Financial management Basics by Indranil Bhattacharjee
Financial Management - IPart A: Basic ConceptsQ. When the required rate of return is equal to the coupon rate, value of the redeemable bond isequal to itsa. Market Valueb. Face Valuec. Present Value of the stream of interest inflowsd. Average of par value and maturity valuee. None of the aboveQ. Which of the following is an assumption of CAPM?a. The investors are risk loversb. The assets can be sold or bought in the lots of 100 unitsc. The transaction costs and taxes form significant amountd. Expectations of one investor is not same as that of the another for expected returns and risksassociated with the securitye. The investors consider the expected return and the standard deviation of returns as thecriteria for making investmentQ. Which of the following is not a money market instrument?a. Treasury billsb. Certificate of depositsc. Debenturesd. Call moneye. None of the aboveQ. Which of the following members would you not find in the secondary stock market?a. Investorsb. Stock exchangesc. Stock brokersd. Companiese. UnderwritersQ. The objective of financial management is toa. Generate the maximum net profitb. Generate the maximum retained earningsc. Generate the maximum wealth for its shareholdersd. Generate maximum funds for the firm at the least coste. All of the above
Q. The amount that can be realized by a company when it sells its business as an operating one istermed asa. Going concern valueb. Market valuec. Book valued. Replacement valuee. Liquidation valueQ. Systematic risk factor(s) involved in investing in bondsa. Purchase power riskb. Interest rate riskc. Yield riskd. Both (a) and (b) abovee. Both (b) and (c) aboveQ. Which of the following statements is true of Beta?a. Beta of a security is the slope of the Security Market lineb. Beta of a security is a measure of the diversifiable risk of a securityc. High beta of a security assures high returnd. Beta of a security can never be negativee. Beta of a security is a measure of systematic risk of a securityQ. The price of the share will increase ifa. The dividend decreasesb. The required rate of return increasesc. The growth rate increasesd. Both (b) and (c) abovee. All of (a) (b) and (c).Q. You want to buy an ordinary annuity that will pay you Rs. 8,000 a year for the next 20 years. Youexpect annual interest rates will be 8 percent over that time period. The maximum price you wouldbe willing to pay for the annuity is closest toa. Rs. 78,544b. Rs. 64,000c. Rs. 80,000d. Rs. 84,000e. Rs. 68,523
Q. With continuous compounding at 10 percent for 30 years, the future value of an initial investmentof Rs. 4,000 is closest toa. Rs. 69,796b. Rs. 80,342c. Rs. 64,558d. Rs. 78,595e. Rs. 81,243Q For Rs. 1,000 you can purchase a 5-year ordinary annuity that will pay you a yearly payment ofRs. 263.80 for 5 years. The compound annual interest rate implied by this arrangement isa. 10 per centb. 9.5 per centc. 9.0 per centd. 8.5 per cente. 10.5 per centQ. An "aggressive" common stock would have a "beta"a. Equal to zerob. Greater than onec. Equal to oned. Less than onee. InfiniteQ. Garware Paints common stock has a beta of 0.90, while Acme Dynamite Company common stockhas a beta of 1.80. The expected return on the market is 10 percent, and the risk-free rate is 6percent. According to the capital-asset pricing model (CAPM) and making use of the informationabove, the required return on Garware Paints common stock should be ________, and therequired return on Acmes common stock should be __________a. 3.6 percent; 7.2 percentb. 9.6 percent; 13.2 percentc. 9.6 percent; 12.3 percentd. 9.0 percent; 18.0 percente. 14.0 percent; 23.0 percentQ. Virgo Airlines will pay a $4 dividend next year on its common stock, which is currently selling at$100 per share. What is the markets required return on this investment if the dividend is expectedto grow at 5% forever?a. 4 percentb. 5 percentc. 7 percentd. 9 percente. 8 percent
Q. The current market interest rate is 10%. A coupon bond with a coupon payment of Rs. 70, a facevalue of Rs. 1000, and with still ten years to maturity, will trade at what discount?a. Rs. 1,000b. Rs. 800c. Rs. 700d. Rs. 300e. Rs. 200Q. Primary marketsa. Are markets in which primary goods and services are tradedb. Are markets in which bonds of only medium term and long term maturity are tradedc. Are markets in which short term debt is tradedd. Are markets in which claims that have already been issued are sold by one investor to anothere. Are markets in which newly issued claims are sold to initial buyersQ. Say you buy a bond with a face value of Rs. 1000 at a discount for Rs. 750. The bond still has 10years to maturity, and the coupon rate on the bond is 10%. The yield to maturity of this bond isa. 14.28 per centb. 13.52 per centc. 12.98 per centd. 11.99 per cente. None of the aboveQ. The cost of equity capital is all of the following EXCEPT:a. The minimum rate that a firm should earn on the equity-financed part of an investmentb. A return on the equity-financed portion of an investment that, at worst, leaves the market priceof the stock unchangedc. By far the most difficult component cost to estimated. Generally lower than the before-tax cost of debte. None of aboveQ. A company limited’s Rs.100 par value preferred stock just paid its Rs. 10 per share annualdividend. The preferred stock has a current market price of Rs. 96 a share. The firms marginal taxrate is 40 percent, and the firm plans to maintain its current capital structure relationship into thefuture. The component cost of preferred stock to the company would bea. 6.00 percentb. 6.25 percentc. 10.00 percentd. 10.42 percente. 9.89 percent
Q. Dravid is evaluating two conventional, independent capital budgeting projects (X and Y) by makinguse of the risk-adjusted discount rate (RADR) method of analysis. Projects X and Y have internalrates of return of 16 percent and 12 percent, respectively. The RADR appropriate to Project X is18 percent, while Project Ys RADR is only 10 percent. The companys overall, weighted-averagecost of capital is 14 percent. Dravid shoulda. Accept Project X and accept Project Yb. Accept Project X and reject Project Yc. Reject Project X and accept Project Yd. Reject Project X and reject Project Ye. None of the aboveQ. If two projects are completely independent (or unrelated), the measure of correlation betweenthem isa. 0b. 0.5c. 1.0d. 0.75e. -1.0Q. A profitability index of 0.85 for a project means that:a. the present value of benefits is 85% greater than the projects costsb. the projects NPV is greater than zeroc. the project returns 85 paisa in present value for each rupee investedd. the payback period is less than one yeare. None of the aboveQ. Which of the following statements is correct?a. If the NPV of a project is greater than 0, its PI will equal 0b. If the IRR of a project is 0%, its NPV, using a discount rate, k, greater than 0, will be 0c. If the PI of a project is less than 1, its NPV will be less than 0d. If the IRR of a project is greater than the discount rate, k, its PI will be less than 1 and its NPVwill be greater than 0e. None of the aboveQ. Mr. Prasad is considering to purchase a commercial complex that will generate a net cash flow ofRs. 4,00,000 at the end of year one. The future cash flows are expected to grow at the rate of 4%per annum. Mr. Prasad’s required rate of return is 12%. Mr. Prasad would be will to pay theamount of Rs. _________. For the complex if he wishes to sell it at the end of four years at Rs. 40lakh, net of transaction costs.a. Rs. 49,38,921b. Rs. 38,26,958c. Rs. 1,56,13,927d. Rs. 1,61,51,256e. Rs. 1,82,77,509
Q. A payment of a 9 Years annuity of Rs. 10,000 will begin seven years hence. The value of thisannuity now with the discount rate at 12% will be equal to ________a. Rs. 44,315b. Rs. 27,000c. Rs. 35,765d. Rs. 13,400e. Rs. 24,102Q. If a deep discount bond is issued at Rs.5,000, the redemption value of the bond is Rs.1,00,000and the maturity period is 20 years, then the effective yield on the bond isa. 20.00%b. 18.30%c. 17.50%d. 16.16%e. 15.25%Q. A bond with a face value of Rs. 50 provides 8% annual return and pays Rs. 75 at the time ofmaturity, which is 10 years from now. If the investors required rate of return is 12% at _________price should the company issue the bonda. Rs. 75.85b. Rs. 69.35c. Rs. 87.15d. Rs. 91.07e. Rs. 64.38Q. The risk free return is 10% and the market return is 15%. Stock A has a beta of 1.2 and iscurrently selling for Rs. 30. If the expected dividend on the stock is Rs. 4, then the growth rate ofthe company is ________a. 2.16b. 2.11c. 2.33d. 2.67e. 2.70Q. If the nominal rate of interest is 16 per cent and compounding is done quarterly, the effective rateof interest will be ________a. 17.52b. 16.98c. 16.00d. 15.12e. 16.49
Part-B & C1. You have recently won the super jackpot of the Play win lottery. On reading the fine print, youdiscover that you have two options:a. You receive Rs. 100000 at the beginning of each year for 6 years. The income would be taxedat the rate of 28%.b. You win Rs. 858500, but you do not have access to the full amount immediately. The entiresum accrued (i.e. Rs 858500) would be taxed at 28%. You would receive Rs. 20000 of theafter-tax amount now. The remaining Rs. 598120 will be placed in a 5 year annuity accountthat pays a fixed amount of Rs 200000 on a before-tax basis at the end of each year. Interestincome is also liable for 28% tax. Using a discount rate of 10%, which option should youselect?(15 Marks)Suggested Answer:Option IGross 100000Tax 0.28Net 126000Yrs 6i 0.1n-1 5PVA 4.7908Amt recd 344937.6Option II Int @20% Principal O/s Net CF DF @ 10%Gross 858500 0 598120 0.1After tax 618120 1 119624 80376 517744 177495 0.9091Recd now 20000 2 103549 96451 421293 172994 0.8264Balance 598120 3 84259 115741 305552 167593 0.7513Int (IRR) 0.2 4 61110 138890 166662 161111 0.683n 5 5 33338 166662 0 153335 0.6209PVA 2.9906 401880 598120 635480pa 200000PV 598120 Note: Net CF = Principal + Int*(1-0.28)Amt recd 655480(635480+20000)In case of second option, the interest rate offered by the 5 year annuity account has to be arrived at bytrial-and-error method.IRR (-598120,200000,200000,200000,200000,200000) = 20%Option II is better
2. The following is the capital structure of Higgins Ltd.Source of Capital AmountEquity Capital (9,00,000 shares of Rs 10 each) 90,00,00013% Preference Capital (2500 shares of Rs 1000 each) 25,00,0008% Debentures 35,00,000Total 1,50,00,000The current market price of the Higgins is Rs 32. Expected Dividend at the end of current fiscal is80% with a growth rate of 2%. Higgins Ltd needs another 50 lakhs for expansion which it plans toraise through Long term Loans bearing 10% rate of interest. This financing decision may increasethe overall risk perception of the company and thereby reduce its market price to Rs 25.Giventhat the tax rate is 35%, determine its Weighted Average Cost of Capital (WACC) using marketweights both before and after expansion.(12 marks)Suggested AnswerK (new) Mkt ValTotalCost K (old) Mkt ValTotalCostEquity 0.34 22500000 7650000 0.27 28800000 7776000Pref 0.13 2500000 325000 0.13 2500000 325000Debentures 0.052 3500000 182000 0.052 3500000 182000Loan 0.065 5000000 32500033500000 8482000 34800000 8283000WACC 0.253194 0.2380173. Given a budget constraint of 3.25 lakh, IVCL wants to decide the combination of investments. Allthe following projects are independent.Allocate the resources on the basis of IRR, NPV and PI (Profitability Index). Of the three, whichgives the best result? Why?(8 marks)ProjectsInitial Outlayat zero periodIRR (%) NPVA 5000 18 500B 50000 25 65000C 50000 37 55000D 75000 20 50000E 125000 26 5000F 150000 28 210000G 175000 19 75000H 250000 15 60000
Suggested AnswerProject CF @ 0 IRR (%) NPV PIRankIRRRankNPV Rank PIA 5000 18 500 1.1 7 8 7B 50000 25 65000 2.3 4 3 2C 50000 37 55000 2.1 1 5 3D 75000 20 50000 1.67 5 6 4E 125000 26 5000 1.04 3 7 8F 150000 28 210000 2.4 2 1 1G 175000 19 75000 1.43 6 2 5H 250000 15 60000 1.24 8 4 6Rank IRR based NPV based PI basedInvt NPV Invt NPV Invt NPV1 50000 55000 150000 210000 150000 2100002 150000 210000 175000 75000 50000 650003 125000 5000 50000 550004 75000 50000Total 325000 270000 325000 285000 325000 380000Ranking based on PI is better as it maximizes NPV for every rupee of Outlay4. Raja industries limited is contemplating on buying a new moulding machine at Rs. 50 lakh, with anadditional working capital requirement of Rs. 10 lakh. The machine is expected to have aneconomic useful life of 5 years, with no salvage value. The firm follows the straight-line method ofdepreciation and the same is accepted for tax purposes. The machine is expected to generate anincremental increase in the before tax cash operating income of Rs. 12 lakh at the end of the firstyear with a growth of eight per cent per year on the previous year for a period of five years. Therelevant tax rate is 35 per cent and the firms WACC is 10 percent. Advise the company whetherthe machine should be purchased. Show your NPV calculation in real terms assuming the workingcapital requirement will remain unchanged throughout the period, in spite of inflation.(10 marks)Suggested AnswerCash Outflows:Cost of Moulding Machine 50,00,000Additional Working Capital 10,00,00060,00,000
(a) Incremental Cash Operating IncomeYr1 Yr2 Yr3 Yr4 Yr5Operating Income 12 12.96 13.9968 15.11654 16.32587Less: Tax @ 35% 4.2 4.536 4.89888 5.29079 5.714054EAT 7.8 8.424 9.09792 9.825754 10.61181PVIF@10% 0.909091 0.826446 0.751315 0.683013 0.620921CFAT 7.09091 6.961981 6.835404 6.711117 6.589098 34.18851Tax Savings due to Depreciation:Depreciation per annum = 50.00/5 years = 10.00 LakhTax Saving at the rate of 35% of the Depreciation = 10.00 x 0.35 = 3.5 lakhTax Savings on DepreciationYr1 Yr2 Yr3 Yr4 Yr5Dep 10 10 10 10 10Tax @35 3.5 3.5 3.5 3.5 3.5PVIF@10% 0.909091 0.826446 0.751315 0.683013 0.6209213.181818 2.892562 2.629602 2.390547 2.173225 13.26775Release of Working Capital (at the year end – 5) = 10.00 x PVIF10%,5Yrs = 621,000Net Present Value = Cash Inflows – Cash outflows= 34.18851 + 13.26775 + 6.21 – 60.00= - 6.333745. The current dividend on an equity share of Pioneer Technology is Rs 3.00. Pioneer is expected toenjoy an above normal growth rate of 40 percent for 5 years. Thereafter, the growth rate will falland stabilize at 12%. Equity investors require a return of 18% from Pioneer’s stock. What is theintrinsic value of the equity share of Pioneer?(5 marks)
Suggested AnswerPart C: Case Analysis6. You have been provided with the following data on the securities of three firms and the market.Note:1. Second column gives the average return of the security over one year2. Third column is the estimated standard deviation over the same period3. Fourth column is the Beta of the security4. Fifth column is the Expected returns under CAPM assumptionsDo PVIF@18%3Yr 1 4.2 0.847458 3.559322Yr 2 5.88 0.718184 4.222924Yr 3 8.232 0.608631 5.010249Yr 4 11.5248 0.515789 5.944364Yr 5 16.13472 0.437109 7.05263525.78949Div at the end of 6th year = 16.13472(1.12)18.0708864 D1/Ke-g301.1814 0.437109 131.6492PV of 5 years +perpetuity 157.4387SecurityiR iσ iβ )( iRERisk-free asset 0.05 ?? ?? ??Market (Broad based Index) 0.15 0.10 ?? ??A 0.13 0.12 0.90 ??B 0.16 ?? 1.10 ??C 0.25 0.24 ?? ??A & B (50% each) ?? ?? ?? ??A & C (50% each) ?? ?? ?? ??B & C (50% each) ?? ?? ?? ??A, B & C (30%, 30%, 40%) ?? ?? ?? ??
Correlation matrixA B C MarketA 1.00 -0.40 0.70 ??B -0.40 1.00 0.30 0.40C 0.70 0.30 1.00 0.75Market ?? 0.40 0.75 1.00Required:a. Fill in the blanks. Expected returns are based on CAPMb. Are A, B & C overvalued/undervalued assets?(20 Marks)5. Suggested AnswerRet Std dev beta Exp RetA 0.13 0.12 0.9 0.14B 0.16 0.275 1.1 0.16C 0.25 0.24 1.8 0.23Market 0.15 0.1 1 0.15Rf 0.05 0 0 0.05A,B 0.145 0.126 1 0.15A,C 0.19 0.1676 1.35 0.185B,C 0.205 0.208 1.45 0.195A,B,C 0.187 0.1566 1.32 0.182A B C MarketA 1.00 -0.40 0.70 0.75B -0.40 1.00 0.30 0.40C 0.70 0.30 1.00 0.75Market 0.75 0.40 0.75 1.00Expected return for A is higher than the actual while the expected return for C is lower than the actual.For B the expected return is same as the quantum inferred from the market.
The variance for each portfolio is estimated using matrix approach (where variance is given by thesummation of the elements)Portfolio A,B0.0036 -0.00792-0.00792 0.1089Sum = 0.09666Portfolio A,C0.0036 0.005040.00504 0.0144Sum = 0.02808Portfolio B,C0.1089 0.011880.01188 0.0144Sum = 0.14706Portfolio A,B,C0.001296 -0.00285 0.002419-0.00285 0.039204 0.0057020.002419 0.005702 0.009216
Sum = 0.060257Note: Square root of the above summation is the standard deviationPortfolio return is estimated as the weighted average of individual returnsPortfolio beta is estimated as weighted averaged of individual beta.Expected return = Risk-free + beta*(Market return – Risk free return)Combinations sorted in ascending order of Standard DeviationCombo Std Dev Expected ReturnA 0.12 0.14A,C 0.167571 0.185C 0.24 0.23A,B,C 0.245473 0.182A,B 0.310902 0.15B,C 0.383484 0.195B 0.66 0.16Of the various combinations A, (A,C) and C are the best combinations. All other combinations areinefficient.(A,B,C) offers similar return as (A,C) with higher risk and lower return than C (although with similar riskas C).Similarly (A,B), (B,C) and B offers similar return to existing efficient portfolio but with higher level ofrisk.END OF THE QUESTION PAPER