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 decisions are inter related. Hint: Financial management is concerned with raising funds, investing them in the desired areas and distributing surplus so earned to the shareholders. (b) Cost of retained earnings is the opportunity cost of results obtained in a similar investment elsewhere. Hint: Retained earnings has also its own cost. Retained earnings are the funds which belong to the equity shareholders of the company because if these funds would not have retained, these would have been distributed to the shareholders in the form of dividend. (c) Wealth maximisation objective of the financial management is redefined as value maximisation. Hint: The objective of wealth maximisation talks about increasing the wealth of equity shareholders. (d) Exchange rate is the price of one country s money in terms of other country s money. (5 Marks each) Hint: Exchange rate is defined as the price of one country s money in terms of the other country s money. Attempt all parts of either Q. No. 2 or Q. No. 2A 2. Distinguish Between the following: (a) Interest rate parity and purchasing power parity. Hint: Interest rate differentials, forward premium, depreciation in the currency. (b) Ask price an bid price Hint: Ask price: Rate at which the market marker is ready to sell a particular currency pair. Bid Price: Rate at which the market marker is 1
prepared to buy a specific currency pari. (c) Corporate finance and Business finance. Hint: Corporate Finance: Deals with the finance of corporate bodies. Business Finance: It deals with the financial practices applicable for all types of business enterprises. (d) Financial Distress and Insolvency. Hint: Financial position and affairs of any firm is endangered. Under financial distress the firm repays and debt taken and accumulated interest by resorting to such practices like selling asset at low prices. OR (Alternative Question to Q. No. 2) 2. (A) The cash flow approach of measuring future benefits of a project is superior to the accounting approach. Discuss. Hint: Cash flow approach also takes into consideration the non cash expense, cash flows are calculated by adjusting depreciation and other non cash expenses. (B) State with reasons whether the investment, financing and dividend decisions are inter-related. Hint: Investment decisions are concerned with allocation of funds. Financing decision ambits in itself the decision regarding the proportion of debt and equity. Dividend decision takes into account the manner in which the surplus generated is to distributed and how much to retain. (C) Explain the net income approach to capital structure. Hint: Change in capital structure directly affects the value of the firm, cost of capital is dependent on degree of leverage. (D) Write a note on depository system in India? Hint: Depository system provides the advantage of ensuring faster delivery of securities. They help in transferring securities without handling them in physical from. Attempt all parts of either Q. No. 3 or Q. No. 3A 3. (a) On 1st October, Deepak is retiring from service and he will get an amount of ` 16,32,000 as retirement benefits. He is planning to 2
invest this money in the following three scrips, which he considers grossly under-valued stocks in the market: Stock No. of Shares Price Beta (`) X 2,000 300 0.42 Y 3,000 416 0.65 Z 4,600 330 1.72 It is September now and he plans to take advantage of this mispricing 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 = = 0.1544 + 0.4970 + 1.5998 = 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. (i) Profit on contract purchased = Exercise price of put option 250 3
Less: Price at Expiry Date 189 61 Less: Premium 42 19 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) During a year, the price of British Gilts (Face value 100) rose from 103 to 105 while paying a coupon of 8. At the same time, the exchange rate moved from $/ 1.70 to $/ 1.58. What is the total return to an investor in US who invested in the above security? Amount invested = 103 When; 1 = 1.70 Hence amount invested (in $) = 103 1.70 = 175.1 Amount received = 105 Coupon (Interest) received = 8 Total = 113 When; 1 = 1.58 So Amount received = 113 1.58 = 178.54 Return = 100 = 1.965% (d) An Indian telecom company had approached Punjab National Bank for forward contract of 5,00,000 delivery on 31 st May, 2008. The bank had quoted a rate of `61.60/ for the purchase of pound sterling from the customer. But on 31 st May, 2008, the customer informed the bank that it was not able to deliver the pound sterling as anticipated receivable from London has not materialized and requested the bank to extend the contract for delivery by 31 st July, 2008. The following are the market quotes available on 31 st May, 2008: Spot (`/ ) 62.60/65 1-month forward premium 20/25 2-month forward premium 42/46 4
3-month forward premium 62/68 Flat charges for cancellation of forward contract is `500. You are required to find out the extension charges payable by the telecom company. Indian company enters into forward purchase contract @ ` 61.60 However, on 31 st May i.e. on due date, customer requests bank to extend the contract for delivery by 31 st July 2008 i.e. 2 months after 31 st May. Thus, new contract will be booked at 1 = ` 62.60 2 months premium.42 63.02 Also, charges will be required to be paid in relation to cancellation of the existing contract: Flat charges for cancellation: ` 500 Charges on account of exchange difference 5,00,000 (62.65 61.6) 5,25,000 5,25,500 Thus, Indian telecom company will be required to pay ` 5,25,500 and new contract @ ` 63.02 will be booked. OR (Alternative Question to Q. No. 3) 3. (A) 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 $ 7.5880 and HK $ 7.5920. Local inter-bank market rates for US$ were: Spot US $ 1 = ` 42.70 and ` 42.85. 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: = 5
= = 42.85 = ` 5.64707 As the rate in London is less, the HK$ can be bought in London and the Profit is : Profit = 1,00,00,000 (5.70 5.64707) = ` 5,29,300 (B) Silver Oak Ltd, an Indian company, is mainly engaged in international trade with US and UK. It is currently 1 st January. It will have to make a payment of $7,29,794 in the coming six months time. The company is presently considering the various alternatives in order to hedge its transactional exposure through its London office. The following information is available; Exchange Rates: $/ Spot rate :1.5617 1.5773 6-month $ forward rate :1.5455 1.5609 Money Market Rates Borrow Deposit (% ) (%) US Dollar 6 4.5 Sterling 7 5.5 Foreign currency option prices (Cents per for contract size 12, 500): Exercise Price Call Option (June) Put Option (June) $1.70/ 3.7 9.6 Suggest which of the following hedging option is the most suitable for Silver Oak Ltd: (i) Forward exchange contract (ii) Money market (iii) Currency option. (i) Using Forward Exchange Contract $ 7,29,794/1.5455 = 4,72,206 (ii) Using Money Market Silver Oak Ltd. must make a deposit now 6
(iii) Six month dollar deposit rate: 4.5/2 = 2.25% X 1.0225 = $ 7,29,794 X = = $ 7,13,735 Hence amount required to be deposited @ 4.5% = $ 7,13,735 Cost of buying $ 7,13,735 at current spot rate is 7,13,735/1.5617 = 4,57,024 Six months sterling borrowing rate = 7/2 = 3.5% Interest for six months on 4,57,024 = ( 4,57,024 0.035) = 15,996 Total Cost = 4,57,024 + 15,996 = 4,73,020 Using Currency option Each contract will deliver=1.7 12,500= 21,250 No. of put option contract required =7,29,794/21,250=$ 34.34 or 34 Cost of total contracts =0.096 12,500 34 = $ 40,800 Sterling cost of option =40,800/1.5617= 26,125 Sterling required =34 12,500 = 4,25,000 to buy $ 7,22,500 @ $ 1.70 Shortfall =7,29,794 7,22,500 = 7,294 Cost of sterling using forward rate =7,294/1.5455= 4,720 Total cost using option =26,125 + 4,25,000 + 4,720 = 4,55,845 Therefore currency options are the cheapest mode of hedging transaction exposure. (C) A firm has total credit sales of `80 lakhs and its average collection period is 80 days. The past experience indicates that bad debt losses are around 1% of the credit sales. The firm spends ` 1,20,000 per year on administering its credit sales. This cost includes salary of one officer and two clerks who handle the credit checking, collection, etc. telephone and telefax charges. These are avoidable costs. A factor is prepared to buy the firm's receivables. He will charge 2% commission. He will advance against receivables 7
to the firm at 18% after withholding 10% as reserve. What is the cost of factoring? Should the firm avail factoring service? Evaluation of factoring proposal Benefits of factoring: Savings in Bad Debts (1% of ` 80,00,000) = 80,000 Saving in Administrative cost = 1,20,000 Total Benefits = 2,00,000 --------(1) Costs of factoring: Commission (2% on Debtors) 2% on =35,556 + Interest for 80 days =62,578 Total cost for 80 days 98,134 Annualised cost 360 Total cost = 4,41,603 -------(2) Hence there is an increment cost of ` 2,41,603 (D) Blue Berry Ltd. estimates its carrying cost at 12% and its ordering cost at ` 12 per order. The estimated annual requirement is 40,000 units at a price of `5 per unit. What is the most economical number of units to order and how often will an order need to be placed? (i) EOQ Where ; 8
EOQ = Economic Order Quantity D= Annual Demand C O = Cost of ordering C i = Carrying cost Substituting the values we get: EOQ = 1265 units (ii) Time period within which next order needs to be placed: Time period = Where ; Consumption per day = = = 109.59 Hence, Time period = = = 11.5 Thus, the next order needs to be placed after 11.5 days. 4. (a) Explain the net operating income approach to capital structure. Hint: The capital structure decision is not relevant and change in debt will not affect the total value of the firm. (b) What are the determinants of working capital. Hint: Nature of business, production cycle, dividend policy, size of company growth and diversification programme, sales Policies, operating efficiency, etc. (c) A company believes that it is possible to increase sales if credit terms are relaxed. The profit plan based on the old credit terms envisages projected sales at ` 10,00,000, a 30% profit volume ratio, fixed costs at ` 50,000, bad debts of 1% and an accounts receivable turnover ratio of 10 times. The relaxed credit policy is expected to increase sales to ` 12,00,000. However, bad debts will rise to 2% of sales and accounts receivable turnover ratio will decrease to 6 9
times. Should the company adopt the relaxed credit policy, assuming that the company s expected rate of return is 20%? A company believes that it is possible: Current Proposal Increment Sales 10,00,000 12,00,000 2,00,000 (- )Variable cost (70%) 7,00,000 8,40,000 1,40,000 Contribution 3,00,000 3,60,000 60,000 Less:- (-) fixed cost (50,000) 50,000 - (-)Bad debts (10,000) (24,000) 14,000 (-)Cost of investment in debtors 20% of 15,000 20% of 29,666 14,666 Income 2,25,000 2,56,334 31,334 The proposed change in policy results in an incremental income of ` 31,334 and hence the same should be implemented. (d) Saraswati Engineering Company is considering its working capital investment for the next year. Estimated fixed assets and current liabilities for the next year are ` 2.60 crores and ` 2.34 crores respectively. Sales and profit before interest and taxes (PBIT) depend on investment in current assets-particularly inventories and book debts. The company is examining the following alternative working capital policies: Working capital policy Investment in current assets (` in crore) Estimated sales (` in crore) PBIT (` in crore) Conservative 4.50 12.30 1.23 Moderate 3.90 11.50 1.15 Aggressive 2.60 10.00 1.00 You are required to calculate the rate of return on total assets for 10
each policy. Working Capital Investment Policies Conservative Moderate Aggressive Current assets 4.50 3.90 2.60 Fixed assets 2.60 2.60 2.60 Total assets (X) 7.10 6.50 5.20 Current liabilities 2.34 2.34 2.34 Forecasted sales 12.30 11.50 10.00 Expected PBIT (Y) 1.23 1.15 1.00 Rate of return (Y/X) 17.32% 17.69% 19.23% 5. (a) An Indian importer has to settle an import bill for $1,30,000.The exporter has given the Indian exporter two options: (i) Pay immediately without any interest charges. (ii) Pay after three months with interest @ 5% per annum. The importer s bank charges 15% per annum on overdrafts. The exchange rates in the market are as follows: Spot rate (`/$) : 48.35/48.36 3-Months forward rate (`/$) : 48.81/48.83 The importer seeks your advice. Give your advice. (8 Marks) 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 interest @ 5% p.a. (a) Bill value $1,30,000 (b) Interest @ 5% p.a. for 3 months 11
= $1,30,000 0.05 0.25 $ 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) Elite Ltd. Manufactures a product from a raw material, which is purchased at ` 100 per kg. The company incurs a handling cost of ` 300 plus freight of ` 325 per order. The incremental carrying cost of inventory of raw material is Re. 0.50 per kg. per month. In addition, the annual cost of working capital finance on the investment in inventory of raw material is ` 4 per kg. The annual production of the product is 1,00,000 units and 2 units are obtained from one kg. of raw material. Required : (i) Calculate the economic order quantity (EOQ) of raw materials. (ii) Advise how frequently the orders for procurement of raw materials should be placed. (iii) If the company proposes to rationalise placement of orders for procurement of raw materials on quarterly basis, what percentage of discount in the price of raw materials should be negotiated? (8 Marks) (i) EOQ = Where ; D = Annual Demand C O = Ordering Cost C i = Cost of Carrying = = 2500 kg (ii) Number of orders to be placed = = 20 orders 12
Frequency of the orders for procurement of raw materials = = 18 days (iii) Cost on EOQ basis Purchase Price = (50,000 100) = 50,00,000 Ordering Cost = (20 625) = 12,500 Carrying Cost = = 12,500 Cost on Quarterly basis Ordering Cost = (4 625) = 2500 ` 50,25,000 Carrying Cost = = 62,500 Purchase Price = x 65,000 + x 65,000 + x = 50,25,000 x = 49,60,000 Purchase Price = ` 49,60,000 Discount = 50,00,000 49,60,000 = ` 40,000 Discount Rate = = 0.8% 6. An iron ore company is considering investing in a new processing facility. The company extracts iron ore from an open pit mine. During a year, 1,00,000 ton of iron ore is extracted. If the output from the extraction process is sold immediately upon removal of dirt, rocks and other impurities, a price of ` 1,000 per ton of iron ore can be obtained. The company has estimated that its extraction costs amount to 70% of the net realisable value of the iron ore. As an alternative to selling all the iron ore at ` 1,000 per ton, it is possible to process further 25% of the output. The additional cash cost of further processing would be ` 100 per ton. The processed iron ore would yield 80% final output and can be sold at ` 1,350 per ton. For additional processing, the company would have to install equipments costing ` 100 lakh. The equipment is expected to have a 13
useful life of 5 years with no salvage value. The company follows the straight line method of depreciation. Additional working capital requirement is estimated at ` 20 lakh. The company s cut-off rate for such investments is 15%. Assume corporate tax rate 30% (including surcharge and education cess). Should the company install the equipment for further processing of the iron ore? (16 Marks) Additional output generated = 20,000 tons (1) (since only 80% of 25,000 tons can be sold) Additional Price per unit (1,350-1,000) = 350/ ton (2) Additional Revenue = 70,00,000 Additional Processing Cost = 100/ ton Total Processing Cost (25,000 tons x 100) = 25,00,000 Additional Depreciation charge = = 20,00,000 So, Additional Revenue 70,00,000 (-) Additional Processing Cost 25,00,000 45,00,000 (-) Additional Depreciation 20,00,000 25,00,000 (-) Taxes (@ 30%) 7,50,000 17,50,000 + Depreciation 20,00,000 Cash flow 37,50,000 Y0 Y1 Y2 Y3 Y4 Y5 Cost of Equity Additional Cash flow (1,00,00,000) 37,50,000 37,50,000 37,50,000 37,50,000 37,50,000 Working Capital (20,00,000) Recov ery of Working Capital 20,00,000 (1,20,00,000) 37,50,000 37,50,000 37,50,000 37,50,000 37,50,000 PV @ 15% 1 0.87 0.756 0.658 0.572 0.497 PV (1,20,00,000) 32,62,500 28,35,000 24,67,500 21,45,000 28,57,750 14
N.P.V. = ` 15,67,750 Thus, the company should go in for further processing of iron ore. 15