Semester – II End – Semester Examinations IBS536 – Financial Management - II

Part – A Q. What can be the source of internal financing in the long-term?

a. Depreciation b. Premium on issue of shares c. Revaluation gains d. Increase in capital due to bonus issue e. Issue of debenture

Q. Which of the following is not a service of a factor?

a. Administration of sales ledger b. Collecting Accounts Receivables c. Assuming losses due to bad debts d. Providing finance against bills receivables e. Sales promotion and advertisement

Q. DOL represents degree of operating leverage and DFL represents degree of financial leverage, degree

of total leverage can be defined as a. DOL + DFL b. DOL – DFL c. DOL x DFL d. DOL / DFL e. 2 DOL - DFL

Q. According to the net operating income approach

a. The overall capitalization rate remains constant for all levels of financial leverage b. The cost of equity increases linearly with financial leverage c. The cost of debt remains constant for all levels of financial leverage d. Only (b) and (c) above e. (a), (b) and (c) above

Q. Which approach of dividend policy states that the stock value responds positively to higher dividends and negatively when there are low dividends? a. Traditional position b. Walter model c. Gordon model d. Miller-Modigliani position e. Rational expectations model

Q. According to NOI approach the equity capitalization rate of a firm whose cost of capital is 20%, cost of debt is 15% and debt-equity ratio is 0.67 is

a. 13.55%

b. 21.60%

c. 23.35% d. 20.50%

e. None of the above

Q. What would be the percentage decline in sales, which would wipe out profit before tax is, if the degree of total leverage is 3 and the EPS of the company is expected to be Rs.2?

a. 33.33% b. 41.33%

c. 55.35%

d. 12.09%

e. 47.87%

Q. Which of the following factors does not influence the composition of working capital?

a. Nature of business

b. Nature of raw materials used c. Nature of finished goods

d. Financial leverage of the firm

e. Degree of completion

Q. If the annual demand is Rs.10 lakh units, fixed cost per order is Rs.5000 and cost of carrying per unit per annum is Rs.25, then economic order quantity is

a. 10,000 units

b. 15,000 units

c. 20,000 units d. 25,000 units

e. 30,000 units

Q. Which of the following indicates the business risk of a company?

a. Return on Investment

b. Debt equity ratio

c. Operating leverage d. Financial leverage

e. Interest coverage ratio

Q. ABC analysis is useful for

a. Beginners to have a basic idea about management of inventories

b. Analyzing inventories based on their movements c. Analyzing inventories based on their essentiality

d. Better control of inventories

e. Understanding the procurement of inventories

Q. Which of the following is/are true when a company follows a conservative working capital policy?

a. The current assets turnover is at the minimum

b. Profitability is sacrificed for liquidity

c. The cost of financing current assets is greater as compared to an aggressive policy

d. Both (b) and (c) above

e. Both (a) and (b) above

Q. Net working capital is a measure of the company's

a. Profitability

b. Magnitude of sales

c. Estimated liquidity d. Shareholders' equity

e. Current assets

Q. Which of the following is correct for a firm that reduces its accounts receivable balance from the previous quarter?

a. Collections exceeded beginning receivables balance

b. Sales exceeded collections

c. Beginning receivables balance exceeded sales

d. Collections exceeded sales e. Collections and sales were equal

Q. Which of the following would be least expected to change as a result of a higher average of receivables?

a. Current ratio

b. Total collection costs

c. Accounts payable d. Bad debt expenses

e. Average collection period

Q. Total current assets of a company are Rs.960 lakh while the current liabilities (other than bank borrowings) are Rs.300 lakh. If the company borrowed Rs.350 lakh, what will be the amounts of Maximum Permissible Bank Finance (MPBF) under the methods I and II of the Tandon committee recommendations?

a. Rs.495 lakh and Rs.420 lakh. b. Rs.500 lakh and Rs.410 lakh

c. Rs.505 lakh and Rs.405 lakh

d. Rs.510 lakh and Rs.400 lakh

e. Rs.515 lakh and Rs.395 lakh

Q. Which of the following will not be considered as an item of cost of carrying inventory?

a. Cost of obsolescence

b. Opportunity cost of capital

c. Raw material cost d. Pilferage cost

e. Rent / depreciation for the warehouse

Q. The following information has been furnished by Astoria Ltd.

Average daily

usage in units

Probability

Lead time in number of days

Probability

600 0.60 4 0.30

800 0.40 6 0.70

The normal consumption by the company during the lead time will be

a. 1,776 units

b. 2,720 units

c. 3,672 units d. 4,080 units

e. 4,800 units

Q. Which of the following is not true with regard to cash credit financing?

a. A bank allows its creditworthy to borrow up to a certain predetermined limit

b. The customer is charged interest on the amount actually borrowed

c. The customer is required to pay certain minimum charge

d. No security is required from the customer against the borrowed amount e. The customer can borrow as often as required

Q. Holding cash balance is manifestation of

a. Precautionary motive b. Lack of synchronization between inflows and outflows of cash c. Transaction motive to make payment against past or current transactions d. Speculative motive e. All of the above

Q. ABC Ltd. is considering granting XYZ Ltd. a credit on an anticipated repeat order. The probability of

receiving payment against the first order is 85 %. However, if XYZ Ltd. effects the first payment the

probability of it defaulting on the second payment is 5 %. If the value of both the orders is Rs.10 lakhs each and the cost of sale is Rs.8 lakhs, the benefit to ABC Ltd. from this business opportunity is: a. Rs.1.50 lakhs b. Rs.1.75 lakhs c. Rs.2.00 lakhs d. Rs.2.25 lakhs e. Rs.2.50 lakhs

Q. In which of the following types of factoring the loss due to bad debt is not borne by the factor?

a. Recourse factoring b. Full factoring c. Maturity factoring d. Invoice discounting e. All of the above

Q. Interest exclusion principle is followed while estimating cash flows for a proposed investment project

because: a. The means of financing are not immediately known at the time of estimation b. The basic objective of this exercise is to evaluate the financial attractiveness irrespective of the

means of financing the investment c. The fallacy of double counting under the discounted cash flow technique is to be avoided d. The average cost of capital does not reckon the interest on long term debt e. The interest is not a cash flow expenditure

Q. Which of the following is not a merit of sensitivity analysis?

a. It forces the management to identify the underlying variables and their inter-relationships. b. It shows how robust or vulnerable a project is to changes in underlying variables. c. It indicates need for further work if NPV or IRR turns out to be highly sensitive to changes in some

variables. d. It facilitates study of impact of variation in one variable, keeping all others constant. For example,

studying the effect of variation in price while holding quantity constant. e. It is a useful way of conducting subjective analysis.

Q. Which of the following is not associated with the cash management of a firm?

a. Stretching accounts payable without affecting the credit of the firm.

b. Speedy collection of receivables.

c. Investing surplus funds in long-term securities. d. Avoiding idle funds lying in firm's current accounts.

e. Maintaining liquidity.

Q. Consider the following information:

Equity capitalization rate : 18%

Earnings per share : Rs.20

Dividend pay-out ratio : 25%

Return on investment : 12%

The price per share as per the Walter's model is:

a. Rs.83.33 b. Rs.95.00

c. Rs.101.00

d. Rs.l20.00

e. Rs.183.33

Q. With terms of 4/15, net 45, what is the implied interest rate for foregoing a cash discount and paying at the end of the period?

a. 25.63%.

b. 39.29%.

c. 50.00%. d. 64.32%

e. 70.00%

Q. XYZ corporation has 1000 shares outstanding and retained earnings of Rs.25,000. Theoretically, what would happen to the price of the stock, currently selling for Rs.50 per share, if a 20% stock dividend is declared

a. Price should increase to Rs.60 per share

b. Price should decrease to Rs.40 per share

c. Price should decrease to Rs.41.67 per share d. Price should increase to Rs.62 per share

e. Price should remain at Rs.50

Q. The following information is related to Beta Company:

Annual Consumption of raw materials = Rs.700 lakh

Inventory of Raw materials at the beginning of the year = Rs 30 lakh

Inventory of Raw materials at the end of the year = Rs.50 lakh

The outstanding balances for the creditors at the beginning of the year = Rs.79 lakh

The outstanding balances for the creditors at the end of the year = Rs.93 lakh.

The average payment period for the company (Assuming one year is equal to 360 days and all purchases are made on credit only) will be

a. 39 days

b. 43 days c. 47 days

d. 51 days

e. 55 days

Q. A firm with daily credit sales of Rs.50,000 reduced its average collection period by 5 days. What would be the annual benefit? (Assume that the cost of funds as 12 percent)

a. Rs.10,000

b. Rs.15,000

c. Rs.20,000

d. Rs.25,000

e. Rs.30,000

Part B Problems, Conceptual Understanding, Analytical Ability and Situational Analysis

1. The HM Ltd. needs Rs.500,000 for construction of a new plant. The following three financial plans are feasible:

i. The company may issue 50,000 equity shares at Rs.10 per share.

ii. The company may issue 25,000 equity shares at Rs.10 per share and 2,500 debentures of Rs.100 denomination bearing an 8% rate of interest.

iii. The company may issue 25,000 equity shares at Rs.10 per share and 2,500 preference shares at Rs.100 per share bearing 8% rate of dividend.

If the company's earnings before interest and taxes are Rs.10,000, Rs.20,000, Rs.40,000, Rs.60,000 and Rs.100,000, what are the earnings per share under each of the three financial plans? Which alternative would you recommend and why?

Assume corporate tax rate to be 50%.

(15 marks) Suggested Answer: EPS = (EBIT - Interest) (1- tax rate) - Preference dividend

No. of equity shares

(i) If the company issues 50,000 equity shares and no debentures and preference shares

EPS = (EBIT - 0) (1- Tax rate)

50,000

The effect of EBIT on EPS will be as follows:

EBIT 10,000 20,000 40,000 60,000 100,000

EPS 0.10 0.20 0.40 0.60 1.00

(ii) If the company issues 25,000 equity shares and 2500 debentures (Rs 100 denomination) bearing 8% interest

EPS = (EBIT - 20,000) (1- Tax rate)

25,000

EBIT 10,000 20,000 40,000 60,000 100,000

EPS -0.20 0 0.40 0.80 1.60

(iii) If the company issues 25,000 equity shares and 2500 preference shares (Rs 100 denomination) carrying 8% dividend.

EPS = (EBIT - 0) (1 - Tax rate) - 20,000

25,000

The effect of EBIT on EPS will be as follows:

EBIT 10,000 20,000 40,000 60,000 100,000

EPS -0.6 - 0.4 0 0.4 1.20

When it appears that an investment of Rs 500,000 is unlikely to earn an EBIT of less than 40,000, the alternative (i) is recommended. And when an EBIT of Rs 40,000 or more could be generated from the investment, then the alternative (ii) is clearly superior to the remaining alternatives.

2. The finance department of Aditya Textile Corporation gathered the following information:

i. The carrying cost per unit of inventory is. Rs.10.

ii. The fixed cost per order is Rs.20.

iii. The number of units required is 30,000 per year.

iv. The variable cost per unit ordered is Rs.2.

v. The purchase cost price per unit is Rs.30.

Determine the economic order quantity (EOQ), total number of orders in a year, and the time-gap between two orders.

(5 marks) Suggested Answer: Annual usage (U) = 30,000

Fixed cost per order (F) = Rs 20

Price per unit (P) = Purchase price per unit + Variable cost per unit ordered

= Rs 30 + Rs 2 = Rs 32

Per cent carrying cost (C) = Carrying cost per unit = Rs 10 = 0.3125

Price per unit Rs 32

EOQ =PCFU2

= 3125.032000,30202

xxx

= 346 units.

Total number of orders in a year = 346000,30

= 87

Time gap between two orders = 87365

= about 4 days

3. Better Home Appliances Ltd., manufactures and sells domestic appliances. It has furnished the

following sales forecast for the first three months of the year 2005.

Month Expected sales (in Rs.)

January 2005 20,00,00,000

February 2005 16,00,00,000

March 2005 10,00,00,000

The company has provided the following additional information.

a. Credit sales to the authorized dealers constitute 80 per cent of the total sales. These dealers pay the company in the month following the month of sale. The balance sales are in cash.

b. The cost of sales, which are @ 70 per cent of the sales, include raw material cost (@ 50 % of cost of sales) and direct labour cost (@ 50 % of cost of sales)

c. While direct labour costs are paid in the month they are incurred, raw material costs are paid in the month following the month of purchase.

d. The other operating expenses amount to Rs.3,00,00,000 per month.

e. The company has planned capital expenditure of Rs.2,00,00,000 in the month of February 2005.

f. Tax payments of Rs.2,50,00,000 are due in March 2005.

g. It is the policy of the company to maintain a cash balance of 10 per cent of cost of sales of the previous month. As a result, surplus cash, if any, is invested in short-term fixed deposits. These deposits have maturity periods to suit the future cash requirements.

h. The actual sales in December 2004 amounted to Rs.21,00,00,000.

Prepare a cash budget for the company for the next three months.

(10 marks) Suggested Answer: The cash budget for Better Home Appliances Ltd.; is as follows.

Month of the year 2005 Particulars

January February March

Sales 20,00,00,000 16,00,00,000 10,00,00,000

Cash receipts

Collections of the current month

@ 20 per cent of sales

4,00,00,000 3,20,00,000 2,00,00,000

Collections of the previous months @ 80 per cent of sales

16,80,00,000 16,00,00,000 12,80,00,000

Total cash receipts 20,80,00,000 19,20,00,000 14,80,00,000

Cash payments

Purchase of raw materials (@50 % of cost of sales, which are 70 % of the sales of the previous month)

7,35,00,000 7,00,00,000 5,60,00,000

Direct labour (@ 50 % of cost of sales, which are 70 % of the sales of the same month)

7,00,00,000 5,60,00,000 3,50,00,000

Other operating costs (fixed) 3,00,00,000 3,00,00,000 3,00,00,000

Capital expenditure ---- 2,00,00,000 ----

Tax payments due ---- ----- 2,50,00,000

Total cash payments (17,35,00,000) (17,60,00,000) (14,60,00,000)

Net cash inflow/ (outflow) 3,45,00,000 1,60,00,000 20,00,000

Opening cash balance 1,47,00,000* 1,40,00,000 1,12,00,000

Closing cash balance 4,92,00,000 3,00,00,000 1,32,00,000

Desired cash balance 1,40,00,000 1,12,00,000 70,00,000

Surplus to be invested in STD 3,52,00,000 1,88,00,000 52,00,000

*Assumption: The closing cash balance of December 2004 works out to Rs. 1,47,00,000 as per the company’s policy of having a desired cash balance @ 10 % of the cost of sales of December 2004, which is 0.70 x Rs. 21,00,00,000 = Rs. 14,70,00,000.

4. A project involves an outlay of Rs.100,000. Its expected cash inflow at the end of year 1 is Rs.40,000.

Thereafter it decreases every year by Rs.2,000. It has an economic life of 6 years. The certainty equivalent factor is αt = 1 - .05t. Calculate the net present value of the project if the risk free rate of return is 10%.

(10 marks) Suggested Answer: The net present value is calculated as follows: Year Expected cash Certainty Certainty Discount factor Present value flow equivalent equivalent @ 10 per cent factor value

0 - 100,000 1.00 - 100,000 1.000 - 100,000

1 40,000 0.95 38,000 0.901 34,238

2 38,000 0.90 34,200 0.826 28,249

3 36,000 0.85 30,600 0.751 22,981

4 34,000 0.80 27,200 0.683 18,578

5 32,000 0.75 24,000 0.621 14,904

6 30,000 0.70 21,000 0.564 11,844

Net Present value Rs.30,794

Part C Problems, Conceptual Understanding, Analytical Ability and Situational Analysis

5. Discuss the factors that influence management’s decision to pay dividend of a certain amount?

(10 marks) Suggested Answer: The major factors that determine the dividend policy of a firm are:

a. Legal constraints prohibit the corporation from paying out cash dividends which are considered part of the firm's "legal capital," measured by either the par value of common stock or the par value plus paid-in capital in excess of par.

b. Contractual constraints limit the firm's ability to pay dividends according to the restrictive covenants in a loan agreement.

c. Internal constraints are the corporation's own cash limitations.

d. Growth prospects limit the amount of cash dividends since the firm needs to direct all available funds to finance capital expenditures.

e. Owner considerations take into account factors which lead to a dividend policy favorably affecting the majority of owners. Examples are the tax status of the stockholder, his or her other investment opportunities, and ownership dilution, each of which can direct the firm toward a high or low dividend payout policy.

f. Market considerations are the perceptions of the stockholders and their response to the dividend policy, which may indirectly affect the stock price.

IBS536 FM-II (A) / 0205

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Case Analysis / Applied Theory

6. Read the case and answer the following questions:

ABC Ltd. expects to have sales of Rs.10 million this year under its current operating policies. Its variable costs as a percentage of sales are 80%, and its cost of capital is 16%. Currently the firm's credit policy is net 25 (no discount for early payment). However, its daily sales outstanding (DSO) is 30 days, and its bad debt loss percentage is 2%. ABC Ltd. spends Rs.50,000 per year to collect bad debts, and the tax rate is 50%.

The credit manager is considering two alternative proposals, given below, for changing the firm's credit policy. Find the expected change in net income, taking into consideration anticipated changes in carrying costs for accounts receivable, the probable bad debt losses, and the dis-counts likely to be taken, for each proposal. Should a change in credit policy be made?

Proposal 1: Lengthen the credit period by going from net 25 to net 30. The bad debt collection expenditures will remain constant. Under this proposal, sales are expected to increase by Rs.1 million annually, and the bad debt loss percentage on new sales is expected to rise to 4% (the loss percentage on old sales should not change). In addition, the DSO is expected to increase from 30 to 45 days on all sales.

Proposal 2: Shorten the credit period by going from net 25 to net 20. Again, collection expenses will remain constant. The anticipated effects of this change are (1) a decrease in sales of Rs.1 million per year, (2) a decline in the DSO from 30 to 22 days, and (3) a decline in the bad debt loss percentage to 1% on all sales.

(20 marks) Suggested Answer: Under the current credit policy, the firm has no discounts, collection expenses of Rs. 50,000,

bad debt losses of (0.02)(Rs.10,000,000) = Rs.200,000, and average accounts receivable of (DSO)(Average sales per day) = (30)( Rs.10,000,000/360) = Rs.833,333. The firm's cost of carrying these receivables is (Variable cost ratio or V)(A/R)(Cost of capital) = (0.80)(Rs. 833,333)(0.16) = Rs.106,667. It is necessary to multiply by the variable cost ratio because the actual investment in receivables is less than the dollar amount of the receivables.

Proposal 1: Lengthen the credit period such that

1. Sales increase by Rs.1 million.

2. Discounts = Rs.0.

3. Bad debt losses = (0.02)( Rs.10,000,000) + (0.04)( Rs.1,000,000) = Rs.200,000 + Rs.40,000 = 240,000.

4. DSO = 45 days on all sales.

5. New average receivables = (45)( Rs.11,000,000/360) = Rs.1,375,000.

6. Cost of carrying receivables = (v)(k)(Average accounts receivable) = (0.80)(0.16)(Rs. 1,375,000) = Rs.176,000.

7. Change in cost of carrying receivables = Rs.176,000 - Rs.106,667 = Rs.69,333.

8. Collection expenses = Rs.50,000.

IBS536 FM-II (A) / 0205

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Analysis of proposed change: Income Income Statement Under Effect Of Statement Under

Current Policy Change New Policy

Gross sales Rs.10,000,000 + Rs.1,000,000 Rs.11,000,000

Less discounts 0 + 0 0

Net Sales Rs.10,000,000 +Rs.1,000,000 Rs.11,000,000

Variable costs (80%) 8,000,000 + 800,000 8,800,000 Profit before credit Rs. 2,000,000 + Rs. 200,000 Rs. 2,200,000 costs and taxes Credit-related costs:

Cost of carrying receivables 106,667 + 69,333 176,000

Collection expenses 50,000 + 0 50,000

Bad debt losses 200,000 + 40,000 240,000

Profit before taxes Rs. 1,643,333 + Rs. 90,667 Rs.1,734,000

Taxes (50%) 821,666 + 45,333 867,000

Net income Rs. 821,667 + 45,334 Rs. 867,000

The proposed change appears to be a good one, if the assumptions are correct.

Proposal 2: Shorten the credit period to net 20 such that

1. Sales decrease by Rs.1 million.

2. Discount = Rs.0.

3. Bad debt losses = (0.01)( Rs.9,000,000) = Rs.90,000.

4. DSO = 22 days.

5. New average receivables = (22)( Rs.9,000,000/360) = Rs.550,000.

6. Cost of carrying receivables = (v)(k)(Average accounts receivable) = (0.80)(0.16)(Rs. 550,000) = Rs.70,400.

7. Collection expenses = Rs.50,000.

Analysis of proposed change: Income Income Statement Under Effect Of Statement Under Current Policy Change New Policy Gross sales Rs.10,000,000 - Rs.1,000,000 Rs.9,000,000

Less discounts 0 - 0 0

Net Sales Rs.10,000,000 - Rs.1,000,000 Rs.9,000,000

Variable costs (80%) 8,00,000 - 800,000 7,200,000 Profit before credit Rs. 2,000,000 - Rs. 200,000 Rs.1,800,000 costs and taxes Credit-related costs:

IBS536 FM-II (A) / 0205

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Cost of carrying receivables 106,667 - 36,267 70,400

Collection expenses 50,000 0 50,000

Bad debt losses 200,000 - 110,000 90,000

Profit before taxes Rs.1,643,333 - Rs. 53,733 Rs.1,589,600

Taxes (50%) 821,666 - 26,866 794,800

Net income Rs. 821,667 + 26,867 Rs. 794,800

The change reduces net income, so it should be rejected. The firm will increase profits by accepting Proposal 1 to lengthen the credit period from 25 days to 30 days, if all assumptions are correct. This may or may not be the optimal, or profit-maximizing, credit policy, but it does appear to be a movement in the right direction. However, before a final decision is made, the riskiness of the change must be considered.