Question Paper

Treasury & Forex Management (MB351F): July 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. ECGC issues “Transfer guarantee” which covers:

(a) Any investment made for the purpose of setting up or expansion of overseas projects
(b) Exports of capital goods, differed payments of overseas projects etc.
(c) Due performance against the advance payment or in lieu of retention money to a foreign bank
(d) A bank in India adding its confirmation to a foreign letter of credit
(e) Banks against loss on account of guarantees given to exporters.
< Answer >
2. Which of the following is not the function of EXIM Bank?

(a) Consultancy and technological services to the Indian exporters

(b) Pre-shipment credit to exporters not exceeding 180 days
(c) Forfaiting facility to Indian exporters
(d) Financing of deemed exports
(e) Extending lines of credit to overseas governments or agents.
< Answer >
3. The payments for imports under cash licenses into India shall be made within_______ from the date of shipment

(a) Within 30 days from the date of shipment

(b) Within 6 months from the date of shipment
(c) Within 30 days from the date of arrival of goods at destination
(d) Within 3 months from the date of shipment
(e) Within 3 months from the date of arrival of goods at the destination.
< Answer >
4. A “Yankee Bond” is

(a) A US dollar denominated bond issued in the US market usually by foreign governments or entitites,
supranationals and highly rated corporate borrowers
(b) A Bond issued by non-Japanese borrowers in the domestic Japanese markets
(c) A Bond which is privately placed in Japanese markets
(d) A Sterling denominated foreign bond raised in the UK domestic securities market
(e) A Yen denominated bond issued outside Japan.
 < Answer >
5. Which of the following is not a feature of a commercial paper (CP)?

(a) It is an unsecured instrument issued for a minimum period of 15 days

(b) It is issued in multiples of Rs.5 lakhs
(c) Buy-back facilities are not available for CPs
(d) It is negotiable by endorsement and delivery
(e) It is not generally underwritten.
< Answer >
6. If the intrinsic value of an equity share is Rs.44, the dividend for the current year is Rs.2.40 and the required rate
of return is 16%, then the growth rate of dividends is

(a) 7%
(b) 8%
(c) 9%
(d) 10%
(e) 11%.
< Answer >
7. You are a treasury manager of a finance company and wants to enter into a lease agreement for computerization
of the entire office and branches of the company. Which type of lease do you prefer?

(a) Finance lease

(b) Operating lease
(c) Upgrade lease
(d) Leveraged lease
(e) Swap lease.
< Answer >
8. A repo is a

(a) Security which is traded in the stock market

(b) Contract to buy a specific security at a future date at the price on that date
(c) Contract which gives the holder an option to buy a specific security in future at the predetermined price
(d) Contract in which one party sells a specific security to another party with an agreement to buy it back on
a specified future date at a specified price
(e) Collaterized long term loan.
< Answer >
9. Which theory of international trade considers the possibility of trade between two countries having similar factor
endowments and consumer tastes?

(a) Heckscher – Ohlin Model

(b) Imitation – Gap Theory
(c) Theory of comparative Advantage
(d) International Product Life Cycle Theory
(e) Theory of Absolute advantage.
 < Answer >
10. If the net working capital is negative then it indicates that

(a) A part of the long-term funds has been used for financing short-term assets
(b) A part of the long-term funds has been used for financing long-term assets
(c) A part of the short-term funds has been used for financing long-term assets
(d) The short-term funds have been entirely used for financing short-term assets
(e) The financing structure of the firm is normal.
< Answer >
11. Which of the following is not true in respect of Global Depository Receipts (GDRs):

(a) GDR is a negotiable instrument which represents publicly traded local-currency-equity share
(b) GDR is an instrument which possesses a certain number of underlying shares in the custodial domestic
bank of the company
(c) GDR holders can exercise the voting rights of the shares through the Depository as per the understanding
between the issuing company and the GDR holders
(d) GDRs are considered as common equity of the issuing company and are entitled to dividends and voting
rights since the date of issuance
(e) GDRs can be cancelled and converted into equity shares if the issuing company intends.
< Answer >
12. The exchange rate between two currencies was determined on the basis of the rates at which the respective
currencies could be converted in to gold. This is called the

(a) Purchasing power parity

(b) Mint parity
(c) Currency parity
(d) Interest rate parity
(e) Hybrid exchange rate.
< Answer >
13. Jaico industries has issued bonds with a face value of Rs.100, at a discount of 12.5%. The current market price of
the bond is Rs.85 and the coupon rate is 8%. What is the current yield on the bond?

(a) 8%
(b) 9%
(c) 9.14%
(d) 9.41%
(e) 12.5%.
< Answer >
14. In balance of payments statement, current account deficits are offset by

(a) Merchandise trade deficits

(b) Merchandise trade surpluses
(c) Capital account surpluses
(d) Capital account deficits
(e) Official reserves.
 < Answer >
15. Which of the following will decrease the net operating cycle of a firm, other things remaining the same?

(a) Increase in the work-in-process period

(b) Increase in the raw materials storage period
(c) Increase in the average payment period
(d) Increase in the average collection period
(e) Increase in the finished goods period.
< Answer >
16. Which of the following rules is not true in respect of forward foreign exchange contracts?

(a) Cannot be booked for anticipated transactions

(b) Value of the forward cover should not exceed the value of the goods contracted for
(c) Forward cover can be taken by resident corporate clients in respect of dividend due to overseas
investors who have made a foreign direct investment in India
(d) Ready sale or purchase can be made for which a forward contract is already booked
(e) Forward cover can be taken for foreign currency loans raised.
< Answer >
17. Under FEMA, which of the following transactions does not require RBI’s general or special permissions?

(a) Dealing in foreign exchange or foreign securities

(b) Transferring of foreign exchange/foreign securities to any person other than an authorized person
(c) Releasing of foreign exchange to a resident Indian under Foreign Travel Scheme
(d) Entering into any financial transaction in respect of acquisition of assets outside India
(e) Export, import or holding of foreign currency.
< Answer >
18. If the degree of operating leverage is 3 and the degree of financial leverage is 2, it means that

(a) 1% change in EPS will be caused by 5% change in sales

(b) 1% change in EBIT will result in 3% change in EPS
(c) 1% change in sales will result in 3 percent change in EBIT and 6% change in EPS
(d) 1% change in EPS will be caused by 6% change in EBIT
(e) 1% change in sales will result in 2% change in EPS.
< Answer >
19. Under the gold standard, the loss of gold and reduction in the money supply in the deficit country may lead to

(a) An increase in its interest rate and a capital inflow

(b) An increase in its interest rate and a capital outflow
(c) A decrease in its interest rate and a capital inflow
(d) A decrease in its interest rate and a capital outflow
(e) Capital outflow only.
< Answer >
20. A Mutual fund company from USA is planning to invest in India. The rates of inflation are 5.5% in India and
3.5% in USA. If the spot rate is currently quoted Rs.46.50/$, what spot rate you can expect after 3 years

(a) Rs.43.90/$
(b) Rs.49.25/$
(c) Rs.47.40/$
(d) Rs.45.62/$
(e) Rs.47.22/$.
 < Answer >
21. In ABC analysis items coming under Group ‘A’ are

(a) Low value items

(b) High value items
(c) Low quantity items
(d) High quantity items
(e) Medium value items.
< Answer >
22. The maximum amount of public deposits (excluding shareholders) that can be held by a company at any point of
time shall not exceed

(a) 10% of its aggregate paid-up capital and free reserves

(b) 20% of its aggregate paid-up capital and free reserves
(c) 25% of its aggregate paid-up capital and free reserves
(d) 30% of its aggregate paid-up capital and free reserves
(e) 35% of its aggregate paid-up capital and free reserves.
< Answer >
23. You have obtained the following information from your banker
Rs./£ spot : 80.10/12
LIBOR £ Interest rates 1 month : 4.5%
3 month : 4.6%
6 month : 4.8%
Rupee Interest rate up to 6 months: 7%
What should be the Rs./ £ (bid) third month forward rate to prevent arbitrage?

(a) ≤ 80.59
(b) ≤ 80.64
(c) ≥ 82.45
(d) ≤ 81.60
(e) ≤ 81.70.
< Answer >
24. The following are the exchange rates quoted in New York
$/Euro : 1.2875/76
$/HK$ : 0.1289/90
The synthetic rates of HK$/Euro are

(a) 9.9806/91
(b) 9.9814/83
(c) 9.9810/14
(d) 9.9816/80
(e) 0.1660/61.
 < Answer >
25. Which of the following capital structure theories states that the cost of equity capital and the cost of debt capital
remain constant when the degree of leverage varies?

(a) Traditional approach

(b) Miller and Modigliani approach
(c) Net operating income approach
(d) Net income approach
(e) Realized yield approach.
< Answer >
26. Which of the following is not a source of funds in a funds flow statement drawn on the Total Resources Basis?

(a) Profit after tax

(b) Issue of equity capital
(c) Increase in assets
(d) Increase in liabilities
(e) Depreciation and other non-cash charges.
< Answer >
27. An Indian exporter is expected to receive € 1,000,000 during the 3rdmonth. He obtained the following market
quotation
Spot Rs./€ = 55.32/35
Forward 1 month 02/03
2 month 03/04
3 month 04/05
The rate likely to be offered to the exporter is (ignore bank’s margin)

(a) Rs.59.36
(b) Rs.55.35
(c) Rs.55.39
(d) Rs.55.38
(e) Rs.59.34.
< Answer >
28. Which of the following is false regarding Certificates of Deposit(CDs)
(a) CDs are issued at a discount to face value
(b) CDs are freely transferable by endorsement and delivery
(c) CDs cannot be issued in demat form
(d) CDs are issued in denomination of Rs.1 lakh or multiples of Rs.1 lakh
(e) CDs are issued for a minimum period of 15 days and to a maximum period of one year.
< Answer >
29. Which of the following categories is not covered by agreement on Trade Related aspects of Intellectual
properties Rights (TRIPS)?

(a) Copy right and related rights

(b) Sanitary and Phyto-sanitary measures
(c) Geographical Indications
(d) Trade secrets
(e) Industrial designs.
 < Answer >
30. Which of the following types of guarantee is extended by the DICGC?
(a) Guarantees extended to non-financial contracts
(b) Guarantees for credit extended by banks to priority sector
(c) Guarantees to cover deferred payments to suppliers of equipments
(d) Guarantees on behalf of hire purchase companies to banks
(e) Guarantee for export credit extended by banks.

END OF SECTION A

Section B : Problems/Caselets (50 Marks)

• This section consists of questions with serial number 1 – 6.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanations should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

Raj Financial Services Ltd., furnished the following information regarding its capital structure: < Answer >
1.
• There are 5,00,000 equity shares of par value Rs.100 each. The shares are presently trading at
Rs.110 per share. The company has paid a dividend of 8% to its shareholders in the previous
year. The dividends have been growing at 6% over the years and this growth rate is expected to
continue in the future.
• The reserves and surplus amount to Rs.75 lakhs.
• There are 10,00,000 debentures of face value Rs.100 each, which are redeemable at a premium
of 5% after 6 years. The net amount realized per debenture was Rs.97. The current yield on the
debentures is 10% and the debentures are being traded at a price of Rs.95 per debenture. It is
assumed that the difference between redemption value and the net amount realized per
debenture will not be considered for tax-deduction.
• The amount of term loan is Rs.2.5 cr. and it carries an interest rate of 9% per annum. The
market value of the term loan is equal to its book value.
• The tax rate applicable to the company is 35%.
You are required to find out the following:
a. The costs of the various sources of finance used by the company.
b. The weighted average cost of capital using book value weights and market value weights.
(4 + 4 = 8 marks)

2. Indian Textiles Ltd. Ahemadabad is considering investment in a new machine. The following data < Answer >
pertain to the new investment:
Cost of machine Rs.25 lakhs
Investment in current assets Rs.15 lakhs
Increase in sales Rs.40 lakhs
Increase in manufacturing costs excluding depreciation Rs.24 lakhs
Increase in selling and distribution expenses (this includes
allocated overhead of Rs.1 lakh) Rs.7 lakhs

The total outlay on the capital expenditure will be financed by Rs.30 lakhs of long term funds and
 The total outlay on the capital expenditure will be financed by Rs.30 lakhs of long term funds and
Rs.10 lakhs of working capital advance. The cost of long term funds is 13% and the interest on
working capital advance is 12%. The machine will be depreciated by the straight line method.
The useful life of the machine will be five years at the end of which the entire investment will be
liquidated. The salvage value of the machine at the end of five years will be Rs.5 lakhs. The entire
amount of investment in current assets will be recovered on liquidation at the end of five years and
the working capital advance will be repaid. The tax rate for the company is 30%.
You are required to
a. Find out the net cash flows relating to long term funds arising out of the investment.
b. Appraise the investment using the net present value criterion.
(10 marks)

3. A multinational company in Frankfurt, Germany has surplus funds of euro 5 million for three months. < Answer >
The treasury manager has collected the following information on the exchange rates and interest
rates:
Exchange rates:
Euro/$ spot 0.7767 / 68
3 months forward 0.7747/ 49
Euro / £ spot 1.4594 / 1.4601
3 months forward 1.4607 / 1.4615
3 months interest rates (p.a.):
$ : 2.6% / 2.8%
£ : 3.00% / 3.6%
Euro : 3.2% / 3.4%
You are required to determine, in which currency the MNC should invest to have more returns,
without exposing the investment to exchange risk.
(10 marks)

4. Dev Electronics Ltd., manufacturer of colour tvs importing electronic components from Holland. < Answer >
On April 01, 2006, the company requested its banker to book a forward contract for $ 50000 with an
option to deliver in June 2006.
On April 01, 2006 the following rates prevailed in the inter bank market for US dollars in Mumbai

Rs/$ Spot : 45.09/10

April : 10/11 paise
May : 20/21 paise
June : 30/31 paise

However, the company in Holland could not export the components to due to fire accident in the
factory and the exact time of shipment could not be finalized as the company was not in a position to
resume the work. Hence, the company requested its banker to cancel the contract on June 30, 2006.
On June 30, 2006 the following rates prevailed in the inter-bank market for US dollars in Mumbai.

Rs/$ Spot : 45.95/96

1 month forward : 9/10 paise
2 months forward : 17/18 paise

Exchange margin collected by the bank is 0.10% while quoting the rates.
You are required to compute:
a. The forward rate quoted by the bank on April, 01, 2006.
 a. The forward rate quoted by the bank on April, 01, 2006.
b. The cancellation charges if any payable by or to the company.
(10 marks)

Caselet
Read the caselet carefully and answer the following questions:

< Answer >

5. Explain the difference between floating rate and fixed exchange rate mechanism.
(6 marks)
< Answer >
6. Discuss the role of IMF in the international monetary system.
(6 marks)
The world has witnessed many changes and developments – in technology, politics, culture, as well as economics – over
the years, and the IMF has adapted itself accordingly. At the time of IMF’s establishment, its policy advice focused
mainly on helping members to shape sound macroeconomic and financial policies, within the disciplines of the Bretton
Woods system of fixed exchange rates. The breakdown of that system in the early 1970s, and the resultant Second
Amendment of the IMF’s Articles of Agreement, led to a re-orientation of the IMF’s functions. In particular, the revision
of Article IV, and the introduction of the surveillance process, explicitly recognized the close relationship between
domestic economic policies and international stability. To this day, this forms the basis for systematic and
comprehensive review of economic conditions and policies in each member country. Similarly, the wave of de-
colonization that swept the world from the 1950s onwards placed new and complex responsibilities on the Fund. The
IMF quickly found that countries looked to it for advice and assistance beyond the traditional macroeconomic areas of
fiscal policy, monetary policy, and exchange rate systems. In addition to these subjects, IMF advice and assistance were
also sought on establishing the institutions of monetary and fiscal policy, and on supply-side structural policies to help
promote sustained growth. In the last fifteen years, following the end of the Cold War, new challenges were created in
this regard by the transition of former centrally-planned economies to market-based systems. Through its work in these
areas, it also became increasingly clear that structural and institutional issues were important for stability and growth in
other member countries too, including the major industrial economies. The area of IMF financing has also seen great
transformation. For example, although IMF lending continues to be targeted at short-term balance of payments needs, its
financing instruments have, for nearly two decades, included concessional lending for low-income countries. In response
to the rapid development of international capital markets as a major source of financing for countries, special IMF
financing policies have also been put in place to assist countries facing capital account driven crises. Related to these
capital market developments, the Fund also began to play an unanticipated role in facilitating the resolution of sovereign
debt problems. This function became critically important following the emergence of the debt crisis in 1982, and it
remains so today. All of these changes – ranging from de-colonization and transition, to the rapid development of private
international capital flows and new instruments, to the emergence of capital-account driven crises – posed new
challenges for the IMF. In many cases, these developments touched upon issues which lay at the frontiers of economic
knowledge and research. Addressing them has led to a significant transformation of the Fund, including a broadening of
the skills private financial sectors, and more involvement in institutional development in member countries. In the
process, the IMF has also become a more open and transparent institution.
END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 7 - 8.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.
 < Answer >
7. When a Financial Institution is involved in multi-currency operations, it is exposed to Foreign
Exchange risk. In this context, explain the various categories of Foreign Exchange risk based on the
nature of the exposure.
(10 marks)
< Answer >
8. “Treasury management is the management of an organization’s liquidity to ensure that the right
amount of cash resources are available in the right place in the right currency and at the right time in
such a way to maximize the return on surplus funds, minimize the financing cost of the business, and
control interest risk and currency exposure risk to acceptable level” Briefly explain the various forms
in which liquidity may be maintained by the business organizations for managing the requirements of
cash.
(10 marks)
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Treasury & Forex Management (MB351F): July 2006
Section A : Basic Concepts
1. Answer : (d) < TOP >

Reason : When a bank in India adds its confirmation to foreign Letter of Credit , it binds itself to honor the
drafts drawn by the beneficiary of the Letter of Credit without any recourse provided such drafts are
drawn strictly in accordance with the terms of the Letter of Credit. The confirming bank will suffer a
loss if the foreign bank fails to reimburse the amount paid to the exporter. The transfer guarantee
seeks to safe guard banks in India against losses arising out of such risks.
Overseas Investment Insurance policy provides protection for Indian investments abroad. Any
investment made by way of equity capital or untied loan for the purpose of setting up or expansion
of overseas projects will be eligible for cover under investment insurance
The Exchange Fluctuation Risk Cover Scheme has been formulated to provide a measure of
protection to exporters of capital goods, civil engineering contractors and consultants who often
receive payments over a period of 12 months or more, up to a maximum of 15 years.
The Export Performance Guarantee is in the nature of a counter guarantee to the bank, against
guarantees given by it on behalf of exporters
2. Answer : (b) < TOP >
Reason : EXIM offers pre-shipment credit beyond 180 days, Whereas all the commercial banks extend credit
up to 180 days. Others are functions of EXIM Bank.
3. Answer (b) < TOP >
Reason : As per exchange control regulations, payments for imports into India must be made within six
months from the date of shipment.
4. Answer: (a) < TOP >
Reason : ‘Yankee bonds’ are US dollar bonds denominated issued by foreign borrowers (usually foreign
governments or entities, super nationals and highly peculiar features associated with the US domestic
markets).
‘Samurai Bonds’ are issued by non-Japanese borrowers in the domestic Japanese markets.
‘Bulldog bonds’ are sterling denominated foreign bonds which are raised in the UK domestic
market. The maturity of these bonds will be either for very short periods (5 years) or for very long
maturities(25 years) bonds are generally subscribed by long –term institutional investors like pension
funds or life insurance companies
5. Answer : (c) < TOP >
Reason: C.P can be bought –back. Hence the statement that facility for buy-back is not available is
not a feature of C.P.
6. Answer : (d) < TOP >

D1 D 0 (1 + g )
P0 P0
Reason : ke = +g= +g
1.20(1 + g )
or 0.16 = + 22 g
or 3.52 =1.20 (1 + g) + 22g
or 7.04 = 1.20 + 1.20g + 22g
or 2.32 = 46.4 g
2.32
or g = 23.20 = 0.10 i.e. 10%.
7. Answer (c) < TOP >
Reason : In view of vast technological advancement, computerization of office and accounts is under threat
of obsolescence. Hence , an upgrade lease is used to upgrade the equipment or make additions to the
original equipment configuration, which effectively hedges the risk of obsolescence
8. Answer : (d) < TOP >
Reason : Repo is a security, which is traded in the money market. This is a contract entered into by two
parties, which may include the RBI, a bank or a NBFC. According to this contract, one party sells
certain securities to the second party with an agreement to buy them back on a predetermined future
date at a predetermined rate. This transaction raises short-term funds to the party selling the
securities. Therefore (a), (b), (c), and (e) are false and (d) is true. Thus (d) is the answer.
9. Answer : (b) < TOP >
Reason : Imitation – Gap theory considers the possibility of trade between two countries having similar factor
endowments and consumer tastes.
Hence, option (b) is the correct answer.
10. Answer : (c) < TOP >
Reason : Net working capital = Current assets – Current liabilities
When net working capital is negative current liabilities exceed the current assets and the excess
amount of current liabilities finance the long term assets.
11. Answer: (e) < TOP >
Reason : GDRs may be at the request of the investor – converted into equity shares by cancellation of
GDRs through the intermediation of the depository and the sale of underlying shares in the domestic
markets through local custodian. Hence, option is (c) is wrong
12. Answer : (b) < TOP >
Reason : The determination of exchange rates between the two currencies, on the basis of the rates at which
the respective currencies could be converted in to gold is called the mint parity.
13. Answer : (d) < TOP >

Coupon interest 100(0.08)

Market price 85
Reason : Current yield = = = 0.0941 ≈ 9.41%.
14. Answer : (c) < TOP >
Reason : In balance of payments statement, current account deficits are offset by capital account surplus.
15. Answer : (c) < TOP >
Reason : The average payment period is deducted from the gross operating cycle period which is the total of
the raw materials storage period, work-in-process period, finished goods period and receivables
period. Hence an increase in the payment period will cause a decrease in the net operating cycle
period. All the other alternatives represent changes which cause an increase in the operating cycle
period.
16. Answer : (d) < TOP >

Reason : No ready sale or purchase should be made for a transaction for which a forward contract has
already been booked
17. Answer: (c) < TOP >
Reason : Release of foreign exchange to an Indian resident under Foreign Travel Scheme does not require
general or special permission of RBI, where as all other items requires general or special permission
of the RBI.
18. Answer : (c) < TOP >

Reason : DOL of 3 implies that 1% change in sales will result in 3% change in EBIT and DFL of 2 implies
that 1% change in EBIT will result in 2% change in EPS. DTL is the product of DOL and DFL and
DTL in the given case is 6, which implies that 1% change in sales will result in 6% change in EPS.
Hence, (c) is the answer.
19. Answer : (a) < TOP >
Reason : Under the gold standard, the loss of gold and reduction in the money supply in the deficit country
may lead to an increase in its interest rate and a capital inflow
20. Answer : (b) < TOP >

Reason : F(A/B) = S(A/B) X (1+ r A)n / (1 + rB)n

F Rs/$ = 46.50 (1+0.055)3 / (1 + 0.035)3
 1.1742 
46.50×  
=  1.1087 
= 46.50 × 1.0591
= 49.2481 ≈ 49.25
21. Answer : (b) < TOP >
Reason : ABC is an inventory management technique in which inventory is segregated into three groups- A,
B and C on the basis of value of annual usage. The A items are those in which it has the largest rupee
investment, the B group consists of items accounting for the next largest investment and the C group
consists of items of large number of items accounting for small rupee investment
< TOP >
22. Answer : (c)
Reason : The total amount of public deposits that can be outstanding at any point of time cannot exceed 25%
of the aggregate of paid-up capital and free reserves. In addition to the above limits, it can accept
deposits from its shareholders up to a maximum limit of 10% of the aggregate of paid-up capital and
free reserves. No government company shall accept any deposits in excess of 35% of its paid-up
capital and free reserves
< TOP >
23. Answer : (a)
Reason : Let the Fb be the forward rate (Rs./£)
Suppose we borrow Rs. 100 for 3 months convert into £ for investment for 3 month
Rs. 100/ 80.12 ( 1 + 0.046/4) (Fb)
1.2625
Loan repayment = 100 ( 1+ 0.07/4) = Rs. 101.75
To prevent arbitrage
101.75 ≥ 1.2625 Fb
Fb= 101.75/ 1.2625 = ≤ 80.59
24. Answer : (a) < TOP >
Reason : Synthetic rate of HK$/€ (bid) rate = 1/ $/HK$ (ask) rate X $/€ (bid) rate
= 1/0.1290 X 1.2875 = 9.9806
HK $/ € (ask) rate = 1/ $/HK$ (bid) rate X $/€ (ask) rate
= 1/0.1289 X 1.2876 = 9.9891
25. Answer : (d) < TOP >
Reason : The net income approach states that the cost of equity capital and the cost of debt capital remain
constant when the degree of leverage varies.
26. Answer : (c) < TOP >
Reason : The sources and used of funds in a Funds Flow Statement drawn under the Total Resources Basis
can be summarized as follows:
Sources:
Operations (Profit after tax, and Depreciation and other non-cash charges)
Issue of equity capital
Increase in liabilities
Decrease in assets
Uses:
Dividends
Decrease in liabilities
Increase in assets.
Therefore, increase in assets is not a source of fund. Hence (c) is the answer.
27. Answer : (b) < TOP >
Reason : The swap points are low/high, hence Euro currency is at premium, bid side points to be added to
get forward bid rate, since the bank is buying it will add two months premium assuming that the
customer would exercise option at the beginning of the month, in this case 3 month, hence, it will
give 2 month premium.
28. Answer : (c) < TOP >
Reason : CDs can be issued in demat form and can be transferred as per the procedure applicable to other
demat securities, hence option (c) is false.
29. Answer : (b) < TOP >
Reason : Sanitary and Phytosanitary measures is not covered by agreement on Trade Related Aspects of
Intellectual properties Rights (TRIPS)
30. Answer : (b) < TOP >
Reason : Guarantee for credit extended by banks to priority sector is one of the guarantees extended by
DICGC where as the guarantees of alternatives (a), (c) and (d) are extended by insurance companies
and (e) by ECGC.
END OF SECTION A

Section B : Problems/Caselets

1. (a)
Costs of different sources of finance:
Cost of equity capital
D1
ke = +g
P0
D0 = 100 x 8% = Rs.8
D = D (1+g) = 8 x 1.06 = Rs.8.48
 D1 = D0(1+g) = 8 x 1.06 = Rs.8.48
8.48
ke = + 0.06
110 = 0.1371 i.e. 13.71%
Cost of retained earnings = Cost of equity capital = 13.71%

Cost of debentures
F-P
I(1-t) +
kd = n
F+P
2
I = Coupon interest = Market price x Current yield = 95 x 0.10 = Rs.9.50
t = 0.35
F = 100 + 5% premium = Rs.105
P = Net amount realized per debenture = Rs.97
n = 6 years
105-97
9.50(1-0.35) +
kd = 6
105 + 97
2 = 7.43%
Cost of term loan
kt = i (1 – t) = 0.09 (0.65) = 5.85%

(b) Book values and market values

Book value Book value Market value Market value
(Rs. in lakhs) proportions (Rs. in lakhs) proportions

Equity shares 500 0.274

550 0.314
Retained earnings 75 0.041
Debentures 1000 0.548 950 0.543
Term loan 250 0.137 250 0.143
Total 1,825 1.000 1,750 1.000

∴ WACC (using book value weights) = (0.274 x 13.71) + (0.041 x 13.71) + (0.548 x 7.43) + (0.137 x
5.85)
= 9.19% (approximately)
WACC (using market value wrights) = (0.314 x 13.71) + (0.543 x 7.43) + (0.143 x 5.85)
= 9.18% (approximately) < TOP >

2. a. Total outlay = Investment in machine + Investment in current assets

= 25 + 15 = Rs.40 lakhs
Investment of long term funds = Total outlay – Working capital advance
= 40 – 10 = Rs.30 lakhs.
Cash flows relating to long term funds:
(Rs. in lakhs)
Year 0 1 2 3 4 5
A. Investment (30)
B. Increase in sales 40 40 40 40 40
C. Increase in manufacturing costs 24 24 24 24 24
 C. Increase in manufacturing costs 24 24 24 24 24
D. Increase in selling and distribution 6 6 6 6 6
expenses
(Rs.7 lakhs – Rs.1 lakh)
E. Depreciation 4 4 4 4 4
F. Interest on working capital advance 1.2 1.2 1.2 1.2 1.2
G. Profit before tax 4.8 4.8 4.8 4.8 4.8
H. Tax 1.44 1.44 1.44 1.44 1.44
I. Profit after tax 3.36 3.36 3.36 3.36 3.36
J. Net salvage value of machine 5
K. Net recovery of working capital 15
L. Repayment of working capital advance (10)
M. Initial flow (A) (30)
N. Operating flow (I + E) 7.36 7.36 7.36 7.36 7.36
O. Terminal flow (J + K – L) 10
P. Net cash flow (M + N + O) (30) 7.36 7.36 7.36 7.36 17.36
Note: Profit after tax has been calculated from the point of view of long term funds. Since the
composition of long term funds is not revealed the profit after tax shown above can be said to be accruing
to long term funds.
n CFt
t =1 Σ −I
(1 + k ) t
b. NPV = =
7.36 PVIFA (13%, 4) + 17.36 PVIF (13%, 5) – 30
{7.36 X 2.9755 + 17.36 X 0.5434} - 30
= {21.8996 + 9.4334} -30 = 1.333 lakhs .
The NPV is positive. Hence the investment may be made in the new machine. However it must be noted
that the NPV is marginal in comparison to the investment. Hence, other factors must be considered before
making the investment. < TOP >

3. Alternative I – investing in Euro (home currency)

 0.032 
1 + 
Returns after 3 months = 5000 000  4 
= 5040000
Returns for 3 months = 5040000 – 5000 000
= Euro 40000
Alternative II investing in dollars
Eur / $ spot 0.7767/68
MNC buys dollars at 0.7768/ $
Inflow of dollars for Euro 5 mlliono = 5000 000 ÷0.7768
= $ 6,436663
Invest dollars at 2.6% for 3 months.
 0.026 
1 + 4 
Returns in dollars = 6,436,663  
= $ 6,478,501
MNC will sell $, to buy Euro at forward rate of € 0.7747/ $ = 6478501 X 0.7747
= Euro 5018894.72
Say Euro 5018895
 Returns for three months = 5018895 – 5000000
= Euro 18,895
Alternative III investing in pounds
MNC buys pounds at 1.4601/£ = 5,000,000 ÷ 1.4601 = £ 3,424,423
Invest pounds at 3.00% for 3 months = 3,424,423 (1+ 0.03/4) = £ 3,450,106
MNC will sell £ 3,450,106 at forward rate of €/ 1.4607 £
After 3 months MNC will sell pounds to buy Euro at forward rate of 1.4607 / £
Inflow of Euro = 3,450,106 X 1.4607
= Euro5,039,570
Return for 3 months = 5,039,570 – 5000 000
= 39,570
It is advisable to invest in euro, as the returns are more, when compared to the other alternatives of II and III. < TOP >

4. a. US dollar is at premium. Assuming that the dollar is delivered on the last day of the option period,
premium is to be taken for June 2006 only

Rs/$ Spot ask rate 45.10

Add premium for June 0.31
45.41
Add exchange margin at
0.045
0.10%
Forward buying rate for dollar 45.455
= Rs.45.46/
$
b. On June 30, 2006 the contract is to be cancelled at the T.T. buying rate
Rs/$ spot bid rate = 45.95
0.046
Add Exchange margin at 0.10% = 45.904 = Rs.45.904/$ ≈ 45.90
Cancellation charges≈
$ 50000 sold in the market at Rs. 45.90 due to inability of
= Rs.22,95,000
the company to take delivery before the due date
$ 50000 sold to the company at Rs.45.46 on 01.04.2006 = Rs.22,73,000
Exchange difference payable to the company 22,000
The company has to receive Rs 22,000 towards swap cost less Rs.100/- towards cancellation charges. < TOP >

5. The differences between the floating rate mechanism and fixed rate mechanism are
a. In the floating rate mechanism, the exchange rate is determined by the market forces, while in fixed
rate mechanism, the exchange rate is determined by the government. Therefore, in floating rate
mechanism, the exchange rate depends on the perception of the market about the relative worth of
various currencies while in the fixed rate mechanism, the rate depends on what the government
wants it to be.
b. In fixed rate mechanism, the government needs large amounts of reserves to be able to maintain the
currency at the level it wants. In the floating rate system, the government does not interfere in the
market.
c. In some variations of the fixed rate mechanism, the value of the currency is adjusted upwards or
downwards depending on the values of certain key parameters such as money supply.
d. The fixed rate system though useful for maintaining a stable exchange rate, may give rise to market
distortions in the long run. The floating rate system, on the other hand, may result in wide
fluctuations in the exchange rates over short time intervals but is expected to settle down at its true
value. < TOP >

6. The various roles of IMF are as follows:

6. The various roles of IMF are as follows:
• To promote international monetary cooperation through a permanent institution, which provides the
machinery for consultation and collaboration on international monetary problems.
• To facilitate the expansion and balanced growth of international trade, and to contribute, thereby to the
promotion and maintenance of high levels of employment and real income and to the development of the
productive resources of all members, as primary objectives of economic policy.
• To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid
competitive exchange depreciation.
• To assist in the establishment of a multilateral system of payments, in respect of current transactions
between members and in the elimination of foreign exchange restrictions, which hamper the growth of
world trade.
• To give confidence to members by making the general resources of the Fund temporarily available to
them under adequate safeguards, thus, providing them with opportunity to correct maladjustments in their
balance of payments, without resorting to measures, destructive of national or international prosperity.
• In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of the member countries. < TOP >

Section C: Applied Theory

7. Foreign exchange risk can be classified into three categories based on the nature of the exposure. Listed
below are the three kinds of forex exposures:
• Transaction exposure
• Translation exposure
• Operating exposure.
These three foreign exchange exposures and the risks faced by the financial institutions due to the
same, are discussed below.
Transaction exposure
The transaction exposure measures the risk involved due to the change in the foreign exchange rate
between the time the transaction is executed and the time it is settled. For instance, ALGO Ltd., an
Indian company, enters into a purchase transaction with a US based company and the transaction is
invoiced in US Dollar two Dollar. The terms of contract provide for payment after two months. During
the period of the transaction if the Indian Rupee depreciates, then it will have to pay more rupees to
remit the US Dollar two Dollar than it actually had to at the time of entering into the transaction. Thus,
transaction exposure leads to a risk of loss when there is a conversion of one currency into another. A
gain is also possible if the movement in the currency rate is favorable.
For a financial institution, this type of a risk does not normally occur in its routine business operations.
manufacturing/trading units are more exposed to such risk. If ALGO Ltd. Buys US Dollar from a bank
either on the spot or in the forward market, then the bank will become short having sold the US Dolla.
However, the bank takes up a long position immediately to square up the transaction so as to eliminate
the exposure. Thus banks, in general, hold a square or near square positions at the end of each day by
going long (short) corresponding to every transaction with the customer (Merchant Transaction) which
is short (long). Hence the transaction exposure to the banks mostly remain an intra day exposure. The
bank helps the customers to hedge their exposure while ensuring that it also hedges its exposure.
Translation exposure
Differentiating itself from the transaction exposure is the translation exposure is the translation
exposure which refers to the risk arising on account of changes in exchange rates at the time of
finalizing/consolidating the financial statements which has assets/liabilities denominated in foreign
currencies. When a company has to finalize/consolidate its account, it has to convert its foreign
currency denominated assets/liabilities at the applicable exchange rates as against the rates at which
they are initially recorded. The rates at which the existing liabilities/assets are to be converted are
governed by the guidelines issued by Foreign Exchange Dealers Association of India (FEDAI) and the
Institute of Chartered Accountants of India (ICAI). The financial institution is directly affected by this
translation risk.
Operating exposure
Operating exposure arises because of the impact of the change in currency rates on the profits of a
corporate. This can arise even when a corporate does not deal in foreign currency. For example, the
recent depreciation of south-east Asian currencies has had its impact on the Indian exports even though
 recent depreciation of south-east Asian currencies has had its impact on the Indian exports even though
the Indian exporters do not deal with these exports of south-east Asian countries. However, such an
exposure is not significant for the financial institution. < TOP >

8. Forms of Liquidity
Cash Balance in the Current Account: This is the highest form of liquid asset a company can
conceive of, but the return provided by it is nil. However, companies maintain approximately four to
five percent of their total assets, on the average, in this form despite no returns for reasons already
explained.
Keeping Reserve Drawing Power under Cash Credit/Overdraft Arrangement: This form of
liquidity appears to be quite attractive as it can have access to bank borrowing. However, constraints
imposed by the banking sector make this much less attractive than what it once used to be. Close
scrutiny of the quarterly budgets of the company by banks and imposition of penal interest of two
percent over and above the normal rate of interest on under-or over-utilization make this form more
tedious and time consuming. However, a built-in cushion may possibly be included while preparing the
quarterly budgets and during some periods the full amount may be drawn. The tax benefit on the
interest makes effective after-tax-rate to be much less costly, even if part of it is held in the form of idle
cash. This not only helps as a liquid source but also helps in obtaining equal or higher limits during the
forthcoming year.
Marketable Securities: These are short-term securities of government such as treasury bills and other
gilt edged securities whose default risk is nil and, for that very reason, the return is low. It is preferable
to ensure the maturity structure of these short-term securities with the likely periods of excessive cash
drain on the part of the company. Then, the transaction costs can be considerably minimized as early
liquidation prior to maturity may result in low return from these assets.
Investment in Intercorporate Deposits: A company can invest money with other companies in the
form of short-term deposits ranging from two or three months to five or six months at remunerative
rates. However, these deposits being unsecured in nature, are subject to considerable risk, unless the
companies accepting such deposits have excellent antecedents as to their paying habits.
From among the different forms of liquidity available to a company a deliberate choice has to be made
in selecting an appropriate mix that suits the liquidity requirements of the company and disposition of
its management towards risk. < TOP >

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