Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Paper-12: FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Time Allowed: 3 Hours Full Marks: 100

The figures in the margin on the right side indicate full marks.
Answer Question No. 1 from Part A which is compulsory and any five questions from Part B.
Working notes should form a part of the answer
“Wherever necessary, suitable assumptions should be made and indicated in answers by the
candidates”

PART A (25 Marks)

Question.1

(a) In each, of the cases given below, one out of four answers is correct. Indicate the correct
answer(=1mark)and give workings/reasons briefly in support of your answer (=1mark)
[2x9=18]

(i) Optimistic Ltd has an EPS of `90 per share. Its Dividend Payout Ratio is 40%. Its
earnings and dividends are expected to grow at 5% per annum. Find out the cost of
Equity Capital if its Market Price is `360 per share.
A. 5%
B. 10.5%
C. 15%
D. 15.5%

(ii) X owns a stock portfolio equally invested in a risk free asset and two stocks. If one of
the stocks has a beta of 0.8 and the portfolio is as risky as the market what must be
the beta of the other stocks in the portfolio?
A. 2.1
B. 2.2
C. 2.4
D. 2.6

(iii) An American company‟s Japanese subsidiary, Tahoma Japan, has exposed assets of
¥8 billion and exposed liabilities of ¥6 billion. During the year, the yen appreciates
from ¥125/$ to ¥95/$.What is Tahoma Japan‟s net translation exposure at the
beginning of the year in dollars?
A. $16 million
B. $18 million
C. $14 million
D. $12 million

(iv) The NAV of each unit of a closed-end fund at the beginning of the year was `18.By the end
of the year its NAV equals `18.50. At the beginning of the year each unit was selling at a 2%
premium to NAV and by the end of the year each unit is selling at a 4% discount to NAV. If
the closed-end fund paid year end distribution of income of `2.50 on each unit, the rate of
return to the investor in the fund during the year would be
A. 10.35%
B. 11.51%
C. 11.95%
D. None of the above

(v) The share price of Kaustav Ltd. (F.V. `10) quotes `500 in the NSE and the 3 months future
price quotes at `525. The borrowing rate is 12% p.a.if the expected annual dividend yield is
15% payable before expiry, then the price of 3 months Kaustav Ltd‟s future would be

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

A. `500.00
B. `513.50
C. `516.50
D. Insufficient information

(vi) T Ltd. requires `3 million in cash for meeting its transaction needs over the next 6 months, its
planning horizon for liquidity decision. The company currently has the amount in the form of
marketable securities. The cash payment will be made evenly over the six month period. T
Ltd. earns 12% annual yield on its marketable securities. Conversion and marketable
securities into cash entails a fixed cost of `1000 per transaction. What will be the optimal
conversion size as per Baumol model of cash management?
A. `3,15,628
B. `3,16,228
C. `3,17,678
D. `3,18,428

(vii) The total asset – turnover ratio and total asset to net- worth ratio of a company are 2.20 and
2.60 respectively. If the net profit margin of the company is 6%, what would be the return on
equity?
A. 32.32%
B. 34.32%
C. 35.60%
D. 36.60%

(viii) The price of Swedish krones is $0.14 today. If it appreciates by 10% today, how many
krones a dollar will buy tomorrow?
A. 6.49351
B. 4.69351
C. 3.49513
D. 5.64913

(ix) Samudra Steel earns 12% on the equity. The growth rate of the dividends and earnings
is 6%. The book value per share is `60. If the cost of equity is 14% which of the
following is the market price of the share of company, accounting to the Marakon
Model of Valuation?
A. `36
B. `39
C. `45
D. `48

(b) State if each of the following sentences is true or false: [1 × 7]

(i) The amount of cheques issued by a company not yet paid out is referred to as net float.
(ii) Global Depository Receipts are issued to investors in India, who want to subscribe to shares
of foreign companies.
(iii) IRR and NPV always give the same profitability ranking.
(iv) Retention Ratio is the product between growth rate and rate of return on investments.
(v) If Profitability Index is 1, cash inflow and cash outflow would be equal.
(vi) A currency swap converts a stream of cash flow from one currency to another without
exchange rate risk.
(vii) A call option is „in-the-money‟ when the price of the underlying asset is below the exercise
price of the call.

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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Answer: 1

(a) (i) C
Dividend per share
Ke   g(growth rate)
Market price per share
`90 x 40%
  5%
` 360

= 10% +5% =15%.

(ii) B
Beta of market = βm = βp=1
βp = 1/3(0.8) +1/3(x) + 1/3(0) =1
Solving, we get beta of other stock = 2.2.

(iii) A
Tahoma Japan has net translation exposure of ¥2 (¥8 - ¥6). Converted into
dollars, this figure yields translation exposure of $16 million (2 billion/125).

(iv) A
The price of unit at the beginning of the year
`18 × 1.02 =`18.36.
The price of unit at the end of the year
`18.50 × (1-.04)= `17.76
The price of the fund fell by (`17.76 -`18.36) = -0.60
Rate of return = (2.50 – 0.60)/18.36 =10.35%

(v) B
Future Price = Spot Price + Cost of Carry - Dividend
=500 +[500 × (0.12 × 3)/12]-10 × 0.15
= 500 +15 – 1.50 = `513.50

(vi) B
As per Baumol model of cash management,
2FT
The optimum conversion size = , where
I
F = fixed cost of transaction = `1000
T = total cash required = `30,00,000
I = interest rate for the required period = 12% × 6/12=6%
2 x 1000 x 3000000
Optimal Conversion size = = `316228
6%

(vii) B
Profitafter Tax  Sales TotalAssets 
Return on Equity (ROE) = × × 
Sales  TotalAssets NetWorth 
= 0.06 × 2.20 ×2.60
= 0.3432
= 34.32%

(viii) A
Swedish Krones = $0.140
Add: Appreciation by 10% = [$0.140 × 10%] = $0.014

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Total = ($0.140 +$0.014)= $0.154

Krones a dollar will buy tomorrow = 1/0.154 =6.49351

(ix) C
As per Marakon Model of valuation,
B(r - g)
Formulae for computation of Market price =
k-g
Where, r = return on equity = 12%
g= growth rate of dividend=6%
k = cost of equity = 14%
Book Value = `60
60(12 - 6)
Market Value = = `45
14  6

(b) (i) False. Net float is the total amount of float in a bank account. It is calculated by
subtracting the disbursement float money spent but not yet taken out of the
account from the collection float money deposited but not yet cleared.
(ii) False. Global Depository Receipts financial instruments used by private markets to
raise capital denominated in either U.S. dollars or euros.
(iii) False. Using of IRR and NPV methods will not result in same profitability rankings. When
evaluating mutually exclusive projects, the one with the highest IRR may not be
the one with best NPV.
(iv) False. Under Gordon’s model, the growth rate is determined by the product of
retention ratio and rate of return on investment.
(v) True. If Profitability Index is 1, cash inflow and cash outflow would be equal. As PI= PV
of cash inflow/PV of cash Outflow. If PI is 1, then cash inflow and cash outflow
would be equal.
(vi) True. A currency swap converts a stream of cash flow from one currency to another
without exchange rate risk.
(vii) False. Call option is in –the-money when the price of the underlying asset is above the
striking price of the call.

PART B (75 MARKS)

Question. 2

(a) The annual turnover of S Ltd. is `60 lakhs of which 80% is on credit. Debtors are allowed
one month to clear off the dues. A factor is willing to advance 90% of the bills raised on
credit for a fee of 2% a month plus a commission of 4% on the total amount of debts.S Ltd.
as a result of this arrangement is likely to save `21600 annually in management costs and
avoid bad debts at 1% on the credit sales.
A scheduled bank has come forward to make an advance equal to 90% of the debts at
an interest rate of 18% p.a. However its processing fee will be at 2% on the debts. Would
you accept factoring offer or the offer from the bank? [10]

(b) Discuss Stochastic Model of Cash Management. [5]

Answer:

(a) We calculate in two ways, one using annual turnover and other using monthly turnover.

Note: Fee is charged on amount financed by factor, commission is charged on entire

debts managed.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Cost of Factoring Using Monthly figures Using Annual figures

Fee of 2% on amount financed [Credit =0.02 x 0.9 x `4,00,000 =0.02 x 0.9 x `48,00,000
Sales = 80% of turnover i.e. `48lakhs] = `7200 = `86,400
Commission at 4% = 0.04 x `4,00,000 = 0.04 x `48,00,000
= `16,000 = `1,92,000
Less: Savings in costs
Savings in management cost = `21,600/12= `1,800 = `21,600
1% saving of bad debts = 0.01 x `4,00,000 =0.01 x `48,00,000
= `4,000 = `48,000
Net cost in factoring `17,400 `2,08,800

Cost of Bank Advance: Using Monthly figures Using Annual figures

Interest at 18% p.a. =(0.18 x 0.9x`4,00,000)/12 =0.18 x 0.09 x `48,00,000
= `5,400 = `64,800
Processing Fee 2% =0.02 x `4,00,000 =0.02 x `48,00,000
= `8,000 = `96,000
Add: Bad debts loss that cannot be =0.01 x `4,00,000 =0.01 x `48,00,000
avoided = `4,000 = `48,000
Net cost in Bank Advance `17,400 `2,08,800
Since costs of both alternatives are equal, it is immaterial whether S Ltd. goes in for
factoring or bank loan.

(b) This model is developed to avoid the problems associated with EOQ mode. Model
developed by Miller and Orr. The basic assumption of this model is that cash balances
are irregular. The model prescribed two control limits.

Upper Control Limits (UCL) – When cash balance reaches the upper limits, a transfer of
cash to investment account should be made.

Lower Control Limits (LCL)- When cash balance reaches the lower point, a portion of
securities from investment account should be liquidated to return the cash balances to its
return point.

The Miller and Orr model is the simplest model to determine the optimal behavior in
irregular cash flow situation. The model is a control limit model to determine the time and
size of transfers between an investment account and cash account. The optimal point
(O) of cash balance is determined by
3TV
O= 3
4I

Where O-target (Optimal) cash balance; T-Fixed cost associated with security
transactions; I-Interest per day on marketable securities; V-Variance of daily net cash
flows.

Question. 3

A company has an old machine having book value zero – which can be sold for `50,000.The
company is thinking to choose one from following two alternatives:
(i) To incur additional cost of `10,00,000 to upgrade the old existing machine.
(ii) To replace old machine with a new machine costing `20,00,000 plus installation cost
`50,000.

Both above proposals envisage useful life to be 5 years with salvage value to be nil.
The expected after tax profits for the above alternatives are as under:

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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Year Old Existing Machine Upgraded Machine New Machine

` ` `
1 5,00,000 5,50,000 6,00,000
2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000
The tax rate is 40%. The company follows straight line method of depreciation. Assume cost of
capital to be 15%.PVF of 15% for 5 years= 0.870, 0.756, 0.658, 0.572 and 0.497. You are
required to advise the company as to which alternative is to be adopted. [15]

Answer:

We have three possibilities coming out of this analysis. They are:

(i) Retain the existing machine
(ii) Upgrade the existing machine
(iii) Replace the old with a new machine

However, the problem demands that we evaluate only the second and third option.
Therefore we would adopt the incremental approach of the second and the third option
over the first option. In case the NPV of this incremental approach of both options turn
negative, we would reject both and accept the first option, else choose a better option.

Cash Outflow
(i) In case machine is upgraded:
Up gradation cost = `10,00,000.
(ii) In case new machine installed:
Cost `20,00,000
Add: Installation Cost `50,000
Total Cost `20,50,000
Less: Disposal of old machine
(`50,000 – 40% tax) `30,000
Total Cash Outflow `20,20,000

Working Note:
(i) Depreciation in case machine is upgraded `10,00,000/5 = `2,00,000
(ii) Depreciation in case new machine is installed `20,50,000/5 = `4,10,000
(iii) Old existing machine- book value is zero, hence no depreciation.

Incremental Cash Inflows after taxes (CFAT) of upgraded over Old

1 2 3 4 5 6
Old Machine Upgraded machine
Year PAT/CFAT PAT Depreciation CFAT Incremental CFAT (5-2)
1 5,00,000 5,50,000 2,00,000 7,50,000 2,50,000
2 5,40,000 5,90,000 2,00,000 7,90,000 2,50,000
3 5,80,000 6,10,000 2,00,000 8,10,000 2,30,000
4 6,20,000 6,50,000 2,00,000 8,50,000 2,30,000
5 6,60,000 7,00,000 2,00,000 9,00,000 2,40,000
Total 29,00,000

Incremental Cash Inflows after taxes (CFAT) of New over Old

1 2 3 4 5 6
Old Machine New machine
Year PAT/CFAT PAT Depreciation CFAT Incremental CFAT (5-2)
1 5,00,000 6,00,000 4,10,000 10,10,000 5,10,000

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2 5,40,000 6,40,000 4,10,000 10,50,000 5,10,000

3 5,80,000 6,90,000 4,10,000 11,00,000 5,20,000
4 6,20,000 7,40,000 4,10,000 11,50,000 5,30,000
5 6,60,000 8,00,000 4,10,000 12,10,000 5,50,000
Total 29,00,000

Calculation of NPV of both options

Upgraded Machine New Machine
Year Incremental CFAT PVF Total PV Incremental CFAT PVF Total PV
1 2,50,000 0.870 2,17,500 5,10,000 0.870 4,43,700
2 2,50,000 0.756 1,89,000 5,10,000 0.756 3,85,560
3 2,30,000 0.658 1,51,340 5,20,000 0.658 3,42,160
4 2,30,000 0.572 1,31,560 5,30,000 0.572 3,03,160
5 2,40,000 0.497 1,19,280 5,50,000 0.497 2,73,350
Total PV of CFAT 8,08,680 1,747,930
Less: Cash Outflows 10,00,000 20,20,000
NPV -1,91,320 -2,72,070

As the NPV in both the new (alternative) proposals is negative, the company should continue
with the existing old machine.

Question. 4

(a) Consider the following information for Target Ltd.

EBIT `1120 Lakhs
PBT `320 Lakhs
Fixed Cost `700 Lakhs
Calculate the percentage of change in earnings per share, if sales increased by 5%. [5]
(b) A company plans to manufacture and sell 400 units of a domestic appliance per month
at a price of `600 each. The ratio of cost to selling price are as follows:
Raw materials 30%
Packing materials 10%
Direct labour 15%
Direct expense 5%

Fixed overheads are estimated at `4,32,000 per annum.

The following norms are maintained for inventory management:
Raw materials 30 days
Packing materials 15 days
Finished goods 200 units
Work-in-progress 7 days

Other particulars are given below:

(a) Credit sales represent 80% of total sales and the dealer enjoy 30 working days credit.
Balance 20% are cash sales.
(b) Creditors allow 21 working days credit for payment.
(c) Lag in payment of overheads and expenses is 15 working days.
(d) Cash requirements to be 12% of net working capital.
(e) Working days in a year are taken as 300 for budgeting purpose.
Prepare a working capital requirement forecast for the budget year. [10]

Answer:

(a) Contribution = EBIT + Fixed Cost = `(1120 +700) lakhs = `1820 Lakhs
Operating Leverage = Contribution/EBIT = 1820/1120 = 1.625

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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Financial Leverage = EBIT/EBT = 1120/320 = 3.5

Combined Leverage = Operating Leverage × Financial Leverage
= 1.625 × 3.5 = 5.687
Calculation % change in EPS, if sales increased by 5%
% change in EPS
Combined Leverage =
% change in sales
% change in EPS
5.687 =
5
% change in EPS = 5.687 × 5 = 28.44%

(b)
Selling Price and Cost per unit (`)
Raw materials (`600 × 30/100) 180
Packing materials (`600 × 10/100) 60
Direct labour (`600 × 15/100) 90
Direct expenses (`600 × 5/100) 30
Fixed overheads [`4,32,000/(400 ×12) 90
Total Cost 450
Profit 150
Selling price per unit 600

Forecast of Working Capital Requirement

Current Assets: (`)
Raw materials stock ( 4,800 ×`180 × 30/300) 86,400
Packing material stock (4,800 × `60 × 15/300) 14,400
Work-in-progress (4,800 × `285 × 7/300) 31,920
Finished goods stock (200 × `450) 90,000
Debtors (4,800 × 80/100 ×`600 2,30,400
×30/300)
Total (A) 4,53,120
Current Liabilities:
Creditors for raw material suppliers (4,800 × `180 × 21/300) 60,480
Creditors for packing material (4,800 × `60 × 21/300) 20,160
Creditors for expenses and overheads (4,800 × `120 × 15/300) 28,800
Total (B) 109440
Net Working Capital (A-B) 3,43,680
Add: Cash required(12% of net 41,242
working capital)
Total Working Capital required 3,84,922

Question. 5

(a) How is Economic Value Added (EVA) different from Market Value Added (MVA)? [5]
(b) The capital structure of Assembly Traders Ltd. as on 31.03.2014 is as follows:
(` in crores)
Equity capital(100 lakhs equity shares of `10 each) 10
Reserves 2
14% Debentures of `100 each 3
For the year ended 31.03.2014 the company has paid equity dividend at 20%. As the
company is a market leader with good future, dividend is likely to grow by 5% every
year. The equity shares are now treated at `80 per share in the stock exchange. Income –
tax rate applicable to the company is 50%.
Required:
(I) The current weighted cost of capital.
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

(II) The company has plans to raise a further `5 crores by way of long term loan at 16%
interest. When this takes place the market value of the equity shares is expected to
fall to `50 per share. What will be the new weighted average cost of capital of the
company? [10]

Answer:

(a) MVA is the excess of market value of the firm as reflected in share price and the value of
the debt, over the book value of the capital employed. This book value of the capital
employed includes the value of reserves and surplus. The MVA is considered a better
measure of corporate performance than the market capitalization.
Mathematically, MVA = Market value of the firm – Capital Employed
EVA can be defined from two perspectives – (a) Accounting and (b) Finance
From the accounting perspective, EVA is defined as the difference between the firm’s
net operating profits after tax (NOPAT) and its weighted average rupee cost of capital
Since EVA fully accounts for the firm’s overall capital costs, it differs from the traditional
metrics of financial performance such as EBIT, EBITDA, EAT etc.
Mathematically, EVA = NOPAT – Capital Cost
= NOPAT – (WACC X Capital Employed)
= (r x Capital Employed – c x Capital Employed)
Thus, EVA = (r-c) x Capital Employed

(b)
(I) Current Weighted Average Cost of Capital

(i) Cost of Debt Capital

Kd = I (1-t) = 14% (1 – 0.5) = 7%

(ii) Cost of Equity Capital applying Dividend Growth Model

D 2
Ke = 1 + g = + 0.05 = 0.075 or 7.5%
Po 80

(iii) Weighted Average Cost of Capital (WACC)

Particulars ` Crores Weight Cost of funds %
Shareholder’s Funds
Equity capital 10
Reserves 2 12 0.80 7.5
Debentures (debt) 3 0.20 7.0
Total 15 1.00

WACC = (Cost of Equity x % of Equity) + (Cost of Debt x % of Debt)

= (7.5 x 0.80) + (7 x 0.20)
= 6 + 1.4

(II) Weighted Average Cost of Capital After Rising Further Debt of ` 5 crores
Cost of Existing Debt of ` 3 crores = 7%
Cost of New Debt of ` 5 crores = 16% (1 – 0.5) = 8%
2
Cost of Equity = + 0.05 = 0.09 = 9%
50

New Capital Structure

Particulars Amount (` Crores) Weight Cost of funds %

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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Shareholders Funds 12 0.60 9

Debentures 3 0.15 7
Long-term loan 5 0.25 8
20 1.00
New WACC = (9 x 0.60) + (7 x 0.15) + (8 x 0.25) = 5.4 + 1.05 + 2 = 8.45%

Question. 6

(a) The finance director of Patni Ltd. has been studying exchange rates and interest rates
relevant in India and USA. Patni Ltd. has purchased goods from the US Co. at a cost of $
51 lakhs payable in $ in 3 months time. In order to maintain profit margins the finance
director wishes to adopt, if possible a risk free strategy that will ensure that the cost of
goods to Patni Ltd. is no more than `22crores.
`/$ (Spot) 40/42
`/ $ (1 month forward) 41/43
`/$ (3 months forward) 42/45
Interest rates available to Patni Ltd.

India (Rates in %) USA (Rates in %)

Deposit Borrowing Deposit Borrowing
1 month 13.00 15.00 7.00 10.00
3 month 13.00 16.00 8.00 11.00
Calculate whether it is possible for Patni Ltd. to achieve a cost directly associated with
transaction no more than `22 crores, by means of a forward market hedge or money
market hedge. Transaction costs may be ignored. [9]

(b) The annual interest rate is 5% in the United States and 8% in the UK. The spot exchange rate is
£/$ -1.50 and forward exchange rate, with one year maturity, is £/$ =1.48. In view of the fact
that the arbitrager can borrow $ 100000 at current spot rate, what would be the arbitrageur
profit/loss? [6]

Answer:

(a) Option I -Forward Cover

Patni Ltd. to pay $51 lakhs in 3 months time. Thus the company would hedge forward 3
months. Since they need $, the rate applicable will be `45/$. Thus their outgo would be
`51lakhs × 45 = Total Payment = `22.95 crores.
Option II-Money Market Hedge
$ is payable by Patni after 3 months. Patni would first borrow rupees @16%, convert to $ in
spot, deposit the same @ 8% and use the maturity dollar amount to pay the purchase
cost of goods. Since it needs $51 lakhs after 3 months, the amount deposited + interest
should equal $51 lakhs. Therefore it would deposit:
5100000
= = 50 lakhs.
0.08
1
4
Now to get $50 lakhs from rupee proceeds, it would borrow 50 lakhs × 42 (spot rate
applicable to purchase $) = `21 crores.
Therefore Patni would borrow `21 crores.
Total commitment for Patni = `21 crores + Interest @ 16% for 3 month
Total payment = `21.84 crores.
Since amount under option II is lower & less than `22 crores, it is advisable to go for,
Money Market Hedge (Option II)

(b) We first verify the interest rate parity to decide, whether any arbitrage exists.

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We have spot, 1£ = $1.50

LHS = (1 + rhome country) = 1+ 0.05 = 1.05
RHS = Forward/Spot (1+ rforeign country)=1.48/1.50 x (1+0.08)=1.0656
Since LHS≠RHS, parity does not exist, and there exists an opportunity to arbitrage.
Since LHS is lower, the borrowing would be done in dollars. The borrowed money would be
converted to £ and invested. The profit can be calculated as follows:
Assume borrowing $100000. The repayment would be at the rate of 5% in 12 months i.e.
$100000 x 1.05 = $105000.
$100000 converted to £ at spot would yield £66667. This on deposit for 12 months would yield
£72000. This converted back to $ would give us $106560.
Thus net arbitrage profit would be = $106560- $105000 = $1560.

Question. 7

(a) What is meant by “Exercising the Option”? What are the implications for a buyer? [5]
(b) The actual ratios of a company compared to the industry standard are given below.
Comment on each ratio and indicate in one or two sentences the nature of action to be
taken by the company. [10]

Ratio Industry Standard Actual for the company

Current ratio 2.2 2.7
Debtors‟ Turnover Ratio 6 8
Stock Turnover Ratio 10 3
Net Profit Ratio 5% 2.4%
Total debt to total assets 7.5% 40%

Answer:

(a) The Call option gives the buyer a right to buy the requisite shares on a specific date at a
specific price. This puts the seller under the obligation to sell the shares on that specific
date and specific price. The Call Buyer exercises his option only when he/she feels it is
profitable. This Process is called “Exercising the Option”. This leads us to the fact that if the
spot price is lower than the strike price then it might be profitable for the investor to buy
the share in the open market and forgo the premium paid.
The implications for a buyer are that it is his/her decision whether to exercise the option or
not. In case the investor expects prices to rise far above the strike price in the future then
he/she would surely be interested in buying call options. On the other hand, if the seller
feels that his shares are not giving the desired returns and they are not going to perform
any better in the future, a premium can be charged and returns from selling the call
option can be used to make up for the desired returns. At the end of the options contract
there is an exchange of the underlying asset. In the real world, most of the deals are
closed with another counter or reverse deal. There is no requirement to exchange the
underlying assets then as the investor gets out the contract just before its expiry.

(b)
Ratio Comments
Current Ideal ratio is 2. The company’s position is above the normal value and the
Ratio industry standard. This may also be due to excessive stock.
Debtors’ The industry standard indicates an average collection period of two
Turnover months, while for the company it is only 1 1/2 months. The company’s
Ratio position is better.
Stock The stock is moving very slowly. Obviously there is excessive stock in the
Turnover company. Perhaps this has boosted up the current ratio. The sales volume
Ratio has to be considerably increased and stock level brought down.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

Net Profit Here the company’s performance is very unsatisfactory compared to the
Ratio overall position in the industry. This calls for steps to get better sales
realization and reduction of the cost of production.
Total debt The percentage is disproportionately high in the company indicating a
to Total larger proportion of debt in the capital structure. Too high a debt
assets component means too high a risk for equity shareholders.

Question. 8

Write Short Notes on any three of the following [ 5 × 3]

(a) Euro Convertible Bonds
(b) Money Market Hedge
(c) Greenfield Privatization
(d) Interest Rate Floors

Answer:

(a) A convertible bond is a bond that can be converted into a predetermined amount of
the company’s equity at certain times during its life, usually at the discretion of the
bondholder. A convertible bond is a mix between a debt and equity instrument. It acts
like a bond by making regular coupon and principal payments, but these bonds also
give the bondholder the option to convert the bond into stock. An Euro convertible bond
is a bond issued by a company in a market other than its country of operation. Thus a
bond issued by an Indian Company in the foreign market with an option to convert them
into pre-determined number of equity shares is a Euro Convertible Bond.

These bonds have two types of options. A call option that would provide the issuer to call
back the bonds when the underlying stock price has risen substantially, literally forcing
the investors to opt for conversion. The bonds can also give investors an option to opt for
conversion by selling the bond, if the bond has a put option. Certain countries do not
permit issue of ECBs by its companies since it will add to the external debt of the country.

(b) Money Market Hedge is of two types: (i) hedging payables, and (ii) hedging receivables.
Hedging payables involve the following steps:
Borrow funds in home currency; Use them to purchase the foreign currency; Invest the
foreign currency for the period after which the foreign currency payable due; Use the
proceeds to make the payment; Repay the borrowed amount together with interest.
Hedging receivable involves the following steps: Borrow funds in the foreign currency for
the period after which the receivable is due; The amount to be borrowed should be
equal to the amount of the receivable as discounted by the prevailing rate of interest;
Convert the borrowed amount into home currency and use it till the receivable
arrives; and if the home currency funds cannot be used gainfully in the enterprise itself,
invest them to earn interest.

(c)
 Under new economic policy 1991, concept of privatization of PSEs to improve its
efficiency and to reduce the budgetary support and involvement of stage in PSEs
 Releasing large amount of public resources locked up in non-strategic PSEs.
 Stopping further outflow of resources for sustaining unviable PSEs.
 Reducing burgeoning public debt.
 Transferring commercial risk to private sector.
 Disinvested companies would be exposed no market discipline and they would
become more efficient and survive or will cease on their own.
 Disinvestment would have a beneficial effect on the capital market.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 1

 New private investor will put in more money in privatized PSEs and economic activity
will increase.
 Consumers will be benefited as they would have more choices and cheaper and
better quality products and services.

(d) Variable rate investors are the typical users of Interest Rate Floors. They used Floors to
obtain certainly for their investments and budgeting process by setting the minimum
interest rate they will receive on their investments. By implementing this type of financial
management, variable rate investors obtain peace of mind from falling interest rates and
the freedom to concentrate on their aspect of their business/investments. An Interest
Rate Floor enables variable rate investors to retain the upside advantages of their
variable rate investment while obtaining the comfort of a known minimum interest rate.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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