GUIDELINE ANSWERS FINAL EXAMINATION DECEMBER 2005 GROUP II

Transcription

1 GUIDELINE ANSWERS FINAL EXAMINATION DECEMBER 2005 GROUP II The Institute of Company Secretaries of India IN PURSUIT OF PROFESSIONAL EXCELLENCE Statutory body under an Act of Parliament ICSI House, 22, Institutional Area, Lodi Road, New Delhi Ph. : , ; Fax : info@icsi.edu; Website :

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3 These answers have been written by competent persons and the Institute hopes that the GUIDELINE ANSWERS will assist the students in preparing for the Institute s examinations. It is, however, to be noted that the answers are to be treated only as model and not exhaustive answers and the Institute is not in any way responsible for the correctness or otherwise of the answers compiled and published herein. C O N T E N T S Group II Page 1. Financial, Treasury and Forex Management 1 2. Corporate Restructuring Law and Practice Banking and Insurance Law and Practice 36

4 THE INSTITUTE OF COMPANY SECRETARIES OF INDIA PRICE : Rs Rs (Excluding Postage & Packing) (By Registered Post) Laser Typeset by Delhi Computer Services, , 1st Floor, Pocket 17, Sector 24, Rohini, Delhi Ph: and Printed at Samrat Offset Works/2,000/February 2006

5 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) Answer 1(a) Internal Treasury Control Internal treasury control is a process of self improvement. It is concerned with all flows of funds, cash and credit and all financial aspects of operations. From time to time and on regular basis, the internal treasury control is exercised on financial targets. The financial aspects of operations include procuring of inputs, paying creditors, making arrangement for finance against inventory and receivables. The gaps between inflows and outflows are met by planned recourse to low cost mix of financing. The control aims at operational efficiency and removal of wastages and inefficiencies and promotion of cost effectiveness in the firm. The control is exercised under phases of planning and budgeting. These phases include setting up of targets, laying down financial standards, evaluation of performance as per these norms and reporting in a standard format. Answer 1(b) Benefits to the company (i) Funds are available at low cost. (ii) There is no need to provide security. (iii) Process is very simple and no restrictive covenants are involved. (iv) Restrictions put by the RBI on financial institutions to advance, to prevent hoarding and black marketing leads the companies to accept deposits from the public. (v) Tax deductibility of interest paid on deposits. Benefits to the depositors (i) High rate of interest. (ii) Maturity period is relatively short. 1

6 FFTFM-Dec Answer 1(c) In assessing the financial viability of a lease proposal, the lessor has to look at both the return and risk associated with it. For lessor, lease decision is akin to capital budgeting exercise. As far as lessor s return is concerned, usual capital budgeting techniques are used to evaluate the various decisions such as whether to accept a lease plan or not, or which plan among various alternatives to accept, or how to quote lease rates. For assessing the return from a lease there is a need to define the lease-related cash flows. Cash flow stream from lessor s point of view can not be different from the cash flow stream of the lessee except that the cash outflows of the lessee will constitute the inflows of the lessor. However, the lessor may use a different discount rate and may be in a different tax-bracket. Having identified the cash flows from lessor s point of view, NPV (or other techniques) may be used as a decision criterion. Another aspect of lease evaluation from lessor s point of view is the assessment of risk the variability of NPV (or IRR etc.) around their expected values. Two major concerns of the lessor here are (a) the credit worthiness of the lessee and (b) the residual value of the equipment. And the return accruing from a lease transaction have to be carefully evaluated in terms of these two factors. Answer 1(d) Economic value added is a concept used by various firms to determine whether an existing/proposed investment positively contributes to the owners /shareholders wealth. It is the difference of after-tax operating profits of a firm and cost of funds used to finance investments. Therefore, from the point of view of maximizing shareholders wealth only those investments would be desirable which have positive EVA. For instance, if there are after tax profits of Rs. 10 crore associated with an investment project and its cost of financing is Rs. 8 crore, the difference of Rs. 2 crores reflects EVA. A positive EVA would add value and increase the wealth of the owners and hence would be acceptable. The concept of EVA is simple and easy to use in decision-making process related to investments. However, computation of after tax profits and cost of funds used to finance the project involve various accounting and financial issues. 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)

7 3 FFTFM-Dec (c) Following information is available in respect of EPS and DPS of Intelligent Ltd. for the last five years: Year Answer 2(a) 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 growth model; and (iii) capital asset pricing model (CAPM). (10 marks) The four tools available to cover exchange rate risk are as follows: (a) Invoicing Policies: Invoices to third parties abroad should be denominated in the relatively stronger currency. On the other hand, while importing goods, etc. from third parties, a firm should try to negotiate payments in the weaker currency. Respective bargaining strengths and the need for good customer relations have a bearing on the invoicing decision. (b) 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 currency subsidiaries. (c) Leading and Lagging and extension of Trade Credit: Leading implies speeding up collections on receivables if the foreign currency in which they are invoiced is expected to appreciate. Lagging implies delaying payments of payables invoices in a foreign currency that is expected to depreciate. (d) 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. Answer 2(b) Average receivables = Credit Sales x Average Collection Period 360 Rs. 80, 00, days Average receivables: 360 = Rs. 17,77,778 Evaluation of Factor Proposal (Rs.) Factoring 2% (2% x Rs. 17,77,778) = 35,556 10% of receivables = 1,77,778 Advance payable by the factor (17,77,778 1,77,778 35,556) = 15,64,444 18% (18% of Rs. 15,64, days) = 62,

8 FFTFM-Dec Net Amount of Advance (Rs. 15,64,444 62,578) = 15,01,866 Cost of Factoring: Commission = 35,556 Interest = 62,578 Annualised Cost = Less: Savings in Bad Debts (1% of Rs. 80,00,000) ( ) 80,000 98,134 = 4,41,603 Administrative Cost ( ) 1,20,000 2,00,000 Net Incremental Cost 2,41,603 The total cost of factoring is Rs. 4,41,603 which is more than the existing cost by Rs. 2,41,603. So the firm need not avail the services of the factor. Answer 2(c) Valuation as per Dividend Growth Model: EPS for the year 2000 Rs EPS for the year 2004 Rs Growth rate table for 4 years ( ) In the CVF table for 4 years, the value of lies in between 3% and 4%. So, the growth rate, g. may be taken as 3.5%. R s = I RF + (I RM I RF ) β = ( ) 1.5 = 0.12 or 12% Now, valuation as per dividend growth model is: P 0 = = D0( 1+ g) Ke g Rs ( ) = Rs Earnings Growth Model: P 0 = E( 1 b) k e b r For the last 5 years, the company has been following a dividend payout ratio of 60% (approx). If the same dividend policy is maintained, then retention ratio, b, is 40% and r is 12%. So, b r = 0.12 x 0.4 = 4.8% Now, P o = 14.10(1 0.4) = = Rs

9 5 FFTFM-Dec Valuation as per CAPM: P o = Question = Rs (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. Answer 3(a) (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? Loan Taken : Rs. 20,00,000 Rate of Interest : 6% p.a. Moratorium Period : 3 years (10 marks) Amount due at the end of year two : Rs. 20,00,000 x 1.06 x 1.06 = 22,47,200 Size of instalment : Rs. 22,47,200 (sum of the PV of Re.1 for three years = = 2.673) = Rs. 8,40,703

10 FFTFM-Dec Year Opening Balance (Rs.) Interest at 6% (Rs.) Amount paid (Rs.) Amount due at year end (Rs.) 1 20,00,000 1,20, ,20, ,20,000 1,27, ,47, ,47,200 1,34,832 8,40,703 15,41, ,41,329 92,480 8,40,703 7,93, ,93,106 47,597 8,40, ,22,109 25,22,109 Answer 3(b) (i) Market s Return-Risk Tradeoff = R m R F σ Where, R m = Market rate of return, i.e R F = Risk free return, i.e σ = Standard deviation = = (ii) Security Beta: Where, = β 1 σ σ s m r m β 1 = Beta factor of investment σ s = Standard deviation of investment in security, i.e r m = Co-efficient of Correlation with market portfolio, i.e., 0.85 σ m = Market portfolio standard deviation, i.e., β 1 = = (iii) Equilibrium required for expected rate of return on the security: Where: E(R 1 ) = R F + β 1 (R m R F ) E(R 1 ) = Expected rate of return on investment R F = Riskless investments yield = 0.09 R m = Expected Return on Market Portfolio β 1 = Market sensitive index (Beta factor) of investment i.e, 1.7 E(R 1 ) = ( ) = (0.07) = = = 20.9%

11 7 FFTFM-Dec Answer 3(c)(i) EBIT Return on Investment = 100 Investment EBIT: (Amount in Rs.) Sales - 1,00,00,000 Less: Variable Cost - 60,00,000 Contribution - 40,00,000 Less: Fixed Cost - 10,00,000 EBIT - 30,00,000 Investment: Equity Capital - 75,00,000 Borrowed funds - 60,00,000 Total investment - 1,35,00,000 EBIT ROI = 100 Total Investments 30,00,000 ROI = 100 = 22.22% 1,35,00,000 Answer 3(c)(ii) ROI = 22.22%, Rate of Interest on borrowed funds = 10% Yes, the firm, DIGI Computers Ltd. has favourable financial leverage as the ROI is higher than the interest on borrowed funds. Answer 3(c)(iii) Asset Turnover = Industry Asset Turnover = 1 Sales Total Assets or TotalInvestments Digi Computers Ltd. has lower asset leverage. Answer 3(c)(iv) Operating leverage = Rs.1,00,00,000 = = 0.74 Rs.1,35,00,000 S - V C EBIT = Rs. 40,00,000 = = 1. EBIT Rs. 30,00, Financial Leverage = EBIT EBIT Interest Rs. 30,00,000 = = 1.25 Rs. 30,00,000 6,00,000 C Rs. 40,00,000 Combined leverage = = = EBT Rs. 24,00,000 Answer 3(c)(v) EBIT at sales level of Rs. 50,00,000 Sales Rs. 50,00,000 Less: Variable cost (Rs. 50,00,000 x 0.60) Rs. 30,00,000

12 FFTFM-Dec Contribution Rs. 20,00,000 Less: Fixed Costs Rs. 10,00,000 EBIT Rs. 10,00,000 Alternative Solution Decrease in Sales 50% Operating Leverage 1.33 Decrease in EBIT (50 x 1.33) 66.5% (approx.) Present EBIT Rs. 30,00,000 Less: 66.5% Rs. 20,00,000 (approx.) EBIT Rs. 10,00,000 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'. Answer 4(i) Factoring and Bill Discounting (4 marks each) Under a bill discounting arrangement, the drawer undertakes the responsibility of collecting the bills and remitting the proceeds to the financing agency, whereas under factoring agreement, the factor collects client s bills. Moreover, bill discounting is always with recourse whereas factoring can be either with recourse or without recourse. The finance house discounting bills does not offer any non-financial services unlike a factor which finances and manages the receivables of a client. Answer 4(ii) NPV and IRR Methods of Capital Budgeting Point of Differences: 1. Interest Rate: Under the net present value method rate of discount is assumed as the known factor whereas it is unknown in case of internal rate of return method. 2. Reinvestment Axiom: Under both the methods, it is assumed that cash inflows can be re-invested at the discount rate in the new projects. However, reinvestment of funds, at discount rate is more possible than internal rate of return. So net present value method is more reliable than internal rate of return method for ranking two or more projects. 3. Objective: The net present value method attempts to ascertain the amount which can be invested in a project so that its expected yield will exactly match to repay this amount with interest at the market rate. On the other hand, internal rate of return method attempts to find out the rate of interest which is maximum to repay the invested fund out of the cash inflows.

13 9 FFTFM-Dec Points of Similarities: IRR will give the same results as NPV in terms of acceptance or rejection of investment proposals in the following circumstances: 1. Projects having conventional cash flows i.e, a situation where initial investment (outlay or cash outflow) is followed by series of cash inflows. 2. Independent Investment proposals: Such proposals, the acceptance of which does not exclude the acceptance of others. Answer 4(iii) Bonus issue of shares and stock split A comparison between a bonus issue and a stock split is given below: Bonus Issue The par value of the share is unchanged A part of reserves is capitalized. The shareholders proportional ownership remains unchanged. Total paid up capital increases. The book value per share, the earnings per share, and the market price per share decline. The market price per share is brought within a more popular trading range. Answer 4(iv) Stock Split The par value of the share is reduced. There is no capitalization of reserves. The shareholders proportional ownership remains unchanged. Total paid up capital remains same. The book value per share, the earnings per share, and the market price per share decline. The market price per share is brought within a more popular trading range. Stock future and index future Stock futures are financial contracts where the underlying asset is an individual stock. Stock future contract is an agreement to buy or sell a specified quantity of underlying equity share for a future date at a price agreed upon between the buyer and seller. The contracts have standardized specifications like market lot, expiry day, unit of price quotation, tick size and method of settlement. Index futures are the future contracts for which the underlying is the cash market index. In a normal contract for purchase of equity shares, physical quantity of shares is delivered but in a futures contract, there is nothing to be delivered. In India, futures on both BSE Sensex and NSE Nifty are traded. Any eligible investors who can trade in the cash market, can trade in the futures market. For every buyer there is a seller of the futures. What makes them agree on the contract value is the divergence of their views on the likely value of the index future at the expiry of the contract. Answer 4(v) Futures Contracts and forward contracts A Future represents the right to buy or sell a standard quantity and quality of an asset or security at a specified date and price.

14 FFTFM-Dec In a forward contract, the purchaser and its counter party are obligated to trade in security or other asset at a specified date in future. The price paid for the security of assets is agreed upon at the time the contract is entered into. Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued or Marked to Market daily. The Marking to Market provides both parties with a daily accounting of their financial obligation under the terms of the future. Unlike Forward contracts, the counter party to a Futures contract is the clearing corporation of the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying assets. The difference in forwards and futures relate to contractual features the way markets are organized, profiles of gains and losses, kinds of participants in the markets and the way in which they use the two instruments. 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) 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) Answer 5(a) Credit rating is a symbolic indication of the current opinion regarding the relative capability of a corporate entity to service its debt obligations in time with reference to the instrument being rated. It enables the investor to differentiate between

15 11 FFTFM-Dec instruments on the basis of their underlying credit quality. To facilitate simple and easy understanding, credit rating is expressed in alphabetical or alphanumerical symbols. Credit rating aims to (i) provide superior information to the investors at a low cost; (ii) provide a sound basis for proper risk-return structure; (iii) subject borrowers to a healthy discipline, and (iv) assist in the framing of public policy guidelines on institutional investment. Thus, credit rating financial services represent an exercise in faith building for the development of a healthy financial system. Answer 5(b) (i) Earning per share: Net Profit 120,, 00, 000 EPS = = = Rs No. of Equity Shares 50, 00, 000 (ii) Cost of Capital: Where, Cost of Debenture Fund Int. (1 T) K D = D K D = Cost of debenture fund Int. = Interest paid on debenture funds, i.e. Rs. 50,00,000 T = Corporate tax rate (40%) D = Total Debenture Fund At Book Value: 50,00,000(1 0.40) 30,00,000 K D = = = 0.06 = 6% 500,00, ,00,000 At Market Value: 50, 00, 000( ) 30, 00, 000 K D = = = = 6. 31% 475, 00, , 00, 000 K E = E P E Where, K E = Cost of Equity Capital E = Current earnings per share Rs P E = Market Price of Equity Share Rs. 15 Rs. 2.4 K E = = = 16% Rs. 15 Answer 5(c) Initial investment required = Rs. 50,00,000

16 FFTFM-Dec Internal funds available = Rs. 10,00,000 Rights issue = Rs. 15,00,000 Right issue floatation cost = 5% Term 12% = Rs. 25,00,000 Term loan processing cost = 1% R f = 6.5% R m = 15% β = 1.5 Corporate tax rate = 40% K= R f + β (R m R f ) = ( ) = x 8.5 = ,00,000 35,00,000 (15,00, ,00,000) NPV at 19.25% = ,00, (1.1925) (1.1925) (1.1925) 15,00,000 35,00,000 20,00,000 = ,00, = 12,57, ,61, ,79,383 50,00,000 = Rs. 48,98,290 Rs. 50,00,000 = ( ) Rs. 1,01,710 Impact of financing: Loan amount Rs. 25lakh = = Rs. 25,25,253 (1-0.01) Tax shield = 25,25,253 x 12% x 40% = Rs. 1,21,212 per year Pv. of Tax Shield = 1,21,212 x PVAF (12%, 3 years) = 1,21,212 x = Rs. 2,91,127 Cost of Rights issue = Rs. 15 lakh x 5/95 = Rs. 78,947/- Debt Cost = Rs. 25 lakh x 1/99 = 25,253 Adjusted NPV Rs. Base NPV = ( ) 1,01,710 Issue cost of Rights = ( ) 78,947 Debt = ( ) 25,253 Tax Shield = 2,91,127 NPV = 85,217 Since, adjusted NPV is positive, the project may be taken up. 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.

17 13 FFTFM-Dec The sterling pound deposit rate is 11% per annum. The spot exchange rate is $1.82/pound. The three month forward rate is $1.80/pound. Answer the following questions (i) Where should the company invest for better returns? (ii) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would yield an equilibrium situation? (iii) Assuming that the US interest rate and the spot and forward rates remain as above, where should the company invest if the sterling pound deposit rate were 15% per annum? (iv) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium sterling pound deposit rate? (15 marks) (b) The following quotes are available for 3-months options in respect of a share currently traded at Rs. 31: Strike price Rs. 30 Call option Rs. 3 Put option Rs. 2 An investor devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile if it is given that the rate of interest is 10% per annum. What would be the position if the strategy adopted is selling a call and buying the put and the share? (5 marks) Answer 6(a)(i) US$ Deposit Rate = 9% per annum Sterling Pound Deposit Rate = 11% per annum Spot Exchange Rate = $ 1.82 / pound Three Month Forward Rate = $ 1.80 / pound Option I: Invest in $ 9% per annum for 3 months 9 3 Income = 50,00,000 = $ 1,12, Option II: Available dollars may be converted to pounds at spot rate. Cover forward position and 11% p.a. for three months. Spot exchange rate = $ 1.82/ So, $ 5 million = 5,000,000 = Interest earning on 11% p.a months = = Amount after 3 months = Plus Interest

18 FFTFM-Dec Pound converted to dollar at 1.80 / pound Forward rate = x 1.80 = $ Gain = ,000,000 = $ Hence, Gain Option I = $ 1,12,500 Gain Option II = $ Therefore, Syntex Ltd. must invest under Option I in $ at 9% Answer 6(a)(ii) For an equilibrium situation, amount at the end of three months should be equal. Therefore, amount invested in sterling covered by forward rate = $ 50,00,000 + $1,12,500 = $ 51,12,500 Let forward rate be $ x / at equilibrium equals x = $ 51,12,500 51,12,500 x = = ,22, Forward Rate = $ 1.811/ Answer 6(a)(iii) Interest earned in pounds given same spot and forward rates: 15 3 = = Total = ,03, = Total $ = x 1.80 = $ Gain = $ 51,30, $ 50,00,000 = $ Earlier Gain = $ 1,12,500 Therefore, at 15% Syntex Ltd. should invest in $ Sterling. Answer 6(a)(iv) For equilibrium sterling deposit rate, amount invested in sterling equals $ 51,12,500 after three months. Now, $ 51,12,500 converted to at forward rate = Let sterling rate be X% p.a. $ 5,112, X = X = X = X = 13.54% per annum =

19 15 FFTFM-Dec Answer 6(b) Strategy I: (Buying a Call and Selling a Put and a Share) Initial Cash Inflow (Rs. 31 Rs. 3 + Rs. 2) Rs. 30 Interest Rate 10% Amount grows in 3 months to (30 x e 1.25 ) Rs * If the share price is greater than Rs. 30, he would exercise the call option and buy one share for Rs. 30 and his net profit is Rs (i.e., Rs ) However, if the share price is less than Rs. 30, the counter-party would exercise the put option and the investor would buy one share at Rs. 30. The net profit to the investor is again Rs Strategy II: (Selling a Call and buying a put and a share) In this case, the investor has to arrange a 10% of Rs. 30 (i.e., Rs ). This amount would be repaid after 3 months. Amount payable is: 30 x e 1.25 Rs After 3 months, if the market price is more than Rs. 30, the counter-party would exercise the call option and the investor would be required to sell the share at Rs. 30. The loss to the investor would be Rs (i.e., Rs ) However, if the rate is less than Rs. 30, the investor would exercise the put option and would get Rs. 30 from the rate of share. The loss to the buyer would again be Rs *Interest can also be calculated on simple interest basis instead of continuous compound interest. 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

20 FFTFM-Dec Packing drums (c) Working capital requirements: Imported raw material Local raw material Packing drums stock Finished goods stock Credit to customers Credit from suppliers Cash expenses (d) Expected production: 250 ton per annum. Rs. 30/500 kgs. 6 months 3 months 3 months 1 month 1 month 1 month 1 month 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) Answer 7 (i) Total Capital needed for the project Investment in Fixed Assets: (Amt. in Rs.) (Amt. in Rs.) Land 1,00,000 Building 8,00,000 P & M 12,00,000 21,00,000 Investment in working capital Imported Raw material 6,50,000 x 6/12 3,25,000 Local Raw Material 6,26,000 x 3/12 1,56,500 Packing drums stock 15,000 x 3/12 3,750 Debtors (Rs. 8,500 x 250) 21,25,000 x 1/12 1,77,083 Finished goods stock 18,28,000 x 1/12 1,52,333 Cash exp. 4,48,000 x 1/12 37,334 8,52,000 Creditors Import Rs. 6,50,000 Local Rs. 6,26,000 12,76,000 x 1/12 1,06,333 Working Capital 7,45,667 Total Capital required = Fixed Capital + Working Capital (Rs. 21,00,000 + Rs. 7,45,667) = Rs. 28,45,667 (ii) Sales (Rs. 8,500 x 250 ton) Rs. 21,25,000 Cost of Production Rs. 18,28,000 Profit Rs. 2,97,000 Rate of Return in sales 2,97, = 21,25,000 = 13.98%

21 17 FFTFM-Dec ,97, Yield on Investment of fixed assets = = 14.14% 21,00,000 2,97, Yield on Capital employed = = 10.44% 28,45,667 (iii) Rate of Cash Generation, i.e. FUND FROM OPEERATIONS (Amount in Rs.) Net Profit 2,97,000 + Dep. on Building 20,000 + Dep. on Plant 84,000 4,01,000 Working Notes: Sales 250 ton x Rs. 8,500 = Rs lakhs Cost of Production (Amount in Rs. Lakhs) Imported Raw Material 6.50 Local Raw Material 6.26 Cash expenses: Salaries 1.35 Repairs Plant 5% of Rs. 12 lakhs 0.60 Repairs Bldg 0.2% of Rs. 8 lakhs 0.16 Steam 7000 Rs. 16 per ton 1.12 Power 0.60 Drums for packing (250 tons x Rs. 30/500 Kg) 0.15 Admn. Exp Depreciation: Plant 7% 0.84 Building 2.5% Investment in Finished Goods: Cost of Production (Inc. Dep.): (18,28,000/12) = Rs. 1,52,333 Cash Expenses/month 4,48,000/12 = Rs. 37,334 Debtors 250 ton x Rs. 8500=21,25,000/12 = Rs. 1,77,083 Alternatively, investment in finished goods may be calculated at cash cost also. In that case, total cost is (Rs. 18,28,000 1,04,000) = Rs. 17,24,000) The working capital required for finished goods would be Rs. 17,24,000/12 = Rs. 1,43,667.

22 FFTFM-Dec TABLE 1 : PRESENT VALUE OF RUPEE ONE

23 19 FFTFM-Dec TABLE 2 : PRESENT VALUE OF AN ANNUITY OF RUPEE ONE

24 CORPORATE RESTRUCTURING LAW AND PRACTICE Time allowed: 3 hours Maximum marks: 100 NOTE: Answer SIX questions including Question No. 1 which is COMPULSORY. Question 1 (a) You are the Company Secretary of Strong Base Ltd., which has just now taken over Weak Links Ltd. pursuant to a scheme confirmed by the court. The court order has been received. Briefly mention the various steps required to be taken to give effect to the merger. Also mention the various authorities with whom you will file the order of merger to ensure that the records are updated properly in their offices. (12 marks) (b) Amar Ltd. proposed a scheme of arrangement with its shareholders for the purpose of buying-back the small lot of shares held in physical form. The scheme was approved by majority of shareholders. However, the Registrar of Companies, representing the Central Government, raised an objection that the purpose of the scheme is to buy-back the shares and as such the Answer 1(a) company ought to have followed the provisions of Section 77A. Discuss in the light of judicial pronouncements. (8 marks) Steps required to give effect to merger of Weak Links Ltd. with Strong Base Ltd.: Filling of order with Registrar Sub-section (3) of Section 391 provides that an order made by the Court under Section 391(2) shall have no effect until a certified copy of the order has been filed with the Registrar of Companies. Section 394(3) provides that within 30 days after the making of an order under this section, every company in relation to which the order is made, shall cause a certified true copy thereof to be field with the Registrar for registration. The certified copy is to be filed with Form No.21 prescribed under the Companies (Central Government s) General Rules and Forms, The amalgamation is effective from the date on which From No. 21 and a certified true copy of the order is filed with Registrar, or if it is to be filed with two separate Registrars, the date which is latter of the two dates of filing. Order to be incorporated in memorandum A copy of the High Court under Section 391 shall be annexed to every copy of the memorandum of the company issued after certified copy of the order has been filed with the Registrar as aforesaid [Section 391(4)]. Stamp duty on High Court s order Appropriate stamp duty is to paid. In Gemini Silk Ltd. v. Gemini Overseas Ltd. (2003) 53 CLA 328 (Cal), the High Court directed the Registrar of Companies not to take on record any order sanctioning a scheme until the order was duly stamped. Drawing up a list of eligible shareholders For the purpose of drawing up list of shareholders of the transferor company who will be entitled to get the shares of the transferee company as per the share exchange ratio 20

25 21 FCRLP-Dec The Register of Members of the transferor company will be closed if the transferor company is an unlisted company; A record date will be fixed to ascertain the names of shareholders and their shareholdings in the transferor company, if the transferor company is a listed company. If the transferor company is a listed company, a notice of the proposed record date will be given to the Stock Exchanges on which the company s shares are listed stating the record date, and specifying the purpose for which the record date is fixed. Copies of such notice will be sent to other recognised Stock Exchanges in India simultaneously. A public notice regarding the record date will be given in the newspapers. Where the Register of Members is proposed to be closed, a public notice of the closure of the Register of Members will be given in newspapers in accordance with the requirement under Section 154 of the Companies Act. A statement of allotment will be prepared based on the list of members of the transferor company as on the conclusion of the period of the closure of the Register of Members or the record date. Allotment A meeting of the Board of Directors or Allotment Committee shall be convened for allotment of the shares to the shareholders of the transferor-company. Exchange of share certificates The shareholders of the transferor-company will be intimated about the sanctioning of the scheme of amalgamation and the exchange of shares and will be advised to return the share certificates to the transferee-company or its Registrar & Share Transfer Agent. The shares of the transferor-company are cancelled and the certificates of those shares are extinguished after they have been surrendered to the transferee-company by the shareholders of the transferor-company. In exchange thereof the shares of the transferee-company are allotted to them according to the share exchange ratio stipulated in the scheme of amalgamation as sanctioned by the High Court. New share certificates will be prepared according to the statement of Allotment and dispatched to shareholders by registered post. Listing/Delisting If the transferee-company is a listed company, the shares allotted to the shareholders of the transferee-company will be listed by making an application to all the stock Exchanges on which the transferee-company s shares are listed, regardless of whether the transferor-company s shares are listed or not. If the transferor company is a listed company, its shares will be delisted for which an application will be made to the concerned Stock Exchanges enclosing a certified true copy of High Court s order sanctioning the scheme of merger. Authorities with whom court s order shall be filed /intimation shall be given: Concerned ROC within 30 days of High Court s order. Stock Exchanges.

26 FCRLP-Dec Bankers including for closure of old Bank Accounts. Central Excise/Service Tax Registration authorities. VAT/Sales Tax Registration authorities Customs authorities. With various courts in case of: claims against the transferor company; claims made by the transferor company. Income tax authorities. In all other places, where the transferor company is a party. Answer 1(b) The objection of Registrar is not tenable as Sections 391 and 77A are independent of each other. The Legislative intention behind the introduction of Section 77A is to provide an alternative method by which a company may buyback its own shares upto a certain percentage. There is nothing in the provisions of Section 77A to indicate that the jurisdiction of the Court under Section 391 or 394 has been taken away or substituted. Section 77A is an enabling provision and the Court s power under Sections 100 to 104 and 391 are not in any way affected. [TCI Industries Ltd., (2004) 118 Comp. Cas. 373 (AP) N.V. Ramana J.]. In the case of Union of India v. Sterlite Industries (India) Ltd. (2003)-(113)-Comp Cas 0273, (Bom), the Court observed that the non obstante clause in Section 77A, namely Notwithstanding anything contained in this Act means that notwithstanding the provisions of Section 77 and Sections 100 to 104, the company can buy-back its shares subject to compliance with the conditions mentioned in Section 77A without approaching the Court under Sections 100 to 104 or Section 391.Therefore, Section 77A is an enabling provision and the Court s powers under Sections 100 to 104 and Sections 391 are not in any way curtailed or affected. The provisions of Section 77A are applicable only to buy-back of securities under Section 77A and the conditions applicable to Sections 100 to 104 and Section 391 cannot be imported into or made applicable to buy-back of securities under Section 77A. Similarly, the conditions for buy-back of securities under Section 77A cannot be applied to a scheme under Sections 100 to 104 and Section 391, as the two operate in independent fields. In the case of Himachal Telematics Ltd. v. Himachal Futuristic Communications Ltd. (1996) 86 Comp Cas 325 (Del) a scheme of amalgamation was to be undertaken. However, the transferee company had a subsidiary which was holding shares of the transferor company. An objection was raised that the sanction of the scheme of amalgamation would result in the buying back by the transferee company of shares of its subsidiary and would thereby violate the provisions of Sections 42 and 77 of the Act. Dealing with the argument regarding violation of Section 77, it was held that no violation would result as a consequence of sanctioning the scheme of amalgamation as the transferee company was not buying any of its own shares. In Gurmit Singh v. Polymer Papers Ltd. (2003) 45 SCL 251 (CLB N. Delhi), petitions were filed under Sections 397 and 398. The issue considered in this case was whether the power of CLB is subject to compliance with the provisions of

27 23 FCRLP-Dec Section 77A in view of its non obstante clause. It was observed that the object of Section 77A is to put some checks and balances when a company, on its own, desires to buy-back its own shares and as such Section 77A has no application in a case where the CLB exercises its powers under Section 402. The contention that no court can bypass the provisions of Section 77A would only mean that the provisions of those Sections empowering the Court to pass an order on a company to purchase its own shares would be nugatory. When the Legislature had intended that the CLB should have the power to order purchase of its own shares by a company with the purpose of putting an end to the matters complained of, it would never have intended that such a power was subject to the provisions of other Sections. Thus, the powers of the CLB to pass an order directing a company to purchase its own shares in terms of Section 402 are not curtailed by the provisions of Section 77A. Moreover, Section 402 empowers the CLB to direct purchase of shares of a member not only by the company but even by other members. It was also held that even assuming that Section 77A is a bar to give a direction to a company to purchase its shares, directions can be given to other members to purchase the shares of any member as long as the direction is with a view to put an end to the matters against which complaints were raised. The ultimate aim in such a direction is to safeguard the interest of the company and its members. Question 2 (a) Allen Ltd., a listed company, is in the process of acquiring the entire paid-up share capital of Ben Ltd. The Board meeting of Allen Ltd. is to be convened for approving the issue of offer document. You are required to list out the documents to be placed before the Board meeting for its consideration. (b) Draft a petition to the court for sanctioning the scheme of amalgamation covering in brief all the relevant points mentioned under Section 394(1). (8 marks each) Answer 2(a) Documents to be tabled at the Board meeting held for issue of offer document are: A final draft of the offer document to be dispatched to shareholders of Ben Ltd. A final draft of form of acceptance referred to in the offer document. Individual responsibility letters each signed by one of the directors of the company confirming that they accept responsibility for the information contained in the offer document. Powers of attorney executed by each of the directors authorizing any other director to approve and execute all documents and to do all acts and things necessary or desirable to implement the offer. Letters from the financial advisor, accountants, solicitors of both the companies for inclusion of their names in the offer document. Letter from the auditors of the company in relation to the indebtedness of the company. A schedule of estimated expenses to be incurred by the company and Ben Ltd. in connection with the offer as stated in the offer document.

28 FCRLP-Dec A letter from the auditors relating to the company s working capital requirements. In respect of each director not present at the meeting, a copy of the latest proof of the offer document initialed by him. Draft press announcement to be issued by the company. Answer 2(b) IN THE HIGH COURT OF JUDICATURE AT. Company Petition No of.. In the matter of the Companies Act, 1956 AND In the matter of scheme of amalgamation between ABC Ltd. and XYZ Ltd. ABC Ltd. XYZ Ltd. Petitioner (Transferor) (Transferee) Petition to sanction Amalgamation of ABC Ltd. with XYZ Ltd. The Petition of ABC Ltd., the Petitioner is as follows: The object of this Petition is to obtain sanction of Court to the proposed amalgamation to combine the resources of ABC Ltd. and XYZ Ltd. with a view to optimize their utilization, effect internal economies and improve efficiency. The company was incorporated under the Companies Act, 1956 with a nominal capital of Rs Lakhs divided into 5,000 Equity Shares of Rs. 100/- each. The company is trading company and dealing in the coal business activities mainly. The objects are more particularly described in the company s MOA annexed with the Petition. Both the companies have same business activities and by way of amalgamation, the sales, income and delivery schedule will help in improving market share, self dependency and achieving competitive edge. The company has reserves and surplus of Rs lacs, fixed assets of net value of Rs lacs and current assets of Rs. 452 lacs and against these it has a liability of secured loan of Rs. 106 lacs and current liability of Rs. 210 lacs. Terms and Conditions: Appointed date: 1st April, All the undertakings and liabilities of the company shall be transferred to the transferee company as from the appointed date, etc. By an order made in the above matter on. the Petitioner was directed to convene a meeting of creditors/members for the purpose of considering and, if thought fit, with or without modifications, the said amalgamation, and said order directed that CD or failing him EF should act as the chairman of the said meeting and should report the result thereof to this Court. Notice of the meeting was sent individually to all the members and creditors as directed by the order together with the copy of the scheme of amalgamation and of

29 25 FCRLP-Dec the statement required under Section 393 and a form of proxy. The notice of the meeting was also advertised as directed by the Court in the following newspapers: Dainik Bhaskar on.. Free Press.. On. A meeting of members/creditors duly convened in accordance with the said order was held at and the said EF acted as the Chairman of the meting. The said EF has reported the result of the meeting to this Hon ble Court. The said meeting was attended by all the members/creditors and the total value of their shares/debts is Rs The said amalgamation was approved by all the members/creditors unanimously without any modification and the following resolution was passed as a special resolution: RESOLVED that the arrangement as embodied in the Scheme of Amalgamation of ABC Ltd., the Transferor Company with XYZ Ltd., the Transferee Company, placed before the Meeting and initialled by the Secretary of the Transferee Company for the purpose of identification, be and is hereby approved; RESOLVED FURTHER that the Board of Directors of the Transferee Company be and are hereby authorised to do all such acts, deeds, matters and things as are considered requisite or necessary to effectively implement the said Scheme of Amalgamation and to accept such modifications and/or conditions, if any, which may be required and/or imposed by the Hon ble High Court of Judicature at Bombay and/or by any other authority while sanctioning said Scheme of Amalgamation". The Petitioner/transferor company submits that the transferee company has also filed a similar petition before this Hon ble Court for the sanction of the scheme. The petitioner/transferor company has disclosed all material particulars in relation to itself and the transferee company. It is further submitted that no investigation proceedings in relation to the petitioner/transferor company under Sections of the Companies Act, 1956 are pending or were ever initiated. The petitioner/transferor company submits that the scheme does not affect any material interest of the employees or anybody else. It is submitted that necessary directions may be given to issue notice to the Central Government through the Regional Director,.. Region at.. and the Official Liquidator attached to this High Court at.. and for publication of notice of hearing under Rule 80 of the Companies (Court) Rules, PETITIONER Question 3 (a) In the context of corporate restructuring, briefly mention the provisions of Section 395 relating to powers and duties to acquire shares of shareholders dissenting from scheme or contract approved by majority shareholders. (5 marks) (b) Explain the concept of 'management buy-out'. (5 marks) (c) Explain the concepts of 'financial restructuring' in the cases of undercapitalised and over-capitalised companies. (6 marks)

30 FCRLP-Dec Answer 3(a) Sub-section (1) of Section 395 lays down that where a scheme or contract involving the transfer of shares or any class of shares of transferor company to transferee company has, within four months after the making of the offer by the transferee company, been approved by the holders of not less than nine-tenth in value of the shares whose transfer is involved, the transferee company may, at any time within two months after the expiry of the said four months, give notice in the prescribed manner to any dissenting shareholder, that it desires to acquire his shares. The transferee company shall, unless on an application made by the dissenting shareholder within one month from the date on which the notice was given, the Court thinks fit to order otherwise, be entitled and bound to acquire those shares on the terms on which under the scheme or contract, the shares of the approving shareholders are to be transferred to the transferee company. The Board of Directors of the transferor company is required to consider the draft scheme and either accept it or reject it. If the Board of the transferor company accepts the offer, it must call and hold a general meeting of the shareholders of the company to pass a resolution by the shareholders of not less than nine-tenth in value. If the shares in the transferor company held as aforesaid are in excess of onetenth of the aggregate of the value of all the shares in the company of such class, the provisions of sub-section (1) shall not apply unless (a) the transferee company offers the same terms to all holders of the shares of that class, whose transfer is involved; and (b) the holders who approve the scheme or contract, besides holding not less than nine-tenths in value of the shares (other than those already held as aforesaid), whose transfer is involved, are not less than three fourths in number of the holders of those shares. Any sums received by the transferor company shall be paid into a separate bank account, and any such sums and any other consideration so received shall be held by that company in trust for the several persons entitled to the shares. Answer 3(b) Management Buy-Out Management buy-out is a form of corporate divestment and has become very popular in UK, US and other European nations. When there is a hostile raid for takeover, shareholders offer their equity and voting rights to the senior management executives with a view to pass the management to own persons rather than to unwanted acquirers. Management buy-out is also generally resorted to in those companies where the division or subsidiary is unprofitable and the owner cannot find an alternative buyer at a higher price. A Management Buyout (MBO) is simply a transaction through which the incumbent management buys out all or most of the other shareholders. The management may take on partners, it may borrow funds or it can organize the entire restructuring on its own. An MBO begins with arrangement/raising of finance. Thereafter, an offer to purchase all or nearly all of the shares of a company not presently held by the management has to be made which may necessitate a public offer and even delisting. Consequent upon this, restructuring may be affected and once targets have been achieved, then the company can go public again.