Question Paper

Strategic Financial Management (MB361F): January 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. The most commonly held view of capital structure is that the weighted average cost of capital
(a) Declines steadily as more debt is used
(b) First declines with moderate amounts of leverage and then increases
(c) Increases proportionately with increases in leverage
(d) Is unaffected by the level of debt used
(e) Is minimized at a balanced capital structure of 50% equity and 50% debt.
< Answer >
2. Consider the following information relating to Glenco Ltd :
EBIT = Rs.20 crore
Depreciation = Rs.3 crore
Interest on debt = Rs.3 crore
Annual loan installment = Rs.2 crore
Tax rate = 35%
The fixed charges coverage ratio of the company is
(a) 2.50 (b) 3.33 (c) 3.78 (d) 10.00 (e) None of the above.
< Answer >
3. When there is a capacity constraint in the transferor division, the transfer pricing can be ideally done by
(a) Market price (b) Marginal cost
(c) Shadow price (d) Full cost pricing based on actual cost
(e) Marginal cost + Lumpsum annual payment.
< Answer >
4. Low cost product strategy is used by Nirma in detergents, Ruf & Tuf in denims and Akai in television.
This strategy of pricing low, falls under which of the following costing techniques?
(a) Life cycle costing (b) Target costing (c) Quality costing
(d) Activity based costing (e) Value chain analysis.
< Answer >
5. If the dividend per share for the year is Rs.2.00, growth rate of dividends is 12% and the present market
price of the stock is Rs.52.50, the required return on the stock will be
(a) 16.27% (b) 15.81% (c) 15.00% (d) 8.19% (e) 7.73%.
< Answer >
6. Given total debt-equity ratio = 5:4; total assets = Rs.4,500; short-term debt = Rs.600 and total debt
consists only of long-term debt and short-term debt, the long-term debt is equal to
(a) Rs.1,567 (b) Rs.1,900 (c) Rs.2,167 (d) Rs.2,500 (e) Rs.2,833.
< Answer >
7. The risk that arises out of the assets of a firm being not readily marketable is called
(a) Market risk
(b) Marketability risk
(c) Business risk
(d) Financial risk
(e) Exchange risk.
< Answer >
8. The average collection period of a company is 40 days. If the average receivables balance is Rs.20
lakhs, the sales of the company, assuming 360 days in a year, is
(a) Rs. 60 lakhs (b) Rs. 90 lakhs (c) Rs.120 lakhs (d) Rs.180 lakhs (e) Rs.210 lakhs.
< Answer >
9. In the calculation of the weighted average cost of capital, why are the weights based on the market
values preferred to weights based on book values?
(a) The weights based on the book values are difficult to estimate while calculating the weighted
average cost of capital
1
 (b) Weights based on the market values are fairly constant in nature
(c) Weights based on the book values have a high degree of volatility
(d) Book values are historical in nature and may not reflect the true economic values as compared to
market values
(e) Data on market values are always available whereas data on book values are not always available .
< Answer >
10. According to Pecking Order Theory of financing, which of the following orders of financing is most
preferable for a firm?
(a) Debenture, preference capital, fresh equity, retained earnings
(b) Fresh equity, preference capital, debenture, retained earnings
(c) Retained earnings, fresh equity, debenture, preference capital
(d) Fresh equity, retained earnings, preference capital, debenture
(e) Retained earnings, debenture, preference capital, fresh equity.
< Answer >
11. Which of the following models on dividend policy stresses on the investor’s preference for the current
dividends?
(a) Traditional Model
(b) Walter Model
(c) Gordon Model
(d) Miller and Modigliani Model
(e) Rational expectations model.
< Answer >
12. The current market price of the shares of Tractor India Ltd. is Rs.60. The company recently paid a
dividend of Rs.3.00 per share that is expected to grow at a rate of 8 percent. If the floatation cost will be
2 percent of the current market price, what will be the cost of external equity to Tractor India?
(a) 13.00 percent
(b) 13.67 percent
(c) 14.34 percent
(d) 15.00 percent
(e) 15.67 percent.
< Answer >
13. Holding cash balance to meet contingencies is
(a) A manifestation of the transaction motive
(b) A manifestation of the speculative motive
(c) A manifestation of the precautionary motive
(d) A characteristic of large firms only
(e) A characteristic of small firms only.
< Answer >
14. In the presence of floatation costs, the cost of external equity is
(a) More than the cost of existing equity capital
(b) Less than the cost of existing equity capital
(c) Equal to the cost of existing equity capital
(d) Equal to the cost of long-term debt
(e) Equal to the cost of short-term debt.
< Answer >
15. The equity capital and total debt of Super Industries Ltd. amount to Rs.150 lakhs and Rs.300 lakhs
respectively. The earnings before interest and taxes of the company amount to Rs.90 lakhs. The return
on investment of the company is
(a) 10% (b) 12% (c) 15% (d) 20% (e) 30%.
< Answer >
16. If the net profit margin is 12.50%, asset turnover ratio is 0.85 and return on networth is 24% then, the
debt-asset ratio is approximately
(a) 0.37 (b) 0.44 (c) 0.56 (d) 0.63 (e) 0.97.
< Answer >
17. The debt-asset ratio of a company is 1:3. It implies that for every
(a) 3 rupees of assets there is 1 rupee of equity
(b) 4 rupees of assets there is 1 rupee of debt
(c) 3 rupees of assets there are 2 rupees of debt
(d) 2 rupees of equity there is 1 rupee of debt
(e) 3 rupees of debt there is 1 rupee of equity.
< Answer >
18. If the current ratio is 2.45 and the ratio of inventories to current liabilities is 0.45, the ratio of
inventories to current assets is
2
 inventories to current assets is
(a) 0.184 (b) 0.225 (c) 0.500 (d) 0.900 (e) 2.000.
< Answer >
19. If the upper limit and lower limit of cash balances are Rs.60,000 and Rs.15,000 respectively, then return
point according to Miller and Orr Model is
(a) Rs.20,000
(b) Rs.25,000
(c) Rs.30,000
(d) Rs.45,000
(e) Rs.50,000.
< Answer >
20. Which of the following ratios is not applied in LC Gupta model for prediction of bankruptcy?
(a) EBDIT/Net sales
(b) Operating cash flow/Total assets
(c) Net worth/Total debt
(d) Working capital/Total assets
(e) Operating cash flow/Sales.
< Answer >
21. If the expected inflation rate increases from 4% to 6%, and if the tax rate applicable to the lender is
35%, the nominal interest rate shall rise by
(a) 1.3%
(b) 2.0%
(c) 3.1%
(d) 3.4%
(e) 6.2%.
< Answer >
22. Which of the following is true in the context of stock split?
(a) The par value of the equity share increases
(b) Reserves are capitalized
(c) Shareholders proportional ownership changes
(d) Book value of equity capital increases
(e) Market price of the equity share decreases after a stock split.
< Answer >
23. Which of the following is not an assumption of Modigliani Miller approach to capital structure?
(a) Information is freely available to investors
(b) Transactions are cost free
(c) Investors have homogeneous expectations about future earnings of a company
(d) Growth of a firm is entirely financed through retained earnings
(e) Securities issued and traded in the market are infinitely divisible.
< Answer >
24. Which of the following factors is not considered by Alcar model?
(a) Operating profit margin
(b) Incremental investment in working capital
(c) Income tax rate
(d) Dividend growth rate
(e) Cost of capital.
< Answer >
25. In the context of quality costing, costs associated with materials and products that fail to meet quality
standards and result in manufacturing losses are called
(a) Prevention costs (b) Appraisal costs (c) External failure costs
(d) Internal failure costs (e) Quality cost.
< Answer >
26. During which of the following stages of the product life cycle, the profit margins from a product reach
the peak?
(a) Introduction (b) Growth (c) Maturity (d) Saturation (e) Decline.
< Answer >
27. Which of the following is a non-financial measure of performance?
(a) Return on capital employed
(b) Residual Income
(c) Employee morale and attitude
(d) Net Profit
3
 (e) Return on net worth.
< Answer >
28. Which of the following is not a model for predicting sickness of a firm?
(a) Beaver Model (b) BCG Matrix
(c) Altman’s Z Score Model (d) Argenti Score Board (e) Wilcox Model.
< Answer >
29. If the market price per share of Magnificent Ltd. is Rs.44, EPS is Rs.3.75 and retention ratio is 60%,
then the multiplier according to Graham-Dodd Model of dividend policy is
(a) 14.2 (b) 14.9 (c) 15.8 (d) 16.0 (e) 16.4.
< Answer >
30. The return on investment of a firm is 14% and cost of equity capital is 12%. According to the Walter
Model on dividend policy, in order to maximize the value of the firm, it 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.

END OF SECTION A

4
 Section B : Problems/ Caselets (50 Marks)
• This section consists of questions with serial number 1 – 6.
• 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. Prime Products Ltd. (PPL) had issued 15-year tax-free debentures on July 1, 2000 carrying a coupon rate of 10.5
percent payable semiannually. The issue provisions provide for a call option on these debentures after a term of 5
years at a price, which is 6 percent above the nominal value of the debentures. The interest paid by the company
on these debentures for the period July 1, 2004 to December 31, 2004 amounted to Rs.1,05,000. Because of a fall
in the interest rates, the company is planning to replace these debentures with effect from July 1, 2005, by new
debentures carrying a coupon rate of 8.5 percent payable semi-annually and having a maturity period of 10 years.
The company expects that the net amount realized from the issue of the new debentures will be equal to the total
nominal value of the existing debentures and the issue costs will amount to 1 percent of the net amount realized. It
is assumed that the coupon rate and the terms of coupon payment of the new issue reflect the prevailing effective
annual rate of interest on the debt securities of the companies similar to PPL.
You are required to find out the following:
(a) The direct costs associated with the replacement decision.
(b) The financial viability of the replacement decision being considered by the firm.
(3 + 6 = 9 marks) < Answer >
2. Penta Top Ltd. would like to segregate its client profile into the superior class and inferior class on the basis of the
current ratio and net profit margin. Given below is the information relating to 12 accounts consisting of an equal
number of superior and inferior clients:
Superior clients Inferior clients
Net Profit Margin Client Current Net Profit Margin
Client Current ratio
(%) ratio (%)
A 1.95 25 G 0.85 22
B 1.75 17 H 0.62 10
C 1.58 16 I 0.44 3
D 1.32 20 J 0.58 9
E 1.80 13 K 0.62 5
F 1.78 16 L 0.65 8
From the above information, you are required to estimate the discriminant function that discriminates between
superior and inferior clients.
(12 marks) < Answer >

Caselet 1
Read the following caselet carefully and answer the following questions:
3. For evaluating business performance both in financial and non-financial terms there is a necessity for the investors
to look beyond the ubiquitous information furnished by the media. There is a tendency among the investors to
overlook critically important indicators that would otherwise have enabled them to better discern the firm’s
potential for wealth creation. Do you agree? Justify your opinion.
(8 marks) < Answer >
4. There are different groups of people who read the financial statements, each looking for different types of
information. Earnings might be the most important area for investors, but other areas of information are also of
extreme significance. In this backdrop, explain how notes to accounts and Management Discussion and Analysis
provide insights to the investors.
(6 marks) < Answer >

5
Because there are literally hundreds of things about a company to examine when analyzing its stock, it is tough to know
where to start. Most investors are good at evaluating earnings, growth rates, revenue, and the P/E ratio, but they also
tend to overlook other aspects that can be just as important.
One of the items which the average investor tends to ignore is cashflow. This represents the constant flow of money in
and out of a company. All companies provide separate cash flow statements as part of their financial statements, but
cash flow can also be estimated as net income plus depreciation and other non-cash items. The second aspect which is
also generally overlooked by the typical investor is the management. This is one aspect of a company that can make a
world of difference. Think of management in terms of sports: Michael Jordan might not have been the "whole show"
during his reign at the Chicago Bulls, but he was undoubtedly a huge contributing factor to their success. The same is
true for the management of a business.
Further, receivables and the finished goods inventory are two items in the balance sheet on which the average investor
does not place enough emphasis. Receivables represent the sales for which the company has yet to collect the money.
Sales drive accounts receivable, so when sales are growing, accounts receivable will grow at a similar rate. Inventory of
the finished goods available for sale ties in closely with accounts receivable.
Two other items which the investors tend to lose sight of, in the maze of details that are present in any annual report are
the notes to accounts and the Management Discussion and Analysis(MD &A). These are the items which contain vital
information which can not be expressed in very objective terms or quantifiable in the financial statements.
The technique of looking at the overall company and its outlook is sometimes referred to "qualitative analysis," and it is
a perspective that is often forgotten. Peter Lynch once stated that he found his best investments by looking at the trends
his children follow.
Assessing a company from the fundamental/qualitative standpoint is one of the most effective strategies for evaluating a
potential investment, and it is as important as looking at sales and earnings. These overlooked areas are by no means the
only things investors need to evaluate, but looking at more than just the obvious will give you that extra advantage over
other investors. Earnings are important, but earnings are also the most widely published financial figure for any
company, so why base an investment decision solely on what other people already know? The moral here is always to
dig deeper by doing solid research so that you can aim to be a step ahead of the crowd.
Caselet 2
Read the caselet carefully and answer the following questions:
5. In a dynamic environment the companies can operate in the best interests of their shareholders only if they
effectively manage the risks they face. What are the necessary steps that the companies should take for
establishing effective risk management processes?
(9 marks) < Answer >
6. A company, which wants to establish an effective risk management system, should ideally create a highly
effective risk management group. How can a company create a highly effective risk management group in order to
establish an effective risk management system?
(6 marks) < Answer >
Risk is a fact of business life. Taking and managing risks is part of what companies must do to create profits and
shareholder value. But the corporate meltdowns of recent years suggest that many companies neither manage risk well
nor fully understand the risks they are taking. Such events are thus a reality that managements must deal with rather
than an unlikely "tail event." The directors’ unfamiliarity with risk management is often mirrored by senior managers,
who traditionally focus on relatively simple performance measures, such as net income, earnings per share, or growth
expectations of the market. Risk-adjusted performance seldom figures in these managers’ targets. Improving risk
management thus entails both the effective overseeing by the Board and the integration of risk management into day-to-
day decision making. Companies that fail to improve their risk-management processes face a different kind of risk:
unexpected and sometimes severe financial losses that make their cash flows and stock prices volatile and harm their
reputation to customers, employees, and investors.
Companies might also be tempted to adopt a more risk-averse model of business in an attempt to protect themselves
and their share prices. However, being risk-averse may not help the company in creating or maintainigng shareholder
value. The CEO of one Fortune 500 company, when asked to explain his company’s declining performance, replied that
it was due to the lack of a culture of risk- taking; he explained that its absence meant that the company was unable to
create innovative and successful products. By contrast, a senior partner of a leading investment bank with excellent
risk-management capabilities remarked, "Our operations have created a series of controls that enable us to take more
risk with more entrepreneurialism and, in the end, make more profits."
In order to manage risk effectively the companies must first understand what risks they are taking. They should clearly
6
articulate the major risks they are taking. The companies also need to know the potential impact on their fortunes, of the
risks they face and they should be transparent about it. The CEOs of the companies should then define, with the help of
the board, their companys’ risk strategy. But more often than not, it is determined inadvertently, every day, by dozens
of business and financial decisions. One executive, for instance, might be more willing to take risks than another or
have a different view of a project’s level of risk. The result may be a risk profile that makes the company uncomfortable
or can’t be managed effectively. A shared understanding of the strategy is therefore vital. The companies must then
create a high performing risk management group whose task will be to identify, measure, and assess risk consistently in
every business unit and then to provide an integrated, corporate-wide view of these risks, ensuring that their sum is a
risk profile consistent with the company’s risk strategy. Next the companies should create a risk culture in order to cope
with the dynamic nature of the businesses and to minimise undue risk taking by its managers. Lastly the board of
directors of the companies should understand and oversee the major risks it takes and ensure that its executives have a
robust risk-management capability in place.
Even world-class risk management won’t eliminate unforeseen risks, but companies that successfully put the elements
of effective risk management in place are likely to encounter fewer and smaller unwelcome surprises. Moreover, such
companies will be better equipped to run the risks needed to enhance the returns and growth of their businesses.
Without adequate risk-management processes, companies may inadvertently take on levels of risk that will leave them
exposed to the next risk-management disaster. Alternatively, they may pursue "extremely conservative" strategies,
foregoing attractive opportunities that their competitors can take. Either approach will surely be penalized by the
investors.

END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 7 - 8.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.

7. Reorganization of a firm in financial distress is often a more sensible solution than liquidation as the firm will be
more likely to repay its debts, when it is alive and operating than when it is liquidated. Explain the steps involved
in the reorganization of a financially distressed firm.
(10 marks) < Answer >
8. Corporate decisions are affected by a large number of variables. Many-a-times, the inter linkages between these
variables, and their resultant effect on the decision is extremely complex. Decision support models are used as a
tool to spell-out the relationships clearly in order to help the management to arrive at the optimal decisions.
Discuss the major steps involved in the process of building decision support models.
(10 marks) < Answer >
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Strategic Financial Management (MB361F): January 2005
Section A : Basic Concepts
1. Answer : (b) < TOP >

7
 Reason : According to the traditional approach to capital structure, as debt is added to the capital
structure the cost of capital declines initially because of lower post-tax cost of debt. But as
leverage is increased, the increased financial risk overweighs the benefits of low cost debt
and so the cost of capital starts increasing. Hence the correct answer is (b).
2. Answer : (c) < TOP >

EBIT + D 20 + 3
LR 2
I+ 3+
Reason : Fixed charges coverage ratio = (1 − T) = (1 − 0.35) = 3.78

3. Answer : (c) < TOP >

Reason : The marginal cost rate breaks down under a capacity constraints of transferor division. The
accounting price arrival using mathematical programming method is appropriate for transfer
pricing. This type of price is also called shadow price.
4. Answer : (e) < TOP >

Reason : Low cost strategy is one of the two strategies followed under value chain analysis. The other
strategy being differentiation strategy.
5. Answer : (a) < TOP >

D1 D 0 (1 + g ) 2(1.12)
+g
Reason : Required rate of return on the stock = P0 = P0 + g = 52.50 + 0.12
= 0.1627 i.e. 16.27%
6. Answer : (b) < TOP >

Total debt 5
Reason : Equity = 4 Adding 1 to both sides of the equation we get:

Total debt 5 Total debt + equity 5+ 4 Total asset 9

Equity + 1 = 4 + 1 or Equity = 4 or Equity = 4
Total asset × 4 4500 × 4
From above, Equity = 9 = 9 = Rs.2,000
Now, total assets = Total debt + equity = Rs.4,500
or Total debt + 2000 = 4500
or Total debt = 4500 – 2000 = Rs.2,500
Long term debt = Total debt – Short term debt = 2500 – 600 = Rs.1,900.
7. Answer : (b) < TOP >

Reason : When assets, which are not readily marketable, is required to be sold for need of funds, the
non-marketability may lead to liquidity risk. Thus the assets not being readily marketable
give rise to marketability risk.
8. Answer : (d) < TOP >

Re ceivables balance
Reason : Average collection period = Average daily sales

Sales
Average daily sales = 360

Re ceivables balance
x 360
∴ Average collection period = sales

Average collection period = 40 days (given)

Receivables balance = Rs.20 lakhs
20
x 360
∴ 40 = Sales

8
 20 x 360
or Sales = 40 = Rs.180 lakhs.
9. Answer : (d) < TOP >

Reason : The weights based on the book values are historical in nature and hence these do not reflect
the cost of capital owing to the changes in the business and financial risk of the company.
The reasons mentioned in the other options do not correctly reflect the advantages of
choosing the weights based on the book values in comparison to the market values.
10. Answer : (e) < TOP >

Reason : According to this theory the first and most popular is retained earnings as it has no
associated floatation cost.
11. Answer : (c) < TOP >

Reason : Gordon argued that the investors would prefer the income that they earn currently to that
income in future that may or may not be available. Hence, they prefer to pay a higher price
for the stocks which earn them current dividend income and would discount those stocks,
which either reduce or postpone the current income. For that reason, this model emphasizes
the entire weight on the dividends, while other models consider the dividend payment and
the retained earnings. Hence, the option (c) is correct.
12. Answer : (b) < TOP >

Reason : The cost of equity for Tractor India is:

D1 Do (1 + g )
+g = +g
P
Ke = o P0

3 × 1.08
+ 0.08 = 0.1340 = 13.40
60
= 0.1340 = 13.40%
0.134
Hence, the cost of external equity will be = 0.98 = 0.1367 = 13.67 percent
13. Answer : (c) < TOP >

Reason : Holding cash balance to meet contingencies is a manifestation of precautionary motive.

Transaction motive (a) is manifested when cash balance is held to meet the requirements in
the normal course of business. Speculative motive (b) is manifested when cash balance is
held for gaining from speculative activities. Further holding cash balance is a normal
practice for all types of firms, large or small (d) and (e).
14. Answer : (a) < TOP >

Reason : In the presence of floatation costs, the cost of external equity will always be more than the
cost of existing equity capital (a). It has got no logical connection with cost of long-term or
short-term debt. Hence (b), (c), (d) and (e) are all incorrect.
15. Answer : (d) < TOP >

Reason : Return on investment (ROI) = EBIT / Total assets

Total assets = Debt + Equity = 300 + 150 = Rs. 450 lakhs
EBIT = Rs. 90 lakhs (given)
∴ ROI = 90 / 450 = 20%
16. Answer : (c) < TOP >

Net profit
Reason : Return on net worth (RONW) = Net worth = 0.24 (given)
Net profit
Net profit margin = Net sales = 0.125 (given)
Net sales
Asset turnover ratio = Total assets = 0.85 (given)

9
 Net profit
Net worth
Return on networth Net profit Net sales
×
∴ Net profit margin × Asset turnover ratio = Net sales Total assets

0.24 Total assets

or 0.125 × 0.85 = Net worth

Total assets
or 2.2588 = Net worth
Subtracting 1 from both sides we get
Total assets − Net worth
∴ Net worth = 2.2588 – 1 = 1.2588
Debt
or Net worth = 1.2588.
Net worth 1
∴ Debt = 1.2588
Adding 1 to both sides we get
Net worth + Debt 1+ 1.2588
Debt = 1.2588
Total assets 2.2588
or Debt = 1.2588
Debt 1.2588
∴ Total assets = 2.2588 = 0.56.

17. Answer : (d) < TOP >

Reason : Debt-Asset ratio of 1:3 implies that for every 3 rupees of total assets there is one rupee of
debt and two rupees of equity. Hence, for every 2 rupees of equity there is one rupee of debt.
Hence (d) is true.
∴ In this case, for every 3 rupees of assets there are 2 rupees of equity. Hence (a) is not true.
Again for every 3 rupees of assets there is 1 rupee of debt. Therefore both (b) and (c) are not
true. For every one rupee of debt there are two rupees of equity; hence (e) is not true.
18. Answer : (a) < TOP >

Current assets
Reason : CR = Current liabilities = 2.45
Inventories
Current liabilities = 0.45
Inventories Current liabilities Inventories
×
Current Assets = Current Assets Current liabilities
1 Inventories 0.45
×
= CR Current liabilities = 2.45 = 0.184.
19. Answer : (c) < TOP >
Reason : According to Miller and Orr Model the Upper limit, UL = 3RP – 2LL
Where RP means return point and LL means lower limit.

UL + 2LL 60,000 + 2 × 15,000

⇒ RP = 3 = 3 = Rs. 30,000.

10
20. Answer : (d) < TOP >

Reason : Working capital/Total assets ratio is a balance sheet ratio. In the L C Gupta model, balance
sheet ratios are only the (Net Worth/Total Debt) and (All outside liabilities/Tangible assets)
ratios. All the other key ratios found suitable in predicting failure are profitability ratios.
21. Answer : (c) < TOP >

Reason : The increase in the nominal rate of interest must be higher than the increase in the rate of
inflation, if the interest income is subject to tax. This is necessary for maintaining the real
state of interest. The increase in nominal rate is given by
( Inflation rate after increase- Inflation rate before increase )
∆r = (1 − t r )
∆r = (6 – 4) / (1– .35)
∆r = 2 / .65 = 3.076% or 3.1%.
< TOP >
22. Answer : (e)
Reason : In stock split par value decreases and as a result market price per share decreases
immediately after a stock split.
< TOP >
23. Answer : (d)
Reason : (a), (b), (c) and (e) are the assumptions of Modigliani Miller Approach of capital structure.
Regarding growth no assumption have been made in the M-M approach. Hence (d) is not
correct.
24. Answer : (d) < TOP >

Reason : According to the Alcar model, there are seven value drivers that affect a firm’s value. These
are:
• The rate of growth of sales.
• Operating profit margin.
• Income tax rate.
• Incremental investment in working capital.
• Incremental investment in fixed assets.
• Value growth duration.
• Cost of capital
Obviously, dividend growth rate is a factor not considered in this model. So the correct
answer is (d).
25. Answer : (d) < TOP >

Reason : Costs that arise due to materials and products that fail to meet quality standards and result in
manufacturing losses are called internal failure costs
26. Answer : (b) < TOP >

Reason : Profit margins peak during the growth stage due to experience curve effect which lower the
unit costs and promotion costs are spread over a large volume.
27. Answer : (c) < TOP >

Reason : ROCE, Residual Income, Net Profit and Return on Net worth are all financial measures of
performance. However, employee morale & attitude is a non-financial measure of
performance.
28. Answer : (b) < TOP >

Reason : BCG matrix classifies the products into four broad categories. All others are the models for
predicting sickness of a firm.
29. Answer : (d) < TOP >

Reason : Market price as per Graham – Dodd Model is given by

 E
D + 
Po = m  3

11
 Given : Po = 44, E = 3.75, D = 3.75 (1 – 0.6) = 1.5

44
 3.75 
1.5 + 
⇒m=  3  = 16

30. Answer : (b) < TOP >

Reason : As per Walter Model

D + ( E − D) r / k
P0 = k
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.

12
 Section B : Problems
1. a. Direct cost of the replacement decision = Floatation costs + Call premium
Call premium (total) = Total nominal value × 0.06
1, 05, 000
=
 0.105 
 
Total nominal value =  2  Rs.20,00,000
∴ Call premium (total) = 20,00,000 × 0.06 = Rs.1,20,000
Floatation cost of new debentures = Net amount realized from the new debentures × 0.01
= 20,00,000 × 0.01
= Rs.20,000
∴ Direct cost of the replacement decision = 1,20,000 + 20,000 = Rs.1,40,000
b. NPV of the replacement decision :
Considering in terms of half year :
Interest savings after the new issue =
Total interest on new debentures – Total interest on old debentures
0.085
Total interest on new debentures = (20,00,000 + 20,000) 2
= Rs.85,850
Total interest on old debentures = Rs.1,05,000
Interest savings every half year = 1,05,000 – 85,850 = Rs.19,150
Number of half yearly periods up to maturity = 10 × 2 = 20
Coupon rate on new debentures
Discount rate = 2 = 4.25%
(Because the coupon rate and terms of coupon payment on the new debentures reflect the prevailing effective
rate of interest on the similar debt instruments)
∴NPV = 19150 PVIFA (4.25%,20) – 1,40,000
(1.0425) 20 − 1
20
PVIFA (4.25%, 20) = (1.0425) (0.0425) = 13.294
∴NPV = (19,150 × 13.294) – 1,40,000 = Rs.1,14,580 (Approx.)
Since the NPV is positive the decision is viable.
< TOP >
2. Let the discriminant function be Zi = aXi + bYi
where Zi = Discriminant score for the ith account
Xi = Current ratio for the ith account
Yi = Net profit Margin for the ith account.
CustomerAccount (Xi – (Xi – Xm)
Xi Yi (Yi –Ym) (Xi – Xm)2 (Yi – Ym)2
Xm) (Yi – Ym)
Gr. I A 1.95 25.00 0.79 11.33 0.6241 128.3689 8.9507
B 1.75 17.00 0.59 3.33 0.3481 11.0889 1.9647
C 1.58 16.00 0.42 2.33 0.1764 5.4289 0.9786
D 1.32 20.00 0.16 6.33 0.0256 40.0689 1.0128
E 1.80 13.00 0.64 -0.67 0.4096 0.4489 -0.4288
F 1.78 16.00 0.62 2.33 0.3844 5.4289 1.4446
Gr. II G 0.85 22.00 -0.31 8.33 0.0961 69.3889 -2.5823
H 0.62 10.00 -0.54 -3.67 0.2916 13.4689 1.9818
I 0.44 3.00 -0.72 -10.67 0.5184 113.8489 7.6824
J 0.58 9.00 -0.58 -4.67 0.3364 21.8089 2.7086
K 0.62 5.00 -0.54 -8.67 0.2916 75.1689 4.6818
L 0.65 8.00 -0.51 -5.67 0.2601 32.1489 2.8917
Total 13.94 164.00 0.02 -0.04 3.76 516.67 31.29
Average 1.16 13.67

13
 Xm = 13.94/12 = 1.16
Xm1 = Sum of Xi for Gr. I/6 = 10.18/6 = 1.70
Xm2 = Sum of Xi for Gr. II/6 = 3.76/6 = 0.63
Ym = 164/12 = 13.67
Ym1 = Sum of Yi for Gr. I/6 = 107/6 = 17.83
Ym2 = Sum of Yi for Gr. II/6 = 57/6 = 9.5
σx2 = (1/n-1) Σ(X - Xm)2 = (1/11) x 3.76 = 0.342
σy2 = (1/n-1) Σ(Y - Ym)2 = (1/11) x 516.67 = 46.97
σxy = (1/n-1) Σ(X - Xm) (Y - Ym) = (1/11) x 31.29 = 2.84
dx = Xm1 – Xm2 = 1.70 – 0.63 = 1.07
dy = Ym1 – Ym2 = 17.83 – 9.5 = 8.33
a = (σy2 dx - σxy dy)/ (σx2σy2 - σxy2)
= (46.97 x 1.07 – 2.84 x 8.33)/(0.342 x 46.97 – 2.84 x 2.84)
= 26.60 / 7.998 = 3.32
b = (σx2 dy - σxy dx)/ (σx2σy2 - σxy2)
= (0.342 x 8.33 – 2.84 x 1.07)/(0.342 x 46.97 – 2.84 x 2.84)
= – 0.1899 / 7.998 = – 0.024
Hence, the required discriminant function is Zi = 3.32Xi – 0.024Yi
< TOP >

Caselet 1
3. Figures reported in annual reports mean exactly what the company designs them to appear -neither more nor less.
So investors looking at fundamentals must discern on a company-by-company basis what the earnings whisper.
Thus, investors ought to use different parameters that make earnings evaluation easier, clearer, and more
meaningful. Some of the commonly overlooked indicators are: cashflow, management of the company and
composition of current assets in terms of inventory of finished goods and receivables.
Proper cash flow levels vary from industry to industry, but a company not generating the same amount of cash as
competitors is bound to lose out. A company without available cash to pay bills is in real trouble, even if the
company is profitable. By using the cash flow-to-debt ratio, which compares the amount of cash generated to the
amount of outstanding debt, you can judge the health of cash flow. This comparison reflects the company's ability to
service their loan and interest payments.
Good management doesn't do everything, but it certainly is an integral part of the company. Sam Walton (of Wal-
mart) and Jack Welch (of General Electric) are examples of people who led their firms through thick and thin,
recessions and booms. The responsibility of the management has been greatly enhanced in the wake of financial
turmoils and scandals that have shaken the investor confidence. The large-scale disasters of the likes of Enron and
Worldcom have served the purpose of highlighting the importance of good corporate governance which can only
be ensured by a prudent management.
Normally receivables grow in tandem with sales. So when sales are growing receivables should also grow at a
similar rate. Problems arise from receivables which are increasing faster than sales, which indicates that the
company is not receiving payment for its sales and thus leaving itself short for handling the expense of producing
those sales. Finished goods inventory also tends to respond to sales in a similar way to receivables. High
inventory is bad for several reasons. Firstly, there is a cost associated with storing the extra inventory: increases in
inventory cause higher storage costs. Secondly, a growing inventory can indicate that the company is producing
more than it can sell.
In addition to the above the vital information and crucial insights furnished by the footnotes to the financial
statements, the directors’ report on board responsibility and corporate governance, MD & A etc. tend to be
overlooked or side stepped by the common investors prior to making decisions.
It has been seen in the past that the traditional measures and the GAAP-based reported earnings, leaves companies
with plenty of room for creative accounting and manipulation. Operating earnings, which leaves out one-time
gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately,
many analysts now have their own criteria for what should be excluded, so analyzing and comparing companies
using operating earnings can be difficult for the investors. While it is probably impossible to develop a standard
that can handle every contingency, good and honest reporting is essential to assessing company fundamentals and
value.

14
 < TOP >

4. As a preface to the annual report, a company's management typically spends a few pages talking about the recent
year (or quarter) and gives a background of the company. While this is not the guts of the financial statements, it
does give investors a clearer picture of what the company does. It also points out some key areas where the
company has performed well. The management's analysis is provided at their discretion, so take it for what it's
worth. Issues that analysts might look for in this portion are how candid and accurate are the managers' comments,
does the manager discuss significant financial trends over past couple years, how clear are the managers
comments and do they mention potential risks or uncertainties moving forward? If a company gives an adequate
amount of information in the MD&A, it's likely that management is being honest. It should raise a red flag if the
MD&A portion of the financial statement ignores serious problems that the company has been facing. A good
example would be a company that is known to have large portions of outstanding debt but fails to mention
anything about it in the MD&A. Withholding important information not only deceives those who read the
financial statements, but in extreme cases also makes the company liable for lack of disclosure.
Similarly, the notes to the financial statements (sometimes called footnotes) are also an integral part of the overall
picture. If the income statement, balance sheet, and statement of cash flow are the heart of the financial statements,
then the footnotes are the arteries that keep everything connected. If the analyst does not read the footnotes he may
be missing out on a lot of information.
The footnotes list important information that could not be included in the actual ledgers. The notes list relevant
things like outstanding leases, the maturity dates of outstanding debt, and even details on where the revenue
actually came from. Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business.
This portion of the footnotes tells about the nature of the company's business, when its fiscal year starts and ends,
how inventory costs are determined, and any other significant accounting policies that the company feels that you
should be aware of. This is especially important if a company has changed accounting policies. It may be that a
firm is changing policies only to take advantage of current conditions to hide poor performance.
Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the
financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To
maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt such
as maturity dates and the interest rates at which debt was issued, can give you a better idea of how borrowing costs
are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details
about ominous legal proceedings the company is involved in.
The majority of investors and analysts read the balance sheet, income statement, and cash flow statement. But for
whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking
for information that others typically wouldn't.
< TOP >

Caselet 2
5. The necessary steps that the companies should take for establishing effective risk management processes are as
follows:
Understanding the risks that they are taking
To manage risks properly, companies must first understand what risks they are taking. In order to do so, they need
to make all of their major risks transparent and to define the types and amounts of risk they are willing to take.
Although these steps will go a long way toward improving corporate risk management, companies must also go
beyond formal controls to develop a culture in which all managers automatically look at both risks and returns.
Rewards should be based on an individual’s risk-adjusted—not simply financial—performance.
Achieving transparency
Every company must not only understand the types of risk it bears but also clearly know the amount of money at
stake. It needs to be transparent about the potential impact of these risks on its fortunes. Less obviously, it should
understand how the risks that different business units take, might be linked and what is the effect on its overall
level of risk. In other words, companies need an integrated view. The over-all risk position should be reviewed
frequently (perhaps monthly) by the top-management team and periodically (for instance, quarterly) by the board
to help them decide whether the current level of risk can be tolerated and whether the company has attractive
opportunities to take on more risk and earn commensurately larger returns.
Deciding on a strategy
High concentrations of risk aren’t necessarily bad. Everything depends on the company’s appetite for it.
Unfortunately, many companies never articulate a risk strategy. The CEO, with the help of the board, should
define the company’s risk strategy. Formulating such a strategy is one of the most important activities a company

15
 can undertake, affecting all of its investment decisions. A good strategy makes clear the types of risks the
company can assume to its own advantage or is willing to assume, the magnitude of the risks it can bear, and the
returns it demands for bearing them. Defining these elements provides clarity and direction for business-unit
managers who are trying to align their strategies with the overall corporate strategy while making risk-return
trade-offs.
Creating a high-performing risk-management group
The task of the risk management group is to identify, measure, and assess risk consistently in every business unit
and then to provide an integrated, corporate-wide view of these risks, ensuring that their sum is a risk profile
consistent with the company’s risk strategy. The structure of the organization will vary according to the type of
company it serves. In a complex and diverse conglomerate, such as GE, each business might need its own risk-
management function with specialized knowledge. More integrated companies might keep more of the function
under the corporate wing.
Encouraging a risk culture
The above steps will go a long way toward improving risk management but are unlikely to prevent all undue risk
taking. Companies might thus impose formal controls—for instance, trading limits. Yet since today’s businesses
are so dynamic, it is impossible to create processes that cover every decision involving risk. To cope with it,
companies need to nurture a risk culture. The goal is not just to spot immediately the managers who take big risks
but also to ensure that managers instinctively look at both risks and returns when making decisions.
Overseeing of the risk management processes by the board
A company’s board of directors should understand and oversee the major risks it takes and ensure that its
executives have a robust risk-management capability in place. In order to do this, the board must decide on the
committee on which the responsibility of overseeing the risk management should be vested. It should then ensure
that appropriate reporting to the board and its committees is done. It should also conduct regular training programs
for its existing and new members, and review the effectiveness of the risk management processes periodically.
< TOP >

6. A company, which wants to establish an effective risk management system, can create a highly effective risk
management group by following the steps given below:
Appointing top-notch talent
Risk executives at both the corporate and the business-unit level must have the intellectual power to advise
managers in a credible way and to insist that they integrate risk-return considerations into their business decisions.
Risk management should be seen as an upward career move. A key ingredient of many successful risk-
management organizations is the appointment of a strong chief risk officer who reports directly to the CEO or the
CFO and has enough stature to be seen as a peer by business-unit heads.
Segregation of duties
Companies must separate employees who set risk policy and monitor compliance with it from those who originate
and manage risk. Salespeople, for instance, are transaction driven—not the best choice for defining a company’s
appetite for risk and determining which customers should receive credit.
Clear individual responsibilities
Risk-management functions call for clear job descriptions, such as setting, identifying, and controlling policy.
Linkages and divisions of responsibility also need to be defined, particularly between the corporate risk-
management function and the business units. Should the corporate center have the right to review their risk-return
decisions, for example? Should corporate risk-management policies define specific mandatory standards, such as
reporting formats, for the business units?
Risk ownership
The existence of a corporate risk organization doesn’t absolve business units of the need to assume full ownership
of, and accountability for, the risks they assume. Business units understand their risks best and are a company’s
first line of defense against undue risk taking.
< TOP >

Section C
7. Reorganization
The steps involved in reorganization of a firm are
• Techno- economic viability study

16
 • Formulation and execution of the reorganization plan
• Monitoring the activities of the firm
Techno-economic Viability Study
A reorganization plan is worked out on the basis of a techno-economic viability study of the firm. This study sets
out to identify the strengths and weaknesses of the firm, the causes of failure, the viability of future operations and
the course of action to be taken to bring about a turnaround. The techno-economic viability study is undertaken by
the operating agencies assigned to the firm. These operating agencies are generally financial institutions and banks
such as IDBI , IFCI, ICICI, IRBI, SBI, PNB, etc.
The techno-economic viability study covers all the functional areas of a firm: management, finance, production
and marketing.
Management: The effectiveness and ability of the management is one of the most important factors that
determines the success or failure of a firm. A detailed study is done in terms of the objectives of the firm, both
short-term and long-term, the corporate strategy, the corporate culture, the management-labor relations, the
organizational hierarchy, the decision-making process, etc. The study tries to determine the effectiveness of
management and its integrity. The areas of mismanagement are also determined.
Finance: Finance it the main functional areas of business. It is a measurable indicator of the firm’s health and
performance. A though analysis of the firm’s Balance Sheet and Profit/Loss statement is made.
These statements when properly analyzed give the financial stability and liquidity of the firm; profitability and
uses of funds. The analysis also identifies the capital structure and the sources of unds. The analysis gives insight
into working capital management and management of earnings.
Production and Technology: Production and Technology function assumes immense importance in the viability
study. The various areas that are looked into are, the firm’s equipment and machinery, the maintenance of the
equipment, the technology used in production, the production capacity and utilization, the products being offered
by the firm, the quality control system, production planning and inventory control.
Marketing: A number of firms have failed because of lack of good marketing management. The various areas of
marketing that are studied are, the product mix of the firm, the past sales of the product in terms of quantity and
value, the market share of the firm, the demand for the product range, the study of the customer profile, the price
of the products, the distribution channels being used, the kind of promotion-mix being used and the most
important of all is the marketing team. This study is done in comparison with the competitors.
Formulation and Execution of the Plan
The viability study serves as the basis for formulation of a rehabilitation plan. A thorough study of the various
functional areas of the firm reveals the strengths, weaknesses, opportunities and threats of the firm. It gives a
comprehensive idea about the status of the firm, the viability of the firm both technically and economically and the
additional funds required for rehabilitation.
The formulation plan involves the changes and action to be taken regarding the various functions of the firm. It
may decide to make changes in the management, if it is not found competent. Some of the labour may be
retrenched/recruited depending on the situation. The amount of financial assistance to be given is determined and
arrangements are made to secure the loan. Various steps are taken to improve the production function in terms of
new machinery and new technology. The viable level of operations are determined and steps are taken to achieve
this production level. The product-mix, the pricing, the quality of the products, distribution channels and the
promotion-mix are to be changed to suit the needs of the customers, to achieve the desired sales levels. Once the
plan is formulated, the plan is carefully executed. All the necessary changes prescribed by the plan are made. The
funds are disbursed in a phased manner as and when required. The necessary concessions and reliefs are provided.
A close watch is kept on the activities of the firm and a continuous evaluation is done.
Monitoring
Monitoring is a very important part of a rehabilitation plan. It is done to evaluate the execution of the plan.
Regular meetings are held between the firm, the bankers, the financial institutions and other concerned parties to
verify and evaluate the process of execution. Monitoring is one to ensure the proper utilization of funds and
adherence to the terms of rehabilitation plan. It also ensures the proper working of the firm. Feedback is obtained
and remedial measures are taken as and when the situation demands. The impact of rehabilitation becomes evident
in a short period. Once the success of the firm becomes evident, the role of agencies and banks is confined to
constantly hold meetings to assess and revies the process. This continues till the firm is successful. In case the firm
is found incapable of making a turnaround despite the plan, then the steps to liquidate the firm are undertaken
< TOP >

8. THE MODELING PROCESS

17
The following are the major steps in the process of using a model to arrive at the optimal decision:
• Feasibility study
• Model construction
• Compatibility of the model with the tools used
• Model validation
• Implementation
• Model revision
• Documentation
Feasibility Study
The foremost step in developing a model is to ascertain the feasibility of a model assisting the decision making
process. The various points that are required to be considered are
Whether the decision under consideration is a one-time process, or is required to be taken as a routing measure
• The suitability of the area in which the decision is required to be made, to be supported by a model
• The possibility of all the relevant variable being unambiguously identified
• The possibility of all the variables being built-in into a single model
• The expected effectiveness of the model
• The acceptability of a model replacing human judgment to the management
• The possibility of obtaining the required date on an ongoing basis
• The possibility of integrating the model with the normal decision-making process
• The costs involved with setting up and running the model, and its comparision with the expected benefits.
If it is feasible to construct an efficient and effective model for the decision process under consideration, and if the
model can be easily integrated with the process, the firm can proceed to the next step of constructing the model.
Model Construction
• The construction of the model depends on a number of factors. Some of these are
• The decision to be made using the model
• The issues that are relevant for making the decision
• The way in which these issues and factors affect the decision
• The external factors that restrict the decision making process.
Depending on these factors, the input requirement for the model is identified and the numerical and theoretical
relationship between variable are specified. This is followed by development of the structure of the model.
Model Compatibility
Once the model is in place, it needs to be made compatible to the tools to be used to implement it. For example, if
a particular model is to be solved using computers, the model needs to be programmed and converted to a
language that the computer understands.
Model Validation
A number of test runs are conducted on the model to check whether it produces reasonable accurate results. The
test runs may use actual past data of the input variables, and the results generated by the model compared to the
actual results. Alternatively, the model may be tested by using results. Alternatively, the model may be tested
probability distributions. Test running a model checks the effectiveness of the structure of the model, as well as its
predictive ability.
Implementation
The implementation of a model includes integrating it with the normal decision-making process. Further ,it needs
to be ensured that the results generated by the model are relevant enough for the decision-making to take them into
consideration while making a decision.
Mode Revision
No model remains useful for an indefinite period. The relationship between different variables that forms a basis
for the model may change over a period of time. External factors affecting a model may also change. Use of the
model over a period may provide an insight into its drawbacks. It is necessary that such changes are noted and the
model periodically revised to accommodate them. Unless a model is continuously updated, it may lose its
relevance.
Documentation
Documentation is way of institutionalization of the knowledge created during the process of developing and

18
installing a model. It involves making detailed, systematic notes at all the stages of the process. The records
should be maintained right for the stage when the need for the model was felt, detailing the factors that gave rise to
the need. The various ideas considered at different stages needs to be documented along with the reasons for their
acceptance of rejection. The various problems faced during the development and implementation of the model,
together with their solution should also form a part of the records. Documentation also helps in proper
communication between the members of the team working on the development of the model. In addition, it makes
the process of revision the model less tedious.
While developing the implementing models, certain issues need to be kept in mind. It is not just necessary to
specify the objectives of the model, it is also necessary to build the relative importance of the different objectives
into model. For example, the objective may be to maximize the profits of the firm, while restricting the debt taken
by it to a certain percentage of the total assets. The model should specify the objective(maximum profits or limited
debt) that would be held supreme, if there were a clash between the two. Another important point to be
remembered is that the model should preferable focus on some key aspects, rather than be a collection of all
relevant and irrelevant data. A focused model is more likely to generate effective decision.
< TOP >

< TOP OF THE DOCUMENT >

19