Question Paper

Strategic Financial Management: Theory and Practice (MB3H2F): October

2008
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. Cellulose Industries earns 10% on its equity and the growth rate of dividends and earnings is 5%. The
>
number of shares outstanding is 16,00,000. The current market price per share of Cellulose Industries is
Rs.140 and its cost of equity is 11%. If Marakon model holds good, the net worth of the company is
(a) Rs.15,32,42,080
(b) Rs.16,32,42,080
(c) Rs.17,32,42,080
(d) Rs.26,88,00,000
(e) Rs.27,32,42,080.
<Answer
2. LC Gupta model for predicting bankruptcy of a firm considers profitability ratios and balance sheet ratios.
>
Which of following ratios comes under the profitability ratios of LC Gupta Model?
I. EBDIT/Net sales.
II. Operating cash flow/Total assets.
III. Net worth/Total debt.
IV. Operating cash flow/sales.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (II) and (III) above
(d) (I), (II) and (III) above
(e) (I), (II) and (IV) above.
<Answer
3. Real Traders Ltd., has furnished the following information pertaining to its capital structure:
>
Particulars Rs. in crore
Equity capital (100 lakh equity shares of Rs.10 each) 10
Reserves 2
10% Debentures of Rs.100 each 3
For the year ended 2008, the company has paid equity dividend at the rate of 20%. As the company is a
market leader and dividend is likely to grow by 5% every year. The equity shares are currently trading at
Rs.80 per share. If the income tax applicable to the company is 35%, the current weighted cost of capital of
the company is
(a) 7.40%
(b) 9.50%
(c) 10.13%
(d) 11.34%
(e) 12.87%.
 <Answer
4. Betavision Ltd., has provided the following information pertaining to its operations for a period trial
>
months:
Units produced and sold 15,000
Sale price per unit Rs. 200
Variable cost per unit Rs. 172
Total fixed cost Rs.2,10,000
If the units (produced and sold) increase by 10%, the percentage change in EBIT will be
(a) 10.25%
(b) –11.80%
(c) 12.80%
(d) –18.50%
(e) 20.00%.
<Answer
5. The method that involves making a tender offer to shareholders of the firm to repurchase their shares
>
without fixing predetermined price is known as
(a) Open market repurchase
(b) Fixed price tender offer
(c) Dutch auction tender offer
(d) Stock split
(e) Stocks repurchase.
<Answer
6. Fostering ideal work culture usually involves:
>
I. Hiring people with leadership potential.
II. Articulation of strong corporate purpose.
III. Attempting to control employees using stringent measures.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
<Answer
7. Which of the following assumptions is false with respect to Baumol Model?
>
(a) Cash expenses are incurred evenly over the planning period
(b) Securities for a particular sum are converted into cash at a regular frequency
(c) The cash requirement for the period under consideration is known in advance
(d) Conversion cost depends upon the amount of securities converted
(e) All cash surplus is initially parked in short-term securities.
<Answer
8. Two firms Digital Ltd., and Analog Ltd., are similar in all respects, except that Digital Ltd., is unlevered,
>
while Analog Ltd., has Rs.6 crore of 14% debentures outstanding. Both companies have a net operating
income of Rs.1.2 crore each. The tax rate applicable to both the companies is 40%. The discount rate for
both the companies is 12% p.a. The value of Analog Ltd., considering Modigliani-Miller position on
leverage holds good is
(a) Rs.5.32 crore
(b) Rs.6.82 crore
(c) Rs.7.52 crore
(d) Rs.8.40 crore
(e) Rs.9.22 crore.
<Answer
9. Going for an IPO and making a division as an independent operating firm is referred to as
>
(a) Spin-off
(b) Split-off
(c) Split-up
(d) Carve-out
(e) Divestiture.
 <Answer
10 The term agency costs in the context of capital structure means
>
.
(a) The commission payable by a company to its purchasing agents
(b) The commission payable by a company to its selling agents
(c) The expenses incurred in distribution of the products of the company
(d) The cost on account of restrictive covenants imposed on a company by its lenders
(e) The dividends paid by a company to its shareholders.
<Answer
11 Which of the following models is based on numerical assessment of the firm’s weaknesses that are
>
. classified as defects, mistakes and symptoms?
(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
12 Which of the following is not a ‘value driver’ that affects the value of a firm according to Alcar Model?
>
.
(a) Operating profit margin
(b) Income tax rate
(c) Cost of capital
(d) Growth rate of sales
(e) Book value of the firm.
<Answer
13 Using derivatives like forwards, swaps and futures to hedge the risk is an example of
>
.
(a) Risk avoidance
(b) Loss control
(c) Risk transfer
(d) Risk sharing
(e) Risk separation.
<Answer
14 JayPee Constructions is considering following five projects:
>
. (Rs. in lakh)
Project Initial investment NPV
1 1,000 210
2 6,000 1,560
3 5,000 850
4 2,500 500
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
15 Electrum Ltd., is engaged in manufacturing electronic instruments. The financials of the company are as
>
. follows:
Particulars (Rs. in lakh)
Currents assets 285.50
Fixed assets 450.00
If there is an increase of 20% in current assets, the working capital leverage of the company will be
(a) 0.36
(b) 0.38
(c) 0.39
(d) 0.42
(e) 0.46.
 <Answer
16 Which of the following statements is false with respect to target costing?
>
.
(a) Target costs are predetermined costs calibrated from an internal analysis by industrial engineers
(b) Target costing lead to market driven approach to accounting
(c) A target cost is the maximum manufacturing cost for a product
(d) Target cost is the excess of the sales price for the target market over the pre-determined margin of
profit
(e) Target costing reduces product costs over its entire life cycle.
<Answer
17 As per value chain concept, which of the following areas is/are useful for profit improvement?
>
.
I. Linkages with suppliers.
II. Linkages with customers.
III. Process linkages within the value chain of the firm.
(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.
<Answer
18 Which of the following is false for Certainty Equivalent Approach?
>
.
(a) Each period’s cash flow can be adjusted separately to account for the specific risk of cash flows
(b) The approach provides a clear basis for making decisions
(c) The certainty equivalent ranges from 0 to 1
(d) The firms cost of capital is used as a discount rate for the estimation of the net present value
(e) Higher the factor the more certain is the expected cash flow.
<Answer
19 An option that enables a firm to manage its capacity in response to changing market condition is
>
.
(a) Investment timing option
(b) Abandonment option
(c) Growth option
(d) Flexibility option
(e) Foreign currency option.
<Answer
20 Reyon Ltd., has a target ROE of 14%. The financial leverage of the company is 0.5. The corporate tax rate
>
. applicable to the company is 30%. If the average cost of debt is 9.5%, the ROI that the company should
earn to achieve the target ROE is
(a) 16.50%
(b) 18.25%
(c) 19.35%
(d) 20.20%
(e) 21.22%.
<Answer
21 As per Porter’s Five Forces model of industry analysis, a firm can take an advantage over its rival firm by
>
.
I. Using constant price policy.
II. Improving the product differentiation and distribution system.
III. Exploiting relationship with suppliers.
(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
22 Which of the following statements is/are true with respect to financial statement analysis?
>
.
I. Trade creditors use the financial statement analysis to know the liquidity position of the firm.
II. Long-term creditors use the financial statement analysis to know the long-term solvency of the firm.
III. Investors use the financial statement analysis to know the earnings of the firm.
(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.
 <Answer
23 Sunrise Ltd., has total sales of Rs.6,00,000. The inventory turnover ratio is 5. If its current liabilities are
>
. Rs.1,50,000 and acid-test ratio is 2, the total current assets of the company is
(a) Rs. 2,15,000
(b) Rs. 3,12,000
(c) Rs. 4,20,000
(d) Rs. 5,15,000
(e) Rs. 6,35,000.
<Answer
24 Which of the following is/are the primary reason(s) for adopting non-growth strategy?
>
.
I. Lack of enough additional staff with sufficient expertise and loyalty.
II. High cost of additional funds in the market.
III. Pressure from public opinion.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
<Answer
25 Suppose a project has profitability index of 0.85, it indicates
>
.
(a) PV of the project is 85 times greater than project’s cost
(b) NPV of the project is zero
(c) NPV of the project is positive
(d) NPV of the project is negative
(e) Ratio of NPV to initial investment is 85%.
<Answer
26 Which of the following statements is/are false?
>
.
I. When a company wants to reduce the number of outstanding shares, it can resort to stock split.
II. Stock splits have no implications on the proportion of an individual stakes in the company.
III. A stock repurchase is considered to have a greater signaling power than regular dividend pay-out.
(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
27 Which of the following current assets is considered least liquid?
>
.
(a) Cash
(b) Debtors
(c) Inventories
(d) Short-term securities
(e) Prepaid expenses.
<Answer
28 Consider the following information pertaining to DNA Ltd.:
>
.
Annual yield on marketable securities 10%
Fixed conversion cost Rs. 900
Standard deviation of change in daily cash balance Rs. 200
Lower control limit Rs.50,000
Assuming there are 360 days in a year the return point of DNA limited as per Miller-Orr model is
approximately
(a) Rs.61,480
(b) Rs.54,598
(c) Rs.41,484
(d) Rs.32,580
(e) Rs.25,482.
 <Answer
29 Which of the following is/are the firm specific cause(s) of financial distress?
>
.
I. Barriers to entry.
II. Threat to entry.
III. Leverage.
IV. Rivalry among competing firms.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) All (I), (II), (III) and (IV) above.
<Answer
30 Which of the following statements is/are false about Value at Risk?
>
.
I. VaR is an estimate of the level of gain on a portfolio, which is expected to be equalized or exceeded
with a given small probability.
II. VaR is also used to identify risk arising out of individual assets or individual liabilities, which can be
aggregated later for the whole firm.
III. A portfolio having a VaR of Y at 95% confidence level implies that there is a 5 percent probability of
the portfolio’s value falling by less than Y.
(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.
END OF SECTION A
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 Gadgets Ltd., is a popular consumer electronics manufacturing firm. Demand for its products is <Answer
. increasing day by day and company has an expansion plan to cater this growing demand. For >
the purpose of expansion, company is considering the following two financing alternatives:
I. Raising the entire amount as term loans @ 15% p.a.
II. Issue of shares at a price of Rs.10 per share.
The total fund requirement of company for expansion program is Rs.100 lakh. The company’s
profitability statement prior to expansion is summarized as follows:
Particulars (Rs. in lakh)
Sales 1,300
Less: Cost excluding depreciation 1,000
EBDIT 300
Less: Depreciation 50
EBIT 250
Less: Interest 50
PBT 200
Less: Tax @ 35% 70
PAT 130

No. of shares 50 lakh

EPS Rs.2.60
The various possible values of EBIT after expansion and probabilities associated with each of
the values are as follows:
EBIT (Rs. in lakh) Probability
300 0.10
 500 0.30
600 0.50
700 0.10
You are required to:
a. Calculate company’s expected EBIT, EPS, standard deviations of EPS and coefficient of 1 marks
variation for each plan and make the inference from the calculated values. (0 )
b. Find the indifference point between the two plans. marks
(3 )
2.Dataone Ltd., would like to segregate its client profile into good accounts and bad accounts on <Answer>
the basis of the current ratio and net profit margin. Given below is the information relating to
14 accounts consisting of an equal number of good accounts and bad accounts:
Good accounts Bad accounts
Net Profit Net Profit
Current Client Current
Client Margin Margin
ratio ratio
(%) (%)
A 1.80 31 H 0.95 23
B 1.75 26 I 0.82 26
C 1.62 18 J 0.70 15
D 1.50 22 K 0.63 11
E 1.40 19 L 0.75 10
F 1.70 12 M 0.83 8
G 1.45 18 N 0.22 5
From the above information, you are required to estimate the discriminate function that best
discriminates between good accounts and bad accounts.
(10marks)
3.Flyovers Ltd., a popular construction company operating in Hyderabad expects some degree of <Answer>
certainty to generate following net income and the capital expenditure during next 5 years:
Net Income (NI) Capital expenditure (CE)
Year
(Rs. in lakh) (Rs. in lakh)
1 60 20
2 50 25
3 26 32
4 21 40
5 16 50
The company currently has 15 lakh equity shares and pays dividend of Rs.6 per share.
You are required to calculate:
a. Dividends per share if the dividend policy is treated as residual decision.
( 3 marks)
b. Amount of external financing that will be necessary if the present dividend per share is
maintained. ( 3 marks)
c. Amount of external financing that will be necessary if the dividend pay out ratio of 40%
is maintained. ( 3 marks)
Caselet
Read the caselet carefully and answer the following questions:

4.As per the caselet, Enterprise Risk Management (ERM) is fast becoming the best practice <Answer>
standard because the traditional approach to managing risk has not produced effective results.
Explain the steps included in an enterprise risk management program.
( 9 marks)
5.Complexity of business is increasing day by day and risk management is becoming challenging <Answer>
task. Discuss various areas in which board and senior managers can play an active role to
manage the increasing risk.
( 9 marks)
One of the reasons why risk management has received so much ongoing attention is that
financial disasters seem to occur on a regular basis to remind us of the perils of “not getting it
right”. A few years ago, risk management problems led to the collapse of Barings, Kidder, and
Confederation Life, as well as huge losses related to derivatives trading at other companies.
More recently, global financial markets were threatened by the near collapse of the once high-
flying Long Term Capital Management and the resultant losses at leading financial institutions
that had to fund a $3.5 billion bailout of the hedge fund.
As a result of these wake-up calls and internal risk reviews, leading companies are abandoning
their traditional approach of “managing risk by silos”, whereby different types of risks are the
responsibility of various corporate and business units. Instead, they are adopting an Enterprise
Risk Management (ERM) approach.
ERM is fast becoming the best-practice standard because the traditional approach to managing
risk has not produced effective results. More importantly, organizations that have adopted a
more integrated approach to managing enterprise-wide risks have experienced significant benefits.
In the past, risk management was highly fragmented from an organizational perspective. For
example, business units manage the business risks associated with their overall strategy and
profitability, such as products, pricing, and relationship management; credit and lending units
managed the credit risks associated with lending, trading, portfolio management, and workout
activities; trading, market risk and asset/liability units managed the market/interest rate risks
associated with the investment, trading, and asset/liability portfolios; operations and
technology units managed the operational risks associated with transaction processing and
systems; other units with risk management responsibilities such as finance and accounting,
legal and compliance, security, audit and insurance provided additional corporate oversight.
Over time, it has been increasingly apparent that such a fragmented approach, or “managing
risk by silos,” simply doesn't work because risks are highly interdependent and cannot be
segmented and managed solely by independent units. Moreover, a segmented approach to risk
management doesn't provide senior management and the board with aggregated risk reporting.
This realization has led to the trend towards enterprise risk management, which is supported by
internal demand, external developments, and advances in risk management methodology.
Organizations that have adopted an enterprise risk management approach have experienced
significant and tangible benefits, including an increase in shareholder value, reduction in losses
and earnings volatility, and general improvements in the measurement and management of
overall risks. After all, managing earnings should not mean accounting trickery, but the
proactive management of the underlying drivers of earnings.
Today, the role of the CRO has been widely adopted in risk-intensive businesses such as
financial institutions, energy firms, and non-financial corporations with significant investment
activities and/or foreign operations. At last count, there are over 50 CROs at various
institutions. Some people in a CRO role use other titles, such as Chief Market and Credit
Officer, Principal Risk Officer, and EVP of Risk Management. Nonetheless, these individuals
are responsible for multiple risk functions. In many instances, the CRO reports to the CFO or
CEO, and some CROs have a direct reporting line to the board of directors. Reporting to the
CRO are the heads of credit risk, market risk, operational risk, insurance, and portfolio
management. Other functions that the CRO is commonly responsible for include capital
management, risk analytics and reporting, and the heads of risk management at the business
units.
END OF CASELET

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.

6. Innovation cycles have become shorter in the present day unlike in the past, <Answer>
when they were long. Probably the most important reason is the growing
importance of software and knowledge inputs as opposed to hardware and
physical capital. Under such scenario, how do you manage innovations? ( 10 marks)
 7. To avoid conflict of interest in an organization, various compensation plans <Answer>
have been designed. The very use of executive compensation plan is to align
the interest of managers and shareholders and thus bring in more shared
interests on the part of both shareholders and managers. However, it has
been observed that most of the compensation plans fail to produce the
desired results. Discuss various reasons behind the failure of executive
compensation plans and write down important steps that should be
considered while designing compensation contract. ( 10 marks)

END OF QUESTION PAPER

Suggested Answers
Strategic Financial Management: Theory and Practice (MB3H2F): October 2008
Section A : Basic Concepts
Answer Reason
< TOP >
1. D
P0 =
P0, is Current market price of the firm’s share
B, is Current book value per share
r, is the return on equity
g, is the growth rate in earnings and dividends
b, is the dividend pay-out ratio

140 =
8.4 = 0.05B
B = Rs.168
Total net worth = Rs.168 × 16,00,000 = Rs.26,88,00,000
2. E In the LC Gupta model, balance sheet ratios are only the Net Worth/Total Debt and all < TOP >
outside liabilities/Tangible assets ratios. All the other given ratios are profitability
ratios used in LC Gupta Model for predicting the bankruptcy of a firm.
3. A Cost of debt capital = 10 (1 – 0.35) = 6.50% < TOP >
Cost of equity capital = [2(1.05) ÷ 80] + 0.05 = 0.07625 or 7.625%

Current weighted cost of capital = + = 0.074 or 7.4%.

4. E EBIT at 15,000 units = 15,000 (Rs.200 – Rs.172) – Rs.2,10,000 = Rs.2,10,000 < TOP >
EBIT at 15,000 × 1.10 = 16,500 units = 16,500 (Rs.200 – Rs.172) – Rs.2,10,000 =
Rs.2,52,200.
% increase = (Rs.2,52,200 – Rs.2,10,000) ÷ Rs.2,10,000 = 0.20 or 20%
5. C The method that involves making a tender offer to shareholders of the firm to < TOP >
repurchase their shares without fixing predetermined price is known as Dutch auction
tender offer.
6. C Fostering the ideal work culture involves various steps: < TOP >
• Hiring people with leadership potential rather than just managerial potential.
• Articulating strong corporate purpose that makes people believe that they are
making positive impact on society.
• Treating people with dignity and respect.
• Interacting regularly with employees.
• Attempting to influence rather than control employees.
7. D As per the assumption of the Baumol model the conversion is a fixed sum, irrespective < TOP >
of the securities converted.
< TOP >
8. D
Value of Analog Ltd.= +B×t = + 6 × 0.40
= Rs.6 + Rs.2.4 = Rs.8.40 crore.
9. D Doing an IPO of a division and making it independent operating firm is referred as < TOP >
Carve out
10. D Agency costs are costs on account of restriction imposed by creditors on the firm in the < TOP >
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.
11. E Argenti Score Board is based on numerical assessment of the firm’s weaknesses that < TOP >
are classified as defects, mistakes and symptoms.
12. E Amongst the given alternatives, ‘book value of the firm’ is not a value driver as per the < TOP >
Alcar model. Hence, alternative (e) is answer.
13. C Three ways of risk transfer are as under: < TOP >
• Transferring the asset itself.

Use of hedging instruments like forwards, futures, swaps and options.

Buying insurance.
14. B < TOP >
Cash inflows
Initial investment NPV (PV)
Project (Rs. lakh) (Rs. lakh) (Rs. lakh) 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
< TOP >
15. A
Working capital leverage = = 0.36
16. A Target cost is based on external analysis of markets and competitors. Hence option (a) < TOP >
is false.
17. E From the strategic planning perspective, the value chain concept highlights three < TOP >
potentially useful areas.
i. Linkages with suppliers.
ii. Linkages with customers.
iii. Process linkages within the value chain of the firm.
18. D In certainty equivalent approach the risk free rate and not the firm’s cost of capital are < TOP >
used as a discount rate for the estimation of the net present value. Hence option (d) is
the answer.
19. C Growth option enables a firm to manage its capacity in response to changing market < TOP >
conditions. Hence option (c) is said to be the option.
20. A ROE = [ ROI + (ROI- kd) D/E] (1-t) < TOP >
0.14 = [x + (x – 0.095) 0.5] (1-0.30)
0.14 = [x + 0.5x – 0.0475] 0.70
0.14= 0.70x + 0.35x – 0.03325
0.17325 = 1.05x
x = 16.5%.
21. E According to Five Forces model a firm can take an advantage over the rival firm by < TOP >
changing prices (raising or lowering prices), improving product differentiation, creative
use of distribution system and exploiting relationship with suppliers.
22. E Trade creditors use the financial analysis to know the liquidity position of the firm. < TOP >
Long-term creditors use the financial statement analysis to know the long-term
solvency of the firm. Investors use the financial statement analysis to know the earning
capacity of the firm. Hence, all the given statements are true and the answer is (e).
23. C Current assets – Inventories = Current liabilities x Acid test ratio = 1,50,000 x 2 = < TOP >
Rs.3,00,000
Sales = inventories x Inventories turnover ratio
= X × 5 = Rs.6,00,000.
X= Rs. 1,20,000
Total current assets = 1,20,000 + 3,00,000= Rs.4,20,000.
24. D The primary reasons for using non-growth strategy may include: < TOP >
• Pressure from public opinion.

Maintain an acceptable quality life.

Lack of enough additional staff with sufficient expertise and loyalty.

Enable the owner-manager to retain personal control over operations.

Diseconomies of scale of a particular production set-up.

25. C The profitability index is the ratio of net cash inflows from the project to the cash < TOP >
outflows. So, any value greater than zero indicates positive NPV.
26. A Stock splits involve increase in number of shares outstanding through a decrease in the < TOP >
par value of share. Conversely a company might want to reduce the number of
outstanding shares, it can accomplish this through a reverse stock split. A stock
repurchase is not a regular event and is taken as pointer on the degree of
undervaluation. Hence stock repurchase is considered to have strong signaling power
than regular dividend pay-out.
27. C As the liquidity of the inventories depends on the demand for specific product, < TOP >
therefore, they are less liquid than other current assets.
< TOP >
28. B
RP =

= Rs.54598 (Approx).
29. C Major firm specific factors that contribute substantially to firm’s risk of financial < TOP >
distress are:
• Ownership and governance structures
• Operating risk
• Leverage.
 30. D VAR is an estimate of the level of the loss and not the gain on a portfolio that is < TOP >
expected to be equaled or exceeded with a given small probability. A portfolio having a
VAR of Y at 95% confidence level implies that there is a 5 percent probability of the
portfolio’s value falling by more, and not less than Y. Though not usable in isolation to
quantify risk, VAR is also used to identify risk arising out of individual assets or
individual liabilities that is summed up to compute the VAR for the organization as a
whole.

Section B : Problems/Caselet
1 a. <
. TO
P>

Plan I – Raising entire amount as term loans @ 15%p.a.

(Rs. in lakh)
EBIT 300 500 600 700
Less: Interest 65 65 65 65
PBT 235 435 535 635
Tax @35% 82.25 152.25 187.25 222.25
PAT 152.75 282.75 347.75 412.75
No. of shares 50 50 50 50
EPS 3.05 5.65 6.95 8.25

Plan II – Issue of shares:

EBIT 300 500 600 700
Less: Interest 50 50 50 50
PBT 250 450 550 650
Tax @35% 87.5 157.5 192.5 227.5
PAT 162.5 292.5 357.5 422.5
No. of shares 60 60 60 60
EPS 2.71 4.90 5.95 7.04

As the coefficient of variation is lower in case of issue of shares it is preferable.

b. EBIT Indifference Point
2 <
. TO
CustomerAccou × P>
Xi Yi
nt

Gr. I A 1.80 31  0.65 13.57 0.42 184.14 8.82

B 1.75 26  0.6 8.57 0.36 73.44 5.14
C 1.62 18  0.47 0.57 0.22 0.32 0.27
D 1.50 22  0.35 4.57 0.12 20.88 1.6
E 1.40 19  0.25 1.57 0.06 2.46 0.39
F 1.70 12  0.55 ‐5.43 0.30 29.48 ‐2.99
G 1.45 18  0.3 0.57 0.09 0.32 0.17
Gr. II H 0.95 23  -0.2 5.57 0.04 31.02 ‐1.11
I 0.82 26  -0.33 8.57 0.11 73.44 ‐2.83
J 0.70 15  -0.45 ‐2.43 0.20 5.9 1.09
K 0.63 11  -0.52 ‐6.43 0.27 41.34 3.34
L 0.75 10  -0.4 ‐7.43 0.16 55.2 2.97
M 0.83 8  -0.32 ‐9.43 0.10 88.92 3.01
N 0.22 5  -0.93 ‐12.43 0.86 154.5 11.55
Total 16.1
2 244  3.31 761.36 31.42
Average 1.15 17.43 
n 14

3 a. <
.
Balance TO
Year NI CE (Rs.) DPS = Balance/ P>
(1) (2) (Rs.) (3) (Rs.) (4) = (2)-(3) No. of shares
1 6000000 2000000 4000000 2.67
2 5000000 2500000 2500000 1.67
 3 2600000 3200000 - -
4 2100000 4000000 - -
5 1600000 5000000 - -
b. Total amount of dividend per year = 1500000 * 6 = Rs.90,00,000
NI Dividends CE Ex. Financing
(1) (2) (3) (4) = (2) + (3) – (1)
6000000 9000000 2000000 5000000
5000000 9000000 2500000 6500000
2600000 9000000 3200000 9600000
2100000 9000000 4000000 10900000
1600000 9000000 5000000 12400000
Rs.4,50,00,000 Rs.4,44,00,000
c.
NI Dividends CE Ex. Financing
(1) (2) (3) (4) = (2) + (3) – (1)
6000000 2400000 2000000 0
5000000 2000000 2500000 0
2600000 1040000 3200000 1640000
2100000 840000 4000000 2740000
1600000 640000 5000000 4040000
Rs.69,20,000 Rs.84,20,000
4 The steps toward an enterprise risk management program include: <
. • Creating an enterprise risk management organization, through the appointment of a chief risk officer and the TO
P>
formation of an enterprise risk management committee. The enterprise risk management committee is
responsible for directing all credit, market, and operational risk management activities, as well as
coordinating corporate over sight units such as insurance, security, audit, and compliance. This organization
often reports to the CEO or CFO, and increasingly has a direct reporting relationship to the board.
Establishing an integrated risk management framework to measure and manage all aspects of risk. These risks
include credit risks such as lending and counterparty exposures; market risks such as interest rate, foreign
exchange, equity, and commodity exposures; business risks such as volatility in volumes, margins, or costs;
and operational risks ranging from day-to-day processing errors to fraud and other low-probability but high-
severity events.
Optimizing the return on risk management investments by linking risk management processes and risk transfer
strategies. Typically, different functions within an organization make separate buying decisions in risk
management, including the purchase of risk methodologies from consulting firms, risk models from
technology companies, derivatives from investment banks and insurance policies from insurance companies.
However, the right hand often doesn't know what the left hand is doing. By linking internal risk processes and
external risk transfer, management can improve effectiveness in achieving the organization's risk objectives,
as well as improve efficiency in terms of achieving those objectives at the lowest cost.
Leveraging risk management to make better business decisions by incorporating risk/return considerations in
product development and pricing, relationship management, investment and portfolio management, and
mergers & acquisitions. Leading organizations recognize that risk management is not just about protecting
against the downside, but that it can be a powerful tool for improving business performance. A risk-centric
business management approach can help management identify and grow businesses with the highest risk-
adjusted returns and thus maximize shareholder value.
5 Role of the Senior Management <
. The board and the senior managers need to send strong signals that they consider risk management a priority. The TO
board should play an active role in identifying the risks that may have a significant impact on the fulfillment of P >
corporate objectives. It should review information on these significant risks from time to time. The board
should come to a consensus regarding what risks are acceptable, the probability of their occurrence and the
type of mechanisms and processes needed to reduce their impact. The board should realize that whatever be the
sophistication of the control systems and processes, risks due to poor judgment, human error and unforeseen
circumstances can never be completely eliminated. It should be emphasized that the role of the board is not to
advocate complete elimination of risk. In a competitive market place, not taking risks could turn out to be a risk
in itself. In fact, if effective risk management processes are in place, the board may decide that more risks have to
be taken to exploit the opportunities available for the business to succeed in the long run. The board and the
senior management team should play an active role in the following areas:
• Understanding the Risk Profile: The board members should clearly understand the risks to which the
company is exposed. The board should further decide which risks are acceptable and which must be
eliminated through the use of hedging techniques.

Setting Policy: The board should prepare policy guidelines, including the corrective action to be taken when
things go wrong. For example, there should be guidelines on when and how to unwind an unprofitable
position, if rates move unfavorably. The exit strategy should be based on the amount of money the company is
willing to put to risk.

Establishing Controls: Steps should be taken to ensure effective implementation of policies. An

independent risk management unit is desirable. Ideally, risk managers should not report to traders. It is a
good practice to make risk managers report to people one level higher than those who execute and approve
derivative transactions.

Setting-up Systems: The most expensive but integral part of a comprehensive risk management function is
consolidation and integration of data from a number of different systems across the company's operations.

Checking Compliance: The risk manager should send reports regularly to the senior management and the
board. These reports should check compliance with policies and procedures and make independent
evaluations of the various derivatives positions. The reports should also indicate whether the positions are
synchronous with the company's accounting department and with the disclosures in the company's financial
reports.

Periodic Review: The board must make it clear to traders and treasury managers that any violation of
policies, guidelines or controls will be punished. When limits are violated, the board should not hesitate to
takeimmediate action and send clear signals that indiscipline will not be tolerated.
Section C: Applied Theory
6. Managing Innovations < TOP >
There are broadly two types of innovations product and process. Product innovation refers to
work done to improve the product. Some product innovations are truly radical, such as the
Sony Walkman. Others are incremental, such as adding new features to a. color television set.
Process innovations aim to make the manufacturing process more efficient through
automation, simplification, better process control and lower energy consumption. Normally,
the product and the process innovations are interdependent. In the early stages of the product
life cycle, product innovations tend to be rapid. As the rate of product innovation decreases, it
is common to observe a faster rate of process innovation. But the relative importance of
product and process innovation depends on the nature of the industry. Peter Drucker has listed
seven sources of opportunity for innovative organizations. In order of increasing difficulty and
uncertainty, they are:
The unexpected success that makes a company happy, but is rarely dissected to see why it
occurred.
The incongruity between what actually happens and what was supposed to happen.
The inadequacy in an underlying process that is taken for granted.
The changes in industry or market structure that catch everyone by surprise. The demographic
changes caused by wars, medical improvements and even superstition.
The changes in perception, mood and fashion due to the ups and downs of the economy.
The changes in awareness caused by new knowledge.
Successful technology management is all about bringing a new concept to the market in the
most efficient way. To commercialize an idea successfully, a number of different stages must
be completed, each more difficult than its predecessor. Not only must each of these stages be
completed successfully, but also adequate resources be mobilized to facilitate transition from
one stage to the next.
Imagining: Developing the initial insight about the market opportunity for a particular
technical development.
Incubating: Nurturing the technology sufficiently to gauge whether it can be commercialized.
Demonstrating: Building prototypes and getting feedback from potential investors and
customers.
Promoting: Persuading the market to adopt the innovation.
 Sustaining: Ensuring that the product or process has a long life in the market.
The first three stages obviously cannot be managed like an ordinary business with tight
controls. So they have to be fostered and nurtured in an environment that is culturally quite
different from normal corporate settings.
In order to develop a useful framework for commercializing technological innovations,
organizations must address three important issues.
What is the likelihood that customers will be attracted to the new technology?
What is the price that will attract the largest number of customers?
Will the new technology evolve into or help in building a profitable business?
Successful innovators focus on how the new product' or service will affect customers. They
look at the various stages of customer experience like purchase, delivery, use, maintenance
and disposal. They also consider the utility of the product in terms of environmental
friendliness, convenience, simplicity and customer productivity. In other words, they orient
product development activities towards the customer rather than the technology. The price
chosen by the innovator has to attract and retain a sufficiently large number of customers.
Innovations very often compete with other products that may look quite dissimilar but
perform the same function. What is important here is how people will compare the new
product with other very different-looking products and services. The price level will also
depend on the ease of imitation. If the product is difficult to imitate or well protected by
patents, a high price is possible. On the other hand, if imitation is easy, a low price becomes
essential. Successful innovators understand the importance of generating positive cash flows
as quickly as possible. They generate profits not by raising price but by keeping costs tightly
under control, consistent with the chosen price level. They improve materials selection,
simplify design processes and improve manufacturing efficiencies to cut costs. They may also
consider strategic outsourcing of non-core activities. Moreover, innovators compensate for
their lack of technological capabilities in some areas by partnering and forming alliances. In
spite of all these moves, if the price is still high and beyond the reach of target customers, they
look at options such as leasing or renting the product on a time-share basis, which are more
appealing to customers.
7. The basic reasons for the failure of the executive compensation plan can be enumerated as < TOP >
follows:
i. 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 the payment structure, companies sometimes tend to strive
for a bigger size irrespective of the fact that it adds to the value of the concern.
ii. Emphasis on short-term performance of the company. It has been frequently observed that
short-term performance indicators like sales and growth in the earnings provide a greater
weightage in the incentive compensation that is paid to the executive.
iii. More focus on the accounting measures is given while designing the compensation
contracts. Some of these measures are the earnings and the return on the investments.
Finally it is important to mention that while designing a well laid out
compensation contract, the following points need to be considered:
i. Integrating the incentive plan to the total compensation architecture of the firm.
ii. Choosing an appropriate level of risk bearing and focus on the time.
iii. Using the objective criteria.
iv. Selecting the right set of performance measure.
v. Discouraging parochial behavior.
vi. Abandoning the attempts to measure what the executives control.
vii. Lengthening the "decision making time horizon of the executives.
viii. Employing the stock options plans judiciously.
ix. Ensuring tax efficiency.