Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

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 (= 1 mark) and give workings/reasons briefly in support of your answer (= 1 mark)
[2x9=18]
i) Increase in the degree of operating leverage and decrease in the degree of financial
leverage is 20%. What would be the impact on degree of total leverage?
A. 4% increase
B. 5% increase
C. 4% decrease
D. No change

Answer: C
Degree of Total leverage = Degree of Financial leverage × Degree of operating leverage
= 1.2 × 0.8
= 0.96
Therefore, Degree of Total leverage decreased by 0.04 ie 4% decrease

ii) The rates available in Indian market are:

`/$ Spot 66.68/72
£/$ 0.602/06
If an Indian wants to acquire £, what rate should be charged to him?
A. `89.17/£
B. `110.83/£
C. `112.17/£
D. `90.22/£

Answer: B
Rate to be quoted is the Ask rate
(`/$)Ask × ($/£) Ask
1
(`/$) Ask ×
£/$ Bid
1
66.72 ×
0.602
`110.83/£

iii) Xee Ltd. paid a dividend of `4.00 per share for the year 2013. If the expected growth rate is 12%
and the rate of return is 20%, the intrinsic value for its share would be _______________.
A. `50
B. `200

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

C. `100
D. `55

Answer: A
Dividend
Pr ice
Cost of Capital Growth rate
4
= `50
0.20 0.12

iv) The spot and 6 month forward rates of $ in relation to rupee are `60.34/ 72 and 61.02/66
respectively. What would be the annualized forward margin (premium with respect to bid
price)?
A. 15.32%
B. 12.32%
C. 13.52%
D. 15.23%

Answer: C
Forward Margin (premium with respect to bid price)
= [(61.02 – 60.34) ÷ 60.34] × 12 × 100
= 13.52%

v) Firm A and B are similar in all respect. But firm A uses `5,00,000 debt in its capital. If the rate of
corporate tax is 40%., how would the valuation of both the companies differ?
A. Value of firm A greater than value of firm B by ` 2,00,000
B. Value of firm B greater than value of firm A by ` 2,00,000
C. Value of firm A greater than value of firm B by ` 5,00,000
D. Value of firm B greater than value of firm A by ` 5,00,000

Answer: A
When corporate taxes are considered, the value of a firm that is levered would be equal to
the value of the unlevered firm increased by the tax shield associated with debt.
Hence the value of firm A, would be more than the value of firm B.
The value of firm A would be more than firm B by 0.4 × 5,00,000 = `2,00,000

vi) The current price of a share of Asha Ltd. is `120. The company is planning to go for a rights
issue. The subscription price for one rights share is proposed to be `104. If the company targets
that ex-rights value of a share shall not fall below `116, the number of existing shares required
for 1 right share would be
A. 1
B. 2
C. 3
D. 4

Answer: C
nP0 s
Ex-rights price of a share
n 1
120 n 104
or, 116
n 1
Solving,

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

n=3

vii) The total asset – turnover ratio and total asset to net- worth ratio of a company are 2.10 and
2.50 respectively. If the net profit margin of the company is 6%, what would be the return on
equity?
A. 30.50%
B. 31.50%
C. 30.00%
D. 32.50%

Answer: B
Pr ofit afterTax Sales Total Assets
Return on Equity (ROE) =
Sales Total Assets Net Worth
= 0.06 × 2.10 ×2.50
= 0.315
= 31.5%

viii) AB Ltd. paid a dividend of `5 per share that is expected to grow at a rate of 10% for the next
year, after which it is expected to grow at a rate of 8% forever. What would be the value of the
stock if a 15% rate of return is required? [Given PVIF(15%,1 year) = 0.8696]
A. `78.57
B. `73.79
C. `84.85
D. `75.77

Answer: A
The present value of dividend stream to an investor would be as follows:
For the 1st year = `5 × 1.10 × 0.8696 = 4.7828
For the 2nd year = `5 × 1.10 × 1.08 = 5.94
5.94
Price of the share = 0.8696 4.7828 78.57
0.15 0.08

ix) X Ltd has an ROA of 10% and a profit margin of 2%. The Company’s total asset turnover is
A. 5%
B. 20%
C. 12%
D. 8%

Answer: A
S
ROA = 10%, PM = 2% AT =
TA
NI NI
ROA = , PM =
TA S
1
AT = ROA ×
PM
1
or, AT = 10% × = 5%
2%
Where,
ROA = Return on Assets
PM = Profit Margin

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

AT = Asset Turnover
S = Sales
TA = Total Assets
NI = Net Interest

b) State whether true of false: [1 × 7]

i) Real options are most valuable when the underlying source of risk is very low.
ii) A firm’s capital structure can never affect its free cash flows
iii) Issue of Bonus shares by the subsidiary company out of pre-acquisition profits affects
the cost of control.
iv) CVP analysis assumes a linear revenue function and a linear cost function
v) Leading and netting are internal hedging techniques whereas swap is an external
technique for hedging
vi) In case of projects which are divisible, capital rationing is done by ranking projects on
the basis of Net Present Value (NPV)
vii) If a forward currency is FLAT, it means that the expected spot rate is equal to the
forward rate.

Answer:
i) False
ii) False
iii) False
iv) True
v) True
vi) False
vii) False

PART B (75 MARKS)

Question.2
a) Arjun Ltd. is considering the acquisition of a large equipment for `12,00,000. The equipment is
expected to have an economic useful life of 8 years. The equipment can be financed either
with a 8-year term loan at 14%, repayable in equal installments of `2,58,676 per year, or by
an equivalent amount of lease rent every year. In both case payment is due at the end of
the year. The equipment is subject to straight line method of depreciation for tax purposes.
Assuming no salvage value after the 8-year useful life and 50% tax rate, which of the
financing alternatives should be selected? [10]

Answer:
PV of cash inflows under leasing alternative
Lease payment after taxes PV factor at 0.07
Year end Total PV
(L) (1 – 0.5) (kd)
1–8 `1,29,338 5.971 `7,72,277

Determination of interest and capital components of loan installment

Loan at the Payment of Principal outstanding at
Year Loan
beginning of Interest Principal the end of the year
end Installment
the year (Col 3 × 0.14) (Col 2 – Col 4) (Col 3 – Col 5)
Col 1 2 3 4 5 6
1 `2,58,676 `12,00,000 `1,68,000 `90,676 `11,09,324
2 2,58,676 11,09,324 1,55,305 103,371 10,05,953
3 2,58,676 10,05,953 1,40,833 1,17,843 8,88,110

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

4 2,58,676 8,88,110 1,24,335 1,34,341 7,53,769

5 2,58,676 7,53,769 1,05,528 1,53,148 6,00,621
6 2,58,676 6,00,621 84,087 1,74,589 4,26,032
7 2,58,676 4,26,032 59,644 1,99,032 2,27,000
8 2,58,676 2,27,000 31,676 2,27,000 -

PV of cash outflows under buying alternative

Tax Advantage on Cash outflows
Loan Principal PV
Year Deprecia after tax
Installme Interest Outstandi Interest factor Total PV
end tion [Col 2 – (Col 5+
nt ng (I × t) at 0.07
(D × t) Col 6)]
Col 1 2 3 4 5 6 7 9 8
1 `2,58,676 `1,68,000 `11,09,324 `84,000 `75,000 `99,676 93,197 0.935
2 2,58,676 1,55,305 10,05,953 77,652 75,000 1,06,024 92,559 0.873
3 2,58,676 1,40,833 8,88,110 70,416 75,000 1,13,260 92,420 0.816
4 2,58,676 1,24,335 7,53,769 62,167 75,000 1,21,509 92,711 0.763
5 2,58,676 1,05,528 6,00,621 52,764 75,000 1,30,912 93,340 0.713
6 2,58,676 84,087 4,26,032 42,043 75,000 1,41,633 94,328 0.666
7 2,58,676 59,644 2,27,000 29,822 75,000 1,53,854 95,851 0.623
8 2,58,676 31,676 - 15,838 75,000 1,67,838 97,682 0.582
7,52,088
The borrowing (buying) alternative of financing the purchase of the large equipment should be
selected.

b) Ashi Ltd furnishes the following information for the year, 2013 from which you are requested to
determine the indifference point.
1. Funds required, `50,000
2. Existing number of Equity shares outstanding, 5000 @ `10 per share
3. Existing 10% debt, `20,000
4. Funds required can be raised either by
(a) issue of 2,000 equity shares, netting `25 per share or
(b) new 15% debt
5. The P/E Ratio will be 7 times in equity alternative and 6 times in debt alternative
6. Corporate tax is levied @ 40% [5]

Answer:
( x I 1)(1 t ) ( x I 1 I 2)(1 t )
Indifference point
N1 N2
Where,
x = Earnings before interest and taxes (EBIT), at the indifference point
I1 = Interest payable on existing debt
I2 = Interest payable at additional debt
N1 = Number of equity shares, if only equity shares are issued
N2 = Number of equity share if both debt and equity is issued
t = Corporate income tax rate

Hence, as per the above details:

( x 2000 )(1 0.4) ( x 2000 7500 )(1 0.4)
Indifference point
7000 5000
( x 2000 ) 0.6 ( x 9500 ) 0.6
or,
7000 5000

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

or, 5 0.6x 1200 7 0.6x 5700

or, x = 28,250

Question.3
a) The financial position of Anju Ltd. On Jan. 1 and Dec. 31, 2013 is as follows:
Liabilities 1st Jan(`) 31st Dec(`) Assets 1st Jan(`) 31st Dec(`)
Current Liabilities Cash 4,000 3,600
36,000 40,600
for goods Debtors 35,000 38,000
Loan from ABC Co 20,000 Stock 25,000 22,000
Loan from Bank 30,000 25,000 Land 20,000 30,000
Hire-purchase Building 50,000 55,000
20,000
Vendor Machinery 80,000 86,000
Capital 1,48,000 1,54,000 Delivery Van 25,000
2,14,000 2,59,600 2,14,000 2,59,600
The delivery van was purchased in December, 2013 on hire-purchase basis; a payment of
`5,000 was made immediately and the balance of amount is to be paid in 10 monthly
installments of `2000 each together with an interest @ 15% p.a. During the year the partners
withdrew `20,000 for personal expenditure. The provision for depreciation against machinery on
31-12-2012 was `27,000 and 31-12-2013 was `36,000. You are requested to prepare the Cash
Flow Statement. [10]

Answer:
CASH FLOW STATEMENT AS PER AS – 3 (REVISED)
(Indirect Method)
` `
I. Cash flows from operating activities:
Net profit before tax and extraordinary items 26,000
Adjustment for depreciation 9,000
Operating profit before working capital changes (WN) 35,000
Increase in creditors 4,600
Decrease in stock 3,000
Increase in debtors (3,000)
Net cash flow from operating activities 39,600
II. Cash flow from investing activities:
Payment for delivery van (5,000)
Purchase of Machinery (15,000)
Purchase of Building (5,000)
Purchase of land (10,000)
Net cash flow from investing activities (35,000)
III. Cash flow from financing activities:
Loan from ABC Co 20,000
Payment of Bank Loan (5,000)
Drawings by partners (20,000)
Net Cash flow from financing activities (5,000)
IV. Net increase / decrease in cash & cash equivalents (400)
V. Cash & cash equivalents at the beginning of the period 4,000
VI. Cash & cash equivalents at the end of the period 3600

Working Notes:
1. FUND FROM OPERATIONS
`

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

Capital as on 31.12.2013 1,54,000

Add: Drawings during the year 20,000
1,74,000
Less: Capital as on 01.01.2013 1,48,000
Profit for the year 26,000
Add: Depreciation for the year
(`36,000 - `27,000) 9,000
35,000

2. MACHINERY ACCOUNT
` `
To, Balance b/d 80,000 By, Depreciation for the year 9,000
To, Bank (acquired during the year) 15,000 By, Balance c/d 86,000
95,000 95,000

b) The sales turnover and profit during 2012 and 2013 are as follows.
Sales (`) Profit (`)
Year 2012 20,00,000 2,00,000
Year 2013 30,00,000 4,00,000
Calculate:
i) Profit Volume Ratio
ii) Sales required to earn a profit of `5,00,000
iii) Profit when sales is `10,00,000 [1+2+2]

Answer:
i) Profit Volume Ratio
Net
2012 (`) 2013 (`)
Increase
Sales 20,00,000 30,00,000 10,00,000
Profit 2,00,000 4,00,000 2,00,000
Increase in costs 8,00,000
Since the fixed costs are constant, the increase in cost is the increase in variable cost in tune with
increase in sales volume. So, variable cost is 80% of sales
Profit – volume ratio is 100 – 80 = 20%
ii) Sales required to earn a profit of `5,00,000
Fixed Cost = Contribution – Profit
= 20% of 30,00,000 – 4,00,000 = `2,00,000
Fixed Cost Desired Pr ofit
Required Sales =
P / V Ratio
2,00,000 5,00,000
= 100
20
= `35,00,000
iii) Profit when sales is `10,00,000
Profit at sales of `10,00,000 Sales × P/V Ratio – Fixed Cost
`10,00,000 × 20% - `2,00,000
`2,00,000 - `2,00,000 = Nil

Question.4
a) The spot rate on 1st April, 2013 is 1.785/£. Pound futures contract is sold at $1.790 for June
Delivery and at $1.785 for September delivery. Expecting that pound will depreciate fast

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

after June, a speculator buys the former and sells the latter. Later he finds that pound
may appreciate by June and may not depreciate subsequently. So he reserves the two
contracts respectively at $1.78 and $1.76. Suppose the exchange rate on both the
maturity dates is $1.795/£. Calculate the gain/loss for the speculator. [6]

Answer:
i) Buying pound futures contract:
Gain per pound from the original contract = $1.795 – 1.790 = $ 0.005 and
Gain from the reverse contract = $1.795 – 1.760 = $ 0.035
Total gain $ 0.040/£
ii) Selling pound futures contract:
Loss per pound from the original contract = $ 1.795 – 1.785 = $ 0.010 and
Loss from the reverse contract = $ 1.795 - 1.780 = S 0.015
Total Loss $0.025/£
iii) Net Gain = $0.040 - $0.025 = $ 0.015/£
Net gain in total = $ 0.015/£ × 62500£ = $ 937.50

b) Evaluate the following:

i) A pound option call contract has a strike rate of $1.820/£ and a premium of $0.08.
Spot rate on maturity is $1.920/£.How much would an option buyer gain/lose?
ii) An American exporter exporting goods to UK fears depreciation of pound. Pound
options are available at a strike price of $1.884/£with a premium of $0.03/£. The spot
rate on maturity falls to $1.824/£. How would he compensate for his loss?
iii) Pound is expected to depreciate to $1.730. Pound options are available at a strike
price of $1.830/£ with a premium of $0.03/£. How would speculators react to the
depreciation of pound? [3+3+3]

Answer:
i) Since spot rate > strike rate + premium, hence the option buyer would gain.
Gain to the buyer = $1.920 – $(1.820 + 0.08) = $ 0.02/£
Total gain to the buyer of a lot = $ 0.02/£ × 62,500£ = $1,250

ii) The exporter will buy a put and sell a call.

Put would give him a gain of $ 1.884 - $(1.824+0.03) = $0.03/£
Call would not be exercised by the buyer and so, as a seller of the call, the exporter will
receive the premium of $0.03/£. Consequently, the risk would be reduced by $0.06
Total risk would be reduced to the extent of = $ 0.06/£ × 62,500£ = $3,750.

iii) Speculator will buy a put.

On the maturity, he would get by selling $1.830/£ × 62,500£ = $ 1,14,375.
He would sell the $ immediately at the open market @ $1.730/£
Hence his gain would be $1.830 - $(1.730 + 0.03) × 62,500£ = $4,375

Question.5
a) ABC Co ltd. has 20,000 equity shares of `50 each outstanding. The following is the income
statement relating to the previous year as well as four situations which may arise
corresponding to the new project. The new project is expected to cost `5,00,000.
Actuals Sell 10,000 equity Sell 10% Debentures
Particulars (Previous Yr) shares (`) (`)
` Situation A Situation B Situation A Situation B
Sales 8,00,000 12,00,000 9,00,000 12,00,000 9,00,000
Variable Expenses 2,40,000

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

5,60,000
Fixed Cost 3,00,000
EBIT 2,60,000
Interest Nil
Earnings after interest 2,60,000
Taxes 91,000
EAT 1,69,000
EPS 8.45
Assuming variable cost as per cent of sales remains constant and additional fixed cost with new
project is likely to be `1,00,000, complete the tabulation. Which plan would you recommend to
finance the new project? [8]

Answer:
COMPLETION OF TABLE
(AMOUNT IN ` THOUSAND)
Actuals Sell 10,000 equity Sell 10% Debentures
Particulars (Previous Yr) shares (`) (`)
` Situation A Situation B Situation A Situation B
Sales 800 1200 900 1200 900
Variable Expenses (30% of
Sales) 240 360 270 360 270
560 840 630 840 630
Fixed Cost 300 400 400 400 400
EBIT 260 440 230 440 230
Interest Nil Nil Nil Nil Nil
Earnings after interest 260 440 230 390 180
Taxes @35% 91 154 80.5 136.5 63
EAT 169 286 149.5 253.5 117
EPS 8.45 9.53 4.98 12.67 5.85
The debt form of financing would be recommended to finance the new project as the EPS is
more under debt form of financing than equity, in both situation A and situation B.
Assumption: The company can sell its equity shares at `50 each without incurring any floatation
costs.

b) Ashu Ltd wants to undertake a capital restructuring. It has provided the following
estimates of the cost of debt and equity capital (after Tax) at various levels of debt-equity
mix.
Debt as a % of Total Capital employed Cost of debt (%) Cost of Equity (%)
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
You are expected to determine the optimal debt-equity mix for the company by calculating the
composite cost of capital. [7]
Answer:
TABLE FOR COMPUTATION OF COST OF CAPITAL
Kd (%) Ke (%) W1 (B/V) W2 (S/V) = (1 – B/V) Kd(W1) + Ke(W2) = K0 (%)
5.0 12.0 0.0 1.0 12.00

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

5.0 12.0 0.1 0.9 11.30

5.0 12.5 0.2 0.8 11.00
5.5 13.0 0.3 0.7 10.75
6.0 14.0 0.4 0.6 10.80
6.5 16.0 0.5 0.5 11.25
7.0 20.0 0.6 0.4 12.20
Where,
Kd = Cost of debt
Ke = Cost of Equity
W1 = Relative weight of debt
W2 = Relative weight of Equity
B = Total market value of debt
S = Total market value of equity
V = Total value of the firm = S + B
K0 = Cost of Capital
The optimal debt-equity mix for Ashu Ltd would be at the point where the cost of capital is the
least. In the above situation, the cost of capital is the least when debt is 30% and equity is 70%.
Therefore, this mix of debt and equity should be undertaken by the company.

Question.6
a) Aditya Industries Ltd, wants to assess its working capital requirement for the year 2014. For
this purpose the company has gathered the following data.
ESTIMATED COST PER UNIT OF FININSHED PRODUCT
`
Raw Materials 90
Direct Labour 50
Manufacturing & administrative overhead (excluding depreciation) 40
Depreciation 20
Selling Cost 30
Total Cost 230
The product is subject to excise duty of 10% (levied on cost of production) and is sold at `300 per
unit.
Additional Information:
i. Budgeted level of activity is 1,80,000 units of output for 2014
ii. Raw materials costs consists of the following:
Pig iron `65 per unit, Ferro alloys `15 per unit, and cast iron borings `10 per unit.
iii. Raw materials are purchased from different suppliers having different credit periods:
Pig iron – 2 months, Ferro alloys – ½ month, and cast iron borings – 1 month
iv. Product is in process for a period of ½ month. Production process requires full unit (100%)
of pig iron and ferro alloys in the beginning of production; cast iron boring is required
only to the extent of 50% in the beginning and the remaining is needed at a uniform rate
during the process. Direct labour and other overheads accrue similarly at a uniform rate
throughout production process.
v. Past trends indicate that the pig iron is required to be stored for 2 months and other
material for 1 month.
vi. Finished Goods are in stock for a period of 1 month.
vii. It is estimated that ¼ of the total sales are on cash basis and the remaining sales are on
credit. Credit sales are collected over a period of 2 months.
viii. Average time-lag in payment of all overheads is 1 month and labour is ½ month.
ix. Desired cash balance to be maintained is `20,00,000.
You are required to ascertain the net working capital requirement of the company. [12]

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

Answer:
DETERMINATION OF NET WORKING CAPITAL OF ADITYA INDUSTRIES LTD.
Particulars `
1. Current Assets:
Minimum desired cash balance 20,00,000
Raw Materials:
2
Pig Iron ( 1,80,000 × `65 × ) 19,50,000
12
1
Ferro Alloys (1,80,000 × `15 × ) 2,25,000
12
1
Cast iron Borings ( 1,80,000 × `10 × ) 1,50,000
12
1
Work – in –process ( 1,80,000 × `132.5 × ) 9,93,750
24
1
Finished Goods ( 1,80,000 × `180 × ) 27,00,000
12
3 2
Debtors ( 1,80,000 × × ` 230 × ) 51,75,000
4 12
Total (A) 1,31,93,750
2. Current Liabilities:
Creditors:
2
Pig Iron ( 1,80,000 × `65 × ) 19,50,000
12
1
Ferro Alloys (1,80,000 × `15 × ) 1,12,500
24
1
Cast iron Borings ( 1,80,000 × `10 × ) 1,50,000
12
1
Wages (1,80,000 × `50 × ) 3,75,000
24
1
Total overheads [ 1,80,000 × `(40+30) × ] 10,50,000
12
Total (B) 36,37,500
WORKING CAPITAL REQUIREMENT (A – B) 95,56,250

Working Notes:
i. Determination of Work-in-process:
` `
Pig Iron 65
Ferro alloys 15
Cast iron Borings ( 0.5 × `10) 5
Other costs:
Cast iron Borings ( 0.50 × `5) 2.5
Direct labour ( 0.5 × `50) 25
Manufacturing & administrative overheads ( 0.50 × `40) 20 47.50
Total 132.50
ii. Debtors:
`
Raw Materials 90
Direct labour 50

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

Manufacturing & administrative overheads 40

Selling overheads 30
Excise duty ( 0.10 × `200) 20
Total 230

iii. Cost of Production:

`
Raw Materials 90
Direct labour 50
Manufacturing & administrative overheads 40
Depreciation 20
Cost of Production 200

b) Write a note on GATT. [3]

Answer:
THE GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT):

1) GATT was a treaty, not an organization.

2) Main objective of GATT was the reduction of barriers to international trade through the
reduction of tariff barriers, quantitative restrictions and subsidies on trade through a series
of agreements.

3) It is the outcome of the failure of negotiating governments to create the International

Trade Organization (ITO).

4) The Bretton Woods Conference had introduced the idea of an organization to regulate
trade as part of a larger plan for economic recovery after World War II. As governments
negotiated the ITO, 15 negotiating states began parallel negotiations for the GATT as a
way to attain early tariff reductions. Once the ITO failed in 1950, only the GATT
agreement was left.

5) The functions of the GATT were taken over by the World Trade Organization which was
established during the final round of negotiations in early 1990s.

Question.7
a) Small Co. Ltd., who holds shares of Big Co. Ltd. and is concerned about the fall in its
dividends. The abridged profit & loss account and the Balance Sheet of Big Co. for the
current 2 years are provided below.
ABRIDGED PROFIT & LOSS ACCOUNT
(` IN LACS)
PARTICULARS CURRENT YEAR PREVIOUS YEAR
Income from sales & other sources 19,200 15,500
Expenditure:
Operating & other expenses 15,600 11,900
Depreciation 700 650
Interest 1,850 1,750
18,150 14,300
Profit for the year 1,050 1,200
Taxes 500 200

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Profit after Taxes 550 1,000

Proposed Dividend 200 400

ABRIDGED BALANCE SHEET AS ON MARCH 31 ST

(` IN LACS)
PARTICULARS CURRENT YEAR PREVIOUS YEAR
Sources of funds:
Share Capital (of `10 each) 4,200 2,600
Reserves & Surplus 7,550 1,200
Convertible portion of 12.5% debentures - 500
Loan Funds:
Secured Loans (16%) 10,100 8,700
Unsecured Loans (15%) 1,000 3,300
Total 22,850 16,300
Application of Funds:
Fixed assets:
Cost 14,800 11,200
Less: Depreciation 2,700 2,000
12,100 9,200
Advances on capital A/c and capital work–in-process 1,000 200
13,100 9,400
Current Assets:
Inventories 8,600 7,100
Sundry Debtors 1,400 550
Cash and Bank Balances 850 680
Loans and Advances 3,000 1,600
13,850 9,930
Less: Current Liabilities 4,100 3,030
9,750 6,900
Total 22,850 16,300
You are required to:
i. Compute – Interest cover, return on net worth, earnigs per share, dividend cover
ii. Justify whether the shares are to be disposed off or retained [6+2]

Answer:
i. Computation of the ratios
(` IN LACS)
CURRENT YEAR PREVIOUS YEAR
Sales and other Income 19,200 15,500
Less: Operating and other expenses 15,600 11,900
Depreciation 700 650
Earnings before Interest and Taxes (EBIT) 2,900 2,950
Less: Interest 1,850 1,750
Earnings Before Taxes (EBT) 1,050 1,200
Less: Taxes 500 200
Earnings After Taxes (EAT) 550 1,000
Proposed Dividend (Dp) 200 400
EBIT
Interest Coverage Ratio = 1.57 1.69
Interest

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

EAT
Return on Net Worth = 0.047 0.263
Net Worth
EAT
Earnings per Share = 1.31 3.85
Number of shares
EAT
Dividend Covered = 2.75 2.50
Dp
1. Net worth Calculation:
Previous Year = `(2,600 +1,200) = `3,800
Current Year = `(4,200 + 7,550) = 11,750
2. Number of Shares:
Previous Year = 260 lakh
Current Year = 420 lakh

ii. The aspects of the operations of Big Co. Ltd, is having a sharp decline in the current year
wrt the previous year. These are indicated by the financial ratios. Hence on a prima facie
case the shares should be disposed off.
However the co has raised additional funds (equity and secured loans), during the
current financial year, which have been invested in fixed assets and blocked in capital
work-in-progress. The firm seems to be in a growing stage with plans of expansion, hence
having a positive impact on EPS and DPS. Hence it may be a judicious decision to hold
onto the shares of Big Co. Ltd.

b) The following information is available in respect of the rate of return on investment (r), the
capitalization rate (ke) and earnings per share (E) of Aman Ltd.
r = 12%
E = `30
Determine the values of the shares, assuming the following:
D/P Ratio Retention Ratio Ke (%)
A 10 90 20
B 20 80 19
C 30 70 18
D 40 60 17
E 50 50 16
F 60 40 15
G 70 30 14
[7]
Answer:
COMPUTATION OF VALUE OF SHARES IN DIFFERENT COMBINATIONS
Price of share
Retention Growth Rate
D/P Ratio (1-b) E1 b
= b r
Ratio (b) P
k e br
30 1 0.9 3
A 10 90 P ` 32.60 0.9 × 0.12 = 0.108
0.20 0.108 0.092
30 1 0.8 6
B 20 80 P ` 57 .69 0.8 × 0.12 = 0.096
0.20 0.096 0.104
30 1 0.7 9
C 30 70 P ` 77.58 0.7 × 0.12 = 0.084
0.20 0.084 0.116

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

30 1 0.6 12
D 40 60 P ` 93.75 0.6 × 0.12 = 0.072
0.20 0.072 0.128
30 1 0.5 15
E 50 50 P ` 107 .14 0.5 × 0.12 = 0.060
0.20 0.060 0.14
30 1 0.4 18
F 60 40 P ` 118 .42 0.4 × 0.12 = 0.048
0.20 0.048 0.152
30 1 0.3 21
G 70 30 P ` 128 .04 0.3 × 0.12 = 0.036
0.20 0.036 0.164
Note:
As per Gordon’s model share price is determined as follows:
E1 b
P
k e br
Where,
P = Price of a share
E = Earnings per share
b = Retention ratio
(1 – b) = D/P ratio
ke = Capitalisation Rate
r = Rate of return on investment
br = Growth rate = b × r

Question.8
Write a short note on any three of the following: [5+5+5]
i) Lease Financing
ii) Commercial Paper
iii) Interest Rate swaps
iv) Capital Rationing
v) Factors affecting value of an option relating to stock option value and capital budgeting

Answer:
i) Lease Financing:
A number of non-banking financial companies and even some banks are engaged in the
business of lease financing. The leasing companies pay the full price of all required equipment
and then lease them out to the lessee under a lease agreement providing for repayment of
principal and interest in quarterly or monthly installments. At the end of the lease period, the
ownership of the equipment is transferred to the lessee at a nominal residual value. The rate of
interest charged for lease financing is higher than lending rate. The repayment capacity of the
lessee is the main factor of credit worthiness.
Lease financing has several advantages. The lessee need not invest the capital in full as one
time single investment. Generally, the processing time for sanctioning lease finance is fast. When
the equipment is no longer needed, the lessee can terminate the agreement and ask lessor to
take away the equipment. The lease installment is allowed as deductible expense for tax
purpose.
Lease financing has also certain drawbacks. First the interest payment is high. Second, the
leased assets do not contribute to the net worth. Third, depreciation allowance cannot be
claimed during the period of lease agreement i.e. until the equipment is legally transferred in the
name of lessee. Four in case of termination of lease agreement before its expiry, the installments
paid towards principal are not fully refunded, because the lessor will charge penal interest for
pre-closing the account and since he may not readily find another lessee to take over and use

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

the equipment. And lastly, the lessee has no freedom to move the leased equipment from one
place to another.

ii) Commercial Paper:

Commercial paper, as a source of short -term financing of working capital needs, is a recent
phenomenon. The commercial paper was introduced by RBI in early 1990 with a view to enable
highly rated corporate borrowers to diversify their sources of short term borrowing. Commercial
paper, as defined by Jame C. Van Home in his book Financial Management and Policy, is a
short term unsecured promissory note issued by finance companies and certain industrial
concerns. While the commercial paper as financial instruments is prevalent in both USA and
Europe, its entry in India is recent. The Vaghul Committee set up by RBI in 1986, recommended
the introduction of commercial paper with the objective of providing reasonable access to users
of short term money to meet their requirements at a realistic price. In the opinion of the
Committee, the commercial paper market has the advantage of giving highly rated corporate
borrowers cheaper funds than they could obtain from the banks while still providing institutional
investors with higher earnings than they could obtain from the banking system.

The main features of commercial paper are:

a) Commercial paper is an unsecured promissory note tied to any specific transaction. It is
privately placed with investors through the agency of banks or other financial institution.
b) The issuing company should have a tangible net worth of Rs. 5 crores; enjoy a working
capital limit of not less than Rs. 10 crores; be listed on stock exchange; obtain a minimum
credit rating from an approved credit rating agency, such as CRISIL; and have a minimum
current ratio of 1.33.

iii) Interest Rate Swap:

An interest rate 'swap' is an exchange of interest payments between two parties. It can also be
that fixed rate payments and floating rate payments are exchanged at periodic intervals based
on an underlying notional principal amount by the counterparties. This is an Interest Rate Swap.
Thus Interest rate swaps are generally used for 'swapping' from a floating rate of interest into a
fixed rate of interest, or vice-versa.
Interest rate swaps are used to hedge interest rate risks as well as to take on interest rate risks. If a
treasurer is of the view that interest rates will be falling in the future, he may convert his fixed
interest liability into floating interest liability; and also his floating rate assets into fixed rate assets.
If he expects the interest rates to go up in the future, he may do vice versa. Since there are no
movements of principal, these are off balance sheet instruments and the capital requirements
on these instruments are minimal. It is to be noted that individual borrowers do not perform swap
though they may face similar situations with their borrowings.
Hence, Interest rate swaps may be defined as, a contract which involves two counter parties to
exchange over an agreed period, two streams of interest payments, each based on a different
kind of interest rate, for a particular notional amount.

iv) Capital Rationing:

Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of"
capital expenditures during a particular period. Often firms draw up their capital budget under
the assumption that the availability of financial resources is limited.
Under this situation, a decision maker is compelled to reject some of the viable projects having
positive net present value because of shortage of funds. It is known as a situation involving
capital rationing.
Factors Leading to Capital Rationing - Two different types of capital rationing situation can be
identified, distinguished by the source of the capital expenditure constraint.

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 Answer to PTP_Final_Syllabus 2008_Jun 2014_Set 3

a) External Factors - Capital rationing may arise due to external factors like imperfections of
capital market or deficiencies in market information which might have for the availability of
capital. Generally, either the capital market itself or the Government will not supply unlimited
amounts of investment capital to a company, even though the company has identified
investment opportunities which would be able to produce the required return. Because of
these imperfections the firm may not get necessary amount of capital funds to carry out all
the profitable projects.
b) Internal Factors - Capital rationing is also caused by internal factors which are as follows:
Reluctance to take resort to financing by external equities in order to avoid assumption
of further risk
Reluctance to broaden the equity share base for fear of losing control.
Reluctance to accept some viable projects because of its inability to manage the firm in
the scale of operation resulting from inclusion of all the viable projects.

v) Value of an Option:
The factors which affect the value of an option are given below:

Factor as it relates to stock

Symbol Factor as it relates to capital budgeting
option value
Price of the underlying asset Present Value of expected operation Cash Flows
Po
(i.e., stock price) discounted at the project's cost of capital
Exercise price For call options-the initial investment.
X For put options-the value of the project's assets if sold
or shifted to a more valuable use
T Time until the option expires Time until the option expires or is no longer available
Krf Risk-free rate of interest Risk-free rate of interest (use the yield on U.S. T-bills)
Standard deviation of the Project risk - standard deviation of the operating cash
E underlying asset (volatility of flow as a percent of total investment
stock price)

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