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Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009

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 is not a fundamental part of a firm’s financial structure?<Answer
>  
(a)Ownership structure   
(b)Financial planning   
(c)Financial leverage   
(d)Executive compensation   
(e)Managerial hierarchy.   
  • Feasibility study takes into consideration
  1. Frequency of the decision.
  2. Suitability of the area in which decision is required.
  1. Comparison of costs and benefits.
  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (I) and (II) above
  • All (I), (II) and (III) above.

<Answer

> 

  • Which of the following statements is false with respect to quality costing?
  • Quality of design refers to variation in products that have the same functional use
    • Total Quality Control is often associated with Just-In-Time manufacturing
    • 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 firm in maintaining or improving product quality
    • Quality of conformance refers to the degree with which the final product fails to meet its specifications.

<Answer

> 

4. Which of the following is/are external factor(s) that lead to the bankruptcy of a firm?<Answer
 >  
  1. Shortage in supply of raw materials.
  1. Fraudulent practices by management.

III.   Labour unrest.

IV.   Technological obsolescence.

  • Disputes among promoters.
  • Only (I) above
  • Only (II) above
    • Both (I) and (II) above
    • Both (III) and (IV) above
    • Both (IV) and (V) above.
  • The failure of executive compensation plan is usually because of
  1. Correlation between the size of the company and its payment structure.
  2. Emphasis on short term performance of the company.

III.   More focus on the accounting measures while designing the compensation contracts.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (II) and (III) above
  • All (I), (II) and (III) above.

Page 1 of 18

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<Answer

> 

6. The earnings per share of a Zeta Ltd., is Rs.30 and the dividend payout ratio is 60%. If the share price of the<Answer
>  
company is Rs.56, according to the Graham and Dodd Model the multiplier applicable to the company is   
approximately   
  • 1
  • 2
    • 3
    • 4
    • 5.
  • Which of the following statements is/are false regarding Ratio Comparison Approach?
  1. It provides a popular way of valuing firms, projects or assets.
  2. This method is never used in real asset valuation.

III.   This approach uses ratio of price to earnings for valuation.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (I) and (II) above
  • Both (II) and (III) above.

<Answer

> 

8. The real option valuation approach of valuing a project shows that the value of revolving uncertainty depends<Answer
>  
on   
  1. Future decision involving exploration.
  1. Current value of 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.

9. As per Modigliani and Miller hypothesis value of levered firm is equal to value of unlevered firm. This<Answer
>  
implies   
  1. The cost of equity increases.
  1. Stock holder’s risk exposure increases.
  2. The weighted average cost of capital changes with leverage.

IV.  Leverage does not increase/decrease risk.

  • Only (I) above
  • Only (II) above
  • Both (I) and (II) above
  • Both (I) and (IV) above
  • Both (II) and (III) above.
10Which of the following statements is/are false regarding dividend decisions?<Answer
>  
.(a)Liquidity does not affect dividend decisions   
   
    
 (b)Firms resort to high payout if the profitable investments are lacking   
 (c)The cost of external financing influences dividend decisions   
 (d)Firms tend to have a high pay-out ratio if the shareholders have a strong preference towards current   
  dividends   
 (e)Restrictive covenants limit the flexibility of the company in determining its dividend policy.<Answer
11. All of the following models are used for predicting sickness of a firm except
>  
 (a)Beaver Model   
 (b)BCG Matrix   
 (c)Altman’s Z Score Model   
 (d)Argenti Score Board   
 (e)Wilcox Model.   

Page 2 of 18

13. The substantial loss in the market value of the firm’s equity can result in
  1. The institutionalization of knowledge created during the process of developing and installing a model

.  known as

  • Validation
    • Implementation
    • Construction
    • Documentation
    • Revision.

I.      Losing of professional analysts.

II.    Delisting of stocks.

III.   Decrease in normal bid ask spread.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (I) and (II) above
  • Both (II) and (III) above.
14 Which of the following statements is/are true with respect to Activity Based Costing (ABC)?
.ABC is based on historical costs.
I.
II.ABC does not highlight the causes of costs.
III.ABC divides cost into fixed and variable costs.
  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (I) and (II) above
  • Both (II) and (III) above.

15. As per Marshall and Bansal asset-liability management is an effort to manage/minimize exposure to

  1. Price risk.
  2. Interest rate risk.

III.   Exchange risk.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (II) and (III) above
  • All (I), (II) and (III) above.

<Answer is >

<Answer

> 

<Answer

> 

<Answer

> 

16 Electric Circuits Ltd. is an Indian firm, it imports electric parts from Japan. If the Yen is strengthening, Indian<Answer
>  
.firm is exposed to   
   
  • Translation risk
  • Transaction risk
  • Economic risk
  • Interest rate risk
  • Political risk.

17. Anti trust laws aim to

  1. Protect economic freedom and opportunity.
  2. Provide a better deal to customers by promoting competition in market place.

III.   Create a level playing field and encouraging new entrants into the industry.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (II) and (III) above
  • All (I), (II) and (III) above.

<Answer

> 

Page 3 of 18

The amount of 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.
22 According to Du-Pont equation for Return On Equity (ROE), other things remaining constant, which of the <Answer
> 
.  following statements is/are false?
(a)
An increase in the net profit 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.
Page 4 of 18
Annual interest rate on marketable securities
=  9%
Fixed conversion costs
= Rs.2,000
Estimated cash requirement over 6 months planning period
= Rs.5,00,000
21. The following data is available for Infodata Ltd.:
<Answer
> 
Debt-service coverage ratio of the company is
(a)
1.59
(b)
1.76
(c)
1.84
(d)
2.24
(e)
2.70.
19
<Answer There are two firms, Akash Ltd. and Prakash Ltd. They are similar in all respects except that Akash Ltd. is >
. unlevered, while Prakash Ltd. has Rs.5 crore of 11% debentures outstanding. Both companies have a net operating income of Rs.1 crore each. The tax rate applicable to both the companies is 35%. The discount rate for both the companies is 10% p.a. The value of 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.
20
<Answer The current ratio and quick ratio of Kendra Industries Ltd., are 1.2 and 0.8 respectively. The net working >
.  capital of the firm is Rs.6,00,000 with an inventory of
(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.
<Answer
> 

18. Consider the following data of M/s. Super Colors Ltd. for the year 2008 – 09:

Profit after taxRs.14.98 lakhs
Interest expensesRs..9.2 lakhs
Non cash chargesRs.6.5 lakhs
Repayment of term loanRs.7.5 lakhs
Effective tax rate26%


Page 5 of 18
(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.
I.
II.
III.
IV.
Minimize the probability of occurrence of an adverse event such as an accident. Cut the cost when an accident occurs.
Shift responsibility to other parties to the extent possible, when the event occurs. Obtain more information to make risk assessment methodology as robust as possible.
27. While managing environmental risks, risk managers perform which of the following tasks?
(a)
Only (I) above
(b)
Only (II) above
(c)
Only (III) above
(d)
Only (IV) above
(e)
All (I), (II), (III) and (IV) above.
26 According to which of the following models firm’s
.  symptoms based on numerical assessment of the firm?
(a)
Beaver Model
(b)
The Wilcox Model
(c)
Blum Marc’s Failing Company Model
(d)
Altman’s Z score Model
(e)
Argenti Score Board.
23 Metalic Steel earns 10% on the equity and the growth rate of dividends and earnings is 5%. The book value<Answer
>  
.  per share is Rs.80. If the market price of the shares of Metalic Steel is Rs.70, according to the Marakon 
   
Model, the cost of equity is approximately   
  • 9.67%
  • 10.71%
  • 12.45%
  • 13.78%
  • 14.67%.

24 Infrastructure Ltd., is considering following five projects:

.ProjectInitial investment (Rs.)NPV (Rs.)
 11000210
 260001560
 35000850
 42500500
 550095

The project that will be ranked first as per Profitability Index method is

  • Project 1
  • Project 2
  • Project 3
  • Project 4
  • Project 5.

25 Which of the following factors is/are not considered by Alcar Model?

.   I.      Operating profit margin.

  1. Incremental investment in working capital.

III.   Income tax rate.

IV.   Dividend growth rate.

<Answer

> 

<Answer

> 

weakness are classified as defects, mistakes and<Answer
 >  

<Answer

> 

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28Which of the following statements is/are false with respect to Bankruptcy Models?<Answer
>  
.I.According to Wilcox Model, the net liquidation value of the firm is the best indicator of the financial   
   
    
  health of the firm.   
 II.Blum Marc’s Model is based on liquidity ratios only.   

III.   According to the Beaver Model, the ratio of cash flow to total debt is the single best predictor of corporate failure.

  • Only (I) above
  • Only (II) above
  • Only (III) above
  • Both (I) and (III) above
  • All (I), (II) and (III) above.
29 An organization can achieve goal congruence by<Answer
>  
.Paying bonuses to managers.   
   
I.   
  1. Rewarding managers with shares.

III.   Monitoring managerial behavior.

  • Only (I) above
  • Only (II) above
  • Both (I) and (II) above
  • Both (II) and (III) above
  • All (I), (II) and (III) above.
30 Best Ltd. has net profit margin 8%, the assets to equity ratio 3 and total asset turnover 1.5, the return on<Answer
>  
.equity is   
   
 (a)12%   
 (b)24%   
 (c)36%   
 (d)48%   
 (e)60%.   

END OF SECTION A

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Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009

Section B : Problems/Caselet (50 Marks)

  • This section consists of questions with serial number 1 – 5.
  • Answer all questions.
  • Marks are indicated against each question.
  • Detailed workings/explanations should form part of your answer.
  • Do not spend more than 110 – 120 minutes on Section B.

1 Prakash Pvt. Ltd. manufactures toys for kids. The company intends to maintain the cash balance of

. Rs.5,000. The following additional information is available on the balances of various current assets and liabilities of the company.

ParticularsOpening balancesClosing balances
(Rs.)(Rs.)
 
Raw material3,450.004,100.00
Work-in-progress55.0072.50
Finished goods638.001,100.00
Account receivables756.001,165.00
Accounts payables2,500.007,500.00

<Answer

> 

Purchases basically consist of procuring raw materials for manufacturing of toys, and are generally bought on credit basis. The company incurs manufacturing expenses of Rs.1,140 in the process of manufacturing the toys. The depreciation expenses of 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 of Rs.35,000. During the year, the company pays Rs.1,000 to creditors and receives

Page 6 of 18

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Rs.53,801 from its debtors. Number of units produced is equal to the number of units sold. Market price of each toy is Rs.10. (Assume 360 days in a year).

You are required to:

  1. Calculate the weighted operating cycle of the company.
  1. marks

( 0   )

  • Determine the working capital requirement of the company based on the weighted operating cycle.

2 The following details at the end of the last one year of operations are available with regard to . Xenon Industries Ltd.:

 EBITRs.150 lakh
 Total debtRs.800 lakh
 Paid up equity share capitalRs.250 lakh
 Reserves and surplusRs.150 lakh
 Effective interest rate10%
 Effective tax rate36%
You are required to answer the following questions: 
  1. What was the return on equity of the company in the last year?
  • The company’s business is expected to grow in the current year and it plans to finance the increase in its business entirely by additional debt. It is assumed that the borrowing will be done at the beginning of 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 effective interest rate. The company is planning to increase the return on equity by 4.8 percentage points in the current year. If other factors remain constant then what should be the level of debt in the current financial year?
3 Duracell Ltd. is manufacturing a special type ofcable used by electricity undertaking. 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:

marks ( 2 )

<Answer

> 

marks ( 4 )

marks ( 6 )

<Answer

> 

PlansParticulars
  1. Issue of 20,000 equity shares at a premium of Rs.25 per share entirely.
  • Issue of equity shares at a premium of Rs.25 per share and 8% debentures in the ratio of 2:3 respectively.
  • 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%.

You are required to:

  1. Recommend which of the three financing plans company should implement and why?
  • Compute the indifference level of EBIT between plan (1) and plan (3) above.

marks

( 8 ) marks

( 2      )

Caselet

Read the caselet carefully and answer the following questions:

Page 7 of 18

4 What are the essential features which encompasses Enterprise-Wide Risk Management, that are set . discerned in practice?

5 What is Enterprise Risk Management? Under Enterprise Risk Management discuss the various . objectives and approaches of managing environmental issues.

Today financial services companies operate in increasingly complex, competitive and global

markets. The ability to manage risks across geographies, products, asset classes, customer

segments and functional departments is of paramount importance. The inability to manage these

risks  can  cause  irreparable  damage.  Convergence,  consolidation,  globalization  and  shifting

regulations have posed innumerable and hitherto unprecedented challenges for the financial

services industry. The objective is to give an overview of risk management in the financial services

industry. This defines the major risks from the perspective of financial services industry, which

covers the components of Enterprise wide risk management and the role of technology in risk

management. In general corporate government policies serve numerous objectives like reduction of

cost, motivation of employees, minimization of the possibilities of accidents etc.

An Enterprise-Wide Risk Management which is discerned in practice has various principal and

attributes that encompasses several features. The risk management framework in the enterprise

attempts risk awareness. The temptation to ignore risk that cannot be quantified is avoided. Thus

the risk culture incorporates the value which desires the factors for minimizing risks. The ubiquity

of risk management necessitates other features such as internal audit procedures and management

control systems and looking forward to desired freedom that gained enough paramount irrespective

of the entrepreneurial or conservative culture of the firm.

The last twenty years have been marked by substantial financial deregulation. Accompanying this

deregulation  has  been  a  plethora  of  methodologies  and  technologies  for  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 effective approaches to manage the regulations are

self-regulation and govt. regulation. An important Theory is Valdez Theory, which had to be

accepted by public companies before the group, allowed its funds to be invested in the companies

share. The Valdez Theory includes protection of the Biosphere, Reduction and disposal of waste,

Damage compensation, Disclosure, etc. Environmental management which is performed with a

principle of rational responsibility, a principle of 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 Transfer, Data and Technology resources and Risk Analytics. Risk

management is a continuously evolving mix of science and art. Losses are inevitable, but one must

keep learning from the past. Risk itself 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 of the world or its pockets. A clear distinction should be made

between risk management and risk taking. Risk management oversees and ensures the integrity of

the process with which risks are taken. To maintain the objectivity, risk management cannot be a

part of the risk taking process. Individuals who manage risk need to be completely independent

from individuals who are responsible for taking risk.

<Answer

marks > ( 9 )

<Answer

marks > ( 9 )

END OF CASELET

END OF SECTION B

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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.

Page 8 of 18

6.  One of the most important objectives for the management is creation of value <Answer> 
   
for the shareholders. Measurement of values created by companies is as   
diverse as the objectives themselves. Alcar Approach is a popular value   
measurement approach, which stresses upon the comparison of the pre-   
implementation and post-implementation firm values of various strategies   
before they are implemented. As per this approach, discuss various value   
drivers that affect the value of a firm.( 10 marks) 
      
7.  Emphasis of financial measures alone can result in the ignorance of physical <Answer> 
   
as well as the qualitative measure of performance, by the heads of the   
responsibility centers. Moreover, all the elements of 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-financial measures of   
performance.( 10 marks) 
      
        
  END OF SECTION C     
      
 END OF QUESTION PAPER    
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Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009

Section A : Basic Concepts

 AnswerReason 
1.EManagerial hierarchy is not a fundamental part of a firm’s financial structure.<TOP>
2.EFeasibility Study<TOP>

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 decision is required to be made, to be supported by a model

The possibility 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,

  • E Quality of design refers to variations in products that have the same functional use; and

Total quality control often associated with just-in-time manufacturing.

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 firm in maintaining or improving product quality;

Quality of conformance refers to the degree with which the the final product meets (not fail to meet) its specifications.

4.        A     Shortage in supply of raw materials is an external factor, others are internal factors.

<TOP>

<TOP>

Page 9 of 18

5.         E      The basic reasons for the failure of executive compensation plan are:                     < TOP >

  • Correlation between the size of the company and its payment structure. Because of the existence of the strong correlation between the size of the company based on its asset value and sales and payment structure, companies sometimes tend to strive for bigger size irrespective of the fact that it adds to the value of the concern
  • Emphasis on the short-term performance of the company. It has been frequently observed that the short-term performance indicators such as sales and growth in the earnings provide a greater weightage in incentive compensation that is paid to the executive.
  • More focus on accounting measures is given while designing the compensation contracts. Some of the measures are earnings and the return on investments.

6.         B      P = m(d + e/3)                                                                                                                         < TOP >

  • 56 = m(18 + 30/3)
  • m = 2
  • B A popular way of valuing firms, projects or assets is to compare them with other < TOP > traded firms, projects or assets. The ratio comparison approach provides a way by which such valuations can be accomplished. This is generally predominant in cases of

real asset valuations. The ratio comparison approach uses ratio of price to earnings for valuation.

8.EThe real option valuation approach of valuing a project shows that thevalue of < TOP >
  revolving uncertainty depends on the following factors:  
  •   Future decision involving exploration.  
  Current value of oil prices.  
  Uncertainty type.  
9.CVL = VU implies that an increase in the leverage has following effects: <TOP>
  
  •   The cost of equity increases.  

Stock holder’s risk exposure increases.

The weighted average cost of capital remains unchanged.

M & M do not ignore risk. On contrary, they recognize that leverage increases the stockholder’s risk and that of equity must increase to compensate for that additional risk.

  1. A Traditional theories have postulated that a dividend decision is solely a function of the < TOP > earnings of the firm. While earnings are an important determinant for the dividend decision, the role of liquidity cannot be ignored. Dividend pay-out entails cash out

flow for the firm. Hence the quantum of dividends proposed to be distributed depends critically on liquidity position of the firm. Normally firms tend to have low pay-out if the profitable investment opportunities exist and conversely tend to resort high pay-outs if the profitable investment opportunities are lacking. The cost of external financing has an influence on dividend policy. Firms tend to have a high pay-out ratio if the shareholders have a strong preference towards current dividends. Restrictive covenants limit the flexibility of the company in determining its dividend policy.

  1. B BCG matrix classifies the products into four broad categories. All others are the < TOP > models for predicting

sickness of a firm.

  1. D The institutionalization of knowledge created during the process of developing and < TOP > installing a model is known as documentation

Page 10 of 18

  1. 13.           D The substantial loss in the market value of firm’s equity can result in several liquidity < TOP > effects. They are summarized as :
  • The may go on losing out its professional analysts who play a vital role in supporting the flow of information about a stock.

This may result in normal trading activities of the stock and increase the normal bid ask spread.

The exchange may also delist its stocks based on its listing requirements.

  1. A One of the weakness of ABC is that it is based on historical cost. ABC highlights < TOP > cause of costs. ABC does not partition between fixed and variable costs.
  1. E According to Marshall and Bansal asset-liability management is an effort to < TOP > manage/minimize exposure to

I.   Price risk.

  1. Interest rate risk

III.  Exchange risk.

  1. B Electric Circuits Ltd. is an Indian firm; it imports electric parts from Japan. If the Yen < TOP > is strengthening, Indian firm is exposed to Transaction risk.
  1. E Anti-trust laws aim to protect economic freedom and opportunity and provide a better < TOP > deal to the customers by promoting competition in the market place. The basic premise of anti-trust laws is that increased completion leads to lower prices, better quality and more choice for customers. Anti-trust laws also aim at creating a level playing field and encouraging new entrants into industry.
18.C   Debt service coverage ratio  <TOP>
   PAT + Non-cash charges + Interest 
 = I + Re payment of TL
           
   14.98 + 6.5 + 9.2=30.68=1.84  
 =9.2 + 7.516.7  
      
19.D     O(1 − t)  <TOP>
        
 Value of Prakash Ltd.= k+ B × t
  1 × 0.65        
         
 = 0.10   + 0.35 × 5    
 =6.50 + 1.75       
 =Rs.8.25 crores      

20.                D Given CA/CL = 1.2 and (CA – Inventory)/CL = 0.8 < TOP > 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.

21.B2bT 2× 500000 × 2000 <TOP>
 C === 210818.5107  Rs.2.11Lakh
   
  1. 0.045

Page 11 of 18

22.       B      According to Du-Pont equation:                                                                                         < TOP >

Return On Equity (ROE) = Net Profit Margin x Average Asset Turnover x Equity Multiplier

1

Where, Equity Multiplier = 1 − Debt to assets ratio .

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 profit 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.

23.       B       B(r − g)                                                                                                                               < TOP >

K − g

 80(0.1− 0.05)
  
70  =( 0.01x − 0.05)
 

=   0.7 x – 3.5 = 4

  • =   10.71%.
24.B      
   Cash inflows  
   Initial investmentNPV(PV)  
  Project(Rs.)(Rs.)(Rs.)PIRank
  (1)(2)(3)(4) = (2)+(3)(5) = (4)/(2)
  1100021012101.21II
  26000156075601.26I
  3500085058501.17V
  4250050030001.20III
  5500955951.19IV
  • D According to the Alcar model, there are seven value drivers that affect a firm’s value. These are:


<TOP>

<TOP>

  • The rate of growth of sales. Operating profit margin. Income tax rate.

Incremental investment in working capital. Incremental investment in fixed assets. Value growth duration.

Cost of capital

  • E Argenti Score Card is classified in three weakness namely defects, mistakes and < TOP > symptoms.
  • E All the four tasks have to be performed by the risk managers while managing < TOP > environmental risks.

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  • 28.           B The Wilcox model considers the net liquidation value of the firm as the best indicator < TOP > of a firm’s financial health. Blum Marc’s failing company model is based on a set of

12 ratios divided into liquidity, profitability and variability ratios. The Beaver model identifies the cash flow to total debt as the single best indicator of a firm’s financial health.

  • E Goal congruence can be achieved by paying bonuses, incentives, rewarding managers < TOP > with shares etc. as these measures may motivate the managers to take the decisions which are consistent with the objectives of shareholders. Alternative measures like the management audit to monitor the behavior of the mangers can also help in establishment of goal congruence.
30.C  Net profit×Sales×Total assets <TOP>
    
 ROE= SalesTotal assetsEquity  
         
  =0.08 × 1.5 × 3    
  =0.36 i.e. 36%.    

Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009

Section B : Problems

1. a.   Raw material purchased  = Closing balance of accountspayable + Payments made to < TOP
creditors – Opening balance of accounts payable >  
     

= 7,500 + 1,000 – 2,500 = Rs.6,000

Consumption of raw material = Opening balance of raw material + purchases of raw material – Closing balance of Raw material

  • 3,450 + 6,000 – 4,100 = Rs.5,350. Consumption of raw material per day = 5,350 / 360 = Rs.14.86

3, 450 + 4,100

Average raw material inventory =2= Rs.3,775

Raw material storage period = 3,775 / 14.86 = 254.04 days.

55 + 72.50

Average W-I-P inventory =2= Rs.63.75

Cost of process = Opening WIP + Raw material consumed + Manufacturing expenses + Depreciation – Closing WIP

  • 55 + 5,350 + 1,140 + 245 – 72.50
  • Rs.6,717.50
  6, 717.50    
         
Cost of process per day =360 = Rs.18.66 
63.75     
     
WIP inventory period = 18.66 = 3.42 days 
      638 + 1,100 
    
Average Finished goods inventory =2= Rs.869
Cost of goods sold  =Opening FG inventory + Cost of 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 of goods sold per day = 45,805.50 / 360 = Rs.127.24

869

Finished Goods storage period = 127.24 = 6.83 days

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    Opening balance of debtors + Clo sin g balance of debtors
      
Average debtors= 2 
    756 + 1,165  
      
   =2= Rs.960.5
Sales= Closing balance of debtors + Cash received from debtors – Opening balance of
 debtors    
 = 1,165 + 53,801 – 756 = Rs.54,210
 54,210    
     
Daily sales =  360= Rs.150.58  

960.5

Average collection period = 150.58 = 6.38 days

Average Accounts payable

=

Opening balance of acounts payables + Clo sin g balance of accounts payables

2

 2,500 + 7,500  
     
=2 = Rs.5,000
  6,000 
    
Average purchases per day = 360  = Rs.16.67

5,000

Average payment period = 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 Cost of goods sold per day
Weight to Finished Goods = Sales per day   
       
Weight to finished goods = Rs.127.24/ Rs.150.58 = 0.845
  Sales per day  Rs.150.58
Weight to Accounts receivables = Sales per day =   
 Rs.150.58  = 1
 Purchases per day   
     
Weight to Accounts Payables = Sales per day= Rs.14.86/Rs.150.58 = 0.099

Duration of weighted operating cycle = (Dr x Wr) + (Dw x Ww) + (Df x Wf) + (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
  • 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

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2.    D
 ROI + (ROI – Kd )  
 
a.   ROE =  E  ( 1– t)
  EBIT  150 
ROI = Total assets1=  (800 + 250 + 150) = 0.125 i.e., 12.5%
Kd= 10% (given)     
t= 36% (given)     
  • TOP

> 

  • 800
  • =  (250+150) = 2
  • ROE = [ 0.125 + (0.125 – 0.10) × 2] (1–0.36) = 0.112 i.e., 11.2%

Total asset       =      Total debt + Net worth

  • Total debt + (Paid up equity capital + Retained earnings)
  • Targeted ROE = 11.2 + 4.8 = 16%

Let the required amount of additional debt be D :

  • Total debt = 800 + D

Equity  = 250 + 150 = 400

      (800 + D)
  0.125 + (0.125 – 0.10)   
  400
∴ 0.16 =   (1 – 0.36)
     0.025 (800 + D) 
or 0.25 = 0.125 +400   
 0.125= 800+D    
or  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.
  • a.   An  alternative  which  would  ensure  the  highest  market  price  per  share  should  be < TOP

recommended. Estimated earnings per share (EPS) and market price per share (MPS) under > the various financing plans are as follows:

ParticularsAtPlan (1)
Present
  
   
Earnings before interest and tax  
(EBIT)6,00,0009,00,000
at the rate of 12% on Rs.75 lakh  
(Rs.)  
Less: Interest – Old56,00056,000
Interest- New––
   
Profit before tax (PBT)5,44,0008,44,000
Less: Tax @ 33%1,79,5202,78,520
   
Profit after tax (PAT)3,64,4805,65,480
Less: Preference dividend –1,08,0001,08,000
Old (Rs.)  
   
Profit for equity shares2,56,4804,57,480
No. of equity shares20,00040,000
EPS12.8211.44
P.E. Ratio–21.4
Market price per share (EPS ×–244.82
   

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Plan (2)Plan (3)
  
9,00,0009,00,000
56,00056,000
1,20,0002,00,000
  
7,24,0006,44,000
2,38,9202,12,520
  
4,85,0804,31,480
1,08,0001,08,000
  
3,77,0803,23,480
28,00020,000
13.4716.17
17.015.7
229.00253.87
  

P.E. Ratio)

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 company’s 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.

  • 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.

  • An enterprise-wide risk management culture encompasses several features, some of the principal < TOP

attributes of which, as discerned in practice, are indicated here:                                                        >

  • An awareness of risk pervades the enterprise. Performance measurement and pricing are risk adjusted. The priorities of risk management are reflected in the compensation schemes thereby encouraging risk-taking behavior that is aligned with the capacity to bear risk. The analysts and the stakeholders obtain a more complete understanding of the risks undertaken with the help of risk-adjusted forecasts and returns.

Risks are identified, reported and quantified to the greatest possible extent. This means setting up extensive historical risk and loss databases, and identifying risks precisely. Some risks can be quantified while some risks elude quantification. Nevertheless, both quantifiable and unquantifiable is avoided. The risk charter of the United Bank of Switzerland typically lists reputation protection or reputation risk, generally avoided in reporting, as one of its five risk factors.

The risk culture is defined and enshrined within the organization. The risk appetite of the enterprise is clearly understood in all its spheres. Risk management is aligned with that culture to give managers and employees the desired freedom for taking the right course of action irrespective of the entrepreneurial or conservative culture of the film.

The firm does not venture into those products and/or businesses that are not comprehended by the enterprise with regard to commercial feasibility. To know enough so as to understand the adversities involved with reasonable levels of estimation is proper risk management. A product/business that delivers excellent profits, is nevertheless found by the management to have inherent risks beyond the accepted level of complexity and is kept aside. Not to do what is not understood is the general prescription.

  • ERM is the discipline by which an organization in any industry assesses, control, exploits, < TOP

finances and monitor risks from all sources for the purpose of increasing the organization’s short > and long-term value to its shareholders.

The corporate environmental policies serve the following objectives:

  • Reduction of costs through measures such as recycling or energy conservation. Improvement of the company’s reputation.

Motivation of employees by providing a better environment.

Improvement of relationships with regulatory authorities in general and the government in particular.

Minimizing the possibility of accidents.

Conforming to a code of ethics

The following are the different approaches for managing environmental issues:

Page 16 of 18

  • •      First approach is a strong commitment to environment friendly processes or products through heavy investments.

Firm can influence environmental regulations invest in environment protection and force other firms to make similar investments.

The firm may be able to invest in environmental performance improvement, without any reduction in profits.

Combination of product differentiation, competition management and cost saving to change the basis for competition and redefine the market so that both the firm and the environment can benefit.

The last approach is on risk manage perspective, calling for a systematic method to deal with risks such as accidents and activist attacks.

Section C: Applied Theory

  • The Alcar model uses the discounted cash flow analysis to identify value-adding strategies. < TOP > According to this model, there are seven ‘value drivers’ that affect a firm’s value. These are

•   The rate of growth of sales

Operating profit margin

Income tax rate

Incremental investment in working capital

Incremental investment in fixed assets

Value growth duration

Cost of capital.

Value growth duration refers to the time period for which a strategy is expected to result in a higher than normal growth rate for the firm. The first six factors affect the value of the strategy for the firm by determining the cash flows generated by a strategy. The last term, i.e. the cost of capital affects the value of the strategy by determining the present value of these cash flows. The following figure represents the Alcar approach.

According to the model, a strategy should be implemented if it generates additional value for a firm. For ascertaining the value generating capability of a strategy, the value of the firm’s equity without the strategy is compared to the value of the firm’s equity if the strategy is implemented. The strategy is implemented if the latter is higher than the former. The following steps are undertaken for making the comparison.

Calculate the value of the firm’s equity without the strategy: The present value of the expected cash flows of the firm is calculated using the cost of capital. The cash flows should take the firm’s normal growth rate and its effect on operating flows and additional investment in fixed assets and working capital into consideration. The cost of capital would be the weighted average cost of the various sources of finance, with their market values as the weights. The value of the equity is arrived at by deducting the market value of the firm’s debt from this present value.

Calculate the value of the firm if the strategy is implemented: The firm’s cash flows are calculated over the value growth duration, taking into consideration the growth rate generated by the strategy and the required additional investments in fixed assets and current assets. These cash flows are discounted using the post-strategy cost of capital. The post-strategy cost of capital may be different from the pre-strategy cost of capital due to the financing pattern of the additional funds requirement, or due to a higher cost of raising finance. The PV of the residual value of the strategy is added to the present value of these cash flows to arrive at the

Page 17 of 18

value of the firm. The residual value is the value of the steady perpetual cash flows generated by the strategy, as at the end of the value growth duration. The value of the post-strategy market value of debt is then deducted from the value of the firm to arrive at the post-strategy value of equity.

The value of the strategy is given by the difference between the post-strategy value of the firm’s equity and the pre-strategy value of the firm’s equity. A strategy should be accepted if it generates a positive value.

7.    A brief description of some non-financial measures of performance is presented below.    < TOP >

  1. Employee Productivity: This can be measured by calculating output obtained per employee or sales affected per employee or the value added per employee. In addition to the measurement of employee productivity it is possible to measure the output per unit of the inputs consumed i.e. a measure of overall productivity.
  • Marketing Effectiveness: This would measure the success of the marketing efforts put in by the divisions. For this purpose, a report on market position must be obtained from the divisional managers. The market position is represented by the percentage of sales to total sales in the market and also by the ability of the division to meet the outside competition successfully. An appraisal has to be made of each of the major products handled by the division including an analysis of the product market leadership, superior or inferior of features in the own product compared with outsider’s product.
  • Employee Morale and Attitude: This is a vital aspect of performance. The divisional managers sometimes ignore the impact of their decisions on employees in an attempt to maximize production and profitability. It is, therefore, necessary to evaluate whether during the last one-year employee morale has decreased or increased. Absolute precision in measurement of this element of performance is seldom possible and if attempted, could be a time consuming process. Hence, a judgment made by a team of executives after a thread-bare discussion may be sufficient for this purpose.
  • Social Responsibility: Contribution of social responsibility can also be considered as one of the measures of performance. The managers can sometimes deliberately ignore this aspect of performance in their bid to show a high amount of profit or return on capital employed.
  • Qualitative Aspects of Performance: The qualitative aspects must also figure in the list of performance measures. These include – the number of complaints received from customers, the errors and frauds, timely submission of daily, weekly and monthly reports to higher authorities, regularity of attendance in meetings, etc.
  • Management practices: Adherence to better corporate governance eg. Transparency in the operations, investment handling of investors, client’s grievances dealing with creditors, debtors and development of human resources etc. all reflect the type of management practices being followed.

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