Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

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.

PART A (25 Marks)

1.
a) In each, of the cases given below, one out of four answers is correct. Indicate the correct
answer (= 1 mark) and give workings/reasons briefly in support of your answer (= 1 mark)
[2x9=18]
i) PQ Ltd. is selling its products on credit basis and its customers are associated with 5%
credit risk. The annual turnover is expected at ` 5,00,000 if credit is extended with cost of
sales at 75% of sale value. Credit period for 60 days. The cost of capital of the company
is 15%. Administration cost 2% of sales. The net profit of the company is :
A. ` 1,25,000
B. ` 77,670
C. ` 88,430
D. ` 1,10,500

ii) The average daily sales of a company are `5 lac. The company normally keeps a cash
balance of ` 80000.If the weighted operating cycle of the company is 45 days, its
working capital will be:
A. `112.9 lac.
B. ` 113.3 lac
C. ` 5.8 lac
D. ` 225.8 lac.

iii) HP Leasing Company expects a minimum yield of 10% on its investment in the leasing
business. It proposes to lease a machine costing ` 5,00,000 for ten years. If yearly lease
payments are received in advance , the lease rental to be charged by the company for
lease will be :
A. ` 81372
B. ` 73975
C. ` 72,370
D. None of (A), (B), (C).

iv) The balance sheet of ABC Ltd. Shows the capital structure as follows :
2,50,000 equity shares of ` 10 each; 32,000, 12% preference shares of ` 100 each; general
reserve of ` 14,00,000; securities premium account ` 6,00,000; 25,000, 14% fully secured
non-convertible debentures of ` 100 each.; term loans from financial institutions `
10,00,000.
The leverage of the firm is:
A. 67.2%
B. 62.5%
C. 59.8%
D. 56.3%

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

v) The stock of Blue Company sells for ` 120. The present value of exercise price and the
value of a call option are ` 108.70 and ` 19.80 respectively. Hence the value of the put
option is:
A. ` 8.50
B. ` 9.00
C. ` 10
D. Zero

vi) An investor has ` 5,00,000 to invest. What will be his expected risk premium in investing in
equity versus risk-free securities in the following conditions :
Investment Probability Expected return
0.6 ` 2,00,000
Equity
0.4 (-) ` 1,50,000
Risk-free security 1.0 ` 25,000
A. ` 35,000
B. ` 45,000
C. ` 60,000
D. ` 85,000

vii) Snow White Ltd. has a debt-equity mix of 30/70. If Snow White Ltds debt beta is 0.3 and
overall beta for its activity (or projects) is 1.21, what is the beta for its equity?
A. 1.65
B. 1.60
C. 1.52
D. None of the above

viii) The value of a share of MN Ltd. after right issue was found to be ` 75. The theoretical
value of the right is ` 5. The number of existing shares required for a rights share is 2. The
subscription price at which the right share issued were:
A. ` 22.50
B. ` 40.00
C. ` 65.00
D. ` 82.00

ix) An Indian company is planning to invest in US. The US inflation rate is expected to be 3%
and that of India is expected to be 8% annually. If the spot rate currently is ` 45/ US$,
what spot rate can you expect after 5 years?
A. ` 59.09/US$
B. ` 57.00/US$
C. ` 57.04/US$
D. ` 57.13/US$

b) State if each of the following sentences is T (= true) or F (= false): [5]

i) The key issue of the theory of capital structure is to examine whether a business can
change its value and cost of capital by changing its capital structure.
ii) Commercial paper introduced by RBI in early 1990, is a secured promissory note
tied to any specific transaction.
iii) 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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iv) LIBOR for treasury bill rate is the example of basis swaps.
v) A project is a "One-shot" major undertaking.

c) Match the assumptions to the different Capital Structure theories:

Assumptions
(i) Cost of debt and cost of equity are constant, and overall cost of capital decreases
with increase in leverage.
(ii) Cost of debt and overall cost of capital are constant, and cost of equity will change
with the degree of leverage.
(iii) Value of firm increases with increase in financial leverage upto a certain limit only.
(iv) Overall cost of capital and the value of firm are independent of the capital structure.

Capital Structure theories

(A) Modigliani- Miller Approach
(B) Traditional Approach
(C) Net Income Approach
(D) Net Operating Income Approach

(Note: Your answer may be of the form:

Assumption No----------------------- Capital letter indicating Capital Structure theory)
[1/2x4=2]

Answer:
a)
i) B ` 77,670
Profitability of credit sales (`)
Credit sales 5,00,000
Less: Cost of sales (` 5,00,000 x 75/100) 3,75,000
1,25,000
Less: Cost of granting credit
Default risk (` 5,00,000 x 5/100) 25,000
Opportunity cost (` 5,00,000 x 60/365 x 15/100) 12,330
Administration cost (` 5,00,000 x 2/100) 10,000 47,330
Net profit 77,670

ii) D ` 225.8 lac.

The working capital requirement is for 45 days of the weighted operating cycle plus
normal cash balance = Sales per day weighted operating cycle+ cash balance
requirement
= ` 5 lac 45 + ` 0.80 lac = ` 225.80 lac.

iii) B ` 73975
Let , lease rental per annum be , x
` 500000 = x + x / (1+0.1) + x / (1+0.1)2 + . + x / (1+0.1)9
= x + 5.759 x = 6.759 x
or, x = ` 500000/ 6.759 = ` 73975.

iv) C 59.8%
Fixed income funds = Preference share capital + Debentures + Term loans
= ` 32,00,000 + ` 25,00,000 + ` 10,00,000 = ` 67,00,000

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Equity funds = Equity share capital + General reserve + Securities premium

= ` 25,00,000 + ` 14,00,000 + ` 6,00,000 = ` 45,00,000

Total funds used in the capital structure

= ` 67,00,000 + ` 45,00,000 = ` 1,12,00,000

Leverage = ` 67,00,000 x 100 = 59.8%

` 1,12,00,000

v) A ` 8.50
Value of put option = Value of call option + PV of exercise price Stock price
= ` 19.80 + ` 108.70 ` 120
= ` 8.50

vi) A ` 35,000
Expected premium = (0.6 x ` 2,00,000) + [0.4 x (-) ` 1,50,000] ` 25,000
= ` 1,20,000 ` 60,000 ` 25,000
= ` 35,000

vii) B - 1.60
A = d(D/V) + e (E/V)
1.21 = (0.30 x 0.3) + (e x 0.7)
1.21 = 0.09 + 0.7 e
e = 1.12/0.7
= 1.60

viii) C `65.

P0 PS
Theoretical value of Right Issue: RP
NE 1
Where, Rp = Value of Right
P0 = Current Market Price per share
Ps = Rights Subscription Price
NE = Number of Existing share for every right share
P0 PS
RP
NE 1
P0 PS
5
(2 1)
P0 15 PS .......... .......... .......( i)

P0 NE PS NR
Theoretical Post Right Value: P1
NE NR
P1 = Theoretical Post right Price after right issue
P0 = Market Price per share before right issue
Ps = Right Subscription Price
NE = Number of existing share for every right share.
NR = Number of new share.

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

P0 NE PS NR
P1
NE NR
P0 2 PS 1
75
2 1
Putting the value of P0
15 PS 2 PS
75
3
225 30 2PS PS
3PS 225 30
195
PS 65
3

ix) C ` 57.04/US$
According to Purchase Power Parity, spot rate after 5 years
= ` 45 x [(1 + 0.08)/ (1 + 0.03)] 5= 45 x 1.2675 = ` 57.04

b)
i) True.

ii) False. Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise
funds for a short period, generally varying from a few days to a few months

iii) False: A call option is not out- of- the money when the price of the underlying asset is
below the exercise price of the Call and in- the money when the price of underlying
asset is above the striking price of the call.

iv) True.
v) True.

c)

i) C
ii) D
iii) B
iv) A

Part B (75 Marks)

2.
a) The Directors of Chintamani Ltd. present you with the Balance sheets as on 30th June,
2012 and 2013 and ask you to prepare statements which will show them what has
happened to the money which came into the business during the year 2013.

Liabilities : 30.6.12 30.6.13

Authorised capital 15,000 shares of ` 100 each 15,00,000 15,00,000
Paid up capital 10,00,000 14,00,000
Debentures (2013) 4,00,000
General Reserve 60,000 40,000

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P & L Appropriation A/c 36,000 38,000

Provision for the purpose of final dividends 78,000 72,000
Sundry Trade Creditors 76,000 1,12,000
Bank Overdraft 69,260 1,29,780
Bills Payable 40,000 38,000
Loans on Mortgage 5,60,000

17,59,260 23,89,780

Assets :
Land & Freehold Buildings 9,00,000 9,76,000
Machinery and Plant 1,44,000 5,94,000
Fixtures and Fittings 6,000 5,500
Cash in hand 1,560 1,280
Sundry Debtors 1,25,600 1,04,400
Bills Receivable 7,600 6,400
Stock 2,44,000 2,38,000
Prepayments 4,500 6,200
Share in other companies 80,000 2,34,000
Goodwill 2,40,000 2,20,000
Preliminary expenses 6,000 4,000
17,59,260 23,89,780

You are given the following additional information:

A. Depreciation has been charged (i) on Freehold Buildings @ 2% p.a. on cost `
10,00,000. (ii) on Machinery and plant ` 32,000 (iii) on Fixtures and Fittings @5% on
cost, ` 10,000. No depreciation has been written off on newly acquired Building and
Plant and Machinery.
B. A piece of land costing ` 1,00,000 was sold in 2013 for ` 2,50,000. The sale proceeds
were credited to Land and Buildings.
C. Shares in other companies were purchased and dividends amounting to ` 6,000
declared out of profits made prior to purchase has received and use to write down
the investment (shares).
D. Goodwill has been written down against General Reserve.
E. The proposed dividend for the year ended 30th June 2012 was paid and, in additions,
an interim dividend, ` 52,000 were paid. [10]

b) What are the basic elements of joint venture?

[5]

Answer:
a)

Funds Flow Statement

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

Sources Applications

Decrease in working capital 121500 Purchase of land and building 351000

Sale proceed of land 250000 Purchase of plant and machinery 482000
Dividend received 6000 Purchase of shares (investment) 160000
Issue of Shares 400000 Redemption of debentures 400000
Loan 560000 Dividends for 2012 paid 78000
Funds from operations 185500 Interim dividend paid 52000

1523000 1523000

Working note No.1: Changes in working capital

2012 2013

Current assets

Cash 1560 1280

Debtors 125600 104400
Bills receivable 7600 6400
Prepaid 4500 6200
Stock 244000 238000
Total Current Asset 383260 356280
Current liabilities

Creditors 76000 112000

Overdraft 69260 129780
Bills payable 40000 38000
Total Current Liabilities 185260 279780

Working capital 198000 76500

Decrease in working capital 121500

Working note No.2:

Depreciation
On Buildings 25000
On Plant & Machinery 32000
On Furniture & Fittings 500
57500

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Working note No. 3: Purchase or sale of fixed assets / Investments:

Land and buildings:

2012 (WDV) 900000

(-) Depreciation 25000
875000
(-) Land sold 100000
775000
(+) Purchases (b/f) 351000
1126000
(-) Profit on sale 150000
2013 (WDV) 976000

Plant & machinery:

WDV 144000
(-) Depreciation 32000
112000
(+) Purchase (b/f) 482000
594000
Investments:
2012 80000
(-) Dividend in capital nature 6000
74000
(+) Purchases (b/f) 160000
2013 234000

Working note No.4:

P & L Adjustment A/c
To depreciation 57500 By balance b/d 36000
To dividend proposed 72000 By funds from operation(b/f) 185500
To preliminary expenses written 2000
off 52000
To interim dividend 38000

221500 221500

b) Contractual Agreement. JVs are established by express contracts that consist of one or
more agreements involving two or more individuals or organizations and that are entered
into for a specific business purpose.

Specific Limited Purpose and Duration. JVs are formed for a specific business objective
and can have a limited life span or long-term. JVs are frequently established for a limited
duration because (a) the complementary activities involve a limited amount of assets;
(b) the complementary assets have only a limited service life; and/or (c) the
complementary production activities will be of only limited efficacy.

Joint Property Interest. Each JV participant contributes property, cash, or other assets and
organizational capital for the pursuit of a common and specific business purpose. Thus, a

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JV is not merely a contractual relationship, but rather the contributions are made to a
newly-formed business enterprise, usually a corporation, limited liability company, or
partnership. As such, the participants acquire a joint property interest in the assets and
subject matter of the JV.

Common Financial and Intangible Goals and Objectives. The JV participants share a
common expectation regarding the nature and amount of the expected financial and
intangible goals and objectives of the JV. The goals and objectives of a JV tend to be
narrowly focused, recognizing that the assets deployed by each participant represent
only a portion of the overall resource base.

Shared Profits, Losses, Management, and Control. The JV participants share in the specific
and identifiable financial and intangible profits and losses, as well as in certain elements
of the management and control of the JV.
3.
a) Zenith Industrial Ltd. is thinking of investing in a project costing ` 20 lakhs. The life of the
project is five years and the estimated salvage value of the project is zero. Straight line
method of charging depreciation is followed. The tax rate is 50%. The expected cash
flows before tax are as follows :

Year 1 2 3 4 5
Estimated Cash flow before depreciation 4 6 8 8 10
and tax (` lakhs)
You are required to determine the : (i) Payback Period for the investment, (ii) Average
Rate of Return on the investment, (iii) Net Present Value at 10% Cost of Capital, (iv)
Benefit-Cost Ratio. [10]

b) What is Balance Score Card [BSC]? What are its perspectives? [5]

Answer:
a) Calculation of Annual Cash Inflow After Tax
(` lakhs)
Particulars 1 year 2 year 3 year 4 year 5 year
Cash inflow before depreciation and tax 4 6 8 8 10
Less : Depreciation 4 4 4 4 4
EBT 2 4 4 6
Less : Tax @ 50% 1 2 2 3
EAT - 1 2 2 3
Add : Depreciation 4 4 4 4 4
Cash inflow after tax 4 5 6 6 7

(i) Pay Back Period :

Year Cash inflow after tax Cumulative cash inflow after tax
1 4 4
2 5 9
3 6 15
4 6 21

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5 7 28
` 5 lacks
Pay Back Period = 3 years + 12 Months = 3 years 10 months.
` 6 lacks
(ii) Average Rate of Return

Average Annual Profit After Tax

ARR 100
AverageInvestment
AverageEBIT(1- t)
AverageInvestment

Average return = ` 8 lakhs/5 years = ` 1.6 lakhs

Average investment = ` 20 lakhs/2 = ` 10 lakhs
1.6
Average rate of return = 100 = 16%
10

(iii) Net Present Value at 10% Cost of Capital

Year Cash inflow after tax Discount factor @ 10% Present value
1 4 0.909 3.636
2 5 0.826 4.130
3 6 0.751 4.506
4 6 0.683 4.098
5 7 0.621 4.347
P.V. OF CASH INFLOW 20.717
LESS: Initial investment 20.00
NPV 0.717

P.V. of cash inflow 20.717

(iv) Benefit-Cost Ratio = = 1.036
P.V. of cash outflow 20

b) The balanced scorecard is a strategic planning and management system that is used
extensively in business and industry, government, and nonprofit organizations worldwide
to align business activities to the vision and strategy of the organization, improve internal
and external communications, and monitor organization performance against strategic
goals. It was originated by Dr. Robert Kaplan (Harvard Business School) and David Norton
as a performance measurement framework that added strategic non-financial
performance measures to traditional financial metrics to give managers and executives
a more 'balanced' view of organizational performance. While the phrase balanced
scorecard was coined in the early 1990s, the roots of the this type of approach are deep,
and include the pioneering work of General Electric on performance measurement
reporting in the 1950s and the work of French process engineers (who created the
Tableau de Bord literally, a "dashboard" of performance measures) in the early part of
the 20th century.
The balanced scorecard has evolved from its early use as a simple performance
measurement framework to a full strategic planning and management system. The
new balanced scorecard transforms an organizations strategic plan from an
attractive but passive document into the "marching orders" for the organization on a
daily basis. It provides a framework that not only provides performance measurements,

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but helps planners identify what should be done and measured. It enables executives to
truly execute their strategies.

The balanced scorecard suggests that we view the organization from four perspectives,
and to develop metrics, collect data and analyze it relative to each of these
perspectives:

The Learning and growth perspective - This perspective includes employee training and
corporate cultural attitudes related to both individual and corporate self-improvement.
In the current climate of rapid technological change, it is becoming necessary for
knowledge workers to be in a continuous learning mode.

The Business process perspective - This perspective refers to internal business processes.
Metrics based on this perspective allow the managers to know how well their business is
running, and whether its products and services conform to customer requirements (the
mission).

The Customer perspective - Recent management philosophy has shown an increasing

realization of the importance of customer focus and customer satisfaction in any
business. These are leading indicators: if customers are not satisfied, they will eventually
find other suppliers that will meet their needs. Poor performance from this perspective is
thus a leading indicator of future decline, even though the current financial picture may
look good.

The Financial perspective - Kaplan and Norton do not disregard the traditional need for
financial data. Timely and accurate funding data will always be a priority, and managers
will do whatever necessary to provide it. There is perhaps a need to include additional
financial-related data, such as risk assessment and cost-benefit data, in this category.

4.
a) X Ltd. currently has an annual turnover of ` 20 lakhs and an average collection period of 4
weeks. The company propose to introduce a more liberal credit policy which they hope will
generate additional sales, as shown below:

Additional Collection Period Sales default

1 2 Weeks 2,00,000 2%
2 4 Weeks 2,50,000 3%
3 6 Weeks 3,50,000 5%
4 8 Weeks 5,00,000 8%

The selling price of the product is ` 10 and the variable cost per unit is ` 7.
The current bad debt loss is 1 % and the desired rate of return on investment is 20%. For the
purpose of calculation, a year is to be taken to comprise of 52 weeks. Indicate which of the
above policies you would recommend the company to adopt. [7]

b) A company requires ` 20 lacs and provides the following information:

Target Debt Equity Ratio = 3:2

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Kd = 12%, for the first 4 lacs and 12.5% for the balance
EPS for the current year ` 20 per share
Dividend payout ratio 60%, growth rate 5%
Current MPS ` 90. Flotation Cost ` 6 each
Present Equity Share Capital ` 2 lacs, divided into fully paid shares of ` 10 each.
Corporate Tax Rate 30%.
Calculate weighted Marginal Cost of Capital. [8]

Answer:
a) Comparative statement of various credit policies

Particulars Current Policy 1 Policy 2 Policy 3 Policy 4

Sales ` Lac 20.0 22.0 22.5 23.5 25.0
Contribution @ 30% 6.0 6.6 6.8 7.1 7.5
Bad debts % 1% 2% 3% 5% 6%
Amount of bad debts ` 0.2 0.4 0.7 1.2 1.5
Lac
Average collection 4 6 8 10 12
period in weeks
Average debtors ` Lacs 1.5 2.5 3.5 4.5 5.8
Cost of debtors @ 20% 0.3 0.5 0.7 0.9 1.2
Contribution - bad debts 5.5 5.7 5.4 5.0 4.8
- cost of debtors

The net benefit is highest with Policy 1 with credit period of 6 weeks. It is recommended
for adoption.

b) Calculation of Marginal Cost of Capital:

Particulars ` Proportion After tax cost Marginal WACC

5 = (34)
Equity Share Capital (New) 6,40,000 6.4/20 20.00% 6.40%
Retained Earning 1,60,000 1.6/20 19.00% 1.52%
12% Debenture 4,00,000 4/20 8.40% 1.68%
12.5% Debenture 8,00,000 8/20 8.75% 3.50%
20,00,000 K0 = 13.10%

Working Notes:
(i) Calculation of Retained Earnings:
Retained Earnings = Earning for Eq Share holder (EES) Dividend
= (EPS No. of Share) (DPS No. of Share)
= ` 20 20,000 20 0.60 20,000
= ` 4,00,000 2,40,000 = ` 1,60,000

(ii) External Debt:

` 20,00,000 3/5 = ` 12,00,000
12% Debt = ` 4,00,000
12.5% Debt = ` 8,00,000 (i.e. 12,00,000 4,00,000)

(iii) External Equity Require:

= (Total Fund Proportion of Equity) Retained Earnings

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= ` 20,00,000 2/5 1,60,000

= ` 8,00,000 1,60,000
= ` 6,40,000

(iv) Cost of Equity (For New Shares):

D1
Ke g
NP
whereD1 D0 1 g
20 0.60 1 0.05
0.05
90 6
12 1.05
0.05 20%
84

Where, D1 = Expected dividend per share

D0 = Current dividend per share
g = growth rate
NP = Net Proceeds

(v) Cost of 12% Debt:

= I (1 t)
= 12% (1 0.30)
= 8.4%

Where I = Interest
t = tax rate

(vi) Cost of 12.5% Debt:

= I (1 t)
= 12.5% (1 0.30)
= 8.75%

(vii)Cost of Retained Earnings:

D1 D0 1 g
g g
MP MP
20 0.60 1 0.05
0.05
90
12.6
0.05
90
19%

5.
a) The following data is available for XYZ Ltd. :

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Sales ` 2,00,000
Less : Variable cost @30% 60,000
Contribution 1,40,000
Less : Fixed Cost 1,00,000
EBIT 40,000
Less : Interest 5,000
Profit before tax 35,000
Find out:
(i) Using the concept of financial leverage, by what percentage will the taxable income
increase if EBIT increase by 6%?
(ii) Using the concept of operating leverage, by what percentage will EBIT increase if
there is 10% increase in sales, and
(iii)Using the concept of leverage, by what percentage will the taxable income increase
if the sales increase by 6%? Also verify results in view of the above figures.
[23=6]

b) Mr. Kamal is contemplating purchase of 1000 equity shares of a company. His

expectation of return is 10% before tax by way of dividend with an annual growth of 5%.
The company's last dividend was ` 2 per share. Even as he is contemplating, Mr. Kamal
suddenly finds, due to a budget announcement dividends have been exempted from
tax in the hands of recipients. But the imposition of distribution tax on the company is
likely to yield a fall in dividend of ` 0.20 per share. Kamal's marginal tax rate is 30%

Required: Calculate what should be Mr. kamal's estimate of the price per share before
and after the budget announcement. [5]

c) List out the steps involved to determine the financial viability of a project. [4]

Answer:
a)
(i) Degree of financial leverage:
DFL = EBIT/Profit before Tax = 40,000/35,000= 1.14
If EBIT increase by 6%, the taxable income will increase by 1.146 = 6.85% and it
may be verified as follows :

EBIT (after 6% increase) ` 42,400

Less: Interest 5,000
Profit before Tax 37,400
Increase in taxable income is ` 2,400 i.e., 6.85% of ` 35,000

(ii) Degree of operating leverage:

DOL = Contribution/EBIT = 1,40,000/40,000 = 3.50

If Sales increase by 10%, the EBIT will increase by 3.5010 = 35% and it may be verified
as follows :
Sales (after 10% increase) ` 2,20,000
Less: Variable Expenses @30% 66,000
Contribution 1,54,000

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Less: Fixed cost 1,00,000

EBIT 54,000

Increase in EBIT is ` 14,000 i.e., 35% of ` 40,000.

(iii) Degree of combined leverage:

DCL = Contribution/Profit before Tax = 1,40,000/35,000= 4

If Sales increases by 6%, the profit before tax will increase by 46 = 24% and it
may be verified as follows :
Sales (after 6% increase) ` 2,12,000
Less : Variable Expenses @ 30% 63,600
Contribution 1,48,400
Less : Fixed cost 1,00,000
EBIT 48,400
Less : Interest 5,000
Profit before Tax 43,400

Increase in Profit before tax is ` 8,400 i.e., 24% of ` 35,000.

b) We know that the price of share is found out using the dividend discount model formula
i.e. P D1 , where P is the price, K e is the expected rate of return post tax, g is the
Ke g
anticipated growth rate.

Before Budget Announcement After Budget Announcement

Given D0 = ` 2 Given D0 = ` 2
D1 = 2 x (1.05) x (1- 0.3) = `1.47 D1 = 1.8 x 1.05 = ` 1.89
Ke = 10% x (1 - 0.3) = 7% [Tax 30%] Ke = 10% x (1 - 0.3) = 7% [Tax 30%]
g = 5% g = 5%
Substituting we get Price = ` 73.50 Substituting we get Price = ` 94.50

Note: In the first case Mr. Kamal pays tax on dividend, and in the second it is the
company that pays tax. Therefore Mr. Kamal's receipts are less in the first case. We are
discounting the dividend by a post tax return, Ke = 7%. In case the price is to be found
with a pre-tax return of Ke = 10%, then the answers would be ` 29.4 & ` 37.8 respectively.

b) The steps involved to determine the financial viability of a project are as follows:
(i) Determination of project cost
(ii) Sources of fund/means of financing and proper utilization of fund
(iii) Profitability analysis
(iv) Break-even analysis

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(v) Cash flow/fund flow statement

(vi) Debt service coverage ratio.

6.
a) Given the following quotes for per unit of each currency against US dollar, on two
different dates:

British Pound 1.5398 1.6385

Canadian Dollar 0.6308 0.6591
EMU euro 0.9666 1.0835
Japanese yen 0.008273 0.008343
Mexican peso 0.1027 0.0917
Swedish Krona 0.1033 0.1179

What is the rate of appreciation or depreciation of each currency over the period? [5]

b) AU Ltd., an Indian Company has an export exposure of 120 lakhs Yen value December end.
The current spot rates are:
`/$ = 64.5 and
/$ = 120.25
It is estimated that Yen () will depreciate against dollar to 140 and Rupee will depreciate
against dollar to 70. Forward rate for December, 2013:
/$ = 128.50 and
`/$ = 66.50
(i) You are required to calculate the expected loss, if hedging is not done.
(ii) How the position will change with company taking a forward cover. [3+2]

c) What are currency futures? List the steps involved in the technique of hedging through
futures. [5]

Answer:
a)
Pound ($1.6385 $1.5398)/$1.5398 +0.0641 +6.41%
Canadian dollar ($0.6591 $0.6308)/$0.6308 +0.0449 +4.49%
Euro ($1.0835 $0.9666)/$0.9666 +0.1209 +12.09%
Yen ($0.008343 $0.008273)/$0.008273 +0.0086 +0.86%
Peso ($0.0917 $0.1027)/$0.1027 -0.1071 -10.71%
Krona ($0.1179 $0.1033)/$0.1033 +0.1413 +14.13%

b)

i) Calculation of Current spot rate of /`

`/$ = 64.50

/$ = 120.25

/` = 120.25 x 1/64.5

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

/` = 1.8643

Calculation of expected rate of /`

/$ = 140

`/$ = 70

/` = 140/70 = 2.0000

Calculation of Expected loss without forward cover

Current exposure = 120 lakhs/ 1.8643 = 64,36,800

Expected exposure = 120 lakhs/ 2.0000 = 60,00,000

Expected loss without forward cover = 4,36,800

ii) Computation of Forward rate /`

/$ = 128.50
`/$ = 66.50
/` = 128.50/66.50 = 1.9323

Current exposure = 120 lakhs/ 1.8643 = 64,36,800

Exposure, if forward cover is taken = 120 lakhs/ 1.9323 = 62,10,000
Expected loss if forward cover is not taken = 2,26,8000
Suggested to take forward cover.

c) A currency futures contract is a derivative financial instrument that acts as a conduct to

transfer risks attributable to volatility in prices of currencies. It is a contractual agreement
between a buyer and a seller for the purchase and sale of a particular currency at a
specific future date at a predetermined price. A futures contract involves an obligation
on both parties to fulfil the terms of the contract. A futures contract can be bought or
sold only with reference to the USD.

There are six steps involved in the technique of hedging through futures:
i) Estimating the target income (with reference to the spot rate available on a given
date.)
ii) Deciding on whether Futures Contracts should be bought or sold.
iii) Determining the number of contracts (since contract size is standardised).
iv) Identifying profit or loss on target outcome.
v) Closing out futures position and
vi) Evaluating profit or loss on futures.

7.
a) You are given the following information about current rates for Sterling Spot & Forward.

Spot 1-month Forward 3-month Forward

Canadian Dollar 1.8630 - 0.8640 30 - 20 cents Premium 0.90 - 80 Premium
Belgian Franc 72.20 - 30 10 - 20 cents Discount 45 - 55 Discount

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

Danish Kroner 13.01 - 02 44 - 45 5/8 Discount 18 3/8 19

German DM 3.065 - 075 2 - 1.5 Premium 5.5 - 5.0 Premium
3/4%Discount
Calculate the cost or value in sterling to a customer, who wishesDdidddddddddddddddd
to
ddddddddddisdiscountD
i) Buy Canadian dollars 25000 spot
iscount
ii) Buy Belgian francs 75000 three months forward
iii) Sell Danish Kroner 20000 three months forward
iv) Sell DM 6000 one month forward. [9]

b) An import house in India has bought gods from Switzerland for SF 10,00,000. The exporter
has given the Indian company two options.
(i) Pay immediately the bill for SF 10,00,000;
(ii) Pay after 3 months, with interest Q 5% p.a..

The importers bank charges 14% on overdrafts. If the exchange rates are as follows,
what should the company do?

Spot (`/SF) : 30.00/30.50

3-month (`/SF) : 31.10/31.60. [6]

Answer:

a)
i) To buy 25000 Canadian Dollars (CD) Spot
First get a quote in CD.
1 CD = 1/1.8630 = 0.5368
Therefore to get 25000 CD customer pays = 25000 x 0.5368 = 13420

ii) To buy 75000 Belgian Francs (BF) 3m fwd.

First get a quote in BF.
Spot rate (BF/) 72.20/72.30
3m fwd. rate (BF/) 72.65/72.85 [Swap low/high, ascending order, hence add]
3m fwd. rate (/BF) 0.0137/0.0138 [1 BF = 1/72.65 = 0.0138] [1/7285 / 1/7265]
Therefore to get 75000 BF customer pays = 75000 x 0.0137 = 1027.50

iii) Sell Danish Kroner (DK) 20000 three months forward

Spot rate (DK/) 13.01/13.02
lm fwd. rate (DK/) 13.1938/13.2175 [Swap 18.375/19.75, Asc. order, hence add]
lm fwd. rate (/DK) 0.0757/0.0758 [1 DK = 1/13.1938 - 0.0758]
Therefore to sell 20000 DK customer gets = 20,000 x 0.0757 = 1514

iv) Sell DM 6000 one months forward

Spot rate (DM/) 3.065/3.075
1m fwd. rate (DM/) 3.045/3.060 [Swap 2.0/1.5, Desc. order, hence subtract]
lm fwd. rate (/DM) 0.3268/0.3284 [1 DM = 1/3.045 = 0.3284]
Therefore to sell 6000 DM customer gets = 6000x0.3268 = 1960.8.

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

b) Alternative 1:Pay immediately

Amount paid = SF 10,00,000 = 10,00,000 x ` 30.50 = ` 3,05,00,000
Interest payable to Indian bank for 3 months = 0.14 / 4 x (3,05,00,000) = ` 10,67,500
So, total payment at the end of 3 months = ` 3,15,67,500

Alternative 2: Settle the payable after 3 months.

Amount payable = SF 10,00,000
Interest for 3 months = 0.05 / 4 (AF 10,00,000) = SF 12,500
Total repayment = SF 19,12,500 at the end of 3 months.

To obtain SF 10,12,500, the Company will have to sell forward (`10,12,500) (31.60) = `
3,19,95,000

Since rupee outflow is lesser in the first alternative, it is advisable to settle the payable
immediately. The reason for this disparity is that the 3 month forward premium on the SF
exceeds the interest differential.

8. Write short notes on (any three): [53=15]

a) Index future
b) Bought-out deals
c) Off Balance sheet financing
d) Merchant Banker

Answer:

a) Index futures:
An index future is a derivative whose value is dependent on the value of the underlying
asset (e.g. BSE Senex, S&P, CNX NIFTY). While trading on index futures, an investor is
basically buying and selling the basket of securities comprising an index in their relative
weights.
Unlike commodity and other futures contracts index future contracts are settled in cash.
Index futures contract is basically an obligation to deliver a settlement, an amount equal
to M (Multiplier) times the difference between the stock index value on the expiration
date of contract and the price at which the contract was originally struck (indicated as (I
- P) X M), (the value of M is pre-determined for each stock MARKET INDEX). The
transactions, in actual practice, are settled through clearing house and no actual or
physical delivery of stock is made. At the close of the trading session each day, every
customer's position is marked to Market.
Index futures help an investor to take a position on the market and also hedge the share
portfolio against adverse market conditions.

b) Bought Out Deals:

In bought out deal, a company allots shares in full or in lots to a single investor or a group
of investors at a negotiated price between the company and the investor(s). After a

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

particular period as agreed between the two parties, the shares market. The holding cost
of the sponsor may be either paid by the company or the sponsor may retain the profit
on issue as per terms and conditions of agreement. After the public offering the shares
may be got listed in stock exchange.

BOD are used to takeover a running company. It is a process of investment by a sponsor

directly in a company. Advantages:

1. The company can use the fund immediately and is able to focus its attention to
execution of project.
2. It is very suitable in situation when money needs to be arranged fast without which
the project may suffer.
3. Preliminary expenses are nil or very little.
4. It is easier to convince an investor for an investment in a company rather than the
general public.
5. When the conditions are not favorable for bringing out a public Issue, the bought out
deals offer an immediate and an amicable solution.
6. When the shares are offered to public, the general public becomes more confident
about the issue because a professional banker has already invested in it. The public
expects high rewards in their investment and they are generally not disappointed.

c) Off Balance Sheet Financing

A form of financing in which large capital expenditure are kept off of a companys
balance sheet through various classification methods. Companies will often use off-
balance-sheet financing to keep their debt to equity (D/E) and leverage ratio low,
especially if the inclusion of a large expenditure would break negative debt covenants.
Contrast to loans, debt and equity, which do appear on the balance sheet. Examples of
Off-balance sheet financing includes joint ventures, research and development
partnerships, and operating leases (rather than purchases of capital equipment).
Operating lease are one of the most common forms of off-balance-sheet financing. In
these cases, the asset itself is kept on the lessors balance sheet and the lessee reports
only the required rental expenses for use of the asset. Generally Accepted Accounting
Principles in the U.S. have set numerous rules for companies to follow in determining
whether a lease should be capitalized (including on the balance sheet) or expensed.
This term came into popular use during the Enron bankruptcy. Many of the energy
traders problems stemmed from setting up inappropriate off-balance-sheet entities.

d) Merchant Banker
The term merchant banking has been used differently in different parts of the world and
is so widely used that sometimes, it is applied to banks who are not merchants,
sometimes to merchants who are not bank and sometimes to those agencies who are
neither merchants not banks.
Merchant banking can be defined as a non-banking financial activity resembling
banking being performed all over the world by both banking and non-banking
institutions.
Merchant bank can be defined as an institution or an organization which provides a
number of services including management of share (and debenture) issues, portfolio
management services, underwriting of shares, credit management and other financial

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 Answer to PTP_Final_Syllabus 2008_Jun2014_Set 2

services. The merchant banks offer services for a fee while commercial banks accept
deposits and give loans on interests. Merchant banks do not act as retail banks for
general public and don't accept deposits generally. The merchant banks are also
different from the dealers, traders and brokers of shares and debentures. The merchant
banks mainly deal in new issues while the dealers, traders and brokers mainly deal in
secondary market.

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