PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT

QUESTIONS
Merger and Acquisitions
1. ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They
want to know the value of the new strategy. Following information relating to the year
which has just ended, is available:
Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000
If it adopts the new strategy, sales will grow at the rate of 20% per year for three years.
The gross margin ratio, Assets turnover ratio, the Capital structure and the income tax
rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.
Foreign Exchange Risk Management
2. Bharat Silk Limited, an established exporter of silk materials, has a surplus of US$ 20
million as on 31st May 2015. The banker of the company informs the following exchange
rates that are quoted at three different forex markets:
GBP/ INR 99.10 at London
INR/ GBP 0.01 at London
USD/ INR 64.10 at Mumbai
INR/ US$ 0.02 at Mumbai
USD/ GBP 0.65 at New York
GBP/ USD 1.5530 at New York

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 110 FINAL EXAMINATION: MAY, 2017

Assuming that there are no transaction costs, advice the company how to avail the
arbitrage gain from the above quoted spot exchange rates.
3. On January 28, 2010 an importer customer requested a bank to remit Singapore Dollar
(SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could
effect the remittance only on February 4, 2010. The interbank market rates were as
follows:
January, 28 February 4
Bombay US$1 = ` 45.85/45.90 45.91/45.97
London Pound 1 = US$ 1.7840/1.7850 1.7765/1.7775
Pound 1 = SGD 3.1575/3.1590 3.1380/3.1390
The bank wishes to retain an exchange margin of 0.125%. How much does the customer
stand to gain or lose due to the delay? (Calculate rate in multiples of .0001)
Mutual Funds
4. A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01, 2008. No
entry load was charged. It made the following investments:
Particulars `
50,000 Equity shares of ` 100 each @ ` 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of ` 12,00,000 were received on equity shares. Interest on all
types of debt securities was received as and when due. At the end of the year equity
shares and 10% debentures are quoted at 175% and 90% respectively. Other
investments are at par.
Find out the Net Asset Value (NAV) per unit given that operating expenses paid during
the year amounted to ` 5,00,000. Also find out the NAV, if the Mutual fund had
distributed a dividend of ` 0.80 per unit during the year to the unit holders.
Security Analysis
5. G holds securities as detailed herein below:
Security Face Numbers Coupon Maturity Annual
Value (`) Rate (%) Years Yield (%)
(i) Bond A 1,000 100 9 3 12
(ii) Bond B 1,000 100 10 5 12

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 111

(iii) Preference 100 1,000 11 * 13*

Shares C
(iv) Preference 100 1,000 12 * 13*
Shares C
* Likelihood of being called (redeemed) at a premium over par.
Compute the current value of G’s portfolio.
6. Capital structure of Sun Ltd., as at 31.3.2003 was as under:
(` in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
Sun Ltd., earns a profit of ` 32 lakhs annually on an average before deduction of income-
tax, which works out to 35%, and interest on debentures.
Normal return on equity shares of companies similarly placed is 9.6% provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed
profits.
Sun Ltd., has been regularly paying equity dividend of 8%.
Compute the value per equity share of the company.
7. GHI Ltd., AAA rated company has issued, fully convertible bonds on the following terms,
a year ago:
Face value of bond ` 1000
Coupon (interest rate) 8.5%
Time to Maturity (remaining) 3 years
Interest Payment Annual, at the end of year
Principal Repayment At the end of bond maturity
Conversion ratio (Number of shares per bond) 25
Current market price per share ` 45
Market price of convertible bond ` 1175

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 112 FINAL EXAMINATION: MAY, 2017

AAA rated company can issue plain vanilla bonds without conversion option at an interest
rate of 9.5%.
Required: Calculate as of today:
(i) Straight Value of bond.
(ii) Conversion Value of the bond.
(iii) Conversion Premium.
(iv) Percentage of downside risk.
(v) Conversion Parity Price.
t 1 2 3
PVIF0.095, t 0.9132 0.8340 0.7617
8. Closing values of BSE Sensex from 6th to 17th day of the month of January of the year
200X were as follows:
Days Date Day Sensex
1 6 THU 14522
2 7 FRI 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THU 17000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30
days simple moving average of Sensex can be assumed as 15,000. The value of
exponent for 30 days EMA is 0.062.
Give detailed analysis on the basis of your calculations.
International Capital Budgeting
9. A multinational company is planning to set up a subsidiary company in India (where
hitherto it was exporting) in view of growing demand for its product and competition from
other MNCs. The initial project cost (consisting of Plant and Machinery including

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installation) is estimated to be US$ 500 million. The net working capital requirements are
estimated at US$ 50 million. The company follows straight line method of depreciation.
Presently, the company is exporting two million units every year at a unit price of US$ 80,
its variable cost per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and other data in
respect of proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of
allocated fixed cost will be US $ 3 million p.a. based on principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Existing working capital investment for production & sale of two million units through
exports was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case
the company does not open subsidiary company in India, in view of the presence of
competing MNCs that are in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all
profits will be repatriated, as there will be no withholding tax, estimate Net Present Value
(NPV) of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
Leasing
10. P Ltd. has decided to acquire a machine costing ` 50 lakhs through leasing. Quotations
from 2 leasing companies have been obtained which are summarised below:
Quote A Quote B
Lease term 3 years 4 years
Initial lease rent (` lakhs) 5.00 1.00
Annual lease rent (payable in arrears) (` lakhs) 21.06 19.66
P Ltd. evaluates investment proposals at 10% cost of capital and its effective tax rate is
30%. Terminal payment in both cases is negligible and may be ignored.

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 114 FINAL EXAMINATION: MAY, 2017

Make calculations and show which quote is beneficial to P Ltd. Present value factors at
10% rate for years 1-4 are respectively 0.91, 0.83, 0.75 and 0.68. Calculations may be
rounded off to 2 decimals in lakhs.
Portfolio Management
11. Sunrise Limited last year paid dividend of ` 20 per share with an annual growth rate of
9%. The risk-free rate is 11% and the market rate of return is 15%. The company has a
beta factor of 1.50. However, due to the decision of the Board of Director to grow
inorganically in the recent past beta is likely to increase to 1.75.
You are required to find out under Capital Asset Pricing Model
(i) The present value of the share
(ii) The likely value of the share after the decision.
12. A company has a choice of investments between several different equity oriented mutual
funds. The company has an amount of `1 crore to invest. The details of the mutual funds
are as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required:
(i) If the company invests 20% of its investment in the first two mutual funds and an
equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the
balance in equal amount in the other two mutual funds, what is the beta of the
portfolio?
(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be
the portfolios expected return in both the situations given above?
Indian Capital Market
13. Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap)
on a principal of ` 10 crores and agreed to receive MIBOR overnight floating rate for a
fixed payment on the principal. The swap was entered into on Monday, 2nd August, 2010
and was to commence on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 115

7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.
If Derivative Bank received ` 317 net on settlement, calculate Fixed rate and interest
under both legs.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.
14. The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is Nil.
1. What should be 3 months FRA rate at 3 months forward?
2. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12
USD FRA at 6.50 – 6.75%. Is any arbitrage opportunity available?
Calculate profit in such case.
15. Given below is the Balance Sheet of S Ltd. as on 31.3.2008:
Liabilities ` Assets `
(in lakh) (in lakh)
Share capital Land and building 40
(share of ` 10) 100 Plant and machinery 80
Reserves and surplus Investments 10
Long Term Debts 40 Stock 20
30 Debtors 15
Cash at bank 5
170 170
You are required to work out the value of the Company's, shares on the basis of Net
Assets method and Profit-earning capacity (capitalization) method and arrive at the fair
price of the shares, by considering the following information:
(i) Profit for the current year ` 64 lakhs includes ` 4 lakhs extraordinary income and
` 1 lakh income from investments of surplus funds; such surplus funds are unlikely
to recur.

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(ii) In subsequent years, additional advertisement expenses of ` 5 lakhs are expected

to be incurred each year.
(iii) Market value of Land and Building and Plant and Machinery have been ascertained
at ` 96 lakhs and ` 100 lakhs respectively. This will entail additional depreciation of
` 6 lakhs each year.
(iv) Effective Income-tax rate is 30%.
(v) The capitalization rate applicable to similar businesses is 15%.
16. A company is long on 10 MT of copper @ ` 474 per kg (spot) and intends to remain so
for the ensuing quarter. The standard deviation of changes of its spot and future prices
are 4% and 6% respectively, having correlation coefficient of 0.75.
What is its hedge ratio? What is the amount of the copper future it should short to
achieve a perfect hedge?
17. Miss K holds 10,000 shares of IBS Bank @ 2,738.70 when 1 month Index Future was
trading @ 6,086 The share has a Beta (β) of 1.2. How many Index Futures should she
short to perfectly hedge his position. A single Index Future is a lot of 50 indices.
Justify your result in the following cases:
(i) when the Index zooms by 1%
(ii) when the Index plummets by 2%.
Capital Budgeting with Risk
18. Jumble Consultancy Group has determined relative utilities of cash flows of two
forthcoming projects of its client company as follows :
Cash Flow in ` -15000 -10000 -4000 0 15000 10000 5000 1000
Utilities -100 -60 -3 0 40 30 20 10

The distribution of cash flows of project A and Project B are as follows:

Project A
Cash Flow (`) -15000 - 10000 15000 10000 5000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash Flow (`) - 10000 -4000 15000 5000 10000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why ?

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Dividend Decision
19. X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year. The current
market price per share is ` 120. The Board of Directors of the company is contemplating
` 6.4 per share as dividend. The rate of capitalization, appropriate to the risk-class to
which the company belongs, is 9.6%:
(i) Based on M-M Approach, calculate the market price of the share of the company,
when the dividend is – (a) declared; and (b) not declared.
(ii) How many new shares are to be issued by the company, if the company desires to
fund an investment budget of ` 3.20 crores by the end of the year assuming net
income for the year will be ` 1.60 crores?
20. Write a short note on
(a) Lintner’s Model of actual dividend behaviour
(b) Necessary conditions to introduce ‘Commodity Derivative’
(c) ‘Starting point and end point of an organisation is money’
(d) Benefits of Real Estate Investment Trusts (REITs)
(e) Chop Shop Method of Valuation

SUGGESTED ANSWERS

1.
Projected Balance Sheet
Year 1 Year 2 Year 3 Year 4
Fixed Assets (40% of Sales) 9,600 11,520 13,824 13,824
Current Assets (20% of Sales) 4,800 5,760 6,912 6,912
Total Assets 14,400 17,280 20,736 20,736
Equity 14,400 17,280 20,736 20,736
Projected Cash Flows:
Year 1 Year 2 Year 3 Year 4
Sales 24,000 28,800 34,560 34,560
PBT (10%) of sale 2,400 2,880 3,456 3,456
PAT (70%) 1,680 2,016 2,419.20 2,419.20
Depreciation 800 960 1,152 1,382

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 118 FINAL EXAMINATION: MAY, 2017

Addition to Fixed Assets 2,400 2,880 3,456 1,382

Increase in Current Assets 800 960 1,152 -
Operating cash flow (720) (864) (1,036.80) 2,419.20
Projected Cash Flows:
Present value of Projected Cash Flows:
Cash Flows PVF at 15% PV
-720 0.870 -626.40
-864 0.756 -653.18
-1,036.80 0.658 -682.21
-1,961.79

Residual Value - 2419.20/0.15 = 16,128

Present value of Residual value = 16128/(1.15)3
= 16128/1.521 = 10603.55
Total shareholders’ value = 10,603.55 – 1,961.79 = 8,641.76
Pre strategy value = 1,400 / 0.15 = 9,333.33
∴ Value of strategy = 8,641.76 – 9,333.33 = - 691.57
Conclusion: The strategy is not financially viable
2. The company can proceed in the following ways to realise arbitrage gain:
(a) Buy Rupees from US$ at Mumbai: ` 64.10 x US$ 2,00,00,000 = ` 128,20,00,000
(b) Convert Rupees from US$ at London: ` 128,20,00,000/99.10 = GBP 1,29,36,427.85
(c) Convert GBP into US$ at New York = GBP 1,29,36,427.85 x 1.5530 =
US$ 2,00,90,272.45
There is a Net Gain of = US$ 2,00,90,272.45 - US$ 2,00,00,000 = US$ 90,272.45
3. On January 28, 2010 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = ` 45.90
Pound 1 = US$ 1.7850
Pound 1 = SGD 3.1575
` 45.90 * 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = ` 25.9482

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Add: Exchange margin (0.125%) ` 0.0324

` 25.9806
On February 4, 2010 the rates are
US $ = ` 45.97
Pound 1 = US$ 1.7775
Pound 1 = SGD 3.1380
` 45.97 * 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ` 26.0394
Add: Exchange margin (0.125%) ` 0.0325
` 26.0719
Hence, loss to the importer
= SGD 25,00,000 (`26.0719 – `25.9806) = ` 2,28,250
4. In order to find out the NAV, the cash balance at the end of the year is calculated as
follows-
Particulars `
Cash balance in the beginning
(` 100 lakhs – ` 98 lakhs) 2,00,000
Dividend Received 12,00,000
Interest on 7% Govt. Securities 56,000
Interest on 9% Debentures 45,000
Interest on 10% Debentures 50,000
15,51,000
(-) Operating expenses 5,00,000
Net cash balance at the end 10,51,000
Calculation of NAV `
Cash Balance 10,51,000
7% Govt. Securities (at par) 8,00,000
50,000 equity shares @ ` 175 each 87,50,000
9% Debentures (Unlisted) at cost 5,00,000
10% Debentures @90% 4,50,000
Total Assets 1,15,51000

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 120 FINAL EXAMINATION: MAY, 2017

No. of Units 10,00,000

NAV per Unit ` 11.55
Calculation of NAV, if dividend of ` 0.80 is paid –
Net Assets (` 1,15,51,000 – ` 8,00,000) ` 1,07,51,000
No. of Units 10,00,000
NAV per unit ` 10.75
5. Computation of current value of G’s portfolio
(i) 100 Nos. Bond A, ` 1,000 par value, 9% Bonds maturity 3 years:
`
Current value of interest on bond A
1-3 years: ` 9000 × Cumulative P.V. @ 12% (1-3 years) 21,618
= ` 9000 × 2.402
Add: Current value of amount received on maturity of Bond A
End of 3rd year: ` 1,000 × 100 × P.V. @ 12% (3rd year) 71,200
= ` 1,00,000 × 0.712
92,818
(ii) 100 Nos. Bond B, ` 1,000 par value, 10% Bonds maturity 5 years:
Current value of interest on bond B
1-5 years: ` 10,000 × Cumulative P.V. @ 12% (1-5 years)
= ` 10,000 × 3.605 36,050
Add: Current value of amount received on maturity of Bond B
End of 5th year: ` 1,000 × 100 × P.V. @ 12% (5th year) 56,700
= ` 1,00,000 × 0.567 92,750

(iii) 100 Preference shares C, ` 1,000 par value, 11% coupon

11% × 1000 Nos. × ` 100 11,000 84,615
=
13% 0.13

(iv) 100 Preference shares D, ` 1,000 par value, 12% coupon

12% × 1000 Nos. × R` 100 12,000 92,308
=
13% 0.13
Total current value of his portfolio [(i) + (ii) + (iii) + (iv)] 3,62,491

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 121

6. (a) Calculation of Profit after tax (PAT)

`
Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (` 64,00,000 × 12/100) 7,68,000
Profit before tax (PBT) 24,32,000
Less: Tax @ 35% 8,51,200
Profit after tax (PAT) 15,80,800
Less: Preference Dividend
(` 40,00,000 × 8/100) 3,20,000
Equity Dividend (` 80,00,000 × 8/100) 6,40,000 9,60,000
Retained earnings (Undistributed profit) 6,20,800

Calculation of Interest and Fixed Dividend Coverage

PAT + Debenture interest
=
Debenture interest + Preference dividend
15,80,800 + 7,68,000 23,48,800
= = = 2.16 times
7,68,000 + 3,20,000 10,88,000
(b) Calculation of Capital Gearing Ratio
Fixed interest bearing funds
Capital Gearing Ratio =
Equity shareholders' funds
Preference Share Capital + Debentures 40,00,000 + 64,00,000
= =
Equity Share Capital + Reserves 80,00,000 + 32,00,000
1,04,00,000
= = 0.93
1,12,00,000
(c) Calculation of Yield on Equity Shares:
Yield on equity shares is calculated at 50% of profits distributed and 5% on
undistributed profits: (`)
50% on distributed profits (` 6,40,000 × 50/100) 3,20,000
5% on undistributed profits (` 6,20,800 × 5/100) 31,040
Yield on equity shares 3,51,040

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Yield on shares
Yield on equity shares % = × 100
Equity share capital
3,51,040
= × 100 = 4.39% or, 4.388%.
80,00,000
Calculation of Expected Yield on Equity shares
Note: There is a scope for assumptions regarding the rates (in terms of percentage for
every one time of difference between Sun Ltd. and Industry Average) of risk premium
involved with respect to Interest and Fixed Dividend Coverage and Capital Gearing
Ratio. The below solution has been worked out by assuming the risk premium as:
(i) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii) 2% for every one time of difference for Capital Gearing Ratio.
(a) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the
industry average is 3 times. Therefore, risk premium is added to Sun Ltd.
Shares @ 1% for every 1 time of difference.
Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84%
(b) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75
times. Therefore, risk premium is added to Sun Ltd. shares @ 2% for
every 1 time of difference.
Risk Premium = (0.75 – 0.93) (2%)
= 0.18 (2%) = 0.36%
(%)
Normal return expected 9.60
Add: Risk premium for low interest and fixed dividend coverage 0.84
Add: Risk premium for high interest gearing ratio 0.36
10.80
Value of Equity Share
Actual yield
= × Paid-up value of share = 4.39 × 100 = ` 40.65
Expected yield 10.80
7. (i) Straight Value of Bond
= ` 85 x 0.9132 + ` 85 x 0.8340 + ` 1085 x 0.7617 = ` 974.96
(ii) Conversion Value
= Conversion Ration x Market Price of Equity Share
= ` 45 x 25 = ` 1,125

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(iii) Conversion Premium

Conversion Premium = Market Conversion Price - Market Price of Equity Share
` 1,175
= - ` 45 = ` 2
25
(iv) Percentage of Downside Risk
` 1,175 − ` 974.96
= ×100 = 20.52%
` 974.96
(v) Conversion Parity Price
Bond Price ` 1,175
= = = ` 47
No. of Share on Conversion 25
8.
Date 1 2 3 4 5
Sensex EMA for EMA
Previous day 1-2 3×0.062 2+4
6 14522 15000 (478) (29.636) 14970.364
7 14925 14970.364 (45.364) (2.812) 14967.55
10 15222 14967.55 254.45 15.776 14983.32
11 16000 14983.32 1016.68 63.034 15046.354
12 16400 15046.354 1353.646 83.926 15130.28
13 17000 15130.28 1869.72 115.922 15246.202
17 18000 15246.202 2753.798 170.735 15416.937
Conclusion – The market is bullish. The market is likely to remain bullish for short term
to medium term if other factors remain the same. On the basis of this indicator (EMA) the
investors/brokers can take long position.
9. Financial Analysis whether to set up the manufacturing units in India or not may be
carried using NPV technique as follows:
I. Incremental Cash Outflows
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00

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 124 FINAL EXAMINATION: MAY, 2017

II. Incremental Cash Inflow after Tax (CFAT)

(a) Generated by investment in India for 5 years
$ Million
Sales Revenue (5 Million x $80) 400.00
Less: Costs
Variable Cost (5 Million x $20) 100.00
Fixed Cost 30.00
Depreciation ($500Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Depreciation 100.00
CFAT (1-5 years) 210.50
Cash flow at the end of the 5 years (Release of Working 35.00
Capital)
(b) Cash generation by exports
$ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 years) 39.00
(c) Additional CFAT attributable to Foreign Investment
$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 years) 171.50
III. Determination of NPV
Year CFAT ($ Million) PVF@12% PV($ Million)
1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590

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638.0822
Less: Initial Outflow 535.0000
103.0822

Since NPV is positive the proposal should be accepted.

10. (in lakhs)
Quote A Quote B
Calculation of Present Value (PV) of cash payments:
Initial lease rent (PV) 5.00 1.00
Less: PV of tax benefit on initial payment of lease rent
` 5.00 lakh x 0.30 x 0.91 (1.365) -
` 1.00 lakh x 0.30 x 0.91 - (0.273)
PV of Annual lease rents
` 21.06 lakh x 0.7 x 2.49 36.71 -
` 19.66 lakh x 0.7 x 3.17 - 43.63
Total payments in PV 40.345 44.357

Capital Recovery Factor (reciprocal of Annuity Factor)

1/2.49 0.402 -
1/3.17 - 0.315
Equated Annual Payment or cash outflow (` lakhs) 16.20 13.979
Conclusion: Since Quote B implies lesser equated annual cash outflow, it is better.
11. The value of Cost of Equity with the help of CAPM
Ke = Rf + β(Rm – Rf)
With the given data the Cost of Equity using CAPM will be:
Ke = 0.11 + 1.5(0.15 – 0.11)
Ke = 0.11 + 1.5(0.04) = 0.17 or 17%
The value of share using the Growth Model:
D0 (1 + g)
P=
ke − g

20(1 + 0.09)
P=
0.17 − 0.09

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 126 FINAL EXAMINATION: MAY, 2017

21.80
P= = ` 272.50
0.08
However, if the decision of the Board of Directors is implemented, the beta factor is likely
to increase to 1.75.
Therefore,
Ke = 0.11 + 1.75(0.15 – 0.11)
Ke = 0.11 + 1.75(0.04) = 0.18 or 18%
The value of share using the Growth Model:
D0 (1 + g)
P=
ke − g

20(1 + 0.09)
P=
0.18 − 0.09

21.80
P= = ` 242.22
0.09
12. With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of
various securities calculated as below:
(i)
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 20 32
B 1.0 20 20
C 0.9 20 18
D 2.0 20 40
E 0.6 20 12
100 122
Weighted Beta (β) = 1.22
(ii) With varied percentages of investments portfolio beta is calculated as follows:
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 15 24
B 1.0 30 30
C 0.9 15 13.5
D 2.0 30 60

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 127

E 0.6 10 6
100 133.5
Weighted Beta (β) = 1.335
(iii) Expected return of the portfolio with pattern of investment as in case (i) = 12% × 1.22
i.e. 14.64%
Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%.
13.
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Note: Alternatively, answer can also be calculated on the basis of 360 days in a year.
14. 1. 3 Months Interest rate is 4.50% & 6 Months Interest rate is 5% p.a.
Future Value 6 Months from now is a product of Future Value 3 Months now & 3
Months
Future Value from after 3 Months.
(1+0.05*6/12) =(1+0.045*3/12) x (1+i 3,6 *3/12)
i3,6 = [(1+0.05* 6/12) /(1+0.045 *3/12) – 1] *12/3
i.e. 5.44% p.a.
2. 6 Months Interest rate is 5% p.a. & 12 Month interest rate is 6.5% p.a.
Future value 12 month from now is a product of Future value 6 Months from now
and 6
Months Future value from after 6 Months.

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 128 FINAL EXAMINATION: MAY, 2017

(1+0.065) = (1+0.05*6/12) x (1+i6,6 *6/12)

i6,6 = [(1+0.065/1.025) – 1] *12/6
6 Months forward 6 month rate is 7.80% p.a.
The Bank is quoting 6/12 USD FRA at 6.50 – 6.75%
Therefore there is an arbitrage Opportunity of earning interest @ 7.80% p.a. &
Paying @ 6.75%
Borrow for 6 months, buy an FRA & invest for 12 months
To get $ 1.065 at the end of 12 months for $ 1 invested today
To pay $ 1.060# at the end of 12 months for every $ 1 Borrowed today
Net gain $ 0.005 i.e. risk less profit for every $ borrowed
# (1+0.05/2) (1+.0675/2) = (1.05959) say 1.060
15.
` lakhs
Net Assets Method
Assets: Land & Buildings 96
Plant & Machinery 100
Investments 10
Stocks 20
Debtors 15
Cash & Bank 5
Total Assets 246
Less: Long Term Debts 30
Net Assets 216

Value per share

1,00,00,000
(a) Number of shares = 10,00,000
10
(b) Net Assets ` 2,16,00,000
` 2,16,00,000
= ` 21.6
10,00,000

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 129

Profit-earning Capacity Method ` lakhs

Profit before tax 64.00
Less: Extraordinary income 4.00
Investment income (not likely to recur) 1.00 5.00
59.00
Less: Additional expenses in forthcoming years
Advertisement 5.00
Depreciation 6.00 11.00
Expected earnings before taxes 48.00
Less: Income-tax @ 30% 14.40
Future maintainable profits (after taxes) 33.60
Value of business
33.60 224
Capitalisation factor =
0.15
Less: Long Term Debts 30
194
Value per share 1,94,00,000
` 19.40
10,00,000
Fair Price of share `
Value as per Net Assets Method 21.60
Value as per Profit earning capacity (Capitalisation) method 19.40
21.60 + 19.40 41.00 `20.50
Fair Price= = =
2 2
16. The optional hedge ratio to minimize the variance of Hedger’s position is given by:
σS
H= ρ
σF
Where
σS= Standard deviation of ΔS
σF=Standard deviation of ΔF
ρ= coefficient of correlation between ΔS and ΔF
H= Hedge Ratio
ΔS = change in Spot price.

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 130 FINAL EXAMINATION: MAY, 2017

ΔF= change in Future price.

Accordingly
0.04
H = 0.75 x = 0.5
0.06
No. of contract to be short = 10 x 0.5 = 5
Amount = 5000 x ` 474 = ` 23,70,000
17. Value of Portfolio of Miss. K (` 2,738.70X10,000) ` 2,73,87,000
1.2 × 2738.70 × 10000
Number of index future to be sold by Miss. K is: = 108 contract
6,086 × 50
(i) Justification of the answer if index is zoomed by 1%:
Gain in the value of the portfolio ` 2,73,87,000X1%X1.2 ` 3,28,644
Loss by short covering of index future is 0.01X6,086X50X108 ` 3,28,644
This justifies the result.
(ii) Justification of the answer if index is plummets by 2%:
Loss in the value of the portfolio ` 2,73,87,000X2%X1.2 ` 6,57,288
Gain by short covering of index future is 0.02X6,086X50X108 ` 6,57,288
This justifies the result.
18. Evaluation of project utilizes of Project A and Project B
Project A
Cash flow Probability Utility Utility value
(in `)
-15,000 0.10 -100 -10
- 10,000 0.20 -60 -12
15,000 0.40 40 16
10,000 0.20 30 6
5,000 0.10 20 2
2

Project B
Cash flow Probability Utility Utility value
(in `)
-10,000 0.10 -60 -6

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 131

-4,000 0.15 -3 -0.45

15,000 0.40 40 16
5,000 0.25 20 5
10,000 0.10 30 3
17.55
Project B should be selected as its expected utility is more
19. Modigliani and Miller (M-M) – Dividend Irrelevancy Model:
P1 + D 1
P0 =
1+ K e
Where,
Po = Existing market price per share i.e. ` 120
P1 = Market price of share at the year-end (to be determined)
D1 = Contemplated dividend per share i.e. ` 6.4
Ke = Capitalisation rate i.e. 9.6%.
(i) (a) Calculation of share price when dividend is declared:
P1 + D 1
P0 =
1+ K e
P1 + 6.4
120 =
1 + 0.096
120 × 1.096 = P 1 + 6.4
P1 = 120 × 1.096 – 6.4
= 125.12
(b) Calculation of share price when dividend is not declared:
P1 + D 1
P0 =
1+ K e
P1 + 0
120 =
1 + 0.096
120 × 1.096 = P 1 + 0
P1 = 131.52

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 132 FINAL EXAMINATION: MAY, 2017

(ii) Calculation of No. of shares to be issued:

(` in lakhs)
Particulars If dividend If dividend not
declared declared
Net Income 160 160
Less: Dividend paid 51.20 ------
Retained earnings 108.80 160
Investment budget 320 320
Amount to be raised by issue of new shares (i) 211.20 160
Market price per share (ii) 125.12 131.52
No. of new shares to be issued (ii) 1,68,797.95 1,21,654.50
Or say 1,68,798 1,21,655
20. (a) The classic study of the actual dividend behavior was done by John Lintner in 1956.
The study was conducted in two stages. First, he conducted a series of interviews
with businessmen to form a view of how they went about their dividends decisions.
He then formed a model on the basis of those interviews which could be tested on a
larger data. His formula is
D1 = D0 + [(EPS X Target Payout) – D0] X AF
Where
D1 = Dividend in year 1
D0 = Dividend in year 0
EPS = Earning Per Share
AF = Adjustment Factor
Lintner model has two parameters:
(1) The target pay-out ratio and
(2) The spread at which current dividends adjust to the target.
From the interviews he conducted, it emerged that investment needs were not a
major consideration in the determination of dividend policy, rather the decision to
change the dividend was usually a response to a significant change in earnings
which had disturbed the existing relationship between earnings and dividends.
Lintner concluded that
(1) Companies tend to set long run target dividends-to-earning ratios according to
the amount of positive net present value (NPV) project that are available.

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 133

(2) Earning increases are not always sustainable. As a result, dividend policy is
not changed until managers can see that new earnings level are sustainable.
(b) The following attributes are considered crucial for qualifying for the derivatives
trade:
(1) a commodity should be durable and it should be possible to store it;
(2) units must be homogeneous;
(3) the commodity must be subject to frequent price fluctuations with wide
amplitude; supply and demand must be large;
(4) supply must flow naturally to market and there must be breakdowns in an
existing pattern of forward contracting.
The first attribute, durability and storability, has received considerable attention in
commodity finance, since one of the economic functions often attributed to
commodity derivatives markets is the temporal allocation of stocks.
Since commodity derivatives contracts are standardized contracts, the second
attribute, requires the underlying product to be homogeneous, so that the underlying
commodity as defined in the commodity derivatives contract corresponds with the
commodity traded in the cash market. This allows for actual delivery in the
commodity derivatives market.
The third attribute, a fluctuating price, is of great importance, since firms will feel
little incentive to insure themselves against price risk if price changes are small. A
broad cash market is important because a large supply of the commodity will make
it difficult to establish dominance in the market place and a broad cash market will
tend to provide for a continuous and orderly meeting of supply and demand forces.
The last crucial attribute, breakdowns in an existing pattern of forward trading,
indicates that cash market risk will have to be present for a commodity derivatives
market to come into existence. Should all parties decide to eliminate each and every
price fluctuation by using cash forward contracts for example, a commodity
derivatives market would be of little interest.
(c) No organization can run an existing business and promote a new expansion project
without a suitable internally mobilized financial base or both internally and externally
mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a
strategic plan. The generation of funds may arise out of ownership capital and or
borrowed capital. A company may issue equity shares and / or preference shares
for mobilizing ownership capital.

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 134 FINAL EXAMINATION: MAY, 2017

Along with the mobilization of funds, policy makers should decide on the capital
structure to indicate the desired mix of equity capital and debt capital. There are
some norms for debt equity ratio. However this ratio in its ideal form varies from
industry to industry. It also depends on the planning mode of the organization under
study.
Another important dimension of strategic management and financial policy interface
is the investment and fund allocation decisions. A planner has to frame policies for
regulating investments in fixed assets and for restraining of current assets.
Investment proposals mooted by different business units may be addition of a new
product, increasing the level of operation of an existing product and cost reduction
and efficient utilization of resources through a new approach and closer monitoring
of the different critical activities.
Now, given these three types of proposals a planner should evaluate each one of
them by making within group comparison in the light of capital budgeting exercise.
Dividend policy is yet another area for making financial policy decisions affecting
the strategic performance of the company. A close interface is needed to frame the
policy to be beneficial for all. Dividend policy decision deals with the extent of
earnings to be distributed as dividend and the extent of earnings to be retained for
future expansion scheme of the firm.
It may be noted from the above discussions that financial policy of a company
cannot be worked out in isolation of other functional policies. It has a wider appeal
and closer link with the overall organizational performance and direction of growth.
These policies related to external awareness about the firm, specially the
awareness of the investors about the firm, in respect of its internal performance.
There is always a process of evaluation active in the minds of the current and future
stake holders of the company. As a result, preference and patronage for the
company depends significantly on the financial policy framework. And hence
attention of the corporate planners must be drawn while framing the financial
policies not at a later stage but during the stage of corporate planning itself.
(d) Reits typically offer the following benefits:
 For the Investors: REITs as an investment class provide the common man an
opportunity to invest in fixed income securities which also provide long term
capital appreciation and a natural inflation hedge. It also opens to small
investors an arena (i.e. rent generating real estate assets) which was hitherto
the monopoly of large investors.
 For the Industry: Reits assist in streamlining the real estate sector by creating
a new and transparent source of raising finance in the real estate sector.
Further, Reits can provide developers with institutional capital to sell their
assets and use funds to repay banks and/or utilize the funds for more

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 135

development.
(e) This approach attempts to identify multi-industry companies that are undervalued
and would have more value if separated from each other. In other words as per this
approach an attempt is made to buy assets below their replacement value. This
approach involves following three steps:
Step 1: Identify the firm’s various business segments and calculate the average
capitalization ratios for firms in those industries.
Step 2: Calculate a “theoretical” market value based upon each of the average
capitalization ratios.
Step 3: Average the “theoretical” market values to determine the “chop-shop” value
of the firm.

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