any dividends?
(a) Expectations theory
(b) Residual dividend theory
(c) Modigliani and Miller hypothesis
(d) Dividend preIerence theory
(e) Walter model.
<Ar
16. A number oI test runs that are conducted on the model to check whether it produces reasonably accurate results is
known as
(a) Implementation
(b) Revision
(c) Validation
(d) Compatibility
(e) Documentation.
<Ar
17. To control management Irom taking sub-optimal decisions, which oI the Iollowing internal structure(s) can be
used?
I. The management`s compensation being linked to company`s perIormance.
II. Corporate governance mechanisms that speciIy responsibilities and holds managers accountable Ior their
decisions.
III. Resource allocation among projects guided by speciIic requirements oI the projects rather than past
allocations and capital rationing.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
<Ar
18. Which oI the Iollowing models deIined Iailure oI a Iirm as 'inability oI a Iirm to pay its Iinancial obligations as
they mature?
(a) Beaver Model
(b) Wilcox Model
(c) Balum Marc`s Iailing company Model
(d) Altman`s Z Score Model
(e) Argenti Score Board.
<Ar

4
19. Which oI the Iollowing is Iirm speciIic cause oI Iinancial distress?
(a) Barriers to entry
(b) Threat to entry
(c) Leverage
(d) Rivalry among competing Iirms
(e) Threat oI substitute products.
<Ar
20. II the tax rate on equity dividend income is 10, the tax rate on interest income Irom debt is 12.5 and the
corporate tax rate is 30, the tax advantage associated with a debt capital oI Rs.12,00,000 is
(a) Rs.2,25,000
(b) Rs.3,36,000
(c) Rs.3,62,500
(d) Rs.4,84,000
(e) Rs.5,62,500.
<Ar
21. A company can achieve low cost advantage relative to competitors through
(a) Brand loyalty
(b) Superior customer service
(c) Product design
(d) Learning curve
(e) Dealer network.
<Ar
22. The declining phase oI product liIe cycle may be caused by which oI the Iollowing Iactor(s)?
I. Technical advances.
II. Change in perception.
III. Increase in leverage.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
<Ar
23. Corporate risk management involve(s)
I. Managing risk at acceptable level.
II. Using scientiIic approach to deal with various kinds oI risks.
III. Complete elimination oI risk.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
<Ar
24. When nothing is done to reduce the risk, it is called as
(a) Risk Retention
(b) Risk Sharing
(c) Risk Avoidance
(d) Risk TransIer
(e) Separation.
<Ar
25. Consider the Iollowing data about Srujana Industries Ltd:
Annual credit purchases Rs.86, 94,300.
Opening balance oI accounts payable Rs.19, 50,000.
Closing balance oI accounts payable Rs.36, 10,000.
(Assume 1 Year 365 Days)
What is the average payment period (in days) Ior Srujana Industries Ltd.? (Round oII the value to the nearest
integer).
(a) 113
(b) 117
(c) 120
(d) 126
<Ar


5
(e) 129.
26. According to which oI the Iollowing techniques oI strategic cost management, the cost oI a product should be
determined on the basis oI a sales price necessary to capture a predetermined market share?
(a) Activity based costing
(b) Quality costing
(c) LiIe cycle costing
(d) Target costing
(e) Value chain analysis.
<Ar
27. The term agency costs` in the context oI capital structure means
(a) The commission payable by a company to its purchasing agents
(b) The commission payable by a company to its selling agents
(c) The expenses incurred in distribution oI the products oI the company
(d) The cost on account oI restrictive covenants imposed on a company by its lenders
(e) The dividends paid by a company to its shareholders.
<Ar
28. Grasim Ltd. has provided Iollowing inIormation:
Equity share capital (Rs.25 each) Rs.80,00,000
Reserves and surplus Rs.15,00,000
15 Secured loans Rs.45,00,000
12.5 Unsecured loans Rs.20,00,000
Fixed assets Rs.50,00,000
Investments Rs.15,00,000
Operating proIit Rs.35,00,000
Tax rate 40
Market price per share Rs.74
The P/E ratio oI Grasim Ltd. is
(a) 10.02
(b) 12.30
(c) 15.32
(d) 16.23
(e) 17.21.
<Ar
29. Venus Industries Iollows a strict residual dividend policy. The company has a capital budget oI Rs.40,00,000. It
has a target capital structure which consists oI 40 percent debt and 60 percent equity. Venus Iorecasts that its net
income will be Rs.30,00,000. What will be the company`s expected dividend payout ratio this year?
(a) 20
(b) 30
(c) 35
(d) 40
(e) 45.
<Ar
30. Which oI the Iollowing is/are the assumption(s) oI multiple discriminant analysis?
I. There are two discrete groups to be analyzed.
II. The independent variables can be combined in a linear manner Ior discriminating between the two groups.
III. The values oI the variables are distributed log normally.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
<Ar
END OF SECTION A


6

Section B : Problems/Caselet (50 Marks)
This section consists oI questions with serial number 1 5 .
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should Iorm part oI your answer.
Do not spend more than 110 - 120 minutes on Section B.

1. DLF Ltd. is considering two mutually exclusive projects P1 and P2. The company use Certainty
Equivalent Approach to evaluate these proposals. Estimated cash Ilows and Certainty Equivalent (CE)
Iactor oI P1 and P2 are given below in table 1:
P1 P2
Year
Cash Flows
(Rs.)
CE factor
Cash Flows
(Rs.)
CE factor
0 -50,00,000 1 -60,00,000 1
1 30,00,000 0.95 40,00,000 0.9
2 20,00,000 0.85 30,00,000 0.8
3 15,00,000 0.70 15,00,000 0.7
4 15,00,000 0.65 10,00,000 0.6
(Table: 1)
Suppose you are the project manager oI the DLF Ltd; you required to suggest which project should be
accepted, iI the risk Iree rate oI interest is 7? ( 10 marks)
<Ar
InIotech Ltd. wants to implement project Ior which Rs.80,00,000 is required to be raised Irom market
as a means Ior Iinancing the project. The Iollowing Iinancing plans and options are available:
Plan A Plan B Plan C Option I
Equity shares (No. oI shares) 80,000 80,000 80,000
Option II
Equity shares (No. oI shares)
12PreIerenceShares
10Non-ConvertibleDebentures
40,000
-
40,000
50,000
30,000
-
30,000
30,000
20,000
Assuming the corporate tax to be 50 and the Iace value oI shares and debentures is Rs.100 each. You
are required to calculate:

<Ar
a. IndiIIerence point under each plan. ( 5 marks)
2.
b. Earnings Per Share (EPS) Ior each Iinancing plan. ( 5 marks)
Zenith Industries Ltd. has an earnings per share oI Rs.8 in the recently concluded Iinancial year. The
cost oI capital Ior the company is 12 percent. It is assumed that the Walter`s model oI dividend policy
holds true Ior the company.
You are required to
<Ar
a. Find out the price oI the company`s share at dividend payout ratios oI 50 percent and 75 percent
respectively, iI the Internal Rate oI Return oI the company is 15 percent. ( 4 marks)
b. Find out the price oI the company`s share at dividend payout ratios oI 50 percent and 75 percent
respectively, iI the Internal Rate oI Return oI the company is 10 percent. ( 4 marks)
3.
c. Give your inIerence about the model on the basis oI your solutions to the aIorementioned questions. ( 4 marks)





7
Caselet
Read the caselet carefully and answer the following questions:
4. The caselet states that taking and managing risk is part oI what companies must do to create proIits
and shareholder value. But the corporate meltdowns oI recent years suggest that many companies
neither manage risk well nor Iully understand the risks they are taking. Suggest what the companies
should do Ior creating shareholder value through better risk management.
( 10 marks)
<Ar
5. The caselet mentions that a company`s board oI directors should understand and oversee the major
risks it takes and ensure that its executives have a robust risk-management capability in place. What
are the key issues that must be addressed by the board oI directors in this regard to ensure appropriate
oversight? Discuss.
( 8 marks)
<Ar

Risk is a Iact oI business liIe. Risk comes in Iour main varieties. The Iirst, market risk, takes the Iorm
oI exposure to adverse market price movements, such as the value oI securities, exchange rates,
interest rates or spreads, and commodity prices. Ford, Ior instance, was hit by market risk in 2002,
when palladium prices tumbled and it had to take a $952 million write-down on its stockpile.
Credit risk is exposure to the possibility that a borrower or counterparty might Iail to honor its
contractual obligations. In 2002, Ior instance, The Bank oI New York announced that it would increase
its loan-loss provision by $185 million, to a total oI $225 million, Ior the third quarter oI 2002, largely
because oI loans it had made to telecom companies. Operational risk is exposure to losses due to
inadequate internal processes and systems and to external events. For example, AllIirst, a Baltimore-
based subsidiary oI Allied Irish Banks, lost $691 million at the hands oI a single rogue trader whose
practices went undetected Ior Iive years until he was caught in 2002. Finally, business-volume risk,
stemming Irom changes in demand or supply or Irom competition, is exposure to revenue volatility.
The leading US carrier United Airlines, Ior instance, Iiled Ior protection under Chapter 11 oI the US
bankruptcy code this year aIter Ialling demand hit its revenues.
Taking and managing risk is part oI what companies must do to create proIits and shareholder value.
But the corporate meltdowns oI recent years suggest that many companies neither manage risk well
nor Iully understand the risks they are taking. Directors conIirm this view. The directors` inIamiliarity
with risk management is oIten mirrored by senior managers, who traditionally Iocus on relatively
simple perIormance metrics, such as net income, earnings per share, or Wall Street`s growth
expectations. Risk-adjusted perIormance seldom Iigures in these managers` targets. Improving risk
management thus entails both the provision oI eIIective oversight by the board and the integration oI
risk management into day-to-day decision making. A company`s board oI directors should understand
and oversee the major risks it takes and ensure that its executives have a robust risk-management
capability in place. Companies that Iail to improve their risk-management processes Iace a diIIerent
kind oI risk: unexpected and sometimes severe Iinancial losses that make their cash Ilows and stock
prices volatile and harm their reputation with customers, employees, and investors.
Companies might also be tempted to adopt a more risk-averse model oI business in an attempt to
protect themselves and their share prices. William H. Donaldson, the chairman oI the US Securities
and Exchange Commission (SEC), acknowledged this trend when he told an interviewer that he was
concerned about a "loss oI risk-taking zeal." It is the taking oI risks that ultimately creates shareholder
value. The right response, thereIore, is to strike a balance that protects the company Irom the costs oI
Iinancial distress while allowing space Ior entrepreneurship. Management should have the Ireedom to
work in an environment where the potential rewards oI any business decision are consciously weighed
against the risks and where the company is happy with the level oI risk-adjusted returns resulting Irom
that decision.
In a Iew industries, companies have already begun to invest in developing sound risk-management
processes. For example, many Iinancial institutionsprodded by regulators and shaken by periodic
criseshave worked to upgrade their risk-management capabilities over the past decade. In other
sectors, such as energy, basic materials, and manuIacturing, most companies still have much to learn.

END OF CASELET


END OF SECTION B


8

Section C : Applied Theory (20 Marks)
This section consists oI questions with serial number 6 - 7 .
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on Section C.

6. Corporate Iinancial models are Iormal representations oI company`s operations and process in
Iinancial terms. Explain the major steps involved in the process oI modeling to arrive at optimal
decision. ( 10 marks) <Ars
7. Discuss mechanism oI designing an executive compensation plan so that it will act as a competitive
strategy. ( 10 marks) <Ars

END OF SECTION C

END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management (MB361F) : 1anuary 2008
Section A : Basic Concepts
ANSWER REASON
1. A Maximization oI shareholder wealth is the principal Iinancial objective oI the Iirm whereas welIare oI the
employees, society, management and Leadership in research and development are the non-Iinancial
objectives oI the Iirm.
2. D The basic pillars oI the oI the Iinancial structure oI a Iirm are:
Ownership structure
Financial planning and leverage
Executive compensation policies
Internal audit comes under operating structure oI the Iirm.
3. A The internal governance structure oI the Iirm is made oI shareholders, the board oI directors and Iirms
managerial hierarchy, whereas government, creditors, analysts, media etc constitute the external governance
structure oI a Iirm.
4. C Dividend cover EPS/DPS
ThereIore EPS 20
Asset turnover ratio
(20)(10,000)/0.10
10, 00, 000
2
ThereIore, Option (c) is the correct answer.
5. B Applying Lintner`s model
( )
t t 1 t t 1
D D . E D

=

We have t 1
D

=
Rs.3.00 per share
t
E
Rs.7.5 per share

0.60

0.30.
Putting these values and solving Ior Dt we get
D
t
3 0.30 (0.60 x 7.5 3)


9
D
t
0.3 (4.5 3) 3
D
t
0.3 x 1.5 3
D
t
0.45 3 Rs.3.45 per share.
6. D Return point using miller & Orr model is given by
RP
I 4
b 3
3
2

LL Where the notations are in their standard use



2
3 980 4000
3
4
365
[ [
[
[



14,500 50,500
x 0.092 9.2
7. B According Linter Model the current dividend oI the Iirm depends on its currents earnings and its past
dividends
8. E Some oI the key strategic deteminants oI dividend policy oI a Iirm are:
Liquidity
Investment Opportunities
Access to Iinance
Floation costs
Corporate control
Investment PreIerences
Restrictive Covenants
Taxes
Dividend Stability
9. C According to Atomistic Competition the ideal capital market states that the investors wealth or at least the
wealth that they are willing to bring to purchase the given Iirms securities is small relative to the total value
oI given Iirm`s securities.
10. A
:
2
:
2
2
2 2
(100000) (0.05)
416666.66 .416667
2 2 600
%DXPRO 0RGHO
E7
&
,
6TXDULQJERWKVLGHV
E7
&
,
& ,
7 5V
E
=
=
= = =

;

11. E Type oI asset Iinanced, product liIe cycle, current capital structure and credit rating are all direct
determinants oI capital structure oI a company while the type oI raw material used does not have any direct
relationship with it.
12. D II the expected EBIT is lower than the EBIT EPS indiIIerence point, raising equity is better alternative as
it will give higher EPS. At the EBIT EPS indiIIerence point, a Iirm is indiIIerent between debt and
equity
13. B The principal implication oI the Traditional approach is that the cost oI capital is dependent on the capital
structure and there is an optimal capital structure which minimizes the cost oI capital. According to Net
income approach the cost oI equity capital and debt capital remain unchanged when the degree oI leverage
changes. In other words, average cost oI capital declines as B/S increases because cost debt which is lower
than cost oI equity receives higher weight in calculation oI average cost. According the Net operating
income approach, the overall capitalization rate and the cost oI debt remains constant Ior all degrees oI
leverage, MM approach states the relationship between the leverage and the cost oI capital as explained by

10
the net operating approach in terms oI three basic propositions.
14. B The required rate oI return is the return shareholders demand to compensate them Ior the time value oI
money tied up in their investment and the uncertainty oI the Iuture cash Ilows Irom these investments.
15. B Residual dividend theory propounds that the Iirms Iinance the equity portion oI viable projects with proIits
beIore paying any dividends.
16. C A number oI test runs that are conducted on the model to check whether it produces reasonably accurate
results is known as validation.
17. E A Iirm needs internal structures which can control the tendency oI management to take suboptimal
decisions. These internal structures may include:
The management`s compensation being linked to company`s perIormance
Corporate governance mechanisms that speciIy responsibilities and holds managers accountable Ior
their decisions
Resource allocation among projects guided by speciIic requirements oI the projects rather than the past
allocations and capital rationing
A mechanism Ior making sure that the various projects undetaken Irom part oI a strategy, rather than
being disjointed, discrete projects
18. A Beaver was the Iirst to make a concious eIIort to use Iinancial ratios as predictors oI Iailure. He deIined
Iailure as 'inability oI a Iirm to pay its Iinancial obligations as they mature.
19. C Major Iirm speciIic Iactors that contribute substantially to Iirm`s risk oI Iinancial distress are:
Ownership and governance structures
Operating risk
Leverage.
20. B
Tax advantage associated with debt capital
B
) t 1 (
) t 1 )( t 1 (
1
pd
ps c



1 0 3 1 0 10
1 12 00 000
1 0 125



( . )( . )
, ,
( . )
Rs. 3,36,000.
21. D Low cost advantage can be achived through economies oI scale oI production, learning curve eIIects, tight
cost control, cost minimization in R&D, service sales Iorce, or administration.
22. C The declining phase may be caused by Iollowing Iactors:
Technical advances leading to product substitution
Change in perception like the change in Iashion and taste
The average length oI product liIe cycle is tending to shorten as a result oI economic, social and
technological change.
23. D Corporate risk management reIers to the process oI a company attempting to managing its risk at an
acceptable level. It is a scientiIic approach to deal with various kinds oI risks Iaced by the corporate.
Complete elimination oI risk can never be possible.
24. A When nothing is done to reduce, avoid or transIer the risk, it is called as risk retention.
25. B
Average payment period
Average balance oI trade creditors
Averagedailypurchase

Average balance oI trade creditors
opening creditors closing creditors
2
27,80,000
Average daily purchases
Annual Credit Purchases
Number oI days in a year

86, 94, 300
23, 820
365
=

Average payment period
27, 80, 000
116.71days 117days
23, 820
=

26. D According to target costing the cost oI a product should be determined on the basis oI a sales price
d i d k h


11
necessary to capture a predetermined market share.
27. D Agency cost are cost on account oI restriction imposed by creditors on the Iirm in the Iorm oI some
protective covenants. Commission payable by the company to its purchasing and selling agents, the
expenses incurred in distribution oI the products oI the company, or the dividends paid by the company does
not come under the agency cost.
28. C
Earnings beIore interest and tax (EBIT) Rs.35,00,000
Less: 15 Interest on secured loans
Less:12.5 Interest on unsecured loans
Rs.6,75,000
Rs.2,50,000
ProIit beIore tax (PBT)
Less: tax 40
Rs.25,75,000
Rs.10,30,000
ProIit aIter tax (PAT) Rs.15,45,000
No. oI Equity shares Rs.80,00,000/25 3,20,000
Earnings per share (EPS) Rs.4.83
P/E ratio market price per share / EPS 15.32
29. A Step 1 Find equity required to maintain capital budget:
Capital budget Rs.4,000,000
Percent oI budget Iinanced with equity x 0.60
Rs.2,400,000
Step 2 Calculate dividend:
Earnings Rs.3,000,000
Less equity retained 2,400,000
Dividend Rs.600,000
Step 3 Find payout ratio:
Dividend/Earnings Rs.600,000/Rs.3,000,000 0.2000 20.
30. D The assumptions oI multiple discriminant analysis are :
1. There are two discrete groups to be analyzed.
2. The independent variables can be combined in a linear manner Ior discriminating between two groups.
3. The values oI the variables are distributed normally.
Hence statement III is not an assumption oI multiple discriminant analysis. So the correct option is (d).

12
Section B : Problems/Caselet
1.

P1 P2
Year
(1}
6ash f|ow
(Rs.}
(2}
6E
factor
(3}
6ash f|ow
(Rs.}
(4}
6E
factor
(5}
(} = (2} * (3} (7} = (4} * (5} PV77 (Rs.}
PV77
(Rs.}
0 -5000000 1 -000000 1 -5000000 -000000
1 3000000 0.95 1000000 0.9 2850000 300000 2,3,551.10 3,31,185.98
2 2000000 0.85 3000000 0.8 1Z00000 2100000 1,181,815.81 2,09,252.95
3 1500000 0.Z 1500000 0.Z 1050000 1050000 85Z,112.ZZ 85Z,112.ZZ
1 1500000 0.5 1000000 0. 9Z5000 00000 Z13,822.83 15Z,Z3Z.13

5,Z19,332.81 ,ZZ5,588.83
ThereIore NPV oI P1 -5000000 5,749,332.84 Rs.749332.84
And NPV oI P2 -6000000 6,775,588.83 Rs.775588.83.
ThereIore Project P
2
should be selected as it has higher NPV than P
1

2. a.
( )( )
( )
:
1 (1 )
1 2
1 0.50 ( 400000)(1 0.50)
80000 40000
2( 400000)
2 800000
.8, 00, 000
3ODQ $
(%,7 , W (%,7 W
1 1
(%,7 (%,7
(%,7 (%,7
(%,7 (%,7
(%,7 5V

=

=
=
=
=

:
(1 ) (1 )
1 2
(1 0.50) (1 0.50) 360000
80000 50000
2.5 4 2880000
1.5 2880000
.19, 20, 000
3ODQ%
(%,7 W (%,7 W 3'
1 1
(%,7 (%,7
(%,7 (%,7
(%,7
(%,7 5V

=

=
=
=
=

:
(1 ) ( )(1 )
1 2
(1 0.50) ( 200000)(0.50) 360000
80000 30000
0.50 0.50 100000 360000
80000 30000
1.5 4 800000 2880000 .14, 72, 000
3ODQ&
(%,7 W (%,7 , W 3'
1 1
(%,7 (%,7
(%,7 (%,7
(%,7 (%,7 5V

=

=

=
= =



13
b. Calculation oI EPS:
Plan A Plan B Plan C
Option I Option II Option I Option II Option I Option II
EBIT 800000 800000 1920000 1920000 1472000 1472000
Less:Int 400000 200000
PBT 800000 400000 1920000 1920000 1472000 1272000
Less:tax50 400000 200000 960000 960000 736000 636000
PAT 400000 200000 960000 960000 736000 636000
Less:PreI. Dividend 360000 360000
Net ProIit to equity
share holder 400000 200000 960000 600000 736000 276000
No. oI shares 80000 40000 80000 50000 80000 30000
EPS (Rs.) 5 5 12 12 9.2 9.2
3. According to the Walter`s model on dividend policy the price per share is given by the Iormula:
P k
k
r
) D E ( D +

a. E Rs.8.00 per share (given)
r 15 0.15
k 12 0.12
II dividend payout ratio is 50
D 8 (0.50) Rs.4.00 per share
P
12 . 0
12 . 0
15 . 0
) 4 8 ( 4 +

12 . 0
12 . 0
15 . 0 4
4

+
Rs.75 per share
II dividend payout ratio is 75
D 8 (0.75) Rs.6.00
P
12 . 0
12 . 0
15 . 0
) 6 8 ( 6 +

12 . 0
12 . 0
15 . 0 2
6

+
Rs.70.83 per share.
b. E Rs.8.00 per share (given)
r 0.10
k 0.12
II dividend payout ratio is 50 then
D 8 (0.50) Rs.4.00 per share
P
12 . 0
12 . 0
10 . 0
) 4 8 ( 4 +
Rs.61.11
II dividend payout ratio is 75 then
D 8 x (0.75) Rs.6.00
P
12 . 0
12 . 0
10 . 0
) 6 8 ( 6 +

12 . 0
12 . 0
) 10 . 0 ( 2
6 +
Rs.63.89 per share.
c. Inference:
When the internal rate oI return oI a Iirm is greater than its cost oI capital (i.e. the Iirm is a growth Iirm) the
dividend payout ratio increases as the price per share decreases.
When the internal rate oI return oI a Iirm is less than its cost oI capital (i.e., the Iirm is a declining Iirm) the price
per share increases as the dividend payout ratio increases.
4. Risk management is important iI the company wants to create value Ior shareholders. However, the corporate
meltdown oI recent years suggests that companies neither manage risk well nor they Iully understand the risks they are
taking. For creating shareholder value through better risk management the companies may consider the Iollowing:
i. Gather information about the risks it faces:
To manage risk properly, companies need to know exactly what risks they Iace and the potential impact on their

14
Iortunes. Each industry Iaces its own variations on the Iour types oI risks; each company should thus develop a
taxonomy that builds on these broad risk categories. In pharmaceuticals, Ior instance, a company could Iace
business-volume risk iI a rival introduced a superior drug and higher operational risk iI an unexpected product
recall cut into revenues. In addition, the company would have to consider how to categorize and assess its R&D
risk. To do so, they need to make all oI their major risks transparent and to deIine the types and amounts oI risk
they are willing to take.
ii. Assessment of overall impact of various risks
A company must not only understand the types oI risk it bears but also know the amount oI money at stake. Less
obviously, it should understand how the risks diIIerent business units take might be linked and the eIIect on its
overall level oI risk. In other words, companies need an integrated view.
iii. Deciding on a strategy
High concentrations oI risk aren`t necessarily bad. Everything depends on the company`s appetite Ior it.
UnIortunately, many companies have never articulated a risk strategy.
Formulating such a strategy is one oI the most important activities a company can undertake, aIIecting all oI its
investment decisions. A good strategy makes clear the types oI risks the company can assume to its own
advantage or is willing to assume, the magnitude oI the risks it can bear, and the returns it demands Ior bearing
them. DeIining these elements provides clarity and direction Ior business-unit managers who are trying to align
their strategies with the overall corporate strategy while making risk-return trade-oIIs.
As with any strategy, a company`s risk strategy should be "stress-tested" against diIIerent scenarios. A liIe
insurance company, Ior example, should examine how its returns would vary under diIIerent economic conditions
and ensure that it Ielt comIortable with the potential market and credit losses (or with its ability to restructure the
portIolio quickly) in diIIicult economic times. II it isn`t comIortable, the strategy needs reIining.
iv. Creating a high-performing risk-management group
The task oI the risk organization is to identiIy, measure, and assess risk consistently in every business unit and
then to provide an integrated, corporate-wide view oI these risks, ensuring that their sum is a risk proIile
consistent with the company`s risk strategy. The structure oI the organization will vary according to the type oI
company it serves. In a complex and diverse conglomerate, such as GE, each business might need its own risk-
management Iunction with specialized knowledge. More integrated companies might keep more oI the Iunction
under the corporate wing.
v. Encouraging a risk culture
Today`s businesses are so dynamic, it is impossible to create processes that cover every decision involving risk.
To cope with it, companies need to nurture a risk culture. The goal is not just to spot immediately the managers
who take big risks but also to ensure that managers instinctively look at both risks and returns when making
decisions.
To create a risk culture, companies need a Iormal, company-wide process to review risk, with each business unit
developing its own risk proIile that is then aggregated by the corporate center. The reviews are a way oI ensuring
that managers at every level understand the key risk issues and how they should be dealt with. By Iocusing on
risk-adjusted perIormance, not just on traditional accounting measures, business managers will develop a better
understanding oI the risk implications oI their decisions.
Companies must also provide education and training in risk management, which Ior many managers is quite
unIamiliar, and establish eIIective incentives to encourage the right risk-return decisions at the Iront line. Judging
the perIormance oI business-unit heads on net income alone, Ior instance, could encourage excessive risk taking;
risk-adjusted perIormance should be assessed, too. Ultimately, people must be held accountable Ior their behavior.
Good risk behavior should be acknowledged and rewarded and clear penalties handed out to anyone who violates
risk policy and processes.
5. Company`s board oI directors should understand and oversee the major risks it takes and ensure that its executives have
a robust risk-management capability in place. To assure appropriate oversight, the board must address a Iew key issues.
These are as Iollows:
i. Board structures: The board must decide whether risk oversight should be vested in an existing committee (such
as the audit or Iinance committee), in a new committee, or divided among a number oI committees. The audit
committee might seem the natural choice, but as it already Iaces expanded responsibility to ensure the accuracy oI
Iinancial reporting, it might not be able to cope with a Iurther expansion oI its charter.
ii. Board risk reporting: Reports to the board and its committees must go beyond raw data by setting out, Ior
example, what the key risk-return trade-oIIs might be. Data alone probably won`t reveal the real issues or promote
proper debate.
iii. Education and expertise: Training programs might be needed Ior current and new board members. Boards
should also look at whether they need new members with risk-management expertise.
iv. Board processes: Boards need to review the eIIectiveness oI their own risk-management processes periodically.
They should look at committee structures and charters, how well board members understand risk policies, and the


15
value oI their interactions with management on risk.
Section C: Applied Theory
6. The Modeling Process
The Iollowing are the major steps in the process oI using a model to arrive at the optimal decision:
Feasibility study
Model construction
Compatibility oI the model with the tools used
Model validation
Implementation
Model revision
Documentation.
Feasibility Study
The Ioremost step in developing a model is to ascertain the Ieasibility oI a model assisting the decision making
process. The various points that are required to be considered are
Whether the decision under consideration is a one-time process, or is required to be taken as a routine measure.
The suitability oI the area in which the decision is required to be made, to be
supported by a model.
The possibility oI all the relevant variables being unambiguously identiIied.
The possibility oI all the variables being built-in into a single model.
The expected eIIectiveness oI the model.
The acceptability oI a model replacing human judgment to the management.
The possibility oI obtaining the required data on an ongoing basis.
The possibility oI integrating the model with the normal decision-making process.
The costs involved with setting up and running the model, and its comparison with the expected beneIits.
II it is Ieasible to construct an eIIicient and eIIective model Ior the decision process under consideration, and iI the
model can be easily integrated with the process, the Iirm can proceed to the next step oI constructing the model.
Model Construction
The construction oI the model depends on a number oI Iactors. Some oI these are
The decision to be made using the model.
The issues that are relevant Ior making the decision.
The way in which these issues and Iactors aIIect the decision.
The external Iactors that restrict the decision making process.
Depending on these Iactors, the input requirement Ior the model is identiIied and the numerical and theoretical
relationships between variables are speciIied. This is Iollowed by development oI the structure oI the model.
Model Compatibility
Once the model is in place, it needs to be made compatible to the tools to be used to implement it. For example, iI a
particular model is to be solved using computers, the model needs to be programmed and converted to a language that
the computer understands.
Model Validation
A number oI test runs are conducted on the model to check whether it produces reasonably accurate results. The test
runs may use actual past data oI the input variables, and the results generated by the model compared to the actual
results. Alternatively, the model may be tested by using probability distributions. Test running a model checks the
eIIectiveness oI the structure oI the model, as well as its predictive ability.
Implementation
The implementation oI a model includes integrating it with the normal decision-making process. Further, it needs to
be ensured that the results generated by the model are relevant enough Ior the decision-maker to take them into
consideration while making a decision.
Model Revision
No model remains useIul Ior an indeIinite period. The relationships between diIIerent variables that Iorm a basis Ior
the model may change over a period oI time. External Iactors aIIecting a model may also change. Use oI the model
over a period may provide an insight into its drawbacks. It is necessary that such changes are noted and the model
periodically revised to accommodate them. Unless a model is continuously updated, it may lose its relevance.

16
Documentation
Documentation is a way oI institutionalization oI the knowledge created during the process oI developing and
installing a model. It involves making detailed, systematic notes at all the stages oI the process. The records should be
maintained right Irom the stage when the need Ior the model was Ielt, detailing the Iactors that gave rise to the need.
The various ideas considered at diIIerent stages need to be documented along with the reasons Ior their acceptance or
rejection. The various problems Iaced during the development and implementation oI the model, together with their
solutions should also Iorm a part oI the records. Documentation also helps in proper communication between the
members oI the team working on the development oIthe model. In addition, it makes the process oI revising the
model less tedious.
While developing and implementing models, certain issues need to be kept in mind. It is not just necessary to speciIy
the objectives oI the model, it is also necessary to build the relative importance oI the diIIerent objectives into the
model. For example, the objective may be to maximize the proIits oI the Iirm, while restricting the debt taken by it to
a certain percentage oI the total assets. The model should speciIy the objective (maximum proIits or limited debt) that
would be held supreme, iI there were a clash between the two. Another important point to be remembered is that the
model should preIerably Iocus on some key aspects, rather than be a collection oI all relevant and irrelevant data. A
Iocused model is more likely to generate eIIective decisions.
7. Designing Executive Compensation as a Competitive Strategy
It is to be remembered that the component oI incentives in an executive compensation contract helps in bringing
together the interest oI the executive with that oI the Iirm's shareholders. In normal cases, the executives'
compensation contracts include incentive tools that motivate the management to either increase the Iirm's earnings or
its share price. II the Reitman's (1993) model is taken into account, it is seen .that the optimal compensation plan not
only includes the proIit incentives and grants oI stock, but also stock options. These stock options act as a deterrent to
the overly aggressive behavior oI the management. II not, the aggressive behavior might merge Irom the Iirm's
competitors by competing in diIIicult situations. The main reason that can be attributed to the stock options in acting
as a barrier towards the aggressive behavior oI the management is due to its nonlinearity. The value oI the stock
option is nothing once the stock's price Ialls below its strike price. Thus it can be judged by intuition that, the option
oI a particular Iirm will only be "in the money" iI the competitor Iirm abstains Irom producing too much. This lets the
owners oI the Iirm to allow their managers in playing more aggressively iI the competitor Iirm behaves similarly, but
to counteract with maximizing its sales iI it is Iaced by overly aggressive behavior.
In other words it can be said that, iI the managers in two diIIerent Iirms that are competing with each other are given
stock options, there will be at least some chances that both oI them will opt Ior competing less aggressively, instead
oI violently engaging themselves in mutually destructive research paper. Agarwal and Samwick have Iound an
appropriate answer to the question as to why it is always Iound that the compensation contracts tend to blind the
managers compensation to the Iirms absolute perIormance rather than Iocusing on other perIormance that is relative
to its industry competitors. It seems strange in explaining the Iact that the manager oI high proIit earning industry
gets considerable amount oI bonus, whereas the manager in an industry that makes lower proIits gets lower
perIormance bonuses even when such lower proIit making industry outperIorms its competitors. The answer that the
authors oI the paper give is that, the relative perIormance incentives aIIect the Iirm's competitive strategy in a way
that lessens the returns to the shareholders. The very Iact that there is absence oI relative perIormance based
incentives where the compensation decreases with rival Iirm's perIormance can be explained Irom the existence oI the
strategic interaction within the Iirms. The very Iact that there is a need to soIten the product market competition gives
rise to an optimal compensation contract that gives rise to a positive eIIect on both the Iirm's own as well as its rival
perIormance. At the same time, those Iirms that are in a more competitive industry puts a much greater weight on its
competitive Iirm's perIormance roped to its own perIormance. The paper thoroughly examined the actual executive
compensation contract, and Iound out evidences that were in line with their arguments.
< T0P 0F TlE 00CuVENT >


1
Question Paper
Strategic Financial Management (MB361F): April 2008
Section A : Basic Concepts (30 Marks)
This section consists oI questions with serial number 1 - 30.
Answer all questions.
Each question carries one mark.
Maximum time Ior answering Section A is 30 Minutes.

1. Government oI India issued long-term gilts at a coupon interest rate oI 8 and the market rate oI interest is also
8, the market value oI the securities is Rs.100 which is also the Iace value oI the stock. II the nominal interest
rate in the market rises to 12, the resale value oI the gilts will
(a) Fall to Rs.55.33 per Rs.100
(b) Rise to Rs.66.66 per Rs.100
(c) Fall to Rs.70.00 per Rs.100
(d) Rise to Rs.55.33 per Rs.100
(e) Rise to Rs.76.26 per Rs.100.

2. Which oI the Iollowing decisions is/are oIten taken by the company iI the interest rates are higher?
I. Reduction in debt Iinancing.
II. Switch most oI its investments into equities iI it has surplus oI cash.
III. Raise Iinance through long-term Iunds at Iixed rates oI interest.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

3. Which oI the Iollowing statements is/are true about real options?


I. The underlying in case oI real option is a security like share/bond.
II. The underlying in case oI real option is a tangible asset.
III. The management has a control over the underlying asset on which real options are written.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.

4. In which oI the Iollowing methods cash Ilows are discounted at risk-Iree rate?
(a) Scenario analysis
(b) Dividend discount method
(c) Certainty equivalent method
(d) Risk adjusted discount rate method
(e) Sensitivity analysis.

5. Hista Ltd. is a wholly owned subsidiary oI Vista Ltd., has a beta oI 1.2 when computed against the tangency
portIolio. The tangency portIolio has an expected return oI 18 per year. The risk-Iree rate is 7. The expected
value per share oI Hista Ltd. one year hence is Rs.12. As per Risk Adjusted Discount Rate Method (RADR), the
present value oI the share assuming no dividend payment made is
(a) Rs.10
(b) Rs.12
(c) Rs.14
(d) Rs.16
(e) Rs.18.

6. Which oI the Iollowing costing methods is used to identiIy multiple activities in the production processes that are
associated with costs?
(a) Activity Based Costing
(b) Target Costing


2
(c) Quality Costing
(d) LiIe Cycle Costing
(e) Zero based costing.
7. High asset turnover ratio indicates
(a) Large amount oI investment in the Iixed assets
(b) Large amount oI investment in the current assets
(c) Large amount oI sales value in comparison to total assets
(d) IneIIicient utilization oI the assets
(e) High debt-equity ratio.

8. As per the assumptions oI Extended Probabilistic analysis


I. All sales are credit sales.
II. The duration oI recession is constant.
III. The daily sales during the recession are variable.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

9. Which oI the Iollowing statements is not true?


(a) Quality oI design reIers to variation in products that have the same Iunctional use
(b) Total Quality Control is oIten associated with just-in-time manuIacturing
(c) Appraisal costs are the costs incurred to ensure that materials, products, and services meet quality
standards
(d) A quality-costing system monitors and accumulates the costs incurred by a Iirm in maintaining or
improving product quality
(e) Quality oI conIormance reIers to the degree with which the Iinal product Iails to meet its speciIications.

10.Which oI the Iollowing will cause a decrease in the net operating cycle oI a Iirm?
(a) Increase in the average collection period
(b) Increase in the average payment period
(c) Increase in the Iinished goods storage period
(d) Increase in the raw materials storage period
(e) Increase in the work-in-progress period.

11. According to which oI the Iollowing techniques oI strategic cost management, the cost oI a product should be
determined on the basis oI a sales price necessary to capture a predetermined market share?
(a) Activity based costing
(b) Quality costing
(c) LiIe cycle costing
(d) Target costing
(e) Value chain analysis.

12.The risk that arises out oI the assets oI a Iirm not being readily marketable is known as
(a) Business risk
(b) Marketability risk
(c) Financial risk
(d) Liquidity risk
(e) DeIault risk.

13.Which oI the Iollowing approaches to corporate risk management is also known as aggregation or
diversiIication?
(a) Risk avoidance
(b) Combination
(c) Loss control
(d) Separation
(e) Risk transIer.

14.The medium oI exchange that a bank will accept Ior deposit and creditor will accept Ior payment is called as
(a) Cash
(b) Marketable securities



3
(b) Marketable securities
(c) Accounts receivable
(d) Inventories
(e) Prepaid expenses.
15.Any Iirm that goes bankrupt gradually will reveal which oI the Iollowing symptom(s)?
I. Persistent cash losses.
II. Failure to pay taxes.
III. Cost overruns.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

16.According to the Wilcox model, the best indicator oI the Iinancial health oI an enterprise is
(a) The proIitability ratios
(b) The coverage ratios
(c) Net liquidation value oI the Iirm
(d) Market capitalization oI the Iirm
(e) Share price oI the Iirm.

17.Delta Ltd. expects some degree oI certainty to generate Iollowing net income and to have Iollowing capital
expenditure during the next 5 years:
Year
Net Income(NI)
(Rs.)
Capital expenditure
(CE) (Rs.)
1 60,00,000 20,00,000
2 50,00,000 25,00,000
3 26,00,000 32,00,000
4 21,00,000 40,00,000
5 16,00,000 50,00,000
The company currently has 15,00,000 shares oI equity and pays dividend oI Rs.6 per share, the amount oI
external Iinancing that is necessary iI the present dividend per share is maintained will be
(a) Rs.2,44,00,000
(b) Rs.3,44,00,000
(c) Rs.4,44,00,000
(d) Rs.5,44,00,000
(e) Rs.7,44,00,000.

18.The table below shows the inIormation about XYZ Ltd.


Earnings oI the company 7,00,000
Dividend paid 4,00,000
No. oI shares out standing 1,00,000
Price-earning ratio 6
Rate oI return on investment 16
The dividend payout ratio oI the Iirm is
(a) 57.14
(b) 59.14
(c) 61.14
(d) 63.14
(e) 65.14..

19.Which oI the Iollowing reasons is/are not considered responsible Ior the Iailure oI executive compensation plan?
I. Correlation between the size oI the company and its payment structure.
II. Emphasis on long term perIormance oI the company.
III. Extra Iocus on the accounting measures while designing the compensation contracts.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above


4
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
20.While developing a model, Ieasibility study takes into consideration
I. Frequency oI the decision.
II. Suitability oI the area in which decision is required.
III. Comparison oI costs and beneIits.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

21.Which oI the Iollowing is a non-Iinancial measure oI perIormance?


(a) Return on capital employed
(b) Residual Income
(c) Employee morale and attitude
(d) ProIit
(e) Economic Value Added.

22.Delta Ltd., has total assets oI 550 lakhs and total liabilities oI 60 lakh its debt ratio will be
(a) 0.08
(b) 0.11
(c) 0.13
(d) 0.14
(e) 0.15.

23.Which oI the Iollowing is not an assumption oI Modigliani - Miller Approach to capital structure?
(a) InIormation is Ireely available to investors
(b) The capital market transactions are cost-Iree
(c) Investors have homogeneous expectations about Iuture earnings oI a company
(d) Growth oI a Iirm is entirely Iinanced through retained earnings
(e) Securities issued and traded in the market are inIinitely divisible.

24.Which oI the Iollowing statements is/are false regarding Iinancial statement analysis?
I. Trade creditors use the Iinancial analysis to know the proIitability oI a Iirm.
II. Long-term creditors use the Iinancial statement analysis to know the long-term solvency oI the Iirm.
III. Investors use the Iinancial statement analysis to know the earnings oI the Iirm.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.

25.Which oI the Iollowing is not a model Ior predicting sickness oI a Iirm?


(a) Beaver Model
(b) BCG Matrix
(c) Altman`s Z Score Model
(d) Argenti Score Board
(e) Wilcox Model.

26.Which oI the Iollowing is not a type oI real options?


(a) Investment timing option
(b) Growth option
(c) Abandonment option
(d) Flexibility option
(e) Rainbow option.

27.The rate oI return oI HiFi Ltd. is 12, earnings per share is Rs.20 the cost oI capital is 10. The dividend
payout ratio oI the company is 20. The share price oI the company according to Gordon model is



5
(a) Rs. 700
(b) Rs. 800
(c) Rs.1,000
(d) Rs.1,200
(e) Rs.1,400.
28.According to the Walter Model, iI r is the internal rate oI return, g is the growth rate and k
e
is the cost oI capital,
under which oI the Iollowing conditions the optimal payout ratio is 100?
(a) r k
e
(b) r k
e
(c) r ~ k
e
(d) g ~ k
e
(e) g k
e.

29.Which oI the Iollowing is not a Iundamental part oI a Iirm`s Iinancial structure?


(a) Ownership structure
(b) Financial planning
(c) Financial leverage
(d) Executive compensation
(e) Managerial hierarchy.

30.A stage oI technology management in which prototype is build and Ieedback is received Irom the potential
investors and customers is known as
(a) Imaging
(b) Incubation
(c) Demonstration
(d) Promotion
(e) Sustenance.


END OF SECTION A


6

Section B : Problem/Caselets (50 Marks)
This section consists oI questions with serial number 1 5 .
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should Iorm part oI your answer.
Do not spend more than 110 - 120 minutes on Section B.

1. The Iollowing inIormation is available about the operations oI R.P Enterprises Ltd.
at the end oI a Iinancial year :
Net worth Rs.75 lakh
Current liabilities and provisions Rs.90 lakh
Cost oI goods sold Rs.486 lakh
Gross proIit margin 25
Total asset turnover ratio 3
Accounts receivable turnover ratio 12
Total debt to equity ratio 1.88
Current ratio 1.5
Quick ratio 0.70
You are required to complete the balance sheet oI the company given below as at
the end oI the Iinancial year:
Balance sheet
(Rs. in lakh)
Net worth ? Net Iixed assets ?
Term loan ? Inventories ?
Current liabilities and provisions ? Receivables ?
? Cash and bank ?
Total ? Total ?
It is assumed that the revenues oI the Iirm wholly consisted oI sales and that the
sales are entirely on credit basis. (Assume 1 year 360 days).
(
12 marks)
$QVZHU!

Caselet 1
Read the caselet carefully and answer the following questions

2. What is Enterprise Risk Management (ERM)? What does it aim to achieve?


(
9 marks)
$QVZHU!
3. What are the attributes involved in the discipline oI managing risk?
(
9 marks)
$QVZHU!

A major reason the managers are Irustrated with their progress on Enterprise Risk
Management (ERM) is because they believe that they don`t have adequate tools.
This is particularly the case when it comes to risk modeling, developing probability
distributions oI outcomes that represent the uncertainty associated with speciIic risk
Iactors. Illustration to explain the linkages between risk, risk management, risk
capital and ERM consider the classic statistical example oI a cookie jar Iull oI
white and black marbles. II there is a penalty Ior drawing a black marble Irom the
jar, the draw oI a black marble is risk. Risk management seeks to understand the
Iull penalty Ior drawing the black marble as well as the likelihood that such a draw
will occur. Risk capital calculations assure that iI you draw a black marble or
perhaps several in a row, you will survive the events. ERM Iinds the best way to
put your hand into the cookie jar, so to speak.
ERM, taking the pillars oI a Basel II approach, then looks at the interaction oI
business lines, through dynamic, Iorward-looking scenarios and seeks to structure a
Iirm in a manner to maximize its perIormance relative to its risk appetite.
Achieving this requires both an understanding oI how business lines operate as well
as how they interact with each other and their competitive space.




7
ERM would analyze the likely impact on both revenues and capital to determine iI
the merger made sense. This would then lead to an analysis oI what the optimal
combination oI the three businesses might be going Iorward, iI any and allocating
risk-taking authority (risk capital) in such a Iashion as to maximize the Iirm's
anticipated risk-adjusted perIormance. It is quite conceivable that the three entities
would produce a better risk-adjusted return Ior the merged entity iI their sizes
towards going Iorward were quite diIIerent. In other words, ERM helps to not only
determine iI a merger makes sense, but where the combined capital oI the three
entities is best deployed.
This is exactly the same analysis that is done at any business with multiple existing
business lines. Again, the goals oI ERM are no diIIerent than those oI existing
managerial sciences, but are a vast improvement because oI the emphasis on
improving the understanding oI one's own business through modeling, discipline
and education.

END OF
CASELET
1

Caselet 2
Read the caselet carefully and answer the following questions:

4. Discuss key Iactors, which inIluence the dividend pay-out oI Biocon?
( 10 marks)
$QVZHU!
5. It is likely that a conIlict oI interests arises between the private equity Iund, AIG
AOF, and the other shareholders oI Biocon. In this context, discuss the agency
problem in Biocon.
( 10 marks)
$QVZHU!

Biotechnology deals with modiIication oI DNA or genetic material in plants,
animals and microorganisms to discover useIul products and technologies. It helps
in developing genetically modiIied plants, animals and microorganisms to improve
human lives and environment.
In India, biotechnology had its birth in 1954 when two scientists Irom University oI
Madras, ProI. G N Ramachandran and ProI G Kartha, uncovered the interlocked
three-chain triple helix structure oI collagen, the most abundant protein oI the
connective tissue. ProI. Ramachandran, aIter spending around 20 years in Chennai,
shiIted to the Indian Institute oI Science(IISc), Bangalore, and set up the Molecular
Biophysics Unit. At that time, government laboratories such as the Hyderabad
based Center Ior Cellular and Molecular Biology (CCMB), the Delhi-based Center
Ior Biochemical Technology (CBT) and the Banglore-based National Center Ior
Biological Sciences (NCBS) were also doing Iundamental research in biology. But,
none oI these institutes tried to exploit the commercial opportunities in research.
The major biotechnology companies then were Biocon, Panacea Biotec, Bharath
Serums and Vaccines, Bangalore Genei and the Serum Institute oI India. Except
Bangalore Genei, none oI these could be termed as pure or modern biotechnology
companies. Biocon commenced operations in 1978 as a joint venture between Ms.
Kiran Mazumdar Shaw and Biocon Biochemicals Limited, an Ireland based
multinational Ior extracting two enzymes papain and isinglass Irom papaya and
catIish. Biocon has little debt in its capital structure since its inception. The
company`s bank borrowings are short-term and are used Ior working capital needs.
Biocon started operations with an equity capital oI Rs.5,000 (50 shares with a Iace
value oI Rs.100). Subsequently, the company issued equity shares to diIIerent
parties. In December 1996, the company issued two bonus shares Ior every one
share held. In March 2000, ICICI Ventures, a venture capital Iund and its aIIiliate
Iunds were inducted as shareholders oI Biocon by way oI subscription to 15 oI
the share capital oI the company. ICICI Ventures and its aIIiliate Iunds also
acquired 10 stake in Syngene International. The company sub-divided (split) the
outstanding shares into Rs.10 per share and then Rs.5 per share.
Biocon acquired 99.99 oI Syngene Irom its other shareholders, including ICICI
Venture and its aIIiliate Iunds, who divested their entire stake in Syngene in
exchange Ior issue oI shares by Biocon in March 2002. The early investors in



8
Biocon made very decent returns. ICICI Ventures along with its aIIiliate Iunds
made 156 percent return (ICICI Ventures paid Rs.180 million in March 2000 Ior a
15 and sold it Ior Rs.460 million during May-September 2003) by divesting its
shareholder interests in Biocon in Iavor oI AIG AOF, a private equity Iund. AIG
AOF has the right Ior the next three years to appoint one director to the Board. That
Director has a veto power with respect to some important Board actions including
without limitation the issue oI equity shares, mergers and acquisitions, sale or other
disposition oI subsidiary shares or a material part oI Biocon`s or a subsidiary`s
assets or any amendment to Biocon`s or a subsidiary`s Memorandum and Articles
oI Association. Despite the growth in revenues, there have been no liberal dividend
payouts, as Biocon has been the classic bootstrapped biotech venture.
The company and its subsidiaries have the advantage oI various income tax
exemptions and deductions that are applicable to export-oriented companies and to
the companies in R&D activities. Accordingly, the eIIective tax rates Ior the
company have been signiIicantly low when compared to the statutory corporate
income tax rate in India. Biocon also receives certain beneIits and concessions with
respect to customs duty Irom the Government oI India and sales tax beneIits Irom
the State oI Karnataka.

END OF CASELET 2

END OF SECTION B

Section C : Applied Theory (20 Marks)
This section consists oI questions with serial number 6 - 7 .
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on Section C.

6. Adopting value based mind set and Iinding the value drivers gets you only
halIway home. Managers must establish process that brings this mindset to liIe
in daily activities oI the company. What according to Mckinsey model are the
management processes that collectively govern adoption oI value-based
management?
( 10 marks)
$QVZHU!
7. It is needless to say that most important objective oI company is wealth
maximization. In this context what do you understand by Iinancial and non-
Iinancial objectives oI a Iirm?
( 10 marks)
$QVZHU!

END OF SECTION C

END OF QUESTION PAPER


9
Suggested Answers
Strategic Financial Management (MB361F): April 2008
Section A : Basic Concepts
Answer Reason

1. B
8
100 .66.66 .100
12
5V SHU 5V =

723!
2. A When the interest rates are higher, a company might decide to reduce the amount oI
debt Iinance and to substitute equity Iinance, such as retained earnings. A company
which has a large surplus oI cash and liquid Iunds to invest might switch some oI its
short term investments out oI equities and into interest bearing securities. A company
might opt to raise new Iinance by borrowing short term Iunds and debt at a variable
interest rate (Ior example on overdraIt) rather than long term Iunds at Iixed rate oI
interest, in the hope that interest rates will soon come down.
723!
3. E The basic diIIerence that exists between a Iinancial option and a real option lies in its
underlying. The underlying that exists in case oI the Iormer is security such as a share
oI common stock or a bond, whereas the underlying Ior the latter is a tangible asset
like a business unit or a project. Financial options are most oI the times issued by
independent agents instead oI the by the companies whose shares they are contingent,
thus agents who issue them has no inIluence and control oI the company and the
shares. In case oI real options the management controls the underlying real assets on
which the real options are written.
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4. C Certainty Equivalent method uses risk-Iree rate Ior discounting cash Ilows. 723!
5. A
12
9.98 .10
|1 0.07 1.2(0.18 0.07)
39 5V = =
+ +
;

723!
6. A Activity Based Costing is used to identiIy multiple activities in the production
processes that are associated with costs.
Target Costing uses a market-based cost that is calculated using a sales price
necessary to capture a predetermined market share.
Quality Costing system monitors and accumulates the costs incurred by a Iirm in
maintaining or improving product quality.
LiIe Cycle Costing is the accumulation oI costs Ior activities that occur over the entire
liIe cycle oI a product, Irom inception to abandonment by the manuIacturer and the
customer.
Hence (a) is the answer.
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7. C Asset turnover oI a company is deIined as the ratio between the sales value and total
assets. High asset turnover is possible only when a company can generate a high sales
volume in comparison to the amount invested in the Iixed assets and current assets.
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8. C The assumptions underlying Extended Probabilistic analysis are
All sales are cash sales.
The duration oI recession is variable
The daily sales during the recession are variable.
While the interest burden associated with debt is inescapable, the
principal reypayment obligation can be deIIered till recession lasts.
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9. E Quality oI design reIers to variations in products that have the same Iunctional use;
and
Total quality control oIten associated with just-in-time manuIacturing.
Appraisal costs are the costs incurred to ensure that materials, products, and services
meet quality standards.
A quality-costing system monitors and accumulates the costs incurred by a Iirm in
723!

10
maintaining or improver`s product quality;
Quality oI conIormance reIers to the degree with which the the Iinal product meets
(not Iail to meet) its speciIications.
ThereIore (e) is the answer.
10. B Increase in the average collection period, increase in the Iinished goods storage
period, increase in the raw materials storage period and increase in the work-in
process period all result in increasing the operating cycle oI the Iirm. Only increase
in the average payment period decreases the net operating cycle oI the Iirm. Hence
option (b) is correct.
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11. D According to target costing the cost oI a product should be determined on the basis oI
a sales price necessary to capture a predetermined market share.
723!
12. B Marketability risk arises, iI any security is not being readily marketable.
So, the option (b) is the correct answer.
723!
13. B Combination is also known as aggregation or diversiIication. 723!
14. A The medium oI exchange that a bank will accept Ior deposit and creditor will
accept Ior payment is called cash.
723!
15. E Persistent cash losses, Iailure to pay taxes, cost overruns, low capacity utilization,
accumulation oI Iinished goods, etc., are the symptoms oI bankruptcy.
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16. C As per the Wilcox model, the net liquidation value oI a Iirm is the best indicator oI its
Iinancial health. The net liquidation value is the excess oI the liquidation value oI the
Iirm`s assets over the liquidation value oI the Iirm`s liabilities. Liquidation value is the
market value oI the assets and liabilities at the time oI dissolution.
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17. C Total amount oI dividend per year 1500000 * 6 Rs.90,00,000
NI
(1)
Dividends
(2)
CE
(3)
Ex. Financing
(4) (2) + (3) - (1)
6000000 9000000 2000000 5000000
5000000 9000000 2500000 6500000
2600000 9000000 3200000 9600000
2100000 9000000 4000000 10900000
1600000 9000000 5000000 12400000
Rs.4,50,00,000 Rs.4,44,00,000
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18. A

Earnings oI thecompany 700000


Earnings per share (EPS) .7
No.oI outstandingshares 100000
400000
Dividends per share (DPS) .4
100000
DPS 4
Dividend Payout ratio 0.571429 57.14
EPS 7
5V
5V
= =
=
= = ;

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19. B The basic reasons Ior the Iailure oI executive compensation plan are:
Correlation between the size oI the company and its payment structure. Because
oI the existence oI the strong correlation between the size oI the company based
on its asset value and sales and payment structure, companies sometimes tend to
strive Ior bigger size irrespective oI the Iact that it adds to the valu oI the concern
Emphasis on the short-term perIormance oI the company. It has been Irequently
observed that the short-term perIormance indicators such as sales and growth in
the earnings provide a greater weightage in incentive compensation that is paid
to the executive.
More Iocus on accounting measures is given while designing the compensation
contracts. Some oI the measures are earnings and the return on investments.
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20. E Feasibility Study
The Ioremost step in developing a model is to ascertain the Ieasibility oI a model
assisting the decision making process. The various points that are required to be
considered are
Whether the decision under consideration is a one-time process, or is required to be
723!


11
taken as a routine measure
The suitability oI the area in which the decision is required to be made, to be
supported by a model
The possibility oI all the relevant variables being unambiguously identiIied The
possibility oI all the variables being built-in into a single model
The expected eIIectiveness oI the model
The acceptability oI a model replacing human judgment to the management The
possibility oI obtaining the required data on an ongoing basis
The possibility oI integrating the model with the normal decision-making process
The costs involved with setting up and running the model, and its comparison with the
expected beneIits.
II it is Ieasible to construct an eIIicient and eIIective model Ior the decision process
under consideration, and iI the model can be easily integrated with the process, the
,Iirm can proceed to the next step oI constructing the model,
21. C ROCE, Residual Income, ProIit, EVA are all Iinancial measures oI perIormance.
However, employee morale & attitude is a non-Iinancial measure oI perIormance.
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22. B
Total liabilities 60
Debt Ratio 0.10909 0.11
Total assets 550
= = ;

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23. D The assumptions oI Modigliani Miller approach oI capital structure are :
1) InIormation is Ireely available to investors
2) Transactions are cost-Iree
3) Investors have homogeneous expectations about Iuture earnings oI a company
4) Securities issued and traded in the market are inIinitely divisible.
However, option (d) is not an assumption oI MM approach as MM approach considers
that growth oI a Iirm is Iinanced by a mixture oI debt, equity and retained earnings.
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24. A Trade creditors use the Iinancial analysis to know the liquidity position oI the Iirm.
Long-term creditors use the Iinancial statement analysis to know the long-term
solvency oI the Iirm. Investors use the Iinancial statement analysis to know the
earning capacity oI the Iirm
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25. B BCG matrix classiIies the products into Iour broad categories. All others are the
models Ior predicting sickness oI a Iirm.
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26. E Rainbow option is one which is driven by multiple sources oI uncertainty and is not
an example oI real option
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27. C

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28. B According to Walter model on dividend policy, iI the internal rate oI return is less then
the cost oI capital then the optimal payout ratio is 100.
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29. E Managerial hierarchy is not a Iundamental part oI a Iirm`s Iinancial structure. 723!
30. C A stage oI technology management in which prototype is build and Ieedback is
received Irom the potential investors and customers is known as demonstration
723!


12
Section B : Problems/Caselets
1.
Sales
Cost oI goods sold 486
Rs.648lakh
(1- Gross proIit margin) 1 0.25
= =


Total asset
Sales 648
Total assets turnover 3
= =
Rs.216 lakh
Inventories
Current liabilities
Current ratio Quick ratio
or Inventories (1.50 0.70) 90 Rs.72 lakh
Receivables
Sales 648
Re ceivables turnover ratio 12
=
Rs.54 lakh
Current assets Current liabilities current ratio
90 1.5 Rs.135 lakh
Cash and bank Current assets Receivables Inventories
135 54 72 Rs.9 lakh
Net Iixed asset Total assets Current assets 216 135 Rs.81 lakh
Total debt Total debt to equity ratio Net worth 1.88 75 Rs.141 lakh
Term loan Total debt Current liabilities & provisions 141 90 Rs.51 lakh
Balance Sheet
(Rs. lakh)
Net worth 75 Net Iixed assets 81
Term loan 51 Inventories 72
Current liabilities & provisions 90 Receivables 54
Cash and Bank 9
216 216
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!
2. Businesses Iace a lot oI risks. Risks range Irom those arising due to changes in interest rates and
exchange rates to risks like terrorist attacks. ERM is a tool that allows organizations to examine
all the risk they Iace, measure the potential impact oI those risks on the long-term viability oI the
company, and take appropriate steps to manage or mitigate those risks. Managing all the risks
the organization has to Iace in an integrated manner is the essence oI enterprise risk management
(ERM). In addition to the coherence in risk management Ior the organization as whole, ERM
oIIers other advantages. It helps in identiIying the risks that may oIIset each other and need not
be hedged Ior individually in reducing the costs. To deal proactively with Iinancial, operational
and strategic risks, organizations can adopt ERM.
The range oI risks most business Iace include hazard risk, such as property damage and theIt;
Iinancial risks, such as interest rate and Ioreign exchange Iluctuations; operational risks, such as
supply chain problems or cost overruns; and strategic risks, such as misaligned products. The
ERM is trying to address all those risks in an integrated Iashion. It greatly expands the
company`s deIinition oI risk to include anything that threatens the organization`s continuity. This
approach also divides the concept oI risk into those risks that can help a company to grow and
those that will only lead to loss.
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!
3. Managing risk demands more intuitive inklings oI uncertainty, threats and opportunities.
Managing risk well requires
1. Insight assessments oI threatened losses and potential gains.
2. Awareness oI strategies Ior dealing with these threats and opportunities.
3. Ability to choose and implement the most promising oI these strategies.
4. And objectivity in reviewing results and adapting to change.
These Iour qualities are attributes that most persons naturally possess to some degree. The
discipline called risk management seeks to reIine these qualities and to identiIy and enhance
speciIic skills so that they can be taught and passed across continents and Irom one generation to
the next.
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!
4. Strategic Determinants of Dividend Policy of Biocon
Some oI the key Iactors which inIluence dividend payout oI a Iirm are delineated below.
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!


13
Liquidity: While earnings are an important determinant Ior the dividend decision, the role oI
liquidity cannot be ignored. Dividend payout entails cash outIlow Ior the Iirm. Hence, the
quantum oI dividends proposed to be distributed critically depends on the liquidity position oI
the Iirm. In practice, Iirms oIten Iace cash crunch in spite oI having good earnings. Such Iirms
may not be in a position to declare dividends despite their proIitability.
Investment Opportunities: Another key determinant to the dividend decision is the
requirement oI capital by the Iirm. Normally, Iirms tend to have low payout iI proIitable
investment opportunities exist and conversely, Iirms tend to resort to high payouts iI proIitable
investment opportunities are lacking. Generally, Iirms operating in industries which are in the
nascent and growth phases oI the product liIe cycle are characterized by high dependence on
retained earnings. On the other hand, Iirms operating in industries which are in the maturity and
decline stages normally distribute a larger proportion oI their earnings as dividends.
Access to Finance: A company which has easy access to external sources oI Iinance can aIIord
to be more liberal in its dividend payout. The dividend policy oI such Iirms is relatively
independent oI its Iinancing decisions. Firms having little or no access to external Iinancing
have rather limited Ilexibility in their dividend decisions.
Flotation Costs: Issue oI securities to raise capital in lieu oI retained earnings involves Ilotation
costs. These costs include Iees payable to the merchant bankers, underwriting commission,
brokerage, listing Iees, marketing expenses, etc. Moreover smaller the size oI the issue, higher
will be the Ilotation costs as a percentage oI amounts mobilized. Further there are indirect
Ilotation costs in the Iorm oI underpricing. Normally issue oI shares is made at a discount to the
prevailing market price. The cost oI external Iinancing has an inIluence on the dividend policy.
Corporate Control: Further issue oI shares (unless done through rights issue) results in dilution
oI the stake oI the existing shareholders. On the other hand, reliance on retained earnings has no
impact on the controlling interest. Hence, companies vulnerable to hostile takeovers preIer
retained earnings rather than Iresh issue oI securities. In practice, this strategy can be a double
edged sword. The niggardly payout policy oI the company may result in low market valuation oI
the company vis-a-vis its intrinsic value. Consequently, the company becomes a more attractive
target and is in the danger oI being acquired.
Investor Preferences: The preIerence oI the shareholders has a strong inIluence on the dividend
policy oI the Iirm. A Iirm tends to have a high payout ratio iI the shareholders have a strong
preIerence towards current dividends. On the other hand, a Iirm resorts to retained earnings iI
the shareholders exhibit a clear tilt towards capital gains.
Restrictive Covenants: The protective covenants in bond indentures or loan agreements oIten
include restrictions pertaining to distribution oI earnings. These conditions are incorporated to
preserve the ability oI the issuer/borrower to service the debt. These covenants limit the
Ilexibility oI the company in determining its dividend policy.
Taxes: The incidence oI taxation on the Iirm and the shareholders has a bearing on the dividend
policy. India levies a 10 tax on the amount oI distributed proIits. This tax is a strong Iiscal
disincentive on dividend distribution. These dividends are totally tax-Iree in the hands oI the
shareholders. The capital gains (long-term) are taxed at 20.
Dividend Stability: The earnings oI a Iirm may Iluctuate wildly between various time periods.
Most Iirms do not like to have an erratic dividend pay-out in line with their varying earnings.
They try to maintain stability in their dividend policy. Stability does not mean that the dividends
do not vary over a period oI time. It only indicates that the previous dividends have a positive
correlation with the current dividends. In the long run, the dividends have to be invariably
adjusted to synchronize with the earnings. However, the short-term volatility in earnings need
not be Iully reIlected in dividends.
5. Biocon`s Susceptibility to Agency Problems
Agency theory is oIten described in terms oI the relationships between the various interested
parties in the Iirm. Agency theory is helpIul in explaining the actions oI the various interest
groups in the corporate governance debate. For example, managers can be seen as the agents oI
shareholders, employees as the agents oI managers, managers and shareholders as the agents oI
long and short-term creditors, etc. In most oI these principal-agent relationships, conIlicts oI
interest are seen to exist. It has been widely observed that the conIlicts between shareholders and
managers and in a similar way the objectives oI employees and managers may be in conIlict.
The agency relationship arising Irom the separation oI ownership Irom management is
sometimes characterized as the agency problem. For example, iI managers hold none or very
little oI the equity shares oI the company they work Ior, what is to stop them Irom being
ineIIicient or Irom not bothering to look Ior proIitable new investment opportunities themselves
723
!

14
high salaries and perks or Irom growing.
One power that shareholders possess is the right to remove the directors Irom oIIice. But
shareholders have to take the initiative to do this, and in many companies, the shareholders lack
the energy and organization to take such a step. Even so, directors will want the company`s
report and accounts, and the proposed Iinal dividend, to meet with shareholders` approval at the
AGM. Another reason why managers might do their best to improve the Iinancial perIormance
oI their company is that managers` pay is oIten related to the size or proIitability oI the company.
Managers in very big companies, or in very proIitable companies, will normally expect to earn
higher salaries than managers in smaller or less successIul companies. Perhaps the most
eIIective method is one oI long-term share option schemes to ensure that shareholder and
manager objectives coincide. Management audits can also be employed to monitor the actions oI
managers. Creditors commonly write restrictive covenants into loan agreements to protect the
saIety oI their Iunds. These arrangements involve time and money both in initial set-up, and
subsequent monitoring, these being reIerred to as agency costs.
In case oI Biocon, it is likely that a conIlict oI interests arises between the private equity Iund,
AIG AOF, the minority shareholder and the other shareholders. AIG AOF has the right to veto
some important Board actions, including without limitation the issue oI equity shares, mergers
and acquisitions, sale or other disposition oI subsidiary shares or a material part oI Biocon`s or a
subsidiary`s assets or any amendment to Biocon`s or a subsidiary`s Memorandum and Articles oI
Association. Any disagreement between AIG AOF and the Board may adversely aIIect the
ability oI the company to implement its business strategy.
Section C: Applied Theory
6. The McKinsey model, developed by leading management consultants McKinsey & Company,
is a comprehensive approach to value-based management. It Iocuses on the identiIication oI key
value drivers at various levels oI the organization, and places emphasis on these value drivers in
all the areas, i.e. in setting up oI targets, in the various management processes, in perIormance
measurement, etc. According to Copeland, Koller and\1urrin, value-based management is "an
approach to management whereby the company's overall aspirations, analytical techniques, and
management processes are all aligned to help the company maximize its value by Iocusing
management decision-making on the key drivers oI value". According to this model, the key
steps in maximizing the value oIa Iirm are as Iollows:
IdentiIication oI value maximization as the supreme goal
IdentiIication oI the value drivers
Development oI strategy
Setting oItargets
Deciding upon the action plans
Setting up the perIormance measurement system
Implementation.
Value Maximization - The Supreme Goal
A Iirm may have many conIlicting goals like maximization oI PAT, maximization oI market
share, achieving consumer satisIaction, etc., The Iirst step in maximizing the value oI a Iirm is
to make it the most important goal Ior the: organization. Maximization oI value is generally
reIlected in maximized discounted cash Ilows. The other goals that a Iirm may have are
generally consistent with the goal oI value maximization, but in case oI a conIlict, value
maximization should prevail over all other objectives.
Identification of the Value Drivers
The important Iactors that aIIect the value oI a business are reIerred to as key value drivers. It is
necessary to identiIy these variables Ior value-based management. The value drivers need to be
identiIied at various levels oI an organization, so that the personnel at all levels can ensure that
their perIormance is in accordance with the overall objective. The three main levels at which
the key value drivers need to be identiIied are
The generic level: At this level, the variables that reIlect the achievement or non-
achievement oI the objective oI value maximization most directly are identiIied.
The department level: At this level, the variables that guide the department in the direction
oI the achievement oI the overall objective are identiIied.
The grass roots level: At the grass roots level, the variables that reIlect the perIormance at
the operational level are identiIied.
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!


15
Development of Strategy
The next step is to develop strategies at all levels oI the organization, which are consistent with
the goal oI value maximization, and lead to the achievement oI the same. The strategies should
be aimed at and give directions Ior the achievement oI the desired level oI the key value drivers.
Setting of Targets
Development oI strategies is Iollowed by setting up oI speciIic short-term and long-term
targets. The targets should be speciIied in terms oI the desirable level oI key value drivers. The
short-term targets should be in tune with the long-term targets. Similarly, the target Ior the
various levels oI the organization should be in tune. The targets should be set bo~ Ior Iinancial
as well as non-Iinancial variables.
Deciding upon the Action Plans
Once the strategy is in place and the targets have been determined, there is a need to speciIy the
particular actions that are required to be undertaken to achieve the targets in a mann that is
consistent with the strategy. At this stage, these detailed action plans are laid out. .8
Setting up the PerIormance Measurement System The Iuture perIormance oI personnel is
aIIected by the way their perIormance is measure to a large extent. Hence, it is essential to set
up a precise and unambiguous perIormance measurement system. A perIormance measurement
system should be linked to achievement oI the targets and should reIlect the characteristics oI
each individual department. 1m pie mentation
The Iirst step in implementing value-based management is to identity the current position oI the
Iirm in terms oI the six Iactors shown in the Iigure below.

The next step is to use the action plans laid out to stretch the Iirm to the maximum possible
extent in terms oI each oI these Iactors. The outer limit oI the hexagon reIlects the maximum
limit to which an organization can stretch itselI. The aim oI value maximization is to make the
Iirm reach these limits.
7. The Iinancial and the non Iinancial objectives oI a ,company can be explained as Iollows:
Financial objectives of the Company
It is needles~ to say that one oI the most important objectives oI a company is maximizing the
wealth oI its shareholders. It is to be kept in mind that a company is Iinanced by its ordinary
shareholders, preIerence shareholders, loan stock holders and other long-term and short-term
creditors. The entire Iund that is surplus, belongs to the legal owners oI the company, and its
ordinary shareholders. Any retained proIits are the undistributed wealth oI these equity
shareholders. The non-Iinancial objectives do not ignore Iinancial objectives altogether, but
they point towards the Iact that the simple theory oI company Iinance which postulates that the
primary objective oI a Iirm is to maximize the wealth oI ordinary shareholders, is too simplistic.
In essence, the Iinancial objectives may have to be compromised in order to satisIy non-
Iinancial objective.
Value Enhancement in the Business Parlance
When the prices oI the shares oI a company that are traded on a stock market rises, the wealth
oI the shareholders tends to get increased. The price oI a company's share goes up when the
company is expected to make attractive proIits, which it plans to pay as dividends to its
shareholders or re-invest in the business to achieve Iuture proIit growth and dividend growth.
However, it is also to be kept in mind that in order to increase the price oI the share, the
company should achieve its proIits without taking business risks and Iinancial risks which
might worry its shareholders.
Non-financial Objectives of a Firm
Having discussed the Iinancial objectives oI the Iirm at length, let us now look into some oI the
non-Iinancial objectives. The non-Iinancial objectives oI a Iirm can be as Iollows:
a. General welIare oI the employees, which includes providing the employees with good
wage, salaries, comIortable and saIe working conditions, good training and career
723
!

16
developments and good pensions.
b. WelIare oI the management which includes providing them with the better salaries and
perquisites though it will be at the cost oI the company's expenditure.
c. WelIare oI the society as a whole. For example, the oil companies conIront with the
problem oI protecting the environment and preserving the earth's dwindling energy
resources.
d. FulIillment oI responsibilities towards customers and suppliers.
e. Leadership in research and development.

7232)7+('2&80(17!
1
Question Paper
Strategic Financial Management (MB361F) : 1uly 2008
Section A : Basic Concepts (30 Marks)
- This section consists oI questions with serial number 1 - 30.
- Answer all questions.
- Each question carries one mark.
- Maximum time Ior answering Section A is 30 Minutes.
1. Which oI the Iollowing is a Iinancial objective oI a company?
(a) WelIare oI employees
(b) Wealth maximization
(c) Leadership in Research and Development
(d) WelIare oI management
(e) WelIare oI the society.

2. Internal auditing oIten involves:


I. Collection oI inIormation pertaining to working oI various parties.
II. Checking company`s compliance with quality and cost controls.
III. Determining the accuracy oI reports regarding various activities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

3. The present value oI tracking error will be equal to zero iI


(a) The tracking error consists oI entirely unsystematic risk
(b) The tracking error consists oI entirely systematic risk
(c) The tracking error consists oI 50 unsystematic risk and 50 systematic risk
(d) The tracking error consists oI 40 unsystematic risk and 60 systematic risk
(e) The tracking error consists oI 60 unsystematic risk and 40 systematic risk.

4. Discounted cash Ilow can prove biased against long-term projects because
(a) Less importance is given to direct cashIlows
(b) Less importance is given to indirect cashIlows
(c) More importance is given to indirect cashIlows
(d) Equal importance is given to direct as well as to indirect cashIlows
(e) It involves qualitative parameters oI the project.

5. Successive generations oI original product is an example oI


(a) Financial option
(b) Growth option
(c) Investment timing option
(d) Abandonment option
(e) Flexibility option.

6. Which oI the Iollowing Iinancial system analysis highlights the inter-relationships in the contents oI Iinancial
statements?
(a) Du Pont analysis
(b) Common size analysis
(c) Time series analysis
(d) Index analysis
(e) Comparative analysis.

7. Which oI the Iollowing statements is/are true as per John Linter Model?
I. The current dividend oI a Iirm depends on its current earnings and not its past dividends.
II. A conservative Iirm preIers a high level oI dividend stability and assigns relatively insigniIicant value to

2
weightage given to current earning.
III. An aggressive Iirm which attaches much signiIicance to past dividends will give low value to weightage
given to current earning.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
8. One oI the assumptions oI ideal capital market is atomistic competition, it states that
I. Investor`s wealth or at least the wealth they are willing to bring to purchase a given Iirm`s securities is
small relative to total value oI given Iirm`s securities.
II. Investor is able to purchase substantial portion oI an individual Iirm`s securities.
III. Firm may possess suIIicient cash to engage in substantial repurchases oI outstanding securities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.

9. Which oI Iollowing statements is/are true regarding Marakon Model?


I. Increase in market value to book value ratio depicts increase in Iirm`s value.
II. Creating internal structures Ior maximizing Iirm`s value is irrelevant.
III. Understanding oI strategic Iorces will help to enhance the value oI the Iirm.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.

10.As per Porter`s Five Forces model oI industry analysis, a Iirm can take an advantage over its rival Iirm by
I. Using constant price policy.
II. Improving the product diIIerentiation and creative use oI distribution system.
III. Exploiting relationship with suppliers.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.

11.Which oI the Iollowing Iactors is/are oIten considered responsible Ior initiation oI the declining phase oI product
liIe cycle?
I. Technical advances.
II. Change in perception, economy and technology.
III. Increase in leverage.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.

12.Which oI the Iollowing statements is/are true about bankruptcy models?


I. According to Wilcox model, the net liquidation value oI the Iirm is the best indicator oI the Iinancial health
oI the Iirm.
II. Blum Marc`s Iailing company model is based on liquidity ratios only.
III. According to the Beaver model, the ratio oI cash Ilow to total debt is the single best predictor oI corporate
Iailure.
(a) Only (I) above
(b) Only (II) above

3
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
13.Neon Ltd., is planning an investment oI Rs.20 million. Its optimal capital structure is 40 percent equity and 60
percent debt. Its earnings beIore interest and taxes (EBIT) were Rs.36 million Ior the year. The Iirm has Rs.180
million in assets, pays an average interest oI 10 percent per annum on all its debt, and Iaces a marginal tax rate
oI 40 percent. II the Iirm maintains a residual dividend policy and will keep its optimal capital structure intact,
the amount oI the dividends it will pay aIter Iinancing its capital budget is
(a) Rs. 3.42 million
(b) Rs. 5.42 million
(c) Rs. 7.12 million
(d) Rs.12.02 million
(e) Rs.15.12 million.

14.To control management Irom taking sub-optimal decisions a Iirm can use which oI the Iollowing internal
structure(s)?
I. The management`s compensation being linked to company`s perIormance.
II. Corporate governance mechanisms that speciIy responsibilities and hold managers accountable Ior their
decisions.
III. Resource allocation among projects guided by speciIic requirements oI the projects rather than past
allocations and capital rationing.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

15.Costs associated with materials and products that Iail to meet quality standards and result in manuIacturing
losses are called
(a) Prevention costs
(b) Appraisal costs
(c) External Iailure costs
(d) Internal Iailure costs
(e) Quality cost.

16.Which oI the Iollowing models on dividend policy emphasizes on the investor`s preIerence Ior the current
dividends?
(a) Traditional Model
(b) Walter Model
(c) Gordon Model
(d) Miller and Modigliani Model
(e) Rational expectations model.

17.Which oI the Iollowing is believed to be an external Iactor leading to the bankruptcy oI a Iirm?
(a) Shortage in supply oI raw materials
(b) Fraudulent practices by management
(c) Labour unrest
(d) Technological obsolescence
(e) Disputes among promoters.

18.Sudan Industries Ltd., an Indian company has a subsidiary in FrankIurt and is exposed to the risk oI Euro
weakening and the value oI its assets, and proIit contributions declining in rupee terms in its consolidated
Iinancial statements. The company is exposed to which oI the Iollowing risks?
(a) Transaction risk
(b) Translation risk
(c) Economic risk
(d) Interest rate risk
(e) Market risk.

19.Which oI the Iollowing statements is/are true?


I. Mckinsey Model identiIies value drivers only at generic level.

4
II. Probabilistic analysis can be used at the time oI recession.
III. Alcar Model uses the discounted cash Ilow analysis to identiIy value-adding strategies.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
20.Theta Ltd., has Rs.1.5 oI current assets Ior every Re.1 oI its current liabilities. During the current year, it is able
to generate the sales oI Rs.7 Ior every Re.1 oI investment in inventory. II its current liabilities are Rs.2,000 and
acid-test ratio is 1.2, the total sales generated by the company Ior the year are
(a) Rs.2,560
(b) Rs.3,200
(c) Rs.4,200
(d) Rs.4,800
(e) Rs.5,200.

21.Which oI the Iollowing is an important technique Ior assessing the Iinancial strength oI an organization within
the industry?
(a) Accounting analysis
(b) Time series analysis
(c) Common size statements
(d) Comparative analysis
(e) Market analysis.

22.The equity capital and total debt oI Ratan Industries Ltd., are Rs.300 lakh and Rs.600 lakh respectively. The
earnings beIore interest and taxes oI the company amounts to Rs.180 lakhs. The return on investment oI the
company is
(a) 10
(b) 12
(c) 15
(d) 20
(e) 30.

23.Xenon Ltd., earns 14 on the equity and the growth rate oI dividends and earnings is 8. The book value per
share is Rs.80. II the cost oI equity is 16, the market price oI the shares oI Xenon Ltd., according to the
Marakon model is
(a) Rs.46
(b) Rs.50
(c) Rs.55
(d) Rs.58
(e) Rs.60.

24.Arranging third party to pay Ior losses iI they occur, without transIerring the risk itselI is known as
(a) Risk retention
(b) Risk sharing
(c) Risk Iinancing
(d) Separation
(e) Combination.

25.Economic risk can be determined by which oI the Iollowing Iactor(s)?


I. Location oI production Iacilities.
II. Location oI competitors.
III. Determinants oI input prices.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.

26.Ramprakash Ltd., has taken a term loan oI Rs.27 lakh at an interest rate oI 20 p.a. the cost oI the term loan
assuming that the tax rate is 40 is

5
(a) 9
(b) 10
(c) 11
(d) 12
(e) 13.
27.The most commonly held view oI capital structure is that the weighted average cost oI capital
(a) Declines steadily as more debt is used
(b) First declines with moderate amounts oI leverage and then increases
(c) Increases proportionately with increases in leverage
(d) Is unaIIected by the level oI debt used
(e) Is minimized at a balanced capital structure oI 50 equity and 50 debt.

28.The current assets and liabilities oI Akash Ltd., are Rs.20,00,000 and Rs.13,00,000 respectively. The amount it
can borrow on short-term basis without reducing the current ratio below 1.1 is
(a) Rs.44 lakh
(b) Rs.49 lakh
(c) Rs.52 lakh
(d) Rs.55 lakh
(e) Rs.57 lakh.

29.The Iollowing inIormation available Ior Best Ltd. :


Current Assets Rs.500 million
Net Fixed Assets Rs.400 million
EBIT Rs.100 million
Return on investment 18.
The working capital leverage Ior 10 reduction in current assets will be
(a) 58.82
(b) 60.13
(c) 65.02
(d) 68.22
(e) 69.23.

30.Suppose, the upper limit and lower limit oI cash balances are Rs.80,000 and Rs.20,000 respectively. The return
point according to Miller and Orr Model will be
(a) Rs.20,000
(b) Rs.25,000
(c) Rs.30,000
(d) Rs.40,000
(e) Rs.45,000.

END OF SECTION A
Section B : Problems/Caselet (50 Marks)
- This section consists oI questions with serial number 1 5.
- Answer all questions.
- Marks are indicated against each question.
- Detailed workings/explanations should Iorm part oI your answer.
- Do not spend more than 110 - 120 minutes on Section B.
6
Serum Ltd., is a popular biotech Iirm which produces various antiserums Ior blood
group testing. The Iollowing inIormation is available about Serum Ltd.:
EBIT
Interest on debentures 8.5
Interest on term loans 12
Income tax 40
Number oI equity shares
Market price per share
Rs.75 lakh
Rs.1.275 lakh
Rs.1.92 lakh
Rs.28.7 lakh
Rs.15 lakh Rs.10 per share
Rs.20
The company has undistributed reserves and surplus oI Rs.40 lakh. It is in need oI
Rs.60 lakh to pay the debentures and modernize plans. The company is considering
the Iollowing two plans:
Plan I. Raising the entire amount as term loans 12.5.
Plan II. Issuing 1.5 lakh shares at Rs.15 per share and rest oI the amount in the
Iorm oI term loan 12.5 per annum.
As a result oI modernization, the return on capital is likely to improve by 3. In case
the total amount is raised in the Iorm oI term loans, the P/E ratio oI the company is
likely to decrease by 5.
You are required to:
$QVZHU!
a. Advise the company on the Iinancial plans to be selected. ( 8 marks)
1.
b. Find out the indiIIerence level oI EBIT. ( 4 marks)
Duplex Solutions Ltd., a leading soItware company, reported earnings per share oI
Rs.2.10 in the year 2007, on which it paid dividends per share oI Rs.0.69. Earnings
are expected to grow 15 a year Irom 2008 to 2012, during which period the
dividend payout ratio is expected to remain unchanged. AIter 2012, the earnings
growth rate is expected to drop to a stable 6, and the payout ratio is expected to
increase to 65 oI earnings. Currently, the Iirm has a beta oI 1.40 and it is expected
to have a beta oI 1.10 aIter 2012. The risk-Iree rate is 4.5 and the risk premium is
5.5.
You are required to determine:
$QVZHU!
a. The expected price oI the stock at the end oI 2012. ( 5 marks)
2.
b. The present value oI the stock. ( 5 marks)
3. The Iollowing data is related to Duracell Ltd.:

(Rs. in lakhs)
Average stock oI raw materials and stores 10.00
Average work-in-progress inventory 12.00
Average Iinished goods inventory 7.00
Average accounts receivable 13.00
Average accounts payable 8.00
Average WIP value oI raw-material consumed per day 1.00
Average cost oI goods sold per day 1.50
Average sales per day 2.00
Average credit purchases per day 0.55
Sales price per unit oI its product is Rs.2,500 and processing cost per unit is Rs.300.
The Iirm`s average daily production is 150 units. The minimum cash balance to be
maintained by the Iirm is Rs.1.5 lakhs.
You are required to calculate:
$QVZHU!
a. The weighted operating cycle oI the Iirm.
( 8 marks)
b. The working capital requirement oI the Iirm based on the weighted operating
cycle.
( 2 marks)
Caselet
7
Read the caselet carefully and answer the following questions:
4. Strategically designed changes are aimed to move the companies away Irom their
existing state oI aIIairs toward some desired state oI aIIairs in order to improve their
organizational perIormance by increasing their competitive advantage. Explain the
various types oI strategic changes that may be undertaken by companies Ior
improving their perIormance. ( 9 marks)
$QVZHU!
5. Certain conditions must be prevalent within the organizations so that they can
achieve strategic changes by bringing about a behavioural change among the
employees. What are the conditions which are generally required to bring about a
behavioural change among the employees? ( 9 marks)
$QVZHU!
Over the past 15 or so years, programs to bring in strategic changes in the corporates
and improve their organizational perIormance have become increasingly common.
Yet, they are notoriously diIIicult to carry out. Success depends on persuading
hundreds or thousands oI groups and individuals to change the way they work, a
transIormation people will accept only iI they can be persuaded to think diIIerently
about their jobs. In eIIect, CEOs must alter the mind-sets oI their employeesnot an
easy task. CEOs could make things easier Ior themselves iI, beIore embarking on
complex perIormance-improvement programs, they determined the extent oI the
change required to achieve the business outcomes they seek. But what iI the only
way a business can reach its higher perIormance goals is to change the way its people
behave across the board? Suppose that it can become more competitive only by
changing its culture IundamentallyIrom being reactive to proactive, or
introspective to externally Iocused, Ior instance. Recently, however, several
companies have Iound that linking all oI the major discoveries together in programs
to improve perIormance has brought about startling changes in the behavior oI
employeeschanges rooted in new mind-sets. PerIormance-improvement programs
that apply all oI these ideas in combination can be just as chaotic and hard to lead as
those that don`t. But they have a stronger chance oI eIIecting long-term changes in
business practice and thus oI sustaining better outcomes.
It is generally observed that certain conditions are required to bring about a
behavioural change among the employees. Employees will alter their mind-sets only
iI they see the point oI the change and agree with itat least enough to give it a try.
To Ieel comIortable about change and to carry it out with enthusiasm, people must
understand the role oI their actions in the unIolding drama oI the company`s Iortunes
and believe that it is worthwhile Ior them to play a part. The surrounding structures
(reward and recognition systems, Ior example) must be in tune with the new
behavior. Organizational designers broadly agree that reporting structures,
management and operational processes, and measurement proceduressetting
targets, measuring perIormance, and granting Iinancial and nonIinancial rewards
must be consistent with the behavior that people are asked to embrace. Employees
must have the skills to make relevant changes in behavior. They must be given
suIIicient time to be equipped with such skills. A specialist in adult learning showed
that adults can`t learn merely by listening to instructions; they must also absorb the
new inIormation, use it experimentally, and integrate it with their existing
knowledge. Finally, they must see people they respect modeling new behaviour
actively. In any organization, people model their behavior on "signiIicant others":
those they see in positions oI inIluence. Within a single organization, people in
diIIerent Iunctions or levels choose diIIerent role modelsa Iounding partner,
perhaps, or a trade union representative, or the highest-earning sales rep.Each oI
these conditions is realized independently; together they add up to a way oI changing
the behavior oI people in organizations by changing attitudes about what can and
should happen at work.
END OF
CASELET
END OF SECTION B
Section C : Applied Theory (20 Marks)
8
- This section consists oI questions with serial number 6 - 7.
- Answer all questions.
- Marks are indicated against each question.
- Do not spend more than 25 -30 minutes on Section C.
6. For developing superior strategies to gain sustainable competitive advantage,
strategic cost management uses the cost data. An integral part oI strategic cost
management is Activity Based Costing (ABC). Discuss various steps
involved in ABC system.
( 10 marks)
$QVZHU!
7. It is better to reorganize a Iirm in Iinancial distress rather than to liquidate it
as the Iirm will be more likely to repay its debts, when it is alive and
operating than when it is liquidated. Explain various steps involved in the
reorganization oI a Iinancially distressed Iirm.
( 10 marks)
$QVZHU!
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management (MB361F) : 1uly 2008
Section A : Basic Concepts
Answer Reason
1. B Wealth maximization is a Iinancial objective oI company whereas welIare oI
employees, leadership in R&D, welIare oI management, welIare oI society etc. are
the non-Iinancial objectives oI a company.
723!
2. E While doing the internal auditing internal auditing team oversees the entire product
development process, provides the Iirm with valuable inIormation that may include
inIormation pertaining to whether all the parties involved in the project are working
on consensus basis, whether all workings are done according to plans and iI any
Iurther change is required to those plans. Whether the company is with quality and
cost controls and Iinally the reports on all activities are accurate.
723!
3. A The use oI tracking error approach is relevant Ior valuation when the present value oI
the tracking error is zero. This is possible only when the tracking error consists
entirely oI unsystematic or Iirm speciIic risks.
723!
4. B Discounted cash Ilow is biased against long-term projects, this is because the use oI
DCF involves the quantiIiable parameters oI the project thereby giving less
importance to the indirect cash Ilows.
723!
5. B Successive generation oI original product is an example oI growth option. 723!
6. A Analyzing return ratios is reIerred to as DuPont Analysis. This system highlights the
inter-relationships in the contents oI Iinancial statements. Hence, the answer is (a).
The other alternatives compare the Iinancial statements by taking the individual items
oI diIIerent Iinancial statements and reviewing the changes that have occurred Irom year
to year and over the years.
723!
7. B The Linter model states that current dividends oI a Iirm depend on its current earnings
and past dividends. The degree oI dividend stability can be deduced Irom the
weightages in the model. A conservative Iirm which preIers the high level oI dividend
stability will assign relatively insigniIicant value to weightage given to current
earnings by the Iirm. On the other hand, an aggressive Iirm which does not attach
much signiIicance to past dividends would give high value to weightage given to
current earnings by the Iirm.
723!
8. A Atomistic competition is one oI the assumptions oI ideal capital market which states 723!
9
that all investors are atomistic i.e; their wealth or at least the wealth that they are
willing to bring to purchase the given Iirm`s securities is small relative to the total
value oI given Iirm`s securities.
9. D According to Marakon model, a Iirm`s value is measured by ratio oI its market value
to book value. An increase in this ratio depicts increase in the value oI Iirm and
reduction reIlects a reduction in the Iirm`s value. The model Iurther states that a Iirm
can maximize its value Iollowing Iour steps:
- Understand the Iinancial Iactors that determine the Iirm`s value.
- Understand the strategic Iorces that aIIect the value oI the Iirm.
- Formulate the strategies that lead to higher value oI the Iirm.
- Create internal structures to counter the divergence between the shareholder`s
goals and management`s goals.
723!
10. E According to Five Forces model a Iirm can take an advantage over the rival Iirm by
changing prices raising or lowering prices to gain a temporary advantage, improving
product diIIerentiation, creatively use oI distribution system and exploiting
relationship with suppliers.
723!
11. C The declining phase may be caused by Iollowing Iactors:
- Technical advances leading to product substitution
- Change in perception like the change in Iashion and taste
- The average length oI product liIe cycle is tending to shorten as a result oI
economic, social and technological change.
723!
12. D The Wilcox model considers the net liquidation value oI the Iirm as the best indicator
oI a Iirm`s Iinancial health. Blum Marc`s Iailing company model is based on a set oI
12 ratios divided into liquidity, proIitability and variability ratios. The Beaver model
identiIies the cash Ilow to total debt as the single best indicator oI a Iirm`s Iinancial
health.
723!
13. C Interest cost:
Total assets Rs.180M; debt 60 Rs.180M Rs.108 million in debt.
Interest cost Rs.108M 0.10 Rs.10.8 million.
Net income (in millions):
EBIT Rs.36.0
less: Interest 10.8
EBT Rs.25.2
less: Taxes (40) 10.08
Net income Rs.15.12
The portion oI project Iinanced with retained earnings:
Retained earnings portion: 20M x 0.40 Rs.8.0 million
Debt portion Rs.20M x 0.60 Rs.12.0 million
The residual available Ior dividends Rs.15.12M Rs.8.0M Rs.7.12 million in
dividends
723!
14. E A Iirm needs internal structures which can control the tendency oI management to
take suboptimal decisions. These internal structures may include:
- The management`s compensation being linked to company`s perIormance
- Corporate governance mechanisms that speciIy responsibilities and hold
managers accountable Ior their decisions
- Resource allocation among projects guided by speciIic requirements oI the
projects rather than the past allocations and capital rationing
- A mechanism Ior making sure that the various projects undetaken Irom part oI a
strategy, rather than being disjointed, discrete projects
723!
15. D Costs that arise due to materials and products that Iail to meet quality standards and
result in manuIacturing losses are called internal Iailure costs
723!
16. C Gordon argued that the investors would preIer the income that they earn currently to
that income in Iuture that may or may not be available. Hence, they preIer to pay a
723!
10
higher price Ior the stocks which earn them current dividend income and would
discount those stocks, which either reduce or postpone the current income. For that
reason, this model emphasizes the entire weight on the dividends, while other models
consider the dividend payment and the retained earnings. Hence, option (c) is correct.
17. A Shortage in supply oI raw materials is an external Iactor, others are internal Iactors. 723!
18. B The example given in the question is oI translation risk. The risk arises Irom the
translation oI balance sheets and income statements in Ioreign currencies to the
currency oI the parent company Ior Iinancial reporting purposes.
723!
19. E Mckinsey Model identiIies value drivers at generic level, department level and grass
root level. Statement (I) is not true.
Probabilistic analysis can be used at the time oI recession. Statement (II) is true.
Alcar Model uses the discounted cash Ilow analysis to identiIy value-adding
strategies. Statement (III) is true.
723!
20. C Current assets Current liabilities x Current ratio 2000 x 1.5 Rs.3000
Current assets Inventories Current liabilities x Acid test ratio 2000 x 1.2
Rs.2400
Or , Inventories 3000 -2400 Rs.600
Sales Inventories x Inventories turnover ratio 600 x 7 Rs.4200.
723!
21. D Comparative analysis is an important tool Ior assessing the Iinancial strength oI an
organization within the industry.
723!
22. D Return on investment (ROI) EBIT / Total assets
Total assets Debt Equity 600 300 Rs.900 lakhs
EBIT Rs.180 lakhs (given)
ROI 180 / 900 20.
723!
23. E
P
0

( ) B r g
K g

Where, B Current book value per share


r return on equity
g Growth rate in earnings and dividends
k Cost oI equity

( )
( )
80 0.14 0.08
0.16 0.08

Rs.60
Hence answer is (e).
723!
24. C Arranging third party to pay Ior losses iI they occur, without transIerring the risk itselI
is known as risk Iinancing.
723!
25. E The Iollowing are the Iactors that determine the economic risk:
- DiIIerence between the location Iacilities and where the product is sold
- Location oI competitors
- Determinants oI input prices: are they determined in international markets or
local markets.
723!
26. D
(1 ) 0.20(1 0.40) 0.12 12 = = = = Kt I T
723!
27. B According to the traditional approach to capital structure, as debt is added to the
capital structure the cost oI capital declines initially because oI lower post-tax cost oI
debt. But as leverage is increased, the increased Iinancial risk overweighs the beneIits
oI low cost debt and so the cost oI capital starts increasing.
723!
11
28. E
( )
2000000
1.1
1300000
1300000 1.1 2000000
0.1 2000000 1430000 .57, 00, 000
+
=
+
+ = +
= =
X
X
X X
X Rs
723!
29. A
current assets
working capital leverage
500
58.82
900 ( 50)
+
= =
+
Total assets changeincurrent assets
723!
30. D According to Miller and Orr Model the Upper limit, UL 3RP 2LL
Where RP means return point and LL means lower limit.
RP
3
LL 2 UL+

80, 000 2 20, 000
3
+
Rs. 40,000.
723!
12
Section B : Problems/Caselet
1.a.
(Rs. In lakhs)
EBIT 75
interest on debentures 1.275
Interest on term loans 1.92
3.195 3.195
71.805
Tax 40 28.722
PAT 43.083
No. oI Equity shares 15
EPS 2.8722
Market price oI the share 20
P/E ratio 6.96
Equity share capital (15 10) 150
Reserves and surplus 40
8.5debentures
1.275
0.085
| |
|
\ .
15
12 term loans
( ) 1.92/ 0.12
16
total capital employed 221
return on capital employed
75
221
| |
|
\ .
0.34
Revised Capital Structure
(Rs. In lakhs)
Existing capital 221
less Deb. Redeemed 15
206
Add. Additional Capital to be raised 60
Total capital employed 266
Plan I : Loan Rs.60 lakh 12.5
Plan II : Loan Rs.37.5 lakh 12.5
Equity Rs.22.5 lakh (1.5 lakh shares at Rs.15 per share)
(Rs. In lakhs)
Plan 1 Plan 2
EBIT (34 oI capital employed (i.e 34 3)
37
266
100
| |

|
\ .
98.42 98.42
Less interest 12 1.92 1.92
Less interest on add. Term loan 12.5 7.5 4.69
EBT 89 91.81
Less: Tax 40 35.6 36.72
PAT 53.4 55.09
No. oI equity shares 15 16.5
EPS 3.56 3.34
Expected P/E ratio
( ) 6.96 6.96 0.05 (

6.61 6.96
Expected market price per share
| | EPS P/ E ratio
23.53 23.24
ThereIore, Plan I is advisable to be adopted
b.
IndiIIerence Point:

72
!
13
( )
(EBIT-I )(1 ) (EBIT-I )(1 )
1 2
1 2
-n I ( 15 4.69) 16.5 7.50 70.35 123.75 53.40
1 2 2 1
EBIT .35.60
16.5 15 1.5 1.5
2 1
t t
n n
n I
Rs lakh
n n

=
+ + +
= = = =

2.a. Expected earnings per share in 2013 2.10 x (1.15)
5
x 1.06 Rs.4.48
Expected dividends per share in 2013 Rs. 4.48 x 0.65 Rs.2.91
Cost oI Equity capital aIter 2013 R
I
|(R
m
R
I
) 4.5 1.1 x 5.5 10.55
According to Dividend Discount Model
P
o

1
e
D
k g
ThereIore, the expected price at the end oI 2012
2.91
0.1055 0.06
Rs.63.96
b.
Year EPS (in Rs.) DPS (in Rs.)
2008 2.42 0.79
2009 2.78 0.91
2010 3.19 1.05
2011 3.67 1.21
2012 4.22 1.39
Cost oI equity R
I
|(R
m
R
I
) 4.5 1.4 x 5.5 12.2
Present value oI stock
0.79 x PVIF (12.2, 1) 0.91 x PVIF (12.2, 2) 1.05 x PVIF (12.2, 3) 1.21 x PVIF (12.2, 4)
1.39 x PVIF (12.2, 5) 63.96 x PVIF (12.2, 5)
Rs.35.76.

72
!
3.a.
Rs.
Average WIP value oI raw material consumed per day 1,00,000.00
Less: (Average processing cost per day) 2
300 150
22,500.00
Average raw material and stores consumed per day 77,500.00
Raw material cost per unit
150
500 , 77
516.67
Cost oI goods sold per unit
150
000 , 50 , 1
1,000
Durations:
Raw materials storage period D
rm

day per consumed stores and material raw Average
stores and materials raw oI Stock Average

77500
1000000
12.9 days
Work-in progress D
WIP

day per consumed material raw oI value WIP Average
inventory WIP Average

000 , 00 , 1
000 , 00 , 12
12 days
Finished goods D
Ig

day per sold goods oI t cos Average
inventory goods Iinished Average

000 , 50 , 1
000 , 00 , 7

72
!
14
4.67 days
Debtors collection period D
ar

day per sales Average
receivable accounts Average

000 , 00 , 2
000 , 00 , 13
6.5 days
Creditors` payment period D
ap

day per purchases Credit Average
payable accounts Average

000 , 55
000 , 00 , 8
14.55 days
Weights:
W
rm

unit per price Sales
unit per t cos stores and material Raw

2500
67 . 516
0.21
W
Ig

unit per price Sales
unit per sold goods oI Cost

2500
1000
0.40
W
ar

unit per price Sales
unit per price Sales

2500
2500
1.00
W
ap

unit per price Sales
unit per t cos stores and material Raw

2500
67 . 516
0.21
W
wip

unit per price Sales
unit) per cost g (Processin 0.5 unit per cost stores and material Raw +

2500
) 300 ( 5 . 0 67 . 516 +
0.27
Weighted operating cycle W
rm
D
rm
W
wip
D
wip
W
Ig
D
Ig
W
ar
D
ar
W
ap
D
ap
0.21 (12.9) 0.27 (12) 0.4 (4.67) 1 (6.5) 0.21 (14.55)
11.26 days
b. Working capital Average sales per day Weighted operating cycle Minimum cash
balance
2,00,000 (11.26) 1,50,000
24.02 lakhs.
4.Strategic Change is the movement oI a company away Irom its present state toward some desired Iuture
state to increase its competitive advantage. The various types oI strategic change are re-engineering,
restructuring and innovation.
1. Re-engineering
Re-engineering is the Iundamental rethinking and radical redesign oI business processes to achieve
dramatic improvements in critical, contemporary measures oI perIormance such as cost, quality,
service and speed. The strategists who use re-engineering must completely rethink how their
organization goes about in its business. In re-engineering, the strategic managers make business
processes the Iocus oI attention. A business process is any activity that is vital to delivering goods
and services to customers quickly or at low cost. Some examples oI business processes are order
processing, inventory control or product design.
The organizations that take up re-engineering ignore the existing arrangement oI work activities.
Such organizations start the change process by asking the customers 'How can we reorganize the
way we do our work to provide the best quality and the lowest cost goods?. Such companies realize
that there are more eIIective ways to reorganize their activities. OIten individual jobs (that become
increasingly complex) and people are grouped into cross-Iunctional teams (as business processes)
and are reengineered to reduce costs and increase quality.
ThereIore, re-engineering adopts a diIIerent approach in optimizing its activities. This may be
because oI drastic unexpected changes in the environment such as emergence oI aggressive new
competitors or technological breakthroughs, etc.

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15
2. Restructuring
Restructuring programs involve changes in the relationships between divisions and Iunction. There
are two basic steps to restructuring. They are :
In the Iirst step, the organization reduces its level oI diIIerentiation and integration by eliminating
divisions, departments or levels in the hierarchy.
Next, it downsizes by reducing the number oI its employees to reduce operating costs.
There are many reasons as to why organizations go in Ior restructuring. Sometimes, unIoreseen
changes might occur in the business environment. For example, worldwide recession can reduce the
demand Ior the Iirm`s products. Sometimes, organizations have excess capacity because customers
do not want its products. At times, Iirms on top position restructure to build and improve their
competitive position (so that they can stay on top). Also, organizations downsize because over time
they have grown too tall and bureaucratic and due to this operating costs increase to a large extent.
Moreover, companies are Iorced to downsize because they have not paid attention to the need to
reengineer themselves. In such a situation, restructuring becomes the only way they can survive and
compete in an increasingly competitive environment.
3. Innovation
Innovation is a process by which organizations use their skills and resources to create new
technologies or products, innovation is required because organizations can change and better respond
to the needs oI their customers. It can result in a spectacular success oI the organization. For
example, Apple Computer changes the computer industry when it introduced its personal computers.
The outcomes oI research and development activities are oIten uncertain. Due to this, innovation is
associated with a high level oI risk.
Moreover, innovation is one oI the most diIIicult change processes to manage. This is because, when
organizations rely on innovation as the source oI their competitive advantage they need to adopt
Ilexible structures. Also, Iunctions need to coordinate their activities and work together iI innovation
is to be successIul. OI all the kinds oI change programs, innovation has the prospects Ior the greatest
long-term success but also the greatest risks. Thus, iI organizations are to avoid being leIt behind in
the competitive race to produce new products, they must take steps to introduce them or develop new
technologies to produce those products reliably and at low cost.
5.The conditions which are generally required to bring about a behavioural change among the employees are
explained below:
A purpose to believe in
To Ieel comIortable about change and to carry it out with enthusiasm, people must understand the role oI
their actions in the unIolding drama oI the company`s Iortunes and believe that it is worthwhile Ior them to
play a part. It isn`t enough to tell employees that they will have to do things diIIerently. Anyone leading a
major change program must take the time to think through its "story"what makes it worth
undertakingand to explain that story to all oI the people involved in making change happen, so that their
contributions make sense to them as individuals.
Reinforcement systems
The organizational structures such as reward and recognition systems, reporting structures, management
and operational processes, and measurement procedures (setting targets, measuring perIormance, and
granting Iinancial and nonIinancial rewards) must be consistent with the behavior that people are asked to
adopt. When a company`s objectives Ior new behavior are not reinIorced, employees are less likely to
adopt it consistently; iI managers are urged to spend more time coaching junior staII, Ior instance, but
coaching doesn`t Iigure in the perIormance scorecards oI managers, they are not likely to bother.
Adoption of skills to make relevant changes in behaviour
Employees must be given suIIicient time to be equipped with the skills to make relevant changes in
behavior. In practice, this means that one cannot teach everything there is to know about a subject in one
session. It is much better to break down the Iormal teaching into chunks, with time in between Ior the
learners to reIlect, experiment, and apply the new principles. Large-scale change happens only in steps.
Consistent role models
In any organization, people model their behavior on those they see to be in positions oI inIluence. Within
the same organization, people in diIIerent Iunctions or levels choose diIIerent role models such as a
Iounding partner, or a trade union representative, or the highest-earning sales representative. So to change
behavior consistently throughout an organization, it is not enough to ensure that people at the top are in
line with the new ways oI working; the role models at every level must Iollow the same with letter and
spirit. The way role models deal with their tasks can vary, but the underlying values inIorming their

72
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16
behavior must be consistent. Behavior in organizations is deeply aIIected not only by role models but also
by the groups with which people identiIy. Role modeling by individuals must thereIore be conIirmed by
the groups that surround them iI it is to have a permanent or deep inIluence.
Section C: Applied Theory
6. Activity Based Costing
Applying overhead costs to each product or service based on the extent to which that product
or service causes overhead cost to be incurred is the primary objective oI accounting Ior
overhead costs. In many production processes, overhead is applied to products using a single
predetermined overhead rate based on a single activity measure. With Activity-Based Costing
(ABC), multiple activities are identiIied in the production process that are associated with
costs. The events within these activities that cause work (costs) are called cost drivers.
Examples oI overhead cost drivers are machine set-ups, material-handling operations, and the
number oI'steps in a manuIacturing process. Examples oI cost drivers in non-manuIacturing
organizations are hospital beds occupied, the number oI take-oIIs and landing Ior an airline,
and the number oI rooms occupied in a hotel. The cost drivers are used to apply overhead to
products and services when using ABC.
The Iollowing Iive steps are used to apply costs to products under an ABC system,
i. Choose appropriate activities
ii. Trace costs to activities
iii. Determine cost drivers Ior each activity
iv. Estimate the application rate Ior each cost driver
v. Apply costs to products.
These steps are discussed in more detail below.
CHOOSE APPROPRIATE ACTIVITIES
The Iirst step oI ABC is to choose the activities that result in incurring oI overhead costs.
These activities do not necessarily coincide with existing departments but rather represent a
group oI transactions that support the production process. Typical activities used in ABC are
designing, ordering, scheduling, moving materials, controlling inventory, and controlling
quality.
Each oI these activities is composed oI transactions that result in costs. More than one cost
pool can be established Ior each activity. A cost pool is an account to record the costs oI an
activity with a speciIic cost driver.
TRACE COSTS TO ACTIVITIES
Once the activities have been chosen, costs must be traced to the cost pools Ior diIIerent
activities. To Iacilitate this tracing, cost drivers are chosen to act as vehicles Ior distributing
costs. These cost drivers are oIten called resource drivers. A predetermined rate is estimated
Ior each resource driver. Consumption oI the resource driver in combination with the
predetermined rate determines the distribution oI the resource costs to the activities.
DETERMINE COST DRIVERS FOR ACTIVITIES
Cost drivers Ior activities are sometimes called activity drivers. Activity drivers represent the
event that causes costs within an activity. For example, activity drivers Ior the purchasing
activity include negotiations with vendors, ordering materials, scheduling their arrival, and
perhaps inspection. Each oI these activity drivers represents costly procedures that are
perIormed in the purchasing activity. An activity driver is chosen Ior each cost pool. II two
cost pools use the same cost driver, then the cost pools could be combined Ior product-costing
purposes.
Cooper has developed several criteria Ior choosing activity drivers. First, the data on the cost
driver must be easy to obtain. Second, the consumption oI the activity implied by the activity
driver should be highly correlated with the actual consumption oI the activity. The third
criterion to consider is the behavioral eIIects induced by the choice oI the activity driver.
Activity drivers determine the application oI costs, which in turn can aIIect individual
perIormance measures.
The judicious use oI more activity drivers increase the accuracy oI product costs. Ostrenga
concludes that there is a preIerred sequence Ior accurate product costs. Direct costs are the
most accurate in applying costs to products. The application oI overhead costs through cost
drivers is the next most accurate process. Any remaining overhead costs must be allocated in a
somewhat arbitrary manner, which is less accurate.
723!
17
ESTIMATE APPLICATION RATES FOR EACH ACTIVITY DRIVER
An application rate must be estimated Ior each activity driver. A predetermined rate is
estimated by dividing the cost pool by the estimated level oI activity oI the activity driver.
Alternatively, an actual rate is determined by dividing the actual costs oI the cost pool by the
actual level oI activity oI the activity driver. Standard costs, could also be used to calculate a
predetermined rate.
APPLYING COSTS TO PRODUCTS
The application oI costs to products is calculated by multiplying the application rate times the
usage oI the activity driver in manuIacturing a product or providing a service.
7. Reorganization
The steps involved in reorganization oI a Iirm are
- Techno- economic viability study
- Formulation and execution oI the reorganization plan
- Monitoring the activities oI the Iirm
Techno-economic Viability Study
A reorganization plan is worked out on the basis oI a techno-economic viability study oI the
Iirm. This study sets out to identiIy the strengths and weaknesses oI the Iirm, the causes oI
Iailure, the viability oI Iuture operations and the course oI action to be taken to bring about a
turnaround. The techno-economic viability study is undertaken by the operating agencies
assigned to the Iirm. These operating agencies are generally Iinancial institutions and banks
such as IDBI , IFCI, ICICI, IRBI, SBI, PNB, etc.
The techno-economic viability study covers all the Iunctional areas oI a Iirm: management,
Iinance, production and marketing.
Management: The eIIectiveness and ability oI the management is one oI the most important
Iactors that determines the success or Iailure oI a Iirm. A detailed study is done in terms oI the
objectives oI the Iirm, both short-term and long-term, the corporate strategy, the corporate
culture, the management-labor relations, the organizational hierarchy, the decision-making
process, etc. The study tries to determine the eIIectiveness oI management and its integrity.
The areas oI mismanagement are also determined.
Finance: Finance is the main Iunctional areas oI business. It is a measurable indicator oI the
Iirm`s health and perIormance. A thorough analysis oI the Iirm`s Balance Sheet and
ProIit/Loss statement is made.
These statements when properly analyzed give the Iinancial stability and liquidity oI the Iirm;
proIitability and uses oI Iunds. The analysis also identiIies the capital structure and the
sources oI Iunds. The analysis gives insight into working capital management and
management oI earnings.
Production and Technology: Production and Technology Iunction assumes immense
importance in the viability study. The various areas that are looked into are, the Iirm`s
equipment and machinery, the maintenance oI the equipment, the technology used in
production, the production capacity and utilization, the products being oIIered by the Iirm, the
quality control system, production planning and inventory control.
Marketing: A number oI Iirms have Iailed because oI lack oI good marketing management.
The various areas oI marketing that are studied are, the product mix oI the Iirm, the past sales
oI the product in terms oI quantity and value, the market share oI the Iirm, the demand Ior the
product range, the study oI the customer proIile, the price oI the products, the distribution
channels being used, the kind oI promotion-mix being used and the most important oI all is
the marketing team. This study is done in comparison with the competitors.
Formulation and Execution of the Plan
The viability study serves as the basis Ior Iormulation oI a rehabilitation plan. A thorough
study oI the various Iunctional areas oI the Iirm reveals the strengths, weaknesses,
opportunities and threats oI the Iirm. It gives a comprehensive idea about the status oI the
Iirm, the viability oI the Iirm both technically and economically and the additional Iunds
required Ior rehabilitation.
The Iormulation plan involves the changes and action to be taken regarding the various
Iunctions oI the Iirm. It may decide to make changes in the management, iI it is not Iound
competent. Some oI the labour may be retrenched/recruited depending on the situation. The
amount oI Iinancial assistance to be given is determined and arrangements are made to secure
the loan. Various steps are taken to improve the production Iunction in terms oI new
723!
18
machinery and new technology. The viable level oI operations are determined and steps are
taken to achieve this production level. The product-mix, the pricing, the quality oI the
products, distribution channels and the promotion-mix are to be changed to suit the needs oI
the customers, to achieve the desired sales levels. Once the plan is Iormulated, the plan is
careIully executed. All the necessary changes prescribed by the plan are made. The Iunds are
disbursed in a phased manner as and when required. The necessary concessions and relieIs are
provided. A close watch is kept on the activities oI the Iirm and a continuous evaluation is
done.
Monitoring
Monitoring is a very important part oI a rehabilitation plan. It is done to evaluate the
execution oI the plan. Regular meetings are held between the Iirm, the bankers, the Iinancial
institutions and other concerned parties to veriIy and evaluate the process oI execution.
Monitoring is one to ensure the proper utilization oI Iunds and adherence to the terms oI
rehabilitation plan. It also ensures the proper working oI the Iirm. Feedback is obtained and
remedial measures are taken as and when the situation demands. The impact oI rehabilitation
becomes evident in a short period. Once the success oI the Iirm becomes evident, the role oI
agencies and banks is conIined to constantly hold meetings to assess and review the process.
This continues till the Iirm is successIul. In case the Iirm is Iound incapable oI making a
turnaround despite the plan, then the steps to liquidate the Iirm are undertaken
7232)7+('2&80(17!
Question Paper
Strategic Financial Management: Theory and Practice (MB3H2F): October
2008
Section A : Basic Concepts (30 Marks)
- This section consists oI questions with serial number 1 - 30.
- Answer all questions.
- Each question carries one mark.
- Maximum time Ior answering Section A is 30 Minutes.
1. Cellulose Industries earns 10 on its equity and the growth rate oI dividends and earnings is 5. The
number oI shares outstanding is 16,00,000. The current market price per share oI Cellulose Industries is
Rs.140 and its cost oI equity is 11. II Marakon model holds good, the net worth oI the company is
(a) Rs.15,32,42,080
(b) Rs.16,32,42,080
(c) Rs.17,32,42,080
(d) Rs.26,88,00,000
(e) Rs.27,32,42,080.
$QVZ
!
2. LC Gupta model Ior predicting bankruptcy oI a Iirm considers proIitability ratios and balance sheet ratios.
Which oI Iollowing ratios comes under the proIitability ratios oI LC Gupta Model?
I. EBDIT/Net sales.
II. Operating cash Ilow/Total assets.
III. Net worth/Total debt.
IV. Operating cash Ilow/sales.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (II) and (III) above
(d) (I), (II) and (III) above
(e) (I), (II) and (IV) above.
$QVZ
!
3. Real Traders Ltd., has Iurnished the Iollowing inIormation pertaining to its capital structure:
Particulars Rs. in crore
Equity capital (100 lakh equity shares oI Rs.10 each) 10
Reserves 2
10 Debentures oI Rs.100 each 3
For the year ended 2008, the company has paid equity dividend at the rate oI 20. As the company is a
market leader and dividend is likely to grow by 5 every year. The equity shares are currently trading at
Rs.80 per share. II the income tax applicable to the company is 35, the current weighted cost oI capital oI
the company is
(a) 7.40
(b) 9.50
(c) 10.13
(d) 11.34
(e) 12.87.
$QVZ
!
4. Betavision Ltd., has provided the Iollowing inIormation pertaining to its operations Ior a period trial
months:
Units produced and sold 15,000
Sale price per unit Rs. 200
Variable cost per unit Rs. 172
Total Iixed cost Rs.2,10,000
II the units (produced and sold) increase by 10, the percentage change in EBIT will be
(a) 10.25
(b) 11.80
(c) 12.80
(d) 18.50
(e) 20.00.
$
5. The method that involves making a tender oIIer to shareholders oI the Iirm to repurchase their shares
without Iixing predetermined price is known as
(a) Open market repurchase
(b) Fixed price tender oIIer
(c) Dutch auction tender oIIer
(d) Stock split
(e) Stocks repurchase.
$
6. Fostering ideal work culture usually involves:
I. Hiring people with leadership potential.
II. Articulation oI strong corporate purpose.
III. Attempting to control employees using stringent measures.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
$
7. Which oI the Iollowing assumptions is false with respect to Baumol Model?
(a) Cash expenses are incurred evenly over the planning period
(b) Securities Ior a particular sum are converted into cash at a regular Irequency
(c) The cash requirement Ior the period under consideration is known in advance
(d) Conversion cost depends upon the amount oI securities converted
(e) All cash surplus is initially parked in short-term securities.
$
8. Two Iirms Digital Ltd., and Analog Ltd., are similar in all respects, except that Digital Ltd., is unlevered,
while Analog Ltd., has Rs.6 crore oI 14 debentures outstanding. Both companies have a net operating
income oI Rs.1.2 crore each. The tax rate applicable to both the companies is 40. The discount rate Ior
both the companies is 12 p.a. The value oI Analog Ltd., considering Modigliani-Miller position on
leverage holds good is
(a) Rs.5.32 crore
(b) Rs.6.82 crore
(c) Rs.7.52 crore
(d) Rs.8.40 crore
(e) Rs.9.22 crore.
$
9. Going Ior an IPO and making a division as an independent operating Iirm is reIerred to as
(a) Spin-oII
(b) Split-oII
(c) Split-up
(d) Carve-out
(e) Divestiture.
$
10
.
The term agency costs in the context oI capital structure means
(a) The commission payable by a company to its purchasing agents
(b) The commission payable by a company to its selling agents
(c) The expenses incurred in distribution oI the products oI the company
(d) The cost on account oI restrictive covenants imposed on a company by its lenders
(e) The dividends paid by a company to its shareholders.

11
.
Which oI the Iollowing models is based on numerical assessment oI the Iirm`s weaknesses that are
classiIied as deIects, mistakes and symptoms?
(a) Beaver Model
(b) The Wilcox Model
(c) Blum Marc`s Failing Company Model
(d) Altman`s Z score Model
(e) Argenti Score Board.

12
.
Which oI the Iollowing is not a value driver` that aIIects the value oI a Iirm according to Alcar Model?
(a) Operating proIit margin
(b) Income tax rate
(c) Cost oI capital
(d) Growth rate oI sales
(e) Book value oI the Iirm.

13
.
Using derivatives like Iorwards, swaps and Iutures to hedge the risk is an example oI
(a) Risk avoidance
(b) Loss control
(c) Risk transIer
(d) Risk sharing
(e) Risk separation.

14
.
JayPee Constructions is considering Iollowing Iive projects:
(Rs. in lakh)
Project Initial investment NPV
1 1,000 210
2 6,000 1,560
3 5,000 850
4 2,500 500
5 500 95
The project that will be ranked Iirst as per ProIitability Index Method is
(a) Project 1
(b) Project 2
(c) Project 3
(d) Project 4
(e) Project 5.

15
.
Electrum Ltd., is engaged in manuIacturing electronic instruments. The Iinancials oI the company are as
Iollows:
Particulars (Rs. in lakh)
Currents assets 285.50
Fixed assets 450.00
II there is an increase oI 20 in current assets, the working capital leverage oI the company will be
(a) 0.36
(b) 0.38
(c) 0.39
(d) 0.42
(e) 0.46.

16
.
Which oI the Iollowing statements is false with respect to target costing?
(a) Target costs are predetermined costs calibrated Irom an internal analysis by industrial engineers
(b) Target costing lead to market driven approach to accounting
(c) A target cost is the maximum manuIacturing cost Ior a product
(d) Target cost is the excess oI the sales price Ior the target market over the pre-determined margin oI
proIit
(e) Target costing reduces product costs over its entire liIe cycle.
$
17
.
As per value chain concept, which oI the Iollowing areas is/are useIul Ior proIit improvement?
I. Linkages with suppliers.
II. Linkages with customers.
III. Process linkages within the value chain oI the Iirm.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$
18
.
Which oI the Iollowing is false Ior Certainty Equivalent Approach?
(a) Each period`s cash Ilow can be adjusted separately to account Ior the speciIic risk oI cash Ilows
(b) The approach provides a clear basis Ior making decisions
(c) The certainty equivalent ranges Irom 0 to 1
(d) The Iirms cost oI capital is used as a discount rate Ior the estimation oI the net present value
(e) Higher the Iactor the more certain is the expected cash Ilow.
$
19
.
An option that enables a Iirm to manage its capacity in response to changing market condition is
(a) Investment timing option
(b) Abandonment option
(c) Growth option
(d) Flexibility option
(e) Foreign currency option.
$
20
.
Reyon Ltd., has a target ROE oI 14. The Iinancial leverage oI the company is 0.5. The corporate tax rate
applicable to the company is 30. II the average cost oI debt is 9.5, the ROI that the company should
earn to achieve the target ROE is
(a) 16.50
(b) 18.25
(c) 19.35
(d) 20.20
(e) 21.22.
$
21
.
As per Porter`s Five Forces model oI industry analysis, a Iirm can take an advantage over its rival Iirm by
I. Using constant price policy.
II. Improving the product diIIerentiation and distribution system.
III. Exploiting relationship with suppliers.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
$
22
.
Which oI the Iollowing statements is/are true with respect to Iinancial statement analysis?
I. Trade creditors use the Iinancial statement analysis to know the liquidity position oI the Iirm.
II. Long-term creditors use the Iinancial statement analysis to know the long-term solvency oI the Iirm.
III. Investors use the Iinancial statement analysis to know the earnings oI the Iirm.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$
23
.
Sunrise Ltd., has total sales oI Rs.6,00,000. The inventory turnover ratio is 5. II its current liabilities are
Rs.1,50,000 and acid-test ratio is 2, the total current assets oI the company is
(a) Rs. 2,15,000
(b) Rs. 3,12,000
(c) Rs. 4,20,000
(d) Rs. 5,15,000
(e) Rs. 6,35,000.

24
.
Which oI the Iollowing is/are the primary reason(s) Ior adopting non-growth strategy?
I. Lack oI enough additional staII with suIIicient expertise and loyalty.
II. High cost oI additional Iunds in the market.
III. Pressure Irom public opinion.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.

25
.
Suppose a project has proIitability index oI 0.85, it indicates
(a) PV oI the project is 85 times greater than project`s cost
(b) NPV oI the project is zero
(c) NPV oI the project is positive
(d) NPV oI the project is negative
(e) Ratio oI NPV to initial investment is 85.

26
.
Which oI the Iollowing statements is/are false?
I. When a company wants to reduce the number oI outstanding shares, it can resort to stock split.
II. Stock splits have no implications on the proportion oI an individual stakes in the company.
III. A stock repurchase is considered to have a greater signaling power than regular dividend pay-out.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.

27
.
Which oI the Iollowing current assets is considered least liquid?
(a) Cash
(b) Debtors
(c) Inventories
(d) Short-term securities
(e) Prepaid expenses.

28
.
Consider the Iollowing inIormation pertaining to DNA Ltd.:
Annual yield on marketable securities 10
Fixed conversion cost Rs. 900
Standard deviation oI change in daily cash balance Rs. 200
Lower control limit Rs.50,000
Assuming there are 360 days in a year the return point oI DNA limited as per Miller-Orr model is
approximately
(a) Rs.61,480
(b) Rs.54,598
(c) Rs.41,484
(d) Rs.32,580
(e) Rs.25,482.

29
.
Which oI the Iollowing is/are the Iirm speciIic cause(s) oI Iinancial distress?
I. Barriers to entry.
II. Threat to entry.
III. Leverage.
IV. Rivalry among competing Iirms.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) All (I), (II), (III) and (IV) above.

30
.
Which oI the Iollowing statements is/are false about Value at Risk?
I. VaR is an estimate oI the level oI gain on a portIolio, which is expected to be equalized or exceeded
with a given small probability.
II. VaR is also used to identiIy risk arising out oI individual assets or individual liabilities, which can be
aggregated later Ior the whole Iirm.
III. A portIolio having a VaR oI Y at 95 conIidence level implies that there is a 5 percent probability oI
the portIolio`s value Ialling by less than Y.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.

END OF SECTION A
Section B : Problems/Caselet (50 Marks)
- This section consists oI questions with serial number 1 5.
- Answer all questions.
- Marks are indicated against each question.
- Detailed workings/explanations should Iorm part oI your answer.
- Do not spend more than 110 - 120 minutes on Section B.
1
.
Gadgets Ltd., is a popular consumer electronics manuIacturing Iirm. Demand Ior its products is
increasing day by day and company has an expansion plan to cater this growing demand. For
the purpose oI expansion, company is considering the Iollowing two Iinancing alternatives:
I. Raising the entire amount as term loans 15 p.a.
II. Issue oI shares at a price oI Rs.10 per share.
The total Iund requirement oI company Ior expansion program is Rs.100 lakh. The company`s
proIitability statement prior to expansion is summarized as Iollows:
Particulars (Rs. in lakh)
Sales
Less: Cost excluding depreciation
1,300
1,000
EBDIT
Less: Depreciation
300
50
EBIT
Less: Interest
250
50
PBT
Less: Tax 35
200
70
PAT 130
No. oI shares 50 lakh
EPS Rs.2.60
The various possible values oI EBIT aIter expansion and probabilities associated with each oI
the values are as Iollows:
$
EBIT (Rs. in lakh) Probability
300
500
600
700
0.10
0.30
0.50
0.10
You are required to:
a. Calculate company`s expected EBIT, EPS, standard deviations oI EPS and coeIIicient oI
variation Ior each plan and make the inIerence Irom the calculated values.
(
1
0
marks
)
b. Find the indiIIerence point between the two plans.
( 3
marks
)
2.Dataone Ltd., would like to segregate its client proIile into good accounts and bad accounts on
the basis oI the current ratio and net proIit margin. Given below is the inIormation relating to
14 accounts consisting oI an equal number oI good accounts and bad accounts:
Good accounts Bad accounts
Client
Current
ratio
Net ProIit
Margin
()
Client Current
ratio
Net ProIit
Margin
()
A 1.80 31 H 0.95 23
B 1.75 26 I 0.82 26
C 1.62 18 J 0.70 15
D 1.50 22 K 0.63 11
E 1.40 19 L 0.75 10
F 1.70 12 M 0.83 8
G 1.45 18 N 0.22 5
From the above inIormation, you are required to estimate the discriminate Iunction that best
discriminates between good accounts and bad accounts.
(10marks)
$QVZHU
3.Flyovers Ltd., a popular construction company operating in Hyderabad expects some degree oI
certainty to generate Iollowing net income and the capital expenditure during next 5 years:
Year
Net Income (NI)
(Rs. in lakh)
Capital expenditure (CE)
(Rs. in lakh)
1 60 20
2 50 25
3 26 32
4 21 40
5 16 50
The company currently has 15 lakh equity shares and pays dividend oI Rs.6 per share.
You are required to calculate:
$QVZHU
a. Dividends per share iI the dividend policy is treated as residual decision.
( 3 marks)
b. Amount oI external Iinancing that will be necessary iI the present dividend per share is
maintained.
( 3 marks)
c. Amount oI external Iinancing that will be necessary iI the dividend pay out ratio oI 40
is maintained.
( 3 marks)
Caselet
Read the caselet carefully and answer the following questions:
4.As per the caselet, Enterprise Risk Management (ERM) is Iast becoming the best practice
standard because the traditional approach to managing risk has not produced eIIective results.
Explain the steps included in an enterprise risk management program.
( 9 marks)
$QVZHU
5.Complexity oI business is increasing day by day and risk management is becoming challenging
task. Discuss various areas in which board and senior managers can play an active role to
manage the increasing risk.
( 9 marks)
$QVZHU
One oI the reasons why risk management has received so much ongoing attention is that
Iinancial disasters seem to occur on a regular basis to remind us oI the perils oI 'not getting it
right. A Iew years ago, risk management problems led to the collapse oI Barings, Kidder, and
ConIederation LiIe, as well as huge losses related to derivatives trading at other companies.
More recently, global Iinancial markets were threatened by the near collapse oI the once high-
Ilying Long Term Capital Management and the resultant losses at leading Iinancial institutions
that had to Iund a $3.5 billion bailout oI the hedge Iund.
As a result oI these wake-up calls and internal risk reviews, leading companies are abandoning
their traditional approach oI 'managing risk by silos, whereby diIIerent types oI risks are the
responsibility oI various corporate and business units. Instead, they are adopting an Enterprise
Risk Management (ERM) approach.
ERM is Iast becoming the best-practice standard because the traditional approach to managing
risk has not produced eIIective results. More importantly, organizations that have adopted a
more integrated approach to managing enterprise-wide risks have experienced signiIicant beneIits.
In the past, risk management was highly Iragmented Irom an organizational perspective. For
example, business units manage the business risks associated with their overall strategy and
proIitability, such as products, pricing, and relationship management; credit and lending units
managed the credit risks associated with lending, trading, portIolio management, and workout
activities; trading, market risk and asset/liability units managed the market/interest rate risks
associated with the investment, trading, and asset/liability portIolios; operations and
technology units managed the operational risks associated with transaction processing and
systems; other units with risk management responsibilities such as Iinance and accounting,
legal and compliance, security, audit and insurance provided additional corporate oversight.
Over time, it has been increasingly apparent that such a Iragmented approach, or 'managing
risk by silos, simply doesn't work because risks are highly interdependent and cannot be
segmented and managed solely by independent units. Moreover, a segmented approach to risk
management doesn't provide senior management and the board with aggregated risk reporting.
This realization has led to the trend towards enterprise risk management, which is supported by
internal demand, external developments, and advances in risk management methodology.
Organizations that have adopted an enterprise risk management approach have experienced
signiIicant and tangible beneIits, including an increase in shareholder value, reduction in losses
and earnings volatility, and general improvements in the measurement and management oI
overall risks. AIter all, managing earnings should not mean accounting trickery, but the
proactive management oI the underlying drivers oI earnings.
Today, the role oI the CRO has been widely adopted in risk-intensive businesses such as
Iinancial institutions, energy Iirms, and non-Iinancial corporations with signiIicant investment
activities and/or Ioreign operations. At last count, there are over 50 CROs at various
institutions. Some people in a CRO role use other titles, such as ChieI Market and Credit
OIIicer, Principal Risk OIIicer, and EVP oI Risk Management. Nonetheless, these individuals
are responsible Ior multiple risk Iunctions. In many instances, the CRO reports to the CFO or
CEO, and some CROs have a direct reporting line to the board oI directors. Reporting to the
CRO are the heads oI credit risk, market risk, operational risk, insurance, and portIolio
management. Other Iunctions that the CRO is commonly responsible Ior include capital
management, risk analytics and reporting, and the heads oI risk management at the business
units.
END OF CASELET
Section C : Applied Theory (20 Marks)
- This section consists oI questions with serial number 6 - 7.
- Answer all questions.
- Marks are indicated against each question.
- Do not spend more than 25 - 30 minutes on Section C.
6. Innovation cycles have become shorter in the present day unlike in the past,
when they were long. Probably the most important reason is the growing
importance oI soItware and knowledge inputs as opposed to hardware and
physical capital. Under such scenario, how do you manage innovations? ( 10 marks)
$QVZHU!
7. To avoid conIlict oI interest in an organization, various compensation plans
have been designed. The very use oI executive compensation plan is to align
the interest oI managers and shareholders and thus bring in more shared
interests on the part oI both shareholders and managers. However, it has been
observed that most oI the compensation plans Iail to produce the desired
results. Discuss various reasons behind the Iailure oI executive compensation
plans and write down important steps that should be considered while
designing compensation contract. ( 10 marks)
$QVZHU!
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management: Theory and Practice (MB3H2F): October
2008
Section A : Basic Concepts
Answer Reason
1. D
P
0

P
0
, is Current market price oI the Iirm`s share
B, is Current book value per share
r, is the return on equity
g, is the growth rate in earnings and dividends
b, is the dividend pay-out ratio
140
8.4 0.05B
B Rs.168
Total net worth Rs.168 16,00,000 Rs.26,88,00,000
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2. E In the LC Gupta model, balance sheet ratios are only the Net Worth/Total Debt and all
outside liabilities/Tangible assets ratios. All the other given ratios are proIitability
ratios used in LC Gupta Model Ior predicting the bankruptcy oI a Iirm.
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3. A Cost oI debt capital 10 (1 0.35) 6.50
Cost oI equity capital |2(1.05) 80| 0.05 0.07625 or 7.625
Current weighted cost oI capital 0.074 or 7.4.
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4. E EBIT at 15,000 units 15,000 (Rs.200 Rs.172) Rs.2,10,000 Rs.2,10,000
EBIT at 15,000 1.10 16,500 units 16,500 (Rs.200 Rs.172) Rs.2,10,000
Rs.2,52,200.
increase (Rs.2,52,200 Rs.2,10,000) Rs.2,10,000 0.20 or 20
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5. C The method that involves making a tender oIIer to shareholders oI the Iirm to
repurchase their shares without Iixing predetermined price is known as Dutch auction
tender oIIer.
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6. C Fostering the ideal work culture involves various steps:
- Hiring people with leadership potential rather than just managerial potential.
- Articulating strong corporate purpose that makes people believe that they are
making positive impact on society.
- Treating people with dignity and respect.
- Interacting regularly with employees.
- Attempting to inIluence rather than control employees.
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7. D As per the assumption oI the Baumol model the conversion is a Iixed sum, irrespective
oI the securities converted.
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8. D
Value oI Analog Ltd. B t 6 0.40
Rs.6 Rs.2.4 Rs.8.40 crore.
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9. D Doing an IPO oI a division and making it independent operating Iirm is reIerred as
Carve out
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10. D Agency costs are costs on account oI restriction imposed by creditors on the Iirm in the
Iorm oI some protective covenants. Commission payable by the company to its
purchasing and selling agents , the expenses incurred in distribution oI the products oI
the company, or the dividends paid by the company does not come under the agency
cost.
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11. E Argenti Score Board is based on numerical assessment oI the Iirm`s weaknesses that
are classiIied as deIects, mistakes and symptoms.
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12. E Amongst the given alternatives, book value oI the Iirm` is not a value driver as per the
Alcar model. Hence, alternative (e) is answer.
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13. C Three ways oI risk transIer are as under:
- TransIerring the asset itselI.
Use oI hedging instruments like Iorwards, Iutures, swaps and options.
Buying insurance.
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14. B
Project
(1)
Initial investment
(Rs. lakh)
(2)
NPV
(Rs. lakh)
(3)
Cash inflows
(PV)
(Rs. lakh)
(4) (2)+(3)
PI
(5) (4)/(2) Rank
1 1000 210 1210 1.21 II
2 6000 1560 7560 1.26 I
3 5000 850 5850 1.17 V
4 2500 500 3000 1.20 III
5 500 95 595 1.19 IV
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15. A
Working capital leverage 0.36
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16. A Target cost is based on external analysis oI markets and competitors. Hence option (a)
is Ialse.
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17. E From the strategic planning perspective, the value chain concept highlights three
potentially useIul areas.
i. Linkages with suppliers.
ii. Linkages with customers.
iii. Process linkages within the value chain oI the Iirm.
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18. D In certainty equivalent approach the risk Iree rate and not the Iirm`s cost oI capital are
used as a discount rate Ior the estimation oI the net present value. Hence option (d) is
the answer.
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19. C Growth option enables a Iirm to manage its capacity in response to changing market
conditions. Hence option (c) is said to be the option.
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20. A ROE | ROI (ROI- k
d
) D/E| (1-t)
0.14 |x (x 0.095) 0.5| (1-0.30)
0.14 |x 0.5x 0.0475| 0.70
0.14 0.70x 0.35x 0.03325
0.17325 1.05x
x 16.5.
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21. E According to Five Forces model a Iirm can take an advantage over the rival Iirm by
changing prices (raising or lowering prices), improving product diIIerentiation, creative
use oI distribution system and exploiting relationship with suppliers.
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22. E Trade creditors use the Iinancial analysis to know the liquidity position oI the Iirm.
Long-term creditors use the Iinancial statement analysis to know the long-term
solvency oI the Iirm. Investors use the Iinancial statement analysis to know the earning
capacity oI the Iirm. Hence, all the given statements are true and the answer is (e).
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23. C Current assets Inventories Current liabilities x Acid test ratio 1,50,000 x 2
Rs.3,00,000
Sales inventories x Inventories turnover ratio
X 5 Rs.6,00,000.
X Rs. 1,20,000
Total current assets 1,20,000 3,00,000 Rs.4,20,000.
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24. D The primary reasons Ior using non-growth strategy may include:
- Pressure Irom public opinion.
Maintain an acceptable quality liIe.
Lack oI enough additional staII with suIIicient expertise and loyalty.
Enable the owner-manager to retain personal control over operations.
Diseconomies oI scale oI a particular production set-up.
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25. C The proIitability index is the ratio oI net cash inIlows Irom the project to the cash
outIlows. So, any value greater than zero indicates positive NPV.
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26. A Stock splits involve increase in number oI shares outstanding through a decrease in the
par value oI share. Conversely a company might want to reduce the number oI
outstanding shares, it can accomplish this through a reverse stock split. A stock
repurchase is not a regular event and is taken as pointer on the degree oI
undervaluation. Hence stock repurchase is considered to have strong signaling power
than regular dividend pay-out.
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27. C As the liquidity oI the inventories depends on the demand Ior speciIic product,
thereIore, they are less liquid than other current assets.
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28. B
RP
Rs.54598 (Approx).
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29. C Major Iirm speciIic Iactors that contribute substantially to Iirm`s risk oI Iinancial
distress are:
- Ownership and governance structures
- Operating risk
- Leverage.
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30. D VAR is an estimate oI the level oI the loss and not the gain on a portIolio that is
expected to be equaled or exceeded with a given small probability. A portIolio having a
VAR oI Y at 95 conIidence level implies that there is a 5 percent probability oI the
portIolio`s value Ialling by more, and not less than Y. Though not usable in isolation to
quantiIy risk, VAR is also used to identiIy risk arising out oI individual assets or
individual liabilities that is summed up to compute the VAR Ior the organization as a
whole.
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Section B : Problems/Caselet
1
.
a.
7
3
c.
NI
(1)
Dividends
(2)
CE
(3)
Ex. Financing
(4) (2) (3) (1)
6000000
5000000
2600000
2100000
1600000
2400000
2000000
1040000
840000
640000
2000000
2500000
3200000
4000000
5000000
0
0
1640000
2740000
4040000
Rs.69,20,000 Rs.84,20,000
4
.
The steps toward an enterprise risk management program include:
- Creating an enterprise risk management organization, through the appointment oI a chieI risk oIIicer and the
Iormation oI an enterprise risk management committee. The enterprise risk management committee is
responsible Ior directing all credit, market, and operational risk management activities, as well as
coordinating corporate over sight units such as insurance, security, audit, and compliance. This organization
oIten reports to the CEO or CFO, and increasingly has a direct reporting relationship to the board.
Establishing an integrated risk management Iramework to measure and manage all aspects oI risk. These risks
include credit risks such as lending and counterparty exposures; market risks such as interest rate, Ioreign
exchange, equity, and commodity exposures; business risks such as volatility in volumes, margins, or costs;
and operational risks ranging Irom day-to-day processing errors to Iraud and other low-probability but high-
severity events.
Optimizing the return on risk management investments by linking risk management processes and risk transIer
strategies. Typically, diIIerent Iunctions within an organization make separate buying decisions in risk
management, including the purchase oI risk methodologies Irom consulting Iirms, risk models Irom
technology companies, derivatives Irom investment banks and insurance policies Irom insurance companies.
However, the right hand oIten doesn't know what the leIt hand is doing. By linking internal risk processes and
external risk transIer, management can improve eIIectiveness in achieving the organization's risk objectives,
as well as improve eIIiciency in terms oI achieving those objectives at the lowest cost.
Leveraging risk management to make better business decisions by incorporating risk/return considerations in
product development and pricing, relationship management, investment and portIolio management, and
mergers & acquisitions. Leading organizations recognize that risk management is not just about protecting
against the downside, but that it can be a powerIul tool Ior improving business perIormance. A risk-centric
business management approach can help management identiIy and grow businesses with the highest risk-
adjusted returns and thus maximize shareholder value.

7
3
5
.
Role of the Senior Management
The board and the senior managers need to send strong signals that they consider risk management a priority. The
board should play an active role in identiIying the risks that may have a signiIicant impact on the IulIillment oI
corporate objectives. It should review inIormation on these signiIicant risks Irom time to time. The board
should come to a consensus regarding what risks are acceptable, the probability oI their occurrence and the
type oI mechanisms and processes needed to reduce their impact. The board should realize that whatever be the
sophistication oI the control systems and processes, risks due to poor judgment, human error and unIoreseen
circumstances can never be completely eliminated. It should be emphasized that the role oI the board is not to
advocate complete elimination oI risk. In a competitive market place, not taking risks could turn out to be a risk
in itselI. In Iact, iI eIIective risk management processes are in place, the board may decide that more risks have to
be taken to exploit the opportunities available Ior the business to succeed in the long run. The board and the
senior management team should play an active role in the Iollowing areas:
- Understanding the Risk Profile: The board members should clearly understand the risks to which the
company is exposed. The board should Iurther decide which risks are acceptable and which must be
eliminated through the use oI hedging techniques.
Setting Policy: The board should prepare policy guidelines, including the corrective action to be taken when
things go wrong. For example, there should be guidelines on when and how to unwind an unproIitable
position, iI rates move unIavorably. The exit strategy should be based on the amount oI money the company is
willing to put to risk.
Establishing Controls: Steps should be taken to ensure eIIective implementation oI policies. An
independent risk management unit is desirable. Ideally, risk managers should not report to traders. It is a
good practice to make risk managers report to people one level higher than those who execute and approve

7
3
derivative transactions.
Setting-up Systems: The most expensive but integral part oI a comprehensive risk management Iunction is
consolidation and integration oI data Irom a number oI diIIerent systems across the company's operations.
Checking Compliance: The risk manager should send reports regularly to the senior management and the
board. These reports should check compliance with policies and procedures and make independent
evaluations oI the various derivatives positions. The reports should also indicate whether the positions are
synchronous with the company's accounting department and with the disclosures in the company's Iinancial
reports.
Periodic Review: The board must make it clear to traders and treasury managers that any violation oI
policies, guidelines or controls will be punished. When limits are violated, the board should not hesitate to
takeimmediate action and send clear signals that indiscipline will not be tolerated.
Section C: Applied Theory
6. Managing Innovations
There are broadly two types oI innovations product and process. Product innovation reIers to
work done to improve the product. Some product innovations are truly radical, such as the
Sony Walkman. Others are incremental, such as adding new Ieatures to a. color television set.
Process innovations aim to make the manuIacturing process more eIIicient through
automation, simpliIication, better process control and lower energy consumption. Normally,
the product and the process innovations are interdependent. In the early stages oI the product
liIe cycle, product innovations tend to be rapid. As the rate oI product innovation decreases, it
is common to observe a Iaster rate oI process innovation. But the relative importance oI
product and process innovation depends on the nature oI the industry. Peter Drucker has listed
seven sources oI opportunity Ior innovative organizations. In order oI increasing diIIiculty and
uncertainty, they are:
- The unexpected success that makes a company happy, but is rarely dissected to see why it
occurred.
The incongruity between what actually happens and what was supposed to happen.
The inadequacy in an underlying process that is taken Ior granted.
The changes in industry or market structure that catch everyone by surprise. The demographic
changes caused by wars, medical improvements and even superstition.
The changes in perception, mood and Iashion due to the ups and downs oI the economy.
The changes in awareness caused by new knowledge.
SuccessIul technology management is all about bringing a new concept to the market in the
most eIIicient way. To commercialize an idea successIully, a number oI diIIerent stages must
be completed, each more diIIicult than its predecessor. Not only must each oI these stages be
completed successIully, but also adequate resources be mobilized to Iacilitate transition Irom
one stage to the next.
Imagining: Developing the initial insight about the market opportunity Ior a particular
technical development.
Incubating: Nurturing the technology suIIiciently to gauge whether it can be commercialized.
Demonstrating: Building prototypes and getting Ieedback Irom potential investors and
customers.
Promoting: Persuading the market to adopt the innovation.
Sustaining: Ensuring that the product or process has a long liIe in the market.
The Iirst three stages obviously cannot be managed like an ordinary business with tight
controls. So they have to be Iostered and nurtured in an environment that is culturally quite
diIIerent Irom normal corporate settings.
In order to develop a useIul Iramework Ior commercializing technological innovations,
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organizations must address three important issues.
- What is the likelihood that customers will be attracted to the new technology?
What is the price that will attract the largest number oI customers?
Will the new technology evolve into or help in building a proIitable business?
SuccessIul innovators Iocus on how the new product' or service will aIIect customers. They
look at the various stages oI customer experience like purchase, delivery, use, maintenance
and disposal. They also consider the utility oI the product in terms oI environmental
Iriendliness, convenience, simplicity and customer productivity. In other words, they orient
product development activities towards the customer rather than the technology. The price
chosen by the innovator has to attract and retain a suIIiciently large number oI customers.
Innovations very oIten compete with other products that may look quite dissimilar but
perIorm the same Iunction. What is important here is how people will compare the new
product with other very diIIerent-looking products and services. The price level will also
depend on the ease oI imitation. II the product is diIIicult to imitate or well protected by
patents, a high price is possible. On the other hand, iI imitation is easy, a low price becomes
essential. SuccessIul innovators understand the importance oI generating positive cash Ilows
as quickly as possible. They generate proIits not by raising price but by keeping costs tightly
under control, consistent with the chosen price level. They improve materials selection,
simpliIy design processes and improve manuIacturing eIIiciencies to cut costs. They may also
consider strategic outsourcing oI non-core activities. Moreover, innovators compensate Ior
their lack oI technological capabilities in some areas by partnering and Iorming alliances. In
spite oI all these moves, iI the price is still high and beyond the reach oI target customers, they
look at options such as leasing or renting the product on a time-share basis, which are more
appealing to customers.
7. The basic reasons Ior the Iailure oI the executive compensation plan can be enumerated as
Iollows:
i. Correlation between the size oI the company and its payment structure. Because oI
the existence oI the strong correlation between the size oI the company based on its
asset value and sales and the payment structure, companies sometimes tend to strive
Ior a bigger size irrespective oI the Iact that it adds to the value oI the concern.
ii. Emphasis on short-term perIormance oI the company. It has been Irequently observed that
short-term perIormance indicators like sales and growth in the earnings provide a greater
weightage in the incentive compensation that is paid to the executive.
iii. More Iocus on the accounting measures is given while designing the compensation
contracts. Some oI these measures are the earnings and the return on the investments.
Finally it is important to mention that while designing a well laid out
compensation contract, the Iollowing points need to be considered:
i. Integrating the incentive plan to the total compensation architecture oI the Iirm.
ii. Choosing an appropriate level oI risk bearing and Iocus on the time.
iii. Using the objective criteria.
iv. Selecting the right set oI perIormance measure.
v. Discouraging parochial behavior.
vi. Abandoning the attempts to measure what the executives control.
vii. Lengthening the "decision making time horizon oI the executives.
viii. Employing the stock options plans judiciously.
ix. Ensuring tax eIIiciency.
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7232)7+('2&80(17!
Question Paper
Strategic Financial Management: Theory and Practice (MB3H2F) : 1anuary 2009
Section A : Basic Concepts (30 Marks)
- This section consists oI questions with serial number 1 - 30.
- Answer all questions.
- Each question carries one mark.
- Maximum time Ior answering Section A is 30 Minutes.
1.
Which oI the Iollowing is not a Iundamental part oI a Iirm`s Iinancial structure?
(a) Ownership structure
(b) Financial planning
(c) Financial leverage
(d) Executive compensation
(e) Managerial hierarchy.
$QVZ
2.
Feasibility study takes into consideration
I. Frequency oI the decision.
II. Suitability oI the area in which decision is required.
III. Comparison oI costs and beneIits.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
$QVZ
3.
Which oI the Iollowing statements is false with respect to quality costing?
(a) Quality oI design reIers to variation in products that have the same Iunctional use
(b) Total Quality Control is oIten associated with Just-In-Time manuIacturing
(c) Appraisal costs are the costs incurred to ensure that materials, products, and services meet quality
standards
(d) A Quality-Costing system monitors and accumulates the costs incurred by a Iirm in maintaining or
improving product quality
(e) Quality oI conIormance reIers to the degree with which the Iinal product Iails to meet its speciIications.
$QVZ
4.
Which oI the Iollowing is/are external Iactor(s) that lead to the bankruptcy oI a Iirm?
I. Shortage in supply oI raw materials.
II. Fraudulent practices by management.
III. Labour unrest.
IV. Technological obsolescence.
V. Disputes among promoters.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (III) and (IV) above
(e) Both (IV) and (V) above.
$QVZ
5.
The Iailure oI executive compensation plan is usually because oI
I. Correlation between the size oI the company and its payment structure.
II. Emphasis on short term perIormance oI the company.
III. More Iocus on the accounting measures while designing the compensation contracts.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
6.
The earnings per share oI a Zeta Ltd., is Rs.30 and the dividend payout ratio is 60. II the share price oI the
company is Rs.56, according to the Graham and Dodd Model the multiplier applicable to the company is
approximately
(a) 1
(b) 2
(c) 3
(d) 4
(e) 5.
$QVZ
7.
Which oI the Iollowing statements is/are false regarding Ratio Comparison Approach?
I. It provides a popular way oI valuing Iirms, projects or assets.
II. This method is never used in real asset valuation.
III. This approach uses ratio oI price to earnings Ior valuation.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
$QVZ
8.
The real option valuation approach oI valuing a project shows that the value oI revolving uncertainty depends on
I. Future decision involving exploration.
II. Current value oI oil prices.
III. Uncertainty type.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
9.
As per Modigliani and Miller hypothesis value oI levered Iirm is equal to value oI unlevered Iirm. This implies
I. The cost oI equity increases.
II. Stock holder`s risk exposure increases.
III. The weighted average cost oI capital changes with leverage.
IV. Leverage does not increase/decrease risk.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (IV) above
(e) Both (II) and (III) above.
$QVZ
10.
Which oI the Iollowing statements is/are false regarding dividend decisions?
(a) Liquidity does not aIIect dividend decisions
(b) Firms resort to high payout iI the proIitable investments are lacking
(c) The cost oI external Iinancing inIluences dividend decisions
(d) Firms tend to have a high pay-out ratio iI the shareholders have a strong preIerence towards current
dividends
(e) Restrictive covenants limit the Ilexibility oI the company in determining its dividend policy.
$QVZ
11.
All oI the Iollowing models are used Ior predicting sickness oI a Iirm except
(a) Beaver Model
(b) BCG Matrix
(c) Altman`s Z Score Model
(d) Argenti Score Board
(e) Wilcox Model.
$QVZ
12.
The institutionalization oI knowledge created during the process oI developing and installing a model is known
as
(a) Validation
(b) Implementation
(c) Construction
(d) Documentation
(e) Revision.
$QVZ
13.
The substantial loss in the market value oI the Iirm`s equity can result in
I. Losing oI proIessional analysts.
II. Delisting oI stocks.
III. Decrease in normal bid ask spread.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
$QVZ
14.
Which oI the Iollowing statements is/are true with respect to Activity Based Costing (ABC)?
I. ABC is based on historical costs.
II. ABC does not highlight the causes oI costs.
III. ABC divides cost into Iixed and variable costs.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
$QVZ
15.
As per Marshall and Bansal asset-liability management is an eIIort to manage/minimize exposure to
I. Price risk.
II. Interest rate risk.
III. Exchange risk.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
16.
Electric Circuits Ltd. is an Indian Iirm, it imports electric parts Irom Japan. II the Yen is strengthening, Indian
Iirm is exposed to
(a) Translation risk
(b) Transaction risk
(c) Economic risk
(d) Interest rate risk
(e) Political risk.
$QVZ
17.
Anti trust laws aim to
I. Protect economic Ireedom and opportunity.
II. Provide a better deal to customers by promoting competition in market place.
III. Create a level playing Iield and encouraging new entrants into the industry.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
18.
Consider the Iollowing data oI M/s. Super Colors Ltd. Ior the year 2008 09:
ProIit aIter tax Rs.14.98 lakhs
Interest expenses Rs..9.2 lakhs
Non cash charges Rs.6.5 lakhs
Repayment oI term loan Rs.7.5 lakhs
EIIective tax rate 26
Debt-service coverage ratio oI the company is
(a) 1.59
(b) 1.76
(c) 1.84
(d) 2.24
(e) 2.70.
$QVZ
19.
There are two Iirms, Akash Ltd. and Prakash Ltd. They are similar in all respects except that Akash Ltd. is
unlevered, while Prakash Ltd. has Rs.5 crore oI 11 debentures outstanding. Both companies have a net
operating income oI Rs.1 crore each. The tax rate applicable to both the companies is 35. The discount rate Ior
both the companies is 10 p.a. The value oI Prakash Ltd., considering Modigliani-Miller position on leverage
holds good is
(a) Rs.1.00 crore
(b) Rs.3.50 crore
(c) Rs.6.50 crore
(d) Rs.8.25 crore
(e) Rs.9.30 crore.
$QVZ
20.
The current ratio and quick ratio oI Kendra Industries Ltd., are 1.2 and 0.8 respectively. The net working capital
oI the Iirm is Rs.6,00,000 with an inventory oI
(a) Rs. 7.50 lakh
(b) Rs. 9.00 lakh
(c) Rs.11.25 lakh
(d) Rs.12.00 lakh
(e) Rs.14.00 lakh.
$QVZ
21.
The Iollowing data is available Ior InIodata Ltd.:
Estimated cash requirement over 6 months planning period Rs.5,00,000
Fixed conversion costs Rs.2,000
Annual interest rate on marketable securities 9
The amount oI securities that should be liquidated per batch is
(a) Rs.3.22 lakh
(b) Rs.2.11 lakh
(c) Rs.1.22 lakh
(d) Rs.1.12 lakh
(e) Rs.1.05 lakh.
$QVZ
22.According to Du-Pont equation Ior Return On Equity (ROE), other things remaining constant, which oI the
Iollowing statements is/are false?
(a) An increase in the net proIit margin will increase the ROE
(b) A decrease in debt to assets ratio will increase the ROE
(c) A decrease in return on assets will decrease the ROE
(d) An increase in the average asset turnover will increase the ROE
(e) An increase in equity multiplier increases the ROE.
$QVZ
23.Metalic Steel earns 10 on the equity and the growth rate oI dividends and earnings is 5. The book value per
share is Rs.80. II the market price oI the shares oI Metalic Steel is Rs.70, according to the Marakon Model, the
cost oI equity is approximately
(a) 9.67
(b) 10.71
(c) 12.45
(d) 13.78
(e) 14.67.
$QVZ
24.InIrastructure Ltd., is considering Iollowing Iive projects:
Project Initial investment (Rs.) NPV (Rs.)
1 1000 210
2 6000 1560
3 5000 850
4 2500 500
5 500 95
The project that will be ranked Iirst as per ProIitability Index method is
(a) Project 1
(b) Project 2
(c) Project 3
(d) Project 4
(e) Project 5.
$QVZ
25.Which oI the Iollowing Iactors is/are not considered by Alcar Model?
I. Operating proIit margin.
II. Incremental investment in working capital.
III. Income tax rate.
IV. Dividend growth rate.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) All (I), (II), (III) and (IV) above.
$QVZ
26.
According to which oI the Iollowing models Iirm`s weakness are classiIied as deIects, mistakes and symptoms
based on numerical assessment oI the Iirm?
(a) Beaver Model
(b) The Wilcox Model
(c) Blum Marc`s Failing Company Model
(d) Altman`s Z score Model
(e) Argenti Score Board.
$QVZ
27.
While managing environmental risks, risk managers perIorm which oI the Iollowing tasks?
I. Minimize the probability oI occurrence oI an adverse event such as an accident.
II. Cut the cost when an accident occurs.
III. ShiIt responsibility to other parties to the extent possible, when the event occurs.
IV. Obtain more inIormation to make risk assessment methodology as robust as possible.
(a) Both (I) and (II) above
(b) Both (II) and (IV) above
(c) (I), (II) and (IV) above
(d) (II), (III) and (IV) above
(e) All (I), (II), (III), and (IV) above.
$QVZ
28.
Which oI the Iollowing statements is/are false with respect to Bankruptcy Models?
I. According to Wilcox Model, the net liquidation value oI the Iirm is the best indicator oI the Iinancial health
oI the Iirm.
II. Blum Marc`s Model is based on liquidity ratios only.
III. According to the Beaver Model, the ratio oI cash Ilow to total debt is the single best predictor oI corporate
Iailure.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
29.
An organization can achieve goal congruence by
I. Paying bonuses to managers.
II. Rewarding managers with shares.
III. Monitoring managerial behavior.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
$QVZ
30.
Best Ltd. has net proIit margin 8, the assets to equity ratio 3 and total asset turnover 1.5, the return on equity is
(a) 12
(b) 24
(c) 36
(d) 48
(e) 60.
$QVZ
END OF SECTION A
Strategic Financial Management: Theory and Practice (MB3H2F) : 1anuary
2009
Section B : Problems/Caselet (50 Marks)
- This section consists oI questions with serial number 1 5.
- Answer all questions.
- Marks are indicated against each question.
- Detailed workings/explanations should Iorm part oI your answer.
- Do not spend more than 110 - 120 minutes on Section B.
1
.
Prakash Pvt. Ltd. manuIactures toys Ior kids. The company intends to maintain the cash balance oI
Rs.5,000. The Iollowing additional inIormation is available on the balances oI various current
assets and liabilities oI the company.
Particulars
Opening balances
(Rs.)
Closing balances
(Rs.)
Raw material 3,450.00 4,100.00
Work-in-progress 55.00 72.50
Finished goods 638.00 1,100.00
Account receivables 756.00 1,165.00
Accounts payables 2,500.00 7,500.00
Purchases basically consist oI procuring raw materials Ior manuIacturing oI toys, and are generally
bought on credit basis. The company incurs manuIacturing expenses oI Rs.1,140 in the process oI
$QVZH
!
manuIacturing the toys. The depreciation expenses oI the company amount to Rs.245. The
company is also paying Rs.4,550 towards selling and distribution expenses and pays customs and
excise duty oI Rs.35,000. During the year, the company pays Rs.1,000 to creditors and receives
Rs.53,801 Irom its debtors. Number oI units produced is equal to the number oI units sold. Market
price oI each toy is Rs.10. (Assume 360 days in a year).
You are required to:
a. Calculate the weighted operating cycle oI the company.
(
1
0
marks
)
b. Determine the working capital requirement oI the company based on the weighted operating
cycle.
( 2
marks
)
The Iollowing details at the end oI the last one year oI operations are available with regard to
Xenon Industries Ltd.:
EBIT Rs.150 lakh
Total debt Rs.800 lakh
Paid up equity share capital Rs.250 lakh
Reserves and surplus Rs.150 lakh
EIIective interest rate 10
EIIective tax rate 36
You are required to answer the Iollowing questions:
$QVZH
!
a. What was the return on equity oI the company in the last year?
( 4
marks
)
2
.
b. The company`s business is expected to grow in the current year and it plans to Iinance the
increase in its business entirely by additional debt. It is assumed that the borrowing will be
done at the beginning oI the current year and the net worth will remain at the existing level
throughout the current year, and the interest rate on the additional debt will be same as the
present eIIective interest rate. The company is planning to increase the return on equity by 4.8
percentage points in the current year. II other Iactors remain constant then what should be the
level oI debt in the current Iinancial year?
( 6
marks
)
Duracell Ltd. is manuIacturing a special type oI cable used by electricity undertaking. The
company has Iurnished the Iollowing inIormation pertaining to its capital structure:
Particulars Rs. in lakh
Equity shares oI Rs.100 each 20
Retained earnings 10
9 PreIerence shares 12
7 Debentures 8
Total 50
The company earns a return oI 12 on capital employed. Owing to the increasing demand oI the
product in the market, the company has made an expansion programme. The company requires a
sum oI Rs.25 lakh to Iinance its expansion programme Ior which the Iollowing plans are available:
Plans Particulars
1 Issue oI 20,000 equity shares at a premium oI Rs.25 per share entirely.
2 Issue oI equity shares at a premium oI Rs.25 per share and 8 debentures in the ratio
oI 2:3 respectively.
3 Issue oI 8 debentures entirely.
It is estimated that the P/E ratios oI the aIorementioned three alternative Iinancing plans would be
21.4, 17.0 and 15.7 respectively. The income-tax rate oI the company is 33.
You are required to:
$QVZH
!
a. Recommend which oI the three Iinancing plans company should implement and why?
( 8
marks
)
3
.
b. Compute the indiIIerence level oI EBIT between plan (1) and plan (3) above.
( 2
marks
)
Caselet
Read the caselet carefully and answer the following questions:
4.What are the essential Ieatures which encompasses Enterprise-Wide Risk Management, that are set
discerned in practice?
( 9 marks)
$QVZHU
5.What is Enterprise Risk Management? Under Enterprise Risk Management discuss the various
objectives and approaches oI managing environmental issues.
( 9 marks)
$QVZHU
Today Iinancial services companies operate in increasingly complex, competitive and global
markets. The ability to manage risks across geographies, products, asset classes, customer segments
and Iunctional departments is oI paramount importance. The inability to manage these risks can
cause irreparable damage. Convergence, consolidation, globalization and shiIting regulations have
posed innumerable and hitherto unprecedented challenges Ior the Iinancial services industry. The
objective is to give an overview oI risk management in the Iinancial services industry. This deIines
the major risks Irom the perspective oI Iinancial services industry, which covers the components oI
Enterprise wide risk management and the role oI technology in risk management. In general
corporate government policies serve numerous objectives like reduction oI cost, motivation oI
employees, minimization oI the possibilities oI accidents etc.
An Enterprise-Wide Risk Management which is discerned in practice has various principal and
attributes that encompasses several Ieatures. The risk management Iramework in the enterprise
attempts risk awareness. The temptation to ignore risk that cannot be quantiIied is avoided. Thus
the risk culture incorporates the value which desires the Iactors Ior minimizing risks. The ubiquity
oI risk management necessitates other Ieatures such as internal audit procedures and management
control systems and looking Iorward to desired Ireedom that gained enough paramount irrespective
oI the entrepreneurial or conservative culture oI the Iirm.
The last twenty years have been marked by substantial Iinancial deregulation. Accompanying this
deregulation has been a plethora oI methodologies and technologies Ior managing the risks/rewards
created by this deregulation. Companies have also been captured by environmental risk. Many
companies equate environmental risk management with regulatory compliance. In actual practice,
there is much more control and discretion when it comes to environment related expenditures, than
commonly assumed. The eIIective approaches to manage the regulations are selI-regulation and
govt. regulation. An important Theory is Jalde: Theorv, which had to be accepted by public
companies beIore the group, allowed its Iunds to be invested in the companies share. The Valdez
Theory includes protection oI the Biosphere, Reduction and disposal oI waste, Damage
compensation, Disclosure, etc. Environmental management which is perIormed with a principle oI
rational responsibility, a principle oI exploitation, aims to create environmentally sustained
environment. Thus the principle involves all the necessary criteria required to protect the
environment.
The Enterprise Risk Management has various components, which covers Corporate Governance,
Line Management, Risk TransIer, Data and Technology resources and Risk Analytics. Risk
management is a continuously evolving mix oI science and art. Losses are inevitable, but one must
keep learning Irom the past. Risk itselI is not bad, but risk that is misplaced, mismanaged,
misunderstood, or unintended is bad. Each institution needs to assess which method best suits its
objectives, its business, its view oI the world or its pockets. A clear distinction should be made
between risk management and risk taking. Risk management oversees and ensures the integrity oI
the process with which risks are taken. To maintain the objectivity, risk management cannot be a
part oI the risk taking process. Individuals who manage risk need to be completely independent
Irom individuals who are responsible Ior taking risk.
END OF CASELET
END OF SECTION B
Section C : Applied Theory (20 Marks)
- This section consists oI questions with serial number 6 7.
- Answer all questions.
- Marks are indicated against each question.
- Do not spend more than 25 -30 minutes on Section C.
6. One oI the most important objectives Ior the management is creation oI value
Ior the shareholders. Measurement oI values created by companies is as diverse
as the objectives themselves. Alcar Approach is a popular value measurement
approach, which stresses upon the comparison oI the pre-implementation and
post-implementation Iirm values oI various strategies beIore they are
implemented. As per this approach, discuss various value drivers that aIIect the
value oI a Iirm.
( 10 marks)
$QVZHU!
7. Emphasis oI Iinancial measures alone can result in the ignorance oI physical as
well as the qualitative measure oI perIormance, by the heads oI the
responsibility centers. Moreover, all the elements oI output turned out by a
responsibility center (and also the inputs) do not lend themselves to a money
measurement. In this context, discuss various non-Iinancial measures oI
perIormance.
( 10 marks)
$QVZHU!
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management: Theory and Practice (MB3H2F) : 1anuary 2009
Section A : Basic Concepts
Answer Reason
1. E Managerial hierarchy is not a Iundamental part oI a Iirm`s Iinancial structure. 723!
2. E Feasibility Study
The Ioremost step in developing a model is to ascertain the Ieasibility oI a model
assisting the decision making process. The various points that are required to be
considered are
Whether the decision under consideration is a one-time process, or is required to be
taken as a routine measure
The suitability oI the area in which the decision is required to be made, to be
supported by a model
The possibility oI all the relevant variables being unambiguously identiIied The
possibility oI all the variables being built-in into a single model
The expected eIIectiveness oI the model
The acceptability oI a model replacing human judgment to the management The
possibility oI obtaining the required data on an ongoing basis
The possibility oI integrating the model with the normal decision-making process
The costs involved with setting up and running the model, and its comparison with
the expected beneIits.
II it is Ieasible to construct an eIIicient and eIIective model Ior the decision process
under consideration, and iI the model can be easily integrated with the process, the
,Iirm can proceed to the next step oI constructing the model,
723!
3. E Quality oI design reIers to variations in products that have the same Iunctional use;
and
Total quality control oIten associated with just-in-time manuIacturing.
Appraisal costs are the costs incurred to ensure that materials, products, and services
meet quality standards.
A quality-costing system monitors and accumulates the costs incurred by a Iirm in
maintaining or improving product quality;
Quality oI conIormance reIers to the degree with which the the Iinal product meets
(not Iail to meet) its speciIications.
723!
4. A
Shortage in supply oI raw materials is an external Iactor, others are internal Iactors.
723!
5. E The basic reasons Ior the Iailure oI executive compensation plan are:
- Correlation between the size oI the company and its payment structure. Because
oI the existence oI the strong correlation between the size oI the company based
on its asset value and sales and payment structure, companies sometimes tend to
strive Ior bigger size irrespective oI the Iact that it adds to the value oI the
concern
- Emphasis on the short-term perIormance oI the company. It has been Irequently
observed that the short-term perIormance indicators such as sales and growth in
the earnings provide a greater weightage in incentive compensation that is paid
to the executive.
- More Iocus on accounting measures is given while designing the compensation
contracts. Some oI the measures are earnings and the return on investments.
723!
6. B
P m(d e/3)
56 m(18 30/3)
m 2
723!
7. B A popular way oI valuing Iirms, projects or assets is to compare them with other
traded Iirms, projects or assets. The ratio comparison approach provides a way by
which such valuations can be accomplished. This is generally predominant in cases oI
real asset valuations. The ratio comparison approach uses ratio oI price to earnings Ior
valuation.
723!
8. E The real option valuation approach oI valuing a project shows that the value oI
revolving uncertainty depends on the Iollowing Iactors:
- Future decision involving exploration.
Current value oI oil prices.
Uncertainty type.
723!
9. C V
L
V
U
implies that an increase in the leverage has Iollowing eIIects:
- The cost oI equity increases.
Stock holder`s risk exposure increases.
The weighted average cost oI capital remains unchanged.
M & M do not ignore risk. On contrary, they recognize that leverage increases the
stockholder`s risk and that oI equity must increase to compensate Ior that additional
risk.
723!
10. A Traditional theories have postulated that a dividend decision is solely a Iunction oI the
earnings oI the Iirm. While earnings are an important determinant Ior the dividend
decision, the role oI liquidity cannot be ignored. Dividend pay-out entails cash out
Ilow Ior the Iirm. Hence the quantum oI dividends proposed to be distributed depends
critically on liquidity position oI the Iirm. Normally Iirms tend to have low pay-out iI
the proIitable investment opportunities exist and conversely tend to resort high pay-
outs iI the proIitable investment opportunities are lacking. The cost oI external
Iinancing has an inIluence on dividend policy. Firms tend to have a high pay-out ratio
iI the shareholders have a strong preIerence towards current dividends. Restrictive
covenants limit the Ilexibility oI the company in determining its dividend policy.
723!
11. B BCG matrix classiIies the products into Iour broad categories. All others are the
models Ior predicting
sickness oI a Iirm.
723!
12. D The institutionalization oI knowledge created during the process oI developing and
installing a model is known as documentation
723!
13. D The substantial loss in the market value oI Iirm`s equity can result in several liquidity
eIIects. They are summarized as :
- The may go on losing out its proIessional analysts who play a vital role in
supporting the Ilow oI inIormation about a stock.
This may result in normal trading activities oI the stock and increase the normal bid
ask spread.
The exchange may also delist its stocks based on its listing requirements.
723!
14. A One oI the weakness oI ABC is that it is based on historical cost. ABC highlights
cause oI costs. ABC does not partition between Iixed and variable costs.
723!
15. E According to Marshall and Bansal asset-liability management is an eIIort to
manage/minimize exposure to
I. Price risk.
II. Interest rate risk
III. Exchange risk.
723!
16. B Electric Circuits Ltd. is an Indian Iirm; it imports electric parts Irom Japan. II the Yen
is strengthening, Indian Iirm is exposed to Transaction risk.
723!
17. E Anti-trust laws aim to protect economic Ireedom and opportunity and provide a better
deal to the customers by promoting competition in the market place. The basic
premise oI anti-trust laws is that increased completion leads to lower prices, better
quality and more choice Ior customers. Anti-trust laws also aim at creating a level
playing Iield and encouraging new entrants into industry.
723!
18. C Debt service coverage ratio

PAT Non-cashcharges Interest


I Re payment oI TL
+ +
+

14.98 6.5 9.2 30.68


1.84
9.2 7.5 16.7
+ +
= =
+
723!
19. D
Value oI Prakash Ltd.
O(1 t)
k

B t

1 0.65
0.10

0.35 5
6.50 1.75
Rs.8.25 crores
723!
20. D Given CA/CL 1.2 and (CA Inventory)/CL 0.8
Net working capital CA CL Rs.6,00,000
1.2 CL CL 6,00,000
CL Rs.30,00,000
CA 1.2 x 30,00,000 Rs.36,00,000
Now, (36,00,000 Inventory)/30,00,000 0.8
36,00,000 Inventory 0.8 x 30,00,000 24,00,000
Inventory Rs.12,00,000.
723!
21. B
2 2 500000 2000
210818.5107 Rs.2.11Lakh
0.045

= = =
bT
C
I
723!
22. B According to Du-Pont equation:
Return On Equity (ROE) Net ProIit Margin x Average Asset Turnover x Equity
Multiplier
Where, Equity Multiplier ratio assets Debt to 1
1
.
Hence ROE will increase when the equity multiplier increases or in other words when
the debt to assets ratio increases. Hence, option (b) is incorrect and option (e) is
correct.
When net proIit margin and /or average asset turnover ratio increases ROE will
increase. Hence, options (a) and (d) are correct.
ROE can also be written as Return On Equity (ROE) Return on assets x Equity
Multiplier.
Hence, Decrease in Return On Assets decreases the ROE. So option (c) is also
correct.
723!
23. B
( ) B r g
K g

70
( )
( )
80 0.1 0.05
0.01x 0.05

0.7 x 3.5 4
x 10.71.
723!
24. B
Project
(1)
Initial investment
(Rs.)
(2)
NPV
(Rs.)
(3)
Cash inflows
(PV)
(Rs.)
(4) (2)+(3)
PI
(5) (4)/(2) Rank
1 1000 210 1210 1.21 II
2 6000 1560 7560 1.26 I
3 5000 850 5850 1.17 V
4 2500 500 3000 1.20 III
5 500 95 595 1.19 IV
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25. D According to the Alcar model, there are seven value drivers that aIIect a Iirm`s value.
These are:
- The rate oI growth oI sales.
Operating proIit margin.
Income tax rate.
Incremental investment in working capital.
Incremental investment in Iixed assets.
Value growth duration.
Cost oI capital
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26. E Argenti Score Card is classiIied in three weakness namely deIects, mistakes and
symptoms.
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27. E All the Iour tasks have to be perIormed by the risk managers while managing
environmental risks.
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28. B The Wilcox model considers the net liquidation value oI the Iirm as the best indicator
oI a Iirm`s Iinancial health. Blum Marc`s Iailing company model is based on a set oI
12 ratios divided into liquidity, proIitability and variability ratios. The Beaver model
identiIies the cash Ilow to total debt as the single best indicator oI a Iirm`s Iinancial
health.
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29. E Goal congruence can be achieved by paying bonuses, incentives, rewarding managers
with shares etc. as these measures may motivate the managers to take the decisions
which are consistent with the objectives oI shareholders. Alternative measures like the
management audit to monitor the behavior oI the mangers can also help in
establishment oI goal congruence.
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30. C
ROE
Equity
assets Total
assets Total
Sales
Sales
proIit Net

0.08 1.5 3
0.36 i.e. 36.
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Strategic Financial Management: Theory and Practice (MB3H2F) : 1anuary 2009
Section B : Problems
1. a. Raw material purchased Closing balance oI accounts payable Payments made to
creditors Opening balance oI accounts payable
7,500 1,000 2,500 Rs.6,000
Consumption oI raw material Opening balance oI raw material purchases oI raw
material Closing balance oI Raw material
3,450 6,000 4,100 Rs.5,350.
Consumption oI raw material per day 5,350 / 360 Rs.14.86
Average raw material inventory
3, 450 4,100
2
+
Rs.3,775
Raw material storage period 3,775 / 14.86 254.04 days.
Average W-I-P inventory
55 72.50
2
+
Rs.63.75
Cost oI process Opening WIP Raw material consumed ManuIacturing expenses
Depreciation Closing WIP
55 5,350 1,140 245 72.50
Rs.6,717.50
Cost oI process per day
6, 717.50
360
Rs.18.66
WIP inventory period
63.75
18.66
3.42 days
Average Finished goods inventory
638 1,100
2
+
Rs.869
Cost oI goods sold Opening FG inventory Cost oI process Excise duty Selling
and administration expenses Closing FG inventory
638 6,717.50 35,000 4,550 1,100 Rs.45,805.50
Cost oI goods sold per day 45,805.50 / 360 Rs.127.24
Finished Goods storage period
869
127.24
6.83 days
Average debtors
Opening balance oI debtors Clo sin g balance oI debtors
2
+

756 1,165
2
Rs.960.5
Sales Closing balance oI debtors Cash received Irom debtors Opening balance oI
debtors
1,165 53,801 756 Rs.54,210
Daily sales
54,210
360
Rs.150.58
Average collection period
960.5
150.58
6.38 days
Average Accounts payable

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!
Opening balance oI acounts payables Clo sin g balance oI accounts payables
2
+

2,500 7,500
2
Rs.5,000
Average purchases per day
6,000
360
Rs.16.67
Average payment period
5,000
16.67
300 days
Calculations of weights:
Weight to raw material Raw material consumed per day/ Sales per day Rs.14.86/150.58
0.099
Processing cost excluding raw material Rs.18.66 Rs.14.86 Rs.3.8
Weight to WIP
Raw material cos t consumed perday (0.50 Pr occe sin g cos t per day)
Sales per day
+
(14.86 0.5 3.8 )/150.58 0.1113
Weight to Finished Goods
Cost oI goods sold per day
Sales per day
Weight to Iinished goods Rs.127.24/ Rs.150.58 0.845
Weight to Accounts receivables
Sales per day
Sales per day

Rs.150.58
Rs.150.58
1
Weight to Accounts Payables
Purchases per day
Sales per day
Rs.14.86/Rs.150.58 0.099
Duration oI weighted operating cycle (Dr x Wr) (Dw x Ww) (DI x WI) (Dd x Wd)
(Dp x Wp)
(254.04 x 0.099) (3.42 x 0.1113) (6.83 x
0.845) (6.38 x 1) (300 x 0.099) 7.98 days
b. Working capital requirements (Sales per Day x Weighted operating cycle) Required
Cash balance
Working capital requirement (150.58 x 7.98) 5,000 Rs.6,201.63
2.
a. ROE
d
D
ROI (ROI - K )
E
(
(

( 1 t)
ROI
1
EBIT
Total assets

150
(800 250 150) + +
0.125 i.e., 12.5
K
d
10 (given)
t 36 (given)
D
E
800
(250 150) +
2
ROE | 0.125 (0.125 0.10) 2| (10.36) 0.112 i.e., 11.2
Total asset Total debt Net worth
Total debt (Paid up equity capital Retained earnings)
b. Targeted ROE 11.2 4.8 16
Let the required amount oI additional debt be D :
Total debt 800 D
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!
Equity 250 150 400
0.16
(800 D)
0.125 (0.125 - 0.10)
400
+ (
(

(1 0.36)
or 0.25 0.125
0.025 (800 D)
400
+
or
800 D 0.125
0.025 400
+
=
or 5.00 400 800 D
or D (5.00 400) 800 1,200
Additional debt to be taken in the current year Rs.1,200 lakh
Total debt in the current year should be 1,200 800 Rs.2,000 lakh.
3. a. An alternative which would ensure the highest market price per share should be
recommended. Estimated earnings per share (EPS) and market price per share (MPS) under
the various Iinancing plans are as Iollows:
Particulars
At
Present
Plan (1) Plan (2) Plan (3)
Earnings beIore interest and tax
(EBIT)
at the rate oI 12 on Rs.75 lakh
(Rs.)
6,00,000 9,00,000 9,00,000 9,00,000
Less. Interest Old 56,000 56,000 56,000 56,000
Interest- New 1,20,000 2,00,000
ProIit beIore tax (PBT) 5,44,000 8,44,000 7,24,000 6,44,000
Less. Tax 33 1,79,520 2,78,520 2,38,920 2,12,520
ProIit aIter tax (PAT) 3,64,480 5,65,480 4,85,080 4,31,480
Less: PreIerence dividend
Old (Rs.)
1,08,000 1,08,000 1,08,000 1,08,000
ProIit Ior equity shares 2,56,480 4,57,480 3,77,080 3,23,480
No. oI equity shares 20,000 40,000 28,000 20,000
EPS 12.82 11.44 13.47 16.17
P.E. Ratio 21.4 17.0 15.7
Market price per share (EPS
P.E. Ratio)
244.82 229.00 253.87
Recommendation. The objective oI Iinancial management is to maximize the wealth oI the
owners, which in the context oI companies means maximizing the market price oI the
company`s equity shares. The above analysis shows that the market price per share in
debenture Iinancing (plan 3) is Rs.253.87, which is maximum. EPS is higher in the case oI
debenture Iinancing without undue Iinancial risk. ThereIore, debenture Iinancing alternative
is recommended.
b. IndiIIerence point on between alternative plans 1 and 3:
(EBIT Rs.56,000)(1 T) 40,000 (EBIT Rs.2,56,000)(1 T) 20,000
EBIT Rs.56,000 2(EBIT Rs.2,56,000)
EBIT Rs.5,12,000 Rs.56,000 Rs.4,56,000.
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!
4. An enterprise-wide risk management culture encompasses several Ieatures, some oI the principal
attributes oI which, as discerned in practice, are indicated here:
- An awareness oI risk pervades the enterprise. PerIormance measurement and pricing are risk
adjusted. The priorities oI risk management are reIlected in the compensation schemes
thereby encouraging risk-taking behavior that is aligned with the capacity to bear risk. The
723
!
analysts and the stakeholders obtain a more complete understanding oI the risks undertaken
with the help oI risk-adjusted Iorecasts and returns.
Risks are identiIied, reported and quantiIied to the greatest possible extent. This means setting up
extensive historical risk and loss databases, and identiIying risks precisely. Some risks can be
quantiIied while some risks elude quantiIication. Nevertheless, both quantiIiable and
unquantiIiable is avoided. The risk charter oI the United Bank oI Switzerland typically lists
reputation protection or reputation risk, generally avoided in reporting, as one oI its Iive risk
Iactors.
The risk culture is deIined and enshrined within the organization. The risk appetite oI the
enterprise is clearly understood in all its spheres. Risk management is aligned with that culture to
give managers and employees the desired Ireedom Ior taking the right course oI action
irrespective oI the entrepreneurial or conservative culture oI the Iilm.
The Iirm does not venture into those products and/or businesses that are not comprehended by the
enterprise with regard to commercial Ieasibility. To know enough so as to understand the
adversities involved with reasonable levels oI estimation is proper risk management. A
product/business that delivers excellent proIits, is nevertheless Iound by the management to have
inherent risks beyond the accepted level oI complexity and is kept aside. Not to do what is not
understood is the general prescription.
5. ERM is the discipline by which an organization in any industry assesses, control, exploits,
Iinances and monitor risks Irom all sources Ior the purpose oI increasing the organization`s short
and long-term value to its shareholders.
The corporate environmental policies serve the Iollowing objectives:
- Reduction oI costs through measures such as recycling or energy conservation.
Improvement oI the company`s reputation.
Motivation oI employees by providing a better environment.
Improvement oI relationships with regulatory authorities in general and the government in
particular.
Minimizing the possibility oI accidents.
ConIorming to a code oI ethics
The Iollowing are the diIIerent approaches Ior managing environmental issues:
- First approach is a strong commitment to environment Iriendly processes or products through
heavy investments.
Firm can inIluence environmental regulations invest in environment protection and Iorce other
Iirms to make similar investments.
The Iirm may be able to invest in environmental perIormance improvement, without any
reduction in proIits.
Combination oI product diIIerentiation, competition management and cost saving to change the
basis Ior competition and redeIine the market so that both the Iirm and the environment can
beneIit.
The last approach is on risk manage perspective, calling Ior a systematic method to deal with
risks such as accidents and activist attacks.
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!
Section C: Applied Theory
6. The Alcar model uses the discounted cash Ilow analysis to identiIy value-adding strategies. 723!
According to this model, there are seven value drivers` that aIIect a Iirm's value. These are
- The rate oI growth oI sales
Operating proIit margin
Income tax rate
Incremental investment in working capital
Incremental investment in Iixed assets
Value growth duration
Cost oI capital.
Value growth duration reIers to the time period Ior which a strategy is expected to result in a
higher than normal growth rate Ior the Iirm. The Iirst six Iactors aIIect the value oI the
strategy Ior the Iirm by determining the cash Ilows generated by a strategy. The last term, i.e.
the cost oI capital aIIects the value oI the strategy by determining the present value oI these
cash Ilows. The Iollowing Iigure represents the Alcar approach.
According to the model, a strategy should be implemented iI it generates additional value Ior
a Iirm. For ascertaining the value generating capability oI a strategy, the value oI the Iirm's
equity without the strategy is compared to the value oI the Iirm's equity iI the strategy is
implemented. The strategy is implemented iI the latter is higher than the Iormer. The
Iollowing steps are undertaken Ior making the comparison.
Calculate the value oI the Iirm's equity without the strategy: The present value oI the expected
cash Ilows oI the Iirm is calculated using the cost oI capital. The cash Ilows should take the
Iirm's normal growth rate and its eIIect on operating Ilows and additional investment in Iixed
assets and working capital into consideration. The cost oI capital would be the weighted
average cost oI the various sources oI Iinance, with their market values as the weights. The
value oI the equity is arrived at by deducting the market value oI the Iirm's debt Irom this
present value.
Calculate the value oI the Iirm iI the strategy is implemented: The Iirm's cash Ilows are
calculated over the value growth duration, taking into consideration the growth rate generated
by the strategy and the required additional investments in Iixed assets and current assets.
These cash Ilows are discounted using the post-strategy cost oI capital. The post-strategy cost
oI capital may be diIIerent Irom the pre-strategy cost oI capital due to the Iinancing pattern oI
the additional Iunds requirement, or due to a higher cost oI raising Iinance. The PV oI the
residual value oI the strategy is added to the present value oI these cash Ilows to arrive at the
value oI the Iirm. The residual value is the value oI the steady perpetual cash Ilows generated
by the strategy, as at the end oI the value growth duration. The value oI the post-strategy
market value oI debt is then deducted Irom the value oI the Iirm to arrive at the post-strategy
value oI equity.
The value oI the strategy is given by the diIIerence between the post-strategy value oI the
Iirm's equity and the pre-strategy value oI the Iirm's equity. A strategy should be accepted iI it
generates a positive value.
7. A brieI description oI some non-Iinancial measures oI perIormance is presented below.
a. Employee Productivity: This can be measured by calculating output obtained per
employee or sales aIIected per employee or the value added per employee. In addition to
the measurement oI employee productivity it is possible to measure the output per unit
oI the inputs consumed i.e. a measure oI overall productivity.
b. Marketing Effectiveness: This would measure the success oI the marketing eIIorts put
in by the divisions. For this purpose, a report on market position must be obtained Irom
the divisional managers. The market position is represented by the percentage oI sales to
total sales in the market and also by the ability oI the division to meet the outside
competition successIully. An appraisal has to be made oI each oI the major products
handled by the division including an analysis oI the product market leadership, superior
723!
or inIerior oI Ieatures in the own product compared with outsider's product.
c. Employee Morale and Attitude: This is a vital aspect oI perIormance. The divisional
managers sometimes ignore the impact oI their decisions on employees in an attempt to
maximize production and proIitability. It is, thereIore, necessary to evaluate whether
during the last one-year employee morale has decreased or increased. Absolute precision
in measurement oI this element oI perIormance is seldom possible and iI attempted,
could be a time consuming process. Hence, a judgment made by a team oI executives
aIter a thread-bare discussion may be suIIicient Ior this purpose.
d. Social Responsibility: Contribution oI social responsibility can also be considered as
one oI the measures oI perIormance. The managers can sometimes deliberately ignore
this aspect oI perIormance in their bid to show a high amount oI proIit or return on
capital employed.
e. Qualitative Aspects of Performance: The qualitative aspects must also Iigure in the list
oI perIormance measures. These include the number oI complaints received Irom
customers, the errors and Irauds, timely submission oI daily, weekly and monthly reports
to higher authorities, regularity oI attendance in meetings, etc.
I. Management practices: Adherence to better corporate governance eg. Transparency in
the operations, investment handling oI investors, client`s grievances dealing with
creditors, debtors and development oI human resources etc. all reIlect the type oI
management practices being Iollowed.
7232)7+('2&80(17!