Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Paper-12: FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Time Allowed: 3 Hours Full Marks: 100

The figures in the margin on the right side indicate full marks.

Answer Question No. 1 from Part A which is compulsory and any five questions from Part B.

PART A (25 Marks)

1. (a) In each, of the cases given below, one out of four answers is correct. Indicate the correct
answer (= 1 mark) and give workings/reasons briefly in support of your answer (= 1 mark)
[2x9=18]

(i) What is the opportunity cost of not taking a discount, when the credit terms are 2/20 net
45? Assume 1 year = 360 days
A. 24.9%
B. 29.4%
C. 22.9%
D. 29.2%

(ii) E Limited has earnings before interest and taxes (EBIT) of ` 10 million at a cost of 7%.,
Cost of equity is 12.5%. Ignore taxes. Calculate the overall cost of capital.
A. 11.26%
B. 11.62%
C. 16.12%
D. 12.61%

(iii) S Limited earns ` 6 per share, has capitalisation rate of 10% and has a return on
investment at the rate of 20%. According to Walter’s model, calculate the price per
share at 30% dividend payout ratio.
A. `120
B. `102
C. `112
D. `106

(iv) On January 1, 2014, X Limited’s begining inventory was `4,00,000. During 2014, X Ltd.
purchased `19,00,000 of additional inventory. On December 31, 2014, X Ltd.’s ending
inventory was `5,00,000. Calculate the X Ltd.’s operating cycle in 2014, if it is assumed
that the average collection period is 42 days.
(1 year =365 days).
A. 123.3 days
B. 132.3 days
C. 126.3 days
D. 133.3 days

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

(v) From the following, what is the amount of sales of A Ltd.? Financial Leverage —
3:1; Interest—`200; Operating Leverage — 4 : 1; Variable Cost as a % of sales —
66.67%.
A. `3,600
B. `6,300
C. `6,030
D. `3,060

(vi) The dollar is currently trading at `40. If rupee depreciates by 10%, what will be the
spot rate?
A. `0.0525
B. `0.0552
C. `0.0225
D. `0.0522

(vii) If the following rates are prevailing: Euro/$ : 1.1916/1.1925 and $/£ : 1.42/1.47 what will
be the corss rate between Euro/Pound?
A. 1.6921/1.750
B. 1.7530/1.6921
C. 1.6921/1.1925
D. 1.7530/1.1916

(viii) A company has expected Net Operating Income – ` 2,40,000; 10% Debt – `7,20,000
and Equity Capitalisation rate - 20% what is the weighted average cost of capital for
the company?
A. 0.15385
B. 0.13585
C. 0.18351
D. 0.15531

(ix) The P/V ratio of a firm dealing in precision instruments is 50% and margin of safety is 40%.
Calculate net profit, if the sales volume is ` 50,00,000.
A. ` 1,00,000
B. ` 5,00,000
C. ` 10,00,000
D. ` 6,00,000

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

(b) State if each of the following sentences is T (= true) or F (= false): [1×7=7]

(i) Deterministic model of financial planning yield multiple — point estimate.
(ii) Risk under transaction exposure can be minimized using Money Market Hedge.
(iii) Flexibility is one among the performance indicators of the organisation.
(iv) A project is a "One-shot" major undertaking.
(v) Fund Managers use futures as a more economical way of achieving their portfolio goals.
(vi) The profit or loss associated with converting foreign currency dominated assets/liabilities
in reporting currency is called Economic Exposure.
(vii) TRIMs are the rules; a country applies to the domestic regulations to promote Foreign
investment, often as a part of an Industrial Policy.

Answer:

1. (a)

(i) (B) 29.4%

discount percent 360

Opportunity cost = x
100 discount percent N

2 360
= x
98 25
= 29.4%

(ii) (A) 11.26%

EBIT - 1 `10,000,000- 1,400,000

Market Value of equity(S) = =
ke 0.125

= `68,800,000
Total value of Firm(V) = S+ D = `68,800,000 + `20,000,000
= `88,800,000

EBIT - 1
 Overall cost of capital (K0) =
V
`10,000,000
=
` 88,800,000
= 11.26%

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

(iii) (B) `102

r
D (E  D)
Ke
Market Value of share (P) =
Ke

0.20
1.80  (6  1.80)
= 0.10
0.10
= `102

(iv) (D) 133.3 days

Cost of goods sold = `(4,00,000 + 1,900,000 – 500,000)

= `1,800,000

`1,800,000
Inventory turnover = =4
` 450,000

365
Average age of Inventory = = 91.3 days
4
 Operating cycle = Average age inventory + Average Collection Period
= 91.3 = 42 = 133.3 days

(v) (A) `3,600

EBIT 3
Financial Leverage = =
EBIT 1
EBIT = 3EBT
EBIT – 200 = EBT
EBIT = 3[EBIT – 200]  EBIT = `300
SV 4
Operating Leverage = 
EBIT 1
S – V = 4 EBIT = 4X300 = 1200
(100 – 66.67%)S = 1200
1200
 Sales =  = `3600
1
33
3

(vi) (C) `0.0225

Re quote : Re.1 = $1/40 = 0.25

If rupee depreciates by 10%, then = 0.025 – 0.0025

= `0.0225

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

(vii) (A) 1.6921/1.7530

Bid (Euro/£) = Bid (Euro/$) x Bid ($/£)
Bid rate for ε /£ = 1.1916 x 1.42 = 1.6921
Ask rate for ε/£ = 1.1925 x 1.47 = 1.7530
 Quote as ε/£ = 1.6921/1.7530

(viii) (A) 0.15385

2,40,000 72000(I)
Market value of equity (S) =  840000
0.20
Total value of firm (V) = S + D = 840000 + 720000 = 1560000
N0I 240000
K0   = 0.15385
V 1560000

(ix) (C) `10,00,000

Margin of Safety = 50,00,000@40% = `2000000
BEP Sales = 50,00,000 – 20,00,000 = `30,00,000
Fixed cost = BEP (s)× p/v ratio = 30,00,000@50% = 1500000
Contribution = 5000000 x 50/100 = `2500000
Profit = 25,00,000 – 15,00,000 = `10,00,000

(b)
(i) False

(ii) True

(iii) True.

(iv) True

(v) True

(vi) False

(vii) True

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Part B (75 Marks)

2 (a). GMBH is in software development business. It has recently been awarded a contract
from an Asian country for computerisation of its all offices and branches spread across
the country. This will necessitates acquisition of a super computer at a total cost of `10
crore. The expected life of computer is 5 years. The scrap value is estimated at `5 crore.
However, this value could even be much lower depending upon the developments
taking place in the field of computer technology.

A leasing company has offered a lease contract will total lease rent of `1.5 crore per
annum for 5 years payable in advance with all maintenance costs being borne by
lessee.

The other option available is to purchase the computer by taking loan from the bank with
variable interest payment payable semi-annually in arrears at a margin of 1% per annum
above MIBOR. The MIBOR forecast to be at a flat effective rate of 2.4% for each 6 month
period, for the duration of loan.

Tax rate applicable to corporation is 30%. For taxation purpose depreciation on

computer is allowed at 20% as per WDV method, with a delay of 1 year between the tax
depreciation allowance arising and deduction from tax paid & capital gain tax arising on
sale of computer. You are required to calculate:

I. Compound annualised post tax Cost of Debt.

II. NPV of lease payment v/s purchase decisions at discount rate of 5% & 6%.
III. The break even post tax Cost of debt at which corporation will be indifferent
between leasing and purchasing the computer.
IV. Which option should be opted for? [1+(3+4)+1+1]

Answer to 2 (a):

I. First we shall compute annual interest rate as follows:

Annual Interest Rate = (1.024)2 - 1 = 4.9%

Thus, Pre Tax Interest and Post Tax Interest Rate = 4.9% + 1% = 5.9%

= 5.9% (1 - 0.30) = 5.9% x 0.70 = 4.13%

II. Working Notes:

Calculation of Tax Savings on Depreciation (`)

Year Opening value Depreciation Closing value Tax saving @ 30%
1 10,00,00,000 2,00,00,000 8,00,00,000 60,00,000
2 8,00,00,000 1,60,00,000 6,40,00,000 48,00,000
3 6,40,00,000 1,28,00,000 5,12,00,000 38,40,000
4 5,12,00,000 1,02,40,000 4,09,60,000 30,72,000
5 4,09,60,000 81,92,000 3,27,68,000 24,57,600

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Capital Gain tax = (`5,00,00,000 - `3,27,68,000) x 30% = `51,69,600 Total

Tax Liability for Year 5 = `51,69,600 - `24,57,600 = `27,12,000

Statement showing NPV Lease Option (`)

Particulars Period Cash flow 5% 6%
PVF PVCO PVF PVCO
(`)
Lease payment 0-4 1,50,00,000 4.546 6,81,90,000 4.465 6,69,76,584
(45,00,000) 4.329 (1,94,80,500) 4.212 (1,89,54,000)
(-) Tax savings 1-5
PVCO (A) 4,87,09,500 4,80,22,584

Statement showing NPV in Borrow & Buy decision (`)

Period Cash flows (`) 5% 6%
PVF PVCO PVF PVCO
0 10,00,00,000 1.000 10,00,00,000 1.000 10,00,00,000
(-) Tax Savings 1 0 0.962 0 0.943 0
Initial outlay 2 (60,00,000) 0.907 (54,42,000) 0.890 (53,58,000)
3 (48,00,000) 0.864 (41,47,200) 0.840 (40,32,000)
4 (38,40,000) 0.823 (31,60,320) 0.792 (30,41,280)
5 (30,72,000) 0.784 (240,84,48) 0.747 (22,94,784)
(+) Tax Liability 6 27,12,000 0.746 20,23,152 0.705 19,11,960
(-) Terminal Value 5 (5,00,00,000) 0.784 (3,92,00,000) 0.797 (3,73,50,000)
4,76,65,184 4,98,35,896
PVCO (B) (10,44,316) 18,13,312

Net NPV (B) - (A)

 `10,44,316 
5%  1% 
III.  ` 28,57,628 
 5.37%

IV. Since the Break Even post tax Cost of debt at which corporation will be indifferent
between leasing and purchasing the computer (i.e. IRR of Lease Option) is 5.37%, which
is higher than the actual post tax cost of borrowing of 4.13%. Hence, it is advised to the
corporation to go for borrow and buy option instead of lease option.

2 (b). List the relevance of Social Cost Benefit Analysis for Private Enterprise. [5]

Answer to 2(b):

Relevance of Social Cost Benefit Analysis for Private Enterprises

I. Social cost benefit analysis is important for private corporations also which have a
moral responsibility to undertake socially desirable projects.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

II. If the private sector includes social cost benefit analysis in its project evaluation
techniques, it will ensure that it is not ignoring its own long-term interest, since in the
long run only projects that are socially beneficial and acceptable, will survive.
III. Methodology of social cost benefit analysis can be adopted either from the
guidelines issued by the United Nations Industrial Development Organisation (UNIDO)
or the Organisation of Economic Cooperation and Development (OECD). Financial
Institutions e.g. IDBI, IFCI, etc. even insist on social cost benefit analysis of a private
sector project before sanctioning any loan.
Private enterprise cannot afford to lose sight of social aspects of a project.

3 (a). List out the steps involved to determine the financial viability of a project. [4]

Answer to 3(a):

The steps involved to determine the financial viability of a project are as follows:
(i) Determination of project cost
(ii) Sources of fund/means of financing and proper utilization of fund
(iii) Profitability analysis
(iv) Break-even analysis
(v) Cash flow/fund flow statement
(vi) Debt service coverage ratio.

3 (b). The following data is available for Bajaj Ltd.:

Sales ` 2,00,000
Less : Variable cost @30% 60,000
Contribution 1,40,000
Less : Fixed Cost 1,00,000
EBIT 40,000
Less : Interest 5,000
Profit before tax 35,000

Find out:
(i) Using the concept of financial leverage, by what percentage will the taxable income
increase if EBIT increase by 6%?
(ii) Using the concept of operating leverage, by what percentage will EBIT increase if
there is 10% increase in sales, and
(iii) Using the concept of leverage, by what percentage will the taxable income increase
if the sales increase by 6%? Also verify results in view of the above figures. [2×3=6]

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Answer to 3(b):

(i) Degree of financial leverage:

DFL = EBIT/Profit before Tax = 40,000/35,000= 1.14
If EBIT increase by 6%, the taxable income will increase by 1.14×6 = 6.85% and it
may be verified as follows :

EBIT (after 6% increase) ` 42,400

Less: Interest 5,000
Profit before Tax 37,400
Increase in taxable income is ` 2,400 i.e., 6.85% of ` 35,000

(ii) Degree of operating leverage:

DOL = Contribution/EBIT = 1,40,000/40,000 = 3.50

If Sales increase by 10%, the EBIT will increase by 3.50×10 = 35% and it may be verified
as follows :
Sales (after 10% increase) ` 2,20,000
Less: Variable Expenses @30% 66,000
Contribution 1,54,000
Less: Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is ` 14,000 i.e., 35% of ` 40,000.

(iii) Degree of combined leverage:

DCL = Contribution/Profit before Tax = 1,40,000/35,000= 4

If Sales increases by 6%, the profit before tax will increase by 4×6 = 24% and it
may be verified as follows :
Sales (after 6% increase) ` 2,12,000
Less : Variable Expenses @ 30% 63,600
Contribution 1,48,400
Less : Fixed cost 1,00,000
EBIT 48,400
Less : Interest 5,000
Profit before Tax 43,400

Increase in Profit before tax is ` 8,400 i.e., 24% of ` 35,000.

3 (c). The following figures are collected from the annual report of XYZ Ltd:
`
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of Equity 16%

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

What should be the approximate dividend pay-out ratio so as to keep the share price at `
48 by using Walter’s model? [5]

Answer to 3(c):

` in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = ` 6.00

Let, the dividend pay out ratio be x and so the share price will be:
r E  D 
D Ke
P 
Ke Ke

Here D = 6x; E = ` 6; r = 0.20 and Ke = 0.16 and P = ` 48

6x 0.2 6  6x 
Hence ` 48 = 
0.16 0.16  0.16
or, ` 48 = = 37.50x + 46.875 (1 – x)
or, 9.375x = 1.125
or, x = 0.12

So, the required dividend payout ratio will be = 12%

4 (a). The Directors of Grasswood Ltd. present you with the Balance sheets as on 30th June,
2013 and 2014 and ask you to prepare statements which will show them what has
happened to the money which came into the business during the year 2014.

Liabilities : 30.6.13 30.6.14

Authorised capital 15,000 shares of ` 100 each 15,00,000 15,00,000
Paid up capital 10,00,000 14,00,000
Debentures (2014) 4,00,000 —
General Reserve 60,000 40,000
P & L Appropriation A/c 36,000 38,000
Provision for the purpose of final dividends 78,000 72,000
Sundry Trade Creditors 76,000 1,12,000
Bank Overdraft 69,260 1,29,780
Bills Payable 40,000 38,000
Loans on Mortgage — 5,60,000
17,59,260 23,89,780

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Assets :
Land & Freehold Buildings 9,00,000 9,76,000
Machinery and Plant 1,44,000 5,94,000
Fixtures and Fittings 6,000 5,500
Cash in hand 1,560 1,280
Sundry Debtors 1,25,600 1,04,400
Bills Receivable 7,600 6,400
Stock 2,44,000 2,38,000
Prepayments 4,500 6,200
Share in other companies 80,000 2,34,000
Goodwill 2,40,000 2,20,000
Preliminary expenses 6,000 4,000
17,59,260 23,89,780

You are given the following additional information:

A. Depreciation has been charged (i) on Freehold Buildings @ 2½% p.a. on cost `
10,00,000. (ii) on Machinery and plant ` 32,000 (iii) on Fixtures and Fittings @5% on
cost, ` 10,000. No depreciation has been written off on newly acquired Building and
Plant and Machinery.
B. A piece of land costing ` 1,00,000 was sold in 2014 for ` 2,50,000. The sale proceeds
were credited to Land and Buildings.
C. Shares in other companies were purchased and dividends amounting to ` 6,000
declared out of profits made prior to purchase has received and use to write down
the investment (shares).
D. Goodwill has been written down against General Reserve.
E. The proposed dividend for the year ended 30th June 2013 was paid and, in additions,
an interim dividend, ` 52,000 were paid. [10]

Answer to 4(a):
Funds Flow Statement

Sources Applications
Decrease in working capital 121500 Purchase of land and building 351000
Sale proceed of land 250000 Purchase of plant and machinery 482000
Dividend received 6000 Purchase of shares (investment) 160000
Issue of Shares 400000 Redemption of debentures 400000
Loan 560000 Dividends for 2013 paid 78000
Funds from operations 185500 Interim dividend paid 52000

1523000 1523000

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Working note No.1: Changes in working capital

2013 2014

Current assets

Cash 1560 1280

Debtors 125600 104400
Bills receivable 7600 6400
Prepaid 4500 6200
Stock 244000 238000
Total Current Asset 383260 356280
Current liabilities

Creditors 76000 112000

Overdraft 69260 129780
Bills payable 40000 38000
Total Current Liabilities 185260 279780

Working capital 198000 76500

Decrease in working capital 121500

Working note No.2:

Depreciation
On Buildings 25000
On Plant & Machinery 32000
On Furniture & Fittings 500
57500

Working note No. 3: Purchase or sale of fixed assets / Investments:

Land and buildings:

2013 (WDV) 900000

(-) Depreciation 25000
875000
(-) Land sold 100000
775000
(+) Purchases (b/f) 351000
1126000
(-) Profit on sale 150000
2014 (WDV) 976000

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Plant & machinery:

WDV 144000
(-) Depreciation 32000
112000
(+) Purchase (b/f) 482000
594000
Investments:
2013 80000
(-) Dividend in capital nature 6000
74000
(+) Purchases (b/f) 160000
2014 234000

Working note No.4:

P & L Adjustment A/c
To depreciation 57500 By balance b/d 36000
To dividend proposed 72000 By funds from operation(b/f) 185500
To preliminary expenses written 2000
off 52000
To interim dividend 38000
221500 221500

4 (b). Describe are the basic elements of joint venture? [5]

Answer to 4 (b):

Contractual Agreement. JVs are established by express contracts that consist of one or
more agreements involving two or more individuals or organizations and that are entered
into for a specific business purpose.

Specific Limited Purpose and Duration. JVs are formed for a specific business objective
and can have a limited life span or long-term. JVs are frequently established for a limited
duration because (a) the complementary activities involve a limited amount of assets;
(b) the complementary assets have only a limited service life; and/or (c) the
complementary production activities will be of only limited efficacy.

Joint Property Interest. Each JV participant contributes property, cash, or other assets and
organizational capital for the pursuit of a common and specific business purpose. Thus, a
JV is not merely a contractual relationship, but rather the contributions are made to a
newly-formed business enterprise, usually a corporation, limited liability company, or
partnership. As such, the participants acquire a joint property interest in the assets and
subject matter of the JV.

Common Financial and Intangible Goals and Objectives. The JV participants share a
common expectation regarding the nature and amount of the expected financial and
intangible goals and objectives of the JV. The goals and objectives of a JV tend to be
narrowly focused, recognizing that the assets deployed by each participant represent
only a portion of the overall resource base.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Shared Profits, Losses, Management, and Control. The JV participants share in the specific
and identifiable financial and intangible profits and losses, as well as in certain elements
of the management and control of the JV.

5 (a). A company requires ` 20 lacs and provides the following information:

 Target Debt Equity Ratio = 3:2
 Kd = 12%, for the first 4 lacs and 12.5% for the balance
 EPS for the current year ` 20 per share
 Dividend payout ratio 60%, growth rate 5%
 Current MPS ` 90. Flotation Cost ` 6 each
 Present Equity Share Capital ` 2 lacs, divided into fully paid shares of ` 10 each.
 Corporate Tax Rate 30%.
Calculate weighted Marginal Cost of Capital. [8]

Answer to 5 (a):

Calculation of Marginal Cost of Capital:

Particulars ` Proportion After tax cost Marginal WACC

5 = (3×4)
Equity Share Capital (New) 6,40,000 6.4/20 20.00% 6.40%
Retained Earning 1,60,000 1.6/20 19.00% 1.52%
12% Debenture 4,00,000 4/20 8.40% 1.68%
12.5% Debenture 8,00,000 8/20 8.75% 3.50%
20,00,000 K0 = 13.10%

Working Notes:
(i) Calculation of Retained Earnings:
Retained Earnings = Earning for Eq Share holder (EES) – Dividend
= (EPS × No. of Share) – (DPS × No. of Share)
= ` 20 × 20,000 – 20 × 0.60 × 20,000
= ` 4,00,000 – 2,40,000 = ` 1,60,000

(ii) External Debt:

` 20,00,000 × 3/5 = ` 12,00,000
12% Debt = ` 4,00,000
12.5% Debt = ` 8,00,000 (i.e. 12,00,000 – 4,00,000)

(iii) External Equity Require:

= (Total Fund × Proportion of Equity) – Retained Earnings
= ` 20,00,000 × 2/5 – 1,60,000
= ` 8,00,000 – 1,60,000
= ` 6,40,000

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

(iv) Cost of Equity (For New Shares):

D1
Ke = +g
NP
where D1 = D0 1+ g 
 20 ×0.60  1+ 0.05 
= + 0.05
90 - 6
12 ×1.05
= + 0.05 = 20%
84

Where, D1 = Expected dividend per share

D0 = Current dividend per share
g = growth rate
NP = Net Proceeds

(v) Cost of 12% Debt:

= I (1 – t)
= 12% (1 – 0.30)
= 8.4%

Where I = Interest
t = tax rate

(vi) Cost of 12.5% Debt:

= I (1 – t)
= 12.5% (1 – 0.30)
= 8.75%

(vii)Cost of Retained Earnings:

D D 1  g
 1 g  0 g
MP MP

20  0.601 0.05  0.05
90
12.6
  0.05
90
 19%

5 (b). Zenith Ltd. currently has an annual turnover of ` 20 lakhs and an average collection period of 4
weeks. The company propose to introduce a more liberal credit policy which they hope will
generate additional sales, as shown below:

Additional Collection Period Sales default

1 2 Weeks 2,00,000 2%
2 4 Weeks 2,50,000 3%
3 6 Weeks 3,50,000 5%
4 8 Weeks 5,00,000 8%
The selling price of the product is ` 10 and the variable cost per unit is ` 7.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

The current bad debt loss is 1 % and the desired rate of return on investment is 20%. For the
purpose of calculation, a year is to be taken to comprise of 52 weeks. Indicate which of the
above policies you would recommend the company to adopt. [7]

Answer to 5 (b):

Comparative statement of various credit policies

Particulars Current Policy 1 Policy 2 Policy 3 Policy 4

Sales ` Lac 20.0 22.0 22.5 23.5 25.0

Contribution @ 30% 6.0 6.6 6.8 7.1 7.5
Bad debts % 1% 2% 3% 5% 6%
Amount of bad debts ` 0.2 0.4 0.7 1.2 1.5
Lac
Average collection 4 6 8 10 12
period in weeks
Average debtors ` Lacs 1.5 2.5 3.5 4.5 5.8
Cost of debtors @ 20% 0.3 0.5 0.7 0.9 1.2

Contribution - bad debts 5.5 5.7 5.4 5.0 4.8

- cost of debtors

The net benefit is highest with Policy 1 with credit period of 6 weeks. It is recommended
for adoption.

6 (a). The following data relates to ABC Ltd.’s share prices:

Current price per share ` 180

Price per share in the 6m futures market: ` 195

It is possible to borrow money in the market for securities transactions at the rate of 12%
per annum.
Required:
I. Calculate the theoretical minimum price of a 6-month futures contract.
II. Explain if any arbitrage opportunities exist. [2+5]

Answer to 6 (a):

I. Theoretical Minimum Price of a 6-month forward contract:

Future’s Price = Spot + Cost of Carry – Dividend
F = 180 + 180 × 0.12 × - 0
= 190.80
Thus we see that Futures price by calculation is ` 190.80 and is quoting at ` 195 in the
exchange.

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II. Analysis:
Fair Value of Futures LESS than Actual Futures Price;
Futures Overvalued. Hence SELL. Do Arbitrage by buying stock in Cash Market.

Step I
Buy ABC Ltd. stock at ` 180 by borrowing at 12% for 6 months. Therefore his outflows are
Cost of Stock 180.00
Add: Interest @ 12% for 6 months i.e. 0.5 year (180 × 0.12 × 0.5) = 10.80
Total outflows (A) 190.80

Step II
He will sell 6-month futures at ` 195. Hence, his inflows are
Sales proceeds of futures 195.00
Add: Dividend received for his stock 0.00
Total outflows (B) 195.00

Inflow – Outflow = Profit earned by Arbitrageur

= 195 – 190.80 = ` 4.20 per share.
Note: We have ignored transaction costs like commission, margin, etc.

6 (b). Nifty Index is currently quoting at 1300. Each lot is 250. Mr. X purchases a March contract
at 1300. He has been asked to pay 10% initial margin. Calculate the amount of initial
margin. To what level Nifty futures should rise to get a percentage gain of 5%. [1+2]

Answer to 6 (b):

Initial margin = 10% of Transaction value of futures.

= 0.10 × 1300 × 250
= ` 32500

Now gain = 5% = 0.05 = Return + Investment

= Return ÷ 32500
 Return = ` 1625
i.e., Return per unit = 1625 / 250 = ` 6.50
 Index futures should rise to 1306.50.

6 (c). The annual interest rate is 5% in the United States and 8% in the UK. The spot exchange
rare is £/$ -1.50 and forward exchange rate, with one year maturity, is £/$ = 1.48 In view
of the fact that arbitrager can be borrow $ 1000000 at current spot rate, calculate the
arbitrageur profit/ loss? [5]

Answer to 6 (c):

We first verify the interest rate parity to decide first, whether any arbitrage exists.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

We have spot = 1£ = $ 1.50

LHS = (1+rh) = 1 + 0.05 = 1.05
RHS = F/S (1+rf) = 0.987 × (1 + 0.08) = 1.0656 ($ return)
Since LHS ≠ RHS, parity does not exist, and there exists and opportunity to arbitrage.
Since LHS is lower, the borrowing would be done in dollars. The borrowed money would
be converted to £ and invested. The profit can be calculated as follows:

Assume borrowing $1000000. The repayment would be at the rate of 5% in 12 months i.e.,
$ 1000000 × 1.05 = $1050000. $1000000 converted to £ at spot would yield £666667. This on
deposit for 12 months would yield £720000. This converted back to $ would give us
$1065600.

Thus our net arbitrage profit would be = $1065600 - $1050000 = $15600.

Note: Inverse Notations £ / $ - 1.50 used.

7 (a). For imports from UK, Philadelphia Ltd. of USA owes £650000 to London Ltd., payable on
May, 2014. It is now 12 February, 2015. The following future contracts (contract size
£62,500) are available on the Philadelphia exchange:

Expiry Current futures rate

May 1.4900 $/£ 1
June 1.4960 $/£ 1

I. Illustrate how Philadelphia Ltd. can use future contracts to reduce the transaction risk
if, on 20 May the spot rate is 1.5030 $/£ 1 and June futures are trading at 1.5120 $/£.
The spot rate on 12 February is 1.4850 $/£ 1.
II. Calculate the hedge efficiency and comment on it. [8+2]

Answer to 7(a):

I. Philadelphia Ltd. of USA owes £ 650000 to London Ltd., payable on May, 2015. This
company would therefore buy Futures contracts. Since information on June Contracts
are given for both spot and expiry, and the firm can buy either May or June Futures for
hedging, we illustrate the hedging procedure by using June Futures:

Value of exposure today (12th February) = £650000 × 1.4850 = $965250

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Since each contract sixe = £ 62,500, the firm can buy 10 June expiry contracts at
$1.4960/£ i.e. can cover the exposure to the extent of £625000, thus leaving the balance
£650000 - £625000 = £25,000 uncovered. When the payment is due in May, the spot rate
would be 1.5030 $/£ and the June contracts would be trading at 1.5120 $/£.

At expiry, the value of exposure would increase to £650000 × 1.5030 = $976950.

Therefore, increase in exposure = $976950 = $965250 = $11,700.

However, since the firm bought futures at 1.4960, it can sell of the same at a higher rate
of 1.5120/£.
This would result in a profit = 10 × 62500 × (1.5120 – 1.4960) = $10000 [Savings due to
hedging]
Net loss = $11700 - $10000 = $1700.

II. Owing to hedging in the futures market the company could reduce its losses by $10000.
i.e., out of a possible loss of $ 11700, $10000 could be saved owing to hedging. Thus
hedging thus hedging efficiency is = $10000/$11700 = 85.5%, which is reasonably good,
despite the inability of the firm to hedge 100% of the exposure.

7 (b). State currency futures? List the steps involved in the technique of hedging through
futures. [5]

Answer to 7 (b):

A currency futures contract is a derivative financial instrument that acts as a conduct to

transfer risks attributable to volatility in prices of currencies. It is a contractual agreement
between a buyer and a seller for the purchase and sale of a particular currency at a
specific future date at a predetermined price. A futures contract involves an obligation
on both parties to fulfill the terms of the contract. A futures contract can be bought or
sold only with reference to the USD.

There are six steps involved in the technique of hedging through futures:
(i) Estimating the target income (with reference to the spot rate available on a
given date.)
(ii) Deciding on whether Futures Contracts should be bought or sold.
(iii) Determining the number of contracts (since contract size is standardised).
(iv) Identifying profit or loss on target outcome.
(v) Closing out futures position and
(vi) Evaluating profit or loss on futures.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

8 (a). ‘Fixed Costs are unrelated to output and irrelevant for decision making purpose in all
circumstances’.- Justify. [3]

Answer to 8(a):

Fixed Costs are unrelated to output and are generally irrelevant for decision making
purpose. However, in the following circumstances, Fixed Costs become relevant for
decision-making:
1. When Fixed Costs are specifically incurred for any contract,
2. When Fixed Costs are incremental in nature,
3. When the fixed portion of Semi-Variable Cost increases due to change in level of
activity consequent to acceptance of a contract,
4. When Fixed Costs are avoidable or discretionary,
5. When Fixed Costs are such that one cost is incurred in lieu of another (the difference in
costs will be relevant for decision-making).

8 (b). A company wants to invest in a machinery that would cost ` 50,000 at the beginning of
year 1. It is estimated that the net cash inflows from operations will be `18,000 per annum
for 3 years; if the company opts to service a part of the machine at the end of year 1 at
`10,000 and the scrap value at the end of year 3 will be `12,500. However, of the
company decides not to services the part, it will have to be replaced at the end of year 2
at `15,400. But in this case, the machine will work for the 4th year also and get
operational cash inflow of `18,000 for the 4th year. It will have to be scrapped at the end
of year 4 at `9,000. Assuming cost of capital at 10% and ignoring taxes, will you
recommend the purchase of this machine based on the net present value of its cash
flows?

If the supplier gives a discount of ` 5,000 for purchase, what would be your decision? (The
present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091,
0.8264, 0.7513, 0.6830, 0.6209 and 0.5644). [5+2]

Answer to 8(b):

(i) Statement showing evaluation of mutually exclusive proposals

Particulars Time P. V. Factor Service Part Replace Part
Cash Outflows: Amount P.V. Amount P.V.
Cost of machinery 0 1 50,000 50,000 50,000 50,000
Service cost 1 0.9091 10,000 9,091 --- ---
(+) Replace Part 2 0.8264 --- --- 15,400 12,727
P.V. of Cash Outflows (A) 59,091 62,727

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Cash Inflows:
Cash inflows from 1-3 2.4869 18,000
operation
1-4 3.1699 44,764 18,000 57,058
Scrap value of machine 3 0.7513 12,500 9,391
4 0.6830 9,000 6,147
P.V. of Cash Inflows (B) 54,155 63,205
NPV (B) – (A) (4,936) 478
Advise: Purchase machine & Replace the part at end of second year.

(ii) If the supplier gives a discount of `5,000 on purchase of machine

Proposals Service Part Replace Part

NPV 64 5,478
Cumulative P.V.A.F. 2.4869 3.1699
Equivalent Annual NPV 25.73 1,728

Advise: Purchase machine A Replace the part at end of second year.

8 (c). S Ltd. has ` 10,00,000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined: [5]
Project Amount (`) Profitability Index

1 3,00,000 1.22

2 1,50,000 0.95

3 3,50,000 1.20

4 4,50,000 1.18

5 2,00,000 1.20

6 4,00,000 1.20

Advice which of the above investment should be undertaken. Assume that projects are
indivisible and there is no alternative use of the money allocated for capital budgeting.

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 Answer to MTP_Final_Syllabus 2008_Jun2015_Set 1

Answer to 8(c):

Computation of NPV of Viable Projects:

Project NPV(`)

1 3,00,000 x 0.22 = 66,000

3 3,50,000 x 0.20 = 70,000

4 4,50,000 x 0.18 = 81,000

5 2,00,000 x 0.20 = 40,000

6 4,00,000 x 0.20 = 80,000

Combinations Initial Cash Outflows (`) Overall N.P.V. (`)

1,3,5 8,50,000 1,76,000

1,4,5 9,50,000 1,87,000

1,5,6 9,00,000 1,86,000

3,4,5 10,00,000 1,91,000

3,5,6 9,50,000 1,90,000

4,6 8,50,000 1,61,000

Advise: Best combination of projects = 3, 4, 5.

Note: Project 2 should not be considered as it provides a negative NPV.

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