Question Paper Financial Management – II (142): January 2006
| · Answer all questions. · Marks are indicated against each question. |

1. | Which of the following long-term sources of finance puts maximum restraint on managerial freedom? (a) Retained earnings (b) Equity capital (c) Preference capital (d) Debenture capital (e) Term loan. (1 mark) | < Answer >
2. | Which of following is/are true with respect to rights issue? I. It involves the issue of securities to the existing shareholders and to the public simultaneously. II. It involves the issue of securities to the existing shareholders at a price, which is generally lower than the current market price. III. It generally entails lower cost of issue. IV. It is generally made to high networth individuals. (a) Only (I) above (b) Only (III) above (c) Both (II) and (III) above (d) Both (II) and (IV) above (e) All (I), (II), (III) and (IV) above. (1 mark) | < Answer >
3. | A company declares a rights issue of 1 share for every 5 shares held. An investor, who holds 1000 shares will have (a) 25 rights (b) 50 rights (c) 200 rights (d) 500 rights (e) 1000 rights. (1 mark) | < Answer >
4. | Which of the following statements is/are true regarding Earnings Price Ratio Approach? I. The ratio assumes that the growth in EPS is constant. II. The results are accurate, when the dividend pay-out ratio is 100 percent. III. The results are accurate, when the retained earnings are expected to earn a rate of return more than the cost of equity. (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. (1 mark) | < Answer >
5. | Which of the following is false? (a) If the probability of bankruptcy is very high, assets are likely to be sold at a significant discount to their true economic values (b) Bankruptcy entails high legal and administrative costs (c) Other things remaining the same, the probability of bankruptcy is lower for a levered firm than for an unlevered firm (d) The equity shareholders expect a higher rate of return from a firm, which is faced with the problem of bankruptcy (e) Beyond a threshold level, the probability of bankruptcy increases at an increasing rate, as the debt-equity ratio increases. (1 mark) | < Answer >
6. | Traditional Incorporation’s balance sheet shows debt of Rs.74.20 million. The firm has 16 million outstanding shares, and the market price of each share is Rs.7.5 (Face Value Rs.10). It is considering to issue Rs.45 million more debt and use the cash to repurchase its equity at current market price. Management estimates that as a result of this restructuring, the market price per share will jump to Rs.11. The value lost, if the firm doesn’t take up the restructuring is (a) Rs.0 million (b) Rs.20 million (c) Rs.25 million (d) Rs.32 million (e) Rs.35 million. (2 marks) | < Answer >
7. | The following details are available regarding the long term sources of finance of M/s. Surendra Infotech Ltd.:
Source of finance | Range of new financing from the source (Rs. crore) | Post tax cost (%)
Equity | 0 – 10 | 14
| 10 – 20 | 15
| 20 & above | 16
Preference | 0 – 2 | 13
| 2 & above | 14
Debt | 0 – 12 | 8
| 12 – 18 | 9
| 18 & above | 10
The company is considering expanding its operations and requires Rs.50 crore for the same. It is planning to raise funds in the following proportions:
Equity shares | 0.4
Debt | 0.4
Preference shares | 0.2
The weighted marginal cost of capital of new financing in the range of Rs.25 crore – Rs.30 crore is (a) 11.4% (b) 12.0% (c) 12.8% (d) 13.0% (e) 13.2%. (2 marks) | < Answer >
8. | Deepti Financials Ltd. has 2,00,000 equity shares each trading at Rs.20 in the market. In addition to equity, it has Rs.10,00,000, 10% Preference share capital and Rs.30,00,000, 14% Debenture capital. The expected dividend next year is Rs.2 per share, which will grow at 7% forever. If the company raises an additional Rs.10,00,000 debt by issuing 15% debentures, the expected dividend increases to Rs.3 and the price of share falls by 25% from the current market price. However, the growth rate remains the same. The company falls under the tax bracket of 30%. If the company issues additional debt, the change in the weighted average cost of capital approximately is (a) 1.37% (b) 1.90% (c) 2.24% (d) 2.94% (e) 3.12%. (2 marks) | < Answer >
9. | Consider the following data for Floak Ltd:
Year | 1 | 2 | 3 | 4 | 5
Earnings Per Share (Rs.) | 4.80 | 4.00 | 3.00 | 5.00 | 4.50
Payout (%) | 63 | 75 | 67 | 60 | 67
Price per share at the end (Rs.) | 42.00 | 45.00 | 33.00 | 38.00 | 36.00
If the price at the beginning of year 1 is Rs.40, the realized yield over the five year period is (a) 4.75% (b) 5.06% (c) 5.25% (d) 6.25% (e) 7.00%. (2 marks) | < Answer >
10. | Which of the following approaches is not applicable to measure cost of equity? (a) Dividend forecast approach (b) Realized yield approach (c) Capital asset pricing model approach (d) Earning price ratio approach (e) Miller and Modigliani approach. (1 mark) | < Answer >
11. | Which of the following is not an internal device for containing agency cost? (a) Separation of management and control (b) Linking managerial compensation to share holder returns (c) Development of a market for corporate control (d) Establishment of system for performance monitoring (e) Establishment of system for responsibility accounting. (1 mark) | < Answer >
12. | Which of the following statements best explains the fact that capital structure policy reflects a trade-off between risk and return? (a) Increasing debt will increase stockholder’s risk but will decrease the expected rate of return (b) Increasing debt will increase stockholder’s risk and will also increase the expected rate of return (c) Increasing business risk will increase stockholder’s risk and will also increase the expected rate of return (d) Increasing business risk will increase stockholder’s risk but will decrease the expected rate of return (e) Increasing debt will decrease stockholder’s risk but will increase the expected rate of return. (1 mark) | < Answer >
13. | Which of the following statements is/ are true? I. The presence of personal tax increases the value of the tax shield in any way. II. The value of a levered firm is more than the value of an unlevered firm because of the presence of tax shield. III. The value of tax shield is lower due to uncertainty in its utilization. (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. (1 mark) | < Answer >
14. | The cost of debt remains more or less constant up to a certain degree of leverage but rises there after at an increasing rate. This proposition is based on (a) Net income approach on capital structure (b) Net operating income approach on capital structure (c) Traditional approach on capital structure (d) Modigliani and Miller approach (e) Merton Miller’s argument. (1 mark) | < Answer >
15. | A company is expecting annual net operating income (EBIT) of Rs.2,00,000. The company has Rs.5,00,000, 10% debentures. The equity capitalization rate of the company is 15%. Assuming that there are no taxes, total cost of capital would be (a) 11.00% (b) 12.14% (c) 13.33% (d) 14.24% (e) 15.00%. (2 marks) | < Answer >
16. | Quick and Trans Industries Ltd. has the following capital structure: Equity share capital: There are 1,50,00,000 equity shares of Rs.10 each fully paid up. Presently the shares have a market price of Rs.27 per share. The cost of equity capital is 14.4%. Debentures: There are 20,00,000 debentures of Rs.100 each. The coupon rate on these debentures is 10.8% and the current yield on these debentures is 11.25%. Term loan: The amount of term loan is Rs.80 crore and carries an interest rate of 12.5%. The market value of the term loan is equal to its’ book value. The tax rate applicable to the company is 30%. The weighted average cost of capital using market value weights would be (a) 10.22% (b) 10.81% (c) 10.95% (d) 11.29% (e) 11.84%. (2 marks) | < Answer >
17. | The following information is available from the books of Suvarangan & Co.
Total assets of the company | Rs.8 crore
Return on assets | 10%
Overall capitalization rate | 16%
Equity capitalization rate | 18%
Total interest on debt | Rs.0.06 crore
According to the net operating income approach, the approximate debt-equity ratio of Suvarangan & Co. would be (a) 0.17 (b) 0.22 (c) 0.30 (d) 1.00 (e) 1.50. (2 marks) | < Answer >
18. | In a world with corporate taxes but no possibility of firm’s financial distress, the value of the firm will be maximized, when (a) Pure debt is used (b) Pure equity is used (c) Debt and equity are used in equal proportion (d) Debt equity ratio is 2:1 (e) Debt equity ratio is 3:2. (1 mark) | < Answer >
19. | Which of the following statements is/are true? I. The total income available for both the stockholders and debenture holders is greater, when debt capital is used. II. If return on debt and stock are taxed at the same personal tax rate, corporate tax advantage remains intact. III. If returns on all types of personal income as well as corporate income are taxed at the same rate, the tax advantage of debt capital is equal to the amount of debt times (1-tax rate). (a) Only (II) above (b) Both (I) and (II) above (c) Both (I) and (III) above (d) Both (II) and (III) above (e) All (I), (II) and (III) above. (1 mark) | < Answer >
20. | Which of the following can be inferred from the Miller and Modigliani model on dividend policy? (a) As the dividend payout ratio increases, the share price decreases, if the rate of return is greater than the cost of capital (b) As the dividend payout ratio decreases, the share price decreases, if the rate of return is less than the cost of capital (c) The dividend policy of the firm does not influence its value (d) Irrespective of the rate of return and cost of capital the share price increases, as the amount of dividend payout ratio increases (e) The optimal dividend pay out ratio should be 100% to maximize the value of the firm. (1 mark) | < Answer >
21. | Which of the following approaches to dividend policy assumes a constant amount of EPS? (a) Net income approach (b) Net operating approach (c) Walter approach (d) Gordon approach (e) Miller & Modigliani approach. (1 mark) | < Answer >
22. | Deccan Paints Ltd. has 10 lakh equity shares outstanding and these shares are traded in NSE at Rs.150 each. The rate of capitalization appropriate to the risk class to which the firm belongs is 12%. The net income for the year is Rs.2 crore and the investment budget is Rs.4 crore. Assume that no dividend is declared and the additional fund requirement is financed by new issue of equity shares. If Modigliani-Miller hypothesis holds good, the number of equity shares to be issued by the company is (a) 1,09,048 (b) 1,09,248 (c) 1,19,048 (d) 1,19,248 (e) 1,29,348. (2 marks) | < Answer >
23. | Consider the following information regarding Swapna Ltd.
Face value of the share | Rs.10
Market price of the share | Rs.30
Cost of equity capital | 15%
Internal rate of return | 13%
Expected earnings per share | Rs.10
If the market price per share has to increase by 100% from current level, according to Walter’s model on dividend policy, the dividend payout ratio of the company should be approximately (a) 0% (b) 12% (c) 25% (d) 72% (e) 80%. (2 marks) | < Answer >
24. | Which of the following statements is/are true? I. According to the policy of stable dividend payout ratio, the rupee level of dividends may either remain stable or increase or decrease. II. As per the policy of stable dividend pay out ratio, the percentage of earnings paid out as dividends remains constant. III. Dividend pay out ratio is the ratio between earning per share and dividend per share. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (II) above (e) Both (II) and (III) above. (1 mark) | < Answer >
25. | While using IRR, NPV or PI in capital budgeting, (a) Mutually exclusive projects are always ranked the same (b) Direct estimates of the increase or decrease in shareholder value can be obtained (c) The time value of money is taken into account (d) Accounting measures of profit are considered (e) The methods are simple and decisions are intuitive. (1 mark) | < Answer >
26. | By maintaining a relatively stable dividend level, the firm I. Hopes to decrease holdings of its common shares. II. Hopes to increase the discount rate applied to future dividends. III. Hopes to decrease the discount rate applied to future dividends. IV. Hopes to reduce the uncertainty in the minds of investors. (a) Only (I) above (b) Both (I) and (II) above (c) Both (II) and (IV) above (d) Both (III) and (IV) above (e) (I), (II) and (IV) above. (1 mark) | < Answer >
27. | Prasanth Inc. has average inventory of Rs.5 million. Its estimated annual sales are Rs.80 million and the firm estimates its receivables conversion period to be thrice as long as its inventory conversion period. The firm pays its trade credit on time. The firm wants to decrease its net operating cycle by 12 days. It believes that it can reduce its average inventory to Rs.3 million, while maintaining the same level of sales. Assuming a 365-day year, by how much must the firm also reduce its accounts receivable to meet its goal of a 12-day reduction in its net operating cycle? (a) Rs.1.37 million (b) Rs.1.19 million (c) Rs.0.63 million (d) Rs.0.037 million (e) Rs.0.019 million. (2 marks) | < Answer >
28. | Which of the following is/are true regarding aggressive financing policy for current assets? I. The financing mix will be tilted towards equity. II. Risk of technical insolvency will be high. III. The cost of financing will be high. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) Both (II) and (III) above. (1 mark) | < Answer >
29. | Which of the following is/are true regarding a company following a conservative working capital policy? I. The company will finance its current assets more from long-term sources. II. The technical insolvency of the company will be high. III. The company will have a higher current ratio than the one following an aggressive working capital policy. IV. The company will have a lower current assets turnover ratio than the one following an aggressive working capital policy. (a) Only (I) above (b) Both (II) and (III) above (c) Both (III) and (IV) above (d) (I), (II) and (III) above (e) (I), (III) and (IV) above. (1 mark) | < Answer >
30. | Homemaker, a reputed washing machine manufacturer, plans to manufacture 12,000 sets of washing machines for the next year. The cost components are as follows:
Item | Unit Cost (Rs.)
Raw Material Manufacturing Expenses Selling, administrative and financial expenses | 5,000 2,000 1,000
The selling price per unit is Rs.10,000 and sales may be assumed to be uniform throughout the year, while the manufacturing expenses are expected to be incurred evenly throughout the month. The durations at various stages of the operating cycle are given below:
Raw material stage | 2 months
Work in process stage | 1 month
Finished goods stage | 1 month
Debtors stage | 3 months
If the minimum cash balance required is Rs.20,00,000, what is the estimate for the working capital requirement of the company? (a) Rs.350 lakh (b) Rs.400 lakh (c) Rs.450 lakh (d) Rs.500 lakh (e) Rs.560 lakh. (2 marks) | < Answer >
31. | Which of the following statements is true with respect to working capital management? (a) A policy of holding a relatively large proportion of the firms' total assets in the form of current assets will tend to result in a higher expected profitability or rate of return on the total assets of the firm (b) A policy of holding a relatively lower proportion of the firms' total assets in the form of current assets will tend to result in a constant amount of expected profitability or rate of return on the total assets of the firm (c) A policy of holding a relatively constant proportion of the firms' total assets in the form of current assets will tend to result in a higher expected profitability or rate of return on the total assets of the firm (d) A policy of holding a relatively constant proportion of the firms' total assets in the form of current assets will tend to result in a lower expected profitability or rate of return on the total assets of the firm (e) A policy of holding a relatively small proportion of the firms' total assets in the form of current assets will tend to result in a higher expected profitability or rate of return on the total assets of the firm. (1 mark) | < Answer >
32. | Under the recommendations of the Tandon committee, which of the following methods of lending ensures the highest current ratio? (a) Method I (b) Method II (c) Method III (d) Method IV (e) Same ratio under all the methods. (1 mark) | < Answer >
33. | Which of the following is/are not true? I. If the spread between credit period and cash discount period is greater, the cost of trade credit will be higher. II. If the spread between credit period and cash discount period is lower, the cost of trade credit will be higher. III. If the discount rate increases, the cost of trade credit decreases. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) Both (II) and (III) above. (1 mark) | < Answer >
34. | Indira Ltd. purchased raw materials from its suppliers on credit for 45 days. However, the supplier has offered a discount of 2% on early payment. If the cost associated with such credit terms is 21%, the discount period is approximately (assume 360 days in a year) (a) 8 days (b) 10 days (c) 13 days (d) 15 days (e) 26 days. (2 marks) | < Answer >
35. | Consider the following data regarding a product:
Total cost of ordering and carrying inventory | Rs.870
Quantity per order | 1,000 units
Carrying cost as a percentage of the purchase price | 3%
Fixed cost per order | Rs.100
Purchase price | Rs.10
The annual usage of the material is (a) 3,000 units (b) 7,200 units (c) 8,900 units (d) 9,000 units (e) 9,950 units. (2 marks) | < Answer >
36. | The average daily usage rates of inventory, lead time and their respective probabilities are as follows:
Daily Usage Rate (in units) | Probability | Lead time (in days) | Probability
150 360 450 | 0.20 0.50 0.30 | 20 35 | 0.60 0.40
The possible usage levels at which stock-outs can occur and the probability of stock-out respectively are (a) 3,000 units, 5,250 units and 7,200 units and 50% (b) 5,250 units, 7,200 units and 9,000 units and 56% (c) 9,000 units, 12,600 units and 15,750 units and 50% (d) 5,250 units, 9,000 units and 12,600 units and 46% (e) 7,200 units, 9,000 units and 12,600 units and 68%. (2 marks) | < Answer >
37. | Mr. Rudra, materials manager of a transformer manufacturing company procures annual requirement of the copper bolts from its supplier by four equal sized orders. The total number of copper bolts the company requires in a year is 6,00,000. The fixed cost per order is Rs.300. The market price of the each copper bolt is Rs.100. The carrying cost is 10% of the average inventory value. If Mr. Rudra decides to change from existing system to EOQ system, how much annual monetary benefit this decision would bring to the company? (a) Rs.60,000 (b) Rs.3,36,000 (c) Rs.6,91,200 (d) Rs.7,50,000 (e) Rs.7,51,200. (2 marks) | < Answer >
38. | Shelf stock refers to (a) Items that are stored by the firm and sold with little or no modification to customers (b) Items that are sold with a major modification to customers (c) Items that are stored by the firm and are not sold at all (d) Items that lost their value and are sold as scraps (e) Items that are stored by the firm and sold, when there is sudden increase in demand. (1 mark) | < Answer >
39. | Which of the following statements is/are incorrect? I. A stock out is a situation, when the firm does not have an item in stock but there is a demand for that from a customer or from production department. II. Stock out management requires a trade off between carrying cost and stock out cost. III. The economic order quantity is the order quantity that minimizes total ordering costs. (a) Only (I) above (b) Only (II) above (c) Only (III) above (d) Both (I) and (III) above (e) Both (II) and (III) above. (1 mark) | < Answer >
40. | Which of the following statements is correct for a firm that currently has total costs of carrying and ordering inventory that is 50% higher than total carrying costs? (a) Current order size is greater than optimal (b) Current order size is less than optimal (c) Per unit carrying costs are too high (d) The optimal order size is currently being used (e) Ordering cost is too high. (1 mark) | < Answer >
| 41. | The annual usage of a raw material is 40,000 units for the Jain Ltd. The price of the raw material is Rs.50 per unit. The ordering cost is Rs.200 per order and the carrying cost is 20 percent of the average value of inventory. The supplier has recently introduced a discount of 4 percent on the price of material for orders of 1500 units and above. The company’s E.O.Q. prior to the introduction of discount and the change in carrying cost after the discount is introduced are respectively (a) 875 units, Rs.1,265 (b) 1,000 units, Rs.80,000 (c) 1,265 units, Rs.875 (d) 1,265 units, Rs.80,125 (e) 1,500 units, Rs.80,125. (2 marks) | < Answer >
| 42. | If the material is priced at the value that is realizable at the time of issue, such pricing method is referred to as (a) Standard price method (b) Replacement method (c) LIFO method (d) Weighted average cost method (e) FIFO method. (1 mark) | < Answer >
| 43. | If a company changes its inventory valuation method from LIFO to FIFO during inflationary situation, it will result in I. An increase in the value of closing stock. II. An increase in the value of raw material issued. III. A decrease in the amount of profits. (a) Only (I) above (b) Only (III) above (c) Both (I) and (II) above (d) Both (I) and (III) above (e) Both (II) and (III) above. (1 mark) | < Answer >
| 44. | Taurus Ltd. is considering the liberalization of existing credit terms to two of its big customers A and B. The credit period and the likely quantity that will be purchased by the customers are as follows:
Credit period (in days) | Quantity Purchased (in units)
| A | B
0 | 1000 | -
30 | 1500 | -
60 | 2500 | 1500
90 | 2500 | 2500
The selling price per unit is Rs.9,000. The expected contribution is 20% of the selling price. If the cost of carrying debtors is 20% per annum, the profit when credit period is extended for B to 90 days is (Assume 360 days in a year) (a) Rs.15.6 lakh (b) Rs.18.0 lakh (c) Rs.21.6 lakh (d) Rs.25.2 lakh (e) Rs.36.0 lakh. (2 marks) | < Answer >
| 45. | Sri Sai Associates has a contribution ratio of 20% and average book debts of Rs.10 lakh. The average collection period is 24 days. The company has reorganized the credit administration department recently and introduced a cash discount of 5%. The discount is available to customers making payment in 10 days. When company reviewed its policy after few months, it found that the average collection period has declined to 20 days and the average book debts have increased to Rs.10.5 lakh. About 50% of the customers availed of the discount facility. If the required rate of return of the company is 20%, the net benefit as a result of cash discount facility is (a) Rs.2,97,500 (b) Rs.4,82,500 (c) Rs.7,80,000 (d) Rs.10,50,000 (e) Rs.15,00,000. (2 marks) | < Answer >
| 46. | Consider the following information for Indian infotech: Annual sales Rs.24,00,000 Selling price Rs.10 per unit Variable cost to sales ratio 70% Annual Collection expenditure Rs.50,000 Bad debt losses 3% of sales Average collection period 2 months Required rate of return 20% Indian infotech is considering to change its credit policy. The consultants have recommended the following two programmes – A and B:
| Programme A | Programme B
Average Collection Period (in months) Annual Collection expenditure (in Rs.) Bad Debt losses (%) | 1.5 75,000 2 | 1 1,50,000 1
The operation costs of the programmes A and B respectively are (a) Rs.1,65,000 and Rs.1,94,000 (b) Rs.1,94,000 and Rs.1,65,000 (c) Rs.1,65,000 and Rs.2,02,000 (d) Rs.1,82,000 and Rs.1,95,000 (e) Rs.1,94,000 and Rs.2,02,000. (2 marks) | < Answer >
| 47. | The finance manager should establish a credit policy that ultimately achieves which of the following objectives? (a) To maximize the credit period to be offered to the buyers (b) To minimize the amount of bad debt losses (c) To maximize the total credit sales (d) To maximize the total profit from the accounts receivable operation (e) To maximize the amount of the discount to be offered to the buyers. (1 mark) | < Answer >
| 48. | Swathi must decide whether her firm should relax its credit standards. The proposed change would increase sales by 10,000 units. The cost of the increased investment in accounts receivable would be Rs.9,345, with a cost of increased bad debts of Rs.23,495. Swathi’s company sells its product for Rs.10 per unit, with variable costs per unit of Rs.6, fixed costs of Rs.1,25,000 per year, and a required return of 10 percent on investments of equal risk. Swathi 's firm should (a) Relax its credit standards, because the change would provide Rs.27,160 net profit (b) Relax its credit standards, because the change would provide Rs.7,160 net profit (c) Maintain its current credit standards, because the change does not meet the 10 percent required rate of return (d) Maintain its current credit standards, because the change would cost Rs.5,340 (e) Maintain its current credit standards, because the change would cost Rs.32,070. (1 mark) | < Answer >
| 49. | Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days? (a) Days Sales Outstanding will vary from month to month (b) The amount of uncollected balances schedule will differ from one quarter to another (c) The level of accounts receivable will be constant from month to month (d) The ratio of accounts receivable to sales will vary from month to month (e) The cost of maintaining receivables will vary from month to month. (1 mark) | < Answer >
| 50. | Suvaran Industries presently offers credit on terms 1/10, net 30 days. It is proposing to change its credit terms to 1/15, net 30 days. Which of the following is/are the most likely consequences of the above change in credit policy? I. The existing customers who pay within the discount period will pay at the time of the extended period for discount. II. Sales will increase under all market conditions. III. The amount of discount allowed will not change under any circumstances. (a) Only (I) above (b) Only (III) above (c) Both (I) and (II) above (d) Both (I) and (III) above (e) All (I), (II) and (III) above. (1 mark) | < Answer >
| 51. | Which of the following is a logical consequence of liberalizing credit standards? (a) Collection costs tend to decrease (b) Bad debt losses tend to increase (c) Sales tend to decrease (d) Cost of funds locked in receivables tend to decrease (e) Requirement for financing working capital tends to decrease. (1 mark) | < Answer >
| 52. | Which of the following statements is/are true regarding ‘Numerical Credit Scoring’? (a) It is a method for computing the cash discount to be extended to the customer (b) It is a method of computing the credit period (c) It is an index that is used to study the creditworthiness of a customer (d) It is an index used to study the efficiency of the credit standards of the firm (e) It is a technique for evaluating the effort of a company in collecting the receivables. (1 mark) | < Answer >
| 53. | Currently, M/s. Fine Components Ltd sells 30,000 units at an average price of Rs.28,000 per unit. The variable cost is 90% of the selling price. The credit terms of the company are 1/20, net 30. 10% of the customers avail of the discount and the average collection period is 26 days. The bad-debts to sales ratio is 0.015. To increase the sales level, the finance manager has suggested changing the credit terms to 2/10, net 30. With the new policy sales are expected to increase by 4,000 units and 40% of the old customers and 60% of the new customers are expected to avail of the discount. The average collection period and bad debt to sales ratio are expected to remain the same. If the cost of financing is 15%, the net benefit (ignoring taxes) of the new policy is (Assume 360 days in a year) (a) Rs.9.36 lakh (b) Rs.10.56 lakh (c) Rs.12.04 lakh (d) Rs.13.84 lakh (e) Rs.15.86 lakh. (2 marks) | < Answer >
| 54. | Evercare Pharma Ltd. is planning to relax its receivable collection efforts that may be expected to propel a pickup in sales. Its current monthly sales are Rs.25 lakh at a contribution margin of 20 percent and the average collection period is 30 days. Presently, the amount of bad debts is on an average 1 percent of sales. With the relaxation of the collection efforts, the sales value is expected to increase by 20 percent but the average collection period would go up to 45 days and the bad debts may rise to 2.5 percent of total sales. What would be the change in profits of the company owing to the relaxation in the collection efforts? (Assume cost of capital = 14 percent, one year = 360 days and ignore taxes) (a) Increase by 3.11 lakh (b) Increase by 3.41 lakh (c) Increase by 3.71 lakh (d) Decrease by 3.11 lakh (e) Decrease by 3.41 lakh. (2 marks) | < Answer >
| 55. | A financial services company is considering offering credit to Mr.Santh. The probability that he pays is 0.9. If cost of sales is 70% of sales, net profit or loss to the firm, if it offers credit, is (a) A loss of 20% on sales (b) A profit of 20% on sales (c) No profit and no loss (d) A loss of 17% on sales (e) A profit of 17% on sales. (2 marks) | < Answer >
| 56. | Once each year, ABC Ltd. purchases a perishable commodity. It processes and packages the commodity immediately and holds the cartons for sale a year later. Purchases have to be made in units of 100 kgs. The current purchase price is Rs.60 per 100 kgs. Each 100 kgs yield sufficient output for a batch of 100 cartons and the processing and packaging of each 100 kgs cost Rs.140. Storage costs excluding interest amount to Rs.50 per 100 cartons per annum. It also incurs fixed operating costs of Rs.1,40,000 each year. The selling price next year for current output is estimated at Rs.400 per 100 cartons. The probability of different volumes of sales has been estimated as under:
Cases of 100 cartons | Probability
2,000 | 0.20
2,500 | 0.50
3,000 | 0.30
Assuming that the quantity purchased is 3,00,000 kgs, the expected value of annual net cash flow will be (a) Rs.50,000 (b) Rs.60,000 (c) Rs.70,000 (d) Rs.1,30,000 (e) Rs.1,70,000. (2 marks) | < Answer >
| 57. | Which of the following is not a relevant factor in cash management? (a) Prompt billing and mailing the same to the customers (b) Branch wise collection of receivables (c) Centralized purchases and payments to the suppliers (d) Availing of term loans to the maximum possible limit (e) Prompt depositing of the cheques received from customers in the bank. (1 mark) | < Answer >
| 58. | Which of the following statements is/are correct? I. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control. II. The cash budget and the capital budget are planned separately and they are independent of each other. III. The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it is changed to reflect long-term changes in the firm’s operations. (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. (1 mark) | < Answer >
| 59. | The amount of cheques deposited by a company in the bank awaiting clearance is called (a) Margin (b) Collection float (c) Balance (d) Payment Float (e) Net float. (1 mark) | < Answer >
| 60. | Which of the following statements is/are not true with respect to cash management? I. A cash management system with lower collection float and higher payment float is better than the one with higher collection float and lower payment float. II. A cash management system with higher collection float and lower payment float is better than the one with lower collection float and higher payment float. III. If interest rates are increasing; it is a cause of concern for a finance manager to review his cash management system. IV. If a firm permits its customers to pay online rather than to write cheques, this will increase its net float and thus reduce its required cash balances. V. Decrease in interest rates increases the opportunity cost of idle cash. (a) Only (I) above (b) Both (II) and (V) above (c) Both (III) and (IV) above (d) (I), (III) and (V) above (e) (II), (IV) and (V) above. (1 mark) | < Answer >
| 61. | The weakness/es of the internal rate of return approach is/are that I. It does not directly consider the timing of the cash flows from a project. II. It fails to provide a straightforward decision-making criterion. III. It cannot be a meaningful criterion for the projects with multiple internal rates of return, whose cash inflows and outflows are interspersed. (a) Only (I) above (b) Only (III) above (c) Only (II) above (d) Both (II) and (III) above (e) Both (I) and (III) above. (1 mark) | < Answer >
| 62. | Which of the following criteria is/are generally least important in selecting marketable securities for inclusion in the firm's portfolio for cash management purposes? (a) Length of maturity (b) Yield (c) Marketability (d) Default risk (e) Liquidity. (1 mark) | < Answer >
| 63. | Which of the following is/are true regarding the choice of the mix of cash and near cash assets? I. If the degree of uncertainty surrounding cash flow projections is low, the companies will be tilted more towards marketable securities and intercorporate deposits. II. If the company has access to non-bank sources of funds, it will tend to have a higher proportion of intercorporate deposits and marketable securities. III. When a high degree of uncertainty is associated with the future cashflows of a firm, the firm should invest all the cash in equity shares. IV. When a high degree of uncertainty is associated with the future cashflows of a firm, the firm should maintain adequate cash balance and have an overdraft arrangement with a bank. V. When the management of a firm is averse towards risk, the firm should maintain a higher proportion of funds invested in equity shares and intercorporate deposits, than free cash. (a) Only (I) above (b) Only (III) above (c) (I), (II) and (IV) above (d) (I), (III) and (V) above (e) All (I), (II), (III), (IV) and (V) above. (1 mark) | < Answer >
| 64. | Pratima Industries had bank balance of Rs.1,00,000 on 1st September, 2005 according to both the company’s account and bank pass book. From that day, it issues daily cheques for Rs.25,000 that are cleared on the 3rd working day and deposits daily cheques of Rs.18,000 which are realized on the 2nd working day. The amount of net float on 3rd Septemebr is (a) Rs.42,000 (b) Rs.38,000 (c) Rs.32,000 (d) – Rs.42,000 (e) – Rs.32,000. (2 marks) | < Answer >
| 65. | The "shortage" costs associated with inadequate liquid asset balances include I. Higher cash discounts. II. Possible financial insolvency. III. Lower interest expense. (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. (1 mark) | < Answer >
| 66. | Which of the following is not a part of the economic appraisal of projects? (a) Impact of the project on income distribution (b) Impact of the project on the extent of savings and investment (c) Impact of the project on the wealth of the shareholders (d) Impact of the project on employment generation (e) Impact of the project on the self-sufficiency of economy. (1 mark) | < Answer >
| 67. | Which of the following statements is/are correct for a project with a positive net present value? I. Internal rate of return exceeds the cost of capital. II. Net benefit cost ratio is less than zero. III. Benefit cost ratio is greater than 1. (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. (1 mark) | < Answer >
| 68. | Other things remaining the same, which of the following project appraisal criteria will remain unchanged, eventhough the cost of capital is changed? (a) Net present value (b) Internal rate of return (c) Benefit cost ratio (d) Net benefit cost ratio (e) Discounted payback period. (1 mark) | < Answer >
| 69. | Which of the following is false with regard to the net present value (NPV) as an appraisal criterion for projects? (a) It gives more weight to the earlier cashflows than the later cashflows (b) NPVs of multiple projects can be added to give a combined NPV (c) It considers the cashflows over the entire life of the project (d) It represents the contribution of the project to the wealth of the lenders of the firm (e) It considers the time value of money. (1 mark) | < Answer >
| 70. | Cost of an investment is Rs.5,000 and it pays Rs.425 p.a. in perpetuity. If the implicit rate of interest is 10%, the benefit cost ratio of the investment is (a) –0.85 (b) –0.15 (c) 0.15 (d) 0.85 (e) 1.85. (2 marks) | < Answer >
| 71. | A single, overall cost of capital is often used to evaluate projects because (a) It avoids the problem of computing the required rate of return for each investment proposal (b) It is the only way to measure a firm’s required return (c) It acknowledges that most new investment projects have about the lower degree of risk (d) It acknowledges that most new investment projects offer about the same expected return (e) It considers agency and bankruptcy costs. (1 mark) | < Answer >
| 72. | An investment project is expected to generate earnings before taxes (EBT) of Rs.60,000 per year. Annual depreciation from the project is Rs.30,000 and the firms’ tax rate is 40 percent. The project’s annual net cash flows are (a) Rs.36,000 (b) Rs.40,000 (c) Rs.48,000 (d) Rs.54,000 (e) Rs.66,000. (2 marks) | < Answer >
| 73. | The risk-free security has a beta equal to ----- , when the market portfolio’s beta is equal to---- (a) One; more than one (b) One; less than one (c) Zero; one (d) Less than zero; more than zero (e) Zero; more than zero. (1 mark) | < Answer >
| 74. | The cost of monitoring management is considered to be a (an) (a) Bankruptcy cost (b) Transaction cost (c) Agency cost (d) Institutional cost (e) Floatation cost. (1 mark) | < Answer >

Suggested Answers
Financial Management – II (142): January 2006

1. | Answer : (e) Reason : Financial institutions grant term loans and they put different conditions to avoid default risk. These conditions are stricter, when loan amount constitutes large portion of capital structure. | < TOP >
2. | Answer : (c) Reason : Rights issue involves the issue of securities to the existing shareholders at the price, which is generally lower than the current market price and it involves lower issue cost. As statements (II) and (III) are true, alternative (c) is answer. | < TOP >
3. | Answer : (e) Reason : The number of rights is always equal to the number of shares. However, 5 rights give the investor the right to receive 1 new rights share. | < TOP >
4. | Answer : (b) Reason : Earnings price ratio approach assumes that the EPS is constant. There are two parameters, which have to be analyzed to see if this approach will provide an accurate result or not. They are dividend pay-out ratio and the rate of return the firm is capable of earning on the retained earnings. The results are accurate in the following two scenarios. a. When all the earnings are paid out as dividends. Here the rate of return the firm is capable of earning becomes irrelevant. Or, b. The dividend pay-out ratio is less than 100 percent and retained earnings are expected to earn a rate of return equal to the cost of equity. In all other cases, there is a scope for this approach for not giving an accurate estimate. Hence, statement (II) is true, (I) and (III) are incorrect and the answer is (b). | < TOP >
5. | Answer : (c) Reason : If the probability of bankruptcy is high, the assets are likely to be sold at a significant discount to their true economic values (a). Bankruptcy entails substantial expenditure on legal and administrative proceedings (b). The equity shareholders will require a higher rate of return, if the firm faces the problem of bankruptcy (d). The probability of bankruptcy is higher for a levered firm than for an unlevered firm. Hence (c) is false. Beyond a threshold level, the probability of bankruptcy increases at an increasing rate, as the debt-equity ratio increases. | < TOP >
6. | Answer : (e) Reason : Current market value of the firm = = Rs.194.20 million Market value after restructuring = Rs.(10 × 11 + (74.2+45) million = Rs.229.2 million Value lost if the firm doesn’t go for restructuring = Rs.(229.2 – 194.2) million = Rs.35 million | < TOP >
7. | Answer : (b) Reason : Calculation of breaking point:
Source of finance | Cost (%) | Range of new financing | Breaking point | Range of total new financing
|  | (Rs. in crore) | (Rs. in crore) | (Rs. in crore)
Equity | 14 | 0 – 10 | 10/0.4 = 25 | 0 – 25
| 15 | 10 – 20 | 20/0.4 = 50 | 25 – 50
| 16 | 20 and above | – | 50 and above
Preference | 13 | 0 – 2 | 2/0.2 = 10 | 0 – 10
| 14 | 2 and above | – | 10 and above
Debt | 8 | 0 – 12 | 12/0.4 = 30 | 0 – 30
| 9 | 12 – 18 | 18/0.4 = 45 | 30 – 45
| 10 | 18 and above | – | 45 and above
If the new financing is in the range of Rs.25 – 30 crore Cost of equity = 15% Cost of preference = 14% Cost of debt = 8% Weighted marginal cost of capital in the above range = 0.15 x 0.4 + 0.14 x 0.2 + 0.08 x 0.4 = 12% Hence, answer is (b). | < TOP >
8. | Answer : (d) Reason : The capital structure of Deepti Financials Ltd before the issue of 15% debentures will be
| Source | Amount (in Rs.) | Proportion
| Ordinary shares (2,00,000 x Rs.20) | 40,00,000 | 0.500
10% | Preference shares | 10,00,000 | 0.125
14% | Debentures | 30,00,000 | 0.375
| Total: | 80,00,000 | 1.000
Cost of equity prior to this change can be calculated as follows: Weighted average cost of capital = 0.5 x 17% +0.125 x 10% +0.375 x 9.8% = 13.425% The capital structure of Deepti Financials Ltd after the issue of 15% debentures will be
| Source | Amount (in Rs.) | Proportion
| Ordinary shares (2,00,000 x Rs.15) | 30,00,000 | 0.375
10% | Preference shares | 10,00,000 | 0.125
14% | Debentures | 30,00,000 | 0.375
15% | Debentures | 10,00,000 | 0.125
| Total: | 80,00,000 | 1.000
Cost of equity after the change in capital structure Substituting the given values, we get WACC = 0.375 × 0.27 + 0.125 × 0.10 + 0.375 × 0.098 + 0.125 × 0.105 = 16.3625%. Change in weighted average cost of capital = 2.9375% = 2.94% | < TOP >
9. | Answer : (b) Reason : Wealth ratio (wt) = Yield for an n-year period is (W1 ´ W2 ´ ……….´ Wn )1/n –1 The wealth ratios for Beta Ltd will be as follows:
| 1 | 2 | 3 | 4 | 5
Wealth Ratio | 1.1256 | 1.143 | 0.78 | 1.242 | 1.027
Yield = (1.1256 ´ 1.143 ´ 0.78 ´ 1.242 ´ 1.027) 1/5 – 1 = 1.0506 – 1 = 0.0506 = 5.06%. | < TOP >
10. | Answer : (e) Reason : All the approaches are used to measure the cost of equity except Miller and Modigliani approach. | < TOP >
11. | Answer : (c) Reason : Agency cost arises from the divergence between the goal of share holders and that of debt holders. A market for corporate control can not resolve the problem. All other alternatives mentioned above can resolve the problem. | < TOP >
12. | Answer : (b) Reason : Even if revenue declines, a higher level of debt must still be paid off, as it increases risk to stock holders. On the other hand, debt can be used to fund expanded or modernized operation, allowing great potential revenues and profit for share holders, thereby increasing the expected rate of return. | < TOP >
13. | Answer : (d) Reason : The presence of personal taxes reduces the value of the tax shield because capital gains are generally taxed at a lower rate than regular income. Statement (I) is false. Statements (II) is true, as the value of a levered firm is more than the value of an unlevered firm because of the presence of tax shield. The value of tax shield is lower since it can be utilized only when there are profits and in case of losses taxes are not paid and tax advantages can not be obtained. Hence, statement (III) is true. Hence, alternative (d) is answer. | < TOP >
14. | Answer : (c) Reason : As per traditional approach on capital structure theory, up to a certain amount of leverage the cost of debt will decrease but there after as the default risk increases, cost of debt also increases. So (c) would be the correct answer. | < TOP >
15. | Answer : (c) Reason : EBIT = Rs.2,00,000 Less: Interest on 10% debentures = Rs.50,000 Earnings available to equity holders = Rs.1,50,000 Equity capitalization rate = 15% Market value of equity (1,50,000/0.15) = Rs.10,00,000 Market value of debt = Rs.5,00,000 Total cost of capital = 10 (5,00,000/15,00,000) + 15(10,00,000/15,00,000) = 3.33%+10% = 13.33%. | < TOP >
16. | Answer : (a) Reason : Computation of market values: (Rs. in crore)
Equity share capital: Rs.27 ´ 1.5 crore | 40.5
Debenture capital : |
= |
= Rs.19,20,00,000 i.e., | 19.2
Term loan | 80
Total market value | 139.7
Computation of weights:
Weight for equity capital (we) = | 0.29
Weight for debenture capital (wd) = | 0.14
Weight for term loan (wt) = | 0.57
| 1.00
Cost of debenture capital = 10.8(1-0.3) =7.56% Cost of term loan = 12.5(1-0.3) =8.75% Weighted average cost of capital = we ke + wd kd + wt kt = (0.29) (14.4) + (0.14) (7.56) + (0.57) (8.75) = 10.22% (approximately) | < TOP >
17. | Answer : (b) Reason : According to the net operating income approach – The net operating income = Total assets × Return on assets = 8,00,00,000 × 0.10 = 80 lakh Total market value of firm = = 80/0.16= Rs. 500 lakh Market value of equity = = = (80-6)/0.18= Rs. 411 lakh Market value of debt = Total market value of firm – Market value of equity = 500 – 411 = Rs. 89 lakh \ Debt equity ratio = 89/411= 0.22. | < TOP >
18. | Answer : (a) Reason : Since interest on debt is tax deductible and there is no possibility of firms’ financial distress, the value of the firm maximizes with more use of leverage. Hence, the correct answer is (a). | < TOP >
19. | Answer : (e) Reason : All the statements mentioned are correct. Hence, alternative (e) is answer. | < TOP >
20. | Answer : (c) Reason : According to the Miller and Modigliani model on dividend policy, if the entire amount of profit is disbursed among the shareholders in the form of dividends, it will have to raise additional capital from the market. Therefore, the appreciation of the share prices due to the higher dividend payment will be automatically dampened with the issue of the new equity shares. Hence, it can be concluded that the dividend policy of the firm does not significantly influence the share prices. | < TOP >
21. | Answer : (c) Reason : Net income approach and net operating income approach are concerned with the capital structures of a company. While explaining the impact of dividend policy on value of the firm, Walter model assumes constant EPS. Gordon model on dividend policy is not based on such assumption. M&M approach does not assume constant EPS. Hence, the option (c) is correct. | < TOP >
22. | Answer : (c) Reason : The market price per share is given by where, symbols are in standard use. If no dividends are declared 150 P1 = Rs.168 Net Income = Rs.2 crore Investments budget = Rs.4 crore Amount to be raised by issue of new shares = Rs.2 crore \ Number of shares to be issued = | < TOP >
23. | Answer : (c) Reason : According to Walter’s model on dividend policy P = + 60 = + or 60 (0.15) = D + (10 – D) or 9 = D + 0.867 (10) – 0.867 D or 0.133 D = 0.33 or D = = Rs.2.481 \ Dividend payout ratio should be = = = 0.2481 i.e., 24.81%. | < TOP >
24. | Answer : (d) Reason : Stable dividend pay out ratio refers to the same percentage of dividend on earning per share over the years. As per this policy, the rupee level of dividends may increse, may decrease or may remain the same. Dividend pay out ratio is the ratio between DPS and EPS. Hence, alternative (d) is answer. | < TOP >
25. | Answer : (c) Reason : While using IRR, NPV, or PI in capital budgeting the time value of money is taken into account. But these methods do not rank the same to all mutually exclusive projects. Accounting measures of profit are not considered and these methods are not simple and decisions are also not intuitive. | < TOP >
26. | Answer : (d) Reason : By keeping dividends stable, the firm hopes to reduce the uncertainty and there by to lower the discount rate applied to dividends thus raising the value of the firm. Hence, the answer is (d). | < TOP >
27. | Answer : (c) Reason : Inventory Conversion Period (ICP) = 365 days/(Rs.80 million/Rs.5 million) = 22.8125 days. Receivables collection period = 3.0 ´ ICP = 3 ´ 22.8125 = 68.4375 days. Receivables collection period = 68.4375 = Accounts receivable/Sales per day Sales per day = Rs.80 million/365 = Rs.0.2192 million Accounts receivable = 68.4375 ´ Rs.0.2192 = Rs.15 million. New inventory conversion period = 365/(Rs.80 million/Rs.3 million) = 13.6875 days. Net change in inventory conversion period = -9.125 days. Total reduction in net operating cycle required = 12 days. Reduction in receivables conversion period needed = 12 – 9.125 = 2.875 days. New receivables conversion period required = 68.4375 – 2.875 = 65.5625 days. Receivables conversion period = 65.5625 = [(Accounts receivable)/(Rs.80 million/365)] Accounts Receivable = 65.5625 ´ Rs.0.2192 = Rs.14.37 million. Old Accounts Receivable = Rs.15 million New Accounts Receivable = Rs.14.37 million Reduction required in Accounts Receivable = Rs.15 – Rs.14.37 = Rs.0.63 million. | < TOP >
28. | Answer : (b) Reason : Statement (I) is not true because in an aggressive financing policy for current assets the financing mix is tilted more towards short term sources of financing. Statement (II) is true because risk of technical insolvency is high in aggressive current asset financing policy, as the debt servicing obligations are high in the short run. Statement (III) is not true because cost of financing is usually low in aggressive current asset financing policy, as short term financing is less expensive than long term financing. | < TOP >
29. | Answer : (e) Reason : Under a conservative working capital policy, the financing mix will consist of a higher proportion of long-term sources of finance like equity and to some extent debentures also. Hence statement (I) is correct. As a conservative working capital policy involves financing of current assets more from long-term sources, the company will have a lower debt-servicing cost compared to an aggressive policy and consequently a lower degree of the risk of technical insolvency. Hence statement (II) is incorrect. A company following a conservative working capital policy will invest more in current assets than a company following an aggressive working capital policy. Hence it will have a higher current ratio than the one following an aggressive working capital policy. So statement (III) is correct. Under a conservative worming capital policy, a firm invests more in current assets than a firm following an aggressive policy. Therefore the current assets turnover ratio computed as Sales ÷ Current assets will be lower incase of a conservative working capital policy. So statement (IV) is also correct. Hence option (e) is the correct choice as statements (I), (III) and (IV) are correct. | < TOP >
30. | Answer : (e) Reason : (in Rs. Lakh)
| Period (months) | Raw materials | Work in Process | Finished Goods | Debtors | Total |
Raw Material |  |  |  |  |  |  |
In raw material In W I P In finished Goods In debtors | 2 | 100 |  |  |  |  |
1 |  | 50 |  |  |  |
1 |  |  | 50 |  |  |
3 |  |  |  | 150 | 350 |
Manufacturing Expenses |
In WIP | 1/2 |  | 10 |  |  |
In finished goods | 1 |  |  | 20 |  |
In debtors | 3 |  |  |  | 60 | 90
Selling, Administrative and financial expenses |
In finished goods | 1 |  |  | 10 |  |
In debtors | 3 |  |  |  | 30 | 40
Profit |  |  |  |  |  |
In debtors | 3 |  |  |  | 60 | 60
Total |  | 100 | 60 | 80 | 300 | 540
Hence, the amount of working capital requirement is Rs.540 lakh + Rs.20 lakh = Rs.560 lakh. | < TOP >
31. | Answer : (e) Reason : Option (e) is the correct answer. All other things being equal, a policy of holding a relatively small proportion of the firm's total assets in the form of current assets will tend to result in a higher expected profitability or rate of return on the total assets of the firm. It is because, the firm is emphasizing more investment in fixed assets than in current assets, thereby giving more importance to profitability than to liquidity. | < TOP >
32. | Answer : (c) Reason : Under Method I, the bank will finance at the most 75 percent of the working capital gap i.e., maximum permissible abnk finance = 0.75 (Current Assets – Current Liabilities) This method will ensure a minimum current ratio. Under Method II, the borrower will finance 25 percent of total current assets through long-term sources. The bank will finance at the most working capital gap i.e., maximum permissible bank finance = (0.75 × Current Assets) – Current Liabilities. Under Method III, there will be further reduction in bank borrowings, which will ensure a still higher current ratio. The amount of excess borrowing calculated as the difference between the amount of bank borrowing and the maximum permissible bank borrowing to which the borrower is eligible will be converted into a term loan, that is to be repaid over a suitable period, depending upon the cash generating capacity and ability to raise additional equity etc., maximum permissible bank finance = 0.75 (Current Assets – Core Current Assets) – Current Liabilities. There is no IV method suggested by Tandon Committee. | < TOP >
33. | Answer : (d) Reason : Cost of trade credit = (Discount Rate/ 1- Discount Rate) × [360 /(Credit Period – Discount Period)] By careful observation of the above formula, it can interpreted that, there is a positive relationship between discount rate and cost of trade credit and negative relationship between the spread between credit period and discount period and cost of trade credit. As statements (I) and (III) are not true, alternative (d) is answer. | < TOP >
34. | Answer : (b) Reason : Cost of Trade Credit = × 0.21 = × = 45 – x = 34.29 x = 10.71 Þ 10 days Hence option (b) is the correct choice. | < TOP >
35. | Answer : (b) Reason : Total costs associated with inventory = Ordering cost + Carrying cost = Where U is the annual usage Q is the quantity ordered F is fixed cost per unit P is the purchase price per unit C is the carrying cost expressed as a percentage of the purchase price. Hence, 870 = Hence, U = 7,200 units. | < TOP >
36. | Answer : (c) Reason : The possible levels of usage and their corresponding probabilities are computed in the following table:
Daily Usage | Rate | Lead Time |  | Possible levels of usage
Units | Probability | Number of days | Probability | Possible Usage Levels = (Column 1 x Column 3) | Probability = (Column 2 x Column 4)
150 | 0.2 | 20 35 | 0.6 0.4 | 3,000 5,250 | 0.12 0.08
360 | 0.5 | 20 35 | 0.6 0.4 | 7,200 12,600 | 0.30 0.20
450 | 0.3 | 20 35 | 0.6 0.4 | 9,000 15,750 | 0.18 0.12
Normal Usage during lead time = Average Daily Usage rate x Average Lead Time Average Daily Usage rate = 150 x 0.20 + 360 x 0.50 + 450 x 0.30 = 345 units. Average Lead Time = 20 x 0.6 + 35 x 0.4 = 26 days Normal Usage during lead time = 345 x 26 = 8,970 units. Stock outs will occur, if the usage is above 8,970 units. From the table computed above, we can infer that stock-outs will occur, when the usage levels are 12,600 (with probability 0.20); 9,000 (with probability 0.18) and 15,750 (with probability 0.12). The total probability of stockout is 0.2 + 0.18 + 0.12 = 50%. Hence, (c) is the answer. | < TOP >
37. | Answer : (c) Reason : Existing cost of inventory = = 1,200 + 7,50,000 = Rs.7,51,200 EOQ = = 6,000 units Cost of inventory in the EOQ system = = 30,000 + 30,000 = 60,000 \Benefit = 7,51,200 – 60,000 = Rs.6,91,200. | < TOP >
38. | Answer : (a) Reason : Shelf stock refers to items that are stored by the firm and sold with little or no modification to customers. | < TOP >
39. | Answer : (c) Reason : The economic order quantity is that order quantity that minimizes total costs, and not only the ordering costs. As statement (III) is false, it is answer. The other two statements are true | < TOP >
40. | Answer : (a) Reason : TC=PC + UF/Q As per the given information, 1.5 PC = PC + UF/Q 0.5PC = UF/Q 0.5PCQ = UF Q = UF/0.5PC = 2UF/PC which is more than optimal or economic order quantity size i.e., (2UF/PC)1/2 Hence, current order size is greater than optimal and (a) is answer. | < TOP >
41. | Answer : (c) Reason : Let us first arrange the data contained in the problem in accordance with the notations familiar to us by now. U = 40,000 units F = Rs.200 per order P = Rs.50 per unit C = 20% D = Rs.2 per unit E.O.Q. without discount, Q* = = = 1,265 units Incremental carrying cost = = = Rs.7,200 – Rs.6,325 = Rs.875 ….....(3). | < TOP >
42. | Answer : (b) Reason : If the material is priced at the value that is realizable at the time of issue, such pricing method is called replacement method. Answer is (b). Under FIFO method, the pricing will be based on the cost of material that was obtained first. Under LIFO method, the pricing will be based on the material that has been purchased recently. Under statndard price method, the pricing is based on predetermined price. Under weighted average cost method, pricing is based on weighted average basis. | < TOP >
43. | Answer : (a) Reason : If a company changes it’s inventory valuation method from LIFO to FIFO during inflationary situation, it will result in an increase in the value of closing inventory, a decrease in the value of rawmaterial issued and an increase in the amount of profit. Hence, statements (II) and (III) are false and statement (I) is true. | < TOP >
44. | Answer : (e) Reason : Contribution = (2,500 ´ 9,000) ´ 0.20 = Rs.2,25,00,000 ´ 0.2 =Rs.45,00,000 Cost of Investment in debtors = 2,25,00,000´0.8´´0.2 = Rs.9,00,000 Profit = Contribution – Investment cost of receivables = 45,00,000 – 9,00,000 = Rs.36,00,000. | < TOP >
45. | Answer : (a) Reason : Average Collection period = Present Credit Sales = =Rs.1,50,00,000 New credit sales = = Rs.1,89,00,000 Incremental Contribution =(1,89,00,000 –1,50,00,000)´ 0.20 = Rs.7,80,000 Cost of cash discount = 1,89,00,000 ´0.5 ´0.05 = Rs.4,72,500 Cost of additional debtors = (10,50,000–10,00,000) ´0.20 = Rs.10,000 Total incremental cost = Rs.4,82,500 Net benefit = Incremental contribution – Incremental cost = 7,80,000 – 4,82,500 = Rs.2,97,500 | < TOP >
46. | Answer : (c) Reason :
| Programme A (in Rs.) | Programme B (in Rs.)
Annual Collection expenditure Bad Debt losses Cost of investment in Debtors Total | 75,000 48,000 42,000 1,65,000 | 1,50,000 24,000 28,000 2,02,000
Cost of Investment in Debtors for programme A = 24,00,000 ´ 0.7 ´´ 0.20 = Rs.42,000. Cost of Investment in Debtors for programme B =24,00,000 ´ 0.7 ´ ´ 0.20 = Rs.28,000 | < TOP >
47. | Answer : (d) Reason : The credit policy of the finance manager should be such that it can minimize the profit from accounts receivable operation. This objective includes the remaining objectives of increasing total credit sales and minimizing bad debt losses etc. | < TOP >
48. | Answer : (b) Reason : Cost of changing the credit policy = Cost of increase in investment in accounts receivable + Cost of increased bad debts = Rs.9,345 + Rs.23,495 = Rs.32,840 Incremental Contribution = 10,000 ´ 4 = Rs.40,000 Net Benefit = Rs.40,000 – Rs.32,840 = Rs.7,160. | < TOP >
49. | Answer : (c) Reason : Since sales are seasonal, DSO will vary from month to month. The ratio of accounts receivable to sales will also vary from month to month. The quarterly uncollected balances schedule and the level of accounts receivable will be different in each quarter as sales are seasonal. The statement given in (c) that accounts receivable will be constant from month to month is not correct. Hence the correct answer is (c). | < TOP >
50. | Answer : (a) Reason : Statement (I) is the most likely consequence because the existing customers can take the advantage of the same cash discount over an extended period of discount. Statement (II) is not the likely consequence when the market for the companys’ product is declining. Statement (III) is not the likely consequence, because, in an expanding market the credit sales will increase and so will be the cash discount allowed, and in a declining market the sales may actually decrease (and so will be the cash discount allowed) in spite of the liberalization of the credit policy. | < TOP >
51. | Answer : (b) Reason : With the liberalization of credit standards, sales turnover of the company tends to increase, thereby increasing the requirement of the working capital financing as well as the cost of funds locked in the receivables. As more amount of funds are blocked in the receivables, collection costs will experience upward trend and the bad debt losses will also increase. | < TOP >
52. | Answer : (c) Reason : Numerical credit scoring is an index based on several factors that is used to study the creditworthiness of a customer. It is the weighted sum of the facts that ostensibly have a bearing on the credit worthiness of the customer. Hence (c) is the correct choice. | < TOP >
53. | Answer : (b) Reason : Incremental profit = 4,000 × 28,000 × 0.1 = Rs.1,12,00,000 Old Discount = 30,000×28,000×0.01×0.1 = Rs.8,40,000 New Discount = 30,000×28,000×0.02×0.4 + 4,000×28,000×0.02×0.6 = Rs. 80,64,000 Difference = Rs.72,24,000 Old bad debts = 30,000×28,000×0.015 = Rs.1,26,00,000 New bad debts = 34,000×28,000×0.015 = Rs.1,42,80,000 Difference = Rs. 16,80,000 Increase in cost of funds = 4,000×28,000×26/360×0.15×0.9 = Rs.10,92,000 Incremental profit = 1,12,00,000-72,24,000-16,80,000-10,92,000 =Rs.12,04,000. | < TOP >
54. | Answer : (b) Reason : If the collection program is relaxed, the following financial impacts are possible: The increase in contribution owing to the increased sales is 0.20 ´ 25 ´12 ´ 0.20 = Rs.12 lakh Increase in the cost of funds invested in the receivables will be = = = = (12.50 + 6.00) ´ 0.14 = Rs.2.59 lakh Increase in bad debts will be = Rs.360 ´ 2.5 % - Rs.300 ´ 1.0% = 9 – 3 = Rs.6 lakh Hence, the profit of the company will increase by (12 – 2.59 – 6) = Rs.3.41 lakh. | < TOP >
55. | Answer : (b) Reason : Pp × (1– Percentage of Cost on Sales) – (1– Pp) × Percentage of Cost on Sales 0.9 ×0.3 – 0.1 ×0.7 = 0.2 =20% on sales. | < TOP >
56. | Answer : (d) Reason : Purchase of 3,00,000 Kgs
Demand (Cases) | Sales (Rs.) | Probability | Effective Sales (Rs.)
2,000 2,500 3,000 Total | 8,00,000 10,00,000 12,00,000 | 0.20 0.50 0.30 | 1,60,000 5,00,000 3,60,000 10,20,000
Expected Cash Flows: Number of cases purchased 3,000 Purchases @ Rs. 60 per 100 Kgs = Rs. 1,80,000 Processing cost @ Rs.140 per 100 kgs = Rs. 4,20,000 Storage Cost @Rs.50 per case = Rs. 1,50,000 Fixed operating cost = Rs. 1,40,000 Total Cost = Rs. 8,90,000 Expected Surplus = 10,20,000-8,90,000 =Rs. 1,30,000 | < TOP >
57. | Answer : (d) Reason : Whether or not to avail of term loans and to what extent is related with the borrowing policy of a firm; it is not related with cash management. | < TOP >
58. | Answer : (c) Reason : Shorter-term cash budgets, in general, are used primarily for control purposes, while longer-term budgets are used for planning purposes. The cash budget and the capital budget are planned together, they both are important to the firm; they are dependent of each other. The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it is changed to reflect long-term changes in the firm’s operations. Hence, statements (I) and (II) are not correct. Since, statement (III) is correct, answer is (c). | < TOP >
59. | Answer : (b) Reason : The amount of cheques deposited by a company in the bank awaiting clearance is called the collection float. The amount of cheques issued by a company and not yet cleared is called the payment float. The difference between the payment float and the collection float is called the net float. | < TOP >
60. | Answer : (b) Reason : Net float = Payment float – Collection float; Therefore, the larger the payemnt float and the lower the collections float the better the cash management system. If interest rates are increasing, it increases the opportunity cost of idle cash and hence should be a cause of concern for a finance manager. A firm can increase its’ net float by accepting payments from its’ customers through online, which is expected to reduce the time required in encashment. From the above explanation, statements (II) and (V) are false, and alternative (b) is answer. | < TOP >
61. | Answer : (b) Reason : The internal rate of return considers the timing of the cashflows from a project and provides a straight forward decision-making criterion. It assumes that the firm is able to reinvest the interm cash flows from a project at the internal rate of return. It is not a meaningful criterion, if there are multiple internal rates of return due to the intermediate cash outflows. Hence, answer is (b). | < TOP >
62. | Answer : (b) Reason : The reason for holding marketable securities is to keep idle cash in the form of cash equivalents so as to earn some return as well as to have the facility of conversion into cash as and when desired. Given this, length of maturity, default risk, marketability and liquidity are more important than the return earned on these securities. | < TOP >
63. | Answer : (c) Reason : Statement (I) is true, because low degrees of uncertainty surrounding the cash flow projections implies that there will be less uncertainty surrounding the availability of cash from operations. Hence the firm may reduce the amount of cash (because it earns no return) and invest funds in liquid assets like marketable securities and intercorporate deposits, which earn returns. Statement (II) is true, because a company, which has access to non-bank sources of funds, will not tend to keep idle cash and will invest its funds in intercorporate deposits and marketable securities, which earn returns. Hence, there will be a higher proportion of investment in intercorporate deposits and marketable securities. Statement (III) is false, because when a high degree of uncertainty is associated with the future cashflows of a firm, the firm should invest all the cash in safety instruments not in equity shares. Statement (IV) is true, when a high degree of uncertainty is associated with the future cashflows of a firm, the firm should maintain adequate cash balance and have an overdraft arrangement with a bank. Statement (V) is false, because a conservative attitude, on the part of management, towards risk means that the firm will avoid investing its funds in intercorporate deposits and equities, which are unsecured instruments. Since statements (I),(II) and (IV) are true, alternative ( c) is answer. | < TOP >
64. | Answer : (c) Reason : Balance as per the cash book:
Day | 1st January | 2nd January | 3rd January
Opening balance | Rs.100,000 | Rs.93,000 | Rs.86,000
Cheques Deposited | Rs.18,000 | Rs.18,000 | Rs.18,000
Cheques Issued | Rs.25,000 | Rs.25,000 | Rs.25,000
Closing balance | Rs.93,000 | Rs.86,000 | Rs.79,000
Balance as per the pass book:
Day | 1 | 2 | 3
Opening balance | Rs.100,000 | Rs.100,000 | Rs.118,000
Cheque Deposited |  | Rs.18,000 | Rs.18,000
Cheque Issued |  |  | Rs.25,000
Closing balance | Rs.100,000 | Rs.118,000 | Rs.111,000
Net float = Rs.111,000 – Rs.79,000 = Rs.32,000 and positive. | < TOP >
65. | Answer : (b) Reason : Option (b) is the correct answer. Inadequate liquid balances may lead to insolvency. | < TOP >
66. | Answer : (c) Reason : The economic appraisal of projects does not consider the impact of the project on the wealth of the shareholders. Alternatives (a), (b), (d) and (e) are parts of the economic appraisal of projects | < TOP >
67. | Answer : (d) Reason : IRR is the rate at which NPV of the project is zero. If NPV is positive then it implies that IRR exceeds the cost of capital of the project. Hence statement (I) is correct. A positive NPV indicates that the present value of inflows is greater than the present value of outflows. It does not give any relevant information about the pay back period being more than the cut-off rate. Hence statement (II) is incorrect. BCR = Therefore a positive NPV indicates that the present value of inflows is greater than the initial investment, in other words it implies that BCR > 1. Hence option (d) is the answer. | < TOP >
68. | Answer : (b) Reason : The internal rate of return is calculated by equating the present values of all the inflows and outflows. But in other cases, the inflows and outflows are discounted with the cost of capital. Hence, IRR is independent of the cost of capital. | < TOP >
69. | Answer : (d) Reason : NPV gives more weight to earlier cash flows than later cash flows (a). NPVs are additive in nature (b). NPV considers the entire life of the project (c). NPV represents the contribution of the project to the wealth of the equity shareholder. Hence (d) is false. It considers the time value of money (e). | < TOP >
70. | Answer : (d) Reason : Present value of a perpetual inflow of Rs.425 = = = Rs.4,250. BCR= = Hence, option (d) is the correct choice. | < TOP >
71. | Answer : (a) Reason : A single, overall cost of capital is often used to evaluate projects because it avoids the problem of computing the required rate of return for each investment proposal. The other alternatives (b), (c), (d) and (e) are not true. | < TOP >
72. | Answer : (e) Reason : Net Cash Flow = Rs.60,000 (1 – 0.40) + Rs.30,000 = Rs.66,000. | < TOP >
73. | Answer : (c) Reason : The risk-free security has a beta equal to zero, while the market portfolios’ beta is equal to one. | < TOP >
74. | Answer : (c) Reason : The cost of monitoring management is considered to be an agency cost. Hence, alternative (c) is correct. | < TOP >

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