Model Test Paper - 2 CS Professional Programme Module - II Paper - 5 (New Syllabus) Financial, Treasury and Forex Management

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1 Answer All Questions: Model Test Paper - 2 CS Professional Programme Module - II Paper - 5 (New Syllabus) Financial, Treasury and Forex Management 1. Comment on the following: (a) Under capital rationing, the standard net present value (NPV) decision rule no longer holds true. Hint: As in the capital rationing NPV decision rule does not hold true, so it has to be modified. (b) Adequacy of current assets is a myth. Hint: Adequacy of current assets is a pre-requisite for the proper working of a business (c) The depository system functions very much like the banking system. Hint: Depository refers to an organisation in which securities of the shareholder is held in the form of electronic accounts. (d) Depository refers to an organisation in which securities of the shareholder is held in the form of electronic accounts. Hint: Cost of capital is the minimum benchmark for yield, however the company should try to maximize its yield over and above the cost of capital (5 marks each) Attempt all parts of either Q. No. 2 or Q. No. 2A 2. Distinguish Between the following: (a) Investment and speculation. (4 Marks) Hint: Investment is the conscious act of the deployment of funds in the securities Speculation is done to earn the rate of return that is abnormally higher than the prevailing market rate. (b) Accounting exposure and economic exposure. (4 Marks) Hint: Accounting exposure/ translation exposure, risk of decrease in value of assets. Economic exposure: Effect of fluctuations in exchange rate on different future cash flows. 1

2 5.2 Solved Scanner CSPP M-II Paper 5 (New Syllabus) (c) Capital structure and financial structure. (4 Marks) Hint: Capital structure: Deployment of funds for creation of long term assets. Financial structure: Creation of both long term and short term assets. (d) Sensex and Nifty. (4 Marks) Hint: Sensex is an indicator of all major companies of the Bombay Stock Exchange (BSE). Nifty is an indicator of all major companies of the National Stock Exchange (NSE) OR (Alternative Question to Q. No. 2) (a) Describe the responsibilities of treasury manager. (4 Marks) Hint: Treasury manager is responsible for: Management of cash. Management of exchange rate risk as per the group policy. Maintaining a good relationship with all the financers. (b) Derivatives are mainly used to control risk to increase returns. Comment. (4 Marks) Hint: Derivative is a financial instrument or contract which derives its value from some underlying asset (c) Describe the mechanics involved in factoring? (4 Marks) Hint: Account receivables arising due to sale of goods and services are sold by the client to a financial intermediary. (d) Explain 'capital account convertibility. (4 Marks) Hint: The two different aspects of capital convertibility are: 1. Convertibility on current account of balance of payment (BOP) 2. Convertibility on capital account of balance of payment. Attempt all parts of either Q. No. 3 or Q. No. 3A 3. (a) On 1 st October, Deepak is retiring from service and he will get an amount of ` 16,32,000 as retirement benefits. He is planning to invest this money in the following three scrips, which he considers grossly under-valued stocks in the market:

3 Model Test Paper 5.3 Stock No. of Shares Price Beta (`) X 2, Y 3, Z 4, It is September now and he plans to take advantage of this mis-pricing in the stock market by using futures market. How many October contracts will you be trading if the spot index is 3,990 and October futures are quoted at 4,062? The portfolio beta is equal to: Number of contracts = = = 2.25 = = = 4.5 contracts Note: Nifty Contract multiplier 200 is taken for calculation. (b) Identify the profit or loss (ignoring dealing cost and interest) in each of the following cases: (i) A put option with exercise price of ` 250 is bought for a premium of ` 42. The price of underlying share is ` 189 at the expiry date. (ii) A put option with an exercise price of ` 300 is written for a premium of ` 57. The price of the underlying share is ` 314 at the expiry date.

4 5.4 Solved Scanner CSPP M-II Paper 5 (New Syllabus) (i) Profit on contract purchased = Exercise price of put option 250 Less: Price at Expiry Date Less: Premium Hence, there will be a profit of `19 per contract purchased. (ii) The option will not be exercised by the investor and hence the profit earned by the company will be the premium of ` 57. (c) Diva Ltd. has 10 lakh equity shares outstanding at the end of accounting year The current market price of the shares is ` 150 each. The Board of Directors of the company has recommended ` 8 per share as dividend. The rate of capitalisation appropriate to the risk class to which the company belongs is 12%. Based on Modigliani-Miller approach, calculate the market price of the share if the recommended dividend is- (a) declared; and (b) not declared. (A) When dividend is paid: As per Miller-Modigliani dividend model P o = Where, P 0 = Current Market Price D 1 = Dividend in year 1 P 1 = Price at the end of year 1 K e = Capitalisation rate P 0 = 150 D 1 = ` 8 K e1 = 12%

5 Model Test Paper = P 1 = 160 (B) When dividend is not declared: P 0 = 150 = P 1 = ` 168. (d) You sold Hong Kong $ 1,00,00,000 value spot to your customer at ` 5.70/HK $ and covered yourself in London market on the same day, when the exchange rates were: US $1 = HK $ and HK $ Local inter-bank market rates for US$ were Spot US $ 1 = ` and ` Calculate (i) cover rate; and (ii) ascertain profit or loss in transaction. Ignore taxation. In this case, the cover rate can be calculated as the Cross Rate between ` and HK $ in the London market. The cross rates in the London Market can be stated as follows: = = = = ` As the rate in London is less, the HK$ can be bought in London and the Profit is : Profit = 1,00,00,000 ( ) = ` 5,29,300

6 5.6 Solved Scanner CSPP M-II Paper 5 (New Syllabus) OR (Alternative Question to Q. No. 3) (a) The following quotes are available for 3-month options in respect of a share currently traded at ` 31: ` Strike price 30 Call option 3 Put option 2 A funds manager devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile if it is given that the rate of interest is 10% per annum. What would be the profit/loss if the strategy adopted is selling a call and buying a put and a share? Strategy I: (Buying a Call and Selling a Put and a Share) Initial Cash Inflow (` 31 - ` 3 + ` 2) ` 30 Interest Rate 10% Amount grows in 3 months to (30 e 1 x.25 ) ` 30.76* If the share price is greater than ` 30, he would exercise the call option and buy one share for ` 30 and his net profit is ` 0.76 (i.e., ` ). However, if the share price is less than ` 30, the counter-party would exercise the put option and the investor would buy one share at ` 30. The net profit to the investor is again ` Strategy II: (Selling a Call and Buying a Put and a Share) In this case, the investor has to arrange a 10% of ` 30 (i.e., ` ). This amount would be repaid after 3 months. Amount payable is: 30 e1.25 = ` After 3 months, if the market price is more than ` 30, the counter-party would exercise the call option and the investor would be required to sell the share at ` 30. The loss to the investor would be ` 0.76 (i.e., ` ).

7 Model Test Paper 5.7 However, if the rate is less than ` 30, the investor would exercise the put option and would get ` 30 from the rate of share. The loss to the buyer would again be ` *Interest can also be calculated on a simple interest basis instead of continuous compound interest. (b) Your client is holding following securities as proxy of market portfolio: Particulars of securities Purchase Price (`) Dividends (`) Expected Market Price after 1 year (`) BET A(β ) Equity shares: Company-A 8, , Company-B 10, , Company-C 16, , PSU bonds 34,000 3,400 32, Assume a risk free rate of 15%. Calculate expected rate of return in each, using capital asset pricing model if shares are held for 1 year. Calculation of Return of Market Security Purchase Price Dividend Expected Market Price after 1 year A 8, ,200 B 10, ,500 C 16, ,000 PSU Bonds 34,000 3,400 32,300 68,000 5,800 73,000 Return = 73, ,800-68,000 = 10,800 Return (%) = 100

8 5.8 Solved Scanner CSPP M-II Paper 5 (New Syllabus) Rm = % Calculation of Return of Security Return of Security = R F + β (R m - R F ) Return of Security A = ( ) = % Return of Security B = ( ) = % Return of Security C = ( ) = % Return of Security D = ( ) = % (c) Priyanka Corporation has financial structure of 30% debt and 70% equity. The company is considering various investment proposals costing less than ` 30 lakh. The corporation does not want to disturb its present capital structure. The cost of raising the debt and equity are as follows: Project Cost Cost of debt Cost of equity Upto ` 5 lakh 9% 13% Above ` 5 lakh and upto ` 20 lakh Above ` 20 lakh and upto ` 40 lakh 10% 14% 11% 15% If tax rate is 30%, you are required to calculate the cost of capital of two Projects A and B whose funds requirements are ` 8 lakh and ` 21 lakh respectively. Project A Cost of project = 8,00,000 Debt = 30 % of 8,00,000 = 2,40,000 Equity = 70 % of 8,00,000 = 5,60,000. Kd = I (1-t) = 10 (1-0.3)

9 = 7 % Ke = 14 % WACC Model Test Paper 5.9 = K d W d + K e W e = (7 0.3) + (14 0.7) = = 11.9 % Project B Cost of project = 21,00,000 Debt = 30 % of 21,00,000 = 6,30,000 Equity = 70% of 21,00,000 = 14,70,000 (d) Kd = I (1-t) = 11 (1-0.3) = 7.7 % Ke = 15 % WACC = K d W d + K e W e = ( ) + (15 0.7) = = 12.81% The earning per share of a company is ` 10. It has an internal rate of return of 15% and the capitalisation rate of risk class is 12.5%. If Walter s model is used- (a) What should be the optimum payout ratio of the firm? (b) What should be the price of a share at this payout? (c) How shall the price of a share be affected if different payouts were employed? EPS = ` 10 Ri = 15% Rc = 12.5% Since Ri > Rc, as per Walter s Model, the firm should have 0% dividend payout P =

10 5.10 Solved Scanner CSPP M-II Paper 5 (New Syllabus) P = P = ` 96 In case, the company declares the dividend, the price will decrease. 4. (a) Most businesses need cash funds to meet contingencies. Comment. (4 Marks) Hint: Cash is required to be held for uncertainities, operating cycle influences the requirement of cash, (b) Discuss the various products (tools) available in the forex market to cover exchange rate risks? (4 Marks) Hint: netting, matching, leading and lagging, discounting, factoring/ forfeiting, etc. (c) In a portfolio of the company, ` 2,00,000 have been invested in Asset-X which has an expected return of 8.5%, ` 2,80,000 in Asset-Y, which has an expected return of 10.2% and ` 3,20,000 in Asset-Z which has an expected return of 12%. What is the expected return for the portfolio? Expected return of portfolio: Asset Amount Return X 2,00, % 17,00,000 Y 2,80, % 28,56,000 Z 3,20,000 12% 38,40,000 Return = Return = %. 8,00,000 83,96,000

11 (d) Model Test Paper 5.11 Zebra Ltd. has a beta (β ) of The return on market portfolio is 14%. What would be the expected rate of return on the shares of Zebra Ltd., if the risk-free rate of return is 5%? What are the implications? Also compute the alpha, if the actual rate of return over 4 observations are as under: Year 1 Year 2 Year 3 Year 4 Return on Zebra (%) R i = R f + β (R m - R f ) = (14-5) = 15.35% Alpha value Required return = 15.35% Year 1 Year 2 Year 3 Year 4 Return on Zebra % (A) Required return (B) Abnormal Return (A - B) Alpha = [( )/4] = (a) An Indian importer has to settle an import bill for $1,30,000.The exporter has given the Indian exporter two options: (i) Pay immediately without any interest charges. (ii) Pay after three months with 5% per annum. The importer s bank charges 15% per annum on overdrafts. The exchange rates in the market are as follows: Spot rate (`/$) : 48.35/ Month forward rate (`/$) : 48.81/48.83 The importer seeks your advice. Give your advice. (8 marks)

12 5.12 Solved Scanner CSPP M-II Paper 5 (New Syllabus) Evaluation of two options offered by exporter for settlement of payment Option I: Pay immediately without any interest charges (a) Bill value converted to Indian rupees ($1,30,000 ` 48.36) = ` 62,86,800 (b) Interest on the borrowing from bank@ 15% p.a. For three months ` 62,86,800 15/100 3/12 = ` 2,35,755 Total: ` 65,22,555 Option II: Pay after 3 months with 5% p.a. (a) Bill value $1,30,000 (b) 5% p.a. for 3 months = $1,30, $ 1,625 $1,31,625 (c) Forward `/$ rate ($ 1,31,625 ` 48.83) = ` 64,27,249 Thus it is better to exercise option II. (b) Laxmi Ltd. produces an auto part with a monthly demand of 4,000 units. The product requires Component-X which is purchased at ` 20. For every finished product, one unit of Component-X is required. The ordering cost is ` 120 per order and the holding cost is 10% per annum. You are required to calculate - (i) Economic order quantity (EOQ) (ii) If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the company has to incur? (iii) What is the minimum carrying cost, the company has to incur? (8 marks) Answer : Where, A = Annual requirement O = Cost of per purchase order

13 C = Inventory carrying cost per unit per annum = Model Test Paper 5.13 Inventory carrying cost per unit per annum = 10% of 20 = ` 2 Annual requirement = 4, = 48,000 units Thus, EOQ = 2400 units Total cost incurred in case lot size is 2400 units: Cost of Material = 48, = 9,60,000 Ordering Cost = 120 = 2,400 Inventory carrying cost = = 2,400 ` 9,64,800 Total cost incurred in case lot size is 4,000 units: Cost of material = 48, = 9,60,000 Ordering cost = = 1,440 Inventory carrying cost = = 4,000 ` 9,65,440 Thus, if the minimum lot size to be supplied is 4,000 units, the company has to incur extra cost of = (9,65,440-9,64,800) = ` Exacta Ltd. is considering the replacement of its existing machine by a new one which is expected to cost ` 2,70,000 with a life of 5 years and salvage value being ` 20,000. The machine will yield annual cash revenue of ` 5,70,000 and annual cash expenses of ` 2,96,000. The existing machine has a book value of ` 92,000 and can be sold for ` 46,000 today. It has a remaining useful life of 5 years. Cash revenues will be ` 4,50,000 and associated cash expenses will be ` 3,20,000 per annum. The existing machine will have a salvage value of ` 4,600 at the end of 5 years.

14 5.14 Solved Scanner CSPP M-II Paper 5 (New Syllabus) Exacta Ltd. is in a 35% tax bracket and writes off 25% per annum on written down value (WDV) method. Exacta Ltd. has a target debt-equity ratio of 20%. The company in the past has raised debt at 12% and it can now be raised at 10% Exacta Ltd. follows the dividend discount model to estimate the cost of equity capital. Last year the company paid a dividend of ` 1.85 per share. The current market price of the company s equity share is ` 20 per share. A growth rate of 8% per annum is anticipated. (Ignore capital gain tax.) Required : (i) Investment required on incremental basis. (ii) Incremental depreciation per year. (iii) Weighted average cost of capital. (iv) Computation of present worth factors. (v) Before tax incremental cash flows based on revenue and expenses. (vi) Incremental terminal cash flow. (vii) Computation of NPV. (viii) Should the new machine be acquired? Why? (16 marks) (i) Investment required on incremental basis: Cost of new machine ` 2,70,000 ( ) Sale of existing machine (46,000) Incremental Investment 2,24,000 (ii) Incremental depreciation per year: Depreciation of new machine:- Cost of Machine 2,70,000 92,000 Depreciation 25% (-) Depreciation 25% Depreciation 25% (-) (-)

15 Model Test Paper 5.15 Depreciation 25% Depreciation 25% (-) (-) Table considering depreciation element only: Year New Machine Old Machine Incremental Depreciation 1 67,500 23,000 44, ,625 17,250 33, ,969 12,938 25, ,477 9,703 18, ,357 7,277 14,080 (iii) Weighted average cost of capital (WACC) Current Market Price (P O ) = 20 Dividend declared last year (D O ) = 1.85 Growth Rate (g) = 8% K(e) = g D 1 = D O + g = % of 1.85 = Substituting the values, we get: k(e) = = ~ 18% So, Cost of equity [k(e)] = 18% k(d) = I (1 t) = 10 (1.35) = 6.5% ko = KeWe + KdWd ko = 18 x x 0.2 ko = 15.7%

16 5.16 Solved Scanner CSPP M-II Paper 5 (New Syllabus) (iv) Computation of present worth factors:- K(o) = 15.7% For year 1: P.V. = =.864 =.747 =.646 =.558 =.482 (v) Before tax expenses: incremental cash flows based on revenue and

17 Incremental Cash flows = 2,74,000 1,30,000 = ` 1,44,000 (vi) Incremental terminal cash flows: Salvage value of new machine 20,000 Less: Salvage value of existing machine (4,600) Incremental terminal cash flows = ` 15,400 (vii) Computation of N.P.V. Model Test Paper 5.17 Year Earning -2,24,000 1,44,000 1,44,000 1,44,000 1,44,000 1,44,000 Less: Dep. -44,500-33,375-25,031-18,774-14,080 Profit after Dep. 99, ,625 1,18,969 1,25,226 1,29,920 Less: 35% 34,825 38,719 41,639 43,829 45,412 Profit after tax 64,675 71,906 77,330 81,397 84,448 + Depreciation 44,500 33,375 25,030 18,774 14,080 Cashflow 1,09,175 1,05,281 1,02,360 1,00,171 98,528 Salvage value 15,400 Total -2,24,000 1,09,175 1,05,281 1,02,360 1,00,171 1,13,928 P.V. factors Present value 2,24,000 94,327 78,645 66,125 55,895 54,913 Net Present Value 1,25,905 (viii) Should the new machine be acquired. why? Yes, the new machine should be acquired since the N.P.V. calculated in part (vii) above is positive.

Model Test Paper 1 CS Professional Programme Module II Paper 5 (New Syllabus) Financial, Treasury and Forex Management All Hint: Hint: Hint:

Model Test Paper 1 CS Professional Programme Module II Paper 5 (New Syllabus) Financial, Treasury and Forex Management Answer All Questions. 1. Comment on the following: (a) Investment, financing and dividend