1

Question Paper
Financial Management (MB211) : April 2003

Part A : Basic Concepts (30 Points)


This part consists of questions with serial number 1 - 30.
Answer all questions.
Each question carries one point.
Maximum time for answering Part A is 30 Minutes.

1. Which of the following represents the variability of returns due to fluctuations in the level of
interest rates?
a. Interest rate risk
b. Market risk
c. Inflation risk
d. Liquidity risk
e. Financial risk.

2. Which of the following is a spontaneous source of financing current assets?
a. Overdrafts
b. Provision for dividends
c. Letter of credit
d. Cash credit
e. None of the above.

3. The return on investment of a firm is 14% and cost of equity capital is 12%. In order to
maximize the value of a firm according to Walter Model, the firm should
a. Adopt 100% dividend pay-out policy
b. Not pay dividends at all
c. Be indifferent as to the dividend policy
d. Plough back 50% of profits and pay the rest as dividends
e. Leave the decision of dividend payment to the discretion of Board of Directors.

4. Which of the following is/are true?
a. A company following an aggressive working capital policy will finance its current
assets more from long-term sources
b. A company following a conservative working capital policy will finance its current
assets more from long-term sources
c. A company having a conservative working capital policy will have a higher current
ratio than one following an aggressive working capital policy
d. Both (a) and (c) above
e. Both (b) and (c) above.

5. The objective of financial management is to
a. Maximise the revenues
b. Minimise the expenses
c. Maximise the return on investment
d. Minimise the risk
e. Maximise the wealth of the owners by increasing the value of the firm.

6. Net working capital is equal to
a. Current assets Current liabilities.
b. Fixed assets current assets
c. Current Assets Cash
d. Long term loans short term loans
e. Current liabilities provisions.



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7. Which of the following is not a source of long-term finance?
a. Equity capital
b. Preference capital
c. Debenture capital
d. Commercial paper
e. Reserves and surplus.

8. Which of the following is false with regard to the multiperiod valuation model of equity
shares?
a. There is a pre-specified maturity period
b. The value of an equity share is equal to the present value of the dividends over an
infinite duration
c. The model can be applied to the instances of constant dividends and constant growth in
dividends
d. The model can also be applied in case of variable growth in dividends
e. None of the above.

9. Which of the following is not a source of long term finance?
a. Reserves and surplus
b. Equity capital
c. Cash credit
d. Deferred credit
e. Debenture capital.

10. Which of the following is not assumed by the economic order quantity model?
a. Purchase price per unit is constant
b. Carrying cost per unit is constant
c. The ordering cost declines as the order size increases
d. Delivery is instantaneous
e. Demand is uniform over the planning period.

11. Consider the following information regarding Super Toys Ltd:
Annual cost of sales : Rs.18,00,000
Opening stock of finished goods : Rs.60,000
Finished goods storage period : 10 days
Assuming 360 days in a year, the closing stock of finished goods is
a. Rs. 40,000
b. Rs. 50,000
c. Rs. 60,000
d. Rs.1,20,000
e. Rs.1,80,000.

12. Which of the following is not the logical consequence of liberalizing credit standards?
a. Sales tend to increase
b. Investment in receivables tend to increase
c. Bad debt losses tend to increase
d. Requirement of finance for working capital tends to decrease
e. Collection costs tend to increase.

13. The economic order quantity is the order quantity which
a. Minimizes ordering costs
b. Minimizes carrying costs
c. Maximizes ordering costs
d. Maximizes carrying costs
e. Minimizes the total of ordering and carrying costs.



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14. Which of the following is not true with regard to the internal rate of return criterion?
a. It considers the time value of money
b. It considers the cash flow stream over the entire investment horizon
c. It remains unaffected by the pattern of cash inflows and outflows
d. It is the rate of return which equates the present value of cash inflows to the present
value of cash outflows
e. If the net cash flows are discounted by the IRR then the net present value will be equal
to zero.

15. Other things being equal, which of the following will cause an increase in the yield to
maturity?
a. Decrease in coupon rate
b. Increase in the issue price
c. Decrease in the amount repayable at maturity
d. Decrease in the maturity period
e. None of the above.

16. Which of the following appraisal methods is preferred for comparing mutually exclusive
projects providing similar service but having differing patterns of costs and unequal life
spans?
a. Annual capital charge
b. Benefit cost ratio
c. Net present value
d. Accounting rate of return
e. Payback period.

17. Which of the following is/are not considered for the cost-benefit analysis of capital
investment decisions?
a. Opportunity costs
b. Incremental costs
c. Sunk costs
d. Taxes
e. Both (c) and (d) above.

18. If the slope of the Security Market Line is zero then, which of the following is true?
a. Beta is equal to zero
b. Risk free return = Market return = Expected return of the given security
c. The returns on the given security are not correlated with the returns on the market
d. Risk free rate of return Market return
e. Market return Expected return of the given security.

19. Which of the following is not a feature of an optimal capital structure?
a. Profitability
b. Liquidity
c. Flexibility
d. Control
e. Solvency.

20. Which of the following represents the amount that can be realized by a company if it
terminates its business and sells all its assets?
a. Book value
b. Liquidation value
c. Replacement value
d. Going concern value
e. Market value.



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21. Which of the following is not a diversifiable risk?
a. Lock-out in a company due to workers demanding a wage hike
b. Recession in the economy
c. Lack of strategy for the management of a company
d. A change in the product portfolio of a company
e. Entry of new competitors into the market.

22. In which of the following types of issues does the amount of share capital increase without
any increase in the net worth of the company?
a. Public issue
b. Rights issue
c. Bought-out deal
d. Bonus issue
e. Private placement.

23. Which of the following is an external hedging technique?
a. Hedging through sourcing
b. Hedging by choosing the currency of invoicing
c. Hedging through forwards market
d. Hedging by exposure netting
e. Hedging by leading and lagging

24. Which of the following is a disadvantage of bought-out-deals?
a. It is more expensive than public issue
b. It involves time consuming procedure
c. It is difficult to convince a wholesale investor
d. Promoters are not assured of immediate funds
e. There is a chance of misuse of power by the sponsor.

25. Which of the following statements is false?
a. A sole proprietorship firm is inexpensive to set up
b. Death of one of the partners may result in the dissolution of the partnership firm
c. The minimum number of persons required to form a private company is 2 whereas it is
3 in case of a public company
d. The maximum number of members of a private limited company is 50
e. The ability to raise funds is limited for a partnership firm whereas for a public company
it is substantial.

26. The risk that arises when the costs of liabilities and the yields of assets are linked to different
benchmarks resulting in a floating rate, is called
a. Volatility risk
b. Reinvestment risk
c. Rate level risk
d. Real interest rate risk
e. Basis risk

27. Which of the following players cannot act as a borrower in the call money market?
a. Discount and Finance House of India
b. SBI Mutual Fund
c. State Bank of India
d. Securities Trading Corporation of India
e. Reserve Bank of India.



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28. The operating exposure
a. Represents the exposure that arises from the need of a firm to convert values of foreign
currency denominated assets and liabilities into domestic currency values.
b. Represents the exposure that arises from foreign currency denominated transactions
which a firm is committed to complete
c. Represents the exposure of current profits of a firm to the movements in exchange rates
d. Represents a notional exposure as there is no real gain or loss arising out of exchange
rate movements
e. Arises out of the economic consequences of exchange rate movement on the value of a
firm

29. Which of the following is/are the function(s) of the secondary capital market?
a. Providing a market for trading outstanding long term securities
b. Providing a market for trading outstanding short term securities
c. Helping companies to raise funds for long term uses by creating new securities
d. Imparting liquidity to existing long term securities held by investors
e. Both (a) and (d) above.

30. Which of the following is false with regard to the clearing house to a futures exchange?
a. It ensures adherence of system and procedures for smooth trading
b. It minimizes credit risk by being a counter party to all trade
c. It accounts for all the gains or losses on a weekly basis
d. It ensures delivery of payment for the assets on the maturity date for all the outstanding
contracts
e. None of the above.


END OF PART A




























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Part B : Problems (50 Points)
This part consists of questions with serial number 1 - 5
Answer all questions.
Points are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Part B.
1. You are required to answer the following questions:
a. National Finance Ltd. (NFL) has various deposit schemes which offer the same effective rate of
interest as10 percent per annum compounded half yearly. If you save Rs.100 at the beginning of every
month with NFL in a monthly recurring deposit scheme which has a maturity period of three years
then, what will be the maturity value at the end of three years?
b. Mr. Sharma has taken a car loan of Rs.4 lakh from Orient Bank Ltd. (OBL) on the terms that the loan
will be repaid with interest in equated monthly installments, each payable at the end of every month,
over the next five years. On all the loan schemes covering a period of four to six years and having
different terms of payment, the effective rate of interest charged by OBL is equivalent to 12 percent
per annum compounded quarterly.
Calculate the amount of equated monthly installment payable by Mr. Sharma over a period of five
years.
(4 + 4 = 8 points)
2. Modern Trading Ltd. (MTL), a trading concern, had the following receipts of an item, coded TF05, over the
last quarter:
Month January February March
Receipts (Rs.) 63,000 72,000 81,000
The opening balance of the item in January was Rs.54,000 and the closing balance of the item in March
was Rs.90,000. The purchase price of the item is Rs.18 per unit and the carrying cost is 25% of the average
inventory value per annum. The cost for placing an order is fixed and it is Rs.900 per order. The purchase
price per unit of the item has not changed in the last quarter and it is not expected to change in the next six
months which is the planning period. Their supplier, Agrawal Industries Ltd. (AIL), has offered a discount
of 2.5% on order sizes of 6,000 units and above. It is assumed that the demand for the item is evenly
distributed over the entire year.
You are required to find out the following:
a. The economic order quantity of the item.
b. The optimal order size for the item. Clearly show the relevant costs and benefits involved. Ignore
taxes.

(5 + 6 = 11 points)


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3. The following information pertains to Mukund Chemicals Ltd. (MCL) for the financial year 2002-03:
Income Statement
(Rs. in millions)
Sales 1,400
Increase in stocks 100
Other income 50
Revenues 1,550
Purchase of raw materials 700
Wages and salaries 150
Power and fuel 120
Depreciation 40
Excise duty 100
Advertising and promotional expenditure 100
Freight on finished goods 50
General administrative costs 80
Interest and finance charges 50
Expenses 1,390
Profit before tax 160
Tax (40)
Profit after tax 120
Other information:
i. The opening stocks of raw materials, work-in-process and finished goods are:
(Rs. in millions)
Raw materials 105
Work-in-process 30
Finished goods 134
ii. The increase in stocks consists of the following changes:
(Rs. in millions)
Increase in the stock of raw materials : 50
Increase in the stock of work-in-process : 60
Decrease in the stock of finished goods : 10
iii. The sales are entirely on credit basis. The opening balance of sundry debtors was Rs.180 million.
During the year collections made from the sundry debtors amounted to Rs.1340 million.
iv. The purchases are entirely on credit basis. The opening balance of the sundry creditors was Rs.160
million. During the year Rs.740 million was paid to the sundry creditors.
v. Wages and salaries, and depreciation entirely relate to the manufacturing operations of the company.
vi. Assume 1 year = 360 days.
You are required to find out the operating cycle of the company.

(15 points)



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4. Western Ventures Ltd. is considering a project which will entail the following revenues and expenses:
(Rs. in lakhs)
Year 1 2 3 4 5
Sales 50 50 60 60 60
Operating cost 30 30 35 35 35
Depreciation 4 4 4 4 4
Interest on short term bank loan 5 5 5 5 5
Interest on term loan 1.30 1.04 0.78 0.52 0.26
The tax rate applicable to the company is 30%. The project involves the following outlays:
(Rs. in lakhs)
Plant and Machinery 25.00
Working capital 46.25
Total outlay 71.25
The proposed scheme of financing is given below:
(Rs. in lakhs)
Equity capital 30.00
Term loan 10.00
Short term bank loan 31.25
Total financing 71.25
At the end of 5 years the net salvage value of the current assets will be equal to their book value and the net
salvage value of the fixed assets will be equal to Rs.5 lakhs. The short term bank loan will be repaid at the
end of 5 years and the term loan will be repaid over the life of the project in equal installments. The cost of
capital for the project is 19%.
You are required to answer the following questions:
a. Derive the net cash flows relating to the long term funds invested in the project.
b. Appraise the project using the net present value criterion.
(7 + 2 = 9 points)
5. Pioneer Industries Ltd. has the following capital structure:
Equity share capital:
There are 150,00,000 equity shares of Rs.10 each fully paid up. Presently the shares have a market price of
Rs.27 per share. The company has recently paid dividends to its equity shareholders amounting to Rs.4.05
crores. The dividends have been growing at the rate of 4% over the years and this growth rate is expected to
continue in future.
Reserves and surplus:
The reserves and surplus amounts to Rs.41.85 crores.
Debentures:
There are 20,00,000 debentures of Rs.100 each which are redeemable at a premium of 4% after five years.
The coupon rate on these debentures is 10.8% and the current yield on these debentures is 11.25%. The net
amount realized per debenture is Rs.97.
Term loan:
The amount of term loan is Rs.80 crores and carries an interest rate of 12.5%. The market value of the term
loan is equal to its book value.
The tax rate applicable to the company is 30%.
You are required to find out the following:
a. The costs of the various sources of finance used by the company.
b. The weighted average cost of capital using market value weights.
(4 + 3 = 7 points)
END OF PART B


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Part C : Applied Theory (20 Points)
This part consists of questions with serial number 6 - 8.
Answer all questions.
Points are indicated against each question.
Do not spend more than 25 -30 minutes on Part C.

6. Explain briefly the forms in which liquidity may be maintained by an organization in order to manage the
requirements for cash.
(6 points)
7. Briefly explain the functions performed by the financial system in an economy.
(7 points)
8. Briefly explain the different forms of business combinations.
(7 points)

END OF PART C

END OF QUESTION PAPER











































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Suggested Answers
Financial Management (MB211) :
Part A : Basic Concepts
1. Answer : (a)
Reason : Variability of returns due to fluctuations in interest rates is referred to as interest rate risk. Hence,
(a) is true.
Market risk refers to the variability of returns due to fluctuations in the securities market,
inflation risk refers to the reduction of purchasing power, business risk refers to the risk of doing
a particular business and financial risk refers to the risk arising out of the use of debt financing.
2. Answer : (b)
Reason : Spontaneous sources of finance are the one which arise in the normal course of business and they
do not entail any explicit cost to the company e.g. accrued expenses, provisions and trade credit
etc. (a) and (d) are not correct as though they are used as short term source they have cost
attached with them. Further (c) is not correct as letter of credit is not a spontaneous source
3. Answer : (b)
Reason : As per Walter Model
P
0
=
k
k / r ) D E ( D +

Where, the notations are in their standard use.
As the given return on investment (r) > cost of equity (k) the company will maximize the value
of share if no dividends are paid
4. Answer : (e)
Reason : Statement (a) is not correct as an aggressive working capital policy will finance its current assets
more from short-term sources.
5. Answer : (e)
Reason : When the market value of the firm increases the wealth of its owners increases. The ultimate
objective of financial management is to maximize the wealth of the owners. All the other
alternatives may not necessarily maximize the wealth of the owners.
6. Answer : (a)
Reason : Current assets less current liabilities is equal to net working capital.
7. Answer : (d)
Reason : Commercial papers are instruments for raising short term finance. All other alternatives represent
sources/instruments of long term finance.
8. Answer : (a)
Reason : According to the multiperiod valuation model, the value of an equity share is the discounted
value of the stream of dividends over an infinite duration. Hence, (a) is false and (b) is true.
This model can be used for raising, declining, constant or randomly fluctuating dividend stream.
Hence, the model can be applied to the situations given in (c) and (d) above. Hence, (a) is the answer
9. Answer : (c)
Reason : Cash credit is not a source of long term finance. It is a type of short term bank finance.
Alternative (a), (b), (d), and (e) represent sources of long term finance.
10. Answer : (c)
Reason : The EOQ model assumes constant ordering cost irrespective of the order size. Alternatives (a),
(b), (d) and (e) represent assumptions behind the EOQ model.





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11. Answer : (a)
Reason : Finished goods storage period =
sales of cost daily Average
goods finished of stock Average

10 =

,
_

360
000 , 00 , 18
goods finished of stock Average

or Average stock of finished goods = 10 x 5,000 = Rs. 50,000
Average stock =
2
stock Closing stock Opening +

or Closing stock = 2 Average stock Opening stock
= 2 50,000 60,000 = Rs.40,000.
12. Answer : (d)
Reason : Alternatives (a), (b), (c) and (e) represent the logical consequences of liberalizing the credit
standards because such an action leads to increase in credit sales and the aforesaid statements are
the logical consequences.
Alternative (d) is not the logical consequence because the investment in receivables increases
and the financing need for working capital also increases.
13. Answer : (e)
Reason : The economic order quantity is the order size that minimizes the total of ordering and carrying
costs.
14. Answer : (c)
Reason : Alternatives (a), (b), (d) and (e) are true with regard to the internal rate return. Alternative (c) is
not true because the pattern of cash inflows and outflows affect the internal rate of return
15. Answer : (d)
Reason : Other things being equal, if there is a decrease in maturity period, the redemption price is
received earlier and hence the discounted price will be more compared to the discounted price in
case of a higher maturity period. Hence, the yield on the bond will be more in case of lower
maturity period. Hence (d) is true. Decrease in coupon rate will decrease the cash inflows and
hence decrease the yield to maturity. Hence, (a) is not true. Increase in the issue price will
increase the cash outflow (issue price) for the same inflows (amount repayable at maturity and
coupon payments) and hence decrease the yield to maturity. Hence (b) is also not true. Decrease
in the amount repayable at maturity will decrease the cash inflows and hence the yield. Hence,
(c) is also not true.
16. Answer : (a)
Reason : Annual capital charge is generally used for comparing mutually exclusive projects which provide
similar service but have differing patterns of costs and unequal life spans.

17. Answer : (c)
Reason : Sunk costs are not considered for the cost-benefit analysis of capital investment decisions.
Opportunity costs, incremental costs and taxes are considered.
18. Answer : (b)
Reason : According to the SML equation:
k
j
= R
f
+
j
(k
m
R
f
)
The slope is (k
m
R
f
). When the slope is zero, k
j
= R
f
+ 0 = R
f

Further, km R
f
= 0 implies that k
m
= R
f

R
f
= k
m
= k
j

i.e. Risk free rate of return = Market return = Expected return of the given security.


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19. Answer : (b)
Reason : Liquidity is a feature of the investments made out of the funds raised. It is not a feature of the
capital structure of the company.
20. Answer : (b)
Reason : Book Value is an accounting concept. Assets are recorded at historical costs and they are
depreciated over years. Book value may include intangible assets at acquisition cost minus
amortized value.
Replacement Value is the amount that a company would be required to spend if it were to
replace its existing assets in the current condition.
Liquidation Value is the amount that a company could realize if it sold its assets after having
terminated its business.
Going Concern Value is the amount that a company could realize if it sold its business as an
operating one.
Market Value of an asset or security is the current price at which the asset or the security is being
sold or bought in the market
21. Answer : (b)
Reason : Alternatives (a), (c), (d) and (e) represent risk factors which are specific to the firm and can be
diversified away.
22. Answer : (d)
Reason : Some companies distribute profits to the existing shareholders by way of fully paid bonus shares
in the ratio of existing shares held. In this method of issue though the amount of share capital is
increased there will not be any increase in the networth because it is just conversion of eligible
reserves into share capital. Hence, answer is (d).
Public issue is the method of raising capital from the public. In this method there will be an equal
increase in the share capital and networth of the company. Rights issue is the method of raising
capital from the existing members by offering shares to them on pro-rata basis. This method also
results in an increase in share capital and networth of the company. Bought out deals is the
method of raising capital by a company by initially placing its shares, which are to be offered to
the public at a later date, to a merchant banker, who in turn off loads the shares at the appropriate
time. In this method too, share capital and inturn networth of the company are increased by the
issue amount. Private placement, the method raising capital from a limited number of
sophisticated investors, also results in increase in share capital and networth of the company.
Hence, (a), (b), (c) and (e) are not the answers.
23. Answer : (c)
Reason : Hedging through forward markets is an external hedging technique where as the other
alternatives indicate internal hedging techniques.
24. Answer : (e)
Reason : Bought-out deal is the method of raising capital by placing its shares initially with a sponsor
which are later on offered to the public by the sponsor at an appropriate time. This type of issue
provides quickest and cheapest source of fund as it does not involve time consuming and costly
procedure of the public issue. Moreover, as this type of issue involves placing of shares with the
sponsor it is easy to convince the sponsor, rather than the public at large, regarding the real worth
of the shares. However, there is always a chance of misuse of power by the sponsor because the
success or failure of this type of issue depends on the sponsor. Hence, (e) is the correct answer.
25. Answer : (c)
Reason : A group of persons working towards common objective is a company and the minimum number
of persons required to set up a private company is 2 and for a public company it is 7. Hence, (c)
is not true.
The simplest form of business organization is sole-proprietorship firm. As it is owned by a single
person and free from governmental regulations it is very inexpensive to set up. Hence, (a) is true.
A partnership firm is formed by two or more persons by agreement. The life of the firm depends
on the agreement and the death or withdrawal of a partner may result in the dissolution of the
firm. Hence, (b) is true. According to Sec 3(1)(iii) of the Companies Act, 1956, a private
company is one, which cannot have members more than 50. Hence, (d) is true. As a public
limited company can raise equity capital through issuance of shares to the public its ability to


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raise funds is substantial. Hence, (e) is true.
26. Answer : (e)
Reason : The risk that arise when the costs of liabilities and the yields of assets are linked to different
benchmarks resulting in a floating rate with no simultaneous movement in the benchmark rates is
called basis risk.
27. Answer : (b)
Reason : All the participants in the call money market are split into two categories. The first comprises of
the entities who can borrow as well as lend in the market and the second comprises of only
lenders i.e. the participants in the second category cannot borrow in the call money market. RBI,
DFHI, STCIL and commercial banks belong to the first category and all the financial institutions
and mutual funds belong to the second. Hence, (b) cannot borrow in the call money market
28. Answer : (e)
Reason : Operating exposure is a result of economic consequences rather than accounting consequences of
exchange rate movements on the value of a firm
29. Answer : (e)
Reason : Capital market deals with all transactions in long-term securities. Capital market can be
classified as primary or secondary capital markets. A secondary capital market is one, where all
long term securities are traded whereby it imparts liquidity and marketability to these securities.
Hence, (a) and (d) are true.
All short-term securities are traded in secondary money market. Hence, (b) is incorrect. Issuance
of long-term securities to raise funds is done in primary capital markets. Hence, (c) is incorrect.
30. Answer : (c)
Reason : The functions of clearing house include. It ensures adherence to system and procedures for
smooth trading. It minimizes credit risk by being a counter party to all trades. It accounts for all
the gains or losses on daily basis. It ensures delivery of payment for the assets on the maturity
date for all the outstanding contracts.



















14
Part B : Problems
MB211
1. a. Effective monthly rate of interest per month is given by
(1 + r)
12
=
2
2
10 . 0
1
,
_

+ = (1.05)
2

r = {(1.05)
1/6
1} 100% = 0.8165%
This is a case of annuity due because the cash flows occur at the beginning of every month.
Hence, the maturity value will be
= 100
r
} 1 ) r 1 {(
n
+
(1 + r) =
36
(1.008165) 1
(1.008165) 100
0.008165

= Rs.4,199 (approx.)
b. The effective rate of interest k per month is given by
(1 + k)
12
=
4
4
12 . 0
1
,
_

+ = (1.03)
4

k = {(1.03)
1/3
1} 100% = 0.9902%
This is a case of regular annuity.
PVIFA(0.9902%, 60)

=
60
60
) 009902 . 1 ( ) 009902 . 0 (
1 ) 009902 . 1 (
= 45.075
Hence, the required EMI will be:

Rs.4, 00, 000
45.075
= Rs.8,874 (approx.)
2. a. Economic order quality (EOQ) =
C . P
FU 2

Usage (U) during the planning period:
Usage in the last quarter = Opening balance + Total receipts closing balance
= 54,000 + (63,000 + 72,000 + 81,000) 90,000
= Rs.180,000.
Usage in the last quarter (in units) =
18
000 , 180
= 10,000 units
Usage (U) in the planning period of next six months = 10,000 2 = 20,000 units
Fixed cost per order, F = Rs.900 (given)
Unit price P = Rs.18 (given)
Carrying cost for the entire year = 25%
Carrying cost for the planning period of six months, C =
2
25
= 12.5%
Economic order quantity (EOQ) =
) 125 . 0 ( 18
000 , 20 900 2

= 4,000 units
b. Let the EOQ be denoted as Q
*
and let the minimum required order size for getting the discount be
denoted Q .
Net incremental benefit, = UD +
1
]
1

Q
U
* Q
U
F -
1
]
1

2
PC . * Q
2
C ) D P ( Q

Q* = 4000 units (from above)


15
Q = 6000 units (given)
Discount per unit, D = Price per unit Percentage of discount
=
100
) 5 . 2 ( 18
= Re. 0.45
Discount earned over the entire planning period = UD = 20,000 0.45 = Rs.9,000
Savings in ordering cost =
1
]
1

Q
U
* Q
U
F = 900 .
000 , 6
000 , 20
000 , 4
000 , 20
1
]
1

= Rs.1500

Increase in carrying cost =
1
]
1

2
PC . * Q
2
C ) D P ( Q

=
( )
2
) 125 . 0 ( ) 18 ( ) 000 , 4 (
2
125 . 0 ) 45 . 0 18 ( ) 000 , 6 (

= Rs.2081.25
Net incremental benefit, = 9,000 + 1,500 2081.25
= Rs.8418.75 (gain)
Thus we find that there is a gain of Rs.8418.75. Hence the optimal order size should be 6,000 units.

3. a. Raw materials storage period:
1. Annual consumption of raw materials
= Opening stock of raw materials + Purchases Closing stock of raw materials
Closing stock = Opening stock + Increase in stock
= 105 + 50 = Rs.155 millions
Annual consumption of raw materials = 105 + 700 155 = Rs.650 millions
2. Average daily consumption of raw materials =
360
650

3. Average stock raw materials =
2
stock Closing stock Opening +

=
2
155 105+
= Rs.130 millions
4. Raw materials storage period =

,
_

360
650
130
) 2 (
) 3 (
=
650
360 130
= 72 days
b. Work-in-process (WIP) period:
1. Average stock of work-in-process =
2
stock closing stock Opening +

Closing stock = Opening stock + Increase in stock
= 30 + 60 = Rs.90 millions.
Average stock of work-in-process =
2
90 30 +
= Rs.60 millions
2. Annual cost of production =
Opening stock of WIP + consumption of raw materials + wages and salaries + power and fuel +
depreciation closing stock of WIP
30 + 650 + 150 + 120 + 40 90 = Rs.900 millions.



16
3. Average daily cost of production =
360
) 2 (
=
360
900
= Rs. 2.5 millions
4. Work-in-process period =
) 3 (
) 1 (
=
5 . 2
60
= 24 days
c. Finished goods storage period
1. Average stock of finished goods =
2
stock closing stock Opening +

Closing stock = Opening stock Decrease in stock
= 134 10 = Rs.124 millions
Average stock of finished goods =
2
124 134 +
= Rs.129 millions
2. Annual cost of sales = Opening stock of finished goods + Annual cost of production + Excise
duty + Selling and distribution costs + General administrative expenses Closing stock
= 134 + 900 + 100 + (100 + 50) + 80 + 50 124
= Rs.1290 million
3. Average daily cost of sales =
360
) 2 (
=
360
1290
= Rs. 43/12 millions
4. Finished goods storage period =
) 3 (
) 1 (
=
12 / 43
129
= 36 days
d. Average collection period:
1. Annual credit sales = Rs.1400 million
2. Average daily credit sales =
360
1400
= Rs. 35/9 millions
3. Average balance of sundry debtors =
2
balance Closing balance Opening +

Closing balance = Opening balance + Annual credit sales Collections
= 180 + 1400 1340 = Rs.240 millions
Average balance of sundry debtors =
2
240 180 +
= Rs.210 millions.
4. Average collection period =
) 2 (
) 3 (
=
) 9 / 35 (
210
= 54 days
e. Average payment period
1. Annual credit purchases = Rs.700 millions
2. Average daily credit purchases =
360
700
= Rs. 35/18 millions
3. Average balance of sundry creditors =
2
balance Closing balance Opening +

Closing balance = Opening balance + Credit purchases Payments
= 160 + 700 740 = Rs.120 millions
Average balance of sundry creditors =
2
120 160 +
= Rs.140 millions
4. Average payment period =
) 2 (
) 3 (
=
18 / 35
140
= 72 days
Operating cycle period = A + B + C + D E
= 72 + 24 + 36 + 54 72
= 114 days.


17

4. a.
Year 0 1 2 3 4 5
A Investment
1
(40)
B Profit before tax
2
11 11 16 16 16
C Tax (30%) (3.3) (3.3) (4.8) (4.8) (4.8)
D Profit after tax 7.7 7.7 11.2 11.2 11.2
E Net salvage value of fixed assets 5
F Net salvage value of current assets 46.25
G Repayment of short term bank loan (31.25)
H Initial flow (40)
I Operating flow (D + 4)
3
11.7 11.7 15.2 15.2 15.2
J Terminal flow (E + F G) 20
K Net cash flow (H + I + J) (40) 11.7 11.7 15.2 15.2 35.2
Working notes:
1. Investment = Total long term funds invested in the project
= Equity capital + Term loan = 30 + 10 = Rs.40 lakhs.
2. Profit before tax = Sales Operating cost Depreciation Interest on short term bank loan.
Interest on term loan has been excluded from the calculation of profit before tax (PBT) and profit
after tax (PAT) because the post tax cost of long term funds which is used for discounting the net
cash flows relating to long term funds, includes the post-tax cost of term loan.
3. Operating flow = PAT + Depreciation
Depreciation = 4
Operating flow = PAT + 4
b. Net present value (NPV) = I
) k 1 (
CF
t
t
5 t
1 t

= 40
) 19 . 1 (
2 . 35
) 19 . 1 (
2 . 15
) 19 . 1 (
2 . 15
) 19 . 1 (
7 . 11
19 . 1
7 . 11
5 4 3 2
+ + + + = Rs.9.44 lakhs.
5. a. Cost of equity capital (k
e
):
k
e
= g
P
D
0
1
+
D
1
= D
0
(1 + g)
D
0
= Current dividend per share =
crores 5 . 1
crores 05 . 4 . Rs
= Rs.2.70
(Number of equity shares = 150,00,000 = 1.5 crores)
k
e
= 04 . 0
27
) 04 . 1 ( 70 . 2
+ = 0.144 i.e., 14.4%.
Cost of retained earnings i.e., reserves and surplus (k
r
):
K
r
= k
e
= 14.4%
Cost of debenture capital (k
d
):


18

2
P F
n
P F
) t 1 ( I
k
d
+

+

I = Rs.10.80 (given)
t = 0.30 (given)
F = 100 + 4 = Rs.104
P = Rs.97
n = 5 years
k
d
=
2
97 104
5
) 97 104 (
) 30 . 0 1 ( 80 . 10
+

+
= 0.08915 8.92%
Cost of term loan (k
t
):
% 75 . 8 ) 30 . 0 1 ( 5 . 12 k
t

b. Computation of market values: (Rs. in crores)
Equity share capital: Rs.27 1.5 crores 40.5
Debenture capital : debentures of Number x
yield Current
amount Coupon


= 2000000 x
1125 . 0
80 . 10

= Rs.192000000 i.e., 19.2
Term loan 80
Total market value 139.7
Computation of weights:
Weight for equity by capital (w
e
) =
7 . 139
5 . 40
0.29
Weight for debenture capital (w
d
) =
7 . 139
2 . 19
0.14
Weight for term loan (w
t
) =
7 . 139
80
0.57
1.00
Weighted average cost of capital
= w
e
k
e
+ w
d
k
d
+ w
t
k
t

= (0.29) (14.4) + (0.14) (8.92) + (0.57) (8.75)
= 10.41% (approximately)












19
Part C: Applied Theory

6. Forms of Liquidity
Cash Balance in the Current Account: This is the highest form of liquid asset a company can conceive
of, but the return provided by it is nil. However, companies maintain approximately four to five percent of
their total assets, on the average, in this form despite no returns for reasons already explained.
Keeping Reserve Drawing Power under Cash Credit/Overdraft Arrangement: This form of liquidity
appears to be quite attractive as it can have access to bank borrowing. However, constraints imposed by the
banking sector make this much less attractive than what it once used to be. Close scrutiny of the quarterly
budgets of the company by banks and imposition of penal interest of two percent over and above the
normal rate of interest on under-or over-utilization make this form more tedious and time consuming.
However, a built-in cushion may possibly be included while preparing the quarterly budgets and during
some periods the full amount may be drawn. The tax benefit on the interest makes effective after-tax-rate to
be much less costly, even if part of it is held in the form of idle cash. This not only helps as a liquid source
but also helps in obtaining equal or higher limits during the forthcoming year.
Marketable Securities: These are short-term securities of government such as treasury bills and other gilt
edged securities whose default risk is nil and, for that very reason, the return is low. It is preferable to
ensure the maturity structure of these short-term securities with the likely periods of excessive cash drain
on the part of the company. Then, the transaction costs can be considerably minimized as early liquidation
prior to maturity may result in low return from these assets.
Investment in Intercorporate Deposits: A company can invest money with other companies in the form
of short-term deposits ranging from two or three months to five or six months at remunerative rates.
However, these deposits being unsecured in nature, are subject to considerable risk, unless the companies
accepting such deposits have excellent antecedents as to their paying habits.
From among the different forms of liquidity available to a company a deliberate choice has to be made in
selecting an appropriate mix that suits the liquidity requirements of the company and disposition of its
management towards risk.
7. Functions performed by a financial system
The Savings Function
The public savings find their way into the hands of those in production through the financial system.
Financial claims are issued in the money and capital markets which promise future income flows. The
funds in the hands of the producers result in production of better goods and services, increasing society's
living standards. When savings flows decline, however, the growth of investment and living standard
begins to fall.
Liquidity Function
Money in the form of deposits offers the least risk, of all financial instruments. But its value is most eroded
by inflation. That is why one always prefers to store the funds in financial instruments like stocks, bonds,
debentures, etc. The compromise one makes in such investments is (1) that the risk involved is more, and
(2) the degree of liquidity, i.e. conversion of the claims into money is less. The financial markets provides
the investor with the opportunity to liquidate the investments.
Payment Function
The financial system offers a very convenient mode of payment for goods and services. The cheque system,
credit card system et al are the easiest methods of payments in the economy. The cost and time of
transactions are drastically reduced. In India, the cheque system of payment is widely practiced. The credit
card system has entered only urban India and is widely used in these areas for payments of consumption
expenditure.
Risk Function
The financial markets provide protection against life, health and income risks. These are accomplished
through the sale of life and health insurance and property insurance policies. The financial markets provide
immense opportunities for the investor to hedge himself against or reduce the possible risks involved in
various investments.



20

Policy Function
India is a mixed economy. The government intervenes in the financial system to influence macroeconomic
variables like interest rates or inflation. In 1996-97, by bringing about several cuts in the CRR from 12% to
10% the government, the RBI has tried to force the interest rates down and increase the availability of
credit to the corporates at cheaper rates.
Modern day economies require huge sums of money for investment in capital assets (land, equipment,
factory, etc.) which are then used for providing goods and services. The funds required are so huge that it is
not possible for a single government/firm to provide for the requirement. By selling financial claims like
stocks, bonds, etc. the required funds can be quickly raised from a variety of investors. The business
firm/government issuing such a financial claim then hopes to return the borrowed funds from expected
future inflows. Indeed, we see that the financial markets within the financial system have made possible the
exchange of current income for future income and transformation of savings into investments, so that
production and income grow.
8. Forms of Business Combinations
Consolidation: It is a form of business combination caused by the fusion of two or more firms, resulting
in the formation of anew firm. In this combination, all the firms involved loose their individual identity. A
new firm which was hitherto not in existense, comes into being. For example, the combination of two
Swiss firms Sandoz and Ciba Geigy resulted in the formation of Novartis. This form is generally applied in
combinations of firms of equal size. In India, consolidation are generally referred to as amalgamations.
Merger: The terms merger is often abused, by being loosely applied to refer to any form of business
combinations. It has however got a specific connotation. A merger refers to a business combination of two
or more firms in which only one firm survives and the other firms go out of existense. In a merger, the
surviving firm acquires the assets and liabilities of the other firm(s) . For example, the recent marger of
HDFC Bank and Times Bank. After the merger, Times Bank will go out of existense and expanded HDFC
Bank the firms involved in the combination are of unequal size. The larger/stronger firm continues to exist
because of its stronger bargaining power and the smaller/ weaker firms go out of existense. Another form of
merger is the subsidiary merger. In a subsidiary merger, the target firm becomes a subsidiary or is merged
with subsidiary of the acquirer. A variation of the subsidiary merger is the reverse subsidiary merger. In a
reverse subsidiary merger, a subsidiary firm of the acquirer is merged into the target firm of the acquirer is
merged into the target firm. In India, mergers are generally referred to as absorptions.
Takeovers: Takeovers refers to the process of acquiring control over the management of a firm by
acquiring a substantial portion of its equity. After a takeover, the individual firms continue to exist but
under a new management. For example, the acquisition of the leading American investment bank First
Boston by the Credit Suisse group of Switzerland. CS First Boston continues to be a separate legal entity
but under the management control of the Credit Suisse group . A takeover may be a prelude to full fledged
merger or consolidation. The topic of takeover is dealt in detail in a subsequent section.
Asset Purchases: This is the simplest form of business combination from the legal point of view. In this
case, the acquirer buys out a division or an asset of the firm. Both the firms continue to exist but there is a
transfer of the business or the asset. For example, the recent acquisition of the cement division of Tata Steel
by Laffarge of France. Laffarge acquired only the 1.7 million tonnne coment plant and its releated assets
form Tata Steel. The asset being purchased may be intangible in nature. For example, Coca-cole paid
Rs.170 crore to Parle to acquire its soft drinks brands like Thumps Up. Limca, Gold Spot etc.