Question Paper
Financial Management – II (142): April 2006

· Answer all questions.

· Marks are indicated against each question.

1.

Which of the following features distinguishes cumulative preference shares from non-cumulative preference shares?

(a) Cumulative preference shares are always irredeemable

(b) Cumulative preference share holders are eligible to receive dividends at a variable rate not exceeding a specified limit

(c) Cumulative preference share holders are eligible to get all the arrears of preference dividends before the declaration of any equity dividend

(d) Cumulative preference share holders enjoy right to participate in surplus profits after equity dividends have been paid

(e) Cumulative preference shares may be redeemed after a specified maturity period at the discretion of the company.

(1 mark)

< Answer >

2.

Certain restrictions or protective covenants imposed by the creditors on the firm, whenever the firm approaches for more debt are

I. Maintaining current ratio above a certain level.

II. Restriction on rate of dividend.

III. Constraints on the issue of additional capital.

IV. Limitation on further investment of capital.

(a) Both (I) and (II) above (b) Both (II) and (III) above

(c) (I), (II) and (III) above (d) (II), (III) and (IV) above

(e) All (I), (II), (III) and (IV) above.

(1 mark)

< Answer >

3.

The current price of a share of Subhadra Industries Ltd. is Rs.80. The company is planning to issue 2 right shares for every 5 equity shares. If the company targets that the ex-rights value of a share shall not fall below Rs.75, the subscription price for one right share should be

(a) Less than or equal to Rs.58 (b) More than or equal to Rs.62.5

(c) Less than or equal to Rs.62.5 (d) More than or equal to Rs.58

(e) Equal to Rs.75.

(2 marks)

< Answer >

4.

The least expensive form of financing for the firm is

(a) Existing common stock (b) Preferred stock (c) Debenture capital

(d) New common stock (e) Retained earnings.

(1 mark)

< Answer >

5.

Which of the following statements is true with respect to Bought out Deals?

(a) Immediate finance may not be available to the companies

(b) These are known as Angles in UK

(c) The issue price will be current market price prevailing at that time

(d) The timing of the offloading is to be done within a very rigid framework

(e) It is very expensive way of issue.

(1 mark)

< Answer >

6.

When a company makes a rights issue, which of the following is true for a shareholder that lets his/her rights lapse?

(a) His/her wealth increases

(b) His/her wealth remains constant

(c) His/her wealth decreases

(d) His/her wealth may increase or decrease depending on the situation

(e) Insufficient information.

(1 mark)

< Answer >

7.

Agency costs in the context of capital structure of firms represent the

(a) Increase in the cost of production due to the increase in the cost of inputs

(b) Increase in the sales commission payable to the sales agents

(c) Increase in financial costs due to the rise in interest rates

(d) Restrictive conditions imposed by the financial institutions for providing loan to the firm

(e) Regulatory requirements to be met by the firm with regard to its human resources.

(1 mark)

< Answer >

8.

Which of the following statements 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 higher for a levered firm than for an unlevered firm

(d) The equity shareholders expect a lower 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 >

9.

In the calculation of the weighted average cost of capital, why are the weights based on the market values preferred?

I. The weights based on the book values are difficult to estimate, while calculating the weighted average cost of capital.

II. Weights based on the market values are fairly constant in nature.

III. Weights based on the book values have a high degree of volatility.

IV. The weights based on the book values are historical in nature and may not reflect the true economic value.

(a) Only (I) above (b) Only (III) above (c) Only (IV) above

(d) (I), (II) and (III) above (e) (II), (III) and (IV) above.

(1 mark)

< Answer >

10.

The following details are available regarding the long term sources of finance of M/s. VK Ltd.:

Source of finance	Range of new financing from the source (Rs. crore)	Post tax cost (%)
Equity	0 – 20	14
	20 – 40	15
	40 & above	16
Preference	0 – 4	13
	4 & above	14
Debt	0 – 24	8
	24 – 36	9
	36 & above	10

The company is considering expanding its operations and requires funds in the range of Rs.60 crore –Rs.70 crore for the same. The present capital structure of the company is as follows:

(Rs. in crore)

Equity capital	200
Reserves and Surplus	100
Debt	400
Preference shares	100

It is planning to maintain the present capital structure even in future.

The weighted marginal cost of capital of new financing in the range of Rs.60 crore – Rs.70 crore is

(a) 9.475% (b) 10.075% (c) 10.875% (d) 11.075% (e) 11.875%.

(2 marks)

< Answer >

11.

Consider the following data for Beta Ltd:

Year	1	2	3	4	5
Earnings Per Share (Rs.)	5.80	5.00	4.00	6.00	5.50
Dividend Payout (%)	72	80	70	75	65
Capital appreciation (%)	5	7	-10	10	8

If the price at the beginning of year 1 is Rs.70, the approximate realized yield over the five year period is

(a) 4.75% (b) 6.03% (c) 7.25% (d) 8.79% (e) 9.45%.

(2 marks)

< Answer >

12.

Consider the following data of M/s. Global InfoTech Ltd.:

Market Value of Debt	Rs.6,00,000
Interest	Rs.45,000
Net Operating income	Rs.1,50,000
Cost of Equity Capital	12%

If debt-equity ratio changes to 4:5, the revised equity capitalization rate according to net operating income approach is

(a) 10.15% (b) 11.25% (c) 12.31% (d) 14.35% (e) 15.45%.

(2 marks)

< Answer >

13.

Jargon Enterprises Ltd. operates in the electrical spares industry. The income statement of the company is given below:

	(Rs. in lakh)
Sales	200
Cost of sales	120
Net operating income	80
Interest	24
Earnings to equity shareholders	56

The capitalization rate for debt is 12% and the overall capitalization rate for the entire firm is 13.75%. If other things remain the same, what is the maximum amount of funds that the firm can borrow in terms of market value, so that its equity capitalization rate does not exceed 18%?

(Assume that the net operating income approach to capital structure is applicable.)

(a) Rs.56.67 lakh (b) Rs.92.167 lakh

(c) Rs.116.67 lakh (d) Rs.816.67 lakh (e) Rs.212.167 lakh.

(2 marks)

< Answer >

14.

Which of the following statements is false?

(a) A firm with a high capital intensity relies more on long term debt and equity

(b) The capital structure of a firm should be built conservatively, if chances of obsolescence are high

(c) Term loan is the cheapest source of finance

(d) In a non-seasonal and non-cyclical business, investment in current assets is usually financed by short term debt

(e) An aggressive capital structure will be tilted more towards debt than equity.

(1 mark)

< Answer >

15.

The use of safety stock by a firm will

I. Increase ordering costs.

II. Increase carrying costs.

III. Increase stock-out 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 >

16.

If corporate taxes and personal taxes on debt and equity related income are levied, which of the following is/are true regarding the present value of the tax shield on debt?

I. Increases with increase in corporate tax rate.

II. Increases always with increase in personal tax rate on debt related income.

III. Increases or decreases for similar changes in personal tax rate depending on the relative rates of tax on debt and equity related personal income.

(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 >

17.

Which of the following are not assumptions made under the Modigliani and Miller approach for explaining the irrelevance of dividend policy for a firm?

I. Existence of perfect capital markets.

II. Non-existence of differential tax rates for the dividend income and capital gains.

III. Non-influence of single investor on the share value.

IV. Absence of transaction costs.

V. Higher growth rate of dividends compared to cost of equity capital.

VI. Constant investment policy of the firm.

VII. Constant return on investment and cost of equity capital.

(a) Both (I) and (VI) above (b) Both (V) and (VII) above

(c) (II), (III) and (VI) above (d) (I), (III), (IV) and (VII) above

(e) (IV), (V), (VI) and (VII) above.

(1 mark)

< Answer >

18.

Consider the following information regarding Suchitra Ltd.

Face value of the share	Rs.30
Current market price of the share	Rs.40
Cost of equity capital	15%
Internal rate of return	13%
Expected earnings per share	Rs.15

If the market price/face value multiple has to be 3, according to Walter’s model on dividend policy, the dividend ratio of the company should be approximately

(a) 0% (b) 12.4% (c) 18.25% (d) 21.47% (e) 24.8%.

(2 marks)

< Answer >

19.

Singular Corp. has 10 million shares outstanding at the face value of each Rs.10 and posted a net income of Rs.13 million this year. Anticipated capital budget is approximately Rs.18 million. The firm also plans to maintain its present target capital structure of 70% equity and 30% debt. If the firm follows a strict residual dividend policy, the expected dividend ratio would be

(a) 0.1% (b) 0.2% (c) 0.4% (d) 2.3% (e) 3.08%.

(2 marks)

< Answer >

20.

Debentures Ltd. has currently 1,00,000 shares selling at Rs.80 each. The firm is contemplating the declaration of Rs.4 as dividend at the end of the current financial year, which has just begun. The net income of the firm is Rs.15,00,000 and its new investment would be Rs.21,00,000 during the period. As per Modogliani Miller model, the number of shares to be issued towards financing the new investment is 11,628. If there are no taxes, the firm belongs to a risk class for which the capitalization rate is

(a) 9.5% (b) 10.0% (c) 10.5% (d) 11.0% (e) 12.5%.

(2 marks)

< Answer >

21.

Which of the following statements is false?

(a) The basic EOQ model assumes that orders to replenish the inventory of an item are filled instantaneously

(b) Irrespective of the fluctuations in consumption during lead time, re-order point remains constant

(c) In the FIFO method, the issue is in the order of receipt

(d) In the replacement method, the current realizable value is taken for pricing the issues

(e) Cost per order and cost of carrying per unit are assumed to be constant.

(1 mark)

< Answer >

22.

A corporation will typically pay the highest dividends in

(a) Development - Stage I (b) Growth - Stage II

(c) Expansion - Stage III (d) Maturity - Stage IV

(e) Declining – State V.

(1 mark)

< Answer >

23.

Bambino Ltd. has 1.25 million shares outstanding. The current stock price is Rs.13.50 per share. If the company issues a 10% stock dividend, what would you expect the stock price to be after the dividend is paid?

(a) Rs.12.27 per share (b) Rs.12.82 per share (c) Rs.13.30 per share

(d) Rs.13.49 per share (e) Rs.13.71 per share.

(2 marks)

< Answer >

24.

Resham Industries Ltd. is deciding whether to pursue a restricted or relaxed working capital investment policy. Its annual sales are expected to total Rs.58,00,000, its fixed assets turnover ratio equals 5.0 and its debt/equity ratio is 3:2. EBIT is Rs.3,20,000, the interest rate on the firm’s debt is 11 percent, and the firm’s tax rate is 30 percent. If the company follows a restricted policy, its total assets turnover will be 4. Under a relaxed policy, its total assets turnover will be 3.2. If the firm adopts a restricted policy, how much will it save in interest expense?

(a) Rs.13,233 (b) Rs.16,175 (c) Rs.23,925 (d) Rs.29,818 (e) Rs.30,136.

(2 marks)

< Answer >

25.

Which of the following statements is/are true regarding “under-trading”?

I. The symptoms of under trading can be noticed from the lower turnover of working capital.

II. Precautionary measures for under trading can be taken by increasing the asset base.

III. Under-trading arises, when the volume of sales is much less in comparison to the amount of assets employed.

IV. Under trading can be restated as under capitalization.

(a) Only (I) above (b) Only (IV) above

(c) Both (I) and (III) above (d) Both (II) and (III) above

(e) Both (III) and (IV) above.

(1 mark)

< Answer >

26.

Which of the following statements is true with regard to the working capital financing policy of a company?

(a) Working capital margin is generally provided by the short term borrowing by a company

(b) Negative net working capital implies that short term funds are used to finance long term assets

(c) A company that follows conservative working capital management policy generally maintains a very low current ratio in comparison to its peers

(d) Time value of money must be considered for the estimation of the working capital needs

(e) A company that follows aggressive working capital management policy generally experiences lower profitability.

(1 mark)

< Answer >

27.

The following figures are collected from annual report of Hyderabad Ceramics Ltd.:

	2004 (Rs. in 000s)	2005 (Rs. in 000s)
Raw materials inventory – Closing Balance Work in process inventory – Closing Balance Finished Goods inventory – Closing Balance Purchases of raw materials during the year Manufacturing expenses during the year Depreciation Selling, administration and financial expenses during the year Excise Duty paid during the year	160 25 30 1135 1125 75 200 120	192 45 50 1242 1230 100 230 150

Assuming 360 days in a year, what should be the average finished goods storage period of Hyderabad Ceramics for the year 2005?

(a) 2 days (b) 3 days (c) 4 days (d) 5 days (e) 6 days.

(2 marks)

< Answer >

28.

A reputed TV set manufacturer, plans to manufacture 20,000 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	8,000 5,000 3,000

The selling price per unit is Rs.20,000 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	1.5 months
Work in process stage	1 month
Finished goods stage	1 month
Debtors stage	2 months

If the minimum cash balance required is Rs.50,00,000, what is the estimate for the working capital requirement of the company?

(a) Rs.1158.33lakh (b) Rs.1208.33 lakh

(c) Rs.1258.33 lakh (d) Rs.1308.33 lakh

(e) Rs.1358.33 lakh.

(2 marks)

< Answer >

29.

Other things remaining the same, which of the following will decrease the cost of trade credit?

I. Decrease in the rate of discount.

II. Decrease in the credit period.

III. Decrease in the discount period.

(a) Only (I) above (b) Only (II) above

(c) Only (III) above (d) Both (I) and (II) above

(e) Both (I) and (III) above.

(1 mark)

< Answer >

30.

Which of the following is true with regard to letter of credit?

(a) It is an offer of loan by a bank to a firm

(b) It is an offer to supply raw materials on credit to a firm by its supplier

(c) It represents the assurance of a bank to pay a supplier, if its customer fails to pay for the purchases made

(d) It is the letter from a company to its supplier requesting it to increase the credit period

(e) It is the letter by which the supplier of a company confirms the extension of credit period to its customer.

(1 mark)

< Answer >

31.

Which of the following is not a type of bank finance for working capital?

(a) Cash credit (b) Overdraft

(c) Commercial paper (d) Purchasing and discounting of bills

(e) Note lending.

(1 mark)

< Answer >

32.

Which of the following types of factoring does not carry the service elements of factoring?

(a) Recourse Factoring (b) Full Factoring (c) Maturity Factoring

(d) Invoice Discounting (e) Non-Recourse Factoring.

(1 mark)

< Answer >

33.

Which of the following means of financing does not need any collateral security?

(a) Cash credit from a private sector bank

(b) Overdraft from a public sector bank

(c) Cash credit from a co-operative bank

(d) Public deposit

(e) Term loan from a financial institution.

(1 mark)

< Answer >

34.

Which of the following committees has not dealt with working capital financing?

(a) Dahejia Committee (b) Tandon Committee

(c) Kannan Committee (d) Chore Committee

(e) Marathe Committee.

(1 mark)

< Answer >

35.

Working capital gap is

(a) Equal to current assets plus current liabilities including bank borrowings

(b) Equal to current assets less current liabilities including bank borrowings

(c) Equal to current assets less current liabilities excluding bank borrowings

(d) Equal to current assets plus current liabilities excluding bank borrowings

(e) Equal to current liabilities excluding bank borrowings.

(1 mark)

< Answer >

36.

Decreasing the balances of a firm's inventory would result in

(a) Decreasing illiquidity and solvency costs

(b) Decreasing order and setup costs associated with replenishment and production of finished goods

(c) Increasing costs of investment in accounts receivable and bad debts

(d) Increasing opportunity costs of lost sales due to low inventory

(e) Increasing opportunity cost of funds invested in inventory and accounts receivable.

(1 mark)

< Answer >

37.

Which of the following is not an advantage of the ABC system of inventory management?

(a) It is a very selective approach to inventory management

(b) It facilitates a better control on the costlier items

(c) It analyses the items in inventory according to their importance in the production process

(d) It helps the usage of the scientific system for the inventory management

(e) It helps maintain the optimum level of stocks.

(1 mark)

< Answer >

38.

Rajani Cements Limited uses the iron slag for the production of cement. The annual usage of the iron slag is 50 thousand tonnes. The price of the iron slag is Rs.980 per ton. The ordering cost is Rs.200 per order and the carrying cost is 15% of average value of inventory. At present the company procures 5 thousand tonnes of iron slag in each order and avails of a discount of 2% from the supplier. The supplier has introduced 5% discount for an order size of 10 thousand tonnes and above. What would be the annual benefit to the company, if they switch to the new discount offered by the supplier?

(a) Rs.3,37,100 (b) Rs.11,32,900 (c) Rs.14,70,000

(d) Rs.18,29,566 (e) There will not be any monetary benefit to the company.

(2 marks)

< Answer >

39.

Mr. Prasanth Shah, maintenance engineer of National Power Corporation, is worried about the stock level of indication lamps to be maintained. These lamps are imported from Germany. Total 20,000 numbers of these lamps are installed in the factory. The values of consumption rate, lead time and their respective probabilities are as follows:

Average daily consumption (units)	Probability	Lead-time (No. of days)	Probability
50	0.20	14	0.10
100	0.50	21	0.60
200	0.30	30	0.30

If the stock-out cost is estimated to be Rs.10 per unit and the carrying cost for the period under consideration is Rs.3 per unit, the optimum reorder level would be

(a) 2,100 units (b) 2,800 units (c) 3,000 units (d) 4,200 units (e) 6,000 units.

(2 marks)

< Answer >

40.

A firm estimates its carrying cost at 20% and its ordering cost at Rs.10 per order. The estimated annual requirement is 50,000 units at a price of Rs.5 per unit. What is the most economical number of units to be ordered and how often will an order need to be placed? (Assume 360 days in a year)

(a) 895 units, 6 days (b) 1,000 units, 7 days (c) 1,000 units, 10 days

(d) 1,050 units, 10 days (e) 1,068 units, 7 days.

(2 marks)

< Answer >

41.

If the marginal reduction in ordering costs exceeds the marginal increase in carrying cost of inventory,

(a) The firm has minimized its carrying cost

(b) The firm should increase the number of orders

(c) The firm should decrease the number of orders

(d) The firm has maximized its ordering costs

(e) The firm has minimized its total cost.

(1 mark)

< Answer >

42.

Which of the following statements is correct for a firm that currently has total costs of carrying and ordering inventory that is 75% higher than total ordering costs?

(a) Per unit carrying costs are too high

(b) Current order size is less than optimal

(c) Current order size is greater than optimal

(d) The optimal order size is currently being used

(e) Ordering cost is too high.

(1 mark)

< Answer >

43.

Indian Associates Inc. has Rs.40,00,000 in assets, and currently has no debt. It is financed entirely with 3,00,000 shares of common stock, each of which trades at Rs.15 per share. The firm’s EBIT is expected to be Rs.10,00,000 at the year end i.e. at t = 1. The corporate tax rate is 40 percent. Indian Associates expects to pay out a dividend at year-end, which is 55 percent of its net income. The company estimates that its earnings and dividends grow at a constant rate of 5 percent a year. Suppose Indian Associates can issue Rs.12,00,000 in debt at an interest rate of 10% and uses the proceeds to repurchase shares of stock at the original price of Rs.15. The cost of stock after the change in capital structure will be 12 percent. If the expected growth rate and payout ratio don't change, what is the expected price after the change in capital structure?

(a) Rs.17.25 (b) Rs.15.00 (c) Rs.18.86 (d) Rs.20.98 (e) Rs.33.17.

(2 marks)

< Answer >

44.

Which of the following ratios is not affected by the financial structure and tax rate of the company?

(a) Return on equity (b) Net profit margin (c) Earning power

(d) Earning per share (e) Capitalization rate.

(1 mark)

< Answer >

45.

Sravan Industries has received an order from Pushkar Industries, which insists that Rs.80,000 of machinery be supplied on 40 days credit. The probability that Pushkar Industries will pay in 40 days is 0.7. However, if the order is accepted and Pushkar Industries does not default, there is a 80% chance that Pushkar Industries will place further ten identical orders in one year’s time. Experience has shown that once a firm meets the credit terms on an initial order, the probability of default for the subsequent orders reduces to 0.2. Any work on this order will not hamper the regular operations of Sravan Industries. The cost of production is Rs.60,000. The expected net benefit to Sravan Industries from accepting the order, if it expects to receive further ten orders from Pushkar is

(a) Rs.1,500 (b) Rs. 9,200 (c) Rs. 28,000 (d) Rs. 30,980 (e) Rs. 36,240.

(2 marks)

< Answer >

46.

The following is the information pertaining to the inventory of Theta Ltd.:

Annual usage is 15,00,000 units

Carrying cost is 10% of the purchase price

The purchase price is Rs.500 per unit and the ordering cost is Rs.2,000 per order.

Orders must be placed in multiples of 100 units only.

If the carrying cost increases by 40%, assuming that other things remain the same, what would be the proportionate change in EOQ to the proportionate change in carrying cost?

(a) 45.7% (b) -25.28% (c) 30.28% (d) 25.28% (e) -45.7%

(2 marks)

< Answer >

47.

The existing annual sales of a company are Rs.150 crore. Its existing credit terms are 1.5/10, net 35 days. Average collection period of the company is 30 days. It has been observed that 40% of the customers in terms of sales revenue avail of the cash discount incentive. In order to hasten the collection process, the company is contemplating of liberalizing its existing credit terms to 2.5/10, net 35 days. Sales are likely to increase by Rs.30 crore and average collection period to decline to 20 days. 75% of the customers in terms of sales revenue are expected to avail of the cash discount incentive under liberalization scheme. If the contribution to sales ratio is 25% and the cost of funds to the company is 14%, the total incremental cost to the company due to this collection relaxation program is

(a) Rs.206.7 lakh (b) Rs.111.1 lakh (c) Rs.114.2 lakh

(d) Rs.129.0 lakh (e) Rs.171.7 lakh.

(2 marks)

< Answer >

48.

The value of resources used in an investment project should be measured in terms of their

(a) Acquisition cost (b) Historical cost (c) Opportunity cost

(d) Depreciated cost (e) Appreciated cost.

(1 mark)

< Answer >

49.

Increasing collection expenditure is likely to result in

I. Shorter average collection period.

II. Reduced bad-debt losses.

III. Higher accounts receivable balances.

(a) Only (I) above (b) Only (II) above (c) Only (III) above

(d) Both (I) and (II) above (e) Both (I) and (III) above.

(1 mark)

< Answer >

50.

The above graph is related to which of the following approaches of cost of capital?

(a) Net operating income approach (b) Net income approach

(c) Traditional approach (d) Modigliani Miller approach

(e) Merton Miller approach.

(1 mark)

< Answer >

51.

Which of the following statements is/are not correct?

I. Collection policy is how a firm goes about collecting past-due accounts.

II. Collection policy has no impact on sales, since collecting past-due accounts occurs only after the customer has already purchased.

III. A lax collection policy will frequently lead to an increase in accounts receivable.

IV. A more stringent collection policy may decrease sales.

(a) Only (I) above (b) Only (II) above (c) Only (III) above

(d) Both (III) and (IV) above (e) (II), (III) and (IV) above.

(1 mark)

< Answer >

52.

Which of the following statements is correct?

I. Other things held constant, the higher are a firm’s days sales outstanding (DSO), the better its credit department is.

II. If a firm that sells on terms of net 30 changes its policy and begins offering all customers the terms of 2/10, net 30 days, and if no change in sales volume occurs, the firm’s DSO will increase.

III. If a firm sells on terms of 2/10, net 30 days, and its DSO is 30 days, its aging schedule would probably show some past due accounts.

(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 >

53.

Which of the following statements is/are correct?

I. If credit sales as a percentage of a firm’s total sales increase and the selling price per unit decreases, the firm's accounts receivable will surely increase.

II. It is possible for a firm to overstate profits by offering very lenient credit terms, which encourage additional sales to financially "weak" firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts.

III. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity.

(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 >

54.

Race Auto Parts Company sells to a retail auto supply stores on credit terms of "net 60". Annual credit sales are Rs.300 million (spread evenly throughout the year) and the firm’s variable cost ratio is 0.75. On an average, it’s accounts receivable are overdue for 28 days. Assuming 365 days per year, the average investment in receivables of Race is

(a) Rs. 0.822 million (b) Rs. 34.091million

(c) Rs. 52.942 million (d) Rs. 72.329 million

(e) Rs. 82.392 million.

(2 marks)

< Answer >

55.

A financial services company is considering offering credit to Mr. Resham. The probability that he pays is 0.70. If cost of sales is 90% of sales, net profit or loss to the firm, if it offers credit, is

(a) A loss of 5% on sales (b) A profit of 5% on sales

(c) No profit and no loss (d) A loss of 20% on sales

(e) A profit of 17% on sales.

(1 mark)

< Answer >

56.

Which of the following factors influences the choice of liquidity mix to be maintained by a company?

(a) Nature of control with the managers

(b) Extent of leverage

(c) Marginal cost of capital

(d) Quality of the product of the company

(e) Uncertainty in cash flows.

(1 mark)

< Answer >

57.

Anderson Clayton will purchase a new pellet mill that replaces an older and less efficient mill. The new mill costs Rs.3,60,000 and shipping costs are Rs.10,000. Improving the steam lines to the new mill will additionally cost Rs.22,000. The old mill has a book value of Rs.25,000 and can be sold for Rs.12,000.The installation of the new mill will cause inventories to increase by Rs.8,000, accounts receivable by Rs.20,000 and accounts payable by Rs.10,000. If Anderson Clayton has a marginal tax rate of 40%, what is the net investment for the new mill?

(a) Rs.3,92,800 (b) Rs.4,12,800 (c) Rs.3,74,800 (d) Rs.3,98,000 (e) Rs.4,50,000.

(2 marks)

< Answer >

58.

G-III Apparel is considering increasing the size of a warehouse. The cost of the expansion is Rs.8,25,000 and the increase in inventories and accounts payable will be Rs.4,10,000 and Rs.3,60,000 respectively. G-III expects that the expansion will increase net cash flows by Rs.1,50,000 a year for the next 5 years and Rs.2,00,000 a year for years 6-12. G-III has a 14% cost of capital and a marginal tax rate of 35%. What is the NPV of the warehouse expansion?

(a) - Rs.3,38,570 (b) -Rs.3,450 (c) Rs.10,050 (d) Rs.60,050 (e) Rs.95,444.

(2 marks)

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59.

In a broader sense, ‘cash’ may include

(a) Notes and coins only

(b) Notes, coins and deposits in a bank

(c) Notes, coins, deposits in a bank and drafts only

(d) Notes, coins, deposits in a bank, drafts and cheques only

(e) Notes, coins, deposits in a bank, drafts, cheques and highly liquid marketable securities only.

(1 mark)

< Answer >

60.

When the net float is negative, it is said that

I. The company has used the short-term sources of funds for financing long-term assets.

II. The current ratio is less than unity.

III. The bank balance in the company’s books is less than that in the banks’ books.

IV. The payment float is larger than the collection float.

V. The balance in the books of the bank is less than the balance in the books of the firm.

(a) Only (III) above (b) Only (V) above (c) Both (I) and (III) above

(d) Both (II) and (IV) above (e) (I), (III) and (IV) above

(1 mark)

< Answer >

61.

Revathi Industries Ltd. is planning for its cash to be maintained during the month of May. The manager has analyzed the daily cash outgo for the month of April. Eight largest daily cash outflows are as follows:

Date	3rd April	7th April	10th April	15th April	18th April	21nd April	26th April	28th April
Cash outflow (Rs.)	76,000	80,000	63,000	72,000	69,000	68,000	78,000	89,000

It is expected that the pattern of cash outflows in the month of May will remain same as that of the month of April but the magnitude of cash outflows will be 30% more. If the finance manager desires sufficient cash to cover payments of 5 peak days during the month, the safety level of cash to be maintained in the month of May would be

(a) Rs.1,72,400 (b) Rs.2,06,880 (c) Rs.3,29,000 (d) Rs.4,74,800 (e) Rs.5,13,500.

(2 marks)

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62.

Which of the following assumptions underlie the definition of cost of capital under capital expenditure decisions?

I. The risk characterizing the new project under consideration is significantly lower than the risk characterizing the existing investments of the firm.

II. The firm will continue to adopt the same debt to equity ratio.

III. The management of the firm will remain the same.

(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.

(1 mark)

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63.

Which of the following is not true with regard to the internal rate of return (IRR) criterion?

(a) It considers the time value of money

(b) It considers the cash flow stream over the entire investment horizon

(c) It remains unaffected by the pattern of cash inflows and outflows

(d) It is the rate of return which equates the present value of cash inflows to the present value of cash outflows

(e) If the net cash flows are discounted by the IRR, the net present value will be equal to zero.

(1 mark)

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64.

Which of the following statements is/are correct for a project with a negative net present value?

I. Cost of capital is less than internal rate of return.

II. Net benefit cost ratio is less than zero.

III. Benefit cost ratio is less than 1.

(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 >

65.

Which of the following is false with regard to the accounting rate of return as an appraisal criterion for projects?

(a) It considers the profits over the entire life of the project

(b) It gives more weight to the earlier receipts than the later receipts

(c) It considers accounting profits instead of cash flows

(d) It serves as a measure of profitability of the investment

(e) It ignores the time value of money.

(1 mark)

< Answer >

66.

Consider the following information regarding a project:

Initial investment	Rs.10 lakh
Required rate of return on the project	12%
Required payback period	3 years

In which of the following cases can the project be accepted?

(a) Present value of inflows is less than Rs.10 lakh

(b) Internal rate of return is less than 12%

(c) Benefit cost ratio is between 0 and 1

(d) Payback period is less than 3 years

(e) Net benefit cost ratio is less than 0.

(2 marks)

< Answer >

67.

Consider the following information regarding two projects:

	Project A	Project B
Initial Cash Outflow	Rs.2,40,000	Rs.2,50,000
Year 1 Cash flow	Rs.25,000	Rs.1,50,000
Year 2 Cash flow	Rs.1,25,000	Rs.1,00,000
Year 3 Cash flow	Rs.1,75,000	Rs.75,000

Cost of capital is 10%. If these projects are mutually exclusive, which would you accept according to the profitability index criterion?

(a) Project A, since its profitability index is more than 1

(b) Project B, since its profitability index is more than 1

(c) Project B, since its profitability index is more than that of A

(d) Project A, since its initial investment is low

(e) Both A and B, since profitability indexes of both are more than 1.

(2 marks)

< Answer >

68.

Reddy Industries is planning to replace one of their old machines with a new one. The old machine can be presently sold at Rs.50,000 although book value is Rs.70,000 with a useful life of 4 years. The old machine will be depreciated by the straight-line method of depreciation over the remaining life at the end of which the salvage value will be zero. The new machine can be installed at a cost of Rs.3,50,000 with a useful life of 4 years. The new machine will be depreciated by the straight-line method of depreciation over the 4 years period at the end of which the salvage value will be nil. Due to greater efficiency, savings of expenses will be Rs.40,000 per year, while better quality of output will increase the revenue by Rs.60,000 per year. If the applicable tax rate is 40 percent, what is the net present value of the proposal, if the required rate of return is 12 percent?

(a) – Rs.35,744 (b) – Rs.32,744 (c) Zero (d) Rs.32,744 (e) Rs.35,744.

(2 marks)

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69.

The payback method is at best a crude measure of the risk of a project, because it fails to consider the _______ of project’s returns.

(a) Liquidity (b) Variability (c) Timing

(d) Magnitude (e) Profitability.

(1 mark)

< Answer >

70.

When a project has multiple internal rates of return

(a) The analyst should choose the highest rate to compare with the firm’s cost of capital

(b) The analyst should choose the lowest rate to compare with the firm’s cost of capital

(c) The analyst should choose the rate that seems most "reasonable", given the project’s cash flows, to compare with the firm’s cost of capital

(d) The analyst should compute the project’s net present value and accept the project, if its NPV is greater than Rs.0

(e) The analyst should compute the project’s profitability index and accept the project, its profitability index is less than one.

(1 mark)

< Answer >

71.

Value for shareholders, in most companies, is largely derived from which of the following financial decision area?

(a) Financing decisions such as the debt/equity decision

(b) Investment decisions focused on the assets side of the financial balance sheet

(c) Investment decisions focused on the liabilities side of the financial balance sheet

(d) Financing decisions related to dividends paid to shareholders

(e) Liquidity decisions related to composition of current assets.

(1 mark)

< Answer >

72.

Consider a capital expenditure project that has forecasted revenues equal to Rs.32,000 per year and cash expenses are estimated to be Rs.29,000 per year. The cost of the project equipment is Rs.23,000, and the equipment’s estimated salvage value at the end of the project is nil. The equipment will be depreciated on a straight-line basis to Rs.0 over a 10-year estimated economic life. Assume that the project requires initially Rs.7,000 for working capital investment. The company’s marginal tax rate is 30%. Calculate the project’s net present value using a 12% discount rate.

(a) – Rs.10,612.5 (b) – Rs.12,531.4 (c) – Rs.11,982.5 (d) Rs.11,982.5 (e) Rs.12,531.4.

(2 marks)

< Answer >

73.

Firms generally choose to finance temporary working capital with short-term debt because

I. It is easier to match the maturities of short-term assets and short-term liabilities.

II. Short-term interest rates have traditionally been more stable than long-term interest rates.

III. A firm that borrows heavily long-term is more apt to be unable to repay the debt than a firm that borrows heavily short-term.

(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.

(1 mark)

< Answer >

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

1.

Answer : (c)

Reason : In cumulative preference shares, the dividends are to be paid on cumulative basis, including the situations where the dividends are unpaid in any financial year due to lack of profits. The things stated in the other options are not correct in relation to the cumulative preference shares.

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2.

Answer : (e)

Reason : Whenever a firm to obtain debt capital approaches creditors, they may impose all of those above mentioned restrictions on the firm in the form of some protective covenants incorporated in the loan contract. So, the answer would be (e).

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3.

Answer : (c)

Reason : Ex-rights value of a share =

Where,

N is number of existing shares required for a rights share.

P_o is the cum rights price per share

S is the subscription price

75 £

S 75 x 3.5 – 2.5 x 80 Rs.62.5.

Hence option (c) is the answer.

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4.

Answer : (c)

Reason : The debt capital is the cheapest source of financing but it should be used within reasonable limits.

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5.

Answer : (b)

Reason : Bout-out deals are known as Angles in U.K. Buy-out is a process whereby an investor or a group of investors buy-out a significant portion of the equity of an unlilsted company with a view to selling the equity to public within an agreed time frame. The company places the equity shares, to be offered to the public, with a sponsor. At the right time, the shares will be off loaded to the public through the OTCEI route or by way of a public issue. An advantage accruing the investor is that the issue price usually reflects the company’s intrinsic value. This route is relatively inexpensive and funds accrue without much delay. Hence, alternatives (a),(c),(d) and (e) are false. Alternative (b) is true and is answer.

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6.

Answer : (c)

Reason : In rights issue, if a shareholder lets high rights lapse, his wealth decreases.

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7.

Answer : (d)

Reason : In many business entities, the ownership is separated from the management of the company, thereby resulting in agency problems. It does not have any influence on the manufacturing, selling and financial expenses, as well as to meet the several regulatory requirements in order to carry out the business. But considering the safety and security, the lenders generally put some restrictive covenants like further borrowings, payment of dividends, appointment of the key persons, etc. The implications of these restrictions on the operations are known as agency costs.

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8.

Answer : (d)

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). Hence (d) is false and is answer. The probability of bankruptcy is higher for a levered firm than for an unlevered firm. Hence (c) is true. Beyond a threshold level, the probability of bankruptcy increases at an increasing rate, as the debt-equity ratio increases.

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9.

Answer : (c)

Reason : The weights based on the book values are historical in nature and hence these do not reflect the cost of capital owing to the changes in the business and financial risk of the company. The reasons mentioned in the other options do not correctly reflect the advantages of choosing the weights based on the book values in comparison to the market values.

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10.

Answer : (e)

Reason :

Type of finance	Rs. in crore	Proportion
Networth (Equity + R&S)	300	0.375
Debt capital	400	0.500
Preference share capital	100	0.125

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 – 20	20/0.375 = 53.33	0 – 53.33
	15	20 – 40	40/0.375 = 106.67	53.33 – 106.67
	16	40 and above	–	106.67 and above
Preference	13	0 – 4	4/0.125 = 32	0 – 32
	14	4 and above	–	32 and above
Debt	8	0 – 24	24/0.5 = 48	0 – 48
	9	24 – 36	36/0.5 = 72	48 – 72
	10	36 and above	–	72 and above

If the new financing is in the range of Rs.60 – 70 crore

Cost of equity = 15%

Cost of preference = 14%

Cost of debt = 9%

Weighted marginal cost of capital in the above range

= 0.15 x 0.375 + 0.14 x 0.125 + 0.09 x 0.5 = 11.875%

Hence, answer is (e).

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11.

Answer : (d)

Reason : Wealth ratio (w_t) =

Year	1	2	3	4	5
DPS	4.176	4	2.8	4.5	3.575
Price at the beginning	70	73.5	78.645	70.7805	77.85855
Price at the end	73.5	78.645	70.7805	77.85855	84.087234
Wealth ratio	1.11	1.12	0.9356	1.1636	1.126

Yield for an n-year period is (W₁ ´ W₂ ´ ……….´ W_n )^1/n –1

Yield = (1.11 ´ 1.12 ´ 0.9356 ´ 1.1636 ´ 1.126) ^1/5 – 1

= 1.0879 – 1

= 0.0879

= 8.79%.

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12.

Answer : (c)

Reason : As per Net Operating Income Approach

k_e =

where symbols are in their standard use

\ S =

Market value of Debt = Rs.6,00,000 (given)

\ Value of the firm = Rs.14,75,000

Overall cost of capital ×100 = 10.17%

K_d = ×100 = 7.5%

As per NOI approach, overall cost of capital will remain constant even if the debt-equity ratio changes.

\

= 0.1017 +0.02136 = 0.12306= 12.306%~12.31%

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13.

Answer : (e)

Reason : Market value of debt = = = Rs.200 lakh

Total market value of the firm =

= = 581.818 ~ Rs.581.82 lakh

Market value of equity = Total market value of the firm – Market value of debt

= 581.82 – 200 = Rs.381.82 lakh.

Equity capitalization rate = = = 0.146666 i.e., 14.67%

According to the net operating income approach: k_e = k₀ + (k₀ – k_d) B/S

Let the market value of debt after increase be B.

Market value of equity = Total market value of the firm – Market value of debt = 581.82 – B.

k_e £ 18%

\ 0.18 ³ 0.1375 + (0.1375 – 0.12)

or 0.0425 ³

or 24.73– 0.0425B ³ 0.0175B

or 24.73 ³ 0.06B

or B £ 412.167 lakh

\ Increase in market value of debt due to borrowing =412.167 – 200 = Rs.212.167 lakh

Hence, the firm can borrow a maximum amount of Rs.212.167 lakh in terms of market value.

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14.

Answer : (d)

Reason : Forecasting is difficult in a non-seasonal and non-cyclical business and thus long-term finance is preferable instead of short-term debt. Because after a short period of time the debt has to be refunded. So the correct answer is (d).

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15.

Answer : (b)

Reason : Safety stock is extra inventory a firm keeps in case of unforeseen circumstances, which will increase the carrying costs and decrease stock-out costs. It may also decrease ordering costs but may not increase the same.

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16.

Answer : (d)

Reason : Present value of tax shield increases with increase in the corporate tax rate. It may increase or decrease based on the relative rates of the debt related and equity related personal income. Option (II) is not correct, as increase in t_pd will reduce the value of (1 – t_pd) as well as.

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17.

Answer : (b)

Reason : Modigliani and Miller approach makes the following assumptions:

i. Existence of a perfect market in which all investors are rational. There will be no transaction and floatation costs.

ii. It is assumed that there are no differential tax rates for dividend income and capital gains.

iii. The company has a constant investment policy.

Securities are infinitely divisible and hence no single investor is large enough to influence the share value.

M&M has not made any such assumptions that

Growth rate of dividends is more thasn cost of equity capital

Return on investment and cost of equity capital remain constant.

Since, statements (V) and (VII) are false, alternative (b) is answer.

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18.

Answer : (b)

Reason : According to Walter’s model on dividend policy

P = +

90 = +

or 90 (0.15) = D + (15 – D)

or 13.5 = D + 0.867 (15) – 0.867 D

0.495 = 0.133D

or 0.133 D =0.495

or D = = Rs.3.722

\ Dividend ratio should be = = = 0.124 = 12.4 %

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19.

Answer : (c)

Reason : Capital budget = Rs.18 million

Debt equity ratio = 30:70

Therefore debt = 18 ´ = Rs.5.4 million

The amount to be financed through equity = Rs.18 million – Rs.5.4 million =Rs.12.6 million

Net income = Rs.13 million

Therefore residual dividend = Rs.13 – Rs.12.6 = Rs.0.4 million

Dividend ratio = 0.4 million /100 million = 0.4%.

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20.

Answer : (e)

Reason :

11,628×P₁ =21,00,000-(15,00,000-4,00,000)

P₁=10,00,000/11,628

P₁=Rs.86

The price of the share when dividend is declared = Rs.86

= 0.125 = 12.5%.

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21.

Answer : (b)

Reason : Re-order point = Normal consumption during lead time + Safety stock

From the above equation, it can be understood that whenever consumption during lead time fluctuates, reporder point also changes. Hence, alternative (b) is false and other alternatives are true.

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22.

Answer : (d)

Reason : It is during Stage IV (maturity stage) that dividends range from 40%-60% of earnings, the highest of all stages. The reason is, since it has already crossed growth and expansion stages, the further investment opportunities, which can be financed through retained earnings, would be low. Hence, payment of dividend to the share holders would be preferred, as share holders are expected to earn more return on the distributed dividend income than the firm can earn on undistributed earnings.

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23.

Answer : (a)

Reason : Before stock dividend the market capitalization of Bambino Ltd is Rs. 13.50 x 1.25 = Rs.16.875 million

After stock dividend is declared, the total number of outstanding shares would be 1.25million (1.10) = 1.375 million

The expected stock price after the dividend paid is = Rs.16.875 million / 1.375 million = Rs.12.27 per share.

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24.

Answer : (c)

Reason : Step 1:

Calculate net fixed assets, which will be the same under either policy.

Fixed Assets turnover = 5.0

Fixed Assets = Rs.11,60,000

Step 2:

Determine total assets under each policy, given the total assets turnover ratio for each one.

Restricted: Total assets turnover = 4

Total Assets = Rs.14,50,000

Relaxed: Total assets turnover = 3.2

Total Assets = Rs.18,12,500.

Step 3:

Develop balance sheets for each policy to determine the debt level.

Restricted (Rs.) Relaxed (Rs.)

Current assets 2,90,000 6,52,500

Fixed assets 11,60,000 11,60,000

Total assets 14,50,000 18,12,500

Debt 8,70,000 10,87,500

Equity 5,80,000 7,25,000

Total liabilities & equity 14,50,000 18,12,500

Step 4:

Determine interest under each policy:

Restricted: Rs.8,70,000 x 0.11 = Rs.95,700.

Relaxed: Rs.10,87,500 x 0.11 = Rs.1,19,625.

Step 5:

Calculate the difference in interest expense (the savings) between the two policies:

Rs.1,19,625– Rs.95,700= Rs.23,925.

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25.

Answer : (c)

Reason : Statement (I) is true because in a situation of undertrading the turnover of working capital is low.

Statement (II) is not true because increasing the asset base in a situation of undertrading will only aggravate the problem.

Statement (III) is true because in a situation of undertrading the volume of sales is much less in comparison to the assets employed.

Statement (IV) is not true because in a situation of undertrading the capital employed is higher than the normal level, given the level of sales. Hence, undertrading is a case of overcapitalization and not undercapitalization.

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26.

Answer : (b)

Reason : A firm generally employs long-term sources of funds to finance its working capital margin that is the difference between the current assets and current liabilities. A negative net working capital implies that current assets are less than current liabilities. That signifies the usage of the short-term funds for financing the long-term assets. A company that follows a conservative working management policy generally maintains a very high current ratio and low profitability in comparison to its peers while the opposite thing occurs in case of aggressive working capital management policy.

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27.

Answer : (d)

Reason : The amount of raw materials consumed = Opening balance + Purchases during the year – Closing balance = (1,60,000 + 12,42,000 – 1,92,000) = Rs.12,10,000

Annual cost of production = Opening work in process + Consumption of raw materials + Manufacturing expenses + Depreciation – Closing work in process

= 25,000 + 12,10,000 + 12,30,000 + 1,00,000 – 45,000 = Rs.25,20,000

Annual cost of sales = Opening stock of finished goods + Cost of production + Selling, administration and financial expenses + Customs and Excise duties – Closing stock of finished goods = 30,000 + 25,20,000 + 2,30,000 + 1,50,000 – 50,000 = Rs.28,80,000

Average cost of goods sold per day = = Rs.8,000

Average inventory of finished goods = = Rs.40,000

So, the finished goods storage period = = 5 days.

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28.

Answer : (e)

Reason : (in Rs. Lakh)

Input	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	1.5		200
	1			133.33
	1				133.33
	2							266.67			733.33
Manufacturing Expenses
In WIP	1/2			41.67
In finished goods	1					83.33
In debtors	2								166.67			291.67
Selling, Administrative and financial expenses
In finished goods	1						50
In debtors	2									100		150
Profit
In debtors	2									133.33		133.33
Total		200		175			266.66			666.67		1308.33

Hence, the amount of working capital requirement is Rs1308.33lakh + Rs.50 lakh = Rs.1358.33 lakh

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29.

Answer : (e)

Reason : Cost of trade credit =

Other things remaining the same, following factors will decrease the cost of trade credit:

· Decrease in the rate of discount. For example: “1/10 Net 30” will have a lesser cost of trade credit compared to “2/10 Net 30”.

· Decrease in the discount period. For Example: “1/10 Net 30” will have a lesser cost of trade credit compared to “1/15 Net 30”.

· Increase in the credit period. For example “1/10 Net 30” will have a greater cost of trade credit compared to “1/10 Net 45”.

Hence (e) is the required answer.

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30.

Answer : (c)

Reason : By issuing letter of credit (L/C), a bank undertakes to pay the supplier of any machinery, goods or services, if the buyer fails to pay. It is issued by a bank in favour of its customer (the buyer in this case). In case the buyer fails to make the payment, the bank will be required to keep its commitment. Hence the alternative (c) is the answer.

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31.

Answer : (c)

Reason : Commercial paper is a short term instrument which is issued by financially strong companies. Investment in CPs is open to all investors; so it is not necessarily a source of bank finance.

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32.

Answer : (d)

Reason : Invoice discounting does not carry the service elements of factoring like sales ledger administration etc.

Hence, option (d) is the correct choice.

Recourse factoring, Non-recourse or full factoring and maturity factoring include the service elements of factoring.

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33.

Answer : (d)

Reason : Public deposit may be raised by a company by duly following certain norms as per the Companies Act. 1956 without the requirement of any collateral security. While in the other cases, security is to be provided compulsorily.

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34.

Answer : (a)

Reason : Dahejia Committee has not dealt with working capital financing.

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35.

Answer : (c)

Reason : Working capital gap is the difference between current assets and current liabilities excluding bank borrowings.

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36.

Answer : (d)

Reason : Holding lower levels of inventory leads to increasing costs of lost sales.

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37.

Answer : (c)

Reason : ABC system of inventory management has the following advantages:

It leads a closer control on the costly items where a large amount of funds is blocked.

A scientific method of controlling inventories can be developed based on the ABC system that will lead to the reduction of clerical costs.

ABC system also helps to maintain the optimum level of stocks.

The stock turnover rate can be maintained at a comparatively higher level through scientific control of inventories.

But, it does not analyse the items in inventory according to their importance in the production process, but its’ value.

. Hence option (c) is the answer.

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38.

Answer : (b)

Reason : Existing cost to the company : Cost of iron slag + Ordering cost + Carrying cost

= 50,000 ´ 980 ´ (1–0.02) + +

= 4,80,20,000 + 2,000 + 3,60,150

= 4,83,82,150

If the company switches to the new discount, the total cost would be

= 50,000 ´ 980 (1– 0.05) +

= 4,65,50,000 + 1,000 + 6,98,250

= 4,72,49,250

So the total benefit to the company would be

4,83,82,150 – 4,72,49,250 = Rs, 11,32,900.

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39.

Answer : (c)

Reason : Expected daily consumption rate = 50 ´ 0.20 + 100 ´ 0.50 + 200 ´ 0.30

= 120 units per day

Expected lead time=14 ´ 0.10 + 21 ´ 0.60 + 30 ´ 0.30= 23 days

So, Normal consumption during lead time is 120 ´ 23 = 2,760 units

The possible levels of consumption rate

Daily Consumption		Lead time		Possible levels of consumption
Units	Probability	Days	Probability	Units	Probability
50	0.20	14	0.10	700	0.02
		21	0.60	1050	0.12
		30	0.30	1500	0.06
100	0.50	14	0.10	1400	0.05
		21	0.60	2100	0.30
		30	0.30	3000	0.15
200	0.30	14	0.10	2800	0.03
		21	0.60	4200	0.18
		30	0.30	6000	0.09

Levels of safety stocks and associated costs.

Safety Stock (Units)	Stock Outs (Units)	Probability	Expected Stock Outs (Units)	Expected Stock Outs Cost (Rs.)	Carrying Cost (Rs.)	Total Cost (Rs.)
3,240	0	0	0	0	9,720	9,720
1,440	1,800	0.09	162	1,620	4,320	5,940
240	3,000	0.09	270
	1,200	0.18	216
			486	4,860	720	5,580
40	3,200	0.09	288
	1,400	0.18	252
	200	0.15	30
			570	5,700	120	5,820

As the total cost is minimum when safety stock is 240 units i.e. reorder level should be 2,760 + 240 or 3,000 units.

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40.

Answer : (b)

Reason : EOQ == = 1,000 units

Time after which an order is to be placed = EOQ/ Per day consumption

Per day consumption = Annual Usage / 360 days = 138.88

50,000/360 = 138.88 units

1,000/ 138.88 = 7 days.

Working notes:

Carrying cost per unit = Rs.5x20% = Re.1.

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41.

Answer : (b)

Reason : If the marginal reduction in order costs exceeds the marginal carrying cost of inventory, the firm should increase the number of orders, till marginal changes in both the costs are equal to reach the minimum total cost point i.e., EOQ.

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42.

Answer : (c)

Reason : TC=PC + UF/Q

As per the given information,

1.75 UF/Q = PC + UF/Q

0.75 UF/Q = PC

0.75UF =PCQ

Q = 0.75UF/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 (c) is answer.

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43.

Answer : (c)

Reason :

EBIT	Rs.10,00,000
Less: Interest on debt	Rs.1,20,000
EBT	Rs.8,80,000
Less: Tax @40%	Rs.3,52,000
PAT	Rs.5,28,000
Number of equity shares to be repurchased at Rs.15 each share with 12,00,000 debt	Rs.12,00,000/Rs.15 = 80,000
Number of equity shares after repurchase	3,00,000-80,000 = 2,20,000
Earning per share after the change in capital structure	Rs.5,28,000/2,20,000 = Rs.2.4
Dividend per share	Rs.2.4 ´ 0.55 =Rs.1.32
Price per share [D1/(Ke-g)]	Rs.1.32/(0.12-0.05) = Rs.18.86.

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44.

Answer : (c)

Reason : Earning power represented by EBIT/Total Assets is not affected by tax rate and financial struture, since it measures the power of company before payment of taxes and interest. Hence, alternative (c) is answer.

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45.

Answer : (c)

Reason : If first order is accepted from Pushkar:

If Pushkar pays in full in 40 days

Contribution = Rs 80,000 – Rs.60,000 = Rs 20,000

If Pushkar defaults

Cost of production = Rs.60,000

Expected benefit = 20,000 ´0.7 –60,000´0.3 = – Rs.4,000

If 10 further orders are accepted from Pushkar:

Benefit, if Pushkar pays =20,000 ´ 10 = Rs. 2,00,000

Loss, if Pushkar defaults = 60,000´10 = Rs. 6,00,000

Expected benefit = 2,00,000 ´ 0.8 – 0.2´6,00,000 = Rs. 40,000

Probability of placing further 10 orders is 0.8

Expected benefit = 40,000 ´ 0.8 = Rs.32,000

Total expected benefit = –4,000 + 32,000 = Rs. 28,000

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46.

Answer : (a)

Reason : EOQ =( 2UF/PC)^1/2 = ((2×2,000×15,00,000)/500×0.1)^1/2 = 10,954.45 units.

Since orders must be placed in multiples of 100 units, order can be placed 11,000 units

EOQ, when carrying cost increases by 40%

EOQ* =(2x2,000x15,00,000/ 500x0.1x1.4 )^1/2 = 9,258.2 units.

Since orders must be placed in multiples of 100 units, order can be placed 9,300 units

Elasticity of EOQ in response to 40% increase in carrying costs

= % change in EOQ/ % change in carrying costs = = -45.7%.

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47.

Answer : (a)

Reason : Cost of carrying existing receivables before liberalization

=

Cost of carrying existing receivables after liberalization

=

Saving in the cost of carrying existing receivables

= 1.75 –1.167 = Rs.0.583 crore…………….(A)

The cost of funds invested in the receivables arising out of new sales

= crore ………(B)

Amount of discount presently paid

= Rs.150 ´ 0.015 ´0.4 = Rs.0.9 crore

Amount of discount payable after liberalization

= 180 ´ 0.025 ´ 0.75 = Rs.3.375 crore

The additional amount of discount payable

= 3.375 – 0.90 = Rs.2.475 crore…………(C)

Thus the total incremental cost = A – B – C

= + 0.583 – 0.175 – 2.475= – Rs. 2.067 crore

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48.

Answer : (c)

Reason : The value of resources used in an investment project should be measured in terms of their opportunity cost.

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49.

Answer : (d)

Reason : Increasing collection expenditure is likely to result in shorter collection period and reduced bad debt losses, as the collection efforts are improved through the increase in expenditure.

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50.

Answer : (c)

Reason : This diagram is based on traditional approach of capital structure theories .In this theory, it is said that the cost of debt capital remains more or less constant up to a certain degree of leverage but rises thereafter at an increasing rate. Also the cost of equity capital remains more or less constant up to a certain degree of leverage but rises thereafter at an increasing rate. As a consequence of this, the average cost of capital behaves similarly to the cost of equity and cost of debt capital.

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51.

Answer : (b)

Reason : Collection policy will have impact on sales even though, collecting past-due accounts occurs only after the customer has already purchased. It is because, the customer can repeatedly purchase from the same firm. If he experiences strict policy, he may shift from one supplier to another. Similarly, new customers also may consider collection policies of the supplying firm, before making purchases. Hence, statement (II) is not correct. Alternative (b) is the answer.

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52.

Answer : (c)

Reason : Day sales outstanding denote the number of days of average sales that is outstanding at a particular point of time. Thus, if it is higher than the industry norms, it means that the collection department is not efficient enough. If a firm changes its credit terms from net 30 days to 2/10, net 30 this may induce the customers to pay early and hence DSO may decrease. It the firm is selling on 2/10, net 30 and DSO is 30 days, it implies that customers are not availing of the cash discount facility and accounts receivables are due for a longer period of time. Thus statement given in (III) is correct.

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53.

Answer : (b)

Reason : If credit sales as a percentage of a firm's total sales increases and the selling price per unit decreases, the firm's accounts receivable may not increase. It is because, the proportionate fall in selling price may be more than the proportionate increase in total sales, which may lead to fall in sales value resulting in decrease in accounts receivable. A firm with excess production capacity and relatively low variable costs would be more inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity. Hence, statement (I) and (III) are not correct. It is possible for a firm to overstate profits by offering very lenient credit terms, which encourage additional sales to financially "weak" firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts. This is correct and hence the correct answer is (b).

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54.

Answer : (d)

Reason : Average collection period = 60 + 28 = 88 days

Average Investment in Receivables = Rs.300,000,000 ´ 88 /365 = Rs.72,328,767.12.

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55.

Answer : (d)

Reason : P_p × (1– Percentage of Cost on Sales) – (1– P_p) × Percentage of Cost on Sales

0.7 ×0.1 – 0.3 ×0.9 = -0.2 =-20% on sales.

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56.

Answer : (e)

Reason : A company generally chooses the liquidity mix on the basis of the level of uncertainty in the cash flows. Nature of control with the managers, extent of leverage, marginal cost of capital and the quality of the products of the company do not play any role in this respect.

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57.

Answer : (a)

Reason : Option (a) is the correct answer.

	Installed cost	Rs.3,92,000
Less:	Salvage value	- Rs. 12,000
Less:	Tax savings on sale	- Rs.5,200
Add:	Increase in NWC	Rs.18,000
		Rs.3,92,800

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58.

Answer : (e)

Reason : NPV = -Rs.8,25,000 - Rs.4,10,000 + Rs.3,60,000 + Rs.1,50,000PVIFA(14%,5) + Rs.2,00,000

PVIFA(14%,7) PVIF(14%,5) + Rs.50,000PVIF (14%,12)

= -Rs.8,75,000 + 1,50,000 (3.433 ) + 2,00,000 (4.288)(0.519) + Rs.50,000 (0.208)

= Rs.95,444

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59.

Answer : (e)

Reason : In broader sense, cash in comprising of notes, coins, deposits in a bank, drafts, cheques and marketable securities that can be easily converted into cash.

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60.

Answer : (b)

Reason : When the net float is negative the balance in the books of bank is less than the balance in the books of the firm. The relationship between the current asset and current liability does not play any role in the determination of the net float.

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61.

Answer : (e)

Reason : The average cash outflow during the 5 peak days in the month of April was

As the magnitude of cash out flows in the month of May is 30% more than that in the month of April, so the expected average cash out flows during the 5 peak days in the month of May would be

Rs. 79,000 ´ 1.3 = Rs. 1,02,700

So the safety level of cash to be maintained is 5 ´ 1,02,700 or Rs. 5,13,500.

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62.

Answer : (b)

Reason : It is assumed that the risk characterizing the new project under consideration is almost same as the risk characterizing the existing investment of the firm. Therefore, statement (I) is not correct. It is assumed that the firm will continue to pursue the same financing policy, i.e. the debt-equity mix in the capital structure. Hence, (II) is correct.

Further, no assumption is made regarding the management of firm to remain same. Hence, (III) is incorrect. Answer is (b).

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63.

Answer : (c)

Reason : Alternatives (a), (b), (d) and (e) are true with regard to the internal rate of return. Alternative (c) is not true because the pattern of cash inflows and outflows affect the internal rate of return.

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64.

Answer : (e)

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 and vice versa.

Hence statement (I) is incorrect.

NBCR =

BCR =

Therefore a negative NPV indicates that the present value of inflows is less than the initial investment, in other words it implies that BCR < 1 and NBCR <0. Hence, statement (II) and (III) are true.

Hence option (e) is the answer.

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65.

Answer : (b)

Reason : The ARR gives equal weights to all receipts. Hence (b) is incorrect. The ARR considers accounting profits and not cash flows (c). It considers the profits over the entire life of the project (a) and it serves as a measure of profitability of the investment (d). It does not consider the time value of money (e).

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66.

Answer : (d)

Reason : The project cannot be accepted when the present value of inflows is less than Rs.10 lakh, the initial investment. The project cannot be accepted, when the IRR is less than 12%, the required rate of return. The project cannot be accepted when the benefit cost ratio is less than 1.00. The project can be accepted when the payback period is less than 3 years, the required payback period. The project cannot be accepted, when net benefit cost ratio is less than 0.

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67.

Answer : (c)

Reason : Present values of cash inflows from project A = 25,000/1.10 + 1,25,000/1.10² + 1,75,000/1.10³ =2,57,513

Profitability Index of A= 2,57,513/2,40,000=1.073

Present value of cash inflows from project B = 1,50,000/1.10 + 1,00,000/ 1.10² + 75,000/1.10³ =2,75,357

Profitability Index of B= 2,75,357/2,50,000 = 1.10

We would accept only project B, because it has the higher profitability index, even though profitability indexes of both the projects are more 1, they are mutually exclusive.

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68.

Answer : (b)

Reason : The depreciation for the old machines is Rs.70,000/4 = Rs.17,500 while the same for the new one is Rs.3,50,000/4 = Rs.87,500. Hence, the incremental depreciation = Rs.87,500 – Rs.17,500 = Rs.70,000.

The expected cash flows from this investment will be:

Year	0	1	2	3	4
A. Initial Investment	(3,00,000)
B. Incremental revenue		60,000	60,000	60,000	60,000
C. Operational savings		40,000	40,000	40,000	40,000
D. Incremental Depreciation		70,000	70,000	70,000	70,000
E. Incremental profit		30,000	30,000	30,000	30,000
F. Incremental taxes		12,000	12,000	12,000	12,000
G. Incremental PAT		18,000	18,000	18,000	18,000
Incremental Cash flow		88,000	88,000	88,000	88,000

The NPV for this proposal = –3,00,000 + 88,000 ´ PVIFA (12 percent, 4 years)

= –3,00,000 + 2,67,256 = –Rs.32,744.

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69.

Answer : (b)

Reason : The payback method is at best a crude measure of the risk of a project because it fails to consider the variability of a project’s returns.

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70.

Answer : (d)

Reason : When a project has multiple internal rates of return, the analyst should compute the project’s net present value and accept the project, if its’ NPV is greater than Rs.0. Otherwise, he can also compute profitability index and accept the project, if it is more than 1. Hence, (d) is answer.

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71.

Answer : (b)

Reason : Value for shareholders, in most companies, is largely derived from investment decisions focused on the asset side of the financial balance sheet.

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72.

Answer : (c)

Reason : Option (c) is the correct answer.

NINV = Rs.23,000 + Rs.7,000 = Rs.30,000

NCF_1-9 = (Rs.32,000 – Rs.29,000 – Rs.2,300)(1 – 0.3) + Rs.2,300 = Rs.2,790

NCF₁₀ = Rs.2,790 + Rs.7,000 = Rs.9,790

NPV = –Rs.30,000 +Rs.2,790 PVIFA (12%,9) + Rs.9,790PVIF (12%,10)

= –Rs.30,000 + Rs.2,790 ´ 5.328 + Rs. 9,790 ´0.322

NPV = –Rs.11,982.5

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73.

Answer: (a)

Reason: Matching the maturities of assets and liabilities reduces risk. Hence, generally firms choose to finance temporary working capital with short-term debt to match the maturities of assets and liabilities and thereby to reduce risk.

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