Professional Documents
Culture Documents
30. Which of the following is a variable that can be analyzed at the generic level as per the Mckinsey < Answer >
approach?
(a) Return on invested capital
(b) Product mix and Product design
(c) Customer mix and Customer relationship
(d) Level of capacity utilization
(e) Cost of managing inventories.
END OF SECTION A
The number of requisitions raised on the stores was 20 for each product and the number of orders
executed was 42, each order being a batch of 10 units of a product.
You are required to find out:
a. The total costs for each product if all overhead costs are absorbed on the basis of machine
hour.
b. The total costs for each product using Activity-Based Costing.
(2 + 6 = 8 marks)
< Answer >
3. The finance manager of Kalidas Computers Ltd is of the opinion that in the process of
discriminating the high-credit worthy accounts and the low-credit worthy, the two key ratios that
can be employed for discrimination are the current ratio and the earning power where the former is
the ratio of current assets to current liabilities and the latter is the ratio of the earnings before
interest and tax to the total assets. High credit worthy and low credit worthy information relating to
fourteen accounts comprising an equal number of the above mentioned accounts are given below:
High-credit worthy accounts Low-credit worthy accounts
Client Current ratio Earning Client Current Earning
number capacity (%) number ratio capacity (%)
1 1.25 15 8 0.86 10
2 1.43 18 9 0.66 8
3 1.68 15 10 0.49 6
4 1.89 22 11 0.52 9
5 2.12 20 12 0.72 –6
6 0.95 16 13 0.58 7
7 1.05 12 14 0.41 –3
You are required to establish the appropriate discriminant function that best discriminates
between the high-credit worthy accounts and the low-credit worthy accounts.
(9 marks)
Caselet 1
Read the caselet carefully and answer the following questions:
< Answer >
4. For evaluating business performance both in financial and non-financial terms there is a
necessity for the investors to look beyond the ubiquitous information furnished by the media.
There is a tendency among the investors to overlook critically important indicators that would
otherwise have enabled them to better discern the firm’s potential for wealth creation. Do you
agree? Justify your opinion.
(7 marks)
< Answer >
5. There are different groups of people who read the financial statements, each looking for
different types of information. Earnings might be the most important area for investors, but
other areas of information are also of extreme significance. In this backdrop, explain how
notes to accounts and Management Discussion and Analysis provide insights to the investors.
(8 marks)
Because there are literally hundreds of things about a company to examine when analyzing its stock, it is tough to know
where to start. Most investors are good at evaluating earnings, growth rates, revenue, and the P/E ratio, but they also
tend to overlook other aspects that can be just as important.
One of the items which the average investor tends to ignore is cash flow. This represents the constant flow of money in
and out of a company. All companies provide separate cash flow statements as part of their financial statements, but cash
flow can also be estimated as net income plus depreciation and other non-cash items. The second aspect, which is also
generally overlooked by the typical investor, is the management. This is one aspect of a company that can make a world
of difference. Think of management in terms of sports: Michael Jordan might not have been the "whole show" during his
reign at the Chicago Bulls, but he was undoubtedly a huge contributing factor to their success. The same is true for the
management of a business.
Further receivables and the finished goods inventory are two items in the balance sheet on which the average investor
does not place enough emphasis. Receivables represent the sales for which the company has yet to collect the money.
Sales drive accounts receivable, so when sales are growing, accounts receivable will grow at a similar rate. Inventory of
the finished goods available for sale ties in closely with accounts receivable.
Two other items which the investors tend to lose sight of, in the maze of details that are present in any annual report are
the notes to accounts and the Management Discussion and Analysis (MD&A). These are the items, which contain vital
information which cannot be expressed in very objective terms or quantifiable in the financial statements.
The technique of looking at the overall company and its outlook is sometimes referred to "qualitative analysis," and it is
a perspective that is often forgotten. Peter Lynch once stated that he found his best investments by looking at the trends
his children follow.
Assessing a company from the fundamental/qualitative standpoint is one of the most effective strategies for evaluating a
potential investment, and it is as important as looking at sales and earnings. These overlooked areas are by no means the
only things investors need to evaluate, but looking at more than just the obvious will give you that extra advantage over
other investors. Earnings are important, but earnings are also the most widely published financial figure for any
company, so why base an investment decision solely on what other people already know? The moral here is always to
dig deeper by doing solid research so that you can aim to be a step ahead of the crowd.
Caselet 1
Read the caselet carefully and answer the following questions:
< Answer >
6. No one predict an industry’s cycle precisely and any single forecast of performance may lead
to enormous conclusions. Given this, suggest a methodology for valuation of cyclical
companies.
(8 marks)
< Answer >
7. Discuss how mangers can exploit the cyclical nature of their industry.
(5 marks)
Companies in industries prone to significant swings in profitability present special difficulties for mangers and
investors trying to understand how they should be valued. In extreme cases, companies in these so called cyclical
industries-airline travel, chemicals, paper, and steel, for example – challenge the fundamental principles of valuation,
particularly when their shares behave in ways that appear unrelated to the discounted value of their underlying cash
flows. The DCF values is far less volatile than the underlying cash flows. Indeed, there is almost no volatility in the
flows. The DCF values is far less volatile than the underlying cash flows. Indeed, there is almost no volatility in the
DCF value because no single year’s performance affects it significantly. In the real world, of course, the share prices
of cyclical companies are less stable.
On the assumption that the market values of companies are linked to consensus earnings forecasts, when these
consensus earnings forecasts were examined for clues it was found that these forecasts appeared to ignore cyclicality
entirely by almost always showing an upward trend, regardless of whether a company was at the peak or the trough of
a cycle. Earnings forecasts generally have a positive bias. Sometimes this is attributed to the pressures faced by equity
analysts at investment banks. Analysts might fear that a company subjected to negative commentary would cut off
their access or that a pessimistic forecast about a company that is a client of the bank they work for could damage
relations between the two. In light of these, it is reasonable to conclude that analysts as a group are unable or
unwilling to predict the business cycle for these companies. Business cycles, and particularly their inflection points,
are hard for any one to predict. Given this, how the market ought to behave? Should it be able to predict the cycle and
thus avoid fluctuations in share prices? However, that might be asking too much; at any point, a company or industry
could break out it its cycle and move to a new one that is higher or lower.
END OF SECTION B
Suggested Answers
Strategic Financial Management (MB361F) : July 2006
Section A : Basic Concepts
1. Answer : (b) < TOP >
Reason : ABC costing is more expensive than the traditional costing. In many production processes,
overheads are applied to products using a single predetermined overhead rate based on a
single activity measure, but in ABC costing, multiple activities are identified in the
production process that are associated with costs. It is based on historical costs. Therefore
statements (I) and (III) are true and statement (II) is not true. Hence (b) is the answer.
2. Answer : (b) < TOP >
Reason : A non-growth strategy refer to that strategy where there is no growth in earnings, but not
necessarily turnover. Statement (a) is not true.
A company can pursue a non-growth if it rates its non-economic objectives higher than its
economic objectives. Statement (b) is true.
A non-growth strategy is bound to be a corrective strategy. Statement (c) is not true.
A corrective strategy can be used in conjunction with, or as one component of, a growth
strategy. Statement (d) is not true.
The long-term objectives of the company include both survival and growth of the firm.
Statement (e) is not true.
Hence (b) is the answer.
3. Answer : (d) < TOP >
Reason : Working capital/Total assets ratio is a balance sheet ratio. In the L C Gupta model, balance
sheet ratios are only the (Net Worth/Total Debt) and (All outside liabilities/Tangible assets)
ratios. All the other key ratios found suitable in predicting failure are profitability ratios.
4. Answer : (a) < TOP >
Reason : In option (a), the assumption is that their values are zero. Other options are correct with
respect to the possible procedures that can be used in order to deal with the real option.
5. Answer : (d) < TOP >
Reason : The business environment of the firm consisits of the state of the economy, resoruce
availability, external governance groups and internal governance groups.
The operational structure of the firm consists of the capital structure decisions, decision
regarding the size of the company and the production function, interanl audit, and decision
regarding the financial sructure of the company.
The financial structure decisions typically comprises o the ownership structure, financial
leverage, dividend and stock repurchase policies and the executive compensation plans.
Hence (d) is the answer.
6. Answer : (c) < TOP >
Reason :
(EBIT-I1 )(1-T) (60 − 0)(0.6)
= = 3.6
No.of shares 10, 00, 000
(EBIT-I 2 )(1-T)
3.6 =
No.of shares
(60-8)(0.6)
3.6 =
x
X = 8.67 lakhs
Therefore 1.33 lakh (10 lakh – 8.67 lakh) shares should be bought back.
∴Answer is (c).
7. Answer : (c) < TOP >
Reason : While price to book ratio depends upon the return on equity, growth rate of dividends and
the cost of equity under the Marakon approach, the value created for shareholders is
measured by the difference between the book value of equity B and the market value of
equity M, where M stands for how productively the firm has employed its equity or capital
contributed by the shareholders.
Therefore statement (III) is not true and statements (I) and (II) are true. Hence (c) is the
answer.
answer.
8. Answer : (d) < TOP >
Reason : Firm’s cost of equity increases with leverage. Statement (I) is wrong, higher the leverage,
higher the beta of the firm. Statement (II) is wrong. Therefore (d) is the answer.
9. Answer : (e) < TOP >
Reason : When the current ratio is less than 1.00 (a), the current assets are less than current liabilities
i.e. net working capital is negative. Such a situation indicates that short term funds have been
used for long term purposes. Quick ratio (Quick assets / Current liabilities) may be less than
1.00 even when the current ratio is more than or equal to 1.00. Hence (a) is incorrect. Total
debt to equity is greater than 1.00 does not imply that current ratio will be less than 1.00.
Hence (b) is incorrect. A positive net working capital implies that some part of the long term
sources of funds have been invested in short term uses (current assets). Hence (e) is the
correct answer.
10. Answer : (b) < TOP >
Reason : Target costing is based on external analysis of markets and competitors, and is a cost
management tool that reduces a product’s costs over its entire life cycle. But it is difficult to
use in the presence of complex products because on the one hand, analysis of costs needs to
be performed at various levels, while on the other, the activity of tracking costs becomes
more complicated and cumbersome. Hence statemetns (a), (c), (d) and (e) are true and
statement (b) is not true. Hence (b) is the answer.
11. Answer : (c) < TOP >
Reason : As per the Wilcox model, the net liquidation value of a firm is the best indicator of its
financial health. The net liquidation value is the excess of the liquidation value of the firm’s
assets over the liquidation value of the firm’s liabilities. Liquidation value is the market
value of the assets and liabilities at the time of dissolution. Hence (c) is the answer.
12. Answer : (e) < TOP >
Reason : The tracking portfolio approach seeks to develop tracking portfolios for which the present
value of the tracking error is zero. Statement (I) is not true.
Tracking error is the difference between the cash flows of the tracking portfolios and the
cash flows of the projects. Statement (II) is true.
Strategic planning models are normative strategies that consider the firm as an organic entity
that is more interested in self-preservation. Statement (III) is true.
Hence (e) is the answer.
13. Answer : (d) < TOP >
Reason : Agency costs are costs on account of restriction imposed by creditors on the firm in the form
of some protective covenants. Commission payable by the company to its purchasing and
selling agents , the expenses incurred in distribution of the products of the company, or the
dividends paid by the company does not come under the agency cost. Hence (d) is the
answer.
14. Answer : (d) < TOP >
Reason : Open market repurchases are not very effective signals for under valuation of company’s
stock as compared to tender offers because open market repurchases are executed at the
prevailing market prices and do not have any premium content. Dutch auctions are also very
less informative than fixed price offer as signals of under valuation. In Dutch auction
outside shareholders play an active role in establishing terms of trade. Hence option (d) is
the answer.
15. Answer : (c) < TOP >
Reason : Interest cost:
Total assets = Rs.180M; debt = 60% × Rs.180M = Rs.108 million in debt.
Interest cost = Rs.108M × 0.10 = Rs.10.8 million.
Net income (in millions):
EBIT Rs.36.0
less: Interest – 10.8
EBT Rs.25.2
less: Taxes (@40%) – 10.08
Net income Rs.15.12
The portion of project financed with retained earnings:
Retained earnings portion: 20M x 0.40 = Rs.8.0 million
Debt portion = Rs.20M x 0.60 = Rs.12.0 million
The residual available for dividends = Rs.15.12M – Rs.8.0M = Rs.7.12 million in dividends
16. Answer : (b) < TOP >
3bσ2
3 + LL
Reason : RP = 4I
10
I = 360 = 0.0278%
Reason : Comparative analysis is an important tool for assessing the financial strength of an
organization within the industry.
19. Answer : (c) < TOP >
Reason : According to the Alcar 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
Obviously, dividend growth rate is a factor not considered in this model. So the correct
answer is (d).
21. Answer : (b) < TOP >
Reason : Increase in the average collection period, increase in the finished goods storage period,
increase in the raw materials storage period and increase in the work-in process period all
result in increasing the operating cycle of the firm. Only increase in the average payment
period decreases the net operating cycle of the firm. Hence option (b) is correct.
< TOP >
22. Answer : (d)
Reason : Risk avoidance is an extreme way of managing risk by not undertaking the activity that
entails risk. Loss control refers to the attempt to reduce either possibility of or the quantum
of loss. Risk is transferred when the firm originally exposed to a risk transfers it to another
party which is willing to bear the risk. Derivative instruments are used to transfer the risk.
Risk is retained when nothing is done to avoid. The combinations of risk retention and risk
transfer is known as risk sharing. Separation is the technique of reducing risk through
separating parts of businesses or assets or liabilities.
< TOP >
23. Answer : (a)
Reason : Shortage in supply of raw materials is an external factor, others are internal factors.s
24. Answer : (d) < TOP >
Reason : P/B = (r – g)/(k – g)
= (25 – 5)/(15 – 5) = 2.00.
25. Answer : (d) < TOP >
Reason : Current ratio is defined as the ratio between the current assets and current liabilities. While
Quick Ratio is calculated by dividing current assets minus inventories by current liabilities.
Now, among the components of the current assets, inventories are the least liquid
instruments. So, a decreasing quick ratio and same value of the current ratio implies the
increasing volume of inventory, thereby indicating the decreasing level of liquidity
26. Answer : (d) < TOP >
Reason : Expected return from the equity shares of the firm does not figure out when assessing the
present value of an investment by the risk adjusted discount rate method.
27. Answer : (b) < TOP >
Reason : As per Pecking order theory of financings, the preferred order of finance for firms are as
follows: internal equity, debt, preference capital and external equity.
28. Answer : (c) < TOP >
Reason : Economic risk takes into account the long-term consequences of the change in currency
value.
29. Answer : (e) < TOP >
Reason : ERM speaks about some advanced areas of risk management, such as technology risk, anti-
trust risk, environment risk, political risk etc., and all the statements are true.
30. Answer : (a) < TOP >
Reason : At generic level, the variables that reflect the achievement or non-achievement of the
objective of value maximization most directly are identified.
Section B : Problems/Caselets
1. The total cash required over the planning period = Rs. 15,00,000 x 3 = Rs. 45,00,000
The average annual yield on the securities can be determined as follows:
100 (1+ r) 5 = 177
=> r = 12.09 %
Therefore, the yield for three month period = 3%
Fixed conversion cost = Rs. 500 per conversion.
According to Baumol model, the total cost is minimized when conversion size (C ) is given by
2bT I
C= where b= Fixed cost per conversion
T = Total cash required during the planning horizon
I = Yield on marketable securitiesover the planning horizon
Substituting the given values, we get
2 × 500 × 45, 00, 000 0.03
= Rs.3,87298.33
Therefore, the company needs to convert Rs.387298 worth of securities per conversion in order to minimize the
total cost.
< TOP >
2. a. Calculations showing overheads assigned on an Machine Hour Rate Basis
Total overheads = Machine Department Cost + Set-up costs + Stores consumables +
Inspection/quality control + Materials handling and dispatch
= 10430 + 5250 + 3600 + 2100 + 4620
= 26,000
Machine Hours = (output in units) × (Machine Hours per unit)
Product Stereo headphones = 120 × 4 = 480
Product External Modem = 100 × 3 = 300
Product UPS = 80 × 2 = 160
Product Foot Pedals = 120 × 3 = 360
Total Machine Hours 1,300
Total Overheads
Total Machine Hours
Machine Hour Rate =
Rs 26, 000
= 1,300
= Rs 20/- per MHR
Statement showing cost per unit per product
(Rs.)
Products
Particulars Stereo External Modem UPS Foot Pedals Total
headphones
Direct Material 40 50 30 60 180
Direct Labour 28 21 14 21 84
Overheads absorbed 80 60 40 60 240
(Machine Hour Rate × Machine
Hour per unit)
Cost per unit 148 131 84 141 504
Total cost per product 17760 13100 6720 16920 54500
Total cost per product 17760 13100 6720 16920 54500
(Cost per unit × Output in
units)
b. Calculations showing overheads assigned on ABC Basis
Application rate of cost driver for overheads
i. Machine Department
Machine Dept. cos t 10430
=
Total machine Hrs 1300
= Rs.8.0231 per machine hour rate
Total Setup cost
No.of production runs
ii. Setup costs =
Total number of output units of all products 420
No.of requisition raised for each product
No. of Production runs = = 20 = 21
5250
Setup costs = 21 = Rs.250 per production run
Totalstores + Com mod ity cos t 3600
No.of requisitions raised 20 × 4
iii. Stores & Consumables = = Rs.45 per requisition
Inspection / QC cos t 2100
No.of production runs
iv. Inspection/QC = = 21 = Rs.100 per production run
Material handling & dispatch cost 4620
No.of orders executed
v. Materials handling and dispatch = = 42
= Rs.110 orders executed.
Products
Particulars Stereo External Foot Total
UPS
headphones Modem Pedals
Number of Production Runs 6 5 4 6 21
Number of stores requisition 20 20 20 20 80
No. of Sales order (deduced from 12 10 8 12 42
information)
Calculations of the cost per unit and the total costs of each product (Rs.)
Products
Particulars Stereo External UPS Foot
headphones Modem Pedals
Direct Material 40.00 50.00 30.00 60.00
Direct Labour 28.00 21.00 14.00 21.00
Overheads:
i. Machine Department (MHR) 32.09 24.07 16.05 24.07
ii. Setup costs 12.50 12.50 12.50 12.50
iii. Stores receiving 7.50 9.00 11.25 7.50
iv. Inspection / QC 5.00 5.00 5.00 5.00
v. Materials handling and dispatch 11.00 11.00 11.00 11.00
Total overheads 68.09 61.57 55.80 60.07
Cost per unit 136.09 132.57 99.80 141.07
Total cost per product 16,331.08 13,256.92 7983.69 16928.31
Gr. II
8 0.86 10 -0.18 -0.64 0.0324 0.4096 0.1152
9 0.66 8 -0.38 -2.64 0.1444 6.9696 1.0032
10 0.49 6 -0.55 -4.64 0.3025 21.5296 2.552
11 0.52 9 -0.52 -1.64 0.2704 2.6896 0.8528
12 0.72 -6 -0.32 -16.64 0.1024 276.8896 5.3248
13 0.58 7 -0.46 -3.64 0.2116 13.2496 1.6744
14 0.41 -3 -0.63 -13.64 0.3969 186.0496 8.5932
Xm = 14.61/14 = 1.04
Xm1 = Sum of Xi for Gr. I/7 = 10.37/7 = 1.48
Xm2 = Sum of Xi for Gr. II/7 = 4.24/7 = 0.61
Ym = 149/14 = 10.64
Ym1 = Sum of Yi for Gr. I/7 = 118/7 = 16.86
Ym2 = Sum of Yi for Gr. II/7 = 31/7 = 4.43
5. As a preface to the annual report, a company's management typically spends a few pages talking about the recent
year (or quarter) and gives a background of the company. While this is not the guts of the financial statements, it
does give investors a clearer picture of what the company does. It also points out some key areas where the
company has performed well. The management's analysis is provided at their discretion, so take it for what it's
worth. Issues that analysts might look for in this portion are how candid and accurate are the managers' comments,
does the manager discuss significant financial trends over past couple years, how clear are the managers comments
and do they mention potential risks or uncertainties moving forward? If a company gives an adequate amount of
information in the MD&A, it's likely that management is being honest. It should raise a red flag if the MD&A
portion of the financial statement ignores serious problems that the company has been facing. A good example
would be a company that is known to have large portions of outstanding debt but fails to mention anything about it
in the MD&A. Withholding important information not only deceives those who read the financial statements, but in
extreme cases also makes the company liable for lack of disclosure.
Similarly, the notes to the financial statements (sometimes called footnotes) are also an integral part of the overall
picture. If the income statement, balance sheet, and statement of cash flow are the heart of the financial statements,
then the footnotes are the arteries that keep everything connected. If the analyst does not read the footnotes he may
be missing out on a lot of information.
The footnotes list important information that could not be included in the actual ledgers. The notes list relevant
things like outstanding leases, the maturity dates of outstanding debt, and even details on where the revenue
actually came from. Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business.
This portion of the footnotes tells about the nature of the company's business, when its fiscal year starts and ends,
how inventory costs are determined, and any other significant accounting policies that the company feels that you
should be aware of. This is especially important if a company has changed accounting policies. It may be that a
firm is changing policies only to take advantage of current conditions to hide poor performance.
Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the
financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To
maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt such
as maturity dates and the interest rates at which debt was issued, can give you a better idea of how borrowing costs
are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to
details about ominous legal proceedings the company is involved in.
The majority of investors and analysts read the balance sheet, income statement, and cash flow statement. But for
whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking
for information that others typically wouldn't.
< TOP >
6. No one can predict an industry’s life cycle precisely, and any single forecast of performance has to be wrong. But
managers and investors can benefits by explicitly following the probabilistic approach to valuing cyclical
companies. This approach avoids the traps of a single forecast and makes it possible to explore a wider range of
outcomes and their implications.
The following method of valuing cyclical companies involves creating two scenarios. This approach provides an
estimated of a company’s value and scenarios an estimate that puts boundaries on the valuations. Managers can use
the boundaries to think about how they should modify their strategies and possible ways of responding to signals
that one scenario was more likely to materialize than another.
Step 1
Construct and value the “normal-cycle” scenario using information about past cycles. Using information about
past earnings cycle pay particular attention to the long term line of operating profits, cash flow, and return on
invested capital because this will affect the valuation. Make sure the continuous value is base on a “normalized”
level of profit- that is, on the company’s long term flow trend line
Step 2
Construct and value a “new trend – line scenario” based on recent performance. Again, focus most on the long-
term trend line because it will have the greatest impact on value.
Step 3
Develop an economic rationale for each scenario, considering factors such as growth in demand, technological
changes that will affect the balance of supply and demand, and the entry or exit of companies into the industry.
Step 4
Assign probabilities to the scenarios and calculate then weighted value, basing it on your analysis of the likelihood
of the events leading to each of them.
< TOP >
7. Managers have detailed information about their markets and might thus be expected to do a better job than the
stock market at predicting the cycle and reacting appropriately. However, managers do exactly the opposite and
exacerbate the problem. Cyclical companies often commit themselves to big capital spending projects just when
prices are high and the cycle is hitting its peak. They then proceed to retrench when prices are low. Some develop
forecasts that are quite similar to those issuing form equity analysts: upward sloping, regardless of where in the
cycle the company is. In doing so, these companies send wrong signals to the stock market.
Rather than spreading confusion, managers should learn to expoit their superior knowledge. They could first
improve the timing of capital expenditures and then follow up with a strategy of issuing shares at the peak of the
cycle and repurchasing them at the trough. The most aggressive managers could take this one step further and adopt
a trading approach for acquiring assets at the bottom of the cycle and selling them at the top. In this way, a typical
cyclical industry could more than double its returns.
< TOP >