P12 Fac RTP

Revisionary Test Paper_Final_Syllabus 2008_June 2013
Paper-12 : FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE
Q. 1. a) For each of the questions given below, one out of four answers is correct. Indicate the
correct answer and give your workings/ reasons briefly.
i. The traditional view of financial management looks at :
A. Arrangement of short-term and long-term funds from financial institutions.
B. Mobilisation of funds through financial instruments
C. Orientation of Finance function with Accounting function
D. All of the above
ii. A firm seeks to increase its current ratio from 1.5 before its closing date of the
accounts. The action that would make it possible is :
A. Delaying payment of salaries
B. Increase charge for depreciation
C. Making cash payment to creditors
D. Selling marketable securities for cash at book value.
iii. The dividends distributed to the shareholders and taxes paid during the year are shown
as application of funds when provision for dividends and provision for taxes are treated
as :
A. Current liabilities
B. Non-current liabilities
C. Fund items
D. Non-fund items
iv. In using debt-equity ratio in capital structure decisions, there is an optimal capital
structure where :
A. The WACC is minimum
B. The cost of debt is lowest
C. The cost savings are highest
D. The marginal tax benefit is equal to marginal cost of financial distress
v. Where the firm has sufficient profits from its existing operations, the loss on the new
project will :
A. Cause overall loss
B. Reduce the overall taxation liability
C. Increase WACC
D. Increase cost of debt
vi. Buying and selling call and put option with different strike prices and different
expiration dates are called :
A. Butterfly spread
B. Diagonal spread
C. Vertical spread
D. Short hedge
vii. ‘Straddle’ as a type of option trading means :

A. One call, one put, same security, same strike and same period
B. One call, one put, same security, different strike price and same period
C. One call, two puts, same security, same strike price and same period
D. None of the above.
viii. Which of the following is/are basic precondition/s for interest arbitrage theory ?
A. Free capital mobility
B. No taxes
C. No government restrictions on borrowing in foreign currency
D. All of the above
Directorate of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
ix. Global Depository Receipts (GDR) are issued to :

A. Investors of India who want to subscribe to shares of foreign companies
B. Only to persons of Indian origin residing in a foreign country
C. Non resident investors against publicly traded shares of the issuing companies
and denominated in US dollars.
D. Foreign banks as security to raise foreign currency loans.
x. If the amount and timing of a foreign currency outflow are both uncertain, then the
best hedging technique will be to :
A. Buy a put option
B. Buy a call option
C. Sell a call option
D. Buy a forward contract
Q. 1. (b) In each of the questions given below, one out of four is correct. Indicate the correct
answer.
i. Vishnu Steels Ltd. Has issued 30,000 irredeemable 14% debentures of ` 150 each. The
cost of floatation of debentures is 5% of the total issued amount. The company’s
taxation rate is 40%. The cost of debentures is :
A. 8.95%
B. 7.64%
C. 9.86%
D. 8.84%
ii. The balance sheet of ABC Ltd. Shows the capital structure as follows :
2,50,000 equity shares of ` 10 each; 32,000, 12% preference shares of ` 100 each;
general reserve of ` 14,00,000; securities premium account ` 6,00,000; 25,000, 14%
fully secured non-convertible debentures of ` 100 each.; term loans from financial
institutions ` 10,00,000.
The leverage of the firm is :
A. 67.2%
B. 62.5%
C. 59.8%
D. 56.3%
iii. A company has obtained quotes from two different manufacturers for an equipment.
The details are as follows :
Product Cost (` Million) Estimated life (years)
Make X 4.50 10
Make Y 6.00 15
Ignoring operation and maintenance cost, which one would be cheaper ? The
company’s cost of capital is 10%.
[Given : PVIFA (10%, 10 years) = 6.1446 and PVIFA (10%, 15 years) = 7.6061]
A. Make X will be cheaper
B. Make Y will be cheaper
C. Cost will be the same
D. None of the above
iv. According to the second method of lending by a bank as per Tandon committee
suggestion, the maximum permissible bank borrowing – based on the following
information is :
Total current assets ` 40,000; Current assets other than bank borrowings ` 10,000; Core
current assets ` 5,000.
A. ` 22,500
B. ` 20,000
C. ` 16,250
D. ` 18,500
v. ABC Ltd. Is selling its products on credit basis and its customers are associated with 5%
credit risk. The annual turnover is expected at ` 5,00,000 if credit is extended with cost
of sales at 75% of sale value. The cost of capital of the company is 15%. The net profit of
the company is :
A. ` 1,25,000
B. ` 77,670
C. ` 88,430
D. ` 1,10,500
vi. The following various currency quotes are available from a leading bank:
`/£ 75.31/75 .33
£ /$ 0.6391/0.6398
$ /¥ 0.01048/0.01052
The rate at which yen(¥ ) can be purchased with rupees will be
A. Re. 0.5070
B. ` 1.5030
C. ` 1.7230
D. None of the above.
vii. Ms. S buys 10000 shares of RR Ltd. at ` 50 and obtains a complete hedge of shorting
400 Nifties at ` 2200 each. She closes out her position at closing price of next day at
which point the share of RR Ltd. has dropped 2% and the Nifty future has dropped
1.5% . What is the overall profit/(loss) of this set of transaction ?
A. Gain ` 3200
B. Gain ` 2200
C. Loss ` 3200
D. Loss ` 2200
viii. An Indian company is planning to invest in US. The US inflation rate is expected to be
3% and that of India is expected to be 8% annually. If the spot rate currently is ` 45/
US$, what spot rate can you expect after 5 years ?
A. ` 59.09/US$
B. ` 57.00/US$
C. ` 57.04/US$
D. ` 57.13/US$
ix. The stock of Pioneer company sells for ` 120. The present value of exercise price and
the value of a call option are ` 108.70 and RS. 19.80 respectively. Hence the value of
the put option is :
A. ` 8.50
B. ` 9.00
C. ` 10
D. Zero
x. The spot and 6 months forward rates of L in relation to the rupee (Re/L) are `
77.92542/78.1255 and ` 78.8550/78.9650 respectively. What will be the annualized
forward margin (premium with respect to Ask price) ?
A. 2.31%
B. 2.15%
C. 1.80%
D. 1.59%
Answer 1. (a)
i) D
ii) C
iii) B
iv) D
v) B
vi) B
vii) A
viii) D
ix) C
x) B
Answer 1. (b)
i) D – 8.84%
`
Total issued amount (30,000 x ` 150) 45,00,000
Less : Floatation cost (` 45,00,000 x 5/100) 2,25,000
Net proceeds from issue 42,75,000
Annual interest charge = ` 45,00,000 x 14/100 = ` 6,30,000
Kd = I (1 – t) = 6,30,000 (1 – 0.40) = 0.0884 or 8.84%

NP 42,75,000
ii) C – 59.8%
Fixed income funds = Preference share capital + Debentures + Term loans
= ` 32,00,000 + ` 25,00,000 + ` 10,00,000 = ` 67,00,000
Equity funds = Equity share capital + General reserve + Securities premium
= ` 25,00,000 + ` 14,00,000 + ` 6,00,000 = ` 45,00,000
Total funds used in the capital structure
= ` 67,00,000 + ` 45,00,000 = ` 1,12,00,000
Leverage = ` 67,00,000 x 100 = 59.8%

` 1,12,00,000
iii) A – Make X will be cheaper

Make X
Purchase cost = ` 4.50 million
Equivalent annual cost = 4.50/6.1446 = ` 0.73235
Make Y
Purchase cost = ` 6.00 million
Equivalent annual cost = 6.00/7.6061 = ` 0.78884 million
Therefore, equivalent annual cost of make X is lower than make Y, make X is suggested to
purchase.
iv) B – ` 20,000
MPBF under second method
= (75% current assets) – (Current liabilities other than bank borrowings)
= (` 40,000 x 75/100) – ` 10,000 = ` 20,000
v) B – ` 77,670
Profitability of credit sales (`)
Credit sales 5,00,000
Less : Cost of sales (` 5,00,000 x 75/100) 3,75,000
1,25,000
Less : Cost of granting credit
Default risk (` 5,00,000 x 5/100) 25,000
Opportunity cost (` 5,00,000 x 60/365 x 15/100) 12,330
Administration cost (` 5,00,000 x 2/100) 10,000 47,330
Net profit 77,670
vi. A - Re. 0.5070

To purchase (¥ ) we need to have a quote of (¥ ) in terms of ` We need only the ASK
quote.
ASK (` / ¥ ) = ASK (`/ £) * ASK ( £ /$) * ASK($/ ¥)

= 75.33*0.6398 * 0. 01052
= ` 0.5070 (approx.)
vii. A – Gain ` 3,200
Value of bought shares Value of short future

Today’s valuation 50*10000=`5.00 lac 400 * 2200=`8.80 lac
Next day’s valuation 49*10000=`4.90 lac 400 * 2167=` 8.668 lac
Gain /(loss) 2% dropped=Rs0.10 lac 1.5% dropped= `0.132 lac
Net Gain = `0.13200-`0.1000 lac = ` 3200/-.
viii. C – ` 57.04/US$
According to Purchase Power Parity, spot rate after 5 years
5
= ` 45 x [(1 + 0.08)/ (1 + 0.03)] = 45 x 1.2675 = ` 57.04
ix. A – ` 8.50
Value of put option = Value of call option + PV of exercise price – Stock price
= ` 19.80 + RS. 108.70 – ` 120
= ` 8.50
x. B – 2.15%
The forward margin (premium with respect to Ask price) rate :
= F – S x 12 x 100
S n
= 78.9650 – 78.1255 x 12 x 100 = 2.1491% or 2.15%

78.1255 6
Q. 2. Write short notes on :

i. Marking to market
ii. Cross border leasing
iii. ‘Financial Engineering’
iv. Forward to forward contracts
v. Economic value added
Answer 2.
i. Marking to market – Marking to market is a characteristic feature of future contracts. Future
contracts are standardized contracts that trade on organized future markets.
Under a future contract the seller agrees to deliver to the buyer a specified quantity of
security, commodity or foreign exchange at a fixed time in future at a price agreed to at the
time of entering into the contract. To ensure that default risk is reduced to minimum, both
parties are required to deposit some margin money with the organized clearing house, which
is known as the initial margin. Further, with the fluctuation in the price of the underlying
asset, the balance in the margin account may fall below specified minimum level or even
become negative so that it may not happen like this, at the end of each trading session, all
outstanding contracts are appraised at the settlement price of that session. This is known as
Marking to Market.
This would mean that some participants would make a loss while others would stand to gain.
The exchange adjusts this by debiting the margin accounts of those members who made a
loss and crediting the accounts of those members who have gained. A member making a loss
must make good loss and the counter party will receive his profit.
Thus the value of the future contracts is set to zero at the end of each trading day.
ii. Cross border leasing – Cross-border leasing is a leasing agreement where lessor and lessee
are situated in different countries. This raises significant additional issues relating to tax
avoidance and tax shelters. It has been widely used in some European countries, to arbitrage
the difference in the tax laws of different countries.
Cross-border leasing have been in practice as a means of financing infrastructure
development in emerging nations. Cross-border leasing may have significant applications in
financing infrastructure development in emerging nations – such as rail and air transport
equipment, telephone and telecommunications, equipment, and assets incorporated into
power generations and distribution systems – and other projects that have predictable
revenue streams.
A major objective of cross-border leases is to reduce the overall cost of financing through
utilization by the lessor of tax depreciation allowances to reduce its taxable income. The tax
savings are passed to the lessee as a lower cost of finance. The basic prerequisites are
relatively high tax rates in the lessor’s country, liberal depreciation rules and either very
flexible or very formalistic rules governing tax ownership.
iii. ‘Financial Engineering’ involves the design, development and implementation of innovative
financial instruments and processes and the formulation of creative solutions to problems in
finance. Financial Engineering lies in innovation and creativity to promote market efficiency. It
involves construction of innovative asset-liability structures using a combination of basic
instruments so as to obtain hybrid instruments which may either provide a risk-return
configuration otherwise unviable or result in gain by heading efficiently, possibly by creating
an arbitrage opportunity. It is of great help in corporate finance, investment management,
money management, trading activities and risk management.
In recent years, the rapidity with which corporate finance and investment finance have
changed in practice has given birth to a new area of study known as financial engineering. It
involves use of complex mathematical modeling and high speed computer solutions.
It has been practiced by commercial banks in offering new and tailor-made products to
different types of customers. Financial Engineering has been used in schemes of mergers and
acquisitions.
The term financial engineering is often used to refer to risk management also because it
involves a strategic approach to risk management.
iv. A forward-to-forward contract is a swap transaction that involves the simultaneous sale and
purchase of one currency for another, where both transactions are forward contracts. It
allows the company to take advantage of the forward premium without locking on to the spot
rate. The spot rate has to be locked on to before the starting date of the forward-to-forward
contract.
A forward-to-forward contract is a perfect tool for corporate houses that want to take
advantage of the opposite movements in the spot and forward market by locking in the
forward premium at a high or low. Now, CFOs can defer locking on the spot rate to the future
when they consider the spot rate to be moving in their favour. However a forward-to-forward
contract can have serious cash flows implications for a corporate.
v. Economic value added (EVA) measures economic profit/ loss as opposed to accounting
profit/loss. EVA is essentially the surplus left after making an appropriate charge for the
capital employed in the business. It may be calculated in any of the following, apparently
different but essentially equivalent, ways :
EVA = NOPAT – c x Capital
EVA = Capital ( r – c)
EVA = [PAT + Int. (1 – t)] – c x Capital
EVA = PAT – ke x Equity

Where EVA is the economic value added, NOPAT is the net operating profit after tax, c is the
cost of capital, Capital is the economic book value of the capital employed in the firm, r is the
return on capital, PAT is the profit after tax, Int. is the interest expense of the firm, t is the
marginal tax rate of the firm, ke is the cost of equity, and equity is the equity employed in the
firm.
EVA will rise if operating efficiency is improved, if value adding investments are made, if
uneconomic activities are curtailed and if the cost of capital is lowered.
Q. 3. a) What is foreign exchange risk ? Briefly explain the major types of foreign exchange
exposures.
b) ABC Ltd. is contemplating whether to replace an existing machine or to spend money on

overhauling it. ABC Ltd. Currently pays no taxes. The replacement machine costs ` 90,000 now
and requires maintenance of RS. 10,000 at the end of every year for eight years. At the end of
eight years it would have a salvage value of ` 20,000 and would be sold. The existing machine
requires increasing amounts of maintenance each year and its salvage value falls each year as
follows :
Year Maintenance (`) Salvage (`)

Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for ABC Ltd. Is 15%.
Required :
When should the company replace the machine ?
(Notes : Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% :
4.4873; present value of Re. 1 to be received after 8 years at interest rate of 15% : 0.3269)
Answer 3. (a)
Foreign exchange risk concerns the variance of the domestic currency value of an asset, liability or
operating income that is attributable to unanticipated variances in the exchange rates. Foreign exchange
risk is an exposure of facing uncertain future exchange rate. When firm and individuals are engaged in
cross-border transactions, they are potentially exposed to foreign exchange risk that they would not
normally encounter in purely domestic transactions.
Foreign exchange exposures can be classified into three broad categories :
i. Transaction exposure : Transaction exposure arises when one currency is to be
exchanged for another and when a change in foreign exchange rate occurs between the time a
transaction is executed and the time it is settled.
ii. Translation exposure : When the assets and liabilities of trading transactions are
denominated in foreign currencies, then there may be risk of translation from such denominations
into home currencies. This will also be due to fluctuations in the rates of different currencies.
iii. Economic exposure : Economic exposure is the risk of a change in the rate affecting the
company’s competitive position in the market. It is normally defined as the effect on future cash
flows of unpredicted future movements in exchange rates. This affects a firm’s competitive
position across the various markets and products and hence the firm’s real economic value.
Answer 3. (b)
We need to use the equivalent annual cost method as the machine which is currently used and the
replacement machine are having different lives. We first find the equivalent annual cost of new machine
and then see for each of the four years the incremental cost. We choose that year in which incremental
cost is least.
PV of costs of new machine =` 90,000 + ` 10,000 x PVIFA (15%, 8) – ` 20,000 x PVIF (15%, 8)
= ` 90,000 + ` 44,873 – ` 6,538
= ` 1,28,335
Equivalent annual cost of new machine = ` 1,28,335 / PVIFA (15%, 8)
= ` 28,600
If we replace machine now :

We get ` 40,000 now and then spend from the end of first year ` 28,600 for eight years thereafter.
If we replace machine after one year :

We do not get ` 40,000 now. This should be treated as lost opportunity. This should be taken as cost.
Secondly, we get ` 25,000 at the end of the year. Thirdly, we need to spend ` 10,000 on maintenance.
Thus, PV of cost of old machine (if replaced after one year)
= ` 40,000 (opportunity cost) + ` 10,000 PVIF (15%, 1) – ` 25,000 x PVIF (15%, 1)
= ` 26,960
Since, we are to spend this amount after one year only, we need to find the future value of this,
= 1.15 x ` 26,960 = ` 31,000
It is very clear from the above analysis that anyone would prefer to replace it now and spend just ` 28,600
and thereafter, rather than spending ` 31,000 and ` 28,600 thereafter. Though similar calculation can be
performed for each year’s replacement, the calculations are unnecessary. This is because; the opportunity
cost and increasing maintenance would only increase the equivalent annual cost of old machine. The same
would be certainly higher than ` 28,600.
Q. 4. a) What is the difference between Economic Value Added and Accounting Profit ?
b) The following is the condensed Balance sheet of NHPC Ltd. at the beginning and end of the year.
Balance Sheets
As at ………………..
Particulars 31.12.2011 31.12.2012
Cash 50,409 40,535
Sundry debtors 77,180 73,150
Temporary investments 1,10,500 84,000
Prepaid expenses 1,210 1,155
Inventories 92,154 1,05,538
Cash surrender value of Life Insurance Policy 4,607 5,353
Land 25,000 25,000
Building, machinery etc. 1,47,778 1,82,782
Debenture discount 4,305 2,867
5,13,143 5,20,380
Sundry creditors 1,03,087 95,656
Outstanding expenses 12,707 21,663
4% mortgage debentures 82,000 68,500
Accumulated depreciation 96,618 81,633
Allowance for inventory loss 2,000 8,500
Reserve for contingencies 1,06,731 1,34,178
Surplus in P & L A/c 10,000 10,250
Share capital 1,00,000 1,00,000
5,13,143 5,20,380
The following information concerning the transaction are available :
i. Net profit for 2012 as per Profit and loss account was ` 49,097
ii. A 10% cash dividend was paid during the year.
iii. The premium of Life Insurance Policies were ` 2,773 of which ` 1,627 was charged to
Profit and Loss Account of the year.
iv. New machinery was purchased for ` 31,365 and machinery costing ` 32,625 was sold
during the year. Depreciation on machinery sold had accumulated to ` 29,105 at the
date of sale. It was sold as scrap for ` 1,500. The remaining increase in Fixed Assets
resulted from construction of a Building.
v. The Mortgage Debentures mature at the rate of ` 5,000 per year. In addition to the
above, the company purchased and retired ` 8,500 of Debentures at ` 103. Both the
premium on retirement and the applicable discount were charged to Profit and Loss
Account.
vi. The allowance for Inventory Loss was created by a charge to expenses in each year to
provide for obsolete items.
vii. A debit to reserve for contingencies of ` 11,400 was made during the year. This was in
respect of a past tax liability.
You are required to prepare a statement showing the Sources and Applications of funds for the year
2012.
Answer 4. (a)
Earning profit is not sufficient, a business should earn sufficient profit to cover its cost of capital and
surplus to grow. Any surplus generated from operating activities over and above the cost of capital is
termed as Economic Value Added (EVA). Economic Value Added measures economic profit/ loss as
opposed to accounting profit/loss. EVA calculates profit/loss after taking into account the cost of capital,
which is the weighted average cost of equity and debt.
Accounting profit on the other hand ignores cost of equity and thus overstates profit or under states loss.
EVA = NOPAT – K x WACC
Where,
NOPAT = Net operating profit after tax = EBIT (1 – t)
K = Capital employed (Equity + Debt)
WACC = Weighted average cost of equity and debt.
The estimates are fine-tuned through several adjustments. For instance, NOPAT is estimated excluding
non-recurring income or expenditure. PAT is shown in the profit and loss account to include profit available
to the shareholders, both preference and equity. Ability to maintain dividend is not a test of profit
adequacy.
EVA is the right measures for goal setting and business planning, performance evaluation, bonus
determination, capital budgeting and evaluation.
Simply stated Accounting Profit equals Sales Revenue minus all costs except the cost of equity capital,
while Economic Profit is Sales Revenue minus all costs including the opportunity cost of equity capital. Thus
economic profit may be lower than the accounting profit. If accounting profit equals the opportunity cost
of equity capital, economic profit is zero. Only when accounting profit is greater than the opportunity cost
of equity capital, economic profit is positive. Under perfect competition, all firms in the long run earns zero
economic profit.
Answer 4. (b)
Statement of Sources and Applications of Funds
st
For the year ended 31 December 2012
Sources ` Applications `
Sale of Machinery 1,500 Purchase of machinery 31,365
Trading profit (adjusted) 75,457 Payment for construction of building 36,264
76,957 Dividend paid 10,000
Add: Decrease in working capital 28,600 Redemption of debentures 13,755
Tax liability paid 11,400
Premium on Life Policy 2,773
(1,146 + 1,627)
1,05,557 1,05,557
Workings :
Statement of Change in Working Capital
2011 2012
` `
Current Assets :
Cash 50,409 40,535
Sundry debtors 77,180 73,150
Temporary investments 1,10,500 84,000
Prepaid expenses 1,210 1,155
Inventories 92,154 1,05,538
3,31,453 3,04,378
Less : Current Liabilities :
Sundry creditors 1,03,087 95,656
Out. Expenses 12,707 21,663
1,15,794 1,17,319
Working capital 2,15,659 1,87,059
Decrease in working capital - 28,600
2,15,659 2,15,659
4% Mortgage Debenture A/c.

Dr. Cr.
Particulars ` Particulars `
To, 4% Mortgage debenture 13,500 By bal b/d 82,000
holders
To, Bal c/d 68,500
82,000 82,000
4% Mortgage Debenture holders’ A/c.

Dr. Cr.
To, Bank A/c. 13,755 By, 4% Mortgage debenture a/c. 13,500
By, P & L A/c. 255
13,755 13,755
Accumulated Depreciation A/c.

Dr. Cr.
To, Building, machinery etc. 29,105 By, Bal b/d 96,618
To, Bal c/d 81,633 By, P & L A/c. 14,120
1,10,738 1,10,738
Allowance for Inventory Loss A/c.

Dr. Cr.
To, Bal c/d 8,500 By, Bal b/d 2,000
By, P & L A/c. (bal. fig.) 6,500
8,500 8,500
Reserve for Contingencies A/c.

Dr. Cr.
To, Tax liability (paid) 11,400 By, Bal b/d 1,06,731
To, Bal c/d 1,34,178 By, P & L A/c. (bal. fig.) 38,847
1,45,578 1,45,578
Life Insurance Policy A/c.

Dr. Cr.
To, Bal b/d 4,607 By, P & L A/c. (excess over 400
surrender value)
To, Bank (premium) 1,146 By, Balance c/d 5,353
5,753 5,753
Building and Machinery A/c.

Dr. Cr.
To, Balance b/d 1,47,778 By, Accumulated Dep. 29,105
To, Bank a/c (Purchase) 31,365 By, Bank a/c. (sales) 1,500
To, Bank a/c. (bal. fig.) 36,264 By, P & L a/c. (loss on sale) 2,020
(Construction cost of building)
By, Balance c/d 1,82,782
2,15,407 2,15,407
Debenture Discount A/c.
Dr. Cr.
To, Balance b/d 4,305 By, P & L a/c. (bal. fig.) 1,438
By, Balance c/d 2,867
4,305 4,305
Profit and Loss A/c.
Dr. Cr.
To, Dividend 10,000 By, Balance b/d 10,000
To, Life insurance policy 400 By, Trading profit (adjusted bal. 75,457
fig.)
To, Debenture discount 1,438
To, Reserve for contingencies 38,847
To, Allow. For inventory loss 6,500
To, 4% Mort. Debentureholders 255
To, Accumulated depreciation 14,120
To, Building and Mach. (loss) 2,020
To, Bank (life insurance premium) 1,627
To, Balance c/d 10,250
85,457 85,457
Q. 5. a) Venture Capital is considered to be a high risk capital. Do you agree? Enumerate the main
features of Venture Capital investment.
b) A company has the following capital structure :

`
Ordinary shares of ` 10 each, fully paid 40,00,000
7.5% Cumulative preference shares of ` 100 each, fully paid 2,00,000
Reserve & retained profits 45,00,000
11% Long-term loan 6,00,000
Total 93,00,000
In addition, the company has a bank overdraft for working capital and this averages to ` 10 lakhs.
Interest thereon is 15%. You are required to :
Calculate the company’s overall rate of return on capital employed in order to ensure :
i. Payment of all interest
ii. Dividend of preference dividend
iii. Payment of preference dividend
iv. Ordinary shareholder’s dividend is 12%

Assume the tax rate to be 50%.
Answer 5. (a)
The venture capital can be defined as the “long term equity investments in business which display potential
for significant growth and financial return”.
The term ‘venture capital’ comprises of two words viz. ‘venture’ and ‘capital’. The dictionary meaning of
‘venture’ is a course of proceedings associated with risk, the outcome of which is uncertain and ‘capital
means resources to start the enterprise. In a narrower sense venture capital is understood as the capital
which is available for financing new venture. Broadly, it can be interpreted as the investment of long-term
equity finance where the venture capitalist earns his return from capital gain.
The venture capital financing refers to the financing of new high risky venture promoted by qualified
entrepreneurs who lack experience and funds to give shape to their ideas. In a broad sense, under venture
capital financing, venture capitalist make investment to purchase equity of debt securities from
inexperienced entrepreneurs who undertake highly risky venture with potential of success.
The main features of venture capital investment are :
i. Providing finance of entrepreneurial talents
ii. Providing capital to persons having managerial skills.
iii. Expecting a high return in the form of capital gain.
The venture capital schemes are designed to promote technological advancement and innovation through
introduction of new products, process or plants and equipments. The activities which, in general need
venture capital support are :
i. Commercial production of viable new process or products.
ii. Technological up-gradation, including adoption of imported technology suitable to Indian
condition.
iii. Energy conservation with innovative technology.
iv. Commercial exploitation of proven technology.
Thus, the distinguishing characteristic of venture capital sources is an investment policy aimed at achieving
most of the profit through capital gain.
Answer 5. (b)
Calculation of Profit (before tax and interest)
` `
15
Interest on Bank overdraft ` 10,00,000 1,50,000
100
` 6,00,000
11
66,000 2,16,000
100
7.5
7.5% Dividend on cumulative pref. shares ` 2,00,000 15,000
100
12
Ordinary shareholders’ dividend ` 40,00,000 4,80,000
100
Reserve & retained profits
100
[(` 4,80,000 + 15,000) 4,95,000 × = 8,25,000]
60
(8,25,000 – 4,95,000) 3,30,000 8,25,000
Tax @ 50% of Net profit before tax
Therefore, net profit after tax will be 100% i.e. 8,25,000
Profit before tax and interest 18,66,000
Capital employed :
(` 93,00,000 + ` 10,00,000) 1,03,00,000
Therefore, overall return on capital employed = Profit . x 100

Capital Employed
= ` 18,66,000 . x 100
` 1,03,00,000
= 18.12%
Q. 6. a) When a lease can be considered as a Financial Lease ?
b) Aggressive Leasing Company is considering a proposal to lease out a tourist bus. The bus can be
purchased for ` 5,00,000 and, in turn, be leased out at ` 1,25,000 per year for 8 years with
payments occurring at the end of each year :
i. Estimate the internal rate of return for the company assuming tax is ignored.
ii. What should be the yearly lease payment charged by the company in order to earn 20%
annual compound rate of return before expenses and taxes ?
iii. Calculate the annual lease rent to be charged so as to amount to 20% after tax annual
compound rate of return, based on the following assumptions :
I. Tax rate is 40%
II. Straight line depreciation
III. Annual expenses of ` 50,000 and
IV. Resale value ` 1,00,000 after the turn.
Answer 6. (a)
A lease is considered as a Financial lease if the lessor intends to recover his capital outlay plus the required
rate of return on funds during the period of lease. It is a form of financing the assets under the cover of
lease transaction. A financial lease is a noncancellable contractual commitment on the part of the lessee
(the user) to make a series of payments to the lessor for the use of an asset. In this type of leases, lessee
will use and have control over the asset without holding ownership of the asset. The lessee is expected to
pay for upkeep and maintenance of the asset. This is also known by the name ‘capital lease’. The essential
point of this type of lease agreement is that it contains a condition whereby the lessor agrees to transfer
the title for the asset at the end of the lease period at a nominal cost. At the end of lease it must give an
option to the lessee to purchase the asset he has used. Under this lease usually 90% of the fair value of the
asset is recovered by the lessor as lease rentals and the lease period is 75% of the economic life of the
asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all
the benefits arising therefrom is transferred to the lessee who bears the cost of maintenance, insurance
and repairs. Only the title deeds remain with the lessor.
Answer 6. (b)
i) Payback period
= 5,00,000 = 4 years
1,25,000
PV factor close to 4,000 in 8 years is 4.0776 at 18%

Therefore, IRR = 18% (approx.)
We can arrive at 18.63% instead of 18% if exact calculations are made as follows :
PV factor in 8 years at 19% is 3.9544
By interpolating, we can get
IRR = 18% + 4.0776 - 4.000 x 1% = 18.63%

1.0776 – 3.9544
ii) Desired lease rent to earn 20% IRR before expenses and taxes
Present value of inflow annually for 8 years @ 20% = 3.837
Lease Rent = ` 5,00,000 = ` 1,30,310 p.a.

3.837
iii) Revised lease rental on tourist bus to earn 20% return based on the given conditions
PV factor [( X – Expenses – Depreciation) ( 1 – T) + D] + (PV factor x Salvage value) = C0
3.837 [(X – 50,000 – 50,000) (1 – 0.4) + 50,000] + (0.233 x 1,00,000) = 5,00,000
3.837 [0.6 x – 60,000 + 50,000] + 23,000 = 5,00,000
2.3022 x = 5,15,070
X = 2,23,730
Verification `
This may be confirmed as lease rental 2,23,730
Less : Expenses + Depreciation 1,00,000
EBT 1,23,730
Less : Tax 40% 49,492
PAT 74,238
Add : Depreciation 50,000
CFAT 1,24,238
= C0 – PV of SV = ` 5,00,000 – ` 23,300 = 3.837 or 20%

CFAT ` 1,24,238
Q. 7. a) Explain the term “Swaps”. Outline the possible benefits to a Company of undertaking an
Interest rate swap.
b) ABC Ltd. Provides you the following information :

Installed capacity 1,50,000 units
Actual production and sales 1,00,000 units
Selling price per unit Re. 1
Variable cost per unit Re. 0.50
Fixed costs ` 38,000
Funds required ` 1,00,000
Financial plan
Capital structure A B C
Equity shares of ` 100 each to be issued at 25% premium 60% 40% 35%
15% debt 40% 60% 50%
10% preference shares ` 100 each - - 15%
(Assume Income tax @ 40%)
Required :
i. To calculate the degree of operating leverage, degree of financial leverage and degree
to combined leverage for each financial plan.
ii. To calculate earnings per share and market price per share if price earning ratio in A
plan is 10 times and in B and C plan is 8 times.
iii. To suggest which form of financing should be employed if the firm follows the policy of
seeking to maximize the price of its shares.
iv. To calculate the indifference point between A and B plan.
v. To calculate the financial break even point for each plan and to suggest which plan has
more financial risk.
vi. To calculate the cost break even point.
Answer 7. (a)
Swaps, as the name implies, are exchange / swap of debt obligations (interest and/or principal payments)
between two parties. These are of two types, namely interest swaps and currency swaps. While interest
swaps involve exchange of interest obligations between two parties, currency swaps involve two parties
who agree to pay each other’s debt obligations denominated in different currencies.
Benefits of Interest rate swap :
i. A company can lower its overall interest burden by making use of the comparative
advantage; it has of borrowing in one market compared with another company that has a
comparative advantage in another market.
ii. A company that is paying one type of interest can switch to paying another type of
interest, for example from fixed to floating or floating to fixed rates.
iii. Swaps can be a more cost effective way of reducing interest rate risk than other hedging
methods.
iv. A company can change the structure of its borrowing without giving to terminate existing
loan arrangements, and hence incur early termination costs.
v. Swaps are more flexible than other methods of hedging – there are no prescribed sums
or periods of swaps. Swaps can be reversed as required by swapping with another
counter party.
Answer 7. (b)
Part (i), (ii) and (iii) Statement showing the calculation of degree of various leverages etc.
Particulars Financial Financial Financial

Plan A Plan B Plan C
` ` `
Sales 1,00,000 1,00,000 1,00,000
Less : Variable cost 50,000 50,000 50,000
Contribution 50,000 50,000 50,000
Less : Fixed Costs 38,000 38,000 38,000
Earnings before Interest & tax (EBIT) 12,000 12,000 12,000
Less : Interest 6,000 9,000 7,500
Earnings before tax (EBIT) 6,000 3,000 4,500
Less : Tax @ 40% 2,400 1,200 1,800
Earnings after tax (EAT) 3,600 1,800 2,700
Less : Pref. Dividend - - 1,500
Earnings for equity shareholders 3,600 1,800 1,200
No. of equity shares 480 320 280
Earnings per share (EPS) 7.5 5.625 4.286
Price earning ratio 10 8 8
Market price 75 45 34.286
Operating leverage (Contribution/ EBIT) 4.167 4.167 4.167
Financial leverage (EBIT/ EBT) [ EBT .] 2.000 4.000 6.000
EBT - Pref. Dividend
1–t
Combined leverage (Operating leverage x Financial 8.334 16.668 25.002
Leverage)
Recommendation : The market price is highest under Financial Plan A, therefore Financial Plan A is
recommended.
(iv) Calculation of Indifference Point between Plan A and Plan B

Particulars Plan A Plan B
EBIT X X
Less : Interest 6,000 9,000
EBT X – 6,000 X – 9,000
Less : Tax @ 40% 0.4X – 2,400 0.4X – 3,600
EAT 0.6X – 3,600 0.6X – 5,400

No. of shares 480 320
EPS 0.6X – 3,600 0.6X – 5,400
480 320
At different point, EPS under both plans will be equal.
0.6X – 3,60 = 0.6X – 5,400

480 320
192X – 11,52,000 = 288X – 25,92,000

96X = 14,40,000
X = 15,000
The indifference point between Plan A and Plan B is at the EBIT level of ` 15,000
(v) Statement showing the calculation of Financial BEP

Particulars Plan A Plan B Plan C
Interest 6,000 9,000 7,500
Preference dividend (after grossing up to tax) - - 2,500
[Preference Dividend]
1-t
Financial BEP 6,000 9,000 10,000
Comment : Since financial BEP for Plan C is highest, Plan C has the highest Financial Risk.
(vi) Statement showing the calculation of Cost or operating BEP
Particulars Plan A Plan B Plan C

Fixed cost 38,000 38,000 38,000
P/V Ratio 50% 50% 50%
Cost BEP (in `) [ Fixed Cost] 76,000 76,000 76,000
P/V Ratio
Cost BEP (in units) [BEP /Selling price per unit] 76,000 76,000 76,000
Q. 8. a) From the following information, ascertain whether the firm is following an optimal
dividend policy as per Walter’s model :
Total earnings ` 6,00,000
No. of equity shares of ` 100 each 40,000
Dividend paid ` 1,60,000
Price-earnings (P/E) Ratio 10
The firm is expected to maintain its rate of return of fresh investment. What should be the P/E
ratio at which dividend policy will have no effect on the value of the share ? Will your decision
change if the P/E ratio is 5 instead of 10 ?
b) M Ltd. has a capital of ` 10,00,000 in equity shares of ` 100 each. The shares are currently
quoted at par. The company proposes declaration of a dividend of ` 10 per share. The
capitalization rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if – (i) no dividend is declared;
and (ii) 10% dividend is declared ?
Assuming that the company pays the dividend and has net profits of ` 5,00,000 and makes new
investments of ` 10,00,000 during the period, how many new shares must be issued ? Use the
M. M. Model.
Answer 8. (a)
Calculation of market price of share under Walter’s model :
P = D + Ra / Rc (E – D)
Rc
Where P = Market price per share

E = Earnings per share
D = Dividend per share
Ra = Internal rate of return on investment
RC = Cost of capital
Dividend per share (D) = ` 1,60,000 / 40,000 shares = `4

Earnings per share (E) = ` 6,00,000 / 40,000 shares = ` 15
Rate of return on firms investment (Ra )

= ` 6,00,000 x 100 = 15% of 0.15
` 40,00,000
RC = Cost of capital (inverse of P/E ratio i.e. 1/10) = 0.10
P = 4 + (0.15/0.10) (15 – 4) = 20.50 = ` 205

0.10 0.10
Calculation of P/E ratio at which dividend policy will have no effect on the value of the share
Firm’s dividend payout ratio = ` 1,60,000/ ` 6,00,000 =0.2667 or 26.67%
Rate of return of the firm (Ra ) is 15%, which is more than its cost of capital (Rc ) is 10%. Therefore,
by distributing 16.67% of earnings, the firm is not following an optimal dividend policy. The
optimal dividend policy for the firm would be to pay zero dividend and in such case, the market
value of share under Walter’s model would be as follows :
P = 4 + (0.15/0.10) (15 – 0) = 22.50 = ` 225

0.10 0.10
The market value of the share would increase by not paying dividend and by retaining all the
earnings of the company.
Calculation of market value of share when P/E ratio is 5 instead of 10.
The Rc of the firm is the inverse of P/E ratio i.e. 1/5 = 0.20. In such case Rc > Ra
P = 4 + (0.15/0.20) (15 – 4) = 12.25 = ` 61.25

0.20 0.20
The P/E ratio at which the dividend policy will have no effect on the value of the firm when R c is
equal to the rate of return of the firm Ra. Under the situation, P/E ratio is 5, the optimum dividend
policy for the company would be 100% dividend payout at which the value of the firm would be
maximum.
Answer 8. (b)
(i) Calculation of share price under MM – Dividend Irrelevancy Model
P0 = P1 + D 1
1 + Ke
(a) When dividend is not declared
100 = P1 + 0 P1 = 100 x 1.12 = ` 112

1 + 0.12
(b) When dividend is declared
100 = P1 + 10 P1 + 10 = 100 x 1.12 = ` 102

1 + 0.12
(ii) Calculation of No. of shares to be issued (`)

Particulars If no dividend If dividend
declared declared
Net income 5,00,000 5,00,000
Less : Dividend paid - 1,00,000
Retained earnings 5,00,000 4,00,000
New investments 10,00,000 10,00,000
Amount to be raised by issue of new shares (i) 5,00,000 6,00,000
Market price per share (ii) 112 102
No. of new shares to be issued (i)/(ii) 4,464 5,882
Verification of M. M. Dividend Irrelevancy Theory

Particulars If no dividend If dividend
declared declared
Existing shares 10,000 10,000
New shares 4,464 5,882
Total no. of shares at the year end (i) 14,464 15,882
Market price per share (ii) ` 112 ` 102
Total market value of shares at the end of year ` 16,20,000 ` 16,20,000
(i)x(ii)
Analysis – The market value of shares at the end of year will remain the same whether dividends
are distributed or not declared.
Q. 9. a) Explore the interrelationship between Investment, Finance and Dividend Decisions.
b) A newly formed company has applied for a short-term loan to a commercial bank for financing
its working capital requirement.
As a Cost Accountant, you are asked by the bank to prepare an estimate of the requirement of the
working capital for that company. Add 10% to your estimated figure to cover unforeseen contingencies.
The information about the projected Profit and Loss Account of the company is as under :
`
Sales 21,00,000
Cost of goods sold
15,30,000*
Gross profit 5,70,000
Administrative expenses 1,40,000
Selling expenses 1,30,000 2,70,000
Profit before tax 3,00,000
Provision for tax 1,00,000
*Cost of goods sold has been derived as :

Materials used 8,40,000
Wages and manufacturing expenses 6,25,000
Depreciation 2,35,00017,00,000
Less : Stock of finished goods (10 % produced, not yet sold) 1,70,000
15,30,000
The figures given above relate only to the goods that have been finished and not to work-in-progress;
goods equal to 15% of the year’s production (in terms of physical units) are in progress on an average,
requiring full materials but only 40% of the other expenses. The company believes in keeping two
months’ consumption of material in stock.
All expenses are paid one month in arrears’ suppliers of material extend 1 ½ months’ credit; sales are
20% cash; rest are at two months’ credit, 70% of the income-tax has to be paid in advance in quarterly
installments.
You can make such other assumptions as you deem necessary for estimating working capital
requirement.
Answer 9. (a)
The finance functions are divided into three major decisions, viz., investment, financing and dividend
decisions. It is correct to say that these decisions are inter-related because the underlying objective of
these three decisions is the same, i.e. maximisation of shareholders’ wealth. Since investment, financing
and dividend decisions are all interrelated, one has to consider the joint impact of these decisions on the
market price of the company’s shares and these decisions should also be solved jointly. The decision to
invest in a new project needs the finance for the investment. The financing decision, in turn, is influenced
by and influences dividend decision because retained earnings used in internal financing deprive
shareholders of their dividends. An efficient financial management can ensure optimal joint decisions. This
is possible by evaluating each decision in relation to its effect on the shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and to see how
they can help in maximising the shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to
be accepted which is expected to yield at least so much return as is adequate to meet its cost of financing.
This have an influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different
issues. The finance manager has to maintain a proper balance between long-term and short-term funds.
With the total volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds.
The optimum financing mix will increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders
by way of dividends and what portion should be retained in the business. An optimal dividend pay-out ratio
maximises shareholders’ wealth.
We can infer from the above discussion that investment, financing and dividend decisions are interrelated
and are to be taken jointly keeping in view their joint effect on the shareholders’ wealth.
Answer 9. (b)
Statement showing the Net Working Capital Estimate of a Company :
Current Assets :
` ` `
Stock of raw material (2 months) :
(` 8,40,000 x 2/12) 1,40,000
Work-in-progress :
Raw materials (` 8,40,000 x 15/100) 1,26,000
Other expenses :
Wages and manufacturing exp. 6,25,000
(7,65,000 x 40%) 3,06,000 4, 32,000
Stock of finished goods :

Stock 1,70,000
Less : Depreciation 10%
(i.e. 2,35,000 x 10%) 23,500 1,46,500
Debtors (2 months) :
Cost of goods sold – Dep. (15,30,000 – 2,11,500) 13,18,500
[Dep. (2,35,000 – 23,500)]
Selling expenses 1,30,000
Total 15,88,500
Less : Cash sales @ 20% 3,17,700
(12,70,800x2/12) 2,11,800
Cash (say) 50,700
Total investment in current assets 9,81,000
Less : Current liabilities :

Creditors ( 1 ½ months) (` 8,40,000 x 1 ½ ) 1,05,000
12
Lag in payment of expenses (1month) :

Wages and manufacturing expenses
(` 6,25,000 x 1/12) =52,083
Administrative expenses
(` 1,40,000 x 1/12) = 11,667
Selling expenses
(` 1,30,000 x 1/12) = 10,833 74,583 1,79,583
Net working capital 8,01,417
Add : 10% for contingencies 80,142
Estimated working capital requirement 8,81,559
Notes :
1. Depreciation is excluded from the computation of cost of goods sold as it is a non-cash item.
2. Element of profit is excluded here.
3. Assume that cash is required for ` 50,700 in order to meet the day-to-day expenses.
Q. 10. a) What are currency futures ? List the steps involved in the technique of hedging through
futures.
b) Lucky Computer Stores is making a business plan for the next five year s. Sales growth over
the past years has been good. Sales would grow substantially if a major electronics firm is
established in the vicinity as proposed by an investor.
Lucky Computers has 3 options :
i. To enlarge the current store.
ii. To relocate it at a new site and
iii. To simply wait and do nothing
The decision to expand or move would take little time and therefore, the stores would not lose
revenue. If nothing were done in the first year and strong growth occurred, then the decision to
expand would be reconsidered. Waiting longer than one year would allow competition to move in,
making expansion no longer feasible.
The assumptions and conditions are :

I. Strong growth, emanating from the new electronics firm has a probability of 55%
II. Strong growth with new site would give annual returns of ` 1,95,000 p.a.
III. Weak growth with a new site would mean annual returns of ` 1,15,000 p.a.
IV. Strong growth with expansion would yield annual returns of ` 1,90,000 p.a.
V. Weak growth with expansion would mean annual returns of ` 1,00,000 p.a.
VI. There would be returns of ` 1,70,000 p.a. at the existing store with no changes in
case of strong growth and returns of ` 1,05,000 if growth is weak.
VII. Expansion at current site would cost ` 87,000
VIII. A shift to the new site would cost ` 2,10,000
nd
IX. In case of strong growth, if existing site is enlarged during the 2 year, the cost
would still be ` 87,000.
Which option should Lucky Computer Stores take, if operating costs for all options are equal ?
Answer 10. (a)

A currency futures contract is a derivative financial instrument that acts as a conduct to transfer risks
attributable to volatility in prices of currencies. It is a contractual agreement between a buyer and a
seller for the purchase and sale of a particular currency at a specific future date at a predetermined
price. A futures contract involves an obligation on both parties to fulfil the terms of the contract. A
futures contract can be bought or sold only with reference to the USD.
There are six steps involved in the technique of hedging through futures:
i. Estimating the target income (with reference to the spot rate available on a given date.)
ii. Deciding on whether Futures Contracts should be bought or sold.
iii. Determining the number of contracts( since contract size is standardised).
iv. Identifying profit or loss on target outcome.
v. Closing out futures position and
vi. Evaluating profit or loss on futures.
Answer 10. (b)

Decision Tree Analysis :
Strong growth
1
0.55
Weak growth
2
e 0.45
ov
M Strong growth
3
Lucky 0.55
Computer
Stores Expand
I
Do Weak growth
no 4 5
th 0.55
in
g
Strong growth
II
0.55
Weak growth
7
0.55
Computation of expected values for different alternatives from No. 1 to No. 7

Alternatives
(1) (` 1,95,000 x 5 years) – ` 2,10,000 = ` 7,65,000
(2) (` 1,15,000 x 5 years) – ` 2,10,000 = ` 3,65,000
(3) (` 1,90,000 x 5 years) – ` 87,000 = ` 8,63,000
(4) (` 1,00,000 x 5 years) – ` 87,000 = ` 4,13,000
(5) [(` 1,70,000 x 1 year) + (` 1,90,000 x 4 years)] – ` 87,000 = ` 8,43,000
(6) (` 1,70,0000 x 5 years) – 0 = ` 8,50,000
(7) ` 1,05,000 x 5 years) – 0 = ` 5,25,000
Analysis – There is a decision point II between option 5 and 6. Since option 6 has a better expected value
than option 5, we choose option 6 at this decision point.
Expected values
(i) Moving = (7,65,000 x 0.55) + (3,65,000 x 0.45) = `
5,85,000
(ii) Expand Store = (8,63,000 x 0.55) + (4,13,000 x 0.45) = `
6,60,000
(iii) Do nothing now, do not expand next year
= (8,50,000 x 0.55) + (5,25,000 x 0.45) = `
7,03,750
From the above, it is seen that the best decision is to do nothing (both now and next year).
Q. 11. An investment company wants to study the investment projects based on market demand, profit
and the investment required, which are independent of each other. Following probability distributions
are estimated for each of these three factors :
Annual demand (‘000 units) 25 30 35 40 45 50

55
Probability 0.05 0.10 0.20 0.30 0.20 0.10
0.05
Profit per unit 3 5 7 9

10
Probability 0.10 0.20 0.40 0.20
0.10
Investment required (` ‘000) 2,750 3,000

3,500
Probability 0.25 0.50
0.25
Using simulation process, repeat the trial 10 times, compute the investment on each trial taking these
factors into trial. What is the most likely return ?
Use the following random numbers :
(30,12,16) (59,09,69) (63,94,26) (27, 08, 74) (64, 60, 61)
(28,28,72) (31,23,57) (54,85, 20) (64,68,18) (32,31,87)
In the bracket above, the first random number is for annual demand, the second one is for profit and the
last one is for the investment required.
Answer 11.
Annual return (%) = Profit x Number of units demanded x 100

Investment
First of all, random numbers 00-09 are allocated in proportion to the probabilities associated with each of
the three variables as given under :
Annual demand
Units (‘000) Probability Cumulative Random numbers
probability assigned
25 0.05 0.05 00 – 04
30 0.10 0.15 05 – 14
35 0.20 0.35 15 – 34
40 0.30 0.65 35 – 64
45 0.20 0.85 65 – 84
50 0.10 0.95 85 – 94
55 0.05 1.00 95 - 99
Profit per unit

Profit (`) Probability Cumulative Random numbers
3 0.10 0.10 00 – 09
5 0.20 0.30 10 – 29
7 0.40 0.70 30 – 69
9 0.20 0.90 70 – 89
10 0.10 1.00 90 - 99
Investment required
Investments (` ‘000) Probability Cumulative Random numbers
2,750 0.25 0.25 00 – 24
3,000 0.50 0.75 25 – 74
3,500 0.25 1.00 75 - 99
Let us now simulate the process for 10 trials. The results of the simulation are shown in the tables
given below :
Trials Random Simulated Random Simulated Random no. Simulated Simulated

no. of demand no. for profit per for investment return (%)*
demand (‘000 units) profit per unit investment (` ‘000)
unit
1 30 35 12 5 16 2,750 6.36
2 59 40 09 3 69 3,000 4.00
3 63 40 94 10 26 3,000 13.33
4 27 35 08 3 74 3,000 3.50
5 64 40 60 7 61 3,000 9.33
6 28 35 28 5 72 3,000 5.83
7 31 35 23 5 57 3,000 5.83
8 54 40 85 9 20 2,750 13.09
9 64 40 68 7 18 2,750 10.18
10 32 35 31 7 87 3,500 7.00
*The simulated return is calculated as below :
= Demand x profit p.u. x 100

Investment
The above table shows that the highest likely return is 13.33% which is corresponding to the annual
demand of 40,000 units resulting a profit of ` 10 per unit and the required investment will be ` 30,00,000.
Q. 12. A company is evaluating a new venture that will cost ` 10 crore. The venture will have a return on
investment of 20% and the firm forecasts a 12% growth in earnings from the project. The treasurer has
identified the following sources for financing the project :
a. Equity shares to be sold at ` 400 per share.
b. Convertible debentures with a 60% coupon to net ` 980 (face value ` 1,000), and
convertible at ` 500 per share after 2005.
c. Debentures with warrants with a 60% coupon to net ` 980 (face value ` 1,000), and
with each bond having one warrant entitling the holder to buy one equity share at `
500 after 2008.
The financing decision is being made in the fourth quarter of 2003. Over the past ten years, the company
has been growing at a 10% rate of sales and earnings.
The treasurer expects the company to continue to grow at 10% even though the firm has traditionally
paid 40% of its earnings as dividends. The treasurer expects equity shares to continue to rise in price.
Using the price trend over the past 5 years, he has projected probable market price ranges for the next
three years. The historical data and the projections of the treasurer are as below :
Year Historical market Year Forecasted

price (`)
Probability (%) Market price (`)
2005 220 2011 20 450
2006 250 60 500
2007 330 20 600
2008 270 2012 20 480
2009 380 60 550
2010 450 20 620
2013 20 500
60 600
20 700
The proforma balance sheet and income statement prepared by the treasurer for the year 2007 is shown
as below :
Proforma Balance Sheet (December 31,2010) ` ‘000

Liabilities 2010 2009 Assets 2010 2009
Equity shares (` 10 10,000 10,000 Plant and equipment 2,25,000 2,31,000
each)
Shares premium 40,000 40,000 Less : Accumulated 62,000 59,000
depreciation
Retained earnings 1,36,000 1,27,000 1,90,000 1,72,000
Bonds (7%) 90,000 52,000 Inventories 64,000 62,000
Mortgage (6%) 30,000 55,000 Receivables 44,000 45,000
Accounts payable 7,000 6,000 Cash and bank balance 22,000 18,000
Other current liabilities 11,000 10,000 Other current assets 4,000 3,000
3,24,000 3,00,000 3,24,000 3,00,000
Proforma Income Statement

`’000
Sales EBIT Interest* EBT NIAT EPS
2010 4,20,000 71,500 8,000 63,500 31,750 31.75
2009 3,80,000 65,000 7,000 58,000 29,000 29.00
*Rounded off.
The management was initially impressed by the fact that the new venture will increase sales by ` 12
crore. Management is also interested in the expected 12% growth rate of the venture. As per company’s
financial policy, the firm’s debt-asset ratio should not be above 40%.
With the above information and detailed analysis for next 3 years, what will be the long-term sources of
financing for the new proposal ?
Make suitable assumptions in your answer, wherever necessary figures could be rounded off. Income tax
rate applicable to the company is to be taken at 50%.
Answer 12.
Statement showing EPS in 2007 (end) under various financing options (` In lakhs)
Particulars With With new business financed by
existing Equity Convertible Debt (+)
business shares debt Warrant
1
EBIT 786.50 986.50 986.50 986.50
Less : Interest on debt :
Existing (` 9 crore x 0.07) + (` 3 crore x 0.06) 81.00 81.00 81.00 81.00
2
New debt (1,02,040 debentures x ` 60 per debenture) - - 61.22 61.22
Earnings before taxes 705.50 905.50 844.28 844.28
Less : Taxes (0.50) 352.75 452.75 422.14 422.14
Earnings after taxes 352.75 452.75 422.14 422.14
3
Number of shares (in lakhs) 10.00 12.50 10.00 10.00
EPS (`) 35.275 36.22 42.214 42.214
Statement showing EPS in 2010 (end) under various financing options (` In lakhs)
4 5
EBIT 951.66 1,202.54 1,202.54 1,202.54
6 7
Add : Additional EBIT due to additional funds raised - - - 102.04
Less : Interest on existing debt 81.00 81.00 81.00 81.00
Less : Interest on new debt - - - 61.22
(in the case of warrant option)
EBT 870.66 1,121.54 1,121.54 1,162.36
Less : Taxes (0.50) 435.33 560.77 560.77 581.18
EAT 435.33 560.77 560.77 581.18
8 8
Number of shares (lakh) 10.00 12.50 12.04 11.02
EPS (`) 43.533 44.862 46.576 52.74
Statement showing debt (assumed to be long-term) to assets ratio in 2007 and 2010 (` In lakhs)
Year-end 2007
Total assets 3,240 4,240 4,240 4,240
Existing debt 1,200 1,200 1,200 1,200
Additional debt - - 1,020 1,020
Total debt 1,200 1,200 2,220 2,220
Debt/ Assets ratio (%) 37.03 28.30 52.36 52.36
Year-end 2010
9
Total assets 3,949.27 5,152.17 5,124.62 5,142.99
Existing debt 1,200 1,200 1,200 1,200
Additional debt - - - 1,020
Total debt 1,200 1,200 1,200 2,220
Debt/Assets ratio (%) 30.39 23.29 23.42 43.19
Recommendation : Though EPS is the highest (at ` 52.74) under debt plus warrant plan, it cannot be
implemented as debt/ assets ratio exceed 40% (43.19%). IN view of this, the next best alternative is that
the company should opt for convertible debt plan as under this plan potential EPS is the maximum (at `
46.576 in 2010 and at ` 42.214 in 2007).
Working notes : (` In lakhs)
1. a) Without new venture

EBIT (2000) 715.00
Add : 10% growth 71.50 786.50
b) With new venture
Expected EBIT without new venture 786.50
Add: 20% growth on ` 10 crore new investment (` 10 crore x 0.20) 200.00
986.50
2. Number of new debentures to be issued
(Amount to be raised ` 10 crore/Net proceeds per debenture, ` 980) 1,02,040
3. Number of new equity shares to be issued

(` 10 crore/Sale price of equity shares, ` 400) 2,50,000
4. EBIT in 2003 = Current EBIT, ` 715 lakh x Growth factor @ 10% for 3 yrs. i.e. 1.331 951.66
5. EBIT in 2003 wqith new business : ` 951.66 lakh + (` 10 crore

X 20% ROR x 12% growth factor for 2 yrs. i.e. 1.254 = 250.88 lakh) 1,202.54
6. Determination of expected market price in 2008 to 2010

Years
2008 2009 2010
450 x 0.2 = 90 480 x 0.2 = 96 500 x 0.2 = 100
500 x 0.6 = 300 550 x 0.6 = 330 600 x 0.6 = 360
600 x 0.2 = 120 620 x 0.2 = 124 700 x 0.2 = 140
510 550 600
Since expected market price is higher (at ` 550 in 2002 and at ` 600 in 2003) than the
conversion price (i.e. ` 500 after 2002), it is reasonable to assume that debt-holders/ warrant-
holders will like to exercise their option, resulting in higher number of equity shares in 2003.
7. In the case of convertible debt, no additional funds will accrue. There will be additional funds
in the case of warrant option equivalent to (1,02,040 warrants x ` 500 issue price of equity
share) = ` 510.20 lakh.
As per the principle of conservatism, the ROR likely to be earned on these funds (` 510.20
lakh) is ROR promised by a new venture i.e. 20% or existing ROR which-ever is lower.
(Conventionally, ROR is computer on existing long-term funds employed in business at book
value).
ROR (on capital employed) = EBIT .

Equity funds + Long –term debt
= (` 715 lakh/(1860 lakh + 1200 lakh) = 23.37 %
Thus, expected additional EBIT with warrant option is = ` 510.20 lakh x 0.2 = 102.04 lakh
8. Number of new equity shares issued

i. Convertible debts = 1,02,040 debentures x 2 = 2,04,080
ii. Warrants = 1,02,040 x 1 = 1,02,040
9. Increase in retained earnings during 3 years under various options :

It is computer as per the following ratio :
[EAT (year-end 2000) + EAT (year-end 2003)] x Retention ratio x 3 years

2
i. No new venture = [` 352.75 lakh + ` 435.33 lakh] x 0.6 x 3 years = ` 709.27 lakhs
2
ii. Issue of equity shares = [` 452.75 lakh + ` 560.77 lakh] x 0.6 x 3 years = ` 912.17 lakh
2
iii. Issue of convertible debentures = [` 422.14 lakh + ` 560.77 lakh] x 0.6 x 3 years
2
= ` 884.62 lakh
iv. Issue of debt + warrant = [` 422.14 lakh + ` 581.18 lakh] x 0.6 x 3 years
2
= ` 902.99 lakh
It is assumed that the assets will increase by the amount of increase in retained earnings
under various options.
Q. 13. a) Describe the Little – Mirrlees approach to Social Cost Benefit Analysis (SCBA) of a project and
the Indian modification of the same.
b) Superior Engineering proposes a project with the following data :
i. Total asset :` 450 lakhs (` 250 lakhs of Fixed Assets and ` 200 lakhs of Current Assets)
ii. Scheme of financing : ` 100 lakhs equity, ` 200 lakhs term loan, ` 100 lakhs working
capital advance and ` 50 lakhs trade creditors.
iii. Interest rate : Term loan 12% p.a. and working capital advance : 15% p.a.
rd
iv. Term loan is repayable in 5 equal installments, commencing from 3 year of
operations. (Assume that installment for each year is paid on the last day of the year).
v. Depreciation : 30% on written down value.
st
vi. Production is expected to reach 60% of capacity in the 1 year of operations, 70% in the
nd rd
2 year and 80% from the 3 year onwards.
vii. Expected revenue from the project will be ` 500 lakhs p.a. on 10% capacity utilization
and corresponding Direct Costs are ` 200 lakhs. Fixed costs are ` 100 lakhs p.a. Working
capital advance of ` 100 lakhs is on 80% capacity and proportionately reduced in the
first two years.
viii. Tax rate applicable is 50%.
Assuming that each year’s production is sold away in the same year, draw the projected profit & loss
account for each year of operation and the operational cash flow. Also calculate the Debt Service
Coverage Ratio.
Answer 13. (a)

In Social Cost Benefit Analysis (SCBA), the focus is on social costs and benefits of a project. These often
tend to differ form the costs incurred in monetary terms and benefits earned in monetary terms of the
project.
The principal reasons for the discrepancies are :
i. Market imperfections
ii. Externalities
iii. Taxes and levies
iv. Concern for savings
v. Concern for redistribution and
vi. Merit and demerit of goods.
Little-Mirrlees approach to SCBA involved determining the accounting of shadow prices particularly for
foreign exchange, savings and unskilled labour, considering the equity factor and the use of Discounted
Cash Flow (DCF) analysis. It seeks to measure costs and benefits in terms of international prices, rather
than in terms of domestic prices and also in terms of uncommitted social income.
The Project Appraisal Division of the Planning Commission uses a modified and simplified version of the
Little-Mirrlees approach. All industrial projects are evaluated on three aspects – economic rate of return,
effective rate of protection and domestic resource cost.
To calculate economic rate of return, the domestic market prices are substituted with international prices
for all non-labour inputs and outputs. CIF prices for inputs and FOB prices for outputs are used for all
tradable items. For tradable items where international prices are not available and for non-tradable items,
social conversion factors are used.
The effective rate of protection is calculated as follows :
[(Value added at domestic prices) – (Value added at world prices)] x 100

(Value added at world prices)
Domestic selling prices are net of taxes and excise duty but inclusive of selling commission. The selling price
at world prices is the CIF value for imports and FOB value for exports.
Domestic Resource Cost is computed as :

[(Value added at domestic prices)/(Value added at world prices)] x Exchange Rate.
Answer 13. (b)

Projected Profit & Loss Account
Year of operation 1 2 3 4 5 6 7
Capacity utilization (%) 60 70 80 80 80 80 80
(` In lakhs)
Revenue 300 350 400 400 400 400 400
Direct variable costs 120 140 160 160 160 160 160
Fixed costs 100 100 100 100 100 100 100
Int. on working cap. 11.25 13.13 15.00 15.00 15.00 15.00 15.00
adv.
Profit before 68.75 96.87 125.00 125.00 125.00 125.00 125.00
depreciation &
interest on term loan
Depreciation 75.00 52.50 36.75 25.73 18.01 12.61 8.82
Interest on term loan 24.00 24.00 24.00 19.20 14.40 9.60 4.80
Profit after dep. & int. (-)30.25 20.37 64.25 80.07 92.59 102.80 111.38
Tax @ 50% - 10.19 32.13 40.04 46.30 51.40 55.69
PAT - 10.19 32.13 40.04 46.30 51.40 55.69
Operational cash flow 68.75 86.68 92.87 84.96 78.70 73.60 69.31
(PAT + Dep. + Int. on
term loan)
Payments
Int. on term loans 24.00 24.00 24.00 19.20 14.40 9.60 4.80
Repayment of terms - - 40.00 40.00 40.00 40.00 40.00
loan
Total 24.00 24.00 64.00 59.20 54.40 49.60 44.80
DSCR (Op. cash flow/ 2.86 3.61 1.45 1.44 1.45 1.48 1.55
Total payments)
Average DSCR = (Total operation cash flow) / (Total payment against debts)
= (554.87 ÷ 320.00) = 1.73.
Q. 14. a) What category should the following projects be attributed to – Balancing/

Modernisation/Replacement/ Expansion/ Diversification/ Rehabilitation – or a combination of the above
? Justify your answer.
(i) Duracare Ltd., a company producing consumer durables has been having been severe
production constraints due to frequent and long disruption of power supply. They have their
own captive power generation facility which can meet 75% of their capacity. They are
considering augmenting their own generation to take care of their entire capacity at an
investment of ` 60 lakhs.
(ii) XYZ Ltd., produces blue detergent powder. Recent studies carried out by marketing indicate
that there is a growing opportunity for white detergent powder. Producing detergent
powders in two different colours in the same plant requires modification to the existing
plant such as, additional facilities for storage and handling. The total investment involved
would be ` 85 lakhs.
(iii) Economic Producers Ltd., is an ancillary unit producing components for trucks. Their main
machinery was installed 17 years back. The equipment is frequently breaking down
throwing the delivery schedules out of balance. The equipment can produce 700
components per day. New equipment available for producing the same component costs `
25 lakhs with a delivery time of 3 months.
(iv) Sri Ajit Singh owns 25 acres of land on which he grows wheat. He is planning to buy a tractor
to speed up his farm operations as well as reduce input costs.
(v) Milk Products Ltd., is in dairy business, producing milk powder and ghee. Recently, a market
survey carried out by the consultants appointed by the company indicates an opportunity
for selling cheese. The total outlay in terms of capital expenditure would be ` 270 lakhs.
b) The projected cash flows and the expected net abandonment values for a project are given
below :
Year Cash inflows (`) Abandonment value (`)

0 (-) 1,00,000 Nil
1 35,000 65,000
2 30,000 45,000
3 25,000 20,000
4 20,000 nil
Should the project be abandoned and if so, when ?

Cost of capital may be taken as 10%.
Present value (PV) factor @ 10% is 1.000, 0.909, 0.826, 0.751 an d0.683 for 0,1,2,3 & 4 years respectively.
Answer 14. (a)

Project classification :
(i) This is a case of Balancing Project in which the capacity of power generation is being
augmented by investing ` 60 lakhs to cope up with interruptions in power supply and to
ensure continuous production.
(ii) This is a case of Modernisation through expansion. The present plant needs sufficient
modification to adapt to different colour combinations in detergents along with
additional facilities in terms of storage capacity. Thus, it is decided to expand the present
warehouse and handling facilities by investing ` 85 lakhs.
(iii) This is a Replacement Project. Since the existing machinery was installed 17 years back
and is insufficient to support the present demands of the market. It needs to be replaced
rather than modified or modernized.
(iv) This is a case of Modernisation of the farming process. By using tractors on farm land, the
farming can be done more productively than in the case of a conventional process.
Therefore, Shri Ajit Singh is intending to modernize his operations, which would reduce
his time & energy and optimize his costs, while increasing the output considerably.
(v) This is a case of Diversification. Since Milk Products Ltd. is already in the business of dairy
products, it simply is extending the product line in its existing line of business.
Answer 14. (b)

Expected NPV over 4 years of economic life :
Year Cash flow (`) Abandonment PV factor @ NPV (`) of NPV (`) of
value (`) 10% cash flow abandonment
value
0 (-) 1,00,000 - 1.000 (-) 1,00,000 -
1 35,000 65,000 0.909 31,815 59,085
2 30,000 45,000 0.826 24,780 37,170

3 25,000 20,000 0.751 18,775 15,020
4 20,000 - 0.683 13,660 -
Total (-) 10,970
From the table above, the Total NPV of the project (NPV of cash flows + NPV of abandonment value) at the
end of each year are computed as shown below :
Year Total NPV at the end of

3 years 2 years 1 year
0 (-) 1,00,000 (-) 1,00,000 (-) 1,00,000
1 31,815 31,815 31,815
59,085 Abandonment value
2 24,780 24,780
37,170 Abandonment
value
3 18,775
15,020 Abandonment
value
Total (-) 9,610 (-) 6,235 (-) 9,100
Conclusion : The project should be abandoned since there is no +ve NPV at the end of any year. Further, it
nd
should be abandoned at the end of 2 year, where the losses are the minimal.
Q. 15. A company is considering two mutually exclusive projects X and Y. Project X costs ` 30,000 and
Project Y ` 36,000. You are given below the net present value probability.
Project X Project Y
NPV estimate (`) Probability NPV estimate (`) Probability
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
i. Compute the expected net present value of projects X and Y.
ii. Compute the risk attached to each project.
iii. Which project do you consider more risky and why ?
iv. Compute the probability index of each project.
Answer 15.
(i) Statement showing computation of expected net present value of the projects X and Y.
Project X Project Y
NPV estimate Probability Expected NPV estimate Probability Expected
(`) value (`) value
3,000 0.1 300 3,000 0.2 600
6,000 0.4 2,400 6,000 0.3 1,800
12,000 0.4 4,800 12,000 0.3 3,600
15,000 0.1 1,500 15,000 0.2 3,000
1.0 EV = 9,000 1.0 EV = 9,000
Thus the expected net present value of both projects X and Y are same.
(ii) Computation of Standard Deviation of each project :

For Project X
2
Probability (P) NPV Estimates (`) (µ - 9,000) P (µ - 9,000)
(µ)
0.1 3,000 - 6,000 36,00,000
0.4 6,000 - 3,000 36,00,000

0.4 12,000 + 3,000 36,00,000
0.1 15,000 + 6,000 36,00,000
Variance 1,44,00,000
Standard deviation of Project X = √1,44,00,000 = ` 3,794.73
For Project Y
2
Probability (P) NPV Estimates (`) (µ - 9,000) P (µ - 9,000)
(µ)
0.2 3,000 - 6,000 72,00,000
0.3 6,000 - 3,000 27,00,000
0.3 12,000 + 3,000 27,00,000
0.2 15,000 + 6,000 72,00,000
Variance 1,98,00,000
Standard deviation of Project Y = √1,98,00,000 = ` 4,450
(iii) Risk is measured by the possible variation of outcomes around the expected value and the
decision will be taken keeping in view the variation in the expected value where two projects have
the same expected value, the decision maker would choose the project which has smaller
variation in expected value.
In the selection of one of the two projects X and Y, project Y is preferable because the possible
profit which may occur is subject to loss variation (or dispersion), much higher risk is lying with
project Y.
(iv) Computation of profitability of each project :

Profitability Index = Present value of cash inflows ÷ Present value of cash outflow
NPV = Sum of total cash inflows – Project cost
Sum of total cash inflows = Project cost + NPV
Project X = ` 30,000 + ` 9,000 = ` 39,000
Project Y = ` 36,000 + ` 9,000 = ` 45,000
Profitability Index :
Project X = ` 39,000/ 30,000 = 1.30
Project Y = ` 45,000/ 36,000 = 1.25
Thus profitability index of Project X is more than that of Project Y.
Q. 16. a) An Indian software company receives an order from an European union country. The buyer will
pay in four quarterly installments each of €0.5 million, starting from the end of the first quarter.
The rates for euros in India is as follow :
Spot 3 month forward 6 month forward 9 month forward 1 year forward

` 52.80 ` 52.70 ` 52.55 ` 52.50 ` 52.48
If an Indian company hedges its foreign exchange rate risk in the forward market, how much
revenue does it earn ?
b) Are arbitrage gains possible from the following set of information to the arbitrageur ?
Spot rate : 47.88/$
3 month forward rate : ` 47.28/$
3 month interest rates :
Re. : 7% p.a.
$ : 11% p.a.
Answer 16. (a)

Indian software company will have the following income streams :
Installment Euro income (€) Rate (`) Revenue (`)
st
1 quarter-end 5,00,000 52.70/€ 2,63,50,000
nd
2 quarter – end 5,00,000 52.55/€ 2,62,75,000
rd
3 quarter-end 5,00,000 52.50/€ 2,62,50,000
th
4 quarter-end 5,00,000 52.48/€ 2,62,40,000
Total revenue income is 10,51,15,000
Answer 16. (b)

3 month forward rate of the dollar is higher (at ` 48.28) than the spot rate (` 47.88). It implies that the
dollar is at premium.
Premium (%) = (` 48.28 – ` 47.88) x 12 x 100 = 3.34% per annum
` 47.88 3
Interest rate differential = 11% - 7% = 4% per annum
Since interest rate differential (4%) and premium % (3.34%) do not match, there are arbitrage gain
possibilities. An arbitrageur can take the following steps in this regard :
i. Arbitrageur borrows, say , ` 100 million at 7% for 3 months (he borrows in Indian
currency as it carries lower interest rate).
ii. He then converts ` 100 million in US $ at the spot rate of ` 47.88 in the spot market. He
gets an amount of US $ 2,088,554.72 (` 100 million/ ` 47.88).
iii. He invests US $ 2,088,554.72 in the money market at 11% interest per annum for 3
months. As a result of this investment, he obtains the interest of US $ 57,435.2548 ($
2,088,554.72 x 3/12 x 11/100).
iv. Total sum available with arbitrageur, 3 months from now is (US $ 2,088,554.72 amount
invested + US $ 57,435.2548 interest) = US $ 2,145,989.974.
v. Since he would get US $ 2,1451989.974 after 3 months, he sells forward US $
2,145,989.974 at the rate of ` 48.28.
vi. As a result of a forward deal, at the end of 3 months from now, he would get `
103,608,395.90, i.e. ($ 2,1451989.974 x 48.28).
vii. He refunds the ` 100 million borrowed, along with interest due on it. The refunded sum is
` 100 million + ` 1,750,000 i.e. (` 100 million x 3/12 x 7/100) = ` 101,750,000.
viii. Net gain is ` 103,608,395.90 – ` 101,750,000 = ` 18,58,395.90.
Q. 17. The investment manager of a large Indian software company receives the following quotes from
its foreign exchange broker.
US dollar spot rate : ` 47.75/ US $
US dollar option quotation
Strike price Call Put
September December March September December March
45.0000 3.0 - - - - -
45.5000 2.6 2.9 - - - -
46.0000 2.0 2.3 2.45 0.2 - -
46.5000 1.85 1.95 2.15 0.25 - -
47.0000 1.25 1.85 2.00 0.70 - -
47.5000 0.85 1.15 1.45 1.00 1.25 1.75
48.0000 0.50 0.74 0.89 1.59 1.92 2.50
48.5000 0.30 0.52 0.68 1.70 2.20 -
49.0000 0.15 - - 1.90 - -
49.5000 0.10 - - 2.00 - -
50.0000 0.08 - - 2.30 - -
What calculation will the investment manager make for following questions ?
i. What is the intrinsic value for the December 47.5 call option ?
ii. What is the intrinsic value for the September 46 put option ?
iii. What is the break-even exchange rate for the March 46.5 call and the March 48 put ?
iv. If the March spot rate is expected to be ` 48.50/US $, which call option should be
bought ?
v. The software company will receive its export income in March and the expected spot
rate (in March) will be ` 46.5/US $, which put option should be bought ?
Answer 17.
Intrinsic value of an option is the amount by which the option is in-the-money.
For a call option, intrinsic value = Maximum [(Spot rate – Strike rate), 0]
For a put option, intrinsic value = Maximum [(Strike rate – Spot rate), 0]
i. Intrinsic value for the December 47.5 call option
= Max [(` 47.75/US $ - ` 47.5/US $),0]
= Max [` 0.25/ US $, 0] = ` 0.25/ US $
ii. Intrinsic value for the September 46 put option
= Max [(` 46/ US $ - ` 47.75/US $), 0]
= Max [-(` 1.75/ US $), 0] = 0
iii. The break-even exchange rate for the March 46.5 call on settlement date is Re. X/US $
So, The premium paid = ` 2.15/US $
Profit from the call option = ` (X – 46.5)/US $
At break even, ` (X – 46.5)/US $ = ` 2.15/ US $
X = ` 48.65/ US $
The break even exchange rate for March 48 put is :
Premium paid = ` 2.50/US $
Profit from the put option = ` (48 – X)/US $
At break-even, ` (48 – X)/US $ = ` 2.50/US $
X = ` 45.5/US $
iv. For an expected spot rate of ` 48.50/US $,, we need to find out profit from buying the
March call option at various strike prices.
Gain from call option
= Max [(Settlement rate – Strike rate),0] – Premium
= value of option at expiration – Premium
Option Strike price (`) Premium (A) (`) Option value at Gain/ Loss [B –
expiration (B) (`) A]
(`)
March call 46.00/ US $ 2.45/ US $ 2.50 / US $ 0.05/ US $
March call 46.50/ US $ 2.15/ US $ 2.00/ US $ - 0.15/ US $
So, for the expected March spot rate of RS. 48.50/ US $, the March call option of strike
price ` 46.00/ US $ should be bought.
vi. Gain from purchasing the March put option of various strikes, for which quotes are
available, for an expiration price of ` 46.50/ US $.
Option Strike price (`) Premium (A) (`) Option value at

Gain/ Loss [B –
expiration (B) (`)
A]
(`)
March put 47.50/ US $ 1.75/ US $ 1.00 / US $ - 0.75/ US $
March put 48.00/ US $ 2.50/ US $ 1.50/ US $ - 1.00/ US $
As no gains accrue by purchasing the different March put available for the expected
March expiration rate of ` 46.50/ US $, the software company should not hedge through
the put options.
Q. 18. An Indian company is planning to set up a subsidiary in the US. The initial project cost is estimated
to be US $ 400 million; working capital requirements are estimated at US $ 40 million. The Indian
company followed the straight-line method of depreciation.
The finance manager of the Indian company estimated data in respect of the project as follows :
i. Variable cost of production and sales $ 25 per unit.
ii. Fixed cost per annum are estimated at $ 30 million
iii. Plant will be producing and selling 50 million units at $ 100 per unit and
iv. The expected economic useful life of the plant is 5 years with no salvage value.
The subsidiary of the Indian company is subject to 40% corporate tax rate in the US and the required rate
of return of such a project is 12%. The current exchange rate between the two countries is ` 48/ US $ and
the rupee is expected to depreciate by 3% per annum for next five years.
The subsidiary will be allowed to repatriate 70% of the CFAT every year along with the accumulated
arrears of blocked funds at year-end 5, the withholding taxes are 10%. The blocked funds will be invested
in the USA money market by the subsidiary, earning 4% (free of tax) per year.
Determine the feasibility of having a subsidiary company in the USA, assuming no tax liability in India on
earnings received by the parent from the US subsidiary.
Answer 18.
Cash outflows (t = 0) (figures in million)
Cost of plant and machinery $ 400
Working capital requirement 40
Incremental cash outflow in rupees ($ 440 million x ` 48) ` 21,120
Cash inflows after taxes (figures in million)

Sales revenue (5.0 million units x $ 100) 500
Less : Costs :
Variable cost (5.0 million units x $25) $ 125
Fixed cost 30
Depreciation ($400 million/ 5 year) 80 235
Earning before taxes 265
Less : Taxes (0.40) 106
Earning after taxes 159
Add : Depreciation 80
CFAT (T = 1 – 4) 239
th
CFAT in 5 year :
Operating CFAT 239
Add : Release of working capital 40 279
Determination of NPV (figures in million)
Particulars Year
1 2 3 4 5
Operating CFAT $ 239 $ 239 $ 239 $ 239 $ 239
Less : Retention 71.70 71.70 71.70 71.70 -
Repatriation made 167.30 167.30 167.30 167.30 239.00
Less : Withholding tax 16.7 16.7 16.7 16.7 23.9
Accessible funds to parent 150.6 150.6 150.6 150.6 215.1
Add : Repatriation of blocked funds * - - - - 274
Add : Recovery of working capital - - - - 40
Re/$ exchange rate 49.44 50.9232 52.4509 54.0244 55.6451
Rupee equivalent 7,445 7,669 7,899 8,136 29,442
PV factor (0.12) 0.893 0.797 0.712 0.636 0.567
Present value 6,648 6,112 5,624 5,174 16,694
Total present value 40,252
Less : Cash outflow 21,210
Net present value ` 19,042
Recommendation : Since the NPV is positive, having a subsidiary in the US is financially viable for
the Indian company.
*Repatriation of blocked funds after withholding taxes

Future value in year 5 of blocked funds of 17.7 million each during t = 1 to 4 years invested at 4%
per year = 4.246 x 71.7 million = 304.44 million – 30.44 million withholding tax = 274 million.
Q. 19. From the following information, prepare Trading and Profit and Loss Account :
Debt-Equity Ratio (Long-term Debt/Shareholders’ Funds) 2:1
Capital Gearing Ratio (Funds bearing fixed payments to Equity Shareholder’s Funds) 3:1
15% Long-term Debts ` 8,00,000
Return on Equity Shareholder’s Funds 25%
Tax Rate 50%
15% Preference Share Capital ?
Break-up of Cost-Profit :
Materials 40%
Labour 25%
Manufacturing Expenses 10%
Depreciation on Plant 10%
Office & Selling Expenses 2.5%
Operating Profit 12.5%
100%
Answer 19.
Dr. Trading and Profit & Loss Account for the year ended..... Cr.
To Materials 9,60,000 By Sales 24,00,000
To Labour Expenses 6,00,000
To Mfg. Expenses 2,40,000
To Depreciation 2,40,000
To Gross Profit @ 15% 3,60,000
24,00,000 24,00,000
To Office & Adm. Exp. 60,000 By Gross Profit 3,60,000
To Interest @ 15% 1,20,000
To Tax 50% 90,000
To Net Profit after Tax 90,000
3,60,000 3,60,000
To Preference Dividend 15,000 By Net Profit after Tax 90,000
To Balance for Equity
Shareholders @ 25% 75,000
90,000 90,000
Working Notes :
(i) Calculation of Equity Shareholders’ Funds Long-term Debts
Long - term Debts
Debt Equity Ratio =
Shareholders’ Funds
2 = ` 8,00,000 / Shareholders’ Funds
Shareholders’ Funds = ` 8,00,000/2 = ` 4,00,000
Supposing Pref. Share Capital = x
Equity Shareholders’ Funds = ` 4,00,000 – x
(ii) Calculation of Pref. Share Capital

Long - term Debts plus Pref. Share Capital
Capital Gearing Ratio =
Equity Shareholde rs’ Funds
Rs. 8,00,000 x
3 =
Rs. 4,00,000 x
` 12,00,000 – 3x = ` 8,00,000 + x
x = ` 1,00,000
Pref. Share Capital = ` 1,00,000
Equity Shareholders’ Fund = ` 4,00,000 – ` 3,00,000
(iii) Calculation of Operating Profit

Net Profit after Int. Tax & Pref. Div.
Return on Equity =
Equity Shareholde rs’ Funds
25% = x/` 3,00,000
x = ` 75,000
`
A. Net Profit after Int., Tax & Pref. Dividend 75,000
B. Add : Pref. Dividend 15,000
C. Net Profit after Int. & Tax (A+B) 90,000
D. Add : Tax @ 50% 90,000
E. Net Profit before Tax 1,80,000
F. Interest on Long-term Debt @ 15% on ` 8,00,000 1,20,000
G. Operating Profit (E+F) 3,00,000
(iv) Calculation of Sales

Operating Cost Ratio = 87.5%
(Material + Labour + Mfg. Exp. + Dep. + Office & Selling Exp.)
Operating Profit Ratio = 100 – 87.5% = 12.5%
= Operating Profit/Sales × 100
Sales = ` 3,00,000/12.5% = ` 24,00,000
Materials = 40% of ` 24,00,000 = ` 9,60,000
Labour = 25% of ` 24,00,000 = ` 6,00,000

Manufacturing Expenses = 10% of ` 24,00,000 = ` 2,40,000
Office & Selling Expenses = 2.5% of ` 24,00,000 = ` 60,000
Q. 20. (a) The following information is available for the equity stock of Prakash Limited.
S0 = ` 120, E = ` 110, r = 0.12, = 0.40
Calculate the price of a 6 month call option as per the Black-Scholes model.
(b) The following information is avilable for the call and put options on the stock of Zenith Limited.
Call Put
Time to expiration (months) 3 3

Risk free rate 10% 10%
Exercise price ` 50 ` 50
Stock price ` 60 ` 60
Price ` 16 `2
Determine if the put-call parity is working :
Answer 20. (a)

E
C0 = S0 N(d1) N(d2)
ert
S0 1 2
ln r t
E 2
d1 =
t
d2 = d1 t
120 1
ln 0.12 0.16 0.5
110 2
d1 =
0.4 0.5
.0870 0.10
= 0.6612
0.2828
d2 = 0.6612 – 0.2828 = 0.3784
N (d1) = N(0.6612) = 0.7457
N (d1) = N(0.3784) = 0.6474
E 110 110
= 103.60
ert e0.12 0.5 1.0618
C0 = ` 120 × 0.7457 – ` 103.60 × 0.6474 = ` 22.41
Answer 20. (b)

According to the put-call parity
In the problems S0 = ` 60, P0 = ` 2, E = ` 50, r = 10% and t = 0.25

If the put-call parity were to work C0 should be
50
60 2 = ` 13.23
e0.10 0.25
The price of the call option is given to be ` 16, which is different from ` 13.23. So the put-call parity is not
working.
Q. 21. (a) Fresno Corporation Ltd., a US company will need £ 2,00,000 in 180 days. It considers using (1) a
forward hedge, (2) a money market hedge, (3) and option hedge, or (4) no hedge. Its analysts develop the
following information, whichcan be used to assess the alternative approaches to hedging :
• Spot rate of pound as of today = $ 1.50
• 180-days forward rate of pound as of today = $ 1.47
• Interest rates per annum are as follows :
UK US
180-days deposit rate 4.5% 4.5%
180-days borrowing rate 5.0% 5.0%
• A call option on pounds that expires in 180 days has an exercise price of $ 1.48 and a premium of $ 0.03
• Fresno Corporation forecasted the future sport rate in 180 days as follows :
Possible outcome Probability
$ 1.43 20%
1.46 70%
1.52 10%
Evaluate each alternative with necessary calculation and give your recommendations. (Assume 360 days in a
year.) — Ignore Transaction Cost or Taxes.
(b) The following information pertains to RICO Ltd.

(Amount in ` Lakh)
No profit 60
Outstanding 12% preference shares 200
Number of shares outstanding 6 lakh
Return on Investment 20%
Equity capitalization rate 16%
Required :
(i) What should be dividend pay-out ratio so as to keep the share price at ` 41.25 bu using WALTER
MODEL?
(ii) What is the optimum dividend pay-out ratio according to Walter Model.
Answer 21. (a)

Fresno Corporation Ltd.
Forward Hedge :
Purchase pounds 180 days forward :
Dollars needed in 180 days = Payable in £ × Forward Rate of £
= 2,00,000 × $ 1.47 = $ 2,94,000
Money Market Hedge :
Borrow $, Convert to £, Invest £, Repay $ loan in 180 days.
Amount in £ to be invested = £ 2,00,000 / (1+0.0225) = £ 1,95,599
Amount in $ needed to = £ 1,95,599 × $ 1.50
Convert into £ for depost = $ 2,93,398
Interest and principal
owed on $ loand and = 2,93,398 × 1.025
after 180 days = $ 3,00,733
Call Option :
Exercise = $ 1.48 : Premium = $ 0.03
Expected Premium Exercise Total Price Total Price Prob. Expected

Spot Rate Per Unit Option (including Paid for Pi Amount
In 180 days Paid for Premium £ 2,00,000 Pix (xi)
Option Paid per unit (xi)
$ 1.43 $ 0.03 No $ 1.46 $ 2,92,000 0.20 $ 58,400
1.46 0.03 No 1.49 2,98,00 0.70 2,08,600
1.52 0.03 Yes 1.51 3,02,000 0.10 30,200
$ 2,97,200
NO HEDGE Option / Remain Unhedge :
Future Spot Rate Dollars needed Prob. Expected

Expected in to Pi Amount
180 days Purchase £ 2,00,000 (xi) Pix (xi)
$ 1.43 $ 2,86,000 0.20 $ 57,200
1.46 2,92,000 0.70 2,04,400
1.52 3,04,000 0.10 30,400
$ 2,92,000
Decision : The probability distribution Outcomes for no hedge strategy appears to be must preferable to
Fresno Corporation Ltd.
Answer 21. (b)

RICO Ltd.
(` in lakh)
Net Profit 60.00
Less : Preference dividend
(0.12 × 200 lakh) 24.00
Earnings for Equity share holders 36.00
Earnings per share (EPS) = 36 lakh/6 lakh ` 6.00 per share
Let the dividend payout ratio be X. So the share price will be :

Here,
D = Dividend per share = 6x
P = [D + (E – D) (r/Ke)] / Ke
P = Market price per share = ` 41.25
E = Earnings per share = ` 6
r = Return on investment = 20% = 0.20
Ke = Cost of equity = 16% = 0.16
Hefe, ` 41.25 = [6x + (6 – 6x) (0.20/0.16)]/0.16
= [6x + (6 – 6x) ×1.25] / 0.16
= [6x + 7.50 – 7.5x] / 0.16
or, 6.6 = 7.50 – 1.5x
or 1.5x = 7.50 – 6.60 = 0.90
x = 0.90 / 1.5 = 0.60 i.e., 60%
So, the required dividend payout ratio will be : 60%.
(ii) According to Walter’s model where the return on investment (20%) is more than the cost of equity,
(16%) the price per share increase as the dividend payout ratio decrease. Hence the optimum dividend
payout ratio in this case is nil.
Q. 22. (a) What are forwards? How they can be used to hedge?
(b) On August 2, Mr. Tandon buys 5 contracts of December Reliance futures at 840. Each contract covers
50 shares. Initial margin was set at ` 2400 per contract while maintenance margin was fixed at ` 2000 per
contract. Daily settlement prices are as follows :
August 2 818
August 3 866
August 4 830
August 5 846
Mr. Tandon meet all margin calls. Whenever he is allowed to withdraw money from the Margin Account, he
withdraws half the maximum amount allowed.
Compute for each day : (i) Margin call;

(ii) Profit & (Loss) on the contract;
(iii) The balance in the Account at the end of the day.
Answer 22. (a)

Forwards are custom made contracts to buy or sell foreign exchange in the future at a specific price. Maturity
and size of contracts can be determined individually to almost exactly hedge the desired position.
The hedging method uses up bank credit lines even when two forward contracts exactly offset each other.
The company can hedge its receivables. It could sell dollars forward at a rate which it can obtain from the
bank today and thus know for certain the quantum of rupee inflows after three months. A similar approach
can be used in the case of a payable. In this case, the company could buy forward at a rate, which is known
to-day. A partial or full cover can be adopted by the firm depending on its perception of the risk involved.
All corporate treasurers, hedging their forex exposures with forward contracts, are aware that forward
contracts are best hedging instruments for safeguarding against adverse rate movements. Forward contracts
only turn the risk upside and lead to opportunity losses in the event of favourable market movements.
Answer 22. (b)

Computation of Margin Call, Profit/(Loss) and Balance in the account at the end of the day :
Initial Margin : 5 Contracts × 2400 = ` 12,000.
Maintenance Margin : 5 Contracts × 2000 = ` 10,000.
August, 2 Details Amount
`
Opening Balance —
Add : Initial Margin Paid 2400 × 5 Contaacts 12,000
Add : Profit & Loss To-day 5 Contracts × 50 shares × (– 22)/Shares (5,500)
Balance Before Margin 6,500
Add : Margin Call Paid (Balance fell below Maintenance margin)
To bring balance back to Initial Margin 5,500
Closing Balance 12,000

`
Opening Balance 12,000

Add : Profit & (Loss) To-day 5 Contracts × 50 Shares × (+ 48)/shares 12,000
Balance before withdrawl 24,000
Less : Profit withdrawn Half of (24,000 – 12,000) 6,000

`
Add : Profit & (Loss) To-day 5 Contracts × 50 Shares × (– 36)/Shares (9,000)
Balance before Margin Call 9,000
Add : Margin Call paid To bring balance back to initial Margin
(since balance fell below maintenance margin) 3,000

`
Add : Profit & (Loss) To-day 5 Contracts × 50 Shares × (+ 16/Shares) 4,000
Balance before withdrawn 16,000
Less : Profit withdrawn Half of (16,000 – 12,000) 2,000
Margin call whenever balance goes below = 5 Contracts × 2000 = ` 10,000
W ithdrawl (Half) Whenever margin A/c shows balance above 5 × 2,400 = ` 12,000.
Q. 23. (a) Write a short note on Index Future.

(b) An Indian importer has to settle a bill for $ 1,35,000.
The exporter has given the Indian Company two options :
(i) Pay immediately without any interest charge.
(ii) Pay after 3 months, with interest 6% p.a.
The importer’s bank charges 16% p.a. on overdrafts.
If the exchange rates are as follows, what should the company do?
Spot (` /$) : 48.35 / 48.36
3-month (` /$) : 48.81 / 48.83
Give reasons for your advice.
Answer 23. (a)

An index Future is a derivative whose value is dependent on the value of the underlying asset (e.g. BSE
Sensex, S & P, CNX Nifty). While trading on index futures, an investor is basically buying and selling the
basket of securities comprising an index in their relative weights.
Unlike commodity and other futures contracts index future contracts are settled in cash. Index futures
contract is basically an obligation to deliver a settlement, an amount equal to M (Multiplier) times the
difference between the stock index value on the expiration date of contract and the price at which the
contract was originally struck [indicated as (I – P) x M], (the value of M is pre-determined for each stock
Market Index). The transactions, in actual practice, are settled through clearing house and no actual or
physical delivery of stock is made. At the close of the trading session each day, every customer’s position is
marked to Market.
Index futures help an investor to take a position on the market and also hedge the share portfolio against
adverse market conditions.
Answer 23. (b)
INDIAN IMPORTER
Evaluation of comparative options offered by the exporter for settlement of payment.
$ `
Option 1 : Pay immediately without any interest charge
(a) Bill value converted to Indian Rupees (135000 × 48.36) 135000 65,28,600
(b) Interest on borrowing from Bank (O/D) @ 16% p./a. (for 3 month) 2,61,144
Total 67,89,744
$ `
Option 2 : Pay after 3 months, with interest @ 6% p.a.
(a) Bill value 135000
(b) Interest @ 6% p.a. for 3 months 2025
Conversion of Indian Rupees 137025
@ Forward ` / $ Rste (137025 × 48.83) 66,99,931
Saving 98,813
Advice : In the light of evaluated options — Supra, it is advisable to settle the payable after 3 months —
Since
(i) Rupee outflow is less by ` 98813 in the option 2
(ii) the 3 months forward premium on US $ is less than the interest differential.
Q. 24. (a) Explain what is meant by Free Cash Flow?

(b) Sumit Ltd. in planning to import an equipment from Japan at a cost of 3,400 lakh yen. The
company may avail loans at 18 per cent per annum with quarterly rests with which it can import the
equipment. The company has also an offer from Osaka branch of an India based bank extending credit
of 180 days at 2 percent per annum against opening of an irrecoverable letter of credit.
Additional information :
Present exchange rate ` 100 = 340 yen
180 day’s forward rate ` 100 = 345 yen
Commission charges for letter of credit at 2 percent per 12 months.
Advise the company whether the offer the foreign branch should be accepted.
Answer 24. (a)

Free Cash Flow is the cash flow available to a company from operations after interest expenses, tax, debt
repayments and lease obligations, any charge in working capital and capital spending on assets needed to
continue existing operations. The free cash flow is the legitimate cash flow for the purpose of business
valuation in that it reflects the cash flows generated by a company’s operations for all the providers (debt
and equity) of its capital. The free cash flow is a more comprehensive term as it includes cash flows due to
after tax non-operating income as well as adjustment for non-operating assets.
The procedure of determining FCF is exhibited below :
Operating earning after tax xxxxxx
Add : Depreciation, amortization and other non-cash items xxxxxx
Less : Investments in long term assets xxxxxx
Less : Investments in operating net working capital xxxxxx
Operating free cash flows xxxxxx
Add : Non-operating income/ cash flows after tax xxxxxx
Add : Decrease 9less in increase) in non-operating assets
(say marketable securities) xxxxx
Free Cash Flow xxxxx
A company that generates sufficient free cash flow has to decide how to use this cash flow. Primarily the
cash should be invested in such investments as will increase the shareholder wealth.
Any surplus cash after all positive NPV investments have been undertaken, should be returned to the
shareholders, in the form of (i) dividends or, (ii) by share repurchase.
Answer 24. (b)

Alternative I : Purchase of multipurpose machine by availing loan @ 18% interest p.a. (` lakhs)
Cost of machine 3,400 lakhs Yen (Conversion rate ` 100 = 340 Yen) 1,000.00
Add : 1st quarter interest (@ 18% p.a. on ` 1,000 lakhs) 45.00
Add : 2nd quarter interest (@ 18% p.a. on ` 1,045 lakhs) 47.03
Total cash outflow 1,092.03
Alternative II : Extension of 180 days credit by Osaka branch of an India-based bank (` lakhs)
Commission charges for establishment of letter of credit 10.00
(@ 2% per annum for 180 days on ` 1,000 lakhs)
Add : 1st quarter interest 0.45
2nd quarter interest 0.47
10.92
Amount payable at the end of 180 days (lakh Yen)

Cost 3,400.00
Interest @ 2% p.a. (3,400 × 2/100 × 180 / 365) 33.53
Total Yen 3,433.53
Amount in Rupees (` lakhs)

3,433.53
Conversion of Yen into rupees 100 995.23
3435
Add : Charges on letter of credit and interest charges thereon 10.92
Total cash outflow 1,006.15
Recommendation : The total cash outflow is lesser in case of Alternative II by ` 85.88 lakhs. Therefore,
import of machine by establishing letter of credit is suggested.
Q. 25. The following table shows interest rates for the United States Dollar and French Francs. The spot
exchange rate is 7.05 Francs per dollar. Complete the missing entries :
Particulars 3 Months 6 Months 1 Year

Dollar interest rate (annually compounded) 11½% 12¼% ?
Franc interest rate (annually compounded) 19½% ? 20%
Forward Franc per Dollar ? ? 7.5200
Forward discount on Franc per cent per year ? – 6.3% ?
Answer 25.
(a) Calculation of 3 months forward discount on Franc per cent per year and 3 months forward Franc per
Dollar
3 months Dollar interest rate = 11.5% or 0.115
3 months Franc interest rate = 19.5% or 0.195
As per Interest Rate Parity Theorem :
Interest rate differential = Exchange rate differential

1 rd Sf /d
=
1 rf Ff / d
where,
rf = Rate of interest of country with Francs as currency
rd = Rate of interest of country with Dollar as currency
Sf/d = Spot rate between Franc and Dollar
Ff/d = Forward rate between Franc and Dollar
Interest rate differential = Exchange rate differential
1 0.115
= Exchange rate differential (differential between forward rate and spot rate)
1 0.195
Differential between forward and sport = 93.3%
Forward discount on Franc per cent for 3 months = 93.3% – 100% = – 6.7%
Forward discount on Franc per cent for 3 months = – 6.7%/4 = – 1.675%
Sport rate of Franc against Dollar = 1/7.05 = 0.141844
Forward Franc = Today’s spot rate (difference between forward and spot rate)
= 0.141844 dollar (100% – 1.675%) = 0.1394681 dollar
Forward Franc per Dollar = 1/0.1394681 = 7.17
(b) Calculation of 6 months Franc interest rate and 6 months forward Franc per Dollar
6 months Dollar interest rate = 12 1/4% or 12.25%
Forward discount on franc % per year = – 6.3% or – 3.15% for 6 months
Hence 6 months Forward rate = 0.141844 dollar (spot rate) (100% – 3.15%)
= 0.13737 dollars
Forward francs per dollar = 1/0.13737 = 7.28 francs
Differential in interest rate between two countries
= Differential between Forward and Spot rate
1 Dollar interest rate

= Differential between Forward and Spot rate
1 Franc interest rate
1 .1225
= (100% – 6.3%)
1 .1225
= 93.7%
1.1225
1 + Franc interest rate =
93.7%
Franc interest rate = 1.19797 – 1 = 0.19797 or 19.8%
(c) Calculation of one year Dollar interest rate and one year forward discount on Franc
One year Franc interest rate = 20% Forward Franc per
dollar = 7.5200
($)
Today’s spot rate is 7.05 (given) Francs per Dollar i.e., 1 France 0.141844
Forward Frans is 7.52 Frans per Dollar i.e., 1 France 0.132978
Difference 0.008866
Forward discount on Francs per cent per year
0.008866
= 100 = – 6.25% or – 6.3% (rounded off)
0.141844
Differential in interest rates between two countries
= Differential between forward rate and spot rate
1 Dollar interest rate 7.05
=
1 0.20 7.52
Dollar interest rate = 1.20 × 0.9374 – 1
= 1.125 – 1 = 0.125 or 12.5%
Q. 26. (a) XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following information is
available :
Spot rate 1£ = $ 2.00
180 days forward rate of £ as of today = £ 1.96
Interest rates are as follows :
Particulars U.K. U.S.
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below :
Future rate ($) 1.91 1.95 2.05
Probability 25% 60% 15%
Which of he following strategies would be most preferable to XYZ Ltd.?
(i) a forward contract
(ii) a money market hedge
(iii) an option contract
(iv) no hedging
Show calculations in each case.
(b) For imports from UK, Philadelphia Ltd. of USA owes £ 6,50,000 to London Ltd., payable on
May, 2010. It is now 12 February, 2010.
The following future contracts (contract size £ 62,500) are available on the Philadelphia exchange :
Expiry Current futures rate
March 1.4900 $/£ 1
June 1.4960 $/£ 1
(i) Illustrate how Philadelphia Ltd. can use future contracts to reduce the transaction risk if, on 20 May
the spot rate is 1.5030 $/£ 1 and June futures are trading at 1.5120 $/£. The spot rate on 12
February is 1.4850 $/£ 1.
(ii) Calculate the “hedge efficiency” and comment on it.
Answer 26. (a)

(i) Taking a Forward Contract
US $ needed on expiration of 180 days
= £ 3,00,000 × $ 1.96 = $ 5,88,000
(ii) Money Market Hedge Transaction
Now :
Borrow in US dollars and invest in UK pounds on expiration of 180 days
On expiration of 180 days :
Repay in US $ :
US $ needed to purchase UK £
£ 3,00,000
= = £ 2,87,081
1 0.045
US $ needed to convert into UK £
= £ 2,87,081 × $ 2 = $ 5,74,162
Principal and interest payable in US $ loan on expiry of 180 days
= $ 5,74,162 × $ 1.055 = $ 6,05,741
(iii) Entering into Option Market by taking Call Option
Expected Premium Exercise Total price Total price for Probability (px)
spot rate per unit option per unit £ 3,00,000 (x) (p)
in 180 days
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200
2.05 0.04 Yes 2.01 6,03,00 0.15 90,450
5,94,900
Answer 26. (b)

(i) For Philadelphia Ltd. the appropriate futures contract will be the one that will expore soonest after
the end of the exposure period i.e. the June contract.
Number of contracts needed
= £ 6,50,000/£ 62,500 = 10.4 (say 10 contracts)
P Ltd. will buy 10 June contracts now (12 Feb.) at $1.4960/£1 and sell 10 contracts on 20 May for
$1.5120/£1, thus making a profit from the futures trading that will largely but not totally, netate the
‘loss’ from the spot market (since sterling has strengthened between 12 February and 20 May).
We now calculate the profit/loss from the futures contracts trade :
(i) The ‘tick’ movement is (1.5120 – 1.4960) = 0.0160 i.e., 160 ticks (for one tick = 0.00001)
(ii) ‘Tick’ value per contract = £ 62,500 × 0.00001 = $ 6.25
(iii) Profit = 10 contracts × 160 × $ 6.25 = $ 10,000
(iv) Overall cost on 20 May when P Ltd. will exchange $ for £ on the spot market :
(v) The net ‘cost’ to P Ltd.
= $ 9,76,950 – $ 10,000 = $ 9,66,950
(ii) Hedge Efficiency
The spot on February 12 was 1.4850 $/£1. So £650.000 would have cost $ 9,65,250 and the los on
the ‘spot market’ is $ (9,76,950 – 9,65,250) = $ 11,700.
The hedge efficiency is therefore the future contract profit divided by the spot market loss
$10,000
100 85.5%
$11,700
The inefficiency is due to :
(i) rounding the contracts to 10 from 10.4, and
(ii) basis risk - the fact that the movement on the futures price has not exactly equalled the movement
on the spot rate.
Q. 27. (a) The following quotes are avilable for 3-months options in respect of a share currently traded
at ` 31 :
Strike price ` 30
Call option `3
Put option `2
An investor devises a strategy of buying a call and selling the share and a put option. Draw his
profit/loss profile if it is given that the rate of interest is 10% per annum. What would be the
position if the strategy adopted is selling a call and buying the put and the share?
(b) What is the difference between Forward and Futures contracts?
Answer 27. (a)
Strategy I : Buying a call and selling a put and a shre
Initial cash inflow (` 31 – ` 3 + ` 2) = ` 30
Interest rate = 10%
Amount grows in 3 months to (30 × e1 × .25) = ` 30.76*
If the share price is greater than ` 30, he would exercise the call option and buy one share for ` 30 and his
net profit is ` 0.76 (i.e. ` 30.76 – 30).
However, if the share price is less than ` 30, the counter-party would exercise the put option and the
investor would buy one share at ` 30. The net profit to the investor is again ` 0.76.
Strategy II : Selling a call and buying a put and a share
In case, the investor has to arrange a loan @ 10% of ` 30 (i.e. ` 31 + ` 2 – ` ` 3).
This amount would be repaid after 3 months. Amount payable (30 × e1 × .25) is ` 30.76.
After 3 months, if the market price is more than ` 30, the counter-party would exercise the call option and
the investor would be required to sell the share at ` 30. The loss to the investor would be ` 0.76 (i.e. `
30.76 – 30).
However, if the rate is less than ` 30, the investor would exercise the put option and would get ` 30 from
the rate of share. The loss to be buyer would again be ` 0.76.
* Interest can also be calculated on simple interest basis instead of continuous compound interest.
Answer 27. (b)

Fundamentally, forward and futures contracts have the same function: both types of contracts allow people
to buy or sell a specific type of asset at a specific time at a given price.
However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-
traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private
agreements between two parties and are not as rigid in their stated terms and conditions. Because forward
contracts are private agreements, there is always a chance that a party may default on its side of the
agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers
the probability of default to almost never.
Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts,
settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily,
which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement
for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess
one settlement date.
Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in
which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never
happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the
volatility of an asset’s price, and delivery of the asset or cash settlement will usually take place.
Q. 28. Hedging with Commodity Futures :

Bharat Oil Corporation (BOC) imports crude oil for its requirements on a regular basis. Its
requirements are estimated at 100 tonnees per month.
Of late, there has been a surge in the prices of oil. The current price (month of June) of crude oil is `
5,500 per barrel. The firm expects the price to rise in coming months to ` 5,800 by August. It wants to
hedge against the rising prices for its requirements of the month of August.
Multi Commodity Exchange (MCX) in India offers a futures contract in crude oil. The contract size is 100
barrels and August contract is currently traded at ` 5,668 per barrel.
(a) How can BOC hedge its exposure against the rising price of crude oil?
(b) If Bharat Oil Corporation hede its exposure at MCX, how many contracts it must book?
(c) Analyse the position of BOC if in the month of August (i) the spot price is ` 5,750 and futures
price is ` 5,788, (ii) the spot price is ` 5,417 and futures market were matched?
Ignore marking-to-the-market and initial margin on futures contracts.
Answer 28.
1 tonnes = 7.33 barrels
(a) Hedging strategy would be to take position in the futures market opposite to that of in the physical
market.
BOC is short on crude oil and therefore they must go long on the futures of crude oil.
Following would be the hedging strategy :
June : Buy futures contract now
August : Purchase crude oil at the price prevailing then in the spot market, and Sell the future
contracts.
(b) Quantity to be imported/hedged = 100 tonnes or 733 barrels
Contract size = 100 barrels
Nos of contracts bought = 733/100 = 8 (rounded off)
(c) In August, the firm would buy its requirements of crude oil in the market and unwind its position in
the futures market by selling the contracts bought in June. By doing so, the gains/loss in the physical
market would be offset significantly.
August futures on crude oil = ` 5,668 per barrel
(i) When the price of crude oil rises :
Spot crude oil price = ` 5,750 Future price = ` 5,788
Purchase price in the spot for = 733 × 5750 = ` 42,14,750
Cash flow on futures position
Buying price 5668
Selling price 5788
Profit 120
Realizations from futures market = 8 × 100 × 120
= – ` 96,000
Net amount paid ` 41,18,750
Effective price per barrel = 41,18,750/733 = ` 5,619
(ii) When the price of crude oil falls :

Sport crude oil price = ` 5,417
Futures price = ` 5,455
Purchase price in the spot for = 733 × 5417 = ` 39,70,661
Cash flow on futures position
Buying price 5668
Selling price 5455
Profit – 213
Realisations from futures market = 8 × 100 × – 213
= ` 1,70,400
Net amount paid ` 41,41,061
Effective price per barrel = 41,41,061/733 = ` 5,649
(d) If positions in the physical market and futures market were matched then
The effective price would be = S1 – (F1 – F0)
When price rose the effective price paid is
= 5750 – (5788 – 5668) = ` 5,630 per barrel
When price fell the effective price paid is
= 5417 – (5455 – 5668) = ` 5,630 per barrel
Q. 29. Option Pricing – Black Scholes Model :
The following data is given :
Current stock price = ` 100.00
Strike Price = ` 110.00
Time to expiration = 3 months
Risk free rate of return = 6.00%
Variance of return on the stock = 0.0625
(a) Find out the value of the call option using Black Scholes Model.
(b) Find out the intrinsic value and the time value of the call option.
(c) Using put call parity, find out the value of the put option with same parameters.
(d) Find out the intrinsic values and time values of the put option.
Answer 29.
(a) The value of the call option for non-dividend paying stock is given by Black Scholes Model (BSM) :
c = SN(d1) – Xe–rtN(d2)
2
In(S / X) (r / 2)t
where d1 = ; and
t
2
In(S / X) (r / 2)t
d2 = or
t
Following values may be inserted in the BSM to find the value of the call.
Spot Price, s = ` 100.00
Exercise Price, X = ` 110.00
Time to expiry, t = 3 months = 0.25 years
Interest Rate, r = 6% p.a.
Satandard Deviation, = 25% p.a.
Inserting the values, we get :
d1 = – 0.5800; N(d1) = 0.2810
d2 = – 0.7050; N(d2) = 0.2404
S × N(d1) = 28.1000
PV of X = 108.3623
PV(X) × N(d2) = 26.0503
Call Value = S × N(d1) – PV (X) × N(d2) = ` 2.05
(b) Intrinsic value of call, Max (S – X, 0) = ` 0.00

Time value of the call = 2.05 – 0 = ` 2.05
(c) Put Call Parity states that the difference of the call and put price must be equal to the difference of spot
and present value of the exercise price.
c – p = S – PV (X)
p = c – S + PV (X)
= 2.05 – 100 + 108.36 = ` 10.41
(d) Intrinsic value of put, Max (S – X, 0) = ` 10.00

Time value of put Max (S – X, 0) = 10.41 – 10.00 = ` 0.41
Q. 30. A company has borrowed through a fixed rate instrument of 8%. The swap quote from the bank is
7.80/7.90, i.e., bank pays 7.80 fixed for receiving LIBOR and would receive 7.90% fixed for paying
LIBOR. The company enters the swap deal with the bank.
After some time, the swap market changes to 6.40/6.50 and the company again reverses the original
swap by entering into 2nd swap opposite to that of the first one.
(a) What does the structure of the first wap achieve?
(b) What is the cost of funds for the firm before and after the swap?
(c) What is the structure of 2nd swap and what does it do?
(d) Find the cost of funds for the company after the second swap?
Answer 30.
(a)The company would undertake the transform the fixed rate liability to floating rate, as it possibly
expects a decline in the interest rates.
Following would be the structure of the swap with the bank.
LIBOR
Fixed 8.00%
Company
Fixed 7.80%
(b)Cost of funds after swap = L + 0.2%
(c) The company would enter into a swap opposite to that of the first one. In the first swap, the firm
received fixed and paid variable. Now in the second swap, it would pay fixed while receiving LIBOR. This
would enable cancelling the floating leg. The company would gain the differential of the fixed legs of first
and second swap.
LIBOR LIBOR
Company
Fixed 7.80% Fixed 6.50%
Fixed 8.90%
(d) Pay fixed to borrowers 8.00

Receive fixed from bank (1st swap) – 7.80
Pay fixed to bank (2nd swap) 6.50
Effective cost after 2nd swap 6.70

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Revisionary Test Paper_Final_Syllabus 2008_June 2013

Paper-12 : FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

vii. ‘Straddle’ as a type of option trading means :

ix. Global Depository Receipts (GDR) are issued to :

Annual interest charge = ` 45,00,000 x 14/100 = ` 6,30,000

Kd = I (1 – t) = 6,30,000 (1 – 0.40) = 0.0884 or 8.84%

Leverage = ` 67,00,000 x 100 = 59.8%

iii) A – Make X will be cheaper

vi. A - Re. 0.5070

ASK (` / ¥ ) = ASK (`/ £) * ASK ( £ /$) * ASK($/ ¥)

vii. A – Gain ` 3,200

Value of bought shares Value of short future

Net Gain = `0.13200-`0.1000 lac = ` 3200/-.

= 78.9650 – 78.1255 x 12 x 100 = 2.1491% or 2.15%

Q. 2. Write short notes on :

EVA = PAT – ke x Equity

b) ABC Ltd. is contemplating whether to replace an existing machine or to spend money on

Year Maintenance (`) Salvage (`)

If we replace machine now :

If we replace machine after one year :

4% Mortgage Debenture A/c.

4% Mortgage Debenture holders’ A/c.

Accumulated Depreciation A/c.

Allowance for Inventory Loss A/c.

Reserve for Contingencies A/c.

Life Insurance Policy A/c.

Building and Machinery A/c.

b) A company has the following capital structure :

iv. Ordinary shareholder’s dividend is 12%

Therefore, overall return on capital employed = Profit . x 100

Q. 6. a) When a lease can be considered as a Financial Lease ?

PV factor close to 4,000 in 8 years is 4.0776 at 18%

IRR = 18% + 4.0776 - 4.000 x 1% = 18.63%

Lease Rent = ` 5,00,000 = ` 1,30,310 p.a.

= C0 – PV of SV = ` 5,00,000 – ` 23,300 = 3.837 or 20%

b) ABC Ltd. Provides you the following information :

Particulars Financial Financial Financial

(iv) Calculation of Indifference Point between Plan A and Plan B

EAT 0.6X – 3,600 0.6X – 5,400

At different point, EPS under both plans will be equal.

0.6X – 3,60 = 0.6X – 5,400

192X – 11,52,000 = 288X – 25,92,000

(v) Statement showing the calculation of Financial BEP

(vi) Statement showing the calculation of Cost or operating BEP

Particulars Plan A Plan B Plan C

Where P = Market price per share

Dividend per share (D) = ` 1,60,000 / 40,000 shares = `4

Rate of return on firms investment (Ra )

RC = Cost of capital (inverse of P/E ratio i.e. 1/10) = 0.10

P = 4 + (0.15/0.10) (15 – 4) = 20.50 = ` 205

Firm’s dividend payout ratio = ` 1,60,000/ ` 6,00,000 =0.2667 or 26.67%

P = 4 + (0.15/0.10) (15 – 0) = 22.50 = ` 225

Calculation of market value of share when P/E ratio is 5 instead of 10.

P = 4 + (0.15/0.20) (15 – 4) = 12.25 = ` 61.25

100 = P1 + 0 P1 = 100 x 1.12 = ` 112

(b) When dividend is declared

100 = P1 + 10 P1 + 10 = 100 x 1.12 = ` 102

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

Verification of M. M. Dividend Irrelevancy Theory