Question Paper

Treasury & Forex Management (MB351F): October 2005

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

< Answer >

1. Which of the following is not a feature of certificate of deposit issued by a bank?
(a) It is a document of title to a time deposit
(b) There is no lock-in period for transferring it to others
(c) It is not subject to the reserve requirement of the bank
(d) It is transferable by endorsement and delivery
(e) The maximum maturity period is one year.
2. The net worth and total debt of Modern Threads Ltd. are Rs. 300 lakh and Rs. 500 lakh respectively. < Answer >
The EBIT of the company is Rs.160 lakh. The earning power of the company is
(a) 12% (b) 15% (c) 18% (d) 20% (e) 24%.
3. Rs.1,00,000 was borrowed at an interest rate of 10 percent per annum. The amount has to be repaid with < Answer >
interest in ten equal annual installments. Each installment is payable at the end of every year. What will
be the amount of each installment?
(a) Rs.16,273 (b) Rs.17,225 (c) Rs.18,750
(d) Rs.19,375 (e) Rs.20,625.
4. For a firm, if the current ratio remains constant and the quick ratio decreases during the same period, < Answer >
then, which of the following is indicated for the firm?
(a) The proportion of total debt relative to total assets is decreasing
(b) The proportion of total debt relative to net worth is decreasing
(c) The proportion of net worth relative to total assets is increasing
(d) The liquidity is decreasing
(e) The profitability is increasing.
< Answer >
5. The following data pertain to Mehta & Co:
Cost of goods sold = Rs.80 lakh
Inventory turnover = 4
Closing stock = Rs.25 lakh
The opening stock is
(a) Rs.5 lakh (b) Rs.10 lakh (c) Rs.15 lakh
(d) Rs.20 lakh (e) Rs.25 lakh.
6. The data on the current assets and current liabilities of Fitmark Ltd. for the financial year 2004-05 are < Answer >
given below:
(Rs. in lakh)
Debtors Cash balance Inventory Current liabilities
Beginning 80 50 10 40
Closing 100 60 25 35
What is the change in net working capital?
(a) Rs.10 lakh (b) Rs.15 lakh (c) Rs.20 lakh
(d) Rs.25 lakh (e) Rs.50 lakh.
< Answer >
7. Which of the following is true with regard to the degree of financial leverage (DFL)?
(a) DFL of a company is constant irrespective of the earnings before interest and taxes (EBIT)
(b) DFL is equal to zero at the financial break-even point

1
 (c) DFL is less than zero if EBIT lies below the financial break-even point
(d) DFL increases as EBIT increases above the financial break-even point
(e) The change in output does not influence the DFL.
< Answer >
8. Which of the following is a spontaneous source of financing current assets?
(a) Equity capital
(b) Debenture capital
(c) Accrued wages
(d) Term loan
(e) Preference capital.
9. Other things remaining the same, if the average stock of raw materials is increased to two times its < Answer >
original level, then the raw materials storage period
(a) Reduces to half of the original period
(b) Increases to two times the original period
(c) Reduces unpredictably
(d) Increases to four times the original period
(e) Reduces to one-fourth of the original period.
< Answer >
10. Consider the following data about SKF Ltd:
Annual credit purchases Rs.52, 92,500.
Opening balance of accounts payable Rs.15, 50,000.
Closing balance of accounts payable Rs.27, 00,000.
(Assume 1 Year = 365 Days)
The average payment period (in days) for SKF Ltd. is
(a) 126 (b) 147 (c) 176 (d) 186 (e) 196.
11. Dell Ltd has Rs100 preference shares redeemable at a premium of 10% with 15 years maturity. The < Answer >
preference dividend rate is 12%. The cost of the preference capital assuming that shares were issued at
par with floatation cost of 5% is
(a) 12.43% (b) 13.02% (c) 14.25% (d) 14.33% (e) 15.33%.
< Answer >
12. Which of the following items represents a credit entry in India’s Balance of Payments statement?
(a) Purchase of gold by Minerals and Metals Trading Corporation (MMTC) from a Swiss Bank
(b) Repatriation of dividends by an MNC
(c) Investment by an Indian Mutual Fund in the UK
(d) Foreign exchange earned by Minerals and Metals Trading Corporation (MMTC)
(e) Remittance to USA by an American executive based at New Delhi.
13. The process of correction of imbalance in international receipts and payments between the two < Answer >
countries is known as
(a) J-curve effect (b) International Fisher effect
(c) Quantity theory of money (d) Price-specie-flow mechanism
(e) Dornbush sticky price theory.
14. Which of the following theories of international trade explains the trade between two countries having < Answer >
similar factor endowments and consumer tastes?
(a) International product life cycle theory
(b) Imitation gap theory
(c) Theory of absolute advantage
(d) Theory of comparative advantage
(e) Heckscher – Ohlin model.
15. The system under which the exchange rates are determined by the demand and supply position for the < Answer >
currencies in the foreign exchange market is known as
(a) Target zone arrangement system (b) Crawling peg system
(c) Fixed exchange rate system (d) Floating exchange rate system
(e) Currency board system.
< Answer >
16. Any increase or decrease in the value of a foreign liability in terms of the domestic currency is called
(a) Country risk (b) Currency risk

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 (c) Transaction risk (d) Financial risk (e) Interest rate risk.
17. Bank of America of New York is maintaining a rupee account with State Bank of India in Mumbai. < Answer >
Bank of America in New York calls this account as
(a) Nostro account (b) Vostro account
(c) LORO account (d) Special account (e) Mirror account.
< Answer >
18. A quote is called as European quote, if the exchange rate is expressed
(a) In terms of US dollars per unit of any other currency
(b) In terms of number of units of any other currency per unit of US dollar
(c) In terms of number of units of any other currency per unit of British pound
(d) In terms of number of units of any other currency per unit of Euro
(e) Both (a) and (c) above.
19. The exposure that arises from the need to convert values of assets and liabilities denominated in a < Answer >
foreign currency into the domestic currency is called
(a) Transaction exposure (b) Transformation exposure
(c) Translation exposure (d) Operating exposure
(e) Financial exposure.
< Answer >
20. The following are the exchange rates quoted in Singapore
S$/Euro : 2.0118/21
S$/US$ : 1.7384/86
The synthetic rates of US $/Euro are
(a) 1.1572/73 (b) 1.1571/74 (c) 0.8640/41
(d) 0.8639/42 (e) 3.4977/79.
21. If the Euro is quoted $ 1.1410 today and the inflation rates are 2% in Euro-zone and 3% in USA, what < Answer >
should be the $/Euro quote after 3 months?
(a) $ 1.1382/Euro (b) $ 1.1438/Euro (c) $ 1.1522/Euro
(d) $ 1.1300/Euro (e) $ 1.1466/Euro.
22. The pound sterling quote of a bank is Rs.81.79 / 84. If the banker agrees to quote a better rate by 2 paise < Answer >
to an Exporter, who is selling £200000, the rate quoted is
(a) Rs.81.77 (b) Rs.81.86 (c) Rs.81.81 (d) Rs.81.83 (e) Rs.81.82.
23. A banker who relied on the inter bank rate of Rs./$ 43.06/10 is requested by an Exporter for purchase of < Answer >
dollars. What is the rate to be quoted if the banker wants a margin of 0.10%?
(a) Rs.43.14 (b) Rs.43.02 (c) Rs.43.10 (d) Rs.43.06 (e) Rs.43.12.
< Answer >
24. The relationship between the exchange rate and the prices of tradeable goods is known as the
(a) Purchasing power parity theory (b) Asset markets theory
(c) Portfolio balance theory (d) Interest rate parity theory
(e) Fisher open condition.
25. If U.K. interest rates are higher than Japanese interest rates, the theory of covered interest arbitrage < Answer >
would suggest that in the £/Yen exchange markets the Yen would be at a forward _________ and the
pound would ___________.
(a) Discount, be at a forward premium
(b) Discount, also be at a forward discount
(c) Premium, also be at a forward premium
(d) Premium, be at a forward discount
(e) Discount, be stable.
26. Which of the following strategies is classified as production strategies to manage the economic < Answer >
exposure?
(a) Market selection (b) Plant location (c) Product strategy
(d) Promotional strategy (e) Pricing strategy.
< Answer >
27. Which of the following is true under a currency board system?
(a) The interest rates are automatically set by the market mechanism

3
 (b) When there is a higher demand for the anchor currency, the reserves with the currency board gets
enhanced
(c) Lending to either the government or the domestic banks by the currency board is allowed
(d The board can act as the lender of the last resort
(e) Exchange rates are unstable.
< Answer >
28. Samurai bond is a bond
(a) Denominated in yen and issued outside Japan
(b) Denominated in a currency other than yen and issued to the public in Japan
(c) Denominated in yen and issued under private placement by non-Japanese borrowers in Japan
(d) Denominated in yen and issued by non-Japanese borrowers to the public in Japan
(e) Denominated in yen and issued by Japanese borrowers in US.
29. If interest rate parity holds and the transaction costs are zero, covered foreign financing will result in an < Answer >
effective borrowing rate that is
(a) Less than domestic interest rate
(b) Greater than domestic interest rate
(c) Equal to domestic interest rate
(d) Less than domestic interest rate if forward rate is in discount
(e) Negative.
< Answer >
30. Overtrading means
(a) The firm has disproportionately high amount of working capital with respect to the level of sales
(b) The firm has disproportionately low amount of working capital with respect to the level of sales
(c) The firm has disproportionately high level of receivables with respect to total assets
(d) The firm has disproportionately high level of cash with respect to total assets
(e) The firm has been experiencing low turnover of working capital.

END OF SECTION A

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 Section B : Problems/Caselet (50 Marks)
This section consists of questions with serial number 1 – 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
1. Hong Kong Bank can borrow $10 million at 5% annualized. The treasury manager wants to use the loan amount to
invest in euro at 4% annualized over a fortnight period considering the following information.
Interest rates $ - 4.5% – 5%
Euro – 4%- 4.3%

Current rate $/Euro 1.2840 / 45

Expected rate after fortnight $/Euro 1.2885 / 92

You are required to compute the loss or gain if the treasury manager decides to implement his decision for
covered interest arbitrage. Show your workings up to the last unit.
(10 marks) < Answer >
2. The cash flows associated with a project are given below:
Year 0 1 2 3 4 5
Cash flows (Rs. ‘000s) (2200) 900 850 700 650 500
The cost of capital is 15%.
You are required to find out the following:
a. Net present value.
b. Benefit cost ratio.
c. Internal rate of return.
(3 + 2 + 3 = 8 marks) < Answer >
3. A multinational company in New Zealand proposes to invest its surplus funds of NZ$3 million for three months.
The treasury manager has collected the following information from his banker to invest in currencies other than
that of home currency to earn more interest on the funds without exposing the investment to exchange risk by
covering the amounts under forward rates.
Spot NZ $/$ 1.5522/24
Euro/£ 1.4650/52
$/£ 1.7960/62
3 months forward NZ $/$ 1.5663/65
Euro/£ 1.4570/72
$/£ 1.7885/87
3 month interest rates (p.a.)
NZ $ : 3.2% – 3.6%
$ : 2.4% – 2.8%
Euro : 3.0% – 3.4%
£ : 2.8% – 3.2%
You are required to determine the currency in which the company should invest to have more returns.
(10 marks) < Answer >

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4. Pragati Fabrication Company requires steel for its fabrication work. The probability distributions of the daily
usage rate and the lead time for procurement are given below:
Daily usage rate Lead time
Probability Probability
(in tonnes) (in days)
5 0.3 15 0.5
7 0.4 25 0.3
9 0.3 30 0.2
The stock out cost and the carrying cost are estimated as Rs.4,500 and Rs.1,200 per tonne respectively.
You are required to find out the following:
a. Probability of stock out.
b. Optimum level of safety stock.
(6 + 6 = 12 marks) < Answer >

Caselet
Read the caselet carefully and answer the following question:
5. Discuss the factors that affect a country’s exports of goods and services.
(10 marks) < Answer >
India's foreign exchange reserves zoomed by over $12 billion in five weeks ending March 19, 2005. According to
banking sources familiar with Reserve Bank of India data, the major accretion has been on account of invisibles and
external commercial borrowings (ECBs). In invisibles, the areas that have contributed the most are private transfers,
software and export-related services. In ECBs, the number of borrowers have gone up although funds raised are not
very high. The balance of payment data, yet to be released by the RBI for the fourth quarter of financial year ended
March 2005, are likely to show a current account surplus as against deficits in last two quarters, said sources. Non
resident Indian (NRI) deposits’ kitty, which has been drying down with net outflows, has started improving after the
government decided to continue with the tax exemption in the last Union budget. Under capital flows, portfolio
investments stood at over $ 2 billion. While there has been positive accretion in the foreign direct investment,
investment of around $900 million by Holcim was the largest FDI for the quarter, said sources. For the week ended
March 25, the foreign exchange reserves stood at around $141 billion. The comforting factor in the data is the fact that
the foreign exchange inflows are no longer dependent on the interest rate sensitive flows like portfolio investments.
Although there has not been much growth in foreign institutional investor inflows, overall growth in the forex reserves
has been phenomenal. In the third quarter, the current account deficit continued further inflated by clocking $5.4 billion
as against $4 billion in the second quarter 2004-05, according to the balance of payment data released by the Reserve
Bank of India. This has been due to steady expansion in trade deficit taking it to historic heights of $11.8 billion as
against $9.8 billion in the second quarter.
The last BoP data showed that the capital account remains in surplus at $ 12 billion as against $ 4.6 billion , primarily
due to surge in FII inflows, sharp rise in external commerial borrowings, short-term credits and overseas borrowings by
banks. While foreign investment has gone down to $7.3 billion as against $10.1 billion the same quarter last year, ECBs
grew to $ 4.1 billion as against a negative accretion of $3.4 billion. Short-term credit was at $ 2.7 billion. Non-resident
Indian deposits, on the other hand, fell by $1.3 billion as against a growth of $3.7 billion. The components boosting
foreign exchange reserves during the third quarter were a 40 per cent growth in foreign investment, 22.5 per cent
growth in ECBs, 3.8 per cent growth in external assistance, 14.8 per cent growth in short credit. Net invisibles were
marginally down to $6.3 billion as against $7.2 billion in the corresponding quarter last year.

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 6 - 7.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.

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6. There are some problems which may hinder a meaningful analysis of the financial statements. Explain briefly the
problems encountered in financial statement analysis.
(10 marks) < Answer >
7. The various techniques available to hedge a foreign exchange exposure can be categorized as internal and external
hedging techniques. Explain how a firm can hedge transaction and translation exposures through external hedging
techniques.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Treasury & Forex Management (MB351F): October 2005
Section A : Basic Concepts
1. Answer : (c) < TOP >

Reason : Certificate of deposit (CD) is a financial instrument where an investor has to invest a
certain sum to get a fixed amount (principal and accrued interest) on maturity at the
contracted rate.So it is similar to a time deposit. CDs are transferable simply by
endorsement and delivery by the holder without any restriction, whereas its maturity
period ranges from 15 days to one year. But as it is a liability to the issuing banks, CDs are
also subjected to the reserve requirements of the bank
2. Answer : (d) < TOP >

EBIT 160 160

= = = 0.2
Reason : Earning power = Total Assets 300 + 500 800
Hence, earning power of the company = 20%
3. Answer : (a) < TOP >

1, 00, 000 1, 00, 000

= =
Reason : The amount of each installment will be = PVIFA(10%,10 years) 6.145 16,273.393
= 16,273(approx)
4. Answer : (d) < TOP >

Reason : Current ratio is defined as the ratio between the current assets and current liabilities. While
Quick Ratio is calculated by dividing current assets minus inventories by current
liabilities. Now, among the components of the current assets, inventories are the least
liquid instruments. So, a decreasing quick ratio and same value of the current ratio implies
the increasing volume of inventory, thereby indicating the decreasing level of liquidity.
5. Answer : (c) < TOP >

C os t of Goods sold
Reason : Inventory turnover = Average Inventory =4
Now, COGS = Rs.80 lakh, hence average inventory will be = Rs.20 lakh
But the amount of closing stock = Rs.25 lakh
Therefore the amount of opening stock will be = (20 x 2) – 25 = Rs.15 lakh
6. Answer : (e) < TOP >

Reason : Change is net working capital can be calculated as : (100 +60 +25 – 35) –(80 + 50 +10 –

7
 40)
= 150 – 100 = Rs.50 lakh
7. Answer : (c) < TOP >

EBIT
Dp
EBIT − I −
Reason : Degree of Financial Leverage (DFL) = 1− T
Dp
Now, at the financial break – even point, EBIT= I + 1 − T

 Dp 
I+ 
If EBIT <  1 − T  , DFL will be negative.
8. Answer : (c) < TOP >

Reason : Spontaneous sources of financing current assets arise in the course of day to day business
and they do not entail any cash outflows. Equity capital, debenture capital, term loan and
preference capital are not spontaneous sources because they do not arise in the course of
day to day business and they entail cash outflows. However, accrued wages are a
spontaneous source of financing current assets because they arise in the course of day to
day business and they do not entail any cash outflows.
9. Answer : (b) < TOP >

Reason : If the average stock of raw materials is increased to two times its original level then the
raw materials storage period increases to two times the original level.
10. Answer : (b) < TOP >

Average balance of trade creditors

Reason : Average payment period = Average daily purchase

opening creditors + closing creditors

Average balance of trade creditors = 2
= 21,25,000
Annual Credit Purchases
Average daily purchases = Number of days in a year =
52,92,500
= 14,500
365
21, 25, 000
= 146.55days ≈ 147days
Average payment period = 14,500
11. Answer : (b) < TOP >

Reason : Cost of preference capital can be calculated from the following:

n
Dt Pn
Po = ∑ +
(1 + k ) (1 + k )
t n
t =1
p p

where symbols are in their standard use.

Substituting the vine values, we get
95 = 12 × PVIFA (kp,15) + 110 × PVIF (kp, 15)
At kp = 13%
RHS = 12 × 6.462 +110 ×0.160 = 95.144
AT kp = 14%
RHS = 12 × 6.142 +110 ×0.140 = 89.10
Interpolating, we get
 95.144 − 95.00 
13% +   × 1%
kp =  95.144 − 89.10 
= 13.02%

8
12. Answer : (d) < TOP >

Reason : Foreign exchange by MMTC represents a credit entry in India’s Balance of Payments
Statement. Options in a,b,c and e are debit entries in India’s Balance of Payments
Statement.
13. Answer : (d) < TOP >

Reason : The process of correction of imbalance in international receipts and payments between the
two countries is known as price-specie flow mechanism. Options in a,b,c and e are not
correct.
14. Answer : (b) < TOP >

Reason : (a) International product life cycle theory explains the various stages in the life a new
product and the resultant international trade.
(b) According to Imitation gap theory, the resulting inventions and innovations in
existing products give rise to trade between such countries.
(c) According to the theory of absolute advantage international trade takes place because
one country may be more efficient in producing a particular good than another
country which is able to produces some other good more efficiently than the first
one. This provides an incentive to trade as both countries can benefit from
specialization.
(d) According to the theory of comparative advantage, trade is possible as long as the
country experiencing the disadvantage is not equally less efficient in producing all
the products, that is both the countries enjoy comparative advantage in atleast one of
the products.
(e) According to Heckscher-Ohlin model, the reason for two countries benefiting from
the trade is the differences in their factor endowments. Hence the correct answer is
(b).
15. Answer : (d) < TOP >

Reason : The exchange rates under floating exchange rate system are determined by the demand
and supply position for the currencies in the foreign exchange market.
(a) When a group of countries get together and agree to maintain the exchange rates
between the currencies within a certain band around fixed central exchange rates,
then it is called a target zone arrangement.
(b) A crawling peg system is a hybrid of fixed and flexible exchange rate system. Under
this system, while the value of a currency is fixed in terms of a reference currency,
this peg itself keeps changing in accordance with the underlying economic
fundamentals.
(c) Under fixed exchange rate system, the value of a currency in terms of another is
fixed and it is determined by Governments or Central banks of the respective
countries.
(e) Under a currency board system, a country fixes the rate of its domestic currency in
terms of a foreign currency and its exchange rate in terms of other currencies
depends on the exchange rates between the other currencies and the currency to
which the domestic currency is pegged.
16. Answer : (b) < TOP >

Reason : Any increase or decrease in the value of a foreign liability in terms of the domestic
currency is called currency risk.
17. Answer : (a) < TOP >

Reason : Nostro account means, our account with you. For Citibank Newyork, the account is called
as Nostro account.
18. Answer : (b) < TOP >

Reason : (a) A quote in terms of U.S. dollars per unit of any other currency is called an American
quote.
(b) A quote in terms of number of units of any other currency per U.S. dollar is called an
European quote.
(c) & (d) are examples of currencies quoted in American terms.

9
19. Answer : (c) < TOP >

Reason : The exposure that arises from the need to convert values of assets and liabilities
denominated in a foreign currency into the domestic currency is called translation
exposure.
20. Answer : (b) < TOP >

Reason : The synthetic rates of US $/Euro are

(US $/Euro)bid = (US$/S$)bid × (S$/Euro)bid
1
× (S$ / Euro) bid
= (S$ / US$)ask
1
× 2.0118
= 1.7386 = 1.1571.
1
× 2.0121
Similarly (US$/Euro)ask = 1.7384 = 1.1574.
US$/Euro = 1.1571/74.
21. Answer : (b) < TOP >

 0.03 
1+ 4 
  ×1.1410
 1 + 0.02 
Reason : Reason :  4  = $ 1.1438/Euro.
< TOP >
22. Answer : (c)
Reason : Bid rate for pound is Rs.81.79. This means banker gives Rs.81.79 to take one pound. If
banker agrees to quote a better rate he pays still more by 2 paise to take one pound. So 2
paise is to be added to the bid rate. Correct answer is Rs.81.81.
< TOP >
23. Answer : (b)
0.10
Reason : Profit margin of 0.10% is to be deducted from the bid rate. That is 43.06 × 100 =
Rs.0.04
Spot bid rate = 43.06 – 0.04 = 43.02.
24. Answer : (a) < TOP >

Reason : The relationship between the exchange rate and the prices of tradeable goods is known as
the purchasing power parity theory.
25. Answer : (d) < TOP >

Reason : If U.K interest rates are higher than Japanese interest rates, the theory of covered interest
arbitrage would suggest that in the £/yen exchange markets, the yen would be at a forward
premium and the pound would be at a forward discount.
26. Answer : (b) < TOP >

Reason : Options in a, c, d and e are marketing strategies for management of economic exposure.
Option in b is the production strategy for management of economic exposure.
27. Answer : (a) < TOP >

Reason : In the currency board system, the board does not have any discretionary powers over the
monetary policy; the interest rates are automatically set by the market mechanism. Options
(b), (c), (d) and (e) are not true.
28. Answer : (d) < TOP >

Reason : Samurai bond is a bond denominated in yen and issued by non-Japanese borrowers to the
public in Japan.
29. Answer : (c) < TOP >

Reason : According to the Interest rate parity or the covered interest parity condition, the cost of
borrowing money or the rate of return on financial investments, when adjusted for the
cost of covering foreign exchange risk is equal across different currencies.
30. Answer : (b) < TOP >

10
 Reason : Overtrading means that the firm has disproportionately low level of working capital with
respect to the level of sales. To define it as a state in which the firm has disproportionately
high level of working capital with respect to sales or a disproportionately high level of
receivables with respect to total assets or a disproportionately high level of cash with
respect to total assets or low turnover of working capital is incorrect. Hence, alternative
(b) is answer.

Section B : Problems
1. If treasury manager borrows $10 million, the amount payable after a fortnight with interest at 5%pa.
= 10000000 × (1 + .05/24)
= $10020833.33.
Convert $10 million into euro at $1.2845 /euro and invest at 4% pa for a fortnight.
10000000
Inflow of Euro with interest = 1.2845 x (1 + .04/24)
= Euro 7798105.618
Convert Euro into $ at 1.2885 $/Euro.
= 7798105.618 x 1.2885
= $10047859.09.
Repay the loan with interest
Gain = 10047859.09 – 10020833.33
= $27025.76.
< TOP >

5
∑ (1 + it) t
CF

2. a. NPV = t =1 – 2200
900 850 700 650 500
+ + + +
= (1.15) (1.15) 2 (1.15) 3 (1.15) 4 (1.15) 5 – 2200

= 305.820 (in Rs.’000s)

= 305.82 × 1000 = Rs.3,05,820
Pr esent value of benefits
b. Benefit cost ratio = Initial investment

305820 + 2200000
= 2200000 = 1.14 (approx.)
c. Let IRR be ‘r’.
900 850 700 650 500
+ + + +
∴ 2200 = (1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5
For r = 19%; RHS = 2305.593
r = 21%; RHS = 2215.496
r = 22%; RHS = 2172.692
22 − 21
∴ r = 21 + ( 2172. 692 − 2215.496) (2200 – 2215.496)

= 21.36%
∴ Internal rate of return = 21.36%
< TOP >
3. The company can invest in home currency (NZ $) at 3.2%, US $ at 2.4%, £ at 2.8% and Euro at 3.0% for 3
months.

11
  1 + 0.032 
 
I. Investment in NZ $ 3000000 ×  4  = 3024000
Return after 3 months = 3024000 – 3000000
= NZ$24000

II. Investment in US $
Surplus of NZ$3 million is to be converted into US dollars and is invested in US dollars at 2.4%. The amount
in US $ is coverted into NZ $ by covering at 3 month forward rate.
NZ $ 3000000 converted into US$ at the NZ $/$
3000000
Spot selling rate = 1.5524
Amount received in US$ = 1932491.63
Says $1932492

 1 + 0.024 
 
Invest at 2.4% for 3 months = 1932492 ×  4 
= $1944086.95
Says $1944087
Convert into NZ$ at 3 months forward buying rate of 1.5663
= 1944087 × 1.5663
= $3045023.47 says $3045023
Return after 3 months = 3045023 – 3000000 = NZ $45023
III. Investment in £
NZ $/£ spot bid rate = 1.5522 × 1.7960 = 2.7878
NZ $/£ spot ask rate = 1.5524 × 1.7962 = 2.7884
NZ $/£ 3 months forward bid rate = 1.5663 × 1.7885 = 2.8013
NZ $/£ 3 months forward ask rate = 1.5665 × 1.7887 = 2.8020
Surplus of NZ $ 3 million is to be converted into pounds and the amount is invested at 2.8% for 3 months by
covering at 3 month forward rate. NZ$3000000 converted into pounds at NZ$/£ spot selling rate
3000000
= 2.7884
Amount received in pounds = 1075885.81 says £1075886

 1 + 0.028 
 
Invest at 2.8% for 3 months = 1075886 ×  4 
= £1083417.20 says £1083417
Convert into NZ$ at 3 months forward buying rate of 2.8013
= 1083417 × 2.8013
= 3034976.04 says NZ$ 3034976
Return after 3 months = 3034976 – 3000000 = NZ$ 34976
IV. Investment in Euro
1
NZ$ / Euro spot bid rate = 1.5522 × 1.7960 × 1.4652 = 1.9026
1
NZ$ / Euro spot ask rate = 1.5524 × 1.7962 × 1.4650 = 1.9034
1
NZ$ / Euro 3 months forward bid rate = 1.5663 × 1.7885 × 1.4572 = 1.9224

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 1
NZ$ / Euro 3 months forward ask rate = 1.5665 × 1.7887 × 1.4570 = 1.9231
Surplus of NZ$ 3 million is to be converted into Euro and the amount is invested in Euro at 3% for 3 months
by covering at 3 months forward rate.
3000000
NZ$ 3000000 converted into euro at NZ$ / Euro spot selling rate = 1.9034
Amount received in Euro = 1576126.93 say 1576127

 1 + 0.03 
 
Invest at 3% for 3 months = 1576127 ×  4 
= 1587947.95 says 1587948
Convert into NZ$ at 3 months forward buying rate of 1.9224
= 1587948 × 1.9224
= 3052671.24 says NZ$ 3052671
Return after 3 months = 3052671 – 3000000
= NZ$ 52671
The company should invest in Euro, since the return in investment is more when compared to the others.
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4. a. Normal consumption during the lead time = (Expected daily usage rate) x (Expected lead time in
days)
Expected daily usage = 5(0.3) + 7(0.4) + 9(0.3)
= 7
Expected lead time = 15(0.5) + 25(0.3) + 30(0.2)
= 21
Normal consumption = 7 x 21
= 147 tonnes
Since the normal consumption during the lead time is 147 tonnes, stockouts can occur only if the
consumption during the lead time is more than 147 tonnes.
The lead time consumption of more than 147 tonnes along with their respective probabilities of occurrence
can be identified from the following table:
Possible levels of usage

Daily usage rate Lead time in days Possible levels of usage

Units Probability Units Probability Units Probability

15 0.5 75 0.15

5 0.3 25 0.3 125 0.09

30 0.2 150 0.06

15 0.5 105 0.20

7 0.4 25 0.3 175 0.12

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30 0.2 210 0.08

 stockout cost cost (Rs.) (Rs.)
Expected
Safety stock Stockouts Rs. (1) × 1200 (5 + 6) = (7)
Probability stock out
(tones) (tonnes) (4) × 4500 = = (6)
(tonnes)
(5)
123 0 0 0 0 1,47,600 1,47,600
78 45 0.06 2.70 12,150 93,600 1,05,750
63 60 0.06 3.60 22,275 75,600 97,875
15 0.09 1.35
4.95
28 95 0.06 5.70
50 0.09 4.50 58,500 33,600 92,100
35 0.08 2.80
13
3 120 0.06 7.20
75 0.09 6.75
97,875 3,600 1,01,475
60 0.08 4.80
25 0.12 3.00
21.75
0 123 0.06 7.38
78 0.09 7.02
63 0.08 5.04 1,03,410 0 1,03,410
28 0.12 3.36
3 0.06 0.18
22.98
The total cost is least when the safety stock is maintained at 28 tonnes. ∴The optimal safety stock level is 28
tonnes.
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5. Exports of goods and services are affected by the following factors :

• The prevailing exchange rate of the domestic currency : A lower value of the domestic currency results in the
domestic price getting translated into a lower international price. This increases the demand for domestic
goods and services and hence their export. This is likely to result in a higher demand for the domestic
currency. A higher exchange rate would have an exactly opposite effect.
• Inflation rate : The inflation rate in an economy vis-à-vis other economies affects the international
competitiveness of the domestic goods and hence their demand. Higher the inflation, lower the
competitiveness and lower the demand for domestic goods. Yet, a lower the demand for domestic goods and
services need not necessarily mean a lower demand for the domestic currency. If the demand for domestic
goods is relatively inelastic, then the fall in demand may not offset the rise in price completely, resulting in an
increase in the value of exports. This would end up increasing the demand for the local currency. For example,
suppose India exports 100 quintals of wheat to the US at a price of Rs. 500 per quintal. Further, assume that
due to domestic inflation, the price increases to Rs. 530 per quintal and there is a resultant fall in the quantity
demanded to 96 quintals. The exports would increase from Rs. 50,000 to Rs. 52,800 instead of falling.
• World prices of a commodity : If the price of a commodity increases in the world market, the value of exports
for that particular product shows a corresponding increase. This would result in an increase in the demand for
the domestic currency. A fall in the demand for domestic currency would be experienced in case of a reduction
in the international price of a commodity. This impact is different from the previous one. The previous
example considered an increase in the domestic prices of all goods produced in an economy simultaneously,
while this one considers a change in the international price of a single commodity due to some exogenous
reasons.
• Incomes of foreigners : There is a positive correlation between the incomes of the residents of an economy to
which the domestic goods are exported, and exports. Hence, other things remaining the same, an increase in
the standard of living (and hence, an increase in the incomes of the residents) of such an economy will result in
an increase in the exports of the domestic economy. Once again, this would increase the demand for the local
currency.
• Trade barriers : Higher the trade barriers erected by other economies against the exports from a country, lower
will be the demand for its exports and hence, for its currency.
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Section C: Applied Theory

6. Problems Encountered in Financial Statement Analysis

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 Analysis of financial statements using ratios can be very helpful in understanding a company’s financial
performance and condition. Yet there are certain problems which come in the way of such an analysis.
Development of benchmarks
Many companies have operations spread across a number of industries. As there may not be any other company
having a presence in the same industries, that too in the same proportion, development of a benchmark becomes a
problem. Even when the company is not a diversified one, figures for the various firms are needed in addition to
the industry average, in order to draw a meaningful conclusion.
Window-dressing
Firms may window-dress the financial statements in order to show a rosy picture. In such a case, the whole
exercise of analyzing the statements becomes useless. In order to draw some meaningful results out of the
analysis, the average figures over a period of time should be looked into.
Price level changes
Financial statements do not take into account changes in price levels. Analysis of such statements may not give a
true picture of the state of affairs.
Differences in accounting policies
Different companies may follow different accounting policies in respect of depreciation, stock valuation etc.
Comparison between the ratios of two firms following different policies may not give the true result.
Interpretation of results
A problem may arise on two accounts – interpretation of ratios on its own, and interpretation of all the ratios taken
together. It is difficult to decide the optimum level of a ratio, inspite of the presence of industry averages. For e.g.
it is difficult to say whether a high current ratio shows a good liquidity position or an unnecessarily high level of
inventories. Secondly, some ratios may be in favor of a company, while some others may be against it. In such a
case, it may be difficult to form an overall opinion about the company.
Correlation among ratios
There may be a high degree of correlation among the various ratios calculated, due to the presence of some
common factor. This may make interpretation of all the ratios confusing. Hence, it becomes essential to choose a
few ratios which can convey the required information.
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7. The various external hedging techniques used for hedging transaction and translation exposures are
Forward Market
In a forward market hedge, a company that is long on a foreign currency will sell the foreign currency forward,
whereas a company that is short on a foreign currency will buy the currency forward. In this way the company can
fix the domestic currency value of future foreign currency cash flow, regardless of what happens to the future spot
rate.
Futures Market
To hedge in the futures market, go short in futures if you are long in the currency and vice versa. Hedging through
futures has an effect similar to hedging through a forward contract. As the loss/gain on the underlying transaction
has an offsetting impact the gain/loss on the futures contract, the exposure gets almost eliminated.
Options Market
Hedging through options is much more beneficial than hedging through futures or forwards. This is because in an
option contract, the loss is limited whereas the profit is unlimited. Since the firm has the right to buy or sell the
foreign currency but not the obligation, it can let the option expire by not exercising its right in case the exchange
rates move in its favor, thereby making the profits it would not have made had it hedged through forwards or
futures. If there is a receivable, buy a put option. In the case of a payable, buy a call option.
Money Market
A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock
in the domestic currency value of a future foreign currency cash flow. By doing this, the firm knows its total cost
in advance in the form of principal and interest it needs to repay in the domestic markets. For example, a firm has
a dollar payable after three months. It can borrow in the domestic currency now, convert it at the spot rate into
dollars, invest these dollars in the money markets and use the proceeds to pay the payable after three months.
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