Solved Scanner Appendix CS Professional Programme Module - II (New Syllabus) (Solution of June - 2015) Paper - 5: Financial, Treasury and Forex Management Chapter - 1: Nature, Significance and Scope of Financial Management 2015 - June [1] (a) Generally the affairs of a firm should be managed in such a way that the total risk-business as well as financial-borne by equity holders is minimized and is manageable, otherwise, the firm would obviously face difficulties. If cash inflow is inadequate, the firm will face difficulties in payment of interest and repayment of principal. If the situation continues long enough, a time will come when the firm would face pressure from creditors. Failure of sales can also cause difficulties in carrying out production operations. The firm would find itself in a tight spot. Investors would not invest further. Creditors would recall their loans. Capital market would heavily discount its securities. Thus, the firm would find itself in a situation called distress. It may have to sell its assets to discharge its obligations to outsiders at prices below their economic values i.e., resort to distress sale. So when the sale proceeds are inadequate to meet outside liabilities, the firm is said to have failed or become bankrupt or (after due processes of law are gone through) insolvent. 2015 - June [2A] (Or) (ii) Return On Investment: This is an important profitability ratio from the angle of shareholders and reflects on the ability of management to earn a return on resources put in by the shareholders. The beauty of the ROI ratio is that earning of the company can be viewed from different angles so as to take decisions on different causes responsible, to reduce or to enhance the profitability of the company. A high ratio indicates efficient use of assets and low ratio reflects inefficient use of assets by a company. 1
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 2 Chapter - 2 : Capital Budgeting 2015 - June [2] (d) Sensitivity analysis in capital budgeting: (i) Sensitivity analysis is helpful in capital budgeting. (ii) Sensitivity analysis has been evolved to treat risk and uncertainty in capital budgeting decisions. (iii) It comprises of the following steps: (a) Identification of variables. (b) Evaluation of possibilities for these variables. (c) Selection & combination of variables to calculate NPV or rate of return of the project. (d) Substituting different values for each variable in turn while holding all other constant to discover the effect on the rate of return. (e) Comparison of original rate of return with this adjusted rate to indicate the degree of sensitivity of the rate to change in variables. (f) Subjective evaluation of the risk involved in the project. (iv) The objective of sensitivity analysis is to determine how varying assumptions will effect the measures of investment worth. (v) A sensitivity analysis is particularly helpful in large projects that would have a substantial impact on the company s operations. 2015 - June [3A] (Or) (iv) (I) Present value of case outflow : ` P. V. of machine = 7,50,000 Investment in working capital = 50,000 P.V. of cash out flow = 8,00,000 (II) Present value of cash inflow : Present value of savings = ` [ 1,80,000 (1-0.5)] 6.145 = 5,53,050 P. V. of depreciation tax benefit [70,000 0.5 6.145] = 2,15,075 P.V. of salvage = 19,300 (50,000 0.386) P.V. of working capital = 19,300 (50,000 0.386)
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 3 P.V. of cash inflow = 8,06,725 NPV = P.V. of case inflow - P.V. of cash outflow = 8,06,725 8,00,000 NPV = ` 6,725 Since NPV is positive, the firm should purchase a new machine. 2015 - June [6] Calculation of P.V. of cash outflow : P.V. of purchase of dairy plant ` = (400 lakh 0.90) = 360 lakh = P.V. of working capital = 100 lakh = P.V. of cash outflow = 460 lakh P.V. of Cash inflow : Year 1 2 3 4 to 8 Capacity 60% 70% 80% 90% Units (kg) 10,80,000 12,60,000 14,40,000 16,20,000 Sales = 5,40,00,000 6,30,00,000 7,20,00,000 8,10,00,000 VC = 2,16,00,000 2,52,00,000 2,88,00,000 3,24,00,000 Fixed cost = 3,00,00,000 3,00,00,000 3,00,00,000 3,00,00,000 Deb. = 38,75,000 38,75,000 38,75,000 38,75,000 Net Saving = (14,75,000) 39,25,000 93,25,000 1,47,25,000 Less: Tax = (5,16,250) 13,73,750 32,63,750 51,53,750 Saving After tax = (9,58,750) 25,51,250 60,61,250 95,71,250 +Dep. = 38,75,000 38,75,000 38,75,000 38,75,000 Cash Flow = 29,16,250 64,26,250 99,36,250 1,34,46,250 P.V. Factor (10%) = 0.909 0.826 0.751 0.849 P.V. of Cash Flow = 26,50,871 53,08,082 74,62,124 3,83,08,366
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 4 ` P.V. of cash inflow = 5,37,29,443 + P.V. of salvage (50,00,000 0.467) = 23,35,000 + P.V. of working capital (100,00,000.467) = 46,70,000 P.V. of cash inflow = 6,07,34,443 NPV = P.V. of cash inflow - P.V. of cash outflow = 6,07,34,443-4,60,00,000 NPV = ` 1,47,34,443 Chapter - 3 : Capital Structure 2015 - June [4] (b) ` Sales = 2,00,000 Variable cost = 60,000 Contribution = 1,40,000 Fixed cost = 1,00,000 EBIT = 40,000 Interest = 5,000 Profit before tax = 35,000 Operating leverage = Contribution EBIT = Financial leverage = = 3.5 = (i) = 1.14 If EBIT increased by 6% the using the concept of financial leverage taxable income should increase by = 1.14 6 = 6.84%
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 5 (ii) If there is 10% increase in sales. Then using the concept of operating leverage EBIT will increase by = 10 3.5 = 35% 2015 - June [5] (d) According to the theory pronounced by Modigliani and Merton Miller, the value of the firm solely depends upon its future earning stream and hence its value is not dependant on the debt equity composition. The theory used an arbitrage proof to demonstrate that capital structure is irrelevant in determining the price of the share. Under their assumption, if debt financing resulted in a higher value for the firm than equity financing, then investor who owned share in leveraged (debt - financed) firm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an un-leveraged (all equity -financed) firm. The simultaneous selling of the shares in the leveraged firm and buying of the shares in unleveraged firm would drive the prices of the stocks to the point where the value of the two firm s would be identical. Thus according to M M Hypothesis, a firm s stock price is not related to its mix of debt and equity financing. Chapter - 4 : Cost of Capital 2015 - June [1] (c) It is wrong to consider that retained earnings have no cost: Retained earnings have also its own cost. Retained earnings are the funds accumulated by the company over the year. 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. The company has deprived the equity holders of this portion of earnings by retaining the portion of profit with it. Therefore, the cost of retained earnings may be considered as equivalent to the earning forgone by the shareholders.
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 6 Thus the cost of retained earnings is simply the opportunity cost which is equal to the income that they would have otherwise earned by placing these funds in alternate investment. The cost of retained earnings is always less than the cost of equity as there is no flotation cost involved in case of retained earnings. 2015 - June [2] (a) The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital. Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted. 2015 - June [3] (a) Calculation of EPS: ` Earning before interest & taxes = 6,23,000 Less : Interest [8 % of 10,40,000] = 83,200 Earning before taxes = 5,39,800 Less : Taxes = 2,15,920 Earning after tax = 3,23,880 Number of shares = 18,000 EPS = 17.99 EPS =@ ` 18 Per Share Ke = 100 Ke = 100 Ke =12% Kd = Interest (1- Tax) Kd = 8 (1-0.4) Kd = 4.8%
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 7 Calculation of weighted average cost of capital : Particulars Amount Weight Cost Cost of capital Equity 27,00,000 0.722 12 8.664 (18,000 150) Debt. 10,40,000 0.278 4.8 1.334 Total 9.998 Weighted average cost of capital = 9.998% = 10%. Chapter - 6 : Project Planning 2015 - June [1] (d) In respect of banks, a major effort was undertaken to simplify the administered structure of interest rates. In September, 1990, a process of simplification was undertaken by reducing the number of slabs for which lending rates had hitherto been prescribed. Until some time ago, the Reserve Bank was prescribing a minimum lending rate, two concessional rates of lending for small borrowers and a maximum deposit rate. The rationalisation in the structure of interest rates culminated in the Reserve Bank abolishing and minimum lending rate in October, 1994 and leaving banks to determine their prime lending rates. On the deposit side, since July, 1996 the Reserve Bank prescribes only a maximum rate for deposits upto one year. A gradual approach has thus far been adopted in reforming the interest rates structure in India. Care has been taken to ensure that banks and financial intermediaries do not have incentives which tempt them to lend at high rates of interest assuming higher risks. A major safeguard in this regard has been the prescription of prudential norms relating to provisioning and capital adequacy. These combined with higher standards of operational accountability and appraisal of credit risks would ensure that banks lend prudently and with care. 2015 - June [2] (b)
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 8 Domestic resource cost refers to the resource cost involved in manufacturing a particular product rather than importing the same. It reflects the competitive edge the country has in producing the good. It helps in maintaining favourable balance of payment. By calculating the Domestic Resource Cost (DRC) a judicious decision can be made whether or not it is feasible to produce the good or is it better to outrightly purchase (import) the goods under consideration. 2015 - June [5] (b) Steps in the Project Planning Process The planning process consists of the following basic tasks: (a) Define the technical approach used to solve the problem. (b) Define and sequence the tasks to be performed and identify all deliverables associated with the project. (c) Define the dependency relations between tasks. (d) Estimate the resources required to perform each task. (e) Schedule all tasks to be performed. (f) Define a budget for performing the tasks. (g) Define the organization used to execute the project. (h) Identify the known risks in executing the project. (i) Define the process used for ensuring quality. (j) Define the process used for specifying and controlling requirements. Chapter - 7 : Dividend Policy 2015 - June [3A] (Or) (ii) Given, Growth = 15% 5 years = 5% 3 years D = 4 Ke = 6% Year D D PV(6%) 1 4(1+.15) 1 4.6.943 4.3378 2 4(1+.15) 2 5.29.890 4.7081 3 4(1+.15) 3 6.08.840 5.1072 4 4(1+.15) 4 6.99.792 5.5361 5 4(1+.15) 5 8.045.747 6.0096
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 9 6 844.77 844.77.747 631.04 656.74 or 657 W.N.: D6 = = = = 844.77 Chapter - 8 : Working Capital 2015 - June [3] (b) EOQ = Where, D = Annual Demand C 0 = Ordering cost C i = Cost of carrying Annual Demand = 20,000 365 = 73,00,000 meters Annual Demand of Fibre = = 1460 fibres Ordering Cost = ` 4,050 Cost of fibre = ` 5 per metre = ` 5 5000 = ` 25,000 Carrying Cost = 25% of 25,000 = ` 6,250. EOQ = 2015 - June [3A] (Or) (i) = 43.498 = 43.5
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 10 EOQ = where, D Co Ci = Annual Demand = Ordering Cost = Cost of Carrying EOQ = = 200 units Number of lots = = = 10 lots = 2000 20 = ` 40,000 Ordering cost = 10 50 = ` 500 Carrying cost = 200 5 = ` 500 Total Cost = ` 41,000 In case, 3% discount is offered, Number of lots = = 2 lots = 2000 (20-3% of 20) = 38,800 Ordering cost = 2 50 = 100 Carrying cost = [ 1000 (5-3% of 5)] = 2,425 = 41,325 2015 - June [4] (a) In the above case, sales of company is ` 15,00,000 and average collection period is 30 days. Students are advised to analyse each of the credit policy & choose the credit policy that will yield the maximum return.
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 11 Chapter - 9 : Security Analysis and Portfolio Management 2015 - June [5] (a) The CAPM is based on a list of critical assumptions: Investors are risk averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. Investors make their investments decisions based on a single period horizon which is the immediate next time period. Transaction costs are either absent or so low that these can be ignored. Assets can be bought and sold in any desired unit. The investor is limited by his wealth and the price of the asset only. Taxes do not affect the choice of buying assets. All individuals assume that they can buy the assets at the going market price and they all agree on the nature of the return and risk associated with each investment. Chapter - 10: Derivatives and Commodity Exchanges - An Overview 2015 - June [2A] (Or) (i), (iv) (i) The term mark to market settlement refers to the process of daily settlement so as to bring it to the mark/level of that of the market. In mark to market settlement of index futures, the contracts are settled daily until the expiry of the term. On the date of expiry, the settlement price calculated as difference between expiration price and spot price is paid. Mark-to-market settlement is made daily and is mostly settled in cash. Such form of daily settlement actually turns out to be a neutral transaction, since in these cases either the buyer of the contract gets benefit of same amount of which the seller suffers loss or vice-versa. (iv) Credit Default Swaps (CDS): It is a bilateral contract on one or more reference assets in which the protection buyer pays a fees through the life of the contract in return for a contingent payment by the protection seller following a credit event. The amount to be paid by the seller in case of a credit event would be the difference between he original value of the asset and the amount recovered from it.
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 12 For example: Assume investors who owned long maturity bonds issued by a company ABC. The issuer s bonds have seen a widening of credit spreads with 3 year spreads currently quoted at 115 bps and 12 year spreads at 203 bps. The investor could, if concerned with shorter term default risk, hedge with a default swap. Maturity Three years Reference credit ABC Company Reference loan 8.50% 3 year bond Credit event The business day following occurrence of Default payment specific credit event Notional amount ` [100% - market value of reference bond after default] Default swap premium 3.20% payable by the entity purchasing protection The default payment is payable by the entity providing protection upon the occurrence of a credit event. Chapter - 11: Treasury Management 2015 - June [1] (b) Treasury management is the efficient management of liquidity and the financial risk in the business. The objective of treasury management is planning, organising and controlling cash assets to achieve the financial goals which may be to maximise the return on available cash or minimise the interest cost or mobilise cash for different activities/transactions. Treasury management has both macro and micro aspects. Macro Level: At the macro level, the inflows and outflows of cash, credit and other financial instruments are the functions of the government and the business sectors. These inflows are arranged by them as borrowings from the public. Reserve Bank of India manages the macro treasury management of the country through issue of currency notes, maintenance of currency chests, distribution of coins and rupee notes on behalf of government.
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 13 Micro Level: At micro level, the finance manager aims at optimising the value of his assets. He tries to maximise the wealth of stakeholders of the micro unit. He seeks to increase his operational profits. 2015 - June [2A] (Or) (iii) Treasury management is the efficient management of liquidity and the financial risk in the business. The objective of treasury management is planning, organising and controlling cash assets to achieve the financial goals which may be to maximise the return on available cash or minimise the interest cost or mobilise cash for different activities/transactions. Treasury management has both macro & micro aspects. It supports the finance function & also takes into consideration those areas to which finance function does not look into. It interacts and integrates with the other functions & departments of business. Macro Level: At the macro level, the inflows and outflows of cash, credit and other financial instruments are the functions of the government and the business sectors. These inflows are arranged by them as borrowings from the public. Reserve Bank of India manages the macro treasury management of the country through issue of currency notes, maintenance of currency chests, distribution of coins and rupee notes on behalf of government. Micro Level: At micro level, the finance manager aims at optimising the value of his assets. He tries to maximise the wealth of stakeholders of the micro unit. He seeks to increase his operational profits. Chapter - 12 : Forex Management 2015 - June [2] (c) Ask Price Ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer. Bid Price Bid price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency.
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 14 In other words, an ask price is the rate at which the market maker is ready to sell a particular currency pair. In other words, a bid price is the rate at which the market maker is prepared to buy a specific currency pair in the foreign exchange market. 2015 - June [3A] (Or) (iii) 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 = $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. 2015 - June [5] (c) Economic risk may be defined as the uncertainty and unfavourable economic conditions in the country which affect the buyer and seller. Risk can be reduced using the following tools: 1. Netting: All transactions-gross receipts and payments among the parent firm and subsidiaries should be adjusted and only net amounts should be transferred. This technique is called netting. 2. Matching: It is a process whereby cash inflows in a foreign currency are matched with cash outflows in the same currency with regard, to as far as possible, amount and maturation. 3. Leading and Lagging: Leading implies speeding up collections on receivables if the foreign currency in which they are invoiced is expected
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 15 to appreciate. Lagging implies delaying payments of payables invoiced in a foreign currency that is expected to depreciate. 4. Risk Estimation 5. Hedging Shuchita Prakashan (P) Ltd. 25/19, L.I.C. Colony, Tagore Town, Allahabad - 211002 Visit us: www.shuchita.com
Solved Scanner Appendix CSPP M - II Paper-5 (New Syllabus) 16 FOR NOTES