Question Paper

Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009 i.exe

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. Which of the following is not a fundamental part of a firm’s financial structure? >

(a) Ownership structure

(b) Financial planning
(c) Financial leverage
(d) Executive compensation
(e) Managerial hierarchy.
<Answer
2. Feasibility study takes into consideration >
I. Frequency of the decision.
II. Suitability of the area in which decision is required.
III. Comparison of costs and benefits.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
<Answer
3. Which of the following statements is false with respect to quality costing? >

(a) Quality of design refers to variation in products that have the same functional use
(b) Total Quality Control is often associated with Just-In-Time manufacturing
(c) Appraisal costs are the costs incurred to ensure that materials, products, and services meet quality
standards
(d) A Quality-Costing system monitors and accumulates the costs incurred by a firm in maintaining or
improving product quality
(e) Quality of conformance refers to the degree with which the final product fails to meet its
specifications.
<Answer
4. Which of the following is/are external factor(s) that lead to the bankruptcy of a firm? >

I. Shortage in supply of raw materials.

II. Fraudulent practices by management.
III. Labour unrest.
IV. Technological obsolescence.
V. Disputes among promoters.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (III) and (IV) above
(e) Both (IV) and (V) above.
<Answer
5. The failure of executive compensation plan is usually because of >

I. Correlation between the size of the company and its payment structure.
II. Emphasis on short term performance of the company.
III. More focus on the accounting measures while designing the compensation contracts.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.

Page 1 of 18
6. The earnings per share of a Zeta Ltd., is Rs.30 and the dividend payout ratio is 60%. If the share price of the <Answer
>
company is Rs.56, according to the Graham and Dodd Model the multiplier applicable to the company is
approximately
(a) 1
(b) 2
(c) 3
(d) 4
(e) 5.
<Answer
7. Which of the following statements is/are false regarding Ratio Comparison Approach? >

I. It provides a popular way of valuing firms, projects or assets.

II. This method is never used in real asset valuation.
III. This approach uses ratio of price to earnings for valuation.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
8. The real option valuation approach of valuing a project shows that the value of revolving uncertainty depends <Answer
>
on
I. Future decision involving exploration.
II. Current value of oil prices.
III. Uncertainty type.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
9. As per Modigliani and Miller hypothesis value of levered firm is equal to value of unlevered firm. This <Answer
>
implies
I. The cost of equity increases.
II. Stock holder’s risk exposure increases.
III. The weighted average cost of capital changes with leverage.
IV. Leverage does not increase/decrease risk.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (IV) above
(e) Both (II) and (III) above.
<Answer
10 Which of the following statements is/are false regarding dividend decisions? >
.
(a) Liquidity does not affect dividend decisions
(b) Firms resort to high payout if the profitable investments are lacking
(c) The cost of external financing influences dividend decisions
(d) Firms tend to have a high pay-out ratio if the shareholders have a strong preference towards current
dividends
(e) Restrictive covenants limit the flexibility of the company in determining its dividend policy.
<Answer
11.All of the following models are used for predicting sickness of a firm except >

(a) Beaver Model

(b) BCG Matrix
(c) Altman’s Z Score Model
(d) Argenti Score Board
(e) Wilcox Model.

Page 2 of 18
12 The institutionalization of knowledge created during the process of developing and installing a model is <Answer
>
. known as

(a) Validation
(b) Implementation
(c) Construction
(d) Documentation
(e) Revision.
<Answer
13 The substantial loss in the market value of the firm’s equity can result in >
.
I. Losing of professional analysts.
II. Delisting of stocks.
III. Decrease in normal bid ask spread.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
<Answer
14 Which of the following statements is/are true with respect to Activity Based Costing (ABC)? >
.
I. ABC is based on historical costs.
II. ABC does not highlight the causes of costs.
III. ABC divides cost into fixed and variable costs.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
<Answer
15 As per Marshall and Bansal asset-liability management is an effort to manage/minimize exposure to >
.
I. Price risk.
II. Interest rate risk.
III. Exchange risk.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
16 Electric Circuits Ltd. is an Indian firm, it imports electric parts from Japan. If the Yen is strengthening, Indian <Answer
>
. firm is exposed to

(a) Translation risk

(b) Transaction risk
(c) Economic risk
(d) Interest rate risk
(e) Political risk.
<Answer
17 Anti trust laws aim to >
.
I. Protect economic freedom and opportunity.
II. Provide a better deal to customers by promoting competition in market place.
III. Create a level playing field and encouraging new entrants into the industry.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.

Page 3 of 18
 <Answer
18 Consider the following data of M/s. Super Colors Ltd. for the year 2008 – 09: >
.
Profit after tax Rs.14.98 lakhs
Interest expenses Rs..9.2 lakhs
Non cash charges Rs.6.5 lakhs
Repayment of term loan Rs.7.5 lakhs
Effective tax rate 26%
Debt-service coverage ratio of the company is
(a) 1.59
(b) 1.76
(c) 1.84
(d) 2.24
(e) 2.70.
19 There are two firms, Akash Ltd. and Prakash Ltd. They are similar in all respects except that Akash Ltd. is <Answer
>
. unlevered, while Prakash Ltd. has Rs.5 crore of 11% debentures outstanding. Both companies have a net
operating income of Rs.1 crore each. The tax rate applicable to both the companies is 35%. The discount rate
for both the companies is 10% p.a. The value of Prakash Ltd., considering Modigliani-Miller position on
leverage holds good is
(a) Rs.1.00 crore
(b) Rs.3.50 crore
(c) Rs.6.50 crore
(d) Rs.8.25 crore
(e) Rs.9.30 crore.
20 The current ratio and quick ratio of Kendra Industries Ltd., are 1.2 and 0.8 respectively. The net working <Answer
>
. capital of the firm is Rs.6,00,000 with an inventory of

(a) Rs. 7.50 lakh

(b) Rs. 9.00 lakh
(c) Rs.11.25 lakh
(d) Rs.12.00 lakh
(e) Rs.14.00 lakh.
<Answer
21 The following data is available for Infodata Ltd.: >
.
Estimated cash requirement over 6 months planning period = Rs.5,00,000
Fixed conversion costs = Rs.2,000
Annual interest rate on marketable securities = 9%
The amount of securities that should be liquidated per batch is
(a) Rs.3.22 lakh
(b) Rs.2.11 lakh
(c) Rs.1.22 lakh
(d) Rs.1.12 lakh
(e) Rs.1.05 lakh.
22 According to Du-Pont equation for Return On Equity (ROE), other things remaining constant, which of the <Answer
>
. following statements is/are false?
(a) An increase in the net profit margin will increase the ROE
(b) A decrease in debt to assets ratio will increase the ROE
(c) A decrease in return on assets will decrease the ROE
(d) An increase in the average asset turnover will increase the ROE
(e) An increase in equity multiplier increases the ROE.

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23 Metalic Steel earns 10% on the equity and the growth rate of dividends and earnings is 5%. The book value <Answer
>
. per share is Rs.80. If the market price of the shares of Metalic Steel is Rs.70, according to the Marakon
Model, the cost of equity is approximately
(a) 9.67%
(b) 10.71%
(c) 12.45%
(d) 13.78%
(e) 14.67%.
<Answer
24 Infrastructure Ltd., is considering following five projects: >
. Project Initial investment (Rs.) NPV (Rs.)
1 1000 210
2 6000 1560
3 5000 850
4 2500 500
5 500 95
The project that will be ranked first as per Profitability Index method is
(a) Project 1
(b) Project 2
(c) Project 3
(d) Project 4
(e) Project 5.
<Answer
25 Which of the following factors is/are not considered by Alcar Model? >
. I. Operating profit margin.
II. Incremental investment in working capital.
III. Income tax rate.
IV. Dividend growth rate.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) All (I), (II), (III) and (IV) above.
26 According to which of the following models firm’s weakness are classified as defects, mistakes and <Answer
>
. symptoms based on numerical assessment of the firm?

(a) Beaver Model

(b) The Wilcox Model
(c) Blum Marc’s Failing Company Model
(d) Altman’s Z score Model
(e) Argenti Score Board.
<Answer
27 While managing environmental risks, risk managers perform which of the following tasks? >
.
I. Minimize the probability of occurrence of an adverse event such as an accident.
II. Cut the cost when an accident occurs.
III. Shift responsibility to other parties to the extent possible, when the event occurs.
IV. Obtain more information to make risk assessment methodology as robust as possible.
(a) Both (I) and (II) above
(b) Both (II) and (IV) above
(c) (I), (II) and (IV) above
(d) (II), (III) and (IV) above
(e) All (I), (II), (III), and (IV) above.

Page 5 of 18
 <Answer
28 Which of the following statements is/are false with respect to Bankruptcy Models? >
.
I. According to Wilcox Model, the net liquidation value of the firm is the best indicator of the financial
health of the firm.
II. Blum Marc’s Model is based on liquidity ratios only.
III. According to the Beaver Model, the ratio of cash flow to total debt is the single best predictor of
corporate failure.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
<Answer
29 An organization can achieve goal congruence by >
.
I. Paying bonuses to managers.
II. Rewarding managers with shares.
III. Monitoring managerial behavior.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
30 Best Ltd. has net profit margin 8%, the assets to equity ratio 3 and total asset turnover 1.5, the return on <Answer
>
. equity is

(a) 12%
(b) 24%
(c) 36%
(d) 48%
(e) 60%.
END OF SECTION A
Strategic Financial Management: Theory and Practice (MB3H2F) : January
2009
Section B : Problems/Caselet (50 Marks)

• This section consists of questions with serial number 1 – 5.

• 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.

1 Prakash Pvt. Ltd. manufactures toys for kids. The company intends to maintain the cash balance of <Answer
>
. Rs.5,000. The following additional information is available on the balances of various current
assets and liabilities of the company.
Opening balances Closing balances
Particulars
(Rs.) (Rs.)
Raw material 3,450.00 4,100.00
Work-in-progress 55.00 72.50
Finished goods 638.00 1,100.00
Account receivables 756.00 1,165.00
Accounts payables 2,500.00 7,500.00
Purchases basically consist of procuring raw materials for manufacturing of toys, and are generally
bought on credit basis. The company incurs manufacturing expenses of Rs.1,140 in the process of
manufacturing the toys. The depreciation expenses of the company amount to Rs.245. The
company is also paying Rs.4,550 towards selling and distribution expenses and pays customs and
excise duty of Rs.35,000. During the year, the company pays Rs.1,000 to creditors and receives

Page 6 of 18
 Rs.53,801 from its debtors. Number of units produced is equal to the number of units sold. Market
price of each toy is Rs.10. (Assume 360 days in a year).
You are required to:
a. Calculate the weighted operating cycle of the company. 1 marks
(0 )
b. Determine the working capital requirement of the company based on the weighted operating marks
cycle. (2 )
2 The following details at the end of the last one year of operations are available with regard to <Answer
>
. Xenon Industries Ltd.:
EBIT Rs.150 lakh
Total debt Rs.800 lakh
Paid up equity share capital Rs.250 lakh
Reserves and surplus Rs.150 lakh
Effective interest rate 10%
Effective tax rate 36%
You are required to answer the following questions:
a. What was the return on equity of the company in the last year? marks
(4 )
b. The company’s business is expected to grow in the current year and it plans to finance the
increase in its business entirely by additional debt. It is assumed that the borrowing will be
done at the beginning of the current year and the net worth will remain at the existing level
throughout the current year, and the interest rate on the additional debt will be same as the
present effective interest rate. The company is planning to increase the return on equity by 4.8
percentage points in the current year. If other factors remain constant then what should be the marks
level of debt in the current financial year? (6 )
3 Duracell Ltd. is manufacturing a special type of cable used by electricity undertaking. The <Answer
>
. company has furnished the following information pertaining to its capital structure:
Particulars Rs. in lakh
Equity shares of Rs.100 each 20
Retained earnings 10
9% Preference shares 12
7% Debentures 8
Total 50
The company earns a return of 12% on capital employed. Owing to the increasing demand of the
product in the market, the company has made an expansion programme. The company requires a
sum of Rs.25 lakh to finance its expansion programme for which the following plans are available:
Plans Particulars
1 Issue of 20,000 equity shares at a premium of Rs.25 per share entirely.
2 Issue of equity shares at a premium of Rs.25 per share and 8% debentures in the ratio
of 2:3 respectively.
3 Issue of 8% debentures entirely.
It is estimated that the P/E ratios of the aforementioned three alternative financing plans would be
21.4, 17.0 and 15.7 respectively. The income-tax rate of the company is 33%.
You are required to:
a. Recommend which of the three financing plans company should implement and why? marks
(8 )
b. Compute the indifference level of EBIT between plan (1) and plan (3) above. marks
(2 )

Caselet
Read the caselet carefully and answer the following questions:

Page 7 of 18
4 What are the essential features which encompasses Enterprise-Wide Risk Management, that are set <Answer
marks >
. discerned in practice? (9 )
5 What is Enterprise Risk Management? Under Enterprise Risk Management discuss the various <Answer
marks >
. objectives and approaches of managing environmental issues. (9 )
Today financial services companies operate in increasingly complex, competitive and global
markets. The ability to manage risks across geographies, products, asset classes, customer
segments and functional departments is of paramount importance. The inability to manage these
risks can cause irreparable damage. Convergence, consolidation, globalization and shifting
regulations have posed innumerable and hitherto unprecedented challenges for the financial
services industry. The objective is to give an overview of risk management in the financial services
industry. This defines the major risks from the perspective of financial services industry, which
covers the components of Enterprise wide risk management and the role of technology in risk
management. In general corporate government policies serve numerous objectives like reduction of
cost, motivation of employees, minimization of the possibilities of accidents etc.
An Enterprise-Wide Risk Management which is discerned in practice has various principal and
attributes that encompasses several features. The risk management framework in the enterprise
attempts risk awareness. The temptation to ignore risk that cannot be quantified is avoided. Thus
the risk culture incorporates the value which desires the factors for minimizing risks. The ubiquity
of risk management necessitates other features such as internal audit procedures and management
control systems and looking forward to desired freedom that gained enough paramount irrespective
of the entrepreneurial or conservative culture of the firm.
The last twenty years have been marked by substantial financial deregulation. Accompanying this
deregulation has been a plethora of methodologies and technologies for managing the
risks/rewards created by this deregulation. Companies have also been captured by environmental
risk. Many companies equate environmental risk management with regulatory compliance. In
actual practice, there is much more control and discretion when it comes to environment related
expenditures, than commonly assumed. The effective approaches to manage the regulations are
self-regulation and govt. regulation. An important Theory is Valdez Theory, which had to be
accepted by public companies before the group, allowed its funds to be invested in the companies
share. The Valdez Theory includes protection of the Biosphere, Reduction and disposal of waste,
Damage compensation, Disclosure, etc. Environmental management which is performed with a
principle of rational responsibility, a principle of exploitation, aims to create environmentally
sustained environment. Thus the principle involves all the necessary criteria required to protect the
environment.
The Enterprise Risk Management has various components, which covers Corporate Governance,
Line Management, Risk Transfer, Data and Technology resources and Risk Analytics. Risk
management is a continuously evolving mix of science and art. Losses are inevitable, but one must
keep learning from the past. Risk itself is not bad, but risk that is misplaced, mismanaged,
misunderstood, or unintended is bad. Each institution needs to assess which method best suits its
objectives, its business, its view of the world or its pockets. A clear distinction should be made
between risk management and risk taking. Risk management oversees and ensures the integrity of
the process with which risks are taken. To maintain the objectivity, risk management cannot be a
part of the risk taking process. Individuals who manage risk need to be completely independent
from individuals who are responsible for taking risk.

END OF CASELET
END OF SECTION B
Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 – 7.

• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on Section C.

Page 8 of 18
 6. One of the most important objectives for the management is creation of value <Answer>
for the shareholders. Measurement of values created by companies is as
diverse as the objectives themselves. Alcar Approach is a popular value
measurement approach, which stresses upon the comparison of the pre-
implementation and post-implementation firm values of various strategies
before they are implemented. As per this approach, discuss various value
drivers that affect the value of a firm.
( 10 marks)
7. Emphasis of financial measures alone can result in the ignorance of physical <Answer>
as well as the qualitative measure of performance, by the heads of the
responsibility centers. Moreover, all the elements of output turned out by a
responsibility center (and also the inputs) do not lend themselves to a money
measurement. In this context, discuss various non-financial measures of
performance.
( 10 marks)
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009
Section A : Basic Concepts
Answer Reason
1. E Managerial hierarchy is not a fundamental part of a firm’s financial structure. < TOP >

2. E Feasibility Study < TOP >

The foremost step in developing a model is to ascertain the feasibility of a model
assisting the decision making process. The various points that are required to be
considered are
Whether the decision under consideration is a one-time process, or is required to be
taken as a routine measure
The suitability of the area in which the decision is required to be made, to be
supported by a model
The possibility of all the relevant variables being unambiguously identified The
possibility of all the variables being built-in into a single model
The expected effectiveness of the model
The acceptability of a model replacing human judgment to the management The
possibility of obtaining the required data on an ongoing basis
The possibility of integrating the model with the normal decision-making process
The costs involved with setting up and running the model, and its comparison with
the expected benefits.
If it is feasible to construct an efficient and effective model for the decision process
under consideration, and if the model can be easily integrated with the process, the
,firm can proceed to the next step of constructing the model,
3. E Quality of design refers to variations in products that have the same functional use; < TOP >
and
Total quality control often associated with just-in-time manufacturing.
Appraisal costs are the costs incurred to ensure that materials, products, and services
meet quality standards.
A quality-costing system monitors and accumulates the costs incurred by a firm in
maintaining or improving product quality;
Quality of conformance refers to the degree with which the the final product meets
(not fail to meet) its specifications.
4. A Shortage in supply of raw materials is an external factor, others are internal factors. < TOP >

Page 9 of 18
5. E The basic reasons for the failure of executive compensation plan are: < TOP >
• Correlation between the size of the company and its payment structure. Because
of the existence of the strong correlation between the size of the company based
on its asset value and sales and payment structure, companies sometimes tend to
strive for bigger size irrespective of the fact that it adds to the value of the
concern
• Emphasis on the short-term performance of the company. It has been frequently
observed that the short-term performance indicators such as sales and growth in
the earnings provide a greater weightage in incentive compensation that is paid
to the executive.
• More focus on accounting measures is given while designing the compensation
contracts. Some of the measures are earnings and the return on investments.
6. B P = m(d + e/3) < TOP >
⇒ 56 = m(18 + 30/3)
⇒ m=2
7. B A popular way of valuing firms, projects or assets is to compare them with other < TOP >
traded firms, projects or assets. The ratio comparison approach provides a way by
which such valuations can be accomplished. This is generally predominant in cases of
real asset valuations. The ratio comparison approach uses ratio of price to earnings for
valuation.
8. E The real option valuation approach of valuing a project shows that the value of < TOP >
revolving uncertainty depends on the following factors:
• Future decision involving exploration.

Current value of oil prices.

Uncertainty type.
9. C VL = VU implies that an increase in the leverage has following effects: < TOP >
• The cost of equity increases.

Stock holder’s risk exposure increases.

The weighted average cost of capital remains unchanged.

M & M do not ignore risk. On contrary, they recognize that leverage increases the
stockholder’s risk and that of equity must increase to compensate for that additional
risk.
10. A Traditional theories have postulated that a dividend decision is solely a function of the < TOP >
earnings of the firm. While earnings are an important determinant for the dividend
decision, the role of liquidity cannot be ignored. Dividend pay-out entails cash out
flow for the firm. Hence the quantum of dividends proposed to be distributed depends
critically on liquidity position of the firm. Normally firms tend to have low pay-out if
the profitable investment opportunities exist and conversely tend to resort high pay-
outs if the profitable investment opportunities are lacking. The cost of external
financing has an influence on dividend policy. Firms tend to have a high pay-out ratio
if the shareholders have a strong preference towards current dividends. Restrictive
covenants limit the flexibility of the company in determining its dividend policy.
11. B BCG matrix classifies the products into four broad categories. All others are the < TOP >
models for predicting

sickness of a firm.
12. D The institutionalization of knowledge created during the process of developing and < TOP >
installing a model is known as documentation

Page 10 of 18
13. D The substantial loss in the market value of firm’s equity can result in several liquidity < TOP >
effects. They are summarized as :
• The may go on losing out its professional analysts who play a vital role in
supporting the flow of information about a stock.

This may result in normal trading activities of the stock and increase the normal bid
ask spread.

The exchange may also delist its stocks based on its listing requirements.
14. A One of the weakness of ABC is that it is based on historical cost. ABC highlights < TOP >
cause of costs. ABC does not partition between fixed and variable costs.
15. E According to Marshall and Bansal asset-liability management is an effort to < TOP >
manage/minimize exposure to
I. Price risk.
II. Interest rate risk
III. Exchange risk.
16. B Electric Circuits Ltd. is an Indian firm; it imports electric parts from Japan. If the Yen < TOP >
is strengthening, Indian firm is exposed to Transaction risk.
17. E Anti-trust laws aim to protect economic freedom and opportunity and provide a better < TOP >
deal to the customers by promoting competition in the market place. The basic
premise of anti-trust laws is that increased completion leads to lower prices, better
quality and more choice for customers. Anti-trust laws also aim at creating a level
playing field and encouraging new entrants into industry.
18. C Debt service coverage ratio < TOP >

PAT + Non-cash charges + Interest

= I + Re payment of TL
14.98 + 6.5 + 9.2 30.68
= =1.84
= 9.2 + 7.5 16.7
19. D O(1 − t) < TOP >

Value of Prakash Ltd.= k +B×t

1 × 0.65
= 0.10 + 0.35 × 5
= 6.50 + 1.75
= Rs.8.25 crores
20. D Given CA/CL = 1.2 and (CA – Inventory)/CL = 0.8 < TOP >
Net working capital = CA – CL = Rs.6,00,000
1.2 CL – CL = 6,00,000
CL = Rs.30,00,000
CA = 1.2 x 30,00,000 = Rs.36,00,000
Now, (36,00,000 – Inventory)/30,00,000 = 0.8
36,00,000 – Inventory = 0.8 x 30,00,000 = 24,00,000
Inventory = Rs.12,00,000.
21. B < TOP >
2bT 2 × 500000 × 2000
C= = = 210818.5107 Rs.2.11Lakh
I 0.045

Page 11 of 18
22. B According to Du-Pont equation: < TOP >
Return On Equity (ROE) = Net Profit Margin x Average Asset Turnover x Equity
Multiplier
1
Where, Equity Multiplier = 1 − Debt to assets ratio .
Hence ROE will increase when the equity multiplier increases or in other words when
the debt to assets ratio increases. Hence, option (b) is incorrect and option (e) is
correct.
When net profit margin and /or average asset turnover ratio increases ROE will
increase. Hence, options (a) and (d) are correct.
ROE can also be written as Return On Equity (ROE)= Return on assets x Equity
Multiplier.
Hence, Decrease in Return On Assets decreases the ROE. So option (c) is also
correct.
23. B B(r − g) < TOP >
K −g
80 ( 0.1 − 0.05 )
70 = ( 0.01x − 0.05 )
= 0.7 x – 3.5 = 4
x = 10.71%.
24. B Cash inflows < TOP >
Initial investment NPV (PV)
Project (Rs.) (Rs.) (Rs.) PI
(1) (2) (3) (4) = (2)+(3) (5) = (4)/(2) Rank
1 1000 210 1210 1.21 II
2 6000 1560 7560 1.26 I
3 5000 850 5850 1.17 V
4 2500 500 3000 1.20 III
5 500 95 595 1.19 IV
25. D According to the Alcar model, there are seven value drivers that affect a firm’s value. < TOP >
These are:
• The rate of growth of sales.

Operating profit margin.

Income tax rate.

Incremental investment in working capital.

Incremental investment in fixed assets.

Value growth duration.

Cost of capital
26. E Argenti Score Card is classified in three weakness namely defects, mistakes and < TOP >
symptoms.
27. E All the four tasks have to be performed by the risk managers while managing < TOP >
environmental risks.

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 28. B The Wilcox model considers the net liquidation value of the firm as the best indicator < TOP >
of a firm’s financial health. Blum Marc’s failing company model is based on a set of
12 ratios divided into liquidity, profitability and variability ratios. The Beaver model
identifies the cash flow to total debt as the single best indicator of a firm’s financial
health.
29. E Goal congruence can be achieved by paying bonuses, incentives, rewarding managers < TOP >
with shares etc. as these measures may motivate the managers to take the decisions
which are consistent with the objectives of shareholders. Alternative measures like the
management audit to monitor the behavior of the mangers can also help in
establishment of goal congruence.
Net profit Sales Total assets < TOP >
30. C × ×
ROE = Sales Total assets Equity

= 0.08 × 1.5 × 3
= 0.36 i.e. 36%.

Strategic Financial Management: Theory and Practice (MB3H2F) : January 2009

Section B : Problems
1. a. Raw material purchased = Closing balance of accounts payable + Payments made to < TOP
creditors – Opening balance of accounts payable >
= 7,500 + 1,000 – 2,500 = Rs.6,000
Consumption of raw material = Opening balance of raw material + purchases of raw
material – Closing balance of Raw material
= 3,450 + 6,000 – 4,100 = Rs.5,350.
Consumption of raw material per day = 5,350 / 360 = Rs.14.86
3, 450 + 4,100
Average raw material inventory = 2 = Rs.3,775
Raw material storage period = 3,775 / 14.86 = 254.04 days.
55 + 72.50
Average W-I-P inventory = 2 = Rs.63.75
Cost of process = Opening WIP + Raw material consumed + Manufacturing expenses +
Depreciation – Closing WIP
= 55 + 5,350 + 1,140 + 245 – 72.50
= Rs.6,717.50
6, 717.50
Cost of process per day = 360 = Rs.18.66
63.75
WIP inventory period = 18.66 = 3.42 days
638 + 1,100
Average Finished goods inventory = 2 = Rs.869
Cost of goods sold = Opening FG inventory + Cost of process + Excise duty + Selling
and administration expenses – Closing FG inventory
= 638 + 6,717.50 + 35,000 + 4,550 – 1,100 = Rs.45,805.50
Cost of goods sold per day = 45,805.50 / 360 = Rs.127.24
869
Finished Goods storage period = 127.24 = 6.83 days

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 Opening balance of debtors + Clo sin g balance of debtors
Average debtors = 2
756 + 1,165
= 2 = Rs.960.5
Sales = Closing balance of debtors + Cash received from debtors – Opening balance of
debtors
= 1,165 + 53,801 – 756 = Rs.54,210
54,210
Daily sales = 360 = Rs.150.58
960.5
Average collection period = 150.58 = 6.38 days
Average Accounts payable
=
Opening balance of acounts payables + Clo sin g balance of accounts payables
2
2,500 + 7,500
= 2 = Rs.5,000
6,000
Average purchases per day = 360 = Rs.16.67
5,000
Average payment period = 16.67 = 300 days
Calculations of weights:
Weight to raw material = Raw material consumed per day/ Sales per day = Rs.14.86/150.58
= 0.099
Processing cost excluding raw material = Rs.18.66 – Rs.14.86 = Rs.3.8
Weight to WIP =
Raw material cos t consumed perday + (0.50 × Pr occe sin g cos t per day)
Sales per day
= (14.86 + 0.5 × 3.8 )/150.58 = 0.1113
Cost of goods sold per day

Weight to Finished Goods = Sales per day

Weight to finished goods = Rs.127.24/ Rs.150.58 = 0.845
Sales per day Rs.150.58
Weight to Accounts receivables = Sales per day = Rs.150.58 = 1
Purchases per day

Weight to Accounts Payables = Sales per day = Rs.14.86/Rs.150.58 = 0.099

Duration of weighted operating cycle = (Dr x Wr) + (Dw x Ww) + (Df x Wf) + (Dd x Wd)
– (Dp x Wp)
= (254.04 x 0.099) + (3.42 x 0.1113) + (6.83 x
0.845) + (6.38 x 1) – (300 x 0.099) = 7.98 days
b. Working capital requirements = (Sales per Day x Weighted operating cycle) + Required
Cash balance
Working capital requirement = (150.58 x 7.98) + 5,000 = Rs.6,201.63

Page 14 of 18
 ⎡ D⎤ < TOP
2. ⎢ ROI + (ROI - K d ) E ⎥ >
a. ROE = ⎣ ⎦ ( 1– t)
EBIT 150
1
ROI = Total assets = (800 + 250 + 150) = 0.125 i.e., 12.5%
Kd = 10% (given)
t = 36% (given)

D 800
E = (250+150) = 2
∴ ROE = [ 0.125 + (0.125 – 0.10) × 2] (1–0.36) = 0.112 i.e., 11.2%
Total asset = Total debt + Net worth
= Total debt + (Paid up equity capital + Retained earnings)
b. Targeted ROE = 11.2 + 4.8 = 16%
Let the required amount of additional debt be D :
∴ Total debt = 800 + D
Equity = 250 + 150 = 400
⎡ (800 + D) ⎤
⎢ 0.125 + (0.125 - 0.10) 400 ⎥⎦ (1 – 0.36)
∴ 0.16 = ⎣
0.025 (800 + D)
or 0.25 = 0.125 + 400
0.125 800 + D
=
or 0.025 400
or 5.00 × 400 = 800 + D
or D = (5.00 × 400) – 800 = 1,200
∴ Additional debt to be taken in the current year = Rs.1,200 lakh
∴ Total debt in the current year should be = 1,200 + 800 = Rs.2,000 lakh.
3. a. An alternative which would ensure the highest market price per share should be < TOP
recommended. Estimated earnings per share (EPS) and market price per share (MPS) under >
the various financing plans are as follows:
At
Particulars Plan (1) Plan (2) Plan (3)
Present
Earnings before interest and tax
(EBIT) 6,00,000 9,00,000 9,00,000 9,00,000
at the rate of 12% on Rs.75 lakh
(Rs.)
Less: Interest – Old 56,000 56,000 56,000 56,000
Interest- New – – 1,20,000 2,00,000
Profit before tax (PBT) 5,44,000 8,44,000 7,24,000 6,44,000
Less: Tax @ 33% 1,79,520 2,78,520 2,38,920 2,12,520
Profit after tax (PAT) 3,64,480 5,65,480 4,85,080 4,31,480
Less: Preference dividend – 1,08,000 1,08,000 1,08,000 1,08,000
Old (Rs.)
Profit for equity shares 2,56,480 4,57,480 3,77,080 3,23,480
No. of equity shares 20,000 40,000 28,000 20,000
EPS 12.82 11.44 13.47 16.17
P.E. Ratio – 21.4 17.0 15.7
Market price per share (EPS × – 244.82 229.00 253.87

Page 15 of 18
 P.E. Ratio)

Recommendation: The objective of financial management is to maximize the wealth of the

owners, which in the context of companies means maximizing the market price of the
company’s equity shares. The above analysis shows that the market price per share in
debenture financing (plan 3) is Rs.253.87, which is maximum. EPS is higher in the case of
debenture financing without undue financial risk. Therefore, debenture financing alternative
is recommended.
b. Indifference point on between alternative plans 1 and 3:
(EBIT – Rs.56,000)(1 – T) ÷ 40,000 = (EBIT – Rs.2,56,000)(1 – T) ÷ 20,000
EBIT – Rs.56,000 = 2(EBIT – Rs.2,56,000)
EBIT = Rs.5,12,000 – Rs.56,000 = Rs.4,56,000.
4. An enterprise-wide risk management culture encompasses several features, some of the principal < TOP
attributes of which, as discerned in practice, are indicated here: >
• An awareness of risk pervades the enterprise. Performance measurement and pricing are risk
adjusted. The priorities of risk management are reflected in the compensation schemes
thereby encouraging risk-taking behavior that is aligned with the capacity to bear risk. The
analysts and the stakeholders obtain a more complete understanding of the risks undertaken
with the help of risk-adjusted forecasts and returns.

Risks are identified, reported and quantified to the greatest possible extent. This means setting up
extensive historical risk and loss databases, and identifying risks precisely. Some risks can be
quantified while some risks elude quantification. Nevertheless, both quantifiable and
unquantifiable is avoided. The risk charter of the United Bank of Switzerland typically lists
reputation protection or reputation risk, generally avoided in reporting, as one of its five risk
factors.

The risk culture is defined and enshrined within the organization. The risk appetite of the
enterprise is clearly understood in all its spheres. Risk management is aligned with that culture to
give managers and employees the desired freedom for taking the right course of action
irrespective of the entrepreneurial or conservative culture of the film.

The firm does not venture into those products and/or businesses that are not comprehended by the
enterprise with regard to commercial feasibility. To know enough so as to understand the
adversities involved with reasonable levels of estimation is proper risk management. A
product/business that delivers excellent profits, is nevertheless found by the management to have
inherent risks beyond the accepted level of complexity and is kept aside. Not to do what is not
understood is the general prescription.
5. ERM is the discipline by which an organization in any industry assesses, control, exploits, < TOP
finances and monitor risks from all sources for the purpose of increasing the organization’s short >
and long-term value to its shareholders.
The corporate environmental policies serve the following objectives:
• Reduction of costs through measures such as recycling or energy conservation.

Improvement of the company’s reputation.

Motivation of employees by providing a better environment.

Improvement of relationships with regulatory authorities in general and the government in

particular.

Minimizing the possibility of accidents.

Conforming to a code of ethics

The following are the different approaches for managing environmental issues:
Page 16 of 18
 • First approach is a strong commitment to environment friendly processes or products through
heavy investments.

Firm can influence environmental regulations invest in environment protection and force other
firms to make similar investments.

The firm may be able to invest in environmental performance improvement, without any
reduction in profits.

Combination of product differentiation, competition management and cost saving to change the
basis for competition and redefine the market so that both the firm and the environment can
benefit.

The last approach is on risk manage perspective, calling for a systematic method to deal with
risks such as accidents and activist attacks.
Section C: Applied Theory
6. The Alcar model uses the discounted cash flow analysis to identify value-adding strategies. < TOP >
According to this model, there are seven ‘value drivers’ that affect a firm's value. These are
• The rate of growth of sales

Operating profit margin

Income tax rate

Incremental investment in working capital

Incremental investment in fixed assets

Value growth duration

Cost of capital.

Value growth duration refers to the time period for which a strategy is expected to result in a
higher than normal growth rate for the firm. The first six factors affect the value of the
strategy for the firm by determining the cash flows generated by a strategy. The last term, i.e.
the cost of capital affects the value of the strategy by determining the present value of these
cash flows. The following figure represents the Alcar approach.
According to the model, a strategy should be implemented if it generates additional value for
a firm. For ascertaining the value generating capability of a strategy, the value of the firm's
equity without the strategy is compared to the value of the firm's equity if the strategy is
implemented. The strategy is implemented if the latter is higher than the former. The
following steps are undertaken for making the comparison.
Calculate the value of the firm's equity without the strategy: The present value of the expected
cash flows of the firm is calculated using the cost of capital. The cash flows should take the
firm's normal growth rate and its effect on operating flows and additional investment in fixed
assets and working capital into consideration. The cost of capital would be the weighted
average cost of the various sources of finance, with their market values as the weights. The
value of the equity is arrived at by deducting the market value of the firm's debt from this
present value.
Calculate the value of the firm if the strategy is implemented: The firm's cash flows are
calculated over the value growth duration, taking into consideration the growth rate generated
by the strategy and the required additional investments in fixed assets and current assets.
These cash flows are discounted using the post-strategy cost of capital. The post-strategy cost
of capital may be different from the pre-strategy cost of capital due to the financing pattern of
the additional funds requirement, or due to a higher cost of raising finance. The PV of the
residual value of the strategy is added to the present value of these cash flows to arrive at the

Page 17 of 18
 value of the firm. The residual value is the value of the steady perpetual cash flows generated
by the strategy, as at the end of the value growth duration. The value of the post-strategy
market value of debt is then deducted from the value of the firm to arrive at the post-strategy
value of equity.
The value of the strategy is given by the difference between the post-strategy value of the
firm's equity and the pre-strategy value of the firm's equity. A strategy should be accepted if it
generates a positive value.
7. A brief description of some non-financial measures of performance is presented below. < TOP >
a. Employee Productivity: This can be measured by calculating output obtained per
employee or sales affected per employee or the value added per employee. In addition to
the measurement of employee productivity it is possible to measure the output per unit
of the inputs consumed i.e. a measure of overall productivity.
b. Marketing Effectiveness: This would measure the success of the marketing efforts put
in by the divisions. For this purpose, a report on market position must be obtained from
the divisional managers. The market position is represented by the percentage of sales to
total sales in the market and also by the ability of the division to meet the outside
competition successfully. An appraisal has to be made of each of the major products
handled by the division including an analysis of the product market leadership, superior
or inferior of features in the own product compared with outsider's product.
c. Employee Morale and Attitude: This is a vital aspect of performance. The divisional
managers sometimes ignore the impact of their decisions on employees in an attempt to
maximize production and profitability. It is, therefore, necessary to evaluate whether
during the last one-year employee morale has decreased or increased. Absolute precision
in measurement of this element of performance is seldom possible and if attempted,
could be a time consuming process. Hence, a judgment made by a team of executives
after a thread-bare discussion may be sufficient for this purpose.
d. Social Responsibility: Contribution of social responsibility can also be considered as
one of the measures of performance. The managers can sometimes deliberately ignore
this aspect of performance in their bid to show a high amount of profit or return on
capital employed.
e. Qualitative Aspects of Performance: The qualitative aspects must also figure in the list
of performance measures. These include – the number of complaints received from
customers, the errors and frauds, timely submission of daily, weekly and monthly reports
to higher authorities, regularity of attendance in meetings, etc.
f. Management practices: Adherence to better corporate governance eg. Transparency in
the operations, investment handling of investors, client’s grievances dealing with
creditors, debtors and development of human resources etc. all reflect the type of
management practices being followed.

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