FM THEORY NOTES - Arun Setia Classes · Forfeiting Vs export factoring. Answer Forfaiting is similar to cross-border factoring to the extent both have common features of non-recourse

CA ARUN SETIA CLASSES

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FM THEORY NOTES DIFFERENCE BETWEEN

Question 1 Profit Maximisation vs Profit Maximisation Answer

PROFIT MAXIMISATION WEALTH MAXIMISATION

Does not consider the effect of future cash flows, dividend decisions,

Recognizes the effect of all future cash flows, dividends,

A firm with profit Maximisation objective may refrain from payment of dividend to its Shareholders.

A firm with Wealth Maximisation objective may pay regular dividends to its Shareholders

Ignores time pattern of returns. Recognizes the time pattern of returns.

Focus on Short-Term. Focus on Medium / Long-Term.

Does not consider the effect of uncertainty / risk.

Recognizes the risk-return relationships.

Comparatively easy to determine the relationship between financial decision and profits.

Offers no clear or specific relationship between financial decisions and share market prices.

Question 2 Liquidity Versus Profitability Answer. Another important aspect of a working capital policy is to maintain and provide sufficient liquidity to the firm. A firm must maintain enough cash balance or other liquid assets so that it never faces problems of payment to liabilities. Does it mean that a firm should maintain unnecessarily large liquidity to pay the creditors? Can a firm adopt such a policy? Certainly not. There is also another side of the coin. Greater liquidity makes the firm meeting easily its payment commitments, but simultaneously greater liquidity involves cost also. The risk-return trade-off involved in managing the firm’s working capital is a trade-off between the firm’s liquidity and its profitability. By maintaining a large investment in current assets like cash, inventory, etc., the firm reduces the chances of (i) production stoppages and the lost sales from the inventory shortages, and (ii) the inability to pay the creditors on time. However, as the firm increases its investment in working capital, there is not a corresponding increase in its expected returns. This means that the firm’s return on investment drops because the profits are unchanged while the investment in current assets increases.


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In addition to the above, the firm’s use of current liability versus long-term debt also involves a risk-return trade-off. Other things being equal, the greater the firm’s reliance on the short-term debts or current liabilities in financing its current assets, the greater the risk of illiquidity. On the other hand, the use of current liability can be advantageous as it is less costly and flexible means of financing. A firm can reduce its risk of illiquidity and the profitability. When liquidity increases, the risk of insolvency is reduced but the profitability is also reduced. However, when the liquidity is reduced, the profitability increases but the risk of insolvency also increases. So, the profitability and risk move in the same direction. What is required on the part of the financial manager is to maintain a balance between risk and profitability. Question.3 Difference between financial distress and insolvency Answer Generally the affairs of a firm should be managed in such a way that the total risk – business as well as financial – borne by equity holders is minimized and is manageable, otherwise, the firm would obviously face difficulties. In managing business risk, the firm has to cope with the variability of the demand for its products, their prices, input prices, etc. It has also to keep a tab on fixed costs. As regards financial risk, high proportion of debt in the capital structure entails a high level of interest payments. If cash inflow is inadequate, the firm will face difficulties in payment of interest and repayment of principal. If the situation continues long enough, a time will come when the firm would face pressure from creditors. Failure of sales can also cause difficulties in carrying out production operations. The firm would find itself in a tight spot. Investors would not invest further. Creditors would recall their loans. Capital market would heavily discount its securities. Thus, the firm would find itself in a situation called distress. It may have to sell its assets to discharge its obligations to outsiders at prices below their economic values i.e. resort to distress sale. So when the sale proceeds is inadequate to meet outside liabilities, the firm is said to have failed or become bankrupt or (after due processes of law are gone through) insolvent. Failure of a firm is technical if it is unable to meet its current obligations. The failure could be temporary and might be remediable. When liabilities exceed assets i.e. the net worth becomes negative, bankruptcy, as commonly understood, arises. Technical bankruptcy can be ascertained by comparing current assets and current liabilities i.e. working out current ratio or quick ratio and other solvency ratios. Question.4 Distinguish between the following Answer NET present value and profitability ratio


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While NPV is the difference between present value of future cash inflows and present value of future cash outflows, profitability index is the ratio of present value of cash inflows over the present value of cash outflows.

NPV is absolute measurement technique while PI is a relative one. The criteria for selection of a project in case of NPV is when NPV is greater than zero

whereas in case of PI, the same is selected when it is greater than 1. Question. 5 What is difference between Financial structure and capital Structure. Answer - Capital structure relates to deployment of funds for creation of long term asset whereas financial structure involves creation of both term and short term assets. - Capital structure is the main source of financial structure. Capital structure refers to the funds for the long term. - Where the firm has no current liabilities, the capital structure of the firm is equal to the financial structure. - Capital structure can be considered as one of the major component of financial structure. So capital structure is narrower in sense as compared to financial structure which is broader and includes current liabilities also. Question.6 Distinguish between Operating Leverage and Financial Leverage. Answer

OPERATING LEVERAGE FINANCIAL LEVERAGE

1. Operating leverage is associated with investment activities of the company.

Financial leverage is associated with financing activities of the company

2. Operating leverage consists of fixed operating expenses of the company.

Financial leverage consists of fixed financial expenses of the company.

3. It represents the ability to use fixed operating cost.

It represents the relationship between EBIT and EPS

4. Operating leverage is calculated using formula contr/EBIT

Financial leverage is calculated Using formula EBIT/EBT

5. A percentage change in the profits resulting from a percentage change in the sales is called as

A percentage change in taxable profit resulting from percentage


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degree of operating leverage.

change in EBIT is called as degree of financial leverage

6. Trading on equity is not possible while the company uses operating leverage.

Trading on equity is possible only when the company uses financial leverage.

7. Tax rate and interest rate will not affect the operating leverage.

Financial leverage will change due to tax rate and interest rate.

Question. 7 Finance Lease VS Operating lease Answer A Financial Lease: Is a non-cancelable contractual commitment on the part of the lessee (the user) to make a series of payments to the lessor (the owner) for the use of an asset. The lessor is only the financier and is not interested in the asset. Under this type of lease, the lessee will use and have control over the asset without holding the title to it. The period of financial lease is stretched to the useful commercial life of the asset. The amount due is fully amortized during the tenure of the lease period. The lessee is expected to pay for all maintenance, repairs, and operating costs The ‘Operating Lease’ is a short term lease. The lease period is significantly less than the useful life of the equipment. Lease facility is provided on a period to period basis and is usually cancelable on short notice. The lease rental is generally not sufficient to fully amortize the cost of the asset. The lessor recovers the cost of the assets from another party on cancellation of the lease by leasing out the asset again. The lessor is expected to pay for all maintenance & repair costs. The lessor of equipment is always exposed to the risk of technological obsolescence in operating lease. Question.8 Distinguish Between financial aspect & Economic aspect of project appraisal? Answer The financial Aspects of Project Appraisal The financial aspects of the project are analyzed under the following heads:

(i) Amount of resources required to bring the project into operation and the sources from which finance will be obtained.

(ii) Equity-debt ratio. (iii) Profitability and cash flow. (iv) Security.


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Economic Aspects of project appraisal An economic analysis of industrial projects is made on the basis of the following techniques of economic appraisal. There are three measures commonly used for economic appraisal:

1. Economic rate of return (ERR) 2. Domestic Resource Cost (DRC) 3. Effective Rate of protection (ERP)

Question.9 Difference between factoring & Account Receivable loans Answer

Account Receivable Loan Factoring

Account receivable loan is simply a loan secured by firm’s accounts receivable by way of hypothecation or assignment of such receivable with power to collect debt under power to attorney. In A.R. Loan bank may debit client’s Account for handling charges if debt turns out to be bad.

In case of factoring, however there is an outright sale of receivables. In case of non-recourse factoring bad debt assume by factor it self

Question.10 Distinguish b/w Factoring & Bill Discounting. Answer

Bill Discounting Factoring

Under Bill discounting arrangement, drawer undertakes responsibility of collecting the bills & remitting proceeds to financing agency

Bill discounting shall always be recourse

Financial house discounting bills does not offer any Non-Financial services.

In factoring arrangement factor collect client’s bills

Factoring can be recourse or without recourse.

Factor provides Non-Financial service also.


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Question.11 Forfeiting Vs export factoring. Answer Forfaiting is similar to cross-border factoring to the extent both have common features of non-recourse and advance payment. But they differ in several important respects-

(a) A forfaiter discounts entire value of note/bill but factor finances between 75-85% & retains a factor reserve which is paid after maturity.

(b) The avaling bank which provides an unconditional & irrevocable guarantee is a critical element in forfaiting arrangement where as in factoring (particularly non-recourse) no such guarantee is involved.

(c) Forfaiting is a pure financing arrangement while factoring also includes ledger

administration, collection & so on. A factor does not guard against exchange rate fluctuation, a for faiter charges a premium for such risk Question.12 Difference between CML(Capital Market Line,) and SML (Security Market Line) Answer CML stands for Capital Market Line, and SML stands for Security Market Line. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time. One of the differences between CML and SML, is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML. The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios. While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML.


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Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML. Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks. Well, the Capital Market Line is considered to be superior when measuring the risk factors.

Summary: 1. The CML is a line that is used to show the rates of return, which depends on risk-free

rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient portfolios, the Security Market

Line graphs define both efficient and non-efficient portfolios. 4. The Capital Market Line is considered to be superior when measuring the risk factors.

5. Where the market portfolio and risk free assets are determined by the CML, all security

factors are determined by the SML. Question.13 Write difference between systematic Risk and unsystematic Rick Answer

Systematic Risk Unsystematic Risk

(1) Systematic risk refers to the risk which affects the whole stock market

(1) unsystematic Risk refers to the risk which affect price of a particular security

(2) Systematic Risk is market specific (2) unsystematic Risk is based on factory which are unique to company


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(3) This type of risk is called as non-diversifiable risk, as no amount of diversification can reduce this risk.

(3) this type of risk is called as diversifiable risk as risk can be diversified away by investing in more than one company.

(4) Example of systematic risk are global turmoil change in interest rate etc.

(4) Examples of unsystematic risk are poor management strike of worker, excess debt etc.

Question.14 Standard deviation Vs Beta Answer Standard deviation of return from an investment measures the total risk associated with that investment. Beta indicates only towards the systematic risk. Suppose the beta of a security is 1.2, SD of returns from the market is 5. It means that the systematic risk of the security is 6. If we have a choice between Beta and SD, we should prefer SD as a measure of risk as it will take case of both systematic and unsystematic risk (while the Beta takes case of only systematic risk.) Some investment advisors have different views. They hold that investors with long-term time horizon should consider SD while the investors with short-term time horizon may base their decision on the basis of Beta. Investors with long-term time horizon (investing from long term point of view) should view SD as the proper measure of Security’s risk. SD is a measure of total risk and if the investment if from long term point of view total risk should be considered. Longer the period, larger the risk- as in long run fundamentals of the economy as well as company may change. All these changes are reflected in SD of past return of security (the implied assumption is that the history repeats itself). Investors with short run time horizon should view beta as the proper measure of risk. Beta measure systematic risk of the security. Any bad news (say no-trust motion against government, slightest possibility of war, death or serious illness of some key person of the economy) may upset the market and result is adverse impact on the price of the security. If beta of the security is high, even slight adverse factor resulting in slight adverse impact on the market may have substantial adverse impact on price of the security.


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Question.15 Distinguish between Efficient and optimal portfolio. Answer

Efficient Portfolio Optimal Portfolio

1. efficient portfolio is a portfolio that yields the highest return for a specification risk, or lowest risk for a given return

optimal portfolio, which is one that provides the most satisfaction, the greatest return for an investor based on his tolerance for risk

2. Set of all efficient portfolios that yield the highest return for each level of risk are represented through efficient frontier

Optimal portfolio is formed by combining Efficient frontier with an investor’s utility function

Question.16 Distinguish between the following ‘semi-strong form’ & ‘Strong form’ of efficient market hypothesis Answer

Semi strong form of efficient market hypothesis Strong form of efficient market hypothesis

1. According to this hypothesis, prices of security are directly affected by financial information publicly made available in form of report etc.

1. According to this hypothesis, market forces have a supreme role. Information of any form whether publicly available or otherwise proves out to be useless

2. If publicly available information about securities is positive it will have a favourable impact on prices of securities and vice-versa.

2. No information can be used to earn better return than the market.

Question.17 Write a short note on Types of Derivatives. Answer Exchange Traded Derivative Markets – Market where standardised contracts are traded over an exchange such as NCDEX – Quantities and qualities cannot be customized – Counterparty for each transaction is the exchange Over-The-Counter (OTC) – Usually done between two financial institutions/corporate bodies – Not listed


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– Trades are typically larger than exchange traded derivative transactions – Structure can be customised as per the requirements of the two parties. Question.18

(i) What are derivatives? (ii) Enumerate the basic differences between cash and derivatives market.

Answer

(i) Meaning of derivatives: Derivatives are contracts which derive their values from the value of one or more of other assets (known as underlying assets). Underlying assets include securities, foreign exchange, interest bearing securities and commodities. The derivatives are most modern financial instruments in hedging risk.

(ii) Basic differences between Cash and Derivatives Market:

Cash Market Derivatives Market

1 Tangible assets are traded Tangible or intangibles assets like index are traded.

2 In cash market we can purchase even one share.

in futures and options minimum lots are fixed.

3 Buying securities in cash market involves putting up all the money upfront

Buying futures simply involves putting up the margin money

4 More risky than F&O segment. Risk is limited as margin is less than asset value

5 Cash assets may be meant for consumption or investment

Derivates contracts are for hedging, arbitrage or speculation

6 with the purchase of share of the company in cash market, the holder becomes part owner of the company

In F & O segment, it does not happen.

7 Cash assets values are not dependent on derivatives assets values.

Value of derivative contract is always based on and linked to the underlying security.

8 In the cash market, a customer must open securities trading account with a securities depository

In the derivatives market, a customer must open a derivatives trading account with a derivative broker.


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Question.19 What is meant by Covered Option & uncovered Options? Answer. Covered Option: An option contracts considered covered if the writer owns the underlying asset (in case of a call options contract) or has another offsetting options position. Call writers are considered to be covered if they have any of the following positions:

1. A long position in the underlying asset. 2. A security that is convertible into requisite number of share of the underlying security. 3. A warrant exercisable for requisite number of shares of the underlying security. 4. A long position in a call on the same security that has the same or a lower strike price

and that expires at the same time or later than that option being writer.

There is only one way for put writers to be covered. They must own a put on the same underlying asset with the same or later expiration month and the same or higher strike price. Uncovered Option: The writer is exposed to the risk of having, to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price. When they face such a risk, writers are said to be uncovered (or naked). Question.20 Distinguish between Caps and Collars. Or Give the meaning of ‘Caps, Floors and Collars’ options. Answer Cap- Variable rate borrowers are the users of Interest rate Caps. They use caps to obtain

certainty for their business and budgeting process by setting the maximum interest rate, they will pay on their borrowings. An interest rate cap is an option bought by an issuer which limits/ restricts the maximum rate of interest that may be payable by an issuer to its investors on the variable debt instruments issued by it. The borrower decides to buy an interest rate cap option to limit the maximum interest rate payable in a period without forfeiting the possibility of benefit of lower interest rates. The option holder pays an upfront premium and a strike rate of interest is fixed. If at any time, the variable borrower will exercise the option and the counter party to the option contract will have to pay the borrower the difference amount. An interest rate cap ensures that you will not pay any more than a predetermined level of interest on your loan.

Collar- A combination of buy caps and sell floors is called collar. If interest rates have no

predefined trends & they may either rise or fall in future, in such a casem an issuer may create a collar strategy to minimize his interest rates & cost involved. A collar is a


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simultaneous buying of a cap & selling of a floor by an issuer after charging premium for floor & paying premium for cap.

Floor- A floor is an option which guarantee the minimum rate of interest that may be received

by an investor in lieu of an option premium paid in advance. A floor may be written by a bank/financial institution or by the issuer itself.

Question.21 Differences between spot contract and forward contract Answer

(i) In a spot contract, at least one component, i.e. either the price or the goods/services is tendered at the time of the contract. In a forward contract, both the components are exchanged at a specified future date.

(ii) In a spot contract, both the parties transact on the basis of their presents capability. The buyer purchases according to his ability to pay for the goods or services and the seller according to his ability to deliver the goods or services. In a forward contract, a leveraging of capabilities is involved. Since no down payment is involved, the buyer might contract to buy a larger number of goods or services, expecting to derive some benefits from the perceived price differential between the spot price and the likely price at the perceived maturity of the forward contract. Also the seller, seller, feeling that a larger number of goods shall be available at the contracted price at the time of maturity, agrees to sell a far larger number of goods.

(iii) In a spot contract, execution of the contract is more or less certain because both the

components, i.e. money and goods are available. Even through the transaction does not pass through a regulated delivery and payment mechanism yet the changes of default are very less. The problems of payment and delivery get magnified in the case of a forward contract.

Question. 22 What is difference between commodity derivative & financial derivatives. Answer

Commodity Derivative Financial Derivative

1. In commodity derivative underlying assets are commodities like wheat, corn, oil etc.

1. In Financial Derivative underlying Assets are share, stock, debenture bond etc

2. Commodity derivative can be cash or physical settled

2. Most of financial Derivative are Cash settled.

3. Due to bulky nature of undertaking 3. In Case of physical settlement financial


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asset physical settlement in commodity derivatives creates the need for warehousing.

assets do not need spl. Facility for storage.

4. Quality of asset underlying a contract can vary largely

4. Concept of varying quality a asset does not really exist in financial derivatives.

Question.23 What Difference between Financial Management and Treasury management? Answer Following differences can be observed between financial management and treasury management 1. Control Aspects: The objective of financial management is to establish, coordinate and administer as an integral part of the management, an adequate plan for control of operations. Such a plan should provide for capital investment programs, profit budgets, sales forecasts, expenses budgets and cost standards. The objective of treasury management is to execute the plan of finance function. Execution of the plan takes care of the issues arising in routine operations of the firm which have a bearing upon the funds position. Thus the finance function of a firm would fix the limit for investment in short term instruments for a firm & It is the treasury function that would decide which particular instruments are to be invested in within the overall limit having regard to safety, liquidity and profitability. 2. Reporting Aspects: Financial management is concerned with the preparation of overall financial reports of the firm such as Profit and Loss account and the Balance Sheet. It also takes care of the taxation aspects and external audit. Based upon the performance of the firm, budgets for the upcoming years are fixed. The reports are submitted to the top management of the firm. Treasury management is concerned with monitoring the income and expense budgets on a periodic basis visà- vis the budgets. The budgets are fixed department/ segment wise so as to relate with the overall corporate budgets. Variances from the budgets are analysed by the treasury department on a continual basis for taking corrective measures. 3. Strategic Aspects: The finance function is involved in formulating overall financial strategy for the firm. The top management chooses the line of activity for the firm. The finance function firms up the investment and financing plans for the activity. The strategic choices before the financial manager are the options of investment and financing. While making these choices, the finance manager is taking a long-term view of the state of affairs. Strategy for treasury management is more short-term in nature. The maintenance of proper systems of accounting is one of the objectives of treasury management. Another strategic objective for treasury management would be maintenance of short-term liquidity. This is done through regulation of payments and speedy realization of receivables.


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4. Nature of assets: The finance manager is concerned with creation of fixed assets for the firm. Fixed assets are those assets which yield benefit to the firm over a longer period of time. It can be said that the time span of a project coincides with the span of the fixed assets. In case the fixed assets have depreciated physically by a significant measure, then a decision has to be taken for up gradation and replacement of the assets. The treasury manager is concerned with the net current assets of the firm. Net current assets are the difference between the current assets and current liabilities of the firm, both normally realizable within a period of one year. Current assets should always be more than the current liabilities for ensuring liquidity of the firm. Current assets are the inventory, receivables and cash balances. Current liabilities are the trade creditors, statutory payables and loan repayable within one year. To ensure a healthy level of net current assets, the treasury manager is to ensure that the quality of the assets does not deteriorate. Question.24 What Distinguish between forward and futures contracts: Answer DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS

Point of distinction Forward contract Futures contract

1. Trading: Over the counter in nature Traded on an organized exchange

2. Size of contract: Individually tailored and have no standardized size

standardized in terms of quantity

3. Margin requirement: No margin requirement.

Margin payment is required to be maintained with the clearing house of an exchange

4. Regulation: Usually non- regulated Stringent regulations.

5. Volume:

Less More

6. Cost size: Comparatively higher Comparatively lower

7. Reason for contract: Basically allows hedging Allows speculation as well as hedging

8. Parties to contract: Only buyer & seller. Three parties i.e. buyer, seller and clearing house


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9. Final settlement: Settled by delivery Settled by delivery or cash

10. Credit risk: Every party has to bother for the creditworthiness of the counter party

Parties need not bother for the creditworthiness of each party

11. Liability: Unlimited because market fluctuation may be wide

Extent of loss/profit is known every next day hence, depending on the risk taking capacity of the party, exposure may be limited.

Question.25 What is difference b/w Netting & Matching Answer

Netting Matching

All transactions- gross receipt & payment among parent firm & subsidiaries should be adjusted & only net amount should be transferred. This technique is called as netting. It involves centralization of data at corporate level, selection of time period at which netting is to be done & choice of currency in which it is to be done. The currency could be home-currency of firm. It reduces cost of remittance of funds & lower exchange cost.

It is process whereby cash inflow in a foreign currency are matched with cash outflows, in same currency with regards to as far as possible, amount & maturation. Hedging of exchange risk could be done for unmatched portion when there are cash inflows in one foreign currency & outflow in another two could still be matched, provided they are truly correlated, reduces hedging cost.

Question.26 Differentiate between the following: Current Account Convertibility and Capital Account Convertibility Answer Current account convertibility: means currency can be freely converted into other convertible currencies for purchase and sale of commodities and services. For example, a German company should be able to freely convert the mark (DM) into rupees to pay an Indian software constancy


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firm for its services. It is evident that the ideal of free trade lies at the heart of current account convertibility. Capital account convertibility: on the other hand, implies the right to transact in financial and other assets with foreign countries without restrictions. For example, if a currency is convertible on the capital account, the residents of the domestic currency can freely convert it into other (convertible) currencies to purchase and maintain bank account abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments . In India, we have full current account convertible concept & capital account transaction are not fully convertible. Question.27 Differentiate between Forfaiting and Export Factoring. Answer Forfaiting is similar to cross border factoring to the extent both have common features of non recourse and advance payment. But they differ in several important respects:

(a) A forfeiter discounts the entire value of the note/bill but the factor finances between 75-85% and retains a factor reserve which is paid after maturity.

(b) The availing bank which provides an unconditional and irrevocable guarantee is a critical element in the forfaiting arrangement whereas in a factoring deal, particularly non-recourse type, the export factor bases his credit decision on the credit standards of the exporter.

(c) Forfaiting is a pure financing arrangement while factoring also includes ledger

administration, collection and so on. (d) Factoring is essentially a short term financing deal. Forfaiting finances notes/bills arising

out of deferred credit transaction spread over three to five years. (e) A factor does not guard against exchange rate fluctuations; a forfeiter charges a

premium for such risk.


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Question 28 Differentiate between Futures and Options. Answer Difference between Futures and Options

FUTURES OPTIONS

Both the parties are obliged to perform the contract.

Only the seller (writer) is obligated to perform the contract.

No premium is paid by either party. The buyer pays the seller (writer) a premium.

The holder of the contract is exposed to the entire spectrum of downside risk and has potential for all the upside return,

The buyer’s loss is restricted to downside risk to the premium paid, but retains upward indefinite potentials.

The parties of the contract must perform at the settlement date. They are not obligated to perform before the date.

The buyer can exercise his option any time prior to the expiry date.

Question 29 Differentiate between Interest Rate Parity and Purchasing Power Parity Answer ‘Interest Rate Parity’ and ‘Purchasing Power Parity’ 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. Purchasing Power Parity : According to the Purchasing Power Parity (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. Question 30 What are the various types of Foreign Exchange Risk exposures? Answer 1. Transaction Exposure: A transaction exposure occurs when a value of a future transaction, known with certainty, is denominated in some currency other than the domestic currency. In


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such cases, the monetary value is fixed in terms of foreign currency at the time of agreement which is completed at a later date. Transaction exposure basically covers the following: (a) Rate Risk: it will occur when at time of transaction exchange rate fluctuate (b) Credit Risk: A situation when the borrower is not in a position to pay. (c) Liquidity Risk: Same as in the case of credit risk. 2. 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. 3. Economic Exposure: The economic exposure refers to the probability that the change in foreign exchange rate will affect the value of the firm. Since the intrinsic value of the firm is equal to the sum of the present values of future cash flows discounted at an appropriate rate of return, the risk contained in economic exposure requires a determination of the effect of changes in exchange rates on each of the expected future cash flows. Question 31 Differentiate between Ask price and Bid price. Answer The Ask Price is the rate at which the foreign exchange dealer asks its customers to pay in local currency in exchange of the foreign currency. In other words, ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer. On the other hand, the Bid price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency. So, the bid price is the rate which the dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore, it is the buying rate.

COMMENT Question 32 What are the forms of dividend explain. Answer Dividends can be divided into following forms:

(i) Cash dividend : The company should have sufficient cash in bank account when cash dividends are declared. If it does not have enough bank balance, it should borrow funds in advance. For stable dividend policy, a cash budget may be prepared for coming period to indicate necessary funds to meet regular dividend payments.


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The cash account and reserve account of the company is bound to reduce on payment of cash dividend . Both total assets as well as net worth of the company are reduced when cash dividend is distributed. Accordingly market price of share drops by the amount of cash dividend distributed.

(ii) Stock Dividend (Bonus shares) : It is distribution of shares in lieu of cash dividend to existing shareholders. Such shares are distributed proportionately thereby retaining proportionate ownership of the company. If a shareholder owns 100 shares at a time, when 10% dividend is declared he will have 10 additional shares thereby increasing the equity share capital and reducing reserves and surplus (retained earnings). The total net worth is not affected by bonus issue.

Advantages : There are many advantages both to the shareholders and to the company. Some of the important advantages are listed as under: 1) To Share Holders:

(a) Tax benefit –At present, there is no tax on dividend received. (b) Policy of paying fixed dividend per share and its continuation even after

declaration of stock dividend will increase total cash dividend of the share holders in future.

2) To Company:

(a) Conservation of cash for meeting profitable investment opportunities. (b) Cash deficiency and restrictions imposed by lenders to pay cash dividend.

Question 33 “Bonus issue is a common method of distribution of dividend, however it has many limitations” comment. Answer Limitations of stock bonus:

1. To Shareholders: Stock dividend does not affect the wealth of shareholders and therefore, has no value for them. This is because, the declaration of stock dividend is a method of capitalising the past earnings of the shareholders and is a formal way of recognising earnings which the shareholders already own. It merely divides the company's ownership into a large number of share certificates. James Porterfield regards stock dividends as a division of corporate pie into a larger number of pieces.

Stock dividend does not give any extra or special benefit to the shareholder. His proportionate ownership in the company does not change at all. Stock dividend creates a favourable


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psychological impact on the shareholders and is greeted by them on the ground that it gives an indication of the company's growth.

2. To Company: Stock dividends are costlier to administer than cash dividend. It is disadvantageous if periodic small stock dividends are declared by the company as earnings. Since small issue of stock dividend are not adjusted at all and only significant stock dividends are adjusted hence growth rate measured in EPS being less than growth rate based on per share.

Question 34 What are the different motives for holding cash? Answer a) Transactional Motive This is the most essential motive for holding cash because cash is the medium through which all the transactions of the firm are carried out. Some examples of transactions of a manufacturing firm are given below: – Purchase of Capital Goods like plant and machinery – Purchase of raw material and components – Payment of rent and wages – Payment for utilities like water, power and telephone – Payment for service like freight and courier These transactions are paid for from the cash pool or cash reservoir which is all the time being supplemented by inflows. These inflows are of the following kinds: – Capital inflows from promoters’ capital and borrowed funds – Sales proceeds of finished goods – Capital gains from investments The size of the cash pool depends upon the overall operations of the firm. Ideally, for transaction purposes, the working capital inflows should be more than the working capital outflows at any point of time. b) Speculative Motive Since cash is the most liquid current asset, it has the maximum potential of value addition to a firm’s business. The value addition can come in two forms. First, as the originating and terminal point of the operating cycle, cash is invaluable. But cash has an opportunity cost also and if cash is kept idle, it becomes a liability rather than an asset. Therefore, efficient firms seek to deploy surplus cash in short term investments to get better returns. It is here that the second form of


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value addition from cash can be had. Since this deployment of cash needs to be done skillfully, not all the firms hold cash for speculative motive. Further the amount of cash held for speculative motive should not cause any strain upon the operating cycle. c) Contingency Motive This motive of holding cash takes into account the element of uncertainty associated with any form of business. The uncertainty can result in prolongation of the working capital operating cycle or even its disruption. It is possible that cost of raw materials or components might go up or the time taken for conversion of raw materials into finished goods might increase. For such contingencies, some amount of cash is kept by every firm. Question.35 Write short notes on Effect on Inflation on Inventory Management. Answer Effect on Inflation on Inventory Management: The main objective of inventory management is to determine and maintain the optimum level of investment in inventories. For inventory management a moderate inflation rate say 3% can be ignored but if inflation rate is higher it becomes important to take into consideration the effect of inflation on inventory management. The effect of inflation on goods which the firm stock is relatively constant can be dealt easily, one simply deducts the expected annual rate of inflation from the carrying cost percentage and uses modified version in the EOQ model to compute the optimum stock. The reason for making this deduction is that inflation causes the value of the inventory to raise, thus offsetting somewhat the effects of depreciation and other carrying cost factors. Since carrying cost will now be smaller, the calculated EOQ and hence the average inventory will increase. However, if rate of inflation is higher the interest rates will also be higher, and this will cause carrying cost to increase and thus lower the EOQ and average inventories.

Question36 The forward rate is an accurate predictor of the future spot rate. Do you agree? Answer Theoretically, in the efficient market and in the absence of intervention or control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found: Interest Rate Parity : According to interest rate parity principle, the forward premium (or discount) on currency of acountry 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 andvice-versa.

(i) 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


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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.

(ii) International Fisher Effect : The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.

However, even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found. Question.37 What is the role of Company Secretary as a forex manager? Answer Company Secretary as a forex manager The developments in international trade have resulted in the emergence of a new brand of manager called the forex manager. The forex manager is a category apart from the finance manager or the treasury manager. He has to transact with dealers, brokers and bankers in the foreign exchange market. He has to face special kind of risk. Yet his vocation is full of opportunities and challenges. For effective management of forex transactions, the forex manager is expected to have awareness of historical development of world trade, ability to forecast future trends in exchange movements, have comparative analysis skills, have in- depth knowledge of forex market and movement of interest rates,. He should also be able to hedge his position. By virtue of their training and education, a company secretary is competent in dealing with all these situations Question38 “A firm’s stock price is not related to its mix of debt and equity financing.” Do you agree with the statement? Give reasons. Answer According to theory of modern financial management by Modigliani and Miller, the value of a firm depends solely on its future earnings stream, and hence its value is unaffected by its debt/equity mix. They concluded that a firm’s value stems from its assets, regardless of how those assets are financed. MM Hypothesis was based on restrictive set of assumptions, including perfect capital markets (which implies zero taxes). They used an arbitrage proof to demonstrate that capital structure is irrelevant. If debt financing resulted in a higher value for the firm than equity financing, then investors who owned shares in a leveraged (debt-financed) firm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equity-financed) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in the unleveraged firm would drive the prices of the stocks to the point


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where the values of the two firms would be identical. Thus, according to MM Hypothesis, a firm’s stock price is not related to its mix of debt and equity financing. However, according to according to Net income approach the capital structure decision is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. A higher debt content in the capital structure means a high financial leverage and this result in decline in the overall or weighted average cost of capital. This results in increase in the value of the firm and also increase in the value of the equity shares. In an opposite situation, the reverse condition prevails. Assumptions of this approach are: 1. Corporate taxes do not exist 2. Debt content does not change the risk perception of the investors. 3. Cost of debt is less than cost of equity i.e., debt capitalization rate is less than the equity capitalization rate. Question.39 What are business risk and financial risk? How does each of them influence the firm’s capital structure decisions? Answer BUSINESS RISK Business risk is inherent in any company’s operations. If a firm is unable to cover its operating costs, it is exposed to business risk. In general, the greater the firm's operating leverage- the use of fixed operating costs-the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors also affect it. i) revenue stability and ii) cost stability Revenue stability reflects the relative variability of the firm's sales revenues. Firms with stable levels of demand and product prices tend to have stable revenues. The result is low levels of business risk. Firms with highly volatile product demand and prices have unstable revenues that result in high levels of business risk. Cost stability reflects the relative predictability of input prices such as those for labour and materials. The more predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the higher the business risk. Business risk varies among firms, regardless of their lines of business, and is not affected by capital structure decisions. The higher a firm's business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk therefore tend toward less highly leveraged capital structures, and firm with low business risk tend toward more highly leveraged capital structures.


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FINANCIAL RISK If a firm is unable to cover its required financial obligations, it is exposed to financial risk. In general, the greater the firm's financial leverage- the use of fixed charge source of funds - the higher its financial risk. The firm's capital structure directly affects its financial risk which is the risk to the firm of being unable to cover required financial obligations. The penalty for not meeting financial obligations is bankruptcy. The more fixed cost financing-debt (including financial leases) and preferred stock firm has in its capital structure, the greater its financial leverage and risk. Financial risk depends on the capital structure decision made by the management and, that decision is affected by the business risk the firm faces. Question 40 What do you mean by capital rationing? Illustrate some of its advantages. Answer Capital rationing is a common practice in most of the companies as they have more profitable projects available for investment as compared to the capital available. In theory, there is no place for capital rationing as companies should invest in all the profitable projects. However, majority of companies follow capital rationing as a way to isolate and pick up the best projects under the existing capital restrictions. Capital rationing is a technique of selecting the projects that maximizes the firm’s value when the limited budget of company/firm is allocated optimally between different projects. This aims in choosing only the most profitable investments for capital investment decision. This can be accomplished by putting restrictive limits on the budget or selecting a higher cost of capital as the hurdle rate for all the projects under consideration. There are few advantages of practicing capital rationing:

Budgeting: The first and an important advantage is that capital rationing introduces a sense of strict budgeting of corporate resources of a company. Whenever there is an injunction of capital in the form of more borrowings or stock issuance capital, the resources are properly handled and invested in profitable projects.

Less wastage: Capital rationing prevents wastage of resources by not investing in each and every new project available for investment.

Fewer projects: Capital rationing ensures that limited number of projects are selected by imposing capital restrictions. This helps in keeping the number of active projects to minimum and thus manages them well.

Higher returns on investments: Through capital rationing, companies invest only in projects where the expected return is high, thus eliminating projects with lower


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returns on capital. Stability: As the company is not investing in every project, the finances are not over-extended. This helps in having adequate finances for tough times and ensures more stability and increase in the stock price of the company Thus, there is no evidence as to whether inflation raises or lowers the optimal level of inventories of firms in the aggregate. Question.41 A higher financial leverage is better than higher operating leverage. Comment. Answer Operating leverage indicates the proportion of fixed operating charges. Higher operating leverage indicates higher quantum of fixed operating charges. If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage. The financial leverage indicates the proportion of fixed financial charges, in the form of interest cost. Higher financial leverage indicates higher quantum of fixed financial charges. T he company can differ or somewhat convince the financial institution and banks, to accept the delay in payment, which cannot be possible in the case of provider of operating activities. Hence we can say that higher financial leverage is better than higher operating leverage. Question.42 Write short note on effect of a Government imposed freeze on dividends on stock prices and the volume of capital investment in the background of Miller-Modigliani (MM) theory on dividend policy. Answer According to MM theory, under a perfect market situation, the dividend decision of any firm is irrelevant as it does not affect the value of firm. Thus, under MM’s theory, the government imposed freeze on dividends should make no difference on stock prices. Firms not paying dividends will have higher retained earnings and will either reduce the volume of new stock issues, repurchase more stock from market or simply invest extra cash in marketable securities. In all of the above cases, the loss by investors of cash dividends will be made up in the form of capital gains. Whether the Government imposed freeze on dividends has an effect on volume of capital investment in the background of MM theory on dividend policy fetches two arguments. First argument is that if the firms keep their investment decision separate from their dividend and financing decision, then the freeze on dividend by the Government will have no effect on volume of capital investment. If the freeze restricts dividends the firm can repurchase shares or invest excess cash in marketable securities e.g. in shares of other companies. Other argument is that the firms do not separate their investment decision from dividend and financing decisions. Rather, they prefer to make investment from internal funds. In this case,


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the freeze of dividend by government could lead to increased real investment. Question.43 Describe the logic underlying the use of target weights to calculate the WACC, and compare and contrast this approach with the use of historical weights. What is the preferred weighting scheme? Answer First, we have to understand the concept of book value weight and market value weight to calculate WACC. Book value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure. Market value weights measure the proportion of each type of capital at its market value. Market value weights are appealing because the market values of securities closely approximate the actual Rupees to be received from their sale. Moreover, because firms calculate the costs of the various types of capital by using prevailing market prices, it seems reasonable to use market value weights. In addition, the long-term investment cash flows to which the cost of capital is applied are estimated in terms of current as well as future market values. Market value weights are clearly preferred over book value weights. HISTORICAL VERSUS TARGET WEIGHT Historical weights can be either book or market value weights based on actual capital structure proportions. For example, past or current book value proportions would constitute a form of historical weighting, as would past or current market value proportions. Such a weighting scheme would therefore be based on real—rather than desired—proportions. However, Target weights, which can also be based on either book or market values, reflect the firm’s desired capital structure proportions. Firms using target weights establish such proportions on the basis of the “optimal” capital structure they wish to achieve. Considers the somewhat approximate nature of the calculation of weighted average cost of capital, the choice of weights may not be critical. However, from a long term perspective, the preferred weighting scheme should be target market value proportions. Question44 The scope of financial services in India is very wide. Discuss the various activities covered under financial services. Answer Scope of Financial Services


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(i) Traditional Activities Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can be grouped under two heads:

(a) Fund based activities : The traditional services which come under fund based activities are the following: o Underwriting or investment in shares, debentures, bonds, etc. of new issues

(primary market activities). o Dealing in secondary market activities. o Participating in money market instruments like commercial Papers, certificate of

deposits, treasury bills, discounting of bills etc. o Hire purchase o Leasing o Venture capital

(b) Non-fund based activities : Financial intermediaries provide services on the basis of

non-fund activities also. This can be called ‘fee based’ activity. They include: o Merchant banking o Broking service o Credit rating o Portfolio management o Underwriting etc.

Question.45 ‘Loan syndication is one of the project finance services. ’Discuss. Answer Loan syndication involves obtaining commitment for term loans from the financial institutions and banks to finance the project. Basically it refers to the services rendered by merchant


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bankers in arranging and procuring credit from financial institutions, banks and other lending and investment organisation or financing the client project cost or working capital requirements. Loan syndication is infact a tie up of term loans from the different financial institutions. The process of loan syndication involves various formalities such as:

Preparation of project details,

Preparation of loan application,

Selection of financial institutions for loan syndication,

Issue of sanction letter of intent from the financial institutions,

Compliance of terms and conditions for the availment of the loan,

Documentation, and

Disbursement of the loan. Question46 Explain the process of securitization of debt and the participants involved in the process. Answer Securitisation of debt is a technique by which identified receivables and other financial assets can be packaged into transferable securities and sold to investors. The instruments issued under a securitisation deal derive their value from the cash flows (current or future) or collateral value of a specified financial asset or pool of financial assets, general debt obligations or other financial receivables. Participants of the securitization process

The following parties are involved in a typical securitization deal:

1. Originator: This is the entity that requires the financing and hence is the driver of the deal. Typically the Originator owns the assets or cash flows around which the transaction is structured.

2. SPV (Special Purpose Vehicle): An SPV is typically used in structured transaction for ensuring bankruptcy remoteness from the Originator. The SPV is the issuer of securities or the entity through which the financing is channeled. Typically the ownership of the cash flows or assets around which the transaction is structured is transferred from the Originator to the SPV at the time of execution of the transaction. The SPV is typically a marginally capitalized entity with narrowly defined purposes and activities and usually has independent trustees/directors.

3. Investors : The investors are the providers of funds and could be individuals or institutional investors like banks, financial institutions, mutual funds, provident funds, pension funds, insurance companies, etc.


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4. Obligor(s) : The Obligor is the Originator’s debtor. The amount outstanding from the Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is of paramount importance in a structured finance transaction.

5. Guarantor/Credit Enhancement Provider/Insurer : These are entities that provide protection to the Investor for the finance provided and the returns thereon against identified risks. Typically, on the happening of pre-identified events, affecting the underlying assets or cash flows or the payment ability of the Obligors, these entities pay moneys, which are passed on, to the Investor.

Besides these primary parties, the other parties involved in a deal are given below:

1. Rating Agency: Since structured finance deals are generally complex with intricate payment structures and legal mechanisms, rating of the transaction by an independent qualified rating agency plays an important role in attracting Investors.

2. Administrator or Servicer: The Servicer performs the functions of collecting the cash flows, maintaining the assets, keeping records and general monitoring of the Obligors. In many cases, especially in the Indian context, the Originator also performs the role of the Servicer.

3. Agent and Trustee: The Trustee is the manager of the SPV and plays a key role in the transaction. The Trustee generally administers the transaction, manages the inflow and outflow of moneys, and does all acts and deeds for protecting the rights of the Investors including initiating legal action against various participants in case of any breach of terms and triggering payment from various credit enhancement structures.

4. Structurer: Normally, an investment banker acts as the structurer and designs and executes the transaction. The Structurer also brings together the Originator, Credit Enhancement Provider, the Investors and other parties to a deal. In some cases (like ICICI), the Investor also acts as the Structurer.


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A securitisation deal normally has the following stages:- 1. The originator issues loan to the obligors 2. The cash flows (principal + interest) on the loan are collected by the collection agent

on behalf of the originator. 3. Support mechanisms (or credit enhancements) are appointed in the structure in

order to minimise or mitigate potential credit risks. 4. The loan pool is selected and credit rating is taken. 5. A structure, generally, a merchant banker is appointed. 6. The SPV is formed. It acquires the receivables under an agreement at their

discounted value. 7. The SPV pays the purchase consideration to the originator. 8. & 9. The SPV funds the purchase by issuing class A (senior) Pass Through Certificates

(PTCs) and class B (Subordinated)PTCs. 9. The collection agent collects the receivables, usually in an escrow mechanism, and

pays off the collection to the SPV. The SPV either passes the collection to the investors, or reinvests the same to pay off to investors at stated intervals. Question47 What is Social Cost benefit analysis (SCBA) of project? Explain the approaches for SCBA. Answer Social cost-benefit analysis is a systematic and cohesive method to survey all the impacts caused by a project. It comprises not just the financial effects (investment costs, direct benefits like tax and fees, etc), but all the social effects, like: pollution, safety, indirect (labour) market, legal aspects, etc. The main aim of a social cost benefit analysis is to attach a price to as many effects as possible in order to uniformly weigh the abovementioned heterogeneous effects. As a result, these prices reflect the value a society attaches to the caused effects, enabling the decision maker to form a statement about the net social welfare effects of project. Two approaches for SCBA – UNIDO Approach: - This approach is mainly based on publication of UNIDO (United Nation Industrial Development Organisations) named Guide to Practical Project Appraisal in1978. The UNIDO guidelines provide a comprehensive framework for appraisal of projects and examine their desirability and merit by using different yardsticks in a step-wise manner. The desirability is examined from various angles, such as the impact on

(a) Financial profitability of utilization of domestic resources, (b) Savings and consumption pattern, (c) Income distribution, and (d) Production of merit and demerit goods.


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– L-M Approach :- The seminal work of Little and Mirrlees on benefit-cost analysis systematically develops a theoretical basis for the analysis and its underlying assumptions and lays down step-wise procedure for undertaking benefit-cost studies of public projects. The mathematical formulation is identical to the UNIDO method except for differences in assigning value to discount rates and accounting for imperfections and other market failures and social considerations. Like UNIDO guidelines, the Little-Mirrlees method also suggests valuation of project investment at opportunity cost (shadow prices) of resources to correct distortions due to market imperfections. Question48 “In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear-cut means of ‘making a statement’ that speaks louder than thousand words.”Explain. Answer In an uncertain environment, verbal statements about the performance of the company may not be significant but changes in dividends cannot be ignored as they contain information vital to the investors. The payment of dividend conveys to the shareholders information relating to the profitability of the firm. An increase in the amount of dividend signify that the firm expects its profitability to improve in future or vice versa. The dividend policy is likely to cause a changes in the market price of the shares. Although Modigliani and Miller they still maintain that dividend policy is irrelevant as dividends do not determine the market price of shares. However, empirical studies have proved that changes in dividends convey more significant information than what earnings announcements do. Further, the market reacts to dividend changes – prices rise in response to a significant increase in dividends and fall when there is a significant decrease or omission in payment of dividend Modern activities Thus from above it is proved that dividend action provide a clear cut mean of making a statement. Question49 State with reason whether the investment, financing and dividend decisions are inter-related. Answer Financial Management, to be more precise, is concerned with investment, financing and dividend decisions in relation to objectives of the company, in the ultimate analysis; such decisions have to take care of the interest of the shareholders. Investment ordinarily means profitable utilization of funds. Investment decisions are concerned with the question whether adding to capital assets today will increase the net worth of the firm. Financing is next step in


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financial management for executing the investment decision once taken. Finance decision making is concerned with the question as to how funds requirements should be met keeping in view their cost and how far the financing policy influences cost of capital. This would provide a cut off rate whether corporate fund be committed to or withheld from certain projects and how the expected returns on projects be measured. The dividend decision is another major area of financial management. The financial manager helps in deciding whether the firm should distribute all profits or retain them or distribute a portion and retain the balance. Thus, from the point of view of a corporate unit, financial management is related not only to ‘fund raising’ but encompasses wider perspective of investing and distributing the finances of the company efficiently. As such it is true to stay that investment, financing and dividend decisions are inter- related. Question50 Define scenario analysis. Answer Scenario analysis is a process of analyzing possible future events by considering alternative possible outcome. Thus, the scenario analysis, which is a main method of projection, does not try to show one exact picture of the future. Instead it presents consciously several alternatives future development consequently a scope of possible future outcomes observable, also the development paths leading to the outcomes. It does not rely on historical data & does not expect past observations to be still valid in the future. Instead it tries to consider possible developments & turning points. In short several scenarios are demonstrated in a scenario analysis to show possible future outcomes. Question51 Define sensitivity analysis Answer. Capital budgeting remain unrealistic in the circumstances when despite a set of reliable estimates of return, outlays, discount rate and project life time uncertainty surrounds some of all of these figures. Sensitivity analysis is helpful in such circumstances. It is a computer based device. Sensitivity analysis has been evolved to treat risk and uncertainty in capital budgeting decisions. The analysis is comprised of the following steps: (1) Identification of variables; (2) Evaluation of possibilities for these variables; (3) Selection and combination of variables to calculate NPV or rate of return of the project; (4) substituting different values for each variables in turn while holding all other constant to discover the effect on the rate of return; (5) Comparison of original rate of return with this adjusted rate to indicate the degree


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of sensitivity of the rate to change in variables; (6) subjective evaluation of the risk involved in the project. The purpose of sensitivity analysis is to determine how varying assumptions will effect the measures of investment worth. Ordinarily, the assumptions are varied one at a time i.e. cash flows may be held constant with rate of discount used to vary; or discount rate is assumed constant and cash flow may vary with assumed outlay; or the level of initial outlay may change with discount rate and annual proceeds remaining the same. In the context of NPV, sensitivity analysis provides information regarding the sensitivity of the calculated NPV to possible estimation errors in expected cash flows, the required rate of return and project life. Question 52 Risk and uncertainty are quite inherent in capital budgeting decisions. Answer

Risk and uncertainty are quite inherent in capital budgeting decision.

Capital budgeting involves various elements which have uncertainties.

This is so because capital budgeting are actions of today which bears fruits in future which is unforeseen. Future is uncertain and involve risk.

The estimations of cash inflows may not hold true.

The cost of capital which offers cut off rates may also be inflated or deflated under business cycle conditions.

Besides all these, technological developments are other factors that enhance the degree of risk and uncertainty by rendering plant & equipments obsolete and the projects out of date.

Question 53 Define capital structure and its kind. Answer Meaning of Capital Structure By the term capital structure we mean the structure or constitution or break-up of the capital employed by a firm. The capital employed consists of both the owners’ capital and the debt capital provided by the lenders. Debt capital is understood here to mean the long term debt


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which has been deployed to build long term assets. Apart from the elements of equity and debt in the capital structure, a firm could have quasi equity in the form of convertible debt. Capital Structure of a firm is a reflection of the overall investment and financing strategy of the firm. It shows how much reliance is being placed by the firm on external sources of finance and how much internal accruals are being used to finance expansions etc. Capital structure can be of various kinds as described below: 1. Horizontal Capital Structure In a Horizontal capital structure, the firm has zero debt components in the structure mix. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained earning only. The absence of debt results in the lack of financial leverage. Probability of disturbance of the structure is remote. 2. Vertical Capital Structure In a vertical capital structure, the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built. The incremental addition in the capital structure is almost entirely in the form of debt. Quantum of retained earnings is low and the dividend pay-out ratio is quite high. In such a structure, the cost of equity capital is usually higher than the cost of debt. The high component of debt in the capital structure increases the financial risk of the firm and renders the structure unstable. The firm, because of the relatively lesser component of equity capital, is vulnerable to hostile takeovers. 3. Pyramid shaped Capital structure A pyramid shaped capital structure has a large proportion consisting of equity capital and retained earnings which have been ploughed back into the firm over a considerably large period of time. The cost of share capital and the retained earnings of the firm is usually lower than the cost of debt. This structure is indicative of risk averse conservative firms. 4. Inverted Pyramid shaped Capital Structure Such a capital structure has a small component of equity capital, reasonable level of retained earnings but an ever increasing component of debt. All the increases in the capital structure in the recent past have been made through debt only. Chances are that the retained earnings of the firm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable to collapse. Question 54 Write a short note on capital Asset pricing Model. Answer CAPM is defined as an economic theory that describes relationship between risk and expected return and serves as a model for the pricing of risky securities. The CAPM asserts that the only


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risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated. The CAPM sys that expected return of a security or a portfolio is equal to rate on a risk free security plus a risk premium multiplied by asset’s systematic risk. The CAPM is calculated according to the following formula Desired return= Risk free+ β(Rm - Rf) The General idea behind CAPM is that investors need to be compensated for investing their cash in two ways (i)Time value of Money (ii) Risk The time value of money is represented by risk free rate (Rf) & it compensates investors for placing money in any investment over period of time. Risk calculates the amount of compensation the investor needs for taking additional Risk. This is calculated by taking a risk measure (beta) that compares return of the asset to the market over a period of time & to the market premium (Rm--Rf). Question 55 What are assumption of CAPM? Answer Assumptions of CAPM (1) All investors ASIM to Maximize Economic utilities (2) All investors are rational and Risk averse (3) All investors can lend and borrow unlimited amount under the risk free rate of interest. (4) All Investor trade without transaction or taxation cost (5) All investor has all information at same time Question 56 Leasing VS Hire purchase Answer

Leasing Hire Purchase

Ownership In leasing it is only financial lease ownership will get transferred, while in operating lease the ownership is not transferred.

In hire purchase, agreement is entered for transfer of ownership after a fixed period

Depreciation In leasing Depreciation is claimed by lessor in lease agreement

Depreciation is claimed by purchase hire in a hire purchase

Buyer count In operating lease lessor can In hire purchase the goods


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transfer asset to more than one lessee

property is sold once & there can’t be more than one buyer

Relationship Relationship in lease agreement is that of lessor & lessee

Relationship between seller & buyer will be owner & hirer in a hire purchase

Question 57 Write short note on venture capital financing. Answer Venture capital is regarded as risk capital. Venture capital financing refers to financing of new high-risk ventures promoted by qualified entrepreneur who lack experience and funds to give shape to their ideas. A venture capitalist invests in equity or debt securities floated by such entrepreneurs who under take highly risky venture with a potential of success. It is an investment in securities of new and unseasoned enterprises by way of private placement. It plays an important role not only in financing high technology projects but also helps to turn research and development into commercial production. Common methods of venture capital financing include:

(1) Equity financing: The venture capital undertaking generally requires funds for a longer period but may not be able to provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share capital. The equity contribution of venture capital firm does not exceed 49% of the total equity capital of venture capital undertaking so that the effective control and ownership remains with the entrepreneur.

(2) Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India venture capital financers charge royalty ranging between 2% to 15% actual rate depends on other factors of the venture such as gestation period, cash flow patterns, riskiness etc. Some venture capital financers give a choice to the enterprise of paying a high rate of interest (which could be well above 20%) instead of royalty once it becomes commercially sound.

(3) Income note: It is a hybrid security which combines the features both conventional loan

and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates.

(4) Participating Debenture: Such security carries charges in three phases in the start up

phase, no interest is charged, next stage a low rate of interest is charged upto a particular level of operations, after that, a high rate of interest is required to be paid.


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Venture capital funds have been promoted in India by both the private and public sector. Some of the examples are: Private Sector

India Investment Fund (ANZ Grindlays BANK)

Credit Capital Venture Fund (India) Ltd.

20th Century Venture Capital Corporation Ltd.

Indus Venture Capital Fund. Public Sector

Technology Development and Information Company of India Ltd. (TDICI promoted by ICICI)

Industrial Development Bank of India (IDBI) Venture Capital Fund Division

Risk Capital and Technology Finance Corporate (RCTS)

Canfina Venture Capital Fund Division State Financial Institutions

Gujarat Venture Finance Ltd.

APIDC Venture Capital Ltd. (Promoted by Andhra Pradesh Industrial DEVELOPMENT AND Investment Corporation).

The problems areas facing the industry are:

There is insufficient understanding of venture capital as a commercial activity

The support to the venture capital industry, by the government is inadequate;

The exit options available to the venture capitalists are limited;

Market limitations hinder the growth of venture capital industry; and

The inadequacy of the legal framework for venture capital industry. Question 58 -Write a short note on domestic resource cost? Answer

- Domestic resource cost refers to the resource cost involved in manufacturing a particular product rather than importing the same.

- It reflects the competitive edge the country has in producing the good.

- It helps in maintain favourable balance of payment.

- By calculating the domestic resource cost (DRC) a judicious can be made whether or not it is feasible to produce the good or is it better to out rightly purchase (import) the goods under consideration.


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Question 59 Write a short note on ERR. Answer 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 in 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 ability of the project do not represent the true value from the national or economic view point. ERR is based on shadow prices. Shadow prices reflect the real cost of inputs to the society and real benefits of the output instead of market prices. Question 60 Write a short note on ERP. Answer The effective rate of protection offered to a particular stage of manufacture of a product is an important consideration in the determination of competitive strength of the product. In the calculation of ERP, the basic parameter is value added which is the difference of selling prices of a product and the cost of the material inputs. If measures of protections are absent domestically and abroad theoretically , value added computed at domestic prices will be equal to the value added at international or cross border prices. The difference in the value added in two sets of prices reflect a measure of protection. ERP= Value added at domestic prices- Value added at international prices. Question 61. Write a short note on project appraisal under inflationary conditions. Answer Timing for project appraisal is most important consideration for all types of appraisers. A project under normal circumstances is appraised from different angles viz. technical feasibility, managerial aspects, commercial aspects financial viability and economic and social aspects. Under the normal conditions when prices are generally stable, demand pattern as projected in the project report is unchangeable, the project cost described in the project report remains unchanged at current prices and as such there is not much danger of any sudden escalation in project cost or over run in the projected resource. There is practically no risk involved of either business or financial nature and evaluation of the project could be done from different angles without providing for any change in project cost and planning for additional financial resources to meet the over run or escalations. Nevertheless, project appraisal can't avoid inflationary pressures as normal conditions for a project do not exist as the project is to be implemented over a period of time ranging upon the size and magnitude of project.


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In a developing economy like India, inflation grow at a planned steady rate because of the economic development activities and as such provision for a probable escalation in the project cost is generally provided as a cushion to inflationary pressures However, during inflationary conditions the project cost is affected in magnitude of parameters. Cost of project on all heads viz. Labour wage, raw material, fixed assets, equipments, plant and machinery, building material, remuneration of technicians and managerial personnels undergo a change. The financial institution and banks revise their rate of lending and their financing cost further escalate during inflationary conditions. Under such conditions, the appraisal of the project generally be done keeping in view the following guidelines which are usually followed by the Government agencies, banks and financial institutions:

1. Make provisions for delay in project implementation, escalation in project cost as per the forecasted rate of inflation in the economy particularly on all heads of cost.

2. Sources of finance should be carefully scrutinized with reference to revision in the rate of interest to be made by lender and the revision which could be followed in the interest bearing securities. All these factors will push up the cost of financial resources for the corporate unit.

3. Profitability and cash flow projections as made in the project report require revision and

adjustment should be made to take care of the inflationary pressures affecting adversely future projections

4. In inflationary times, early pay back projects should be prepared. Because projects with

long pay back are more subjected to inflationary pressures and the cash flow generated by the project will bear high risk.

Question 62 Project reviews is a very important aspect of entire project life. Comment? Answer Even project that are well designed, comprehensively planned, fully resourced and meticulously executed will face challenges. These challenges can take place at any point in the life of the project and the project team must work to continually revisit the design, planning and implementation of the project to confirm they are valid and to determine whether corrective actions need to be taken when the project's performance deviates significantly from its design and its plan. This is the purpose of the Project Monitoring, Evaluation and Control. Not surprisingly, the three principle categories of activities taking place during the Monitoring, Evaluation and Control Phase are:

Project Monitoring,


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Project Evaluation

Project Control These activities are intended to occur continuously through the entire life of the project. For example, the earliest procedure of the project indicators are already being developed during the Project identification and Design Phase, the Monitoring Plan is developed during the Planning Phase; monitoring visits are conducted during the implementation phase. Project monitoring: - It tracks the operational work of the project. It answer questions like” Have Activities been completed a planned”? Have outputs been produced as anticipated? Is the work of project progressing as projected? Project Evaluation: - It tends to focus on tracking progress at the higher level, Evaluation tends to Explore Questions like, “is the project successful at archiving its outcome”? “Is project contributing to its ultimate goal”? Project Control: - It involves establishing the systems & decision-making process to manage variances between project plans & the realities of project implementation. It also involves establishing how project variances and changes are managed, documented and communicated with stake holders. Question 63 Write a short note on stable dividend policy Answer Stable dividend policy: here the payment of certain sum of money is regularly paid to the shareholders. It is of three types:

(a) Constant dividend per share: here reserve fund is created to pay fixed amount of dividend in the year when the earning of the company is not enough. It is suitable for the firms having stable earning.

(b) Constant payout ratio: it means the payment of fixed percentage of earning as dividend every year.

(c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share constantly + extra dividend in the year when the company earns high profit.

Merits of stable dividend policy: – It helps in creating confidence among the shareholders. – It stabilizes the market value of shares. – It helps in marinating the goodwill of the company. – It helps in giving regular income to the shareholders.


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Question 64 Define Working Capital Leverage. Answer

The term working capital leverage, refers to the impact of level of working capital on company’s profitability.

Higher level of Investment in current Assets than is actually required means increase in the cost of interest charges on the short term loans and working capital finance raised from bank etc. and will result in lower return on capital employed and vice versa. Working capital leverage measures the responsiveness of ROCE (Return on capital employed) for changes in current assets.

It is calculated by using the following formula:

Working capital leverage =𝐶.𝐴

𝑇.𝐴.−𝐷.𝐶.𝐴.

C.A= Current Assets T.A.= Total assets (i.e., net fixed assets + current assets) D.C.A. = change in current assets. Question 65 Define tools of option Derivatives. Answer Tools of Options Derivatives These four tools are known as options derivatives. They are: 1. Delta An options delta is used to measure the anticipated percentage of change in the premium in relation to a change in the price of the underlying security. If a particular call option had a delta of 60% we would expect the option premium to vary by 60% of the change in the underlying stock. If that stock rose 1 point, the option premium should rise approximately 6/10 (60%) of 1 point. 2. Gamma Gamma measures the expected change in the delta factor of an option when the value of the price of the underlying security rises. If a particular option had a delta of 60% and a gamma of 5%, an increase of 1 point in the value of the stock would increase the delta factor by 5% from 60% to 65%. 3. Theta The theta derivative attempts to measure the erosion of an option’s premium caused by the passage of time. We know that at expiration an option will have no time value and will be


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worth only the intrinsic value if, in fact, it has any. Theta is designed to predict the daily rate of erosion of the premium. Naturally other factors, such as changes in the value of the underlying stock will alter the premium. Theta is concerned only with the time value. Unfortunately, we cannot predict with accuracy changes in a stock’s market value, but we can measure exactly the time remaining until expiration. 4. Vega The fourth derivative, Vega is concerned with the volatility factor of the underlying stock. We have pointed out that the volatility varies among different securities. Vega measures the amount by which the premium will rise when the volatility factor of the stock increase. Vega measures the sensitivity of the premium to these changes in volatility. Question 66 What is credit derivative & its types? Answer Credit derivatives are financial contracts that provide insurance against credit-related losses. These contracts give investors, debt issuers, and banks new techniques for managing credit risk that complement the loan sales and asset securitization methods. The general credit risk is indicated by the happening of certain events, called credit events, which include bankruptcy, failure to pay, restructuring etc. There is a party trying to transfer credit risk, called protection seller. A credit derivative being a derivative does not require either of the parties, the protection seller or protection buyer to actually hold the reference asset. When a credit event takes place, there are two ways of settlement – cash and physical. Cash settlement means the reference asset will be valued, and the difference between its par and fair value will be paid by the protection seller. Physical settlement means the protection seller will acquire the defaulted asset, for its par value. Types of credit Derivatives. (1) Credit default swaps (CDS) A swaps designed to transfer the credit exposure of fixed income products between parties. A credit default swap is also referred to as a credit derivative contract, where purchaser of swap makes payment until the maturity date of contract. Payments are made to seller of swaps. In return seller agrees to pay off a third party debt. If this party defaults on loan. A CDS is considered as an insurance against non-payment. The buyer of a CDS might be speculating on the possibility that the third party will indeed default.


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The buyer of CDS receives credit protection, where as seller of CDS of guarantees the credit. Worthiness of debt security. In this way risk of default is transferred from holder of fixed income security to swap. (2) Total Return Swap (TRS) A swap agreement in which one party makes payment based on a set rate either fixed or variable, while the other party makes payment based on return of underlying assets, which includes both the income it generates & any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index. Loans, bonds. This is owned by party receiving the set rate payment. Total return swaps allow the party receiving the total return to gain exposure & benefit from a reference asset without actually having to own it. In a total return swap the party receiving the total will receive any income generated by the asset as well as benefit if the price of asset appreciate over the life of the swap. In return the total receiver must pay the owner of asset the set rate over the life of swap. If the price of asset fall over swaps life the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price. Interest payment (Libor + spread) Loss in value of refer asset Interest rate payment Interest rate payment Increase in value of reference asset Interest payment (3) Credit Link Notes (CLN) A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit INVESTORS. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider. It is issued by a special purpose company or trust, designed to offer INVESTORS par value at maturity unless the referenced entity defaults. In the case of default, the INVESTORS receive a recovery rate.

Bank B

(Protection Seller)

Bank A

(Protection buyer)

Reference Asset


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The trust will also have entered into a default swap with a dealer. In case of default, the trust will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed on to the INVESTORS in the form of a higher yield on their note. The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available. The CLNs themselves are typically backed by very highly rated collateral, such as U.S. Treasury securities. Explanation

A bank lends money to a company, XYZ, and at the time of loan issues credit-linked notes bought by investors. The interest rate on the notes is determined by the credit risk of the company XYZ. The funds the bank raises by issuing notes to investors are INVESTED in bonds with low probability of default. If company XYZ is solvent, the bank is obligated to pay the notes in full. If company XYZ goes bankrupt, the note-holders/investors become the creditor of the company XYZ and receive the company XYZ loan. The bank in turn gets compensated by the returns on less-risky bond INVESTMENTS funded by issuing credit linked notes. CLN Solvent Investor XYZ Comp Money Lend insolvent Money (Risk – free with low coupen)

Question 67

State the main features of Commodity Exchanges in India.

Answer

Features of Commodity Exchanges

A commodities exchange is an exchange where various commodities and derivatives products are traded. Most commodity markets across the world trade in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them.

A commodity exchange is considered to be essentially public because anybody may trade through its member firms. The commodity exchange itself regulates the trading practices of its members while prices on a commodity exchange are determined by supply and demand.

There are four commodity exchanges in India:

Bank

Bond


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(i) National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai; (ii) Multi Commodity Exchange of India Limited (MCX) Mumbai; and (iii) National Multi- Commodity Exchange of India Limited (NMCEIL), Ahmadabad; (iv) Indian Commodity Exchange Limited (ICEX), Gurgaon.

The unique features of commodity exchanges are: (i) They are demutualized, meaning thereby that they are run professionally and there

is separation of management from ownership. The independent management does not have any trading interest in the commodities dealt with on the exchange.

(ii) They provide online platforms or screen based trading as distinct from the openout-cry systems (ring trading) seen on conventional exchanges. This ensures transparency in operations as everyone has access to the same information.

(iii) They allow trading in a number of commodities and are hence multi-commodity exchanges.

(iv) They are national level exchanges which facilitate trading from anywhere in the country.

Question 68

Fixed exchange rate and flexible exchange rate.

Answer

Difference between fixed exchange rate and flexible exchange rate

Fixed Exchange Rate : The exchange rate which the government sets and maintains as the official exchange rate, called fixed exchange rate. A set price will be determined against a major world currency. In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

Flexible Exchange Rate : A flexible exchange rate is determined by the private market through supply and demand. A flexible rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. A flexible exchange rate is constantly changing.

Question 69

Leading and lagging

Answer

Difference between Leading and Lagging

Leading is the payment of an obligation before due date. It is attractive for the company. This technique is used when there is apprehension that in future foreign currency will be dearer.


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Lagging is delaying the payment of an obligation past due date. There is possibility to incur loss due to increase in exchange rate.

The purpose of these techniques is for the company to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible. This technique is used when there is apprehension that in future foreign currency will be cheaper.

Question 70

Intrinsic Value of Option

Answer

Intrinsic Value

This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as in-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant’s exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time value - to be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in-the-money.

The following equations will allow you to calculate the intrinsic value of call and put options:

Call Options : Intrinsic value = Underlying Stock’s Current Price - Call Strike Price

Put Options : Intrinsic value = Put Strike Price - Underlying Stock’s Current Price

Question 71

Time Value of Option

Answer

Time Value

Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiration of the warrant gets closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiration. Time value is affected by time to expiration, volatility, dividends and interest rates.

Time value is the amount by which the price of an option exceeds its intrinsic value.

Also referred to as extrinsic value, time value decays over time.

Time Value = Put Premium - Intrinsic Value


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Time Value = Call Premium - Intrinsic Value

Question 72

“Buying a call option is risky because the holder commits to purchase a share at a later date.” Discuss.

Answer

A call option gives its owner the right to buy the underlying asset at a predetermined price at a future date.

The striking price (also called the exercise price) is the price stated in the option contract at which the call (put) owner can buy (sell) the underlying asset up to the expiration date, the final calendar date on which the option can be traded.

Selling a call option is riskier than buying a call option. This is because the maximum loss for selling a call option is unlimited if the underlying stock price keeps soaring.

The advantage to buying a call option is that it gives the underlying asset its limited risk. For a call option the most a purchaser can lose is the initial investment, the option premium.

So far as the buyer of call is concerned he is not oblige to buy share if it is available in the market at a price below exercise price.

So it is wrong to say that buying a call option is risky because the holder commits to purchase a share at a later date.

Question 73

“Internal treasury control is a process of self-improvement”. Explain

Answer

All economic units have the goal of profit maximization or wealth maximization.

This objective is achieved by short-term and long-term planning for funds. The plans are incorporated in the budget in the form of activities and corresponding targets are fixed accordingly. The next step in the process is the control function to see that the budgets are being implemented as per plans. Control is thus part of planning and budgeting in any organization.


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Control is a process of constant monitoring to ensure that the activities are being carried out as per plans. It is also noticed whether there is any divergence from the plans, what are the reasons for the divergence and what remedial action can be suggested.

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.

The quarterly and annual budgets would set the targets for each department and financial standards are set out for each activity. Monthly budgets are evaluated by the performance sheets maintained daily and regular reports go to the financial controller.

Reporting and evaluation go together and on the basis of information system built in the past, plans are prepared for the next period.

Internal treasury control 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.

Hence it is true to say “Internal treasury control is a process of self improvement”.

Question 74

“Stability in payment of dividends has a marked bearing on the market price of the shares of a corporate firm.” Explain the statement

Answer

The dividend decision should reflect the different factors already mentioned above as well as company’s present operating and financial position. In this total framework, the firm will find that it has a choice of several dividend policies to follow, viz.:

Steady dividend, dividend fluctuating, low regular dividend plus extra dividends; elimination of dividend entirely.

Profit of the firm fluctuates considerably with changes in the level of business activity.

Most companies seek to maintain a target dividend per share. However, dividend increase with a lag after earnings rise and this increase in earnings appear quite sustainable and


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relatively permanent. When dividends are increased strenuous efforts are made to maintain them at increased new level. This stability could take three forms:

1) keep dividends at a stable rupee amount but allow its payout ratio to fluctuate, or 2) maintain stable payout ratio and let the rupee dividend fluctuate, or 3) set low regular dividend and then supplement it with year end “extras” in years when

earnings are high.

As earnings of the firm increase the customary dividend will not be altered but a year end “extras” will be declared.

The dividend policy has to be adopted to the nature and environments of the firm, industry and economy. If the company is operating in highly cyclical industry, like the machine tools industry, its management cannot create through regular dividends as stability does not exist. A low pay out in boom period cannot be off set by continuing dividends in prolonged period of large losses. It is better to relate dividends to earnings and not unduly attempt to protect shareholders from large fluctuations in earnings so inherent in business. Failure to pay dividends in one year may shock the market price of share and remove the security from the approved list of the investments used by institutional investors.

A stable Dividend policy may lead to higher stock prices because it sustains investors confidence as they value more the dividend which are certain to be received. If dividends fluctuate investors may discount with some percentage probability factor i.e. the likelihood of receiving any particular amount of dividend. Hence it is better to keep a consistent dividend payment policy.

Question 75

Treasury management has both macro and micro aspects. Discuss

Answer

Government sector, business sector and the foreign sector are the major sectors of country’s economy. For macro operations of these sectors, there is requirement of cash, currency and credit. In broader terms, all financial resources including foreign exchange are to be made available to the industrial or business units. Similarly, at the macro level return flow of funds in the form of taxes and repayment of loans is needed.

Such to and from movement of funds is part of the financial functioning.

Any business enterprise requires finance to start business operations. The first requirement is in the form of capital for setting up of the project. Project finance needs long term funds.


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These funds can be obtained from equity and debt both. Equity and internal accruals are considered the owners’ contribution whereas debt is treated as the outsiders’ stake in the project. Once the company starts operations of production and manufacture, it needs working capital funds also. These funds are required to meet the payments for raw materials and other inputs, spares, utilities etc. The quantum of funds needed for working capital depends upon nature of the company’s business and nature of its products or services.

The function of treasury management is concerned with both macro and micro facts of the economy. At the macro level, the pumping in and out of cash, credit and other financial instruments are the functions of the government and business sectors, which borrow from the public. These two sectors spend more than their means and have to borrow in order to finance their ever-growing operations. They accordingly issue securities in the form of equity or debt instruments. The latter are securities including promissory notes and treasury bills which are redeemable after a stipulated time period. Such borrowings for financing the needs of the government and the business sector are met by surplus funds and savings of the household sector and the external sector. These two sectors have a surplus of incomes over expenditure. The micro units utilize these surpluses and build up their capacities for production of output and this leads to the productive system and distribution and consumption systems.

Question 76

Social cost-benefit analysis.

Answer

In Social Cost-Benefit Analysis, a project is analyzed from the point of view of the benefit it will generate for the society as a whole.

There are three principal measures which may be employed to select projects that would best sub-serve the goal of economic development of a nation. These are as follows:

1) Maximum social benefits— Which is equal to the present value of total project benefits minus present value of total costs;

2) Benefit cost ratio — present value of total benefits divided by present value of total costs;

3) Internal rate of return — it is the discount rate which makes the present net worth of a project equal to zero, it represents the average earning power of the money used in the project over the project life and the higher it is, the more profitable for the nation.

The important questions in making cost benefit analysis are what cost to be included, what benefit to be sought, what are the main and immediate objectives of the project, how to value them, what rate of interest will be appropriate at which these are to be


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discounted, what are the relevant constraints etc. Some of the answers to these queries are that costs are to interpreted in economic terms. Further, costs are to be calculated in terms of the opportunities foregone for employing factors of production for a particular project. Similarly, labour costs are not to be calculated at the existing rate in places where serious unemployment or under employment exist, because existing rate may be artificial due to minimum wage legislation. Therefore, shadow price of labour will have to be calculated. Based on these guidelines, cost-benefit analysis is done to assess the following gains:

1) impact on national income 2) impact on government finance 3) impact on immediate beneficiaries.

Question 77

Depreciation is a non-cash item of an expense and it is said that it is a source of finance.” – Discuss.

Answer

Depreciation is the funds set apart for replacement of worn-out assets. Depreciation is a deduction out of profits of the company calculated as per accounting rules on the basis of estimated life of each assets each year to total over the life of the assets to an amount equal to original value of the assets. Although depreciation is meant for replacement of particular assets but generally it creates a pool of funds which are available with a company to finance its working capital requirements and sometimes for acquisition of new assets including replacement of worn-out plant and machinery. Depreciation is an expenditure recorded in the accounting system of a company and is allowed to be deducted while arriving at the net profits of the company subject provisions of the tax laws.

Amongst all the sources of internal finance, main source is depreciation on an average as revealed by some research studies done by research scholars. The second source is reserves and surplus and lastly the bonus issue of preference shares or equity shares.

There exists a controversy whether depreciation should be taken as a source of funds. Whatever may be the outcome of such controversy, the fact remains that the depreciation is a sum that is set apart out of profits and retained within the business and finance the capital needs in the normal business routine, and as such depreciation in true academic sense be deemed as a source of internal finance.


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Question 78

Describe the meaning of ‘index futures’.

Answer

Index Futures: Futures contracts in which underlying assets is based on indexes such as the S & P 500, SENSEX, NIFTY or Value Line Index. An index future entitles the buyer to any appreciation in the index over and above the index futures price and the seller to any depreciation in the index from the same benchmark. Index future represents to buy /sell a set/basket of securities. Since index cannot be purchased or delivered hence these are the cash settlement contracts.

Question 79

What are the steps taken by financial institutions while appraising the project?

How do the financial institutions monitor the projects financed by them?

Answer

Project appraisal is a process whereby a lending financial institution makes an independent and objective assessment of the various aspects of an investment proposal, for arriving at a financing decision.

Appraisal exercises are aimed at determining the viability of a project, and sometimes reshape the project so as to upgrade its viability Steps in Appraisal : Major steps undertaken by Financial Institutions under project

appraisal are — (a) Promoters’ Capacity : Promoters capacity and competence is examined, with reference

to their Management Background,

Traits as entrepreneurs,

Business or industrial experience,

Past performance, etc.

Different considerations are applied in the case of new entrepreneurs.

(b) Project Report : Project report must be complete in all aspects so that its appraisal

becomes easy and relevant. For this purpose, the project report should be a self-contained study with necessary feasibility report, market surveys, etc.

(c) Viability Test : Viability test of a project is to be carried out by examining the project from different aspects viz. technical, economic, financial, commercial, management, social and other related aspects as discussed below :- (i) Technical Feasibility

It involves consideration of technical aspects like location and size of the project, availability, quality and cost of services, supplies of raw materials, fuel, power, land, labour, housing, transportation, etc.


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(ii) Economic Viability

It is done on the basis of market analysis of the product or service with particular reference to the size of the market, projected growth in market demand, and the market share expected to be captured. (iii) Financial Viability

It involves evaluation of project cost in the light of period of construction work, provision for cost escalation, timing of raising funds, projected cost of production and profitability, and cash flow projections, to ensure the potentiality of the project to meet the current and long-term obligations. (iv) Commercial Viability

This is assessed in terms of the potential demand for the product, estimated sales price, cost structure, the ability of the Firm to achieve the target sales at competitive price, and the intensity of competition. (v) Management Capability

It is an examination of the track record of Promoters, their background and capabilities, and competence of the management team. (vi) Social Relevance

Social relevance of a project like conformity with national policies and plant priorities are also important factors to be considered in project appraisal.

(d) Appraisal in Inflationary and Deflationary Situations : Project Appraisal during inflationary and deflationary conditions does not differ materially from that of an appraisal during normal conditions, except that the financial, economic and commercial aspects require to be taken care of:-

Inflationary Situations

Deflationary Situations (i) Project Cost, prices of raw materials and labour cost will go up. Hence, there would

be a decline in the profitability, as the prices of end products are controlled by the Government or market.

(ii) Market may not be prepared to pay a higher price during an inflationary period. Such a situation impairs the financial viability of the project.

(iii) During a recessionary period, the stock of finished goods tends to accumulate resulting in the blocking up of working capital, and thereby contributing to the sickness of the project.

(iv) It is important to take into consideration the economic conditions while appraising a project.

Question 80

“Economic value added (EVA) concept is in conformity with the objective of wealth maximization”. Explain.


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Answer

Economic value added (EVA) is the after tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. Representing real profit versus paper profit, EVA underlines shareholder value, increasingly the main target of leading companies strategies. Shareholders are the players who provide the firm with its capital; they invest to gain a return on that capital.

There are two key components to EVA. The net operating profit after tax (NOPAT) and the capital charge, which is the amount of capital times the cost of capital. In other words, it is the total pool of profits available to provide cash return to those who provided capital to the firm. The capital charge is the product of the cost of capital times the capital tied up in the investment. In other words, the capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. On the one hand, the cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk-a cut-off rate to create value and capital is the amount of cash invested in the business, net of depreciation (Dierks and Patel, 1997). In formula form,

EVA = (Operating Profit) - (A Capital Charge)

EVA = NOPAT - (Cost of Capital x Capital)

There is growing evidence that EVA, not earnings, determines the value of a firm.

There is difference between EVA, earnings per share, return on assets, and discounted cash flow, as a measure of performance.

Earnings per share tells nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) as say, 15 per cent, then a 14 per cent earning is actually a reduction, not a gain, in economic value. Profits also increase taxes, thereby reducing cash flow.

Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital. Leading firms can obtain capital at low costs, via favourable interest rates and high stock prices, which they can then invest in their operations at decent rates of return on assets. That tempts them to expand without paying attention to the real return, economic value-added.

Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital.

Hence it is true that “Economic value added (EVA) concept is in conformity with the objective of wealth maximization.”


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Question 81

Lockers Pvt. Ltd. is considering the use of a lockbox system to handle its daily collections. The company’s credit sales are Rs.160 crore per year, and it currently processes 1,300 cheques per day. The cost of the lockbox system is Rs.95,000 per year. The system allows for up to 1,000 cheques per day. Any additional cheques are processed at an additional charge of Rs.1.50 per cheque. The company estimates that the system will reduce its float by 3 days. The firm’s discount rate for equally risky projects is 15 per cent, its tax rate is 40 per cent, and its cost of short-term capital is 12 per cent. (Assume a 360-day year).

(a) How much cash will be released for other uses if the lockbox system is used ? (b) What net benefit will Lockers Ltd. gain from using lockbox system ? (c) Should Lockers Ltd. adopt the proposed lockbox system ? (d) Assume now that the institution that offers the lockbox system requires a Rs.7,00,000

compensating balance to be held for the complete year in a non-interest-bearing account. Should Lockers Ltd. adopt the system ?

Answer 1) Credit sales per day = 160 croe / 360 days = 44,44,444 2) Cost if lock box system is adopted

Cost of lock box = Rs.95,000

Additional cost for cheques = 300 cheque x Rs.1.5 x 360 = Rs. 1,62,000

Opportunity cost = 2,57,000 x 12% = 30,840

Total cost = 257,000 + 30,840 = 2,87,840. 3) Cost of Funds = 7,00,000 x 12% = 84,000. 4) Reduction in float days = 3

a) Cash that will be released for other use = 44,44,444 x 3 days = 1,33,33,332. b) Cost of locker = 2,87,840.

Gain on release of fund = 1,33,33,332 x 15% = 20,00,000 Apprx.

Hence net benefit from use of lock box = 20,00,000 - 287,840 =17,12,160. c) Lockers Ltd. should adopt the lock box system. d) Total cost if Rs. 7,00,000 to be deposited = 84,000 + 2,87,840 = 3,71,840.

Net gain = 20,00,000 - 371,840 = 16,28,160. Still Lockers Ltd. should adopt the lock box system.

FM THEORY NOTES - Arun Setia Classes · Forfeiting Vs export factoring. Answer Forfaiting is similar to cross-border factoring to the extent both have common features of non-recourse

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