Question Paper

Strategic Financial Management (MB361F) : January 2006

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. Instead of capital gains, if investors show a leaning towards current dividends, then
(a) The cost of equity shall remain unaffected by a change in dividend policy
(b) The cost of equity will decrease with an increase in the rate of retention
(c) The cost of equity will increase with a reduction in the pay-out ratio
(d) A change in dividend policy shall not affect the cost of capital of the firm
(e) The stock price can be maximized through the residual dividend model.
< Answer >
2. According to the Wilcox model, the best indicator of the financial health of an enterprise is/are
(a) The profitability ratios
(b) The coverage ratios
(c) Net liquidation value of the firm
(d) Market capitalization of the firm
(e) Share price of the firm.
< Answer >
3. Which of the following statements is/are true?
(a) Financial risk can be reduced by replacing common equity with preferred stock
(b) If Firm A has a higher degree of business risk than Firm B, Firm A can offset this risk by
increasing its operating leverage
(c) A firm exposed to a high business risk should take recourse to a higher-than-average financial
leverage
(d) A capital structure that minimizes the weighted average cost of capital, in general, does not
necessarily maximize the earnings per share of the firm
(e) Both (b) and (c) above.
< Answer >
4. 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 >
5. Which of the following statements is/are correct?
(a) Hazard risk refers to natural hazards, accidents, fire etc. that can be insured
(b) Strategic risk covers systems, processes and people and includes issues such as succession
planning, human resources, information technology, control systems and compliance with
regulations
(c) Operational risk covers systems, processes and people and includes issues such as succession
planning, human resources, information technology, control systems and compliance with
regulations
(d) Both (a) and (b) above
(e) Both (a) and (c) above.
< Answer >
6. Which of the following statements is/are not true with respect to the Baumol Model?
I. Cash expenses are incurred evenly over the planning horizon.
II. Cash inflows are random and hence the balance in cash movements are random.
III. Neither the amount of conversion nor the timing of conversion of securities into cash and vice
versa is fixed.

(a) Only (I) above (b) Only (II) above

1
 (c) Only (III) above (d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer >
7. White Squire strategy, as a defense against takeover threat involves
(a) The target firm inviting another firm to make a counter offer to takeover
(b) The repurchase of a block of shares from specific shareholder(s) at a substantial premium
(c) The target company issuing a large block of shares or convertible preference shares to a
friendly party
(d) The payment of huge severance package to senior management cadres in case of takeover of the
firm
(e) The target firm making a tender offer on the raider as a response to the raider’s tender offer on the
target.
< Answer >
8. Which of the following statements is/are false with respect to product liability?
I. Product liability arises when a defective product causes injury to persons or damages property.
II. Class action suits ensure that many suppliers of the same product can be held liable according to
their market share, if it is difficult to pinpoint the defect on one particular producer.
III. In U.S., product liability judgements often favour plaintiffs and include substantial awards for
economic and non-economic damages.

(a) Only (I) above (b) Only (II) above

(c) Only (III) above (d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
9. According to the Pecking order theory of financing, the preferred order of finance for firms is
(a) External equity, debt, preference capital, internal equity
(b) Internal equity, debt, preference capital, external equity
(c) Debt, preference capital, internal equity, external equity
(d) Internal equity, external equity, debt, preference capital
(e) External equity, internal equity, debt, preference capital.
< Answer >
10. For a firm, if the current ratio remains constant and the quick ratio decreases during the same period,
then, which of the following is indicated?
(a) The proportion of total debt relative to total assets is decreasing
(b) The proportion of total debt relative to net worth is decreasing
(c) The proportion of net worth relative to total assets is increasing
(d) The liquidity is decreasing
(e) The profitability is increasing.
< Answer >
11. Which of these is/are not the stated advantage(s) of a divisional structure?
(a) Allows local control of local situations
(b) Leads to a competitive climate within a firm
(c) Accountability is clear
(d) Promotes specialization of labor
(e) Both (a) and (c) above.
< Answer >
12. Which of the following is/are considered to be a value driver as per the ‘Alcar’ approach to value based
management?
(a) Cash flow from operations (b) Long-term capital gains
(c) Incremental fixed capital investment (d) Value growth duration
(e) Both (c) and (d) above.
< Answer >
13. Converting an existing division into a wholly owned subsidiary is called
(a) Split-off (b) Split-up (c) Divestiture (d) Equity carveout (e) Spin-off.
< Answer >
14. Which of the following is not an assumption of Walter model on dividend policy?
(a) The firm is a going concern and has a perpetual life
(b) The only source of finance available to the firm is debt
(c) The cost of capital of the firm remains constant throughout the life of the firm
(d) The return on investment remains constant throughout the life of the firm
(e) Both (a) and (d) above.

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 < Answer >
15. Which of the following adjustments is recommended by Current Cost Accounting method to determine
the current cost operating profit?
(a) Tax-Shield adjustment (b) Cost adjustment
(c) Equity value adjustment (d) Monetary Working Capital adjustment
(e) Debt value Adjustment.
< Answer >
16. Which of the following statements regarding the adjusted book value approach to valuation of
companies is/are true?
(a) The expected future cash flows of the firm are discounted at the weighted average cost of capital
(b) Current assets like deposits made are valued at book value
(c) The ratio of share price to book value per share is applied to the book value of the assets to
determine their market value
(d) Long term debt is valued using the standard equity valuation model
(e) Short term debt is valued using the standard bond valuation model .
< Answer >
17. Which of the following statements regarding the Current Purchasing Power (CPP) method of
accounting for inflation is/are true?
I. It is aimed at measuring all items in the financial statements in a unit of measurement that
represents the same amount of general purchasing power.
II. It attempts to measure the gains or losses that arise from holding financial assets.
III. The figures given on CPP basis are equivalent to the current replacement values.

(a) Only (I) above (b) Only (II) above

(c) Only (III) above (d) Both (I) and (II) above
(e) Both (I) and (III) above
< Answer >
18. Which of the following is not an assumption of Modigliani - Miller Approach to capital structure?
(a) Information is freely available to investors
(b) The capital market 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 >
19. The strategy of inviting another friendly firm to make a counter offer to a hostile offer is called
(a) Golden parachute (b) Green mail (c) White Knight
(d) Poison pill (e) Blue Squire.
< Answer >
20. As per SEBI guidelines on take over if the acquirer crosses a certain x1% of voting capital of target
company it should inform the concerned stock exchange and at the same time it should offer to other
shareholders of the target company through a public announcement, to acquire minimum of x2% of
voting capital of the target company through an offer document.
The x1 and x2 in above paragraph are
(a) 5 and 10 respectively (b) 5 and 15 respectively
(c) 10 and 15 respectively (d) 10 and 20 respectively
(e) 15 and 20 respectively.
< Answer >
21. 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 >
22. 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 >
23. Which of the following is/are the assumptions of multiple discriminant analysis?
I. There are two discrete groups to be analyzed.
II. The independent variables can be combined in a linear manner for discriminating between the two
groups.
III. The values of the variables are distributed lognormally.

(a) Only (I) above (b) Only (II) above

3
 (c) Only (III) above (d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
< Answer >
24. Which of the following is true in the context of stocksplit?
(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 >
25. According to the traditional approach to capital structure, the weighted average cost of capital
(a) Declines steadily as more debt is used
(b) First declines with moderate application 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 >
26. 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) Profit
(e) Economic Value Added.
< Answer >
27. Which of the following is/are true regarding valuation models for firms?
(a) They give an accurate measure of firm value
(b) The valuation processes are entirely objective in nature
(c) The inputs used in the valuation model leave some room for subjective judgements
(d) Both (a) and (c) above
(e) All (a), (b) and (c) above.
< Answer >
28. Which of the following statements is/are true?
I. Market price adjustments for a firm that is on the verge of bankruptcy are not a significant cost to
the investors.
II. Value of the firm is given by the sum of the value of an all-equity finance firm, the present value
of the tax shield less the present value of the costs of financial distress.
III. Costs incurred by financially troubled firms as a result of differences between the concerns of
shareholders and creditors are known as bankruptcy costs.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer >
29. Which of the following statements is true with respect to merger waves?
(a) Vertical integration was the salient feature of the first wave of merger
(b) Horizontal combination was the salient feature of the second wave of merger
(c) The third merger wave was characterized by conglomerate mergers
(d) The fourth merger wave was characterized by the emergence of a combination of forward and
backward integration
(e) The fifth merger wave was characterized by the emergence of professional corporate raiders.
< Answer >
30. 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.
END OF SECTION A

Section B : Problems/Caselets (50 Marks)

This section consists of questions with serial number 1 – 7.
Answer all questions.
Marks are indicated against each question.
Detailed workings/explanations should form part of your answer.
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 Do not spend more than 110 - 120 minutes on Section B.

1. The following information pertain to the operations of Agarwal Enterprises Ltd. at the end of financial year
March 31, 2005:

Net worth Rs.75 lakh

Current liabilities and provisions Rs.90 lakh
Cost of goods sold Rs.486 lakh
Gross profit margin 25%
Total asset turnover ratio 3

Total debt
Current
Quick to equity ratio
ratio
ratio 1.88
1.5
0.70
You are required to complete the following balance sheet of the company as at the end of the financial year
March 31, 2005:
Balance sheet
(Rs. in lakh)

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 FCF 7 4 1 –2 3 7 4 1 –2 3 7
In future the trend is expected to remain the same. The cost of capital of the firm is 15%.
You are required to find the value of the firm as on April 01, 2005.
(6 marks) < Answer >

Caselet 1
Read the caselet carefully and answer the following questions:
4. Forward-looking approach towards estimating cost of equity is often conceptually preferable. However it is often
not a straightforward technique to apply. Discuss the various issues associated with the application of forward-
looking approach for estimating the cost of equity.
(7 marks) < Answer >
5. The caselet also talks about the historical approach towards the estimation of cost of equity. Explain the critical
issues that are associated with the application of this approach towards the estimation of cost of equity.
(7 marks) < Answer >
The concept of cost of equity is central to every decision at the core of corporate finance. However, there has never
been a consensus on how to estimate the cost of equity and the equity risk premium associated with it. Conflicting
approaches towards calculating risk have resulted in differing estimates of the equity risk premium ranging from 0
percent to 8 percent—although many of the practitioners use a narrower range of 3.5 percent to 6 percent. With
expected returns from long-term government bonds being about 5 percent in the US and UK capital markets, the
narrower range implies a cost of equity for the typical company of between 8.5 percent and 11.0 percent. This variation
in cost of equity can lead to a variation in the estimated value of a company by more than 40 percent and have profound
implications for financial decision making.

Comprehensive discussions about the cost of equity often involve such debateable issues as where the stock market is
heading and whether the stocks are over or undervalued. For instance, the run-up in stock prices in the late 1990s
prompted two contradictory points of view. On the one hand, as prices soared ever higher, some investors expected a
new era of higher equity returns driven by increased future productivity and economic growth. On the other hand, some
analysts and academics suggested that the rising stock prices meant that the risk premium was declining. Pushed to the
extreme, a few analysts even argued that the premium would fall to zero, that the Dow Jones industrial average would
reach 36,000 and that stocks would earn the same returns as government bonds. While these views were at the extreme
end of the spectrum, it is still easy to get carried away by complex explanations and the numbers.

There are two broad approaches towards estimating the cost of equity and market risk premium. The first is historical,
based on what equity investors have earned in the past. The second is forward-looking, based on projections implied by
current stock prices relative to earnings, cash flows, and expected future growth.

The latter approach is conceptually more appealing. After all, the cost of equity should reflect the return expected
(required) by investors. But forward-looking estimates are fraught with various problems the most difficult of which is
estimation of future dividends or earnings growth. Some theorists have attempted to tackle that difficulty by surveying
equity analysts, but the objectivity of analysts projections is also questionable. Other researchers have constructed
elaborate models of forward-looking returns, but such models are generally so complex that it is difficult to draw
meaningful conclusions or come out with anything but highly unstable results. Depending on the assumptions
underlying the models, recently published research suggests that market risk premiums can vary between 0 percent and
4 percent.

Unfortunately, the historical approach is almost equally difficult to apply because of the subjectivity of the assumptions
underlying it. For instance, over what time period should returns be measured—the previous 5, 10, 20, or 80 years or
more? How should the average returns be calculated? How frequently should average returns be sampled? Depending
on the answers to the above questions, the market risk premium based on historical returns can be estimated to be as
high as 8 percent. It appears from this discussion that both historical and forward-looking approaches, as practiced, may
not lead to clear cut conclusions.

Caselet 2
Read the caselet carefully and answer the following questions:
6. According to caselet, all the countries may not reap the potential benefits of cross broder mergers and acquisitions.
In your view, what are the issues to be considered before going for cross border mergers & acquisitions?
6
 (7 marks) < Answer >
7. According to caselet, there may be commonalities as well as differences between domestic mergers and cross
border mergers. However, the single factor for cross border mergers and acquisitions is to have access to new
markets. Explain the other benefits of cross border mergers and acquisitions.
(6 marks) < Answer >
The compulsions and competitions arising out of the effects of liberalization, privatization and globalization (popularly
known as LPG) of economic polices around the globe have reoriented the thinking of the government and the corporate
sector towards change for survival, without being left isolated. The beginning of the 21st century is an era for corporate
mergers, takeovers, synergies, re-mergers, de-mergers, acquisitions etc. and these effects are not only taking place fast
within the national boundaries, but are seen across borders as well. Some of the causes for this phenomenon are
increasing global competition, integration of markets, and the compulsions of the WTO. While mergers and
acquisitions within the country and across borders have common features, they may be different because of differences
in national polices, exchange rates, national cultures, ethos and other factors. Whatever may be the commonalities and
differences between the two transactions, yet the single factor for cross-border mergers and acquisitions is access to
new markets. MNCs find growing markets with skilled labor and advanced technologies more attractive. If the cross-
border gates are kept open, the expansion of the corporate businesses, stock markets and new sources for future and
potential is possible.
The surveys conducted by the UNCTAD during the first quarter of the year 2004 reveals an optimistic outlook. China,
India and Poland are well-positioned to receive upswing of FDI inflows. In their analysis, it has been predicted that
greenfield investment will dominate the FDI in the developing countries and cross-border M&As in the developed
countries. The recovery sign as predicated, however, does not mean that all countries will reap the potential benefits of
FDIs or M&A. The phenomenon is mostly driven by Transnational Corporations (TNCs) from developed countries,
with increasing participation by firms of developing country. Also, the trends may vary from region to region with
turnarounds in Africa, Asia and the Pacific.
The next question that needs to be answered is that how FDI’s are going to be with M&As? This is important, as
various sectors flow into the channels of investment. The question is, which is the prime sector? Again a probable
answer that has been predicted is that the “service sector”, as compared to its counterpart the “manufacturing sector”, is
going to catch up and be the order for M&As. Although, the service sector is less transnationalized, it may generate a
value-addition to the employment potential of sale of services, due to the fact that the size of the service sector is larger
than that of the manufacturing sector.
The concerns and the potential of cross-border M&As is full of paradoxes. To benefit from a globalized environment,
there is need for dependence on the other economy in order to strengthen one’s economy. The most important
contributing factors are attracting capital in the form of FDIs, technology etc. and setting up a competitive service
sector. Services have better trading and bargaining power compared to the manufacturing sector. The chain-supply
relationship is much longer and stronger, and the increasing access to international markets is made easier and simpler.
The hurdle for the service sector lies only in the reciprocity for recognition, which is addressed by GATT, and TRIPS
of WTO. While the service sector becomes prominent in the process, some of the services relating to basic utilities and
infrastructure are susceptible to abuse by the monopoly of the market power. In this, the countries have to strike a
balance between economic efficiency and broader developmental objectives.
END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 8 - 9.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.

8. One of the important objectives of Enterprise Risk Management is to include risk management in the day-to-day
practices of the organization. Moreover the right organization culture would encourage entrepreneurial risk taking
and discourage gambling. In this context explain the role of the senior management of the organization.
(10 marks) < Answer >
9. Target costing has recently received considerable attention in the industries around the world as it gives
competitive edge in launching new products. Explain, what is target costing? Also discuss the benefits of target
costing.
(10 marks) < Answer >

7
 END OF SECTION C

END OF QUESTION PAPER

8
 Suggested Answers
Strategic Financial Management (MB361F) : January 2006
Section A : Basic Concepts
1. Answer : (c) <
TOP
Reason : The preference shown by the investors for dividends to capital gains is because they >
view dividends in the hand to be less risky than potential capital gains. The cost of
equity shall be inversely related to the dividend payout ratio if the investors are less
certain of receiving income from capital gains than they are of receiving dividend
payments.
2. Answer : (c) <
TOP
Reason : As per the Wilcox model, the net liquidation value of a firm is the best indicator of its >
financial health. The net liquidation value is the excess of the liquidation value of the
firm’s assets over the liquidation value of the firm’s liabilities. Liquidation value is the
market value of the assets and liabilities at the time of dissolution.
3. Answer : (d) <
TOP
Reason : A high degree of business risk implies that the firm has to use a lower amount of >
financial leverage to counter this risk. Preferred stock being a fixed-income security
would also increase financial risk. Initially EPS rises with the increase in debt but
beyond a point interest rates will rise fast enough to depress EPS despite the decrease
in outstanding shares.
4. Answer : (c) <
TOP
Reason : The marginal cost rate breaks down under 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.
5. Answer : (e) <
TOP
Reason : Hazard risk refers to natural hazards, accidents, fire etc. that can be insured.
>
Operational risk covers systems, processes and people and includes issues such as
succession planning, human resources, information technology, control systems and
compliance with regulations. However, Strategic risk stems from an inability to adapt
to changes in the environment such as change in customer priorities, competitive
conditions and geographical developments. Hence, statement (b) is not correct. So, the
correct option is (e).
6. Answer : (e) <
TOP
Reason : Baumol model is a deterministic model of cash budgeting. It assumes that the cash >
inflows as well as outflows are incurred evenly over the planning horizon. Conversion
of securities into cash takes place at regular intervals. So both statements (II) and (III)
are incorrect. Hence the correct answer is (e).
7. Answer : (c) <
TOP
Reason : White Square strategy as a defense against takeover threat involves the target
>
company issuing a large block of shares or convertible preference shares to a friendly
party.
8. Answer : (e) <
TOP
Reason : Product liability arises when a defective product causes injury to persons or damages >
property. Class action suits ensures that many suppliers of the same product can be held
liable according to their market share, if it is difficult to pinpoint the defect on one
particular producer.. In US, product liability judgements often favour plaintiffs and include
substantial awards for economic and non-economic damages. Hence, all these statements
are true.
9. Answer : (b) <
TOP
Reason : As per Pecking order theory of financings, the preferred order of finance for firms are >
as follows: internal equity, debt, preference capital and external equity.
10. Answer : (d) <
TOP
Reason : Current ratio is defined as the ratio between the current assets and current liabilities. >
While Quick Ratio is calculated by dividing current assets minus inventories by
9
 While Quick Ratio is calculated by dividing current assets minus inventories by
current liabilities. Now, among the components of the current assets, inventories are
the least liquid instruments. So, a decreasing quick ratio and same value of the current
ratio implies the increasing volume of inventory, thereby indicating the decreasing
level of liquidity.

11. Answer : (d) <

TOP
Reason : Divisional structure is a type of departmentalization in which positions are grouped >
according to similarity of products, services or markets. The Divisional structure does
not promote specialization of labor. Whereas options (a), (b) and (c) i.e. it allows local
control of local situations, leads to a competitive climate within a firm, accountability
is clear are the advantages of the divisional structure.
12. Answer : (e) <
TOP
Reason : Shareholders’ return comprises capital gains and dividend income. Cash flow from
>
operations is a valuation component but not a driver as per this approach. Incremental
investment in fixed and working capital are value drivers from the investment decision
angle. Value growth duration is an indicator of the management’s perception of
competitive advantage. It represents the period over which the investments are
expected to earn a return in excess of the cost of capital. Hence, statements (c) and (d)
are correct. So the correct option is (e).
13. Answer : (d) <
TOP
Reason : In a split off, a new company is created to take over the operations of an existing
>
division or unit and a portion of the shares of the parent company is exchanged for the
shares of the new company. When a new legal entity is created to take over the
operations of a particular division or unit of the company and the shares of the new
unit is distributed pro-rata among the existing shareholders, it is known as Spin off. A
Split up refers to the complete breakup of a company into two or more new companies
and the shares of the new company is distributed among the existing shareholders of
the firm. Divestiture involves outright sale of a portion of the firm to outsiders. Equity
carve out involves conversion of an existing division or unit into a wholly-owned
subsidiary. Hence, only option (d) is correct.
14. Answer : (b) <
TOP
Reason : According to the Walter’s model, the firm is a going concern and has a perpetual life
>
span. The cost of capital and the return on investment remain constant throughout the
life of the firm. The only source of finance available to the firm is retained earnings.
Thus the statements given in (a), (c) and (d) are correct. However statement given in
(b) which says that the only source of finance is debt is incorrect. Hence the correct
answer is (b).
15. Answer : (d) <
TOP
Reason : CCA recommends that three different adjustment are to be made in the income
>
statements to determine the current cost operating profit. These are:
• Depreciation adjustment.
• Cost of sales adjustment.
• Monetary Working Capital Adjustment.
Hence the correct answer is (d).
16. Answer : (b) <
TOP
Reason : The statements (b) is correct regarding the adjusted book value approach. (a) is not >
correct as discounted cash flows are not used under adjusted book value approach.
Similarly, (c), (d) and (e) is not correct.
17. Answer : (d) <
TOP
Reason : The following are the basic factors which work under the CPP method of accounting >
for inflation i.e (i) It is aimed at measuring all items in the financial statements in a
unit of measurement that represents the same amount of general purchasing power and
(ii) it attempts to measure the gains or losses that arise from holding financial
assets.Hence,the correct option is (d).
18. Answer : (d) <
TOP
Reason : The assumptions of Modifian Miller approach of capital structure are : >

10
 1) Information is freely available to investors
2) Transactions are cost-free
3) Investors have homogeneous expectations about future earnings of a company
4) Securities issued and traded in the market are infinitely divisible.
However, option (d) is not an assumption of MM approach as MM approach considers
that growth of a firm is financed by a mixture of debt, equity and retained earnings.
19. Answer : (c) <
TOP
Reason : The strategy of inviting another friendly firm to make a counter offer to a hostile offer
>
is called White Knight.
20. Answer : (e) <
TOP
Reason : The requirement of offering for additional 20% share once the acquirer crosses 15% is >
as per SEBI guidelines on takeovers.
21. 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.
<
22. 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.
<
23. Answer : (d)
TOP
Reason : The assumptions of multiple discriminant analysis are :
>
(1) There are two discrete groups to be analysed
(2) The independent variables can be analysed in a linear manner for discriminating
between two groups.
(3) The values of the variables are distributed normally.
Hence statement III is not an assumption of multiple discriminant analysis. So the
correct option is (d).
24. Answer : (e) <
TOP
Reason : In stock split par value decreases. As a result market price per share decreases >
immediately after a stock split.
25. Answer : (b) <
TOP
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).
26. Answer : (c) <
TOP
Reason : ROCE, Residual Income, Profit, EVA are all financial measures of performance.
>
However, employee morale & attitude is a non-financial measure of performance.
27. Answer : (c) <
TOP
Reason : It is a common misconception that valuation models give an exact estimate of value.
>
It is not totally an objective exercise as the inputs used leave some room for subjective
judgements. Hence, only statement (c) is true. So the correct option is (c).
28. Answer : (b) <
TOP
Reason : Value of the firm is given by the sum of the value of an all-equity finance firm and the >
present value of the tax benefit of corporate debt. The value of the levered firm will be
reduced by present value of bankruptcy and agency costs. Bankruptcy costs are
always a significant cost to investors and stakeholders. Agency costs are the costs that
govern the way in which principals and agents write and enforce contracts and
organize the ownership of the firm.
29. Answer : (c) <
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Reason : Vertical Integration was the feature of Second Merger Wave. Horizontal combination
>
was the feature of First Merger Wave. The Third Merger Wave was characterized by
conglomerate transactions. Hence, statement (c) is true. So the correct option is (c).
30. Answer : (b) <
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Reason : BCG matrix classifies the products into four broad categories. All others are the >
models for predicting sickness of a firm.

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 Section B : Problems
Cost of goods sold 486
1. Sales = = = Rs.648lakh
(1- Gross profit margin) 1 − 0.25

Sales 648 Rs.216 lakh

Total asset = = =
Total assets turnover 3

Inventories = Current ratio – Quick ratio

Current liabilities
or Inventories = (1.50 – 0.70) × 90 = Rs.72 lakh
Sales 648 = Rs.54 lakh
Receivables = =
Re ceivables turnover ratio 12
Current assets = Current liabilities × current ratio
= 90 × 1.5 = Rs.135 lakh
Cash and bank = Current assets – Receivables – Inventories
= 135 – 54 – 72 = Rs.9 lakh
Net fixed asset = Total assets – Current assets = 216 – 135 = Rs.81 lakh
Total debt = Total debt to equity ratio × Net worth = 1.88 × 75 = Rs.141 lakh
Term loan = Total debt – Current liabilities & provisions = 141 – 90 = Rs.51 lakh
Balance Sheet
(Rs. lakh)
Net worth 75 Net fixed assets 81
Term loan 51 Inventories 72
Current liabilities & provisions 90 Receivables 54
Cash and Bank 9
216 216

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2. a. Average sales per day = 36506.25 + 36225.28 = Rs.101.02 Lac

2 × 360
Average stock Raw materials and stores

= 416.84 + 441.47 = Rs.429.16 Lac

2

Average finished goods inventory = 331.79 + 262.58 = Rs.297.18 Lac

2

Average WIP inventory = 253.89 + 214.79 = Rs.234.34 Lac

2

Average accounts receivable = 2016.76 + 1399.15 = Rs.1707.96 Lac

2

Average accounts payable 1558.21 + 1324.02

= = Rs.1441.12 Lac
2
Average raw material and stores consumed per day

= 15957.14 + 960.09 + 1655.39

360
= Rs.51.59 Lac

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 Average cost of production per day = 214.79 + 20088.33 + 408.67 − 253.89
360
= 20457.9 = Rs.56.83 Lac
360
Average cost of good sold per day = 262.58 + 20457.9 + 9305.87 + 2425.29 − 331.79
360
= 32119.85 = Rs.89.22 Lac
360
Durations of various stages of the operating cycle
Duration of raw material and stores stage (Drm) = 429.16 = 8.32 days
51.59

Duration of WIP stage (Dlwip) = 234.34 = 4.12 days

56.83

Duration of finished goods stage (Dfg) = 297.18 = 3.33 days

89.22

Duration of accounts receivable stage (Dar) = 1707.96 = 16.91 days

101.02

Duration of accounts payable stage (Dap) = 1441.12 = 27.93 days

51.59
Weights for various stages of the operating cycle

Raw material and stores stage, Wrm = 51.59 = 0.51

101.20

Work in process stage = 51.59 + 0.5 + 5.24 = 0.57

101.02

Finished good stage, Wfg = 89.22 = 0.88

101.02

Account receivable stage, War = 101.02 = 1.00

101.02

Account accounts payable = 51.59 = 0.51

101.02
Duration of weighted operating cycle
Dwoc = Wrm . Drm + Wwip. Dwip + Wfg . Dfg + War . Dar – Wap. Dap
= 0.51 × 8.32 + 0.57 × 4.12 + 0.88 × 3.33 + 1 × 16.91 – 0.51 × 27.93 = 12.19 days.
b. Working capital requirement
= Sales per day × Weighted operating cycle + Cash balance requirement
= (101.02 × 1.10) × 12.19 + 150
= Rs.1504.58 Lac.
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3. Free cash flow scenario for next 5 years
Rs.in crore
2006 2007 2008 2009 2010
4 1 –2 3 7
P.V of explicit free cash flow upto 2010
4 1 −2 3 7
= + + + +
1.15 (1.15 )2 (1.15 )3 (1.15 )4 (1.15 )5
= 3.48 + 0.75 – 1.32 + 1.72 + 3.48
= 8.12
P.V. of free cash flow of all period considering the cyclical nature of the cash flow
= 8.12 + 8.12 PVIF (15%, 5 yrs) + 8.12 PVIF (15%, 10yrs) + 8.12 PVIF (15%, 15yrs) + . . .
1 + 0.497 + (0.497 )2 + (0.497 )3 + ...
= 8.12  
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 1 8.12
= 8.12 × 1 − r = 1 − 0.497 = Rs.16.14 crores.

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4. The forward-looking approach is often fraught with difficulties, the most intractable of which is the difficulty of
estimating future dividends or earnings growth. One possible way of tackling the difficulty could be by surveying
equity analysts, but it has been generally seen at the aggregate level that analyst projections almost always
overstate the long-term growth of earnings or dividends. So the objectivity of analyst projections is hardly beyond
question. Forecasting earnings with any degree of accuracy for one, two, or even three years into the future is
difficult. The gap between forecast and reported earnings can be very wide. It was observed in one of the research
studies that the aggregate earnings forecast exceeded corporate profits by more than 13 percent. The degree of
overestimation generally increases with the number of periods for which the projections are made. Moreover,
forecast errors are typically larger in periods of declining economic growth and they tend to decline when
economic growth accelerates. The phenomenon of overshooting of the forecasts is not only limited to companies
or industries that are rapidly growing and thus more prone to excessive optimism on the part of analysts, but is
also observed in case of companies and industries which are undergoing a slow growth phase. Others have
constructed elaborate models of forward-looking returns, but such models are typically so complex that it is
extremely difficult to draw meaningful conclusions or generate anything but highly unstable results.
Forward-looking models typically link current stock prices to expected cash flows by discounting the cash flows at
the cost of equity. The implied cost of equity thus becomes a function of known current share values and estimated
future cash flows. The problem lies with the estimation of the future cash flows because it is difficult to
objectively make such estimates without making simplifying assumptions. The appropriateness of the model and
the estimate of cost of equity it yields critically depends on the appropriateness of the underlying assumptions.
Another issue that needs to be addressed in this regard is how should the current stock price be measured. Further,
most models use the current level of dividends as a starting point for projecting cash flows to equity. However,
many corporates have changed their way of providing the returns to the equity shareholders. Traditionally the
returns to the equity shareholders were given by paying cash dividends. In the recent times many companies have
adopted the method of buying back shares and also various other ways to return cash to the equity shareholders.
So estimates based on ordinary dividends will not be able to take into consideration a substantial portion of the
cash flows paid out to the equity shareholders. Finally the cash flows in the future are subject to change and the
there should be some basis for estimating the changed cash flows in future. If it is assumed that cash flows tend to
either grow or decline with the passage of time then the question that arises is how should the rate of growth or
decline be estimated. The answers to all these issues will determine the accuracy of the estimate of the cost of
equity.
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5. The historical approach towards the estimation of cost of equity is also not easy to apply. The first issue that needs
to be addressed is the number of time periods over which the returns to the equity shareholders be measured. The
more is the number of time periods covered the greater will be the need for data. And it is often difficult to obtain
data for long periods of time into the past. Also if the the time period covered into the past is too long the data may
not be available for all companies for all the periods. Further, the returns to the equity shareholders do change over
time and the extent of change may be different in different time periods depending upon the situations persisting
both inside the firm as well as the business environment in which it operates. The next question that arises is how
should the returns be represented or measured for any firm. If some measure of central tendency be used then the
question is whether it should be the arithmetic mean or the geometric mean of the past returns. It should then be
decided how frequently should the average returns be sampled. The exercise involved will be more if the sampling
is done too frequently. However if the sampling is done over longer intervals they may fail to capture any
significant change in the average returns over time because the mechanism of averaging tends to pull down the
higher values and pull up the lower values.
Finally the estimation of cost of equity by the historical approach is based on the assumptions: (1) the past returns
to the equity shareholders have been in conformity with their expected returns and (2) the expected returns of the
equity shareholders in the past are similar to their past expecteations. There are many equity shareholders in a
company and their expectations will be different or similar to each other depending upon their assessment of the
cashflows from the company. It is not very realistic to assume that for all the equity shareholders all the past
returns have been in conformity with their expected returns. Secondly the future is uncertain and the economic
conditions such as the inflation rate and the interest rate structure prevailing in the economy may undergo change.
Changes in the future inflation rate and the interest rate structure usually result in a change in the rate of return
required by the investors. The estimate of the cost of equity by the models based on the historical approach will
critically depend upon the methodology and the assumptions underlying them as discussed above.
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15
6. Following issues regarding cross border mergers and acquisitions should be considered before going for it:
• Degree of Openness: Each and every country has its own entry restrictions on some type of services, though
in this connection, it is the developed countries which opt for transformation, as compared to the developing
countries. Services such as computer and related services, commercial services, medical diagnostics,
architectural, engineering and financial services are poised for preference in the FDIs.
• Weeding Out Domestic Firms: M&As have costs and benefits. While the host economy will largely reap
the benefits of advanced technology, generate larger employment potential, yet in the process there is a
danger that small industries and possibly the big domestic firms will have to face stiff competition. There is a
possibility that domestic firms in the crowd and cloud of competitiveness will get weeded out, or meekly
surrender to the processes of M&As.
• Infrastructure Facilities: M&As also largely depend on layout of facilities for infrastructure, which in turn
deserves and demands huge investments for plants, roads, transport, communications etc. This will become a
burden on the economy, and the infrastructure sector will also tend to get privatized in the process.
• Stay Element—A Risk: That M&As are a permanent stay for the host country is a question of serious
thought and discussion. They cannot be considered as a permanent stay for benefits, and in the long-run it
may be a drift as well.
• Drain of National Resources: M&A in the process of reaping benefits may cost the nation its national
resources, and whether they are socially responsible towards the nation at large needs to be examined. The
ecological and biological environments are the heritage of certain nations, and preservation of these elements
will be put at stake by allowing M&As.
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7. Following are the benefits of cross border merger and acquisition:
• Broad-based Capital Market: The capital market of a country is the reflection of the monetary position of
the economy, and also are it should be vibrant and vigorous; it should attract large inflows of FDIs. With the
global fall in interest rates, developed countries see that there is at least a marginal inflation and rate of return
from investing in the upcoming markets. This is seen with a view that developed markets also diversify their
investment, and thus risk and return linkages and lineages are established.
• Better Synergies for Production: One of the most common motives for any M&A is expansion. An
acquisition of a particular company may provide synergistic gains and benefits when lines of business activities
complement one another. An acquisition may be part of a diversification program that allows the company to
move into a completely different line of business, which again may be a part of a turnaround strategy.
• Finance Factors: Most of the M&As are driven by finance factors. In this connection, valuation analysis by
experts is important. This may enable one to find out that the particular firm’s value is neither undervalued
nor overvalued, and value addresses the market realities. Also, professionals such as bankers, accountants,
valuation experts, attorneys provide a host of services, which in turn get brand image and recognition arising
out of M&A’s transactions.
• Better Harmonization between the Laws and the Regulatory Framework: M&As require a better
harmonization of inland laws and regulatory framework with globe laws. Firms prefer to lend their
investments where there are little controls and procedures.
• Opening the Gates of the Economy: A developing country with aspiration to reap maximum benefits for its
own self-development needs to restructure its position, and pave the way for free flow of FDIs and M&As.
This, in the long run, will solve many of the problems being faced by it for a long time. For example, the
potential for savings, investments, employment generation and recognition of local skills and labor
automatically gets realized. Many of its afflictions such as poverty are alleviated in this dual process and
progress.
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Section C: Applied Theory

8. Role of the senior management
The board and the senior managers need to send strong signals that they consider risk management a priority. The
board should play an active role in identifying the risks that may have a significant impact on the fulfillment of
corporate objectives. It should review information on these significant risks from time to time. The board should
come to a consensus regarding what risks are acceptable, the probability of their occurrence and the type of
mechanisms and processes needed to reduce their impact. The board should realize that whatever be the
sophistication of the control systems and processes, risks due to poor judgment, human error and unforeseen
circumstances can never be completely eliminated. It should be emphasized that the role of the board is not to
advocate complete elimination of risk. In a competitive market place, not taking risks could turn out to be a risk in
itself. In fact, if effective risk management processes are in place, the board may decide that more risks have to be
taken to exploit the opportunities available for the business to succeed in the long run. The board and the senior

16
 management team should play an active role in the following areas:
• Understanding the Risk Profile: The board members should clearly understand the risks to which the company
is exposed. The board should further decide which risks are acceptable and which must be eliminated through
the use of hedging techniques.
• Setting Policy: The board should prepare policy guidelines, including the corrective action to be taken when
things go wrong. For example there should be guidelines on when and how to unwind an unprofitable
position, if rates move unfavorably. The exit strategy should be based on the amount of money the company
is willing to put to risk.
• Establishing Controls: Steps should be taken to ensure effective implementation of policies. An independent
risk management unit is desirable. Ideally, risk managers should not report to traders. It is a good practice to
make risk managers report to people one level higher than those who execute and approve derivative
transactions.
• Setting up systems: The most expensive but integral part of a comprehensive risk management function is
consolidation and integration of data from a number of different systems across the company’s operations.
• Checking compliance: The risk manager should send reports regularly to the senior management and the board.
These reports should check compliance with policies and procedures and make independent evaluations of the
various derivatives positions. The reports should also indicate whether the positions are synchronous with the
company’s accounting department and with the disclosures in the company’s financial reports.
• Periodic Review: The board must make it clear to traders and treasury managers that any violation of policies,
guidelines or controls will be punished. When limits are violated, the board should not hesitate to take
immediate action and send clear signals that indiscipline will not be tolerated.
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9. Target costing has recently received considerable attention. It is defined as under:
Target cost = Sales price (for the target market share) – Desired profit
Sony walkman is an excellent example of it. In fact Japanese cost management is known to be guided by the
concept of target cost. In it management decides, before the product is designed, what a product should cost, based
on marketing (rather than manufacturing) factors.
There are several phases in the methodology.
Conception (Planning) Phase
Based upon its strategic business plans, a company must first identify the type of product it wishes to manufacture.
Several steps must be taken in order to establish a reasonable target cost.
1. Market research should be done to determine several factors. First, the products of competitors’ should be
analyzed with regard to price, quality, service and support, delivery, and technology. After a preliminary test
of competitor’s product, it is necessary to establish the features consumers value in this type of product, and
the important features that are lacking.
2. After preliminary testing, a company should be able to pinpoint a market niche it believes is undersupplied,
and in which it believes it might have some competitive advantage. Only then can a company set a target cost
close to competitors’ products of similar functions and value. The target cost is bound to change in the
development and design stages. However, the new target costs should only be allowed to decrease, unless the
company can provide added features that add value to the product.
Development Phase
The company must find ways to attain the target cost. This involves a number of steps.
1. First, an in-depth study of the most competitive product on the market must be conducted. This study will
show materials used and features provided, and it will give an indication of the manufacturing process
needed to complete the product.
2. After identifying the cost structure of the competitor, the company should develop estimates for the internal
cost structure of its own products.
3. After preliminary analysis of the cost structures of both the competition and itself, the company should further
define these cost structures in terms of cost drivers. Focusing on cost drivers can help reduce waste, improve
quality, minimize non-value-added activities, and identify ineffective product design.
Production Phase
In these stages, target costing becomes a tool for reducing costs of existing products. It is highly unlikely that the
design, manufacturing, and engineering groups will develop the optimal, cost-efficient process at the beginning of
production. The search for better, less expensive products should continue in the framework of continuous
improvement.
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< TOP OF THE DOCUMENT >

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