FINANCIAL, TREASURY AND FOREX MANAGEMENT

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2 FINAL EXAMINATION DECEMBER 2005 FINANCIAL, TREASURY AND FOREX MANAGEMENT NOTE: 1. Answer FIVE questions including Question No. 1 which is COMPULSORY. All working notes should be shown distinctly. 2. Tables showing the present value of Re. 1 and the present value of an annuity of Re. 1 for 15 years are annexed. Question 1 (a) "Internal treasury control is a process of self-improvement." Explain. (b) List out the benefits of public deposits to the company as well as to the depositors. (c) "For the lessor, lease decision is akin to a capital budgeting exercise." Examine the statement and explain its implications. (d) "Economic value added (EVA) concept is in conformity with the objective of wealth maximisation." Explain. (5 marks each) Question 2 (a) Mention any four tools available to cover exchange rate risk. (4 marks) (b) A firm has total credit sales of Rs. 80 lakh and its average collection period is 80 days. The past experience indicates that bad debt losses are around 1% of the credit sales. The firm spends Rs. 1,20,000 per year on administering its credit sales. This cost includes salary of one officer and two clerks who handle the credit checking, collection, etc., telephone and telefax charges. These are avoidable costs. A factor is prepared to buy the firm's receivables. He will charge 2% commission. He will advance against receivables to the firm at 18% after withholding 10% as reserve. What is the cost of factoring? Should the firm avail factoring service? (6 marks) (c) Following information is available in respect of EPS and DPS of Intelligent Ltd. for the last five years: Year EPS (Rs.) DPS (Rs.) Dividends for a particular year are paid in the same calendar year. If the same dividend policy is maintained, it is expected that the annual growth rate of earnings will be no better than the average of last four years. The risk-free rate is 6% and the market risk premium is 4%. With reference to the market rate of return, the equity shares of the company have a β of 1.5 and is not expected to change in near future. The company has received a proposal from Smart Ltd. to acquire its operations by paying the value of shares. You are required to value the equity shares of the company using (i) dividend growth model; (ii) earnings

3 FFTFM-Dec growth model; and (iii) capital asset pricing model (CAPM). (10 marks) Question 3 (a) Rex of Mumbai intends to set-up a plant involving a cost outlay of Rs. 20 lakh. After vigorous persuasion, the bankers agree to finance the project and allow a moratorium period of 3 years, i.e., repayment will start from the end of third year with the condition that the loan as such will be squared up by Rex in three equal yearly installments along with 6% per annum. You are required to find out the amount of the yearly installment and also the amount to be paid on account of interest. (4 marks) (b) The market portfolio has a historically based expected return of 0.10 and a standard deviation of 0.04 during a period when risk-free assets yielded The 0.07 risk premium is thought to be constant through time. Riskless investments may now be purchased to yield A security has a standard deviation of 0.08 and a co-efficient of correlation with the market portfolio is The market portfolio is now expected to have a standard deviation of You are required to find (i) market's return-risk trade-off; (ii) security beta; and (iii) equilibrium required expected return of the security. (6 marks) (c) DIGI Computers Ltd. is a manufacturer of computer systems. The company is marketing its products in domestic as well as global markets. It has a total sales of Rs. 1 crore. Its variable and fixed costs amount to Rs. 60 lakh and Rs. 10 lakh respectively. It has borrowed Rs % per annum and has an equity capital of Rs. 75 lakh. (i) What is company's return on investment? (ii) Does it have favourable financial leverage? (iii) If the firm belongs to an industry whose asset turnover is 1, does it have a high or low asset leverage? (iv) What are the operating, financial arid combined leverages of the firm? (v) If sales drop to Rs. 50 lakh, what will be the new EBIT? (10 marks) Question 4 Differentiate between the following: (i) 'Factoring' and 'bill discounting'. (ii) 'NPV' and 'IRR' methods of capital budgeting. (iii) 'Bonus issue of shares' and 'stock split'. (iv) 'Stock future' and 'index future'. (v) 'Futures contracts' and 'forward contracts'. (4 marks each) Question 5 (a) Write a short note on 'credit rating'. (4 marks) (b) Following are the extracts from financial statements of Zipway Ltd.: (Rs. in Lakhs)

4 3 FFTFM-Dec Earnings before interest and tax 250 Less: Interest on debentures 50 Earnings before tax 200 Less: Income-tax (40%) 80 Net profit 120 Equity share capital (shares of Rs. 10 each) 500 Reserve and surplus % Non-convertible debentures 500 1,250 The market price per equity share is Rs. 15 and per debenture is Rs. 95. Calculate the following: (i) earnings per share; and (ii) percentage of cost of capital to the company for the debenture fund and the equity. (8 marks) (c) Madhuri Ltd. is evaluating a project for which the initial investment required is Rs. 50 lakh to be met by internally generated funds of Rs. 10 lakh, from a rights issue of Rs. 15 lakh and the rest from a term 12% per annum. Rights issue will involve flotation cost of 5% and the term loan processing will cost 1%. Corporate tax rate is 40%. The risk-free rate of interest is 6.5%, market return is 15% and the relevant asset beta for the investment is estimated to be 1.5. Net operating cash inflows after tax from the project are: Year-1: Rs. 15 lakh; Year-2: Rs. 35 lakh; and Year-3: Rs. 15 lakh. Besides these cash inflows, residual value of Rs. 5 lakh (net of taxes) is also expected at the end of third year. Should the project be taken up? (8 marks) Question 6 (a) Syntex Ltd. has to make a US $5 million payment in three months' time. The required amount in dollars is available with Syntex Ltd. The management of the company decides to invest them for three months and following information is available in this context: The US $ deposit rate is 9% per annum. The sterling pound deposit rate is 11% per annum. The spot exchange rate is $1.82/pound. The three month forward rate is $1.80/pound. Answer the following questions (i) Where should the company invest for better returns? (ii) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would yield an equilibrium situation? (iii) Assuming that the US interest rate and the spot and forward rates remain as above, where should the company invest if the sterling pound deposit rate were 15% per annum? (iv) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium sterling pound deposit rate? (15 marks) (b) The following quotes are available for 3-months options in respect of a share currently traded at Rs. 31:

5 FFTFM-Dec Strike price Rs. 30 Call option Rs. 3 Put option Rs. 2 An investor devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile if it is given that the rate of interest is 10% per annum. What would be the position if the strategy adopted is selling a call and buying the put and the share? (5 marks) Question 7 Daisy Ltd.. is being floated with a project to manufacture a new product called 'Novo Fresh'. Currently it is being imported at a landed cost of Rs. 8,500 per ton. Following data has been collected relating to the project: Rs. (a) Investment in land 1,00,000 Investment in building 8,00,000 Investment in plant 12,00,000 (b) Cost of production per annum: Imported raw material 6,50,000 Local raw material 6,26,000 Salary 1,35,000 Administrative expenses 50,000 Power 60,000 Repairs and maintenance 5% of plant cost; and 2% of building cost. Depreciation 7% of plant cost; and 2.5% of building cost. Steam 7,000 Rs. 16/ton Packing drums Rs. 30/500 kgs. (c) Working capital requirements: Imported raw material 6 months Local raw material 3 months Packing drums stock 3 months Finished goods stock 1 month Credit to customers 1 month Credit from suppliers 1 month Cash expenses 1 month (d) Expected production: 250 ton per annum. You are required to (i) calculate the total capital needed for the project; (14 marks) (ii) assume that entire production can be sold at import rate, calculate percentage yield on investment and profit on sales; and (3 marks) (iii) calculate rate of cash generation per year. (3 marks)

6 : 1 : 334 RollNo... Time allowed : 3 hours Maximum marks : 100 Total number of questions : 7 Total number of printed pages : 10 NOTE : 1. Answer FIVE questions including Question No.1 which is compulsory. All working notes should be shown distinctly. 2. Tables showing the present value of Re.1 and the present value of an annuity of Re.1 for 15 years are annexed. 1. (a) The choice of an appropriate debt policy involves a trade-off between tax benefits and the cost of financial distress. Comment. (b) (c) (d) In the emerging economic and financial environment, the role and responsibility of treasury manager has become more demanding, complex and important. Elaborate. Cost of retained earnings is the opportunity cost of returns obtained in a similar investment elsewhere. Discuss. Internal treasury control is a process of self-improvement. Comment. (5 marks each) 2/2006/FTFM P. T. O.

7 334 : 2 : 2. (a) Joel Ltd. is commencing a new project for manufacture of a plastic component. The following cost information has been ascertained for annual production of 12,000 units at full capacity : Cost Per Unit (Rs.) Materials 40 Direct labour and variable expenses 20 Fixed manufacturing expenses 6 Depreciation 10 Fixed administrative expenses 4 Selling price per unit is expected to be Rs.96 and selling expenses Rs.5 per unit, 80% of which is variable. In the first two years of operations, production and sales are expected to be as follows : Year Production Sales (No. of Units) (No. of Units) ,000 5, ,000 8,500 Following additional information is available : (i) Stock of materials : 2.25 months average consumption. (ii) Work-in-process : Nil. (iii) Debtors : 1 month s average sales. (iv) Cash balance : Rs.10,000. (v) Creditors for supply of materials : 1 month s average purchase during the year. 2/2006/FTFM Contd...

8 : 3 : 334 (vi) Creditors for expenses : 1 month s average of all expenses during the year. Prepare projected statement of working capital requirements for the two years. (15 marks) (b) Ankit Ltd. is considering to take up Project-X or Project-Y. Both the projects have same life, require equal investment of Rs.80 lakh and have almost same yield. An attempt is made to use Probability Theory to analyse the pattern of cash flow from either project during first year of operation. This pattern is likely to continue during life of these projects. The results of analysis are as follows : Project-X Project-Y Cash Flow Probability Cash Flow Probability (Rs.) (Rs.) 12,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, You are required to decide as to which project is riskier to be dropped by the company. (5 marks) 2/2006/FTFM P. T. O.

9 334 : 4 : 3. (a) Following information is available regarding Faxfit Ltd. : Rs. Earnings before interest and tax (EBIT) lakh Interest on 10% Interest on term 12% Income-tax lakh lakh lakh Market price per share Number of equity shares (Face value Rs.10) lakh (equity shares) The company has undistributed reserves and surplus of Rs.70 lakh. It is in need of Rs.130 lakh to pay off debentures and modernise plants. The company is considering following alternatives of financing : Raising entire amount as term 14% per annum. Issuing 4 lakh Rs.18 per share and rest of the amount as 14% per annum. As a result of modernisation, the return on capital employed is likely to improve by 2.5%. In case the total amount is raised in the form of term loans, the P/E ratio of the company is likely to decline by 10%. You are required to (i) advise the company on financial plan to be selected; and (ii) find out the indifference level of EBIT. (12 marks) 2/2006/FTFM Contd...

10 : 5 : 334 (b) From the following information, ascertain whether the firm is following an optimal dividend policy as per Walter s Model : Total earnings (Rs.). 6,00,000 Number of equity shares of Rs.100 each. 40,000 Dividend paid (Rs.). 1,60,000 Prices-Earnings (P/E) ratio. 10 The firm is expected to maintain its rate of return on fresh investment. What should be the P/E ratio at which dividend policy will have no effect on the value of the share? Will your decision change if the P/E ratio is 5 instead of 10? (8 marks) 4. Distinguish between the following : (i) Sensex and nifty. (ii) Caps and collars. (iii) Financial structure and capital structure. (iv) Forward contract and options. (5 marks each) 5. Karishma Ltd. is considering to manufacture a new product which will involve use of a new machine costing Rs.1,50,000 and an existing machine, which was purchased two year ago at a cost of Rs.80,000, having current book value of Rs.60,000. There is sufficient under-utilised capacity on 2/2006/FTFM P. T. O.

11 334 : 6 : this machine. It is also estimated that annual sales of the product will be 5,000 units at Rs.32 per unit with following cost composition : Rs. Direct material 7 Direct labour (4 Hours per Rs.2 per unit) 8 Fixed cost (including depreciation) 9 The project would have a five year life, with residual value of Rs.10,000 for new machine. Direct labour being continuously in short supply, the labour resources would have to be diverted from other work, currently earning a profit of Rs.1.50 per direct labour hour. Fixed overheads absorption rate would be Rs.2.25 per hour and actual expenditure on fixed overheads will not change. The requirement of working capital would be Rs.10,000 in the first year, Rs.15,000 in the second and subsequent years till the end of the project when it will be recovered. The company s cost of capital is 20%. Ignoring tax implications, decide if the project is worth accepting. (20 marks) 6. (a) From the following data of Abhishek Ltd. as on 30 th September, 2006, compute the operating leverage, financial leverage, combined leverage and percentage change in earnings per share (EPS), if sales are expected to increase by 5% : 24 Rs. Earnings before interest and tax (EBIT) Profit before tax (PBT) Fixed cost 10 lakh 4 lakh 6 lakh (5 marks) 2/2006/FTFM Contd...

12 : 7 : 334 (b) Management of an Indian company is contemplating to import a machine from USA at a cost of US$15,000 at today s spot rate of $ per Rupee. Finance manager opines that in the present foreign exchange market scenario, the exchange rate may shoot up by 10% after two months and accordingly he proposes to defer import of machine. Management thinks that deferring import of machine will cause a loss of Rs.50,000 to the company in the coming two months. As the Company Secretary, you are asked to express your views, giving reasons, as to whether the company should go in for purchase of machine right now or defer purchase for two months. (5 marks) (c) Sales manager of a company proposes to sell goods to a group of new customers with 10% risk of non-payment. This group would require one and a half month s credit and is likely to increase sales by Rs.1,00,000 per annum. Production and selling expenses amount to 80% of sales and income-tax rate is 30%. The company s minimum required rate of return after tax is 25%. Should the sales manager s proposal be accepted? Find the degree of risk of non-payment that the company should be willing to assume, if required rate of return (after tax) is (i) 30%; (ii) 40%; or (iii) 60%. (10 marks) 2/2006/FTFM P. T. O.

13 334 : 8 : 7. Write notes on any four of the following : (i) Relationship between spot rate and forward rate (ii) Sources of real estate funding (iii) Stock lending scheme (iv) Technical charts (v) Economic value added (EVA) and wealth-maximisation. (5 marks each) o 2/2006/FTFM Contd...

14 : 9 : 334 TABLE 1 : PRESENT VALUE OF RUPEE ONE RATE YEAR % % % % % % % % % % % % % % % % % % % % % /2006/FTFM P. T. O.

15 334 : 10 : TABLE 2 : PRESENT VALUE OF AN ANNUITY OF RUPEE ONE PRESENT VALUE OF AN ANNUITY OF RATE YEAR % % % % % % % % % % % % % % % % % % % % % /2006/FTFM Contd...

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