CS-Professional Paper-3 Financial, Treasury and forex Management (Dec - 2010) 1.

Comment on any four of the following : (i) Dividend policy is strictly a financial decision and payment of cash dividend is a passive residual. Answer : As per the Residual theory of Dividend policy, dividend policy is strictly a financing decision and payment of cash dividend is a passive residual. Dividend decision constitutes one of the important decisions which a finance manager has to take. Dividend payout ratio and retention ratio are determined keeping in mind the investment avenues available and expected profitability in such projects. If good investment opportunities exist, the dividend payout will be low, whereas if no such avenues exist, high dividend payout will be there. (ii) Depository system functions very much like banking system. Answer : Please refers to 2007 - Dec [7] (vi) of chapter 8 financial services on page no. 284 (iii) Accounting profit does not take into account all costs of capital invested in business. It is true to state that accounting profit does not take into account all cost of capital invested in business. Accounting profit takes only cost of debt into consideration. It does not gives due importance to cost of equity. Thus, an important segment of cost of capital being cost of equity is ignored and hence accounting profit do not reflect the correct quantum of profit. (iv) The mark to market process is lengthy for index futures. Answer : The mark- to- market proves out to be a lengthy process in case of index futures. Mark -to-market settlement calls for daily settlement of the

surplus deficit of the open position. Such differences are to be settled out on daily basis. These settlements are to be made in cash. Thus mark-to-market settlement in case of index futures is a bit complicated. (v) Financial gearing is a fair weather friend. Financial gearing is often termed as a fair weather friend. Financial leverage is calculated as a relationship between EBIT and EBT. A high financial leverage has a positive impact on EPS and consequently MPS, the maximisation of which is the objective. A higher EBIT has the potential of covering the interest expense and consequently result in higher EPS However, a high financial leverage may at the same time prove out to be quite a risky if EBIT is not sufficient to cover the interest expense. 2(a) Following figures relate to Twinkle Ltd. Solutions : Raw Material Work-in-progress Finished Goods (F.G.) 5,37,500 (WNo1) Debtors Cash Balance Prepaid Sales promotion 10,31,250 1,25,000 1,50,000 Less : Creditors wages Manufacturing expenses Administrative expenses (1,40,625) (75,000) (1,00,000) (25,000) 93,750

Add : Safety margin of 5%

15,96,875.00 79,843.75

Total working capital required 16,76,718.75 Working Notes Sales Gross profit Depreciation 45,00,000 25% of 45,00,000 150,000 = 32,25,000 (W No 2) Debtors = Total manufacturing cost Calculated on + Administration expenses + Sales Promotion expenses = 32,25,000+3,00,000+6,00,000=41,25,000 (b) Gel Corporation presently gives credit term of 'net 30 days' Particulars Sales Increase in sales Inc in contribution @ 20% Debtors = 60,00,000 Investment in debtors Increase in investment in debtors Net Benefit (A)-(B) 60,00,00020% = 12,00,000 = 115,00,000 115,00,00020% 23,00,000 1100,000 (B) 7 lakh Existing 600 lakhs Proposed 690 lakhs 90 lakhs 18 lakhs (A)

So, Gel corporation needs to extend its credit period from the existing 45 days to 75 days as it would result in increase in profits by Rs. 7,00,000 Working Note : Debtors have been calculated by applying 80% because variable cost is 80% only.

3(a) Sushmita Ltd. produces an electronic component with a selling price of Rs 100.............. Present Sales Less : Profit Cost of Production (-) Fixed Cost Contribution Variable cost (Sales contribution) No of units Variable cost per unit Contribution Total Contribution So, profit 5,00,000 (=5000100) 50,000 4,50,000 (2,00,000) 2,50,000 2,50,000 5,000 50 50 2,50,000 (=500050) 50,000 40 = (50 10) 55 385000 (=700055) 1,35,000 (=385000) ( ) 2,00,000 4,0000 (=4,00,000 10%) 50,000 5 4,000 95,000 2.85 4545.4 (2,00,000) Proposed 6,65,000 (=7,00095) (Not given)

(-) Additional investment Profit Operating Leverage BEP

(b) You are given following information of Alpha Ltd. for the.... Solution Sales (-) Variable Cost Contribution (-) fixed cost EBIT (-) Interest EBT (-) Tax@30% PAT (Rs. in thousand) 1,05,000 76,700 28,300 7,500 20,800 11,000 9,800 2,940 6,860

Operating leverage = Contributions EBIT = Financial leverage =

Combined leverage =

or, CL = OL FL = 1.3612.122 = 2.888 (c) Security A offers an expected rate of return of 14% with a standard deviation........... Solution Return Risk Security A 14% 8% Security B 11% 6%

We know Rp = Ra Wa + Rb Wb Where; Rp = Return of portfolio

Ra = Return on Security A Wa = Weight of security A Rb = Return on security B Wb = Weight of security B 12.8 = 14 x +11(1-x) 14x+11-11x = 12.8 3x = 1.8 x = .6 So, Wa = .6, Wb = .4 Thus the percentage of security A in the portfolio will be 60% Q 4) Distinguish between any four of the following : (i) 'Financial distress' and insolvency. Answer : Please refer to 2008 - June [4] (ii) of Distinguish between on page no 16 (ii) Learning and hire purchase Basis 1. Meaning Leasing Lease is an agreement in which the lessor provides the asset to the lessee for a fixed consideration and pre-determined time Lessee is never the owner Hire Purchase It is a contractual arrangement whereby the owner gives his goods on hire to the hirer Hirer becomes the owner on payment of last installment Hirer is entitled to claim deprecation

2.

Owner

3.

Benefits

Lessor claims depreciation while lessee claims tax benefit on lease rentals In case of finance lease or operating lease the lessee may bear the cost of maintenance

4.

Cost of Maintenance

C o s t o f maintenance is always borne by the hirer.

(iii) 'Financial viability of a project' and commercial liability of a project Basis Financial liability Commercial liability Meaning It takes into account whether the project is financially feasible taking into consideration profitability aspects and fixed expenses including interest It takes in its purview cost of project, projection of cash flow forecast of profits etc. It considers whether the project is commercially possible taking into account its ability to withstand n a t i o n a l & international competition Demand of the product, supply of raw materials, import or export are covered in it.

Scope

(iv) 'Clearing mechanism'' and 'settlement mechanism' Basis Clearing mechanism Settlement mechanism Meaning It is a process carried out to calculate which party owner the other and by how much. Settlement mechanism refers to the process of settling out the net position i.e. give or take of the instruments/ securities as well as money. Settlement cycles are fixed in advance such As 1&2 days i.e. settlement will take place after 2 days of entering the transaction.

Who & When

clearing corporation of the stock exchange perform this clearing function.

(v) Return on capital employed and 'return on networth Basis Return on capital Return on net worth employed (ROCE)

Meaning

I t e x p r e s se s t h e relationship between EBI T a nd c ap it al employed

It reflects the relation between profit available for equity shareholders and equity shareholder's funds. It is a tool which examines the profitability from the point of view of shareholders = Profits available for equity shares 10% Equity shareholders fund

Objective

It helps us to analyse the over all profitability of the firm

Formula

ROCE = EBIT 100 Capital employed

Q 5) India Inc's dependence on bank for funding appears to be showing decline with the............. Answer : Please refer to 2007-June [4](a) of chapter A sources of finance on page no. 165 (iii) Unlike deposits and other modes of finance which prove out to be fair weather friends bank finance is not affected by liquidity position of the firm. Q 6 (a) Sushant Ltd. has the following capital structure....... Solution : Particulars Amount Cost of Weight WACC capital Equity shares 10% Preference share 14% Debenture 50,00,000 10,00,000 24% 10% (WNo2) .625 .125 15 1.25

20,00,000 80,00,000

9.8% (WNo1) ---

.250 1.

2.45 18.7

Thus the WACC is 18.70% Working Notes : WNo1 K(d) = I (1-t) = 14 (1 .3) = 9.8% WNo2 K (p) = 10%

WNo3 + .08 = .24 K (e) = 24% (ii) Particulars Amount Cost of capital 33% 10% 9.8% 10.5% -Weight WACC

Equity Shares 10% Preference share 14% Debentures 15% Debentures

50,00,000 10,00,000 20,00,000 20,00,000 100,00,000

.50 .10 .20 .20 1

16.50 1.00 1.96 2.10 21.56

Hence, the cost of capital is 21.56% (ii) W Note : (b) A company is considering there to methods of attracting customers to expand its business......... Alternatives Initial Investment NPV A B C A+B+C A+B A+C B+C 1,00,000 1,50,000 1,50,000 400,000 2,50,000 2,50,000 3,00,000 1,25,000 45,000 90,000 2,90,000 2,00,000 2,15,000 1,35,000

Conclusion : Investment in the following should be made by the company. (a) If firm no budget constraint : As is evident from the table drawn above, all the projects A,B and C are profitable ventures and company should go in for all the

three. In such a case, NPV will be 2,90,000. (ii) If the budget amount is only Rs. 2,50,000 In such a case the company should opt for (A) and (c) modes as in such a case NPV expected is Rs. 2,15,000 7) Write notes on any four of the following : (i) Secured Premium Notes Secured Premium Notes also known as SPN are financial instruments issued for a definite term period with detachable warrants along with them. These warrants entitle the holders of SPN to receive equity shares. Such SPN have a fixed lock in period. For such lock-in-period no interest is paid (ii) Important motives to hold cash Answer : There are three important motives to hold cash, being (a) Transactional Motive : It is the prove motive of holding cash. Cash is the most liquid medium It is cash which helps to carry out all the transaction of the firm. (b) Precautionary Motive : As the name suggests, cash is also required for precautionary reasons. Cash helps to mitigate uncertainty and contingencies. (c) Speculative Motive : The speculative motive covers the aspect that cash can be utilised to earn more cash by making investments in profitable avenues. (iii) Domestic resource cost Please refer to 2009 - Dec [7] (v) of Short Notes of chapter 9 project planning and control on page no. (iv) Purchasing power parity Please refer to 2009 - June [4] (iii) of Distinguish Between of Chapter 12 forex Management on page. no.

10

(v) Factoring Answer : Please refer to 2007 - June (iii) of Chapter 8 Financial Services on page no. 283

11