(June 2013) C.S. Professional (G-2) Paper : Financial, Treasury and Forex Management

Transcription

1 (June 2013) C.S. Professional (G-2) Paper : Financial, Treasury and Forex Management Disclaimer Clause : These solutions are prepared by expert faculty team of Resonance. Views and answers provided may differ from that would be given by ICSI due to difference in assumptions taken in support of the answers. In such case answers as provided by ICSI will be deemed as final. NCE CS-PROFESSIONAL - 1

2 SOLUTION 1. (i) Liquidity & Profitability :The financial manager is responsible for having sufficient funds for the firm to conduct its business and to pay its bills. Money must be located to finance receivables and inventories, to make arrangements for the purchase of assets, and to identify the sources of long-term financing. Cash must be available to pay dividends declared by the board of directors. The management of funds has therefore, both liquidity and profitability aspects. If the firm's funds are inadequate, the firm may default on the payment of liabilities and may have to pay higher interest. If the firm does not carefully choose its financing methods, it may pay excessive interest costs with a subsequent decline in profits. (ii) Internal Rate of Return (IRR) : The internal rate of return refers to the rate which equates the present value of cash inflows and present value of cash outflows. In other words, it is the rate at which net present value of the investment is zero. If the Net Present Value is positive, a higher discount rate may be used to bring it down to equalise the discount cash inflows and vice versa. That is why Internal Rate of Return is defined as the break even financing rate for the project. The necessary steps to calculate IRR is (i) Project the net cash benefit of an investment during the whole of its economic life. Future cash flows should be estimated after taxes, but before depreciation and interest. (ii) Determine the rate of discount that equates the present value of its future cash benefits to its present investment. The rate of discount is determined by the method of trial and error. (iii) Compare the rate of discount as determined above with the cost of capital or any other cut-off rate, and select proposals with the highest rate of return as long as the rate is higher than the cost of capital or cut off rate. (iii) Tools of Treasury Management : Treasury manager is required to work in a fast changing and competitive environment. For carrying out his activities, he has resort to certain tools and techniques. Most of the tools originate from the finance department and as such can not be considered to be an exclusive prerogative of the treasury department. Yet it is the treasury manager which is using these tools most extensively. The tools are being described below: 1. Analytic and planning tools : In treasury function, planning and budgeting are essential to achieve targets and to keep effective control on costs. Analysis of the data and information is necessary for planning and budgeting. Performance budgeting is referred to as setting of physical targets for each line of activity. The financial outlay or expenditure needed for each is earmarked to choose the least cost mode of activity to achieve the targets. Productivity and efficiency improves by decentralization of responsibility and that is achieved by performance budgeting, where each department or section is made a profit center and is accountable for its targets, financial involvement and profits in financial terms, relative to the targets in physical terms. This type of planning involving performance budgeting is best suited for service industry say a financial services company or bank where every department can function in a decentralized manner and achieve the targets. 2. Zero Based Budgeting (ZBB): Another tool of analysis and performance is ZBB wherein each manager establishes objectives for his function and gain agreement on them with top management. Then alternate ways for achieving these targets are defined and most practical way for achieving the targets is selected. This alternative is then broken into incremental levels of effort required to achieve the objective. For each incremental level of activity, costs and benefits are assessed. The alternative with the least cost is then selected. 3. Financial Statement Analysis : Financial analysis of a company is necessary to help the treasury manager to decide whether to invest in the company. Such analysis also helps the company in internal controls. The soundness and intrinsic worth of a company is known only by such analysis. The market price of a share depends, among other things on the sound fundamentals of the company, the financial and operational efficiency and the profitability of that company. These factors can be known by a study of financial statements of the company. NCE CS-PROFESSIONAL - 2

3 (iv) Cost of Capital : Cost of capital is the minimum rate of return expected by its investor It acts as a cut off rate or a hurdle rate or the minimum acceptable rate of return from an investment. It is the weighted average cost of various sources of finance used by the company. The cost of capital is the minimum rate of return expected by the investors which will maintain the market value of shares at its present value. If the firm is not able to achieve the cut off rate, market value of its share will fall. Hence to achieve the objective of wealth maximisation, a firm must earn a rate of return more than its cost of capital. (v) Depository System - The Depository System functions very much like the banking system. A bank holds funds in accounts whereas a Depository holds securities in accounts for its clients. A Bank transfers funds between accounts whereas a Depository transfers securities between accounts. In both systems, the transfer of funds or securities happens without the actual handling of funds or securities. Both the Banks and the Depository are accountable for the safe keeping of funds and securities respectively. In the depository system, share certificates belonging to the investors are to be dematerialised and their names are required to be entered in the records of depository as beneficial owners. Consequent to these changes, the investors' names in the companies' register are replaced by the name of depository as the registered owner of the securities. The depository, however, does not have any voting rights or other economic rights in respect of the shares as a registered owner. The beneficial owner continues to enjoy all the rights and benefits and is subject to all the liabilities in respect of the securities held by a depository. 2. (a) Retained earning being 37.5 % is ` 6 per share EPS 6 / & DPS 10 P/E Ratio is 7.5 times MPS EPS P/E Ratio D (i) Ke 1 g P % Here D 1 D 0 (1 + g) (1.08) 10.8) (ii) Ke D P g P 0 D 1 Ke g 11 P (iii) If cost of capital is 15% & growth rate is 11% then MPS D 1 P 0 Ke g (b) Evaluation of Credit Policy Particulars Existing Proposed Credit Period 36 days 60 days Sales ` 10,00,000 ` 12,00,000 Contribution 3,00,000 3,60,000 Contribution 60,000 Bad Debts 10,000 24,000 Bad Debts 14,000 Cost of Sales 7,50,000 8,90,000 Cost of Debtors 75,000 1,48,333 Interest 15,000 29,667 Interest 14,667 Net Benefit 31,333 NCE CS-PROFESSIONAL - 3

4 2. (c) Income Statement of Honey well Ltd. Particulars Amount (in `) Sales 15,00,000 V.C. 6,00,000 Contribution 9,00,0000 F.C. 2,00,000 EBIT 7,00,000 Interest 24,000 EBT 6,76,000 Tax 2,02,800 EAT 4,73,200 No. of ES 18,000 EPS (i) Operating Leverage Contribution EBIT 9,00,000 7,00,000 EBIT Financial Leverage EBT Combined Leverage ,00, ,76,000 Contribution EBT 9,00,000 6,76, (ii) If EPS is ` 6, then EBIT EBIT (EPS No. of Eq. Sh) (1 t) + Interest ( 6 18,000) ,000 1,78, (a) Annual quantity to buy is boxes (i) Total Annual cost of Inventory Purchase Cost , Ordering Cost , Carrying Cost Total Cost 65, (ii) EOQ 2AO C Total Cost based on EOQ Purchase Cost ,500 Ordering Cost Carrying Cost , ,250 Total Cost 65,000 Thus the company can save ` 62.5 by employing the economic order quantity. NCE CS-PROFESSIONAL - 4

5 3. (b) Calculation of EPS under three financing options : (i) Particulars Option -I Option-II Option - II (` in Lacs) EBIT 1,500 1,500 1,500 Interest 450 EBT 1,500 1,050 1,500 Tax EAT 1, ,050 D P 360 EAS 1, No. ES EPS Option - II ( debt option) gives the highest return. (ii) Indifference point between equity & debt option. ( P EBIT I)(1 t) D n ( x 0)(0.50) x 45x x 1350 Lacs 15 i.e. ` Crore ( P EBIT I)(1 t) D n ( x 450)(0.50) (i) Profit Maximisation : Profit maximisation is considered as an important goal in financial decisionmaking in an organisation. It ensures that firm utilizes its available resources most efficiently under conditions of competitive markets. But in recent years, under the changed corporate environment, profit maximisation is regarded as unrealistic, difficult, unappropriate and socially not much preferred goal for business organisation. Profit maximisation as corporate goal is criticised by scholars mainly on the following grounds: (i) It is vague conceptually. (ii) It ignores timing of returns. (iii) It ignores the risk factor. (iv) It may tempt to make such decisions which may in the long run prove disastrous. (v) Its emphasis is generally on short run projects. (vi) It may cause decreasing share prices. (vii) The profit is only one of the many objectives and variables that a firm considers. Wealth maximisation Presently, maximisation of present value (or wealth) of a course of action is considered appropriate operationally flexible goal for financial decision-making in an organisation. The management of an organisation maximises the present value not only for shareholders but for all including employees, customers, suppliers and community at large. This goal for the maximum present value is generally justified on the following grounds: (i) It is consistent with the object of maximising owners economic welfare. (ii) It focuses on the long run picture. (iii) It considers risk. (iv) It recognises the value of regular dividend payments. (v) It takes into account time value of money. (vi) It maintains market price of its shares. (vii)it seeks growth in sales and earnings. However, profit maximisation can be part of a wealth maximisation strategy. Quite often two objectives can be pursued simultaneously but the maximisation of profit should never be permitted to overshadow the objectives of wealth maximisation. NCE CS-PROFESSIONAL - 5

6 (ii) Netting: All transactions-gross receipts and payments among the parent firm and subsidiaries should be adjusted and only net amounts should be transferred. This technique is called netting. This again involves centralisation of data at the corporate level, selection of the time period at which netting is to be done, and choice of the currency in which netting is to be done. The currency could be the home currency of the firm. Netting reduces costs of remittance of funds, and increases control of intra-firm settlements. It also produces savings in the form of lower float (funds in the pipe-line) and lower exchange costs. Matching: It is a process whereby cash inflows in a foreign currency are matched with cash outflows in the same currency with regard, to as far as possible, amount and maturation. Hedging of exchange risk could be done for the unmatched portion. When there are cash inflows in one foreign currency and cash outflows in another foreign currency, the two could still be matched, provided they are positively correlated i.e. expected to move in tendem. There is the risk of exchange rates going off the expectations. (iii) Currency swaps: A Currency swap is a specified type of forex derivative. A currency swap is an agreement between two parties to agree to exchange different currencies normally at the prevailing spot exchange rate with an agreement to reverse the exchange of currencies, at the same spot exchange rate, at a fixed date in the future, generally at the maturity of the swap. Currency option: Currency options, commonly known as a Forex options are contracts which allows a person the right to buy or sell an item of their choosing at a give price for a limited period of time however it does not oblige them to do so. The only person obliged to perform anything is the seller of the option. (iv) Efficient Portfolio: According to Markowitz Model, investor are mainly concerned with risk & return. For selection of portfolio, various combination of securities can be made according to their risk & return preferences. These all combinations are plotted on the graph. All portfolio on efficient frontier of the graph are known as efficient portfolio. (v) (i) Optimal Portfolio: Efficient portfolio are all possible portfolio at given level of risk, with highest return. Theoritically, optimum portfolio is where risk is minimum and return is maximum but practically it is not possible. Acceptance of level of risk depends on investror s risk preference. Hence optimum portfolio is the portfolio where at given risk level, investor can get optimum return. Interest Rate Parity: According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-à-vis the currency of another country will be exactly offset by the interest rate differential between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa. (ii) Purchasing Power Parity (PPP): According to the PPP Principle, the currency of a country will depreciate vis-à-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of a country would roughly be equal to the excess inflation rate in the country over the other country. 5. (a) (i) When dividend is paid D1 P1 P0 P P P Number of shares to be issued for financing the investment n I [Y nd1] P 1 75,00,000 [65,00,000 4,00000] NCE CS-PROFESSIONAL - 6

7 (ii) When dividend is not paid Ke D1 P1 P P P P Number of shares to be issued for financing the investment n I [Y nd1] P 1 75,00,000 [65,00,000 0] shares Here P 0 Current market price P 1 Expected price at year end. n Number of shares to be issued I Investment requirement Y Net Income n no. of equity shares at the beginning of year D 1 Expected dividend 5. (b) (i) Current market position ,00,000 Hedging required Current Position Beta 3,00, ,50,000 Value of one market Contract lot 4, ,00,000 Hence no. of contract to be taken 1,50,000 4,00, Contract (ii) If price drops in spot market by 10% i.e. fall in value by `25. Loss in market position ,000 Gain in future market 4000 Net Benefit /Loss Nil 5. (c) Given that In New York 1GBP USD calculation of cross- currency rate of USD/GBP USD USD INR GBP INR GBP There is difference in rate. Hence arbitrage is possible. Arbitraguer should sell USD & get INR 1,00,00, ,30,00,000 Now convert the INR into GBP. 48,30,00,000 62,30, Now sell GBP to receive the USD back 62,30, ,01,12,968 Hence arbitraguer can make gain of USD 1,12,968 10% , NCE CS-PROFESSIONAL - 7

8 6. (i) Estimation of working capital Requirement Financial, Treasury and Forex Management Particulars Amount Cash at Bank Given 25,000 Stock of R.M ,64,615 Stock of WIP ,00,000 Stock of of Finished Goods ,60,000 Debtors ,53,846 Creditors [(1,08,000 80) + 6,64,615] O/s wages [(1,04, (4,000 15)] 52 TCA 55,03,461 7,15,740 91,731 (ii) Maximum Permissible Bank Finance (Under the second method) MPBF (CA 25 % of Current Asset) CL (55,03,461 13,75,865) 8,07,471 33,20,125 TCL 8,07,471 NWC 46,95, (i) Factoring may be defined as a relationship between the financial institution or banker (factor) and a business concern (the supplier) selling goods or providing services to trade customers (the customer) whereby the factor purchases book debts with or without recourse (with a recourse means that in the event of bad debts factor can approach the supplier) to the supplier and in relationship there to controls the credit extended to the customers and administers the sales ledger of the supplier. Though the purchase of book debts is fundamental to the functioning of factoring, there are a number of functions associated with this unique financial services. A proper appreciation of these functions would enable one to distinguish it from the other sources of finance against receivables. They are assumption of credit and collection function; credit protection; encashing of receivables; collateral functions such as: (a) loans on inventory, (b) loans on fixed assets, other security and on open credit, (c) advisory services to clients. (ii) Translation Exposure: This is also called the accounting exposure. It refers to and deals with the probability that the firm may suffer a decrease in assets value due to devaluation of a foreign currency even if no foreign exchange transaction has occurred during the year. This exposure needs to be measured so that the financial statements i.e the balance sheet and the income statement reflect the change in value of assets and liabilities. It may be noted that the assets and liabilities are considered exposed to foreign exchange risk if their values are to be translated into parent company currency using the exchange rate effective on the balance sheet date. Other assets and liabilities and the capital that are translated at the historical exchange rates i.e., the rate in effect when these items were first recognized in the balance sheet, are not considered to be exposed. The translation exposure occurs when the firm's foreign balances are expressed in terms of the domestic currency. Changes in exchange rates can therefore, alter the values of assets, liabilities, expenses and profits of foreign subsidiaries. Two related decision areas are involved in translation exposure management: (i) Managing balance sheet items to minimize the net exposure, (ii) Deciding how to hedge against this exposure This exposure is particularly relevant for the companies which have subsidiaries in other countries. These companies have to translate the financial statements of their subsidiaries that are prepared in a foreign currency into the currency of the home country to prepare the consolidated statements. Foreign currency depreciation results in exchange losses if the exposed assets are greater than exposed liabilities. Foreign currency appreciation, on the other hand, will produce exchange gains. NCE CS-PROFESSIONAL - 8

9 The calculation of translation gains and losses is an exercise on paper only. These gains and losses do not involve any actual cash flow. Some companies, however, are concerned about this risk because it affects their cost of capital, earnings per share, and the stock price, besides the ability to raise capital in the market. (iii) Transfer Pricing: It is a mechanism by which profits are transferred through an adjustment of prices on intra-firm transactions. It can be applied to transactions between the parent firm and its subsidiaries or between strong currency and weak currency subsidiaries. Subject to the demands of competition, a parent may charge higher prices to its weak currency subsidiary, thereby increasing its own profit and reducing that of the subsidiary. The taxable income of the subsidiary comes down. Recovering higher level of operating charges from the subsidiaries also serves the same purpose. It is likely that audit profession, exchange controls and customs duties of the host country may supervene to negate this strategy. So, the mechanism may be applied moderately-gradually over a long period, without upsetting the environment in which the subsidiaries operate (iv) Economic Rate of Return (ERR) : ERR is a rate of discount which equates the real economic cost of project outlay to its economic benefits during the life of the project. ERR is an attempt to find out the rate of return to the economy or society and not the private promoters or various agencies involved in promoting a project. The need for ERR arises because current market prices and costs taken into account to determine the financial viability of the project do not represent the true value from the national or economic view point. While computing ERR, analysis is made using shadow prices which reflect the real cost of inputs to the society and real benefits of the output rather than market prices. The capital cost of the project, working capital requirements and operating costs are divided into tradeable, non-tradeable and labour components, which are then revalued using international prices, conversion factors and shadow wage rates respectively. Based on the revalued project cost, working capital, operating costs and revenues, a steam of cash outflows, inflows, and net flows are computed during project implementation period and operating life of the project. The cash flows are then discounted to arrive at the economic internal rate of return. (v) Sweat Equity Shares : Sweat equity share is a instrument permitted to be issued by specified Indian companies, under Section 79A of Companies Act, 1956 inserted by Companies (Amendment) Act, 1999 w.e.f. 31st October, According to this section a public company may issue sweat equity shares of a class of shares already issued if the following conditions are fulfilled: (a) The issue of sweat equity share is authorised by a special resolution passedby the company in the general meeting. (b) The resolution specifies the number of shares, current market price, consideration if any and the class or classes of directors or employees to whom such equity shares are to be issued. (c) Not less than one year has elapsed at the date of the issue, since the date on which the company was entitled to commence business. (d) The sweat equity shares of a company whose equity shares are listed on a recognised stock exchange are issued in accordance with the regulations made by SEBI in this regard. NCE CS-PROFESSIONAL - 9