(All Batches) DATE: 16.04.2018 MAXIMUM MARKS: 100 TIMING: 3¼ Hours FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE SECTION A Q. No. 1 is compulsory. Wherever necessary suitable assumptions should be made by the candidates. Working notes should form part of the answer. Candidates are also required to answer any five questions from the remaining six questions. Answer 1 (a) Working notes: 1. Current assets and Current liabilities computation: Current assets = 2.5 Current liabilities 1 Or Current assets = 2.5 Current liabilities Now, Working capital = Current assets Current liabilities Or Rs. 2,40,000 = 2.5 Current liability Current liability Or 1.5 Current liability = Rs. 2,40,000 Current liabilities = Rs. 1,60,000 So, Current assets = Rs. 1,60,000 2.5 = Rs. 4,00,000 2. Computation of stock Liquid ratio = Liquid assets Current liabilities Or 1.5 = Current assets - Inventories Rs.1,60,000 Or 1.5 Rs. 1, 60,000 = Rs. 4,00,000 Inventories Or Inventories = Rs.4, 00,000 Rs. 2, 40,000 Or Stock = Rs. 1, 60,000 3. Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors Fixed Assets Fixed Asset to Proprietary ratio = 0. 75 Proprietary fund Fixed assets = 0.75 Proprietary fund (PF) [FA + NWC = PF or NWC = PF- FA (i.e..75 PF)] and Net working capital (NWC) = 0.25 Proprietary fund Or Rs. 2,40,000/0.25 = Proprietary fund Or Proprietary fund = Rs. 9,60,000 and Fixed assets = 0.75 proprietary fund 1 P a g e
= 0.75 Rs. 9,60,000 = Rs. 7,20,000 Capital = Proprietary fund Reserves & Surplus Rs. 9,60,000 Rs. 1,60,000 =Rs. = 8,00,000 ½M Sundry creditors = (Current liabilities Bank overdraft) (Rs. 1,60,000 Rs. 40,000) = Rs. = 1,20,000 ½M Balance Sheet Liabilities Rs. Assets Rs. Capital 8,00,000 Fixed assets 7,20,000 Reserves & Surplus 1,60,000 Stock 1,60,000 Bank overdraft 40,000 Current assets 2,40,000 Sundry creditors 1,20,000 11,20,000 11,20,000 (b) Workings: D 1 (i) Cost of Equity (Ke) = g = Rs. 3 0.07 0.1 0.07 = 0.17 = 17% P Rs. 30 0 (ii) Cost of Debentures (Kd) = I (1 - t) = 0.09 (1-0.4) = 0.054 or 5.4% Computation of Weighted Average Cost of Capital (WACC using market value weights) Source of capital Market Value Weight Cost of WACC (%) of capital (Rs.) capital (%) 9% Debentures 30,00,000 0.30 5.40 1.62 12% Preference Shares 10,00,000 0.10 12.00 1.20 Equity Share Capital 60,00,000 0.60 17.00 10.20 (Rs.30 2,00,000 shares) Total 1,00,00,000 1.00 13.02 3M (c) (i) Equipment s initial cost = Rs. 6,00,000 + 80,000 = Rs. 6,80,000 (ii) Annual straight line depreciation = Rs. 6,00,000/5 = Rs. 1,20,000. (iii) Net cash flows can be calculated as follows: = Before tax CFs (1 Tc) + Tc Depreciation (Rs. 000) CFs Year 0 1 2 3 4 5 1. Initial cost (680) 2 P a g e
2. Before tax CFs 240 275 210 180 160 3. Tax @ 35% 84 96.25 73.5 63 56 4. After tax-cfs 156 178.75 136.5 117 104 5. Depreciation tax shield (Depreciation Tc) 42 42 42 42 42 6. Working capital released 80 7. Net Cash Flow (4 + 5 + 6) 198 220.75 178.5 159 226 8. PVF at 12% 1.00 0. 8929 0.7972 0.7118 0.6355 0.5674 9. PV (7 8) (680) 176.79 175.98 127.06 101.04 128.23 10. NPV 29.12 0 1 2 3 4 5 PVF at 15% 1 0.8696 0.7561 0.6575 0.5718 0.4972 PV (680) 172.18 166.91 117.36 90.92 112.37 NPV 20.26 Internal Rate of Return IRR 12% 29.12 49.38 3% = 13.77% Discounted Payback Period Discounted CFs at K = 12% considered = 176.79 + 175.98 + 127.06 + 101.04 + 12 = 4 years and 9.28 months 99.13 128.24 Payback Period (NCFs are considered) 82. 75 = 198 + 220.75 + 178.5 + 12 159 = 3 years and 6.25 months Answer 2: Income Statement Particulars Amount (Rs.) Sales 75,00,000 Less: Variable cost (56% of 75,00,000) 42,00,000 Contribution 33,00,000 Less: Fixed costs 6,00,000 Earnings before interest and tax (EBIT) 27,00,000 Less: Interest on debt (@ 9% on Rs. 45 lakhs) 4,05,000 Earnings before tax (EBT) 22,95,000 3 P a g e
EBIT EBIT (i) ROI = Capital employed 100 = Equity + Debt 100 Rs. 27,00,000 = Rs. (55,00,000 + 45,00,000) 100 = 27% (ROI is calculated on Capital Employed) (ii) Capital Turnover Net Sales = Capital Or = Net Sales = Rs. 75,00,000 = 0.75 Capital Rs. 1,00,00,000 Which is very low as compared to industry average of 3. (iii) Calculation of Operating, Financial and Combined leverages (a) Operating Leverage = (b) Financial Leverage = Contribution = Rs. 33,00,000 = 1.22 (approx) EBIT Rs. 27,00,000 EBIT = Rs. 27,00,000 = 1.18 (approx) EBT Rs. 22,95,000 (c) Combined Leverage = Contribution = Rs. 33,00,000 = 1.44 (approx) EBT Rs. 22,95,000 Or = Operating Leverage Financial Leverage = 1.22 1.18 = 1.44 (approx) (iv) Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased by 1.22 10 i.e. 12.20% (approx) (v) Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to bring EBT to Zero Accordingly, New Sales = Rs. 75,00,000 (1-0.6944) = Rs. 75,00,000 0.3056 = Rs. 22,92,000 (approx) Hence at Rs. 22,92,000 sales level EBT of the firm will be equal to Zero. (vi) Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by 1.18 20 = 23.6% (approx) Answer 3: Statement showing the Evaluation of Debtors Policies Particulars Present Proposed Proposed Policy Policy I Policy II Rs. Rs. Rs. A Expected Profit : (a) Credit Sales 225.00 275.00 350.00 (b) Total Cost other than Bad Debts: Variable Costs 135.00 165.00 210.00 (c) Bad Debts 7.50 22.50 47.50 (d) Expected Profit [(a)-(b)-(c)] 82.50 87.50 92.50 B Opportunity Cost of Investment in Receivables 5.40 8.25 14.00 C Net Benefits [A-B] 77.10 79.25 78.50 4 P a g e
Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy are higher than those under other policies. Working Note: Calculation of Opportunity Cost of Average Investments Opportunity Cost = Total Cost Collection Period Rate of Return 12 100 Present Policy = Rs. 135 lacs x 2.4/12 x 20% = Rs. 5.40 lakhs Proposed Policy I = Rs. 165 lacs x 3/12 x 20% = Rs. 8.25 lakhs Proposed Policy II = Rs. 210 lacs x 4/12 x 20% = Rs. 14.00 lakhs Answer 4: CASE 1: Value of the Firm When Dividends are not Paid. Step 1: Calculate price at the end of the period K e = 10%, P₀= 100, D₁= 0 Pₒ = P 1 +D 1 1+K e 100 = P 1 +0» P₁=110 1+0.10 Step 2: Calculation of funds required for investment Earning Rs. 1,00,000 Dividend distributed nil Fund available for investment Rs. 1,00,000 Total Investment Rs. 2,00,000 Balance Funds required Rs. 2,00,000 - Rs.1,00,000 = Rs.1,00,000 Step 3: No. of shares required to be issued for balance fund No. of shares = Funds required Price at end(p ) 1 n = 1,00,000 110 Step 4: Calculation of value of firm np₀ = (n+ n)p 1 - I+E 1+K e 5 P a g e
(10,000+1,00,000/110)110-2,00,000+1,00,000 np₀ = (1+.10) = Rs. 10,00,000 Case 2: Value of the firm when dividends are paid. Step 1: Calculate price at the end of the period K e = 10%, P₀= 100, D₁= 5 P₀ = P1 +D 1 100 = 1+K e P 1 +5 1+0.10» P₁= 105 Step 2: Calculation of funds required for investment Earning Rs. 1,00,000 Dividend distributed 50,000 Rs. Fund available for investment Rs. 50,000 Total Investment Rs. 2,00,000 Rs. 2,00,000 - Rs.50,000 = Balance Funds required Rs.1,50,000 Step 3: No. of shares required to be issued for balance fund 10.16 No. of shares Step 4: Calculation of value of firm = Funds required n = Price at end(p ) 1 1,50,000 105 (n+ n)p 1 - I+E np 0 = 1+K e np 0 = (10,000+1,50,000/105)105-2,00,000+1,00,000 (1+.10) = Rs. 10,00,000 6 P a g e
Thus, it can be seen from the example that the value of the firm remains the same in either case Answer 5: (i) The decision tree diagram is presented in the chart, identifying various paths and outcomes, and the computation of various paths/outcomes and NPV of each path are presented in the following tables: The Net Present Value (NPV) of each path at 10% discount rate is given below: Path Year 1 Year 2 Total Cash Cash NPV Cash Flows Cash Flows Inflows Outflows (PV) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) 1 50,000 0.909 24,000 0.826 65,274 80,000 (14,726) = 45,450 = 19,824 2 45,450 32,000 0.826 71,882 80,000 (8,118) = 26,432 3 45,450 44,000 0.826 81,794 80,000 1,794 = 36,344 4 60,000 0.909 40,000 0.826 87,580 80,000 7,580 = 54,540 = 33,040 5 54,540 50,000 0.826 95,840 80,000 15,840 = 41,300 6 54,540 60,000 0.826 1,04,100 80,000 24,100 = 49,560 7 P a g e
Statement showing Expected Net Present Value z NPV (Rs.) Joint Probability Expected NPV (Rs.) 1 (14,726) 0.08 (1,178.08) 2 (8,118) 0.12 (974.16) 3 1,794 0.20 358.80 4 7,580 0.24 1,819.20 5 15,840 0.30 4,7.00 6 24,100 0.06 1,446.00 6,223.76 (ii) If the worst outcome is realized the project will yield NPV of Rs. 14,726. The probability of occurrence of this NPV is 8% and a loss of Rs. 1,178 (path 1). (iii) The best outcome will be path 6 when the NPV is at Rs. 24,100. The probability of occurrence of this NPV is 6% and an expected profit of Rs. 1,446. (iv) The project should be accepted because the expected NPV is positive at Rs. 6,223.76 based on joint probability ½M ½M Answer 6: Estimation of Working Capital Needs I. Investment in Inventory Rs. (i) Raw material Inventory = 78,000 4 = Rs. 117 7,02,000 ½M (ii) Work-in-Process Inventory Material = 78,000 2 0.80 117 = 2,80,800 Labour and Overheads Cost (other than depreciation) = 78,000 2 0.60 129 = 2,32,200 5,13,000 (iii) Finished Goods Inventory (Cash Cost) = 78,000 3 246 11,07,000 ½M II. Investment in Debtors (Cash Cost) 17,71,200 6 = 78,000 0.8 246 III Cash Balance 2,50,000 Investment in Current Assets 43,43,200 Current Liabilities and Deferred Payment (i) Creditors=78,000 8 Rs.117 14,04,000 Rs. ½M (ii) Wages outstanding = 78,000 1 49 73,500 8 P a g e
(iii) Overheads outstanding (cash cost)=78,000 2 80 2,40,000 Total Deferred Payments 17,17,500 Net Working Capital (Current assets Non-interest bearing current liabilities) = 43,43,200 17,17,500 = Rs. 26,25,700 1½M Answer 7 : (a) Features of Deep Discount Bonds: Deep discount bonds are a form of zerointerest bonds. These bonds are sold at discounted value and on maturity; face value is paid to the investors. In such bonds, there is no interest payout during the lock- in period. The investors can sell the bonds in stock market and realise the difference between face value and market price as capital gain. IDBI was the first to issue deep discount bonds in India in January 1993. The bond of a face value of Rs. 1 lakh was sold for Rs. 2700 with a maturity period of 25 (b) Features of Commercial Paper (CP) A commercial paper is an unsecured money market instrument issued in the form of a promissory note. Since the CP represents an unsecured borrowing in the money market, the regulation of CP comes under the purview of the Reserve Bank of India which issued guidelines in 1990 on the basis of the recommendations of the Vaghul Working Group. These guidelines were aimed at: (i) Enabling the highly rated corporate borrowers to diversify their sources of short term borrowings, and (ii) To provide an additional instrument to the short term investors. It can be issued for maturities between 7 days and a maximum upto one year from the date of issue. These can be issued in denominations of Rs. 5 lakh or multiples therefore. All eligible issuers are required to get the credit rating from credit rating agencies. 4M 4M 9 P a g e
SECTION - B Q. No. 1 is compulsory. Wherever necessary suitable assumptions should be made by the candidates. Working notes should form part of the answer. Candidates are also required to answer any four questions from the remaining five questions. Answer 1: = Income Method GDPMP = Employee compensation (wages and salaries + employers' contribution towards social security schemes) + profits + rent + interest + mixed income + depreciation + net indirect taxes (Indirect taxes - subsidies) GDPMP = 6,508+ 34 + 1060 + 806+ 682 + 1,000 + 800 = 10,890 GNP MP = GDPMP + NFIA =10,890+ 40 =10,930 4M Expenditure Method Y = C + I + G + (X M) Y = 7314 + 1482 + 2196+ (1346 1408) Y = (7314 + 1482 + 2196) 62 Y = 10930 4M 4M GNP MP = GDPMP + NFIA =10,890+ 40 =10,930 Answer 2: (a) The multiplier refers to the phenomenon whereby a change in an injection of expenditure will lead to a proportionately larger change (or multiple change) in the level of national income. Multiplier explains how many times the aggregate income increases as a result of an increase in investment. When the level of investment increases by an amount say I, the equilibrium level of income will increase by some multiple amounts, Y. The ratio of Y to I is called the investment multiplier, k For example, if a change in investment of Rs. 2000 million causes a change in national income of Rs. 6000 million, then the multiplier is 6000/2000 =3. Thus multiplier indicates the change in national income for each rupee change in the desired investment. The value 3 in the above example tells us that for every Rs. 1 increase in desired investment expenditure, there will be Rs. 3 increase in equilibrium national income. (b)difference between public goods and Private goods are: Public goods 1. Its consumption is essentially collective in nature 2. No direct payment by consumer is involved Private goods Anyone who wants to consume them must purchase them Payment is made by consumer. 10 P a g e
(1 Mark for each point of difference max. 4 Marks) MITTAL COMMERCE CLASSES 3. It is non-rival in consumption, means consumption of one does not effect consumption of other 4. It is non-excludable, means consumer can't be excluded from consumption benefits It is rivalrous, means consumption of one may effect consumption of other. It is excludable, means consumer can be excluded from consumption if he not paid for it. 5. Consumption can't be changed. Consumption can be changed according to need, preference and budget. 6. It is indivisible. It is divisible. Answer 3: (a) Fiscal policy measures to correct different problems created by business-cycle instability are of two basic types namely, expansionary and contractionary. Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in all types of government spending and / or a decrease in taxes. Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a businesscycle expansion which is likely to induce inflation. This is carried out by decreasing the aggregate expenditures and aggregate demand through a decrease in all types of government spending and/ or an increase in taxes. Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a larger budget surplus. In other words, if the state of the economy is such that its growth rate is extraordinarily high causing inflation and asset bubbles, contractionary fiscal policy can be used to confine it into sustainable levels. (b) Repo, is defined as an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. In other words, repo is a money market instrument, which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. The rate charged by RBI for this transaction is called the repo rate. Repo operations thus inject liquidity into the system. Reverse Repo is defined as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent. Reverse repo operation takes place when RBI borrows money from banks by giving them securities. The securities transacted here can be either government securities or corporate securities or any other securities which the RBI permits for transaction. The interest rate paid by RBI for such transactions is called the reverse repo rate. Answer 4: (a) M3 = 128,443.9 Currency with the Public + Demand Deposits with Banks+ Time Deposits with Banks+ Other Deposits with Reserve Bank =12637.1+14,106.3+101,489.5+210.9 = 128,443.9 4M (b) Credit Multiplier =1/ Required Reserve Ratio 1000 x 1/0.02= 50,000 11 P a g e
1000x 1/0.05 20,000 1000x1/0.10= 10,000 Answer 5: Yes as per comparative advantage theory, there is possibility of trade between country A and country B. As per table country A is more proficient in producing both products table and mats. But in country A productivity per hour is more in table while in country B, mats. So country A should produce table only and import mats by exporting tables. Country B should produce mats only and import tables by exporting mats. This will be advantageous for both country. 4M Exchange ratio shall be : For one hour of country A : 12 Tables = 8 Mats For 12 Table of country B : 12 Tables = 24 Mats Exchange ratio = 12 Tables > 8 Mats < 24 Mats 4M Answer 6: (a) Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a foreign country below the sales prices in their domestic market or below their full average cost of the product. Dumping may be persistent, seasonal, or cyclical. Dumping may also be resorted to as a predatory pricing practice to drive out established domestic producers from the market and to establish monopoly position. Dumping is an international price discrimination favouring buyers of exports, but in fact, the exporters deliberately forego money in order to harm the domestic producers of the importing country. This is unfair and constitutes a threat to domestic producers and therefore when dumping is found, anti-dumping measures which are tariffs to offset the effects of dumping may be initiated as a safeguard instrument by imposition of additional import duties so as to offset the foreign firm's unfair price advantage. This is justified only if the domestic industry is seriously injured by import competition, and protection is in the national interest (that is, the associated costs to consumers would be less than the benefits that would accrue to producers). 4M (b) Countervailing Duties: Countervailing duties are tariffs that aim to offset the artificially low prices charged by exporters who enjoy export subsidies and tax concessions offered by the governments in their home country. If a foreign country does not have a comparative advantage in a particular good and a government subsidy allows the foreign firm to be an exporter of the product, then the subsidy generates a distortion from the free-trade allocation of resources. In such cases, CVD is charged in an importing country to negate the advantage that exporters get from subsidies to ensure fair and market oriented pricing of imported products and thereby protecting domestic industries and firms. 4M *** 12 P a g e