PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT

QUESTIONS
Project Planning and Capital Budgeting
1. Project X and Project Y are under the evaluation of XY Co. The estimated cash flows and
their probabilities are as below:
Project X: Investment (year 0) ` 70 lakhs
Probability weights 0.30 0.40 0.30
Years ` lakhs ` lakhs ` lakhs
1 30 50 65
2 30 40 55
3 30 40 45
Project Y: Investment (year 0) ` 80 lakhs.
Probability weighted Annual cash flows through life
` lakhs
0.20 40
0.50 45
0.30 50
(i) Which project is better based on NPV, criterion with a discount rate of 10%?
(ii) Using Hiller’s Model compute the standard deviation of the present value distribution
and analyze the inherent risk of the projects.
Leasing Decisions
2. M/s ABC Ltd. is to acquire a personal computer with modem and a printer. Its price is
` 60,000. ABC Ltd. can borrow ` 60,000 from a commercial bank at 12% interest per
annum to finance the purchase. The principal sum is to be repaid in 5 equal year -end
instalments.
ABC Ltd. can also have the computer on lease for 5 years.
The firm seeks your advice to know the maximum lease rent payable at each year end.
Consider the following additional information:
(i) Interest on bank loan is payable at each year end.
(ii) The full cost of the computer will be written off over the effective life of comput er on
a straight-line basis. This is allowed for tax purposes.
(iii) At the end of year 5, the computer may be sold for ` 1,500 through a second -hand
dealer, who will charge 8% commission on the sale proceeds.

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 69

(iv) The company's effective tax rate is 30%.

(v) The cost of capital is 11%.
Suggest the maximum annual lease rental for ABC Ltd. :
PV Factor at 11%
Year PVF
1 0.901
2 0.812
3 0.731
4 0.659
5 0.593

Dividend Decisions
3. ABC Ltd. has 50,000 outstanding shares. The current market price per share is ` 100 each.
It hopes to make a net income of ` 5,00,000 at the end of current year. The Company’s
Board is considering a dividend of ` 5 per share at the end of current financial year. The
company needs to raise ` 10,00,000 for an approved investment expenditure. The
company belongs to a risk class for which the capitalization rate is 10%. Show, how the M -
M approach affects the value of firm if the dividends are paid or not paid.
Derivative
4. TMC Holding Ltd. has a portfolio of shares of diversified companies valued at ` 400 crore
enters into a swap arrangement with None Bank on the terms that it will get 1.15% quarterly
on notional principal of ` 80 crore in exchange of return on portfolio which is exactly
tracking the Sensex which is presently 21600.
You are required to determine the net payment to be received/ paid at the end of each
quarter if Sensex turns out to be 21,860, 21,780, 22,080 and 21,960.
5. Mr. X established the following spread on the Delta Corporation’s stock:
(i) Purchased one 3-month call option with a premium of ` 30 and an exercise price of
` 550.
(ii) Purchased one 3-month put option with a premium of ` 5 and an exercise price of
` 450.
Delta Corporation’s stock is currently selling at ` 500. Determine profit or loss, if the price
of Delta Corporation:
(i) remains at ` 500 after 3 months.
(ii) falls at ` 350 after 3 months.
(iii) rises to `600.

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 70 FINAL EXAMINATION: MAY, 2018

Assume the size option is 100 shares of Delta Corporation.

6. Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on NSE and
the three months future price quotes at `230 and the one month borrowing rate is given
as 15 percent and the expected annual dividend yield is 25 percent per annum payable
before expiry. Also examine arbitrage opportunities.
Security Analysis and Valuation
7. SAM Ltd. has just paid a dividend of ` 2 per share and it is expected to grow @ 6% p.a.
After paying dividend, the Board declared to take up a project by retaining the next three
annual dividends. It is expected that this project is of same risk as the existing projects.
The results of this project will start coming from the 4 th year onward from now. The
dividends will then be ` 2.50 per share and will grow @ 7% p.a.
An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least ` 2,000 p.a. from
this investment.
Show that the market value of the share is affected by the decision of the Board. Also show
as to how the investor can maintain his target receipt from the investment for first 3 years
and improved income thereafter, given that the cost of capital of the firm is 8%.
8. The following data is available for a bond:
Face Value ` 1,000
Coupon Rate 11%
Years to Maturity 6
Redemption Value ` 1,000
Yield to Maturity 15%
(Round-off your answers to 3 decimals)
Calculate the following in respect of the bond:
(i) Current Market Price.
(ii) Duration of the Bond.
(iii) Volatility of the Bond.
(iv) Expected market price if increase in required yield is by 100 basis points.
(v) Expected market price if decrease in required yield is by 75 basis points .
Portfolio Theory
9. The following information is available in respect of Security X
Equilibrium Return 15%
Market Return 15%

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 71

7% Treasury Bond Trading at $140

Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and Security
Return.
10. An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution
for the possible economic scenarios and the conditional returns for two stocks and the
market index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3
The risk free rate during the next year is expected to be around 11%. Determine whether
the investor should liquidate his holdings in stocks A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
Factoring
11. The credit sale and receivables of A Ltd. at the end of the year are estimated at ` 3.2
crores and its average collection period is 90 days. The past experience indicates that bad-
debt losses are 1.5% on Sales. The expenditure incurred by the firm in administering its
receivable collection efforts are ` 5,00,000. A factor is prepared to buy the firm’s
receivables on recourse basis by charging 2% Commission. The factor will pay advance
on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as reserve.
Calculate the effective cost of factoring to the Firm assuming 360 days a year.
Mutual Funds
12. On 1-4-2012 ABC Mutual Fund issued 20 lakh units at ` 10 per unit. Relevant initial
expenses involved were ` 12 lakhs. It invested the fund so raised in capital market
instruments to build a portfolio of ` 185 lakhs. During the month of April 2012 it disposed
off some of the instruments costing ` 60 lakhs for ` 63 lakhs and used the proceeds in
purchasing securities for ` 56 lakhs. Fund management expenses for the month of April
2012 were ` 8 lakhs of which 10% was in arrears. In April 2012 the fund earned dividends
amounting to ` 2 lakhs and it distributed 80% of the realized earnings. On 30-4-2012 the
market value of the portfolio was ` 198 lakhs.
Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed off the same
at closing NAV on 30-4-2012. What was his annual rate of earning?

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 72 FINAL EXAMINATION: MAY, 2018

13. A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01, 2008. No
entry load was charged. It made the following investments:
Particulars `
50,000 Equity shares of ` 100 each @ ` 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of ` 12,00,000 were received on equity shares. Interest on all
types of debt securities was received as and when due. At the end of the year equity shares
and 10% debentures are quoted at 175% and 90% respectively. Other investments are at
par.
Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the
year amounted to ` 5,00,000. Also find out the NAV, if the Mutual fund had distributed a
dividend of ` 0.80 per unit during the year to the unit holders.
Money Market Operations
14. From the following particulars, calculate the effective rate of interest p.a. as well as the
total cost of funds to Bhaskar Ltd., which is planning a CP issue:
Issue Price of CP ` 97,550
Face Value ` 1,00,000
Maturity Period 3 Months
Issue Expenses:
Brokerage 0.15% for 3 months
Rating Charges 0.50% p.a.
Stamp Duty 0.175% for 3 months
International Financial Management
15. XY Limited is engaged in large retail business in India. It is contemplating for expansion
into a country of Africa by acquiring a group of stores having the same line of operation
as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile.
Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable
future.
Estimated projected cash flows, in real terms, in India as well as African country for

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 73

the first three years of the project are as follows:

Year – 0 Year – 1 Year – 2 Year - 3
Cash flows in Indian -50,000 -1,500 -2,000 -2,500
` (000)
Cash flows in African -2,00,000 +50,000 +70,000 +90,000
Rands (000)
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year
indefinitely. It evaluates all investments using nominal cash flows and a nominal
discounting rate. The present exchange rate is African Rand 6 to ` 1.
You are required to calculate the net present value of the proposed investment considering
the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted
rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s
high risk.
(iii) Ignore taxation.
Year - 1 Year - 2 Year - 3
PVIF @ 20% .833 .694 .579
Foreign Exchange Exposure and Risk Management
16. NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three
months. The company has also exported goods for US $ 4,50,000 and this amount is
receivable in two months. For receivable amount a forward contract is already taken at
` 48.90.
The market rates for Rupee and Dollar are as under:
Spot ` 48.50/70
Two months 25/30 points
Three months 40/45 points
The company wants to cover the risk and it has two options as under:
(A) To cover payables in the forward market and
(B) To lag the receivables by one month and cover the risk only for the net amount. No
interest for delaying the receivables is earned. Evaluate both the options if the cost
of Rupee Funds is 12%. Which option is preferable?

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 74 FINAL EXAMINATION: MAY, 2018

17. Your bank’s London office has surplus funds to the extent of USD 5,00,000/ - for a period
of 3 months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds
in London, New York or Frankfurt and obtain the best yield, without any exchange risk to
the bank. The following rates of interest are available at the three centres for investment
of domestic funds there at for a period of 3 months.
London 5 % p.a.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85
London on Frankfurt
Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will be investment be made & what will be the net gain (to the nearest
pound) to the bank on the invested funds?
Mergers and Acquisition
18. Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry
Ltd. whose stock is currently trading at a total market price of €4 million. For Cranberry
Ltd, the accounting data set forth three business segments: consumer wholesale, retail
and general centers. Data for the firm’s three segments are as follows:
Business Segment Segment Sales Segment Assets Segment Operating
Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 75

Business Sales/ Assets/ Operating Income/

Segment Capitalization Capitalization Capitalization
Wholesale 1.18 1.43 0.11
Retail 0.83 1.43 0.125
General 1.25 1.43 0.25
19. The following information is provided related to the acquiring Firm Mark Limited and the
target Firm Mask Limited:
Firm Firm
Mark Limited Mask Limited
Earning after tax (`) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5

Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition,
assuming P/E ratio of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies after
acquisition.
20. Write short notes on:
(a) Interface of Financial Policy and Strategic Management
(b) Social Cost Benefit Analysis in relation to evaluation of an industrial project
(c) Green Shoe Option
(d) Debt/Asset Securitization
(e) Forfaiting versus Export Factoring

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 76 FINAL EXAMINATION: MAY, 2018

SUGGESTED ANSWERS/HINTS
1. (i) Calculation of NPV of XY Co.:
Project X Cash PVF PV
flow
Year
1 (30  0.3) + (50  0.4) + (65  0.3) 48.5 0.909 44.09
2 (30  0.3) + (40  0.4) + (55  0.3) 41.5 0.826 34.28
3 (30  0.3) + (40  0.4) + (45  0.3) 38.5 0.751 28.91
107.28
NPV: (107.28 – 70.00) = (+) 37.28
Project Y (For 1-3 Years)
1-3 (40  0.2) + (45  0.5) + (50  0.3) 45.5 2.487 113.16
NPV (113.16 – 80.00) (+) 33.16
(ii) Calculation of Standard deviation 
As per Hiller’s model
n
M=  (1+r)-1 Mi
i0

n
2   (1+r)-2i i2
i0

Hence
Project X
Year
1 (30 - 48.5)2 0.30 + (50 - 48.5)2 0.40 + (65 - 48.5)2 0.30 = 185.25 =13.61

2 (30 - 41.5)2 0.30 + (40 - 41.5)2 0.40 + (55 - 41.5)2 0.30 = 95.25 = 9.76

3 (30 - 38.5)2 0.30 + (40 - 38.5)2 0.40 + (45 - 38.5)2 0.30 = 35.25 = 5.94

Standard Deviation about the expected value

185.25 95.25 35.25
= 2 + 4 +
(1+ 0.10) (1+ 0.10) (1+ 0.10)6

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 77

185.25 95.25 35.25

= + + = 153.10+65.06+19.90
1.21 1.4641 1.7716
= 238.06 = 15.43
Project Y (For 1-3 Years)
(40 - 45.5)2 0.20 + (45 - 45.5)2 0.50 + (50 - 45.5)2 0.30 = 12.25 = 3.50

Standard Deviation about the expected value

12.25 12.25 12.25
= 2 + 4 +
(1+ 0.10) (1+ 0.10) (1+ 0.10)6

12.25 12.25 12.25

= + + = 10.12+8.37+6.91
1.21 1.4641 1.7716

= 25.4 = 5.03

Analysis: Project Y is less risky as its Standard Deviation is less than Project X.
2. Workings
60,000 ` 12,000
(i) Annual loan repayment: `
5
(ii) Residual sale value at year 5 ` 1,500
(-) Commission at 8% 120
Profit on sale 1380
(-) Tax @ 30% 414
Net cash flow (` 1,380 - ` 414) ` 966
(iii) Net cash outflow under loan option –
Year 1 2 3 4 5 Total
(R` ) (R` ) (R` ) (R` ) (R` ) (R` )
Principal repayment 12,000 12,000 12,000 12,000 12,000 60,000
Payment of Interest 7,200 5,760 4,320 2,880 1,440 21,600
(-) Tax Savings @ (3,600) (3,600) (3,600) (3,600) (3,600) (18,000)
30% on depreciation
Tax savings on (2,160) (1,728) (1,296) (864) (432) (6,480)
Interest
Net out flow 13,440 12,432 11,424 10,416 9,408 57,120

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 78 FINAL EXAMINATION: MAY, 2018

Discount factor at 0.901 0.812 0.731 0.659 0.593 3.696

11%
PV of cash outflow 12,109 10,095 8,351 6,864 5,579 42,998
Less: PV of Post
tax inflow at (573)
the end of
year 5
(` 966×0.593)
PV of net Cash outflows in 5 years 42,425
Computation of Annual Lease Rentals:
PV of post tax Annual Lease Rentals in 5 years should not exceed ` 42,425.
Or say, PV of Post-tax Lease Rental for one year. Should not exceed
42,425
` = `11,479
3.696
`11479 post-tax = [ ` 11,479/(1-t)] pretax
= ` 11,479/(1 - 0.30) = `16,398
Therefore, maximum pre-tax annual rental should be `16,398
3. A When dividend is paid
(a) Price per share at the end of year 1
1
100 = (` 5  P 1)
1.10
110 = ` 5 + P1
P1 = 105
(b) Amount required to be raised from issue of new shares
` 10,00,000 – (` 5,00,000 – ` 2,50,000)
` 10,00,000 – ` 2,50,000 = ` 7,50,000
(c) Number of additional shares to be issued
7,50,000 1,50,000
 shares or say 7143 shares
105 21
(d) Value of ABC Ltd.
(Number of shares × Expected Price per share)
i.e., (50,000 + 7,143) × ` 105 = ` 60,00,015

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 79

B When dividend is not paid

(a) Price per share at the end of year 1
P
100 = 1
1.10
P1 = 110
(b) Amount required to be raised from issue of new shares
` 10,00,000 – ` 5,00,000 = ` 5,00,000
(c) Number of additional shares to be issued
5,00,000 50,000
 shares or say 4545 shares.
110 11
(d) Value of ABC Ltd.,
(50,000 + 4,545) × `110
= ` 59,99,950
Thus, as per M.M. approach the value of firm in both situations will be the same.
4.
Qtrs. Sensex Sensex Amount Fixed Return Net (`
Return (%) Payable (Receivable) (` Crore) Crore)
(` Crore)
(1) (2) (3) (4) (5) (5) – (4)
0 21,600 - - - -
1 21,860 1.2037 4.8148 4.6000 - 0.2148
2 21,780 -0.3660 -1.4640 4.6000 6.0640
3 22,080 1.3774 5.5096 4.6000 - 0.9096
4 21,960 -0.5435 -2.1740 4.6000 6.7740

5. (i) Total premium paid on purchasing a call and put option

= (`30 per share × 100) + (`5 per share × 100).
= 3,000 + 500 = `3,500
In this case, X exercises neither the call option nor the put option as both will result
in a loss for him.
Ending value = - ` 3,500 + zero gain = - ` 3,500
i.e. Net loss = ` 3,500

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 80 FINAL EXAMINATION: MAY, 2018

(ii) Since the price of the stock is below the exercise price of the call, the call will not be
exercised. Only put is valuable and is exercised.
Total premium paid = `3,500
Ending value = – ` 3,500 + `[(450 – 350) × 100] = – ` 3,500 + ` 10,000 = ` 6,500
 Net gain = `6,500
(iii) In this situation, the put is worthless, since the price of the stock exceeds the put’s
exercise price. Only call option is valuable and is exercised.
Total premium paid = ` 3,500
Ending value = -3,500 +[(600 – 550) × 100]
Net Gain = -3,500 + 5,000 = ` 1,500
6. Future’s Price = Spot + cost of carry – Dividend
F = 220 + 220 × 0.15 × 0.25 – 0.25** × 10 = 225.75
** Entire 25% dividend is payable before expiry, which is ` 2.50.
Thus we see that futures price by calculation is ` 225.75 which is quoted at ` 230 in the
exchange.
Analysis:
Fair value of Futures less than Actual futures Price:
Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock in the
cash market.
Step I
He will buy PQR Stock at ` 220 by borrowing at 15% for 3 months. Therefore, his outflows
are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years (220 × 0.15 × 0.25) 8.25
Total Outflows (A) 228.25
Step II
He will sell March 2000 futures at ` 230. Meanwhile he would receive dividend for his
stock.
Hence his inflows are 230.00
Sale proceeds of March 2000 futures 2.50
Total inflows (B) 232.50

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 81

Inflow – Outflow = Profit earned by Arbitrageur

= 232.50 – 228.25 = 4.25
D1
7. Value of share at present =
ke  g
2(1.06)
= = ` 106
0.08  0.06
However, if the Board implement its decision, no dividend would be payable for 3 years
and the dividend for year 4 would be ` 2.50 and growing at 7% p.a. The price of the share,
in this case, now would be:
2.50 1
P0 =  = ` 198.46
0.08  0.07 (1 0.08)3
So, the price of the share is expected to increase from ` 106 to ` 198.45 after the
announcement of the project. The investor can take up this situation as follows:
Expected market price after 3 years 2.50 ` 250.00
=
0.08  0.07
Expected market price after 2 years 2.50 1 ` 231.48

0.08  0.07 (1 0.08)
Expected market price after 1 years 2.50 1 ` 214.33

0.08  0.07 (1 0.08)2

In order to maintain his receipt at ` 2,000 for first 3 year, he would sell
10 shares in first year @ ` 214.33 for ` 2,143.30
9 shares in second year @ ` 231.48 for ` 2,083.32
8 shares in third year @ ` 250 for ` 2,000.00

At the end of 3 rd year, he would be having 973 shares valued @ ` 250 each i.e.
` 2,43,250. On these 973 shares, his dividend income for year 4 would be @ ` 2.50 i.e. `
2,432.50.
So, if the project is taken up by the company, the investor would be able to maintain his
receipt of at least ` 2,000 for first three years and would be getting increased income
thereafter.

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 82 FINAL EXAMINATION: MAY, 2018

8. (i) Calculation of Market price:

 Discount or premium 
Coupon int erest   
 Years left 
YTM 
Face Value  Market value
2
Discount or premium – YTM is more than coupon rate, market price is less than Face
Value i.e. at discount.
Let x be the market price
 (1,000 - x) 
110   
 6 
0.15 
1,000  x
2
x = ` 834.48
(ii) Duration
Year Cash flow P.V. @ 15% Proportion of Proportion of bond
bond value value x time
(years)
1 110 .870 95.70 0.113 0.113
2 110 .756 83.16 0.098 0.196
3 110 .658 72.38 0.085 0.255
4 110 .572 62.92 0.074 0.296
5 110 .497 54.67 0.064 0.320
6 1110 .432 479.52 0.565 3.39
848.35 1.000 4.570
Duration of the Bond is 4.570 years
(iii) Volatility
Duration 4.570
Volatility of the bond    3.974
(1  yields) 1.15
(iv) The expected market price if increase in required yield is by 100 basis points.
= ` 834.48 1.00 (3.974/100) = ` 33.162
Hence expected market price is ` 834.48 – ` 33.162 = ` 801.318
Hence, the market price will decrease

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 83

(v) The expected market price if decrease in required yield is by 75 basis points.
= ` 834.48 0.75 (3.974/100) = ` 24.87
Hence expected market price is ` 834.48 + ` 24.87 = ` 859.35
Hence, the market price will increase.
9. First we shall compute the β of Security X.
Coupon Payment 7
Risk Free Rate = = = 5%
Current Market Price 140
Assuming equilibrium return to be equal to CAPM return then:
15% = Rf + βX(Rm- Rf)
15%= 5% + βX(15%- 5%)
βX = 1
or it can also be computed as follows:
R m 15%
 =1
R s 15%
(i) Standard Deviation of Market Return
Cov X,m 225%
βm = = =1
m2 m2
σ2m = 225

σm = 225 = 15%
(ii) Standard Deviation of Security Return
X 
βX = Xm = X  0.75 =1
m 15

15
σX = = 20%
0.75

10. Expected Return on stock A = E (A) =  PA

i=G,S,R i i
(G,S & R, denotes Growth, Stagnation and Recession )
(0.40)(25) + 0.30(10)+ 0.30(-5) = 11.5%
Expected Return on ‘B’
(0.40×20) + (0.30×15) +0.30× (-8) =10.1%

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 84 FINAL EXAMINATION: MAY, 2018

Expected Return on Market index

(0.40 × 18) + (0.30 × 13) + 0.30 × (-3) =10.2%
Variance of Market index
(18 - 10.2)2 (0.40) + (13 - 10.2)2 (0.30) + (-3 - 10.2)2 (0.30)
= 24.34 + 2.35 + 52.27 = 78.96%
Covariance of stock A and Market Index M

Cov. (AM) =  ([A -E(A)] [Mi -E(M)]Pi

iG,S,R i
(25 -11.5) (18 - 10.2)(0.40) + (10 - 11.5) (13 - 10.2) (0.30) + (-5-11.5) (-3-10.2)(0.30)
= 42.12 + (-1.26) + 65.34=106.20
Covariance of stock B and Market index M
(20-10.1) (18-10.2)(0.40)+(15-10.1)(13-10.2)(0.30) + (-8-10.1)(-3-10.2)(0.30)= 30.89 +
4.12 + 71.67=106.68
CoV(AM) 106.20
Beta for stock A =   1.345
VAR(M) 78.96

CoV(BM) 106.68
Beta for Stock B = = =1.351
VarM 78.96
Required Return for A
R (A) = Rf + β (M-Rf)

11% + 1.345(10.2 - 11) % = 9.924%

Required Return for B
11% + 1.351 (10.2 – 11) % = 9.92%
Alpha for Stock A
E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%
Alpha for Stock B
E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%
Since stock A and B both have positive Alpha, therefore, they are UNDERPRICED. The
investor should make fresh investment in them.

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 85

11.
Particulars `
Average level of Receivables = 3,20,00,000  90/360 80,00,000
Factoring commission = 80,00,000  2/100 1,60,000
Factoring reserve = 80,00,000  10/100 8,00,000
Amount available for advance =
` 80,00,000 – (1,60,000 + 8,00,000) 70,40,000
Factor will deduct his interest @ 18%:-
` 70,40,000  18  90
Interest  ` 3,16,800
100  360
Advance to be paid = (` 70,40,000  ` 3,16,800) 67,23,200

Annual Cost of Factoring to the Firm: `

Factoring commission (` 1,60,000  360/90) 6,40,000
Interest charges (` 3,16,800  360/90) 12,67,200
Total 19,07,200
Firm’s Savings on taking Factoring Service: `
Cost of credit administration saved 5,00,000
Cost of Bad Debts (` 3,20,00,000  1.5/100) avoided 4,80,000
Total 9,80,000
Net cost to the Firm (` 19,07,200 – ` 9,80,000) 9,27,200
` 9,27,200  100
Effective rate of interest to the firm =
67,23,200 13.79%

12.
Amount in Amount in Amount in
` lakhs ` lakhs ` lakhs
Opening Bank (200 - 185 -12) 3.00
Add: Proceeds from sale of securities 63.00
Add: Dividend received 2.00 68.00
Deduct:
Cost of securities purchased 56.00
Fund management expenses paid (90% of 8) 7.20

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 86 FINAL EXAMINATION: MAY, 2018

Capital gains distributed = 80% of (63 – 60) 2.40

Dividend distributed =80% of 2.00 1.60 67.20
Closing Bank 0.80
Closing market value of portfolio 198.00
198.80
Less: Arrears of expenses 0.80
Closing Net Assets 198.00
Number of units (Lakhs) 20
Closing NAV per unit (198.00/20) 9.90
Rate of Earning (Per Unit)
Amount
Income received (` 2.40 + ` 1.60)/20 ` 0.20
Loss: Loss on disposal (` 200 - ` 198)/20 ` 0.10
Net earning ` 0.10
Initial investment ` 10.00
Rate of earning (monthly) 1%
Rate of earning (Annual) 12%
13. In order to find out the NAV, the cash balance at the end of the year is calculated as
follows-
Particulars `
Cash balance in the beginning
(` 100 lakhs – ` 98 lakhs) 2,00,000
Dividend Received 12,00,000
Interest on 7% Govt. Securities 56,000
Interest on 9% Debentures 45,000
Interest on 10% Debentures 50,000
15,51,000
(-) Operating expenses 5,00,000
Net cash balance at the end 10,51,000
Calculation of NAV `
Cash Balance 10,51,000
7% Govt. Securities (at par) 8,00,000

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 87

50,000 equity shares @ ` 175 each 87,50,000

9% Debentures (Unlisted) at cost 5,00,000
10% Debentures @90% 4,50,000
Total Assets 1,15,51000
No. of Units 10,00,000
NAV per Unit ` 11.55
Calculation of NAV, if dividend of ` 0.80 is paid –
Net Assets (` 1,15,51,000 – ` 8,00,000) ` 1,07,51,000
No. of Units 10,00,000
NAV per unit ` 10.75
 F  P  12
14. Nominal Interest or Bond Equivalent Yield =    100
 P  M
Where
F= Face Vale
P= Issue Price
1,00,000 - 97,550 12
=  100 = 0.025115  4  100 = 10.046 = 10.05% p.a.
97,550 3
0.1005 4
Effective interest rate = [1+ ] – 1 = 10.435% p.a.
4
Cost of Funds to the Company
Effective Interest 10.435
Brokerage (0.150  4) 0.60%
Rating Charge 0.50%
Stamp duty (0.175  4) 0.70%
12.235
15. Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
Cash Flows in ` ’000

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 88 FINAL EXAMINATION: MAY, 2018

Real -50000 -1500 -2000 -2500

Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian ` ’000 (2) -33333 9167 14117 19965
Net Cash Flow in ` ‘000 (1)+(2) -83333 7517 11697 16637
PVF@20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633
NPV of 3 years = -59320 (` ‘000)
16637
NPV of Terminal Value = × 0.579 = 48164 ( ` ’000)
0.20
Total NPV of the Project = -59320 (` ‘000) + 48164 ( ` ’000) = -11156 ( ` ’000)
16. (A) To cover payable and receivable in forward Market
Amount payable after 3 months $7,00,000
Forward Rate ` 48.45
Thus Payable Amount (`) (A) ` 3,39,15,000
Amount receivable after 2 months $ 4,50,000
Forward Rate ` 48.90
Thus Receivable Amount (`) (B) ` 2,20,05,000
Interest @ 12% p.a. for 1 month (C) `2,20,050
Net Amount Payable in (`) (A) – (B) – (C) ` 1,16,89,950
(B) Assuming that since the forward contract for receivable was already booked it shall
be cancelled if we lag the receivables. Accordingly any profit/ loss on cancellation of
contract shall also be calculated and shall be adjusted as follows:
Amount Payable ($) $7,00,000
Amount receivable after 3 months $ 4,50,000
Net Amount payable $2,50,000
Applicable Rate ` 48.45
Amount payable in (`) (A) ` 1,21,12,500
Profit on cancellation of Forward cost (48.90 – 48.30) × 4,50,000 (B) ` 2,70,000
Thus net amount payable in (`) (A) + (B) ` 1,18,42,500

© The Institute of Chartered Accountants of India

 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 89

Since net payable amount is least in case of first option, hence the company should
cover payable and receivables in forward market.
Note: In the question it has not been clearly mentioned that whether quotes given for
2 and 3 months (in point’s terms) are premium points or direct quotes. Although above
solution is based on the assumption that these are direct quotes, but students can
also consider them as premium points and solve the question accordingly.
17. (i) If investment is made at London
Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) = £ 3,24,886
Add: £ Interest for 3 months on £ 324,886 @ 5% =£ 4,061
= £ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
= $ 5,05,000
Equivalent amount of £ required to pay the
above sum ($ 5,05,000/1.5430) = £ 3,27,285
Arbitrage Profit =£ 1,662
(ii) If investment is made at New York
Gain $ 5,00,000 (8% - 4%) x 3/12 =$ 5,000
Equivalent amount in £ 3 months ($ 5,000/ 1.5475) £ 3,231
(iii) If investment is made at Frankfurt
Convert US$ 500,000 at Spot Rate (Cross Rate) 1.8260/1.5390 = € 1.1865
Euro equivalent US$ 500,000 = € 5,93,250
Add: Interest for 3 months @ 3% =€ 4,449
= € 5,97,699
3 month Forward Rate of selling € (1/1.8150) = £ 0.5510
Sell € in Forward Market € 5,97,699 x £ 0.5510 = £ 3,29,332
Less: Amounted invested and interest thereon = £ 3,27,285
Arbitrage Profit =£ 2,047
Since out of three options the maximum profit is in case investment is made in New
York. Hence it should be opted.

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 90 FINAL EXAMINATION: MAY, 2018

18.
Business Segment Capital-to-Sales Segment Sales Theoretical Values
Wholesale 0.85 €225000 €191250
Retail 1.2 €720000 €864000
General 0.8 €2500000 €2000000
Total value €3055250

Business Segment Capital-to-Assets Segment Assets Theoretical Values

Wholesale 0.7 €600000 €420000
Retail 0.7 €500000 €350000
General 0.7 €4000000 €2800000
Total value €3570000

Business Segment Capital-to- Operating Income Theoretical Values

Operating Income
Wholesale 9 €75000 €675000
Retail 8 €150000 €1200000
General 4 €700000 €2800000
Total value €4675000
3055250  3570000  4675000
Average theoretical value   3766750
3
Average theoretical value of Cranberry Ltd. = €3766750
19. Particulars Mark Ltd. Mask Ltd.
EPS ` 2,000 Lakhs/ 200 lakhs ` 400 lakhs / 100 lakhs
= ` 10 `4
Market Price ` 10  10 = ` 100 ` 4  5 = ` 20
(i) The Swap ratio based on current market price is
` 20 / ` 100 = 0.2 or 1 share of Mark Ltd. for 5 shares of Mask Ltd.
No. of shares to be issued = 100 lakh  0.2 = 20 lakhs.
(ii) EPS after merger
` 2,000 lakhs  ` 400 lakhs
= = ` 10.91
200 lakhs  20 lakhs

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 91

(iii) Expected market price after merger assuming P / E 10 times.

= ` 10.91  10 = ` 109.10
(iv) Market value of merged firm
= ` 109.10 market price  220 lakhs shares = 240.02 crores
(v) Gain from the merger
Post merger market value of the merged firm ` 240.02 crores
Less: Pre-merger market value
Mark Ltd. 200 Lakhs  ` 100 = 200 crores
Mask Ltd. 100 Lakhs  ` 20 = 20 crores ` 220.00 crores
Gain from merger ` 20.02 crores
Appropriation of gains from the merger among shareholders:
Mark Ltd. Mask Ltd.
Post merger value 218.20 crores 21.82 crores
Less: Pre-merger market value 200.00 crores 20.00 crores
Gain to Shareholders 18.20 crores 1.82 crores
20. (a) Interface of Financial Policy and Strategic Management: Financial policy of a
company cannot be worked out in isolation of other functional policies. It has a wider
appeal and closer link with the overall organizational performance and direction of
growth.
 Sources of finance and capital structure are the most important dimensions of a
strategic plan. The need for fund mobilization to support the expansion activity
of firm is utmost important for any business.
 Policy makers should decide on the capital structure to indicate the desired mix
of equity capital and debt capital.
 Another important dimension of strategic management and financial policy
interface is the investment and fund allocation decisions.
 Dividend policy is yet another area for making financial policy decisions affecting
the strategic performance of the company. A close interface is needed to frame
the policy to be beneficial for all.
(b) Social Cost Benefit Analysis in relation to evaluation of an industrial project :
This refers to the moral responsibility of both PSU and private sector enterprises to
undertake socially desirable projects – that is, the social contribution aspect needs to
be kept in view.

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 92 FINAL EXAMINATION: MAY, 2018

Industrial capital investment projects are normally subjected to rigorous f easibility

analysis and cost benefit study from the point of view of the investors. Such projects,
especially large ones often have a ripple effect on other sections of society, local
environment, use of scarce national resources etc. Conventional cost-benefit analysis
ignores or does not take into account or ignores the societal effect of such projects.
Social Cost Benefit (SCB) is recommended and resorted to in such cases to bring
under the scanner the social costs and benefits.
SCB sometimes changes the very outlook of a project as it brings elements of study
which are unconventional yet very relevant. In a study of a famous transportation
project in the UK from a normal commercial angle, the project was to run an annual
deficit of more than 2 million pounds. The evaluation was adjusted for a realistic fare
structure which the users placed on the services provided which changed the picture
completely and the project got justified. Large public sector/service projects
especially in under-developed countries which would get rejected on simple
commercial considerations will find justification if the social costs and benefits are
considered.
SCB is also important for private corporations who have a moral responsibility to
undertake socially desirable projects, use scarce natural resources in the best
interests of society, generate employment and revenues to the national exchequer.
Indicators of the social contribution include
(i) Employment potential criterion;
(ii) Capital output ratio – that is the output per unit of capital;
(iii) Value added per unit of capital;
(iv) Foreign exchange benefit ratio.
(c) Green Shoe Option: It is an option that allows the underwriting of an IPO to sell
additional shares if the demand is high. It can be understood as an option that allows
the underwriter for a new issue to buy and resell additional shares upto a certain pre -
determined quantity.
Looking to the exceptional interest of investors in terms of over-subscription of the
issue, certain provisions are made to issue additional shares or bonds to underwriters
for distribution. The issuer authorises for additional shares or bonds. In common
parlance, it is the retention of over-subscription to a certain extent. It is a special
feature of euro-issues. In euro-issues the international practices are followed.
In the Indian context, green shoe option has a limited connotation. SEBI guidelines
governing public issues contain appropriate provisions for accepting over-
subscriptions, subject to a ceiling, say, 15 per cent of the offer made to public. In
certain situations, the green-shoe option can even be more than 15 per cent.

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Examples:
 IDBI had come–up earlier with their Flexi bonds (Series 4 and 5). This is a debt-
instrument. Each of the series was initially floated for ` 750 crores. SEBI had
permitted IDBI to retain an excess of an equal amount of ` 750 crores.
 ICICI had launched their first tranche of safety bonds through unsecured
redeemable debentures of ` 200 crores, with a green shoe option for an identical
amount.
More recently, Infosys Technologies has exercised the green shoe option to
purchase upto 7,82,000 additional ADSs representing 3,91,000 equity shares.
This offer initially involved 5.22 million depository shares, representing 2.61
million domestic equity shares.
(d) Debt/Asset Securitization: Debt Securitisation is a method of recycling of funds.
This method is mostly used by finance companies to raise funds against financial
assets such as loan receivables, mortgage backed receivables, credit card balances,
hire purchase debtors, lease receivables, trade debtors, etc. and thus beneficial to
such financial intermediaries to support their lending volumes. Thus, assets
generating steady cash flows are packaged together and against this assets pool
market securities can be issued. Investors are usually cash-rich institutional investors
like mutual funds and insurance companies.
The process can be classified in the following three functions:
1. The origination function – A borrower seeks a loan from finance company,
bank, housing company or a financial institution. On the basis of credit
worthiness repayment schedule is structured over the life of the loan.
2. The pooling function – Many similar loans or receivables are clubbed together
to create an underlying pool of assets. This pool is transferred in favour of a
SPV (Special Purpose Vehicle), which acts as a trustee for the investo r. Once
the assets are transferred they are held in the organizers portfolios.
3. The securitisation function – It is the SPV’s job to structure and issue the
securities on the basis of asset pool. The securities carry coupon and an
expected maturity, which can be asset base or mortgage based. These are
generally sold to investors through merchant bankers. The investors interested
in this type of securities are generally institutional investors like mutual fund,
insurance companies etc. The originator usually keeps the spread available (i.e.
difference) between yield from secured asset and interest paid to investors.

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 94 FINAL EXAMINATION: MAY, 2018

Generally, the process of securitisation is without recourse i.e. the investor bears the
credit risk of default and the issuer is under an obligation to pay to investors only if
the cash flows are received by issuer from the collateral.
(e) Forfaiting versus Export Factoring
(i) A forfaiter discounts the entire value of the note/bill. In a factoring arrangement
the extent of financing available is 75-80%.
(ii) The forfaiter’s decision to provide financing depends upon the financing standing
of the availing bank. On the other hand in a factoring deal the export factor bases
his credit decision on the credit standards of the exporter.
(iii) Forfaiting is a pure financial agreement while factoring includes ledger
administration as well as collection.
(iv) Factoring is a short-term financial deal. Forfaiting spreads over 3-5 years.

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