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Question Paper

Treasury & Forex Management (MB3H1F) : October 2008 i.exe

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.

1. Which of the following statements is true? <Answer>

(a) Effective rate of interest is always lower than the nominal interest rate
(b) The effective rate of interest increases with increase in the frequency of compounding
(c) The nominal interest rate increases with increase in the frequency of compounding
(d) The effective and nominal interest rates are equal if the frequency of compounding is less than four
(e) The frequency of compounding does not affect the effective and nominal interest rates.
2. Rs.1,40,000 was borrowed at an interest rate of 12% per annum. The amount has to be repaid with interest in ten equated annual<Answer>
installments. Each installment is payable at the end of every year. What will be the amount of each installment?
(a) Rs.27,225
(b) Rs.26,273
(c) Rs.24,778
(d) Rs.23,469
(e) Rs.22,758.
3. A bond with a par value of Rs.3,000 bears coupon rate of 12% and has maturity period of 8 years. If the required rate of return on the<Answer>
bond is 14%, the value of the bond is
(a) Rs.2,684.24
(b) Rs.2,721.80
(c) Rs.2,861.45
(d) Rs.2,904.20
(e) Rs.2,986.36.
4. Micro Ltd., is considering investing in a plant requiring outflow of Rs.250 lakh. The plant has an economic life of 5 years. The<Answer>
financial analyst of the company has projected the following cash flows for the project:
(Rs. Lakh)
Year Cash flow
0 250.00
1 57.50
2 69.50
3 82.10
4 90.20
5 123.68
If the cost of capital for the company is 16%, the discounted pay-back period is approximately
(a) 2.58 years
(b) 3.36 years
(c) 4.25 years
(d) 4.79 years
(e) 5.00 years.

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5. Consider the following data of M/s. Hertz Ltd.: <Answer>

Profit after tax Rs.16.98 lakhs


Interest on loan Rs. 9.6 lakhs
Non cash charges Rs. 7.5 lakhs
Repayment of term loan Rs. 8.4 lakhs
Debt-service coverage ratio of the company is
(a) 1.72
(b) 1.83
(c) 1.89
(d) 1.98
(e) 2.00.
6. Which of the following ratios measure the long-term solvency of a firm? <Answer>

(a) Liquidity ratios


(b) Profitability ratios
(c) Earnings ratios
(d) Leverage ratios
(e) Efficiency ratios.
7. Which of the following reasons of capital expenditure decisions occupy a very important place in corporate finance? <Answer>

I. Once the decision is taken, it has far-reaching consequences which extends over a considerably long period, and influences the
risk complexion of the firm.
II. These decisions involve huge amount of money.
III. These decisions are irreversible in nature.
IV. These decisions are difficult to make when the company is faced with various potentially viable investment opportunities.
(a) Both (I) and (IV) above
(b) Both (II) and (III) above
(c) (I), (II) and (IV) above
(d) (II), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
8. The current ratio and quick ratio of Kendra Industries Ltd., are 1.2 and 0.8 respectively. The net working capital of the firm is<Answer>
Rs.6,00,000 with an inventory of
(a) Rs. 7.50 lakh
(b) Rs. 9.00 lakh
(c) Rs.11.25 lakh
(d) Rs.12.00 lakh
(e) Rs.14.00 lakh.
9. Consider the following rates quoted in forex market: <Answer>

Rs./$ : 45.80/82
£/Euro : 0.6940/42
$/£ : 1.7790/92
The synthetic quotes of Rs./Euro are
(a) 56.55/56.59
(b) 56.56/56.60
(c) 56.57/56.61
(d) 56.54/56.58
(e) 56.53/56.57.
10.The system under which the exchange rates are determined by the demand and supply position of the currencies in the foreign<Answer>
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.

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11. Which of the following is not a function of EXIM Bank? <Answer>

(a) Lending
(b) Guaranteeing
(c) Exporting
(d) Promotional services
(e) Advisory services.
12.Consider the following information about Tide Ltd.: <Answer>

Particulars Rs.
Annual consumption of raw material 20,000
Annual cost of production 25,000
Annual cost of sales 1,00,000
Average stock of raw materials 7,500
Average work-in-process 2,000
Assuming 360 days in a year, the average conversion period of the company is
(a) 7.2 days
(b) 16.0 days
(c) 28.8 days
(d) 32.4 days
(e) 34.2 days.
13.Which of the following statements are true regarding Certificate of Deposits (CDs)? <Answer>

I. CDs can only be subscribed by corporations.


II. CDs are issued at a discount to face value.
III. CDs are freely transferable by endorsement and delivery.
IV. CDs are associated with high amount of default risk.

(a) Both (I) and (II) above


(b) Both (II) and (III) above
(c) Both (III) and (IV) above
(d) (II), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
14.The face value of the equity share of Red Star Ltd., is Rs.100 and the current market price of the share is Rs.80. The company is<Answer>
expected to declare a dividend of 20% during the current year. If the dividends are expected to grow at the rate of 10% p.a., the
expected rate of return on the share is
(a) 8.0%
(b) 12.5%
(c) 17.5%
(d) 32.0%
(e) 37.5%.
15.The following information have been collected about Paradise Ltd.: <Answer>

Total sales Rs.14,00,000


Contribution ratio 25 %
Fixed expenses Rs. 1,50,000
12.5% Debentures Rs. 4,00,000
15% Preference shares Rs. 2,00,000
Corporate tax rate 40 %
The Degree of Financial Leverage (DFL) for Paradise Ltd., is
(a) 1.33
(b) 1.50
(c) 1.67
(d) 2.00
(e) 2.33.

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16.A quote expressed in terms of number of units of domestic currency per unit of foreign currency is known as <Answer>

(a) Direct quote


(b) Indirect quote
(c) American quote
(d) European quote
(e) Merchant quote.
17.According to the Walter model on dividend policy, if the return on investment of a firm is greater than the cost of equity capital, the<Answer>
value of the firm will be maximized, if the firm
(a) Maintains a zero payout ratio
(b) Pays out its entire earnings as dividends
(c) Retains half of its earnings
(d) Pays out more than half of its earnings as dividends
(e) Pays out less than half of its earnings as dividends.
18.Capital Indexed Bond is an instrument designed by RBI to minimize which of the following risks? <Answer>

(a) Currency risk


(b) Political risk
(c) Inflation risk
(d) Reinvestment risk
(e) Default risk.
19.Fund management, forex management and risk management are the responsibilities of <Answer>

(a) Tax Manager


(b) Controller
(c) Treasurer
(d) Accountant
(e) Finance Manager.
20.Stepin Bakers formulates its credit policy on the basis of average days’ sales outstanding (DSO) at the end of every quarter. The<Answer>
monthly sales and outstanding receivables for the year 2008 are as follows:
(Rs. Lakh)
Month Sales Receivables Month Sales Receivables
January 480 1,000 July 500 800
February 540 860 August 550 850
March 550 750 September 600 850
April 400 700 October 500 650
May 450 750 November 600 950
June 450 700 December 600 800
The average collection period in second quarter is
(a) 35 days
(b) 38 days
(c) 44 days
(d) 49 days
(e) 51 days.
21.Which of the following statements is false? <Answer>

(a) Storage lag represents a cost to the firm


(b) The time gap between the sale of goods and collection of cash is known as sales lag
(c) Shelf stock refers to items that are stored by the firm and sold with little or no
modification to customers
(d) Inventories provide a buffer between purchasing, producing and marketing goods
(e) Maintaining inventories increases total ordering costs.

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22.The average collection period of Delta Ltd., is higher than the credit period extended by it, this indicates that firm <Answer>

I. Has Satisfactory liquidity position.


II. Has a Liquidity crunch.
III. Has High liquidity.
IV. Has to make an effective collection effort.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (IV) above
(e) Both (II) and (IV) above.
23.Which of the following is not a direct form of finance provided by banks? <Answer>

(a) Cash credit


(b) Overdraft
(c) Packing credit
(d) Letter of credit
(e) Discounting of bills.
24.Which of the following statements is/are true? <Answer>

I. Liberalizing credit standards will increase investment in accounts receivables by pushing up sales.
II. Shortening the credit period will increase bad debts as customers will not be able to pay within the shorter period.
III. A rigorous collection program will bring down sales and increase the percentage of bad debts.
IV. A cash discount will increase average collection period and increase bad debts.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) Both (III) and (IV) above.
25.A company has retained earnings of Rs.70 lakh and equity capital of Rs.35 lakh. If the equity investors expect a rate of return of 18%<Answer>
and the cost of issuing fresh equity is 7%, the cost of the external equity is
(a) 16.42%
(b) 17.41%
(c) 17.70%
(d) 18.16%
(e) 19.35%.
26.Which of the following is/are reasons for Purchasing Power Parity (PPP) not holding good? <Answer>

I. Constraints on movements of commodities.


II. Price index construction.
III. Effect of the statistical method employed.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
27.Which of the following theories assumes that an identical product or service can be sold in different markets with the same price,<Answer>
provided there are no restrictions on the sales and no transportation costs are involved?
(a) The law of one price
(b) The Fisher effect
(c) Market parity theory
(d) Purchasing power parity
(e) Efficient Market Theory.

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28.Which of the following is true under a currency board system? <Answer>

(a) The interest rates are automatically set by the market mechanism
(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.
29.Current account deficit for a country implies that <Answer>

I. Gross domestic investment is greater than gross domestic savings.


II. Gross domestic savings are greater than gross domestic investment.
III. There is a decline in foreign exchange reserves.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
30.Consider the following information relating to Delux Ltd.: <Answer>

Preference dividend Rs. 30,000


Corporate tax rate 40%
Interest Rs. 65,000
Fixed expenses Rs.6,00,000
Selling price per unit Rs. 900
Variable cost per unit Rs. 400
The level of output at which the DTL will be undefined is
(a) 1,480 units
(b) 1,430 units
(c) 1,390 units
(d) 1,366 units
(e) 1,354 units.

END OF SECTION A

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.

<Answer>
1. JayPee Ltd., a construction company is considering 4 projects – P1, P2, P3 and P4
with the following characteristics:
(Rs. in
Crores)
Initial investment Annual net cash flows
Projects
(Year 0) (Year 1 to 5)
P1 (25) 9.5
P2 (6.5) 2.5
P3 (8) 3.5
P4 (9) 4.0
The funds available for investment are limited to Rs.25 crores and the cost of
funds to the firm is 12%. You are required to:
a. Rank the projects in terms of the NPV and BCR criteria. ( 8 marks)

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b. Recommend which project(s) should be selected, given the limited
availability of funds. ( 2 marks)
<Answer>
2. a. Dataone, in its issue of Flexibonds, offered Growing Interest Bond. The
interest will be paid to the investors every year at the rates given below:
Year Interest (p.a.)
1 10.50%
2 11.00%
3 12.50%
4 15.25%
5 18.00%
You are required to calculate the Yield to Maturity (YTM) of bond assuming
that Mr. Brijesh deposited Rs.5,000 on purchasing the bond and holds it till
maturity. ( 6 marks)
b. Mr. Kiran is planning to invest in the equity stocks of Betavision Ltd. The
current share price of Betavision Ltd., is Rs.150 and the company has
declared a dividend of Rs.10 per share for the current year. Mr. Kiran is of
the opinion that the dividend per share will remain at the same level for the
next two years, after which it will grow at the rate of 25% per annum in the
third and fourth years. From the fifth year onwards dividends are expected to
grow at a normal rate of 12% per annum. If the required rate of return of Mr.
Kiran is 14% per annum, you are required to calculate the intrinsic value of
the share and suggest Mr. Kiran in purchasing of equity shares of Betavision
Ltd. ( 6 marks)
<Answer>
3. Lead Industries, Mumbai imported tanning machines from Holland under an
irrevocable letter of credit. The LC negotiating bank forwarded all the shipping
documents by courier and obtained reimbursement on 28/08/2008. The bank in
Mumbai received the documents on 01/09/ 2008. The bill amount payable was
Euro 50,000. The importer had sufficient funds to settle the import bill on 01/09
/2008, but deferred the settlement to the last date i.e. on 11/09/ 2008 by
anticipating that the rupee would appreciate. Bank quotes the exchange rate by
loading an exchange margin of 0.10%. Commission at the rate of 0.15% was
recovered on the bill amount. Interest is recovered at 12%.
The spot exchange rates as on 01/09/ 2008 and 11/09/ 2008 are given below:
01/09/ 2008 11/09/ 2008
Mumbai Rs. / $ 45.90 / 92 45.96 / 98
London $/£ 1.8969 / 71 1.8993 / 95
Euro / £ 1.4879 / 81 1.4897 / 99
Note: As per FEDAI rules, sight import bills received under LC are to be retired
by the importer on or before 10 days after the date of receipt of the documents by
the bank.
You are required to calculate:
a. The effective exchange rate on 01/09/ 2008. ( 4 marks)
b. Gain or Loss to the importer for settling the amount on 11/09/ 2008. ( 3 marks)
c. Actual rupee outflow to the importer on the date of settlement. ( 3 marks)
Caselet
Read the caselet carefully and answer the following questions:
<Answer>
4. Exchange rate is the value of one currency in terms of another and there are many
ways in which exchange rate can be determined. Explain the difference between
floating exchange rate and fixed exchange rate mechanisms in determining foreign
exchange rates in foreign exchange transactions. ( 9 marks)
<Answer>
5. State and explain the advantages of the flexible exchange rate system. ( 9 marks)
The world has witnessed many changes and developments – in technology,
politics, culture, as well as economics – over the years, and the IMF has adapted
7
itself accordingly. At the time of IMF’s establishment, its policy advice focused
mainly on helping members to shape sound macroeconomic and financial policies,
within the disciplines of the Breton Woods system of fixed exchange rates. The
breakdown of that system in the early 1970s, and the resultant Second Amendment
of the IMF’s Articles of Agreement, led to a re-orientation of the IMF’s functions.
In particular, the revision of Article IV, and the introduction of the surveillance
process, explicitly recognized the close relationship between domestic economic
policies and international stability. To this day, this forms the basis for systematic
and comprehensive review of economic conditions and policies in each member
country. Similarly, the wave of de-colonization that swept the world from the
1950s onwards placed new and complex responsibilities on the Fund. The IMF
quickly found that countries looked to it for advice and assistance beyond the
traditional macroeconomic areas of fiscal policy, monetary policy, and exchange
rate systems. In addition to these subjects, IMF advice and assistance were also
sought on establishing the institutions of monetary and fiscal policy, and on
supply-side structural policies to help promote sustained growth. In the last fifteen
years, following the end of the Cold War, new challenges were created in this
regard by the transition of former centrally-planned economies to market-based
systems. Through its work in these areas, it also became increasingly clear that
structural and institutional issues were important for stability and growth in other
member countries too, including the major industrial economies. The area of IMF
financing has also seen great transformation. For example, although IMF lending
continues to be targeted at short-term balance of payments needs, its financing
instruments have, for nearly two decades, included concessional lending for low-
income countries. In response to the rapid development of international capital
markets as a major source of financing for countries, special IMF financing
policies have also been put in place to assist countries facing capital account
driven crises. Related to these capital market developments, the Fund also began
to play an unanticipated role in facilitating the resolution of sovereign debt
problems. This function became critically important following the emergence of
the debt crisis in 1982, and it remains so today. All of these changes – ranging
from de-colonization and transition, to the rapid development of private
international capital flows and new instruments, to the emergence of capital-
account driven crises – posed new challenges for the IMF. In many cases, these
developments touched upon issues which lay at the frontiers of economic
knowledge and research. Addressing them has led to a significant transformation
of the Fund, including a broadening of the skills private financial sectors, and
more involvement in institutional development in member countries. In the
process, the IMF has also become a more open and transparent institution.

END OF CASELET

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.

<Answer>
6. For running business smoothly, a firm always maintains large number of
inventory items. However, it is extremely difficult to monitor information to
control each item. In this context, explain the ABC system of inventory
management that enables a firm for better control of stock position. Also
discuss its advantages and disadvantages.
( 10 marks)

8
<Answer>
7. Despite all the obvious benefits of international trade, governments have an
inclination to put-up trade barriers in order to discourage imports. Discuss the
various types of trade barriers that a government can resort to.
( 10 marks)

END OF SECTION C

END OF QUESTION PAPER

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Suggested Answers
Treasury & Forex Management (MB3H1F) : October 2008
Section A : Basic Concepts
Answer Reason
1. B The interest rate usually specified on an annual basis in a loan agreement or security is < TOP >
known as the nominal rate of interest. If compounding is done more than once a year,
the actual rate of interest paid (or received) is called effective interest rate. Effective
interest rate would be higher than the nominal interest rate.
The effective rate of interest increases with increase in the frequency of compounding.
For example, the effective rate of interest under quarterly compounding will be more
than the effective rate of interest under semi-annual compounding.
2. C The amount of each installment will be < TOP >
1, 40, 000 1, 40, 000
= =
= PVIFA(12%,10 years) 5.6502 24777.88
= 24,778(approx)
3. B PVIFA(Kd , n ) ) F (PVIF(Kd, n ) ) < TOP >
V = I( +

= 360 ( PVIFA (14% , 8) ) + 3000 ( PVIF(14% , 8) )


= 360 (4.6389) + 3000 (0.3506)
= 1670.004 + 1051.80
= 2721.804.
4. D < TOP >
Year Cash flow PVIF@16% Present value
0 250.00 1.000 250.00
1 57.50 0.862 49.57
2 69.50 0.743 51.64
3 82.10 0.641 52.63
4 90.20 0.552 49.79
5 123.68 0.476 58.87
250-(49.57 + 51.64 + 52.63 + 49.79)
The discounted payback = 4 +
(49.57 + 51.64 + 52.63 + 49.79 +58.87)-(49.57 + 51.64 + 52.63 + 49.79)
250 - 203.63 46.37
The discounted payback = 4 + = 4+ = 4.79
262.5 - 203.63 58.87
5. C Debt service coverage ratio = < TOP >
PAT + Depreciation + Other non-cash charges +Interest on term loan
Interest on term loan + Repayment of the term loan

16.98 + 0 + 7.5 + 9.6


= 9.6 + 8.4
= 1.89
6. D Leverage ratios measure the long-term solvency of a firm. Hence (d) is the answer. < TOP >

7. E Capital expenditure decisions occupy a very important place in corporate finance for < TOP >
the following reasons:
• Once the decision is taken, it has far-reaching consequences which extend over a
considerably long period, and influences the risk complexion of the firm.
• These decisions involve huge amounts of money.
• These decisions are irreversible once taken.
• These decisions are among the most difficult to make when the company is faced
with various potentially viable investment opportunities.

10
8. D Given CA/CL = 1.2 and (CA – Inventory)/CL = 0.8 < TOP >
Net working capital = CA – CL = Rs.6,00,000
1.2 CL – CL = 6,00,000
CL = Rs.30,00,000
CA = 1.2 x 30,00,000 = Rs.36,00,000
Now, (36,00,000 – Inventory)/30,00,000 = 0.8
36,00,000 – Inventory = 0.8 x 30,00,000 = 24,00,000
Inventory = Rs.12,00,000.
9. A (Rs./Euro)bid = (Rs./$)bid × ($/£)bid × (£/Euro)bid < TOP >
= 45.80 × 1.7790 × 0.6940 = 56.55
(Rs./Euro)ask = (Rs./$)ask × ($/£)ask × (£/Euro)ask
= 45.82 × 1.7792 × 0.6942 = 56.59
Rs./Euro = 56.55/59.
10. D The exchange rates under floating exchange rate system are determined by the demand < TOP >
and supply position for the currencies in the foreign exchange market.
a) When a group of countries form 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
11. C Barring export all are functions of EXIM Bank. < TOP >

12. C Average stockof work-in-process < TOP >


Average conversion period = Averagedailycost of production
25,000
Average daily cost of production = 360 = Rs.69.44
2,000
∴ Average conversion period = 69.44 = 28.8 days.
13. B CDs are available for subscription for individuals, corporations, companies, trusts, < TOP >
Funds, Association, etc., Statement (I) is false.
CDs are issued at a discount to face value. Statement (II) is true.
CDs are freely transferable by endorsement and delivery. Statement (III) is true.
CDs are considered as virtually risk less instruments as the default risk is almost nil,
and investors are sure of receiving the invested amount with interest. Statement (IV) is
false.
Hence (b) is the correct answer.

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14. E D1 < TOP >

We know, P0 = k e − g
Where,
P0 = Current market price
ke = Expected rate of return
g = Growth rate in dividends
D1 = Dividend at the end of one year.
The above equation can be rewritten as:
D1
+g
ke = P0
Putting the values for the variables we get:
(100 × 0.20) (1 + 0.10) 20 (1.10)
+ (0.10) + 0.10
ke = 80 = 80
= 0.375 i.e., 37.5%
Hence (e) is the correct answer.
15. D Amount of contribution = Rs.14,00,000 × 25 percent = Rs.3,50,000. < TOP >
EBIT = Rs.3,50,000 – Rs.1,50,000 = Rs.2,00,000
Interest on debentures = Rs.4,00,000 × 12.50 percent = Rs.50,000
Preference Dividends = Rs.2,00,000 × 15 percent = Rs.30,000.
So, the degree of financial leverage (DFL) will be:
EBIT 2, 00, 000 2, 00, 000
=
Dp 30, 000 2, 00, 000 − 1, 00, 000
EBIT − I − 2, 00, 000 − 50, 000 −
DFL = 1− T = 1 − 0.4 = 2.00
The degree of financial leverage (DFL) = 2.00
16. A A quote expressed in terms of number of units of domestic currency per unit of foreign < TOP >
currency is known as direct quote.
17. A As per Walter Model < TOP >
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 value of the firm will be
maximized if the firm does not pay dividends, i.e. maintains a zero payout ratio.
18. C Capital Indexed Bond is an instrument designed by RBI to minimize inflation risk < TOP >

19. C Fund management, forex management and risk management are the responsibilities of < TOP >
Treasurer.
20. E (750 + 700) / 2 < TOP >
(400 + 450 + 450) / 91 = 51 days.

21. E Storage lag is the time lapsed between the production of goods and their sale. It < TOP >
represents a cost to the firm. Statement (I) is true.
The time lapsed between the sale of goods and collection of cash is known as sale lag.
Statement (II) is true.
Shelf stock refers to items that are stored by the firm and sold with little or no
modification to customers. Statement (III) is true.
Inventories provide a buffer between purchasing, producing and marketing goods.
Statement (IV) is true.
Inventories reduce order costs. Statement (V) is not true.
Hence (e) is the answer.

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22. E If the average collection period is found to be consistently higher than the net credit < TOP >
period extended by the company to its customers, then the firm is supposed to have a
liquidity crunch. In such a situation, the collection effort has to be made more effective
as cash is locked up for a period more than what is warranted by the credit terms
extended.
23. D Under the letter of credit (LC) arrangement credit is provided by the supplier but the < TOP >
risk is assumed by the bank which opens the LC. Hence it is an indirect form of
financing.

24. A Liberalizing credit standards will increase investment in receivable while pushing up < TOP >
sales
Shortening the credit period will tend to lower sales, as customers decrease investment
in receivables, and reduce the incidence of bad debts loss.
Rigorous collection program will bring down sales and the amount of receivables and
bad debt losses will reduce to a certain extent.
A cash discount will decrease the average collection period and will also decrease bad
debt losses
25. E < TOP >
Ke 0.18
K'= = = 0.1935 = 19.35%
1− f 1 − 0.07
26. E There are three major reasons for purchasing power parity not holding good: < TOP >
I. Constraints on movements of commodities.
II. Price index construction.
III. Effect of the statistical method employed.
27. A The law of one price assumes that an identical product or service can be sold in < TOP >
different markets with the same price, where there are no restrictions on the sales and
no transportation costs.
28. A In the currency board system, the board does not have any discretionary powers over < TOP >
the monetary policy; the interest rates are automatically set by the market mechanism.
Options (b), (c), (d) and (e) are not true.
29. A Current account deficit for a country indicates that gross domestic investment is < TOP >
greater than gross domestic savings.
30. B The point at which DTL is undefined is called the overall break-even point. At this < TOP >
point the quantity produced can be computed as:
Dp
F+I+
(1 − T)
Q= (S − V) ,
30, 000
6, 00, 000 + 65, 000 +
(1 − 0.40)
Hence Q = (900 − 400) = 1,430 units.

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Section B : Problems/Caselet
1. The NPVs of the 4 projects are: < TOP
>
Projects NPV (Rs. in Crore) Rank
P1 9.5 × PVIFA(12,5) – 25 = (9.5 × 3.605) – 25 = 9.26 I
P2 2.5 × PVIFA(12,5) – 6.5 = (2.5 × 3.605) – 6.5 = 2.51 IV
P3 3.5 × PVIFA(12,5) – 8.0 = (3.5 × 3.605) – 8.0 = 4.62 III
P4 4.0 × PVIFA(12,5) – 9.0 = (4.0 × 3.605) – 9.0 = 5.42 II
The BCR of the 4 projects are:
Project BCR Rank
P1 34.25/25 = 1.37 IV
P2 9.01/6.5 = 1.39 III
P3 12.62/8.0 = 1.57 II
P4 14.42/9.0 = 1.60 I
Based on the NPV and BCR criteria, all 4 projects are acceptable because NPV is positive and
BCR is greater than one for each project. But all 4 projects cannot be taken by the firm because of
the limited availability of funds. Either JayPee Ltd., has to accept project P1or a package
consisting of projects, P2, P3 and P4 but not both. The decision will depend upon which option
maximizes the shareholders’ wealth. In this sort of a decision-making situation, the BCR becomes
inapplicable because there is no way by which we can aggregate the BCRs of projects P2, P3 and
P4. On the other hand NPVs of projects P2, P3 and P4 can be aggregated and compared with the
project P1 to arrive at a decision.
NPV (P2+ P3+ P4) = NPV (P2) + NPV (P3) + NPV (P4) = 2.51 + 4.62 + 5.42 = 12.55 which is
more than NPV (P1). Therefore the package comprising projects P2, P3 and P4 must be accepted.
2. a. < TOP
Years Y0 Y1 Y2 Y3 Y4 Y5 >
Initial deposit (Rs.) –5,000
Annual - Interest 525 550 625 762.5 900
Redemption value 5,000
Interest during ‘n’th year = (Rs.5,000 x interest % in year n)
n It F
∑ +
PV or Intrinsic Value of Bond = t =1 (1 + YTM) (1 + YTM) t
t

Where,
n = Maturity period
It = Interest in year t
F = Face value of the bond
YTM = Yield-to-Maturity
YTM of the bond is ‘i’ in the following equation:

525 550 625 762.5 5,900


+ + + +
5,000 = (1 + i) (1 + i) 2
(1 + i) 3
(1 + i) 4 (1 + i)5

Solving for ‘i’, we get ‘i’ = 12.99%


Hence the yield to maturity of Growing Interest Bond = 12.99%
b.
Year Dividend PV @ 14% PV (Div)
1 10.00 0.877 8.77
2 10.00 0.769 7.69
3 12.50 0.675 8.44
4 15.62 0.592 9.25
34.15

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D 4 (1 + g) 15.62(1.12) 17.4944
=
P4 = k e − g 0.14 − 0.12 = 0.02 = 874.72
PV(P4) = 874.72 x 0.592 = 517.83
PV of CF = 34.15 + 517.83 = Rs.551.98 per share.
Since the intrinsic value of the stock is greater than the market price of Rs.150 per share
investment at current price is recommended.

3. a. The importer has to buy Euro from the bank. Hence the relevant rate is Rs. / Euro ask rate. < TOP
The effective exchange rate on 01,09, 2008. >
(Rs. / Euro) ask rate = (Rs. / $)ask × ($ / £ )ask × (£ / Euro)ask
1
= (Rs. / $)ask × ($ / £ )ask × (Euro / £) bid
1
45.92 ×1.8971×
= 1.4879
= 58.5488
Effective rate offered by the bank = 58.5488 (1 + 0.001)
= 58.6073 ≈ 58.61
b. Actual rupee / Euro ask rate on 11,09, 2008
1
45.98 × 1.8995 × = 58.6286
Rs. / Euro ask rate = 1.4897

Effective rate offered by the bank = 58.6286 (1 + 0.001) = 58.6872 ≈ 58.69


Loss to the customer = 50,000 × (58.69 – 58.61) = Rs.4,000
c. Actual rupee outflow to the importer
Bill amount (50,000 × 58.69) = 29,34,500
Commission at 0.15% = 4,402
Interest at 12% for 14 days
(28, 08, 2008 to 10,09, 2008) = 13,507
= Rs.29,52,409
4. The differences between the floating rate mechanism and fixed rate mechanism are < TOP
a. In the floating rate mechanism, the exchange rate is determined by the market forces, while >
in fixed rate mechanism, the exchange rate is determined by the government. Therefore, in
floating rate mechanism, the exchange rate depends on the perception of the market about
the relative worth of various currencies while in the fixed rate mechanism, the rate depends
on what the government wants it to be.
b. In fixed rate mechanism, the government needs large amounts of reserves to be able to
maintain the currency at the level it wants. In the floating rate system, the government does
not interfere in the market.
c. In some variations of the fixed rate mechanism, the value of the currency is adjusted
upwards or downwards depending on the values of certain key parameters such as money
supply.
d. The fixed rate system though useful for maintaining a stable exchange rate, may give rise to
market distortions in the long run. The floating rate system, on the other hand, may result in
wide fluctuations in the exchange rates over short time intervals but is expected to settle
down at its true value.
5. Many experts favor the flexible exchange rate mechanism on the following arguments: < TOP
• Better adjustment >
• Better confidence
• Better liquidity
• Gains from freer trade
• Increased independence of policy

15
a. Better adjustment: One of the most important arguments for flexible exchange rates is that
they provide a less painful adjustment mechanism to trade imbalances than do fixed
exchange rates. For example, an incipient deficit with flexible exchange rates will merely
cause a decline in the foreign exchange value of the currency, rather than requiring a
recession to reduce income or prices as fixed exchange rates would. It should be clear that a
decline in the value of a currency via flexible exchange rates is an alternative to a relative
decline in local-currency wages and prices to correct payments deficits. The preference for
flexible exchange rates on the grounds of better adjustment is based on the potential for
averting adverse worker reaction by only indirectly reducing real wages.
b. Better confidence: It is claimed as a corollary to better adjustment that if flexible exchange
rates prevent a country from having large persistent deficits, then there will be more
confidence in the country and the international financial system. More confidence means
fewer attempts by individuals or central banks to readjust currency portfolios and this gives
rise to stable forex markets.
c. Better liquidity: Flexible exchange rates do not require central banks to hold foreign
exchange reserves since there is no need to intervene in the foreign exchange market. This
means that the problem of insufficient liquidity does not exist with truly flexible rates, and
competitive devaluations aimed at securing a larger share of an inadequate total stock of
reserves will not take place.
d. Gains from freer trade: When deficits occur with fixed exchange rates, tariffs and
restrictions on the free flow of goods and capital invariably abounds. If, by maintaining
external balance, flexible rates avoid the need for these regulations, which are costly to
enforce, then the gains from trade and international investment can be enjoyed.
e. Increased independence of policy: Maintaining a fixed exchange rate can force a country
to follow the same economic policy as its major trading partners. For example, if the United
States allows a rapid growth in the money supply, this will tend to push up U.S. prices and
lower interest rates in the short run, the former causing a deficit or deterioration in the
current account and the latter causing it in the capital account.
Section C: Applied Theory
6. At the number of items in the inventory is very high then it will be practically difficult to < TOP >
monitor and control information about each item. The ABC analysis on an inventory helps the
management to concentrate its attention and keep a close watch on relatively less number of
items which account for a high percentage of the value of the annual usage of all items of
inventory.
In the ABC analysis the items are segregated into three groups - A, B and C. The A items are
those in which the firm has the largest rupee investment. They may consist of only 10% of the
items but account for more than 70% of the firm's rupee investment in inventory. These are
the costliest and slowest turning items of the inventory. The B group consists of the items
accounting for the next largest investment. The C group typically consists of a large number
of items which account for a small rupee investment.
By classifying the inventory into A, B and C the firm will be able to determine the level and
types of inventory control procedures needed. Control of A items should be the most intensive
due to the high rupee investments involved, while B and C items would be subject to
correspondingly less sophisticated control procedures.
Procedure for categorization into A, B and C
• All items of inventory are to be ranked in the descending order of their annual usage
value.
• The cumulative totals of annual usage values of these items along with their percentages
to the total annual usage value are to be noted alongside.
• The cumulative percentage of items to the total number of items is also to be recorded in
another column.
An approximate categorization of items into A, B and C groups can be made by comparing
the cumulative percentage of items with the cumulative percentage of the corresponding usage
values.
Advantages of the system
• It ensures closer control on costly items in which a large amount of capital has been
invested.
• It helps in developing a scientific method of controlling inventories. Clerical costs are

16
reduced and stock is maintained at optimum level.
• It helps in maintaining the main objective of inventory control at minimum cost. The
stock turnover rate can be maintained at comparatively higher level through scientific
control of inventories.
Limitation
The system analyzes items according to their value and not according to their importance in
the production process.
7. The governments of some countries have an inclination to impose trade barriers in order to < TOP >
discourage imports.
Every country imposes two kinds of trade barriers.
1. Tariff barriers
2. Non-tariff barriers.
Tariff Barriers: A tariff is a duty or tax levied on a product when it crosses national
boundaries. If a tax is imposed on the goods being brought into the country, it is referred
to as “import duty”. Import duty is levied to increase the effective cost of imports and to
increase the demand for domestically produced goods. If a tax is imposed on the goods
being taken out of the country, it is referred to as “export duty”. The export duty is
imposed to discourage export of certain goods, when the country is facing a shortage of
a particular commodity or if the government wants to promote that good in some other
form or sometimes to discourage the export of natural resources. If a tax is levied on the
goods passing through the country, it is called “transit duty”.
Non-tariff barriers: These include the rules, regulations and bureaucratic delays which
help in keeping foreign goods out of domestic markets.
Quota: A quota is a limit on the number of units that can be imported in a specified time
period or the market share that can be held by the foreign producers. Quotas raise the
domestic price by restricting the supply to the domestic market.
Embargo: When the imports to a country are totally banned, it is called an embargo. It is
mostly put due to political reasons.
Voluntary Export Restraint (VER): The VER is a relatively new way of restricting
imports. Under this, a country facing a persistent, huge trade deficit against another
country may pressurize itself to adhere to self-imposed limit on the exports to the deficit
facing country. The negotiations may be between the governments, or between other
bodies, such as associations or manufacturers, acting with the approval of the
government.
Subsidies to local goods: Sometimes, governments may directly or indirectly subsidize
local production to make it more competitive in the domestic and foreign markets.
Local content requirement: A foreign country may find it more cost effective to assemble
its goods in the market in which it expects to sell its products rather than exporting the
assembled products. In such a case, the company may be forced to produce a minimum
percentage of the value added locally. With this, the importing country is benefited by
way of reducing the imports and increasing the employment opportunities in the local
market.
Technical barriers: Countries specify some quality standards to be met by imported
goods for various health, welfare, and safety reasons. Such a system requires consonance
among the trading partners before fixing the standards. It also requires that the domestic
and imported goods be treated equally as far as testing and certification procedures are
concerned and there should be no disparity between the quality standards required to be
fulfilled by these two.
Procurement policies: Governments often follow the policy of procuring their
requirements only from local producers, or at least extend some price advantage to them.
Such an act closes a prospective market to the foreign producers.
International price fixing: Some commodities are produced by limited number of
producers scattered around the world. such producers may form a carrel and limit the
production or price of the commodity so as to protect their profits. Such an artificial
limitation on the production and price of the commodity makes international trade less

17
efficient.
Exchange controls: Controlling the amount of foreign exchange available to residents for
purchasing foreign goods domestically or while traveling abroad may be another way of
restricting imports.
Direct and Indirect restriction on foreign trade: A country may directly restrict foreign
investment to some specific sectors or upto a certain percentage of equity. Countries may
indirectly impose limits on profits that can be repatriated or prohibition of payment of
royalty to a foreign parent country. Such restrictions discourage foreign producers from
setting up domestic operations.
Customers valuation: The invoice values of internationally traded goods reflect their real
cost. This concept led to the subjective system of valuation of imports and exports for
levy of duty. If the value attributed to a particular product is higher than its real cost, the
competitiveness of the product is affected and also increases the total cost to the importer
due to the excess duty. Thus, it is an impediment to the international trade.
Transportation costs: These are similar to tariffs. While, the tariffs are imposed by the
governments, the transportation costs act as natural borders to trade.
< TOP OF THE DOCUMENT >

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