Comment Type Questions

CA ARUN SETIA CLASSES
such cases, the monetary value is fixed in terms of foreign currency at the time of agreement
which is completed at a later date. Transaction exposure basically covers the following:
(a) Rate Risk: it will occur when at time of transaction exchange rate fluctuate
(b) Credit Risk: A situation when the borrower is not in a position to pay.
(c) Liquidity Risk: Same as in the case of credit risk.
2. Translation Exposure: This is also called the accounting exposure. It refers to and deals with
the probability that the firm may suffer a decrease in assets value due to devaluation of a
foreign currency even if no foreign exchange transaction has occurred during the year. This
exposure needs to be measured so that the financial statements i.e the balance sheet and the
income statement reflect the change in value of assets and liabilities.
3. Economic Exposure: The economic exposure refers to the probability that the change in
foreign exchange rate will affect the value of the firm. Since the intrinsic value of the firm is
equal to the sum of the present values of future cash flows discounted at an appropriate rate of
return, the risk contained in economic exposure requires a determination of the effect of
changes in exchange rates on each of the expected future cash flows.
Question 31
Differentiate between Ask price and Bid price.
Answer
The Ask Price is the rate at which the foreign exchange dealer asks its customers to pay in local
currency in exchange of the foreign currency. In other words, ask price is the selling rate or the
offer rate and refers to the rate at which the foreign currency can be purchased from the
dealer. On the other hand, the Bid price is the rate at which the dealer is ready to buy the
foreign currency in exchange for the domestic currency. So, the bid price is the rate which the
dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore,
it is the buying rate.
COMMENT
Question 32
What are the forms of dividend explain.
Answer
Dividends can be divided into following forms:
(i) Cash dividend : The company should have sufficient cash in bank account when cash
dividends are declared. If it does not have enough bank balance, it should borrow
funds in advance. For stable dividend policy, a cash budget may be prepared for
coming period to indicate necessary funds to meet regular dividend payments.
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The cash account and reserve account of the company is bound to reduce on payment of cash
dividend . Both total assets as well as net worth of the company are reduced when cash
dividend is distributed. Accordingly market price of share drops by the amount of cash dividend
distributed.
(ii) Stock Dividend (Bonus shares) : It is distribution of shares in lieu of cash dividend to
existing shareholders. Such shares are distributed proportionately thereby retaining
proportionate ownership of the company. If a shareholder owns 100 shares at a
time, when 10% dividend is declared he will have 10 additional shares thereby
increasing the equity share capital and reducing reserves and surplus (retained
earnings). The total net worth is not affected by bonus issue.
Advantages : There are many advantages both to the shareholders and to the company.
Some of the important advantages are listed as under:
1) To Share Holders:
(a) Tax benefit –At present, there is no tax on dividend received.
(b) Policy of paying fixed dividend per share and its continuation even after
declaration of stock dividend will increase total cash dividend of the share
holders in future.
2) To Company:
(a) Conservation of cash for meeting profitable investment opportunities.

(b) Cash deficiency and restrictions imposed by lenders to pay cash dividend.
Question 33
“Bonus issue is a common method of distribution of dividend, however it has many limitations”
comment.
Answer
Limitations of stock bonus:
1. To Shareholders: Stock dividend does not affect the wealth of shareholders and
therefore, has no value for them. This is because, the declaration of stock dividend is a
method of capitalising the past earnings of the shareholders and is a formal way of
recognising earnings which the shareholders already own. It merely divides the
company's ownership into a large number of share certificates. James Porterfield
regards stock dividends as a division of corporate pie into a larger number of pieces.
Stock dividend does not give any extra or special benefit to the shareholder. His proportionate
ownership in the company does not change at all. Stock dividend creates a favourable
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psychological impact on the shareholders and is greeted by them on the ground that it gives an
indication of the company's growth.
2. To Company: Stock dividends are costlier to administer than cash dividend. It is

disadvantageous if periodic small stock dividends are declared by the company as
earnings. Since small issue of stock dividend are not adjusted at all and only significant
stock dividends are adjusted hence growth rate measured in EPS being less than growth
rate based on per share.
Question 34
What are the different motives for holding cash?
Answer
a) Transactional Motive
This is the most essential motive for holding cash because cash is the medium through which all
the transactions of the firm are carried out. Some examples of transactions of a manufacturing
firm are given below:
– Purchase of Capital Goods like plant and machinery

– Purchase of raw material and components
– Payment of rent and wages
– Payment for utilities like water, power and telephone
– Payment for service like freight and courier
These transactions are paid for from the cash pool or cash reservoir which is all the time being
supplemented by inflows. These inflows are of the following kinds:
– Capital inflows from promoters’ capital and borrowed funds

– Sales proceeds of finished goods
– Capital gains from investments
The size of the cash pool depends upon the overall operations of the firm. Ideally, for
transaction purposes, the working capital inflows should be more than the working capital
outflows at any point of time.
b) Speculative Motive
Since cash is the most liquid current asset, it has the maximum potential of value addition to a
firm’s business. The value addition can come in two forms. First, as the originating and terminal
point of the operating cycle, cash is invaluable. But cash has an opportunity cost also and if cash
is kept idle, it becomes a liability rather than an asset. Therefore, efficient firms seek to deploy
surplus cash in short term investments to get better returns. It is here that the second form of
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value addition from cash can be had. Since this deployment of cash needs to be done skillfully,
not all the firms hold cash for speculative motive. Further the amount of cash held for
speculative motive should not cause any strain upon the operating cycle.
c) Contingency Motive
This motive of holding cash takes into account the element of uncertainty associated with any
form of business. The uncertainty can result in prolongation of the working capital operating
cycle or even its disruption. It is possible that cost of raw materials or components might go up
or the time taken for conversion of raw materials into finished goods might increase. For such
contingencies, some amount of cash is kept by every firm.
Question.35
Write short notes on Effect on Inflation on Inventory Management.
Answer
Effect on Inflation on Inventory Management: The main objective of inventory management
is to determine and maintain the optimum level of investment in inventories. For inventory
management a moderate inflation rate say 3% can be ignored but if inflation rate is higher it
becomes important to take into consideration the effect of inflation on inventory
management. The effect of inflation on goods which the firm stock is relatively constant can
be dealt easily, one simply deducts the expected annual rate of inflation from the carrying
cost percentage and uses modified version in the EOQ model to compute the optimum
stock. The reason for making this deduction is that inflation causes the value of the inventory
to raise, thus offsetting somewhat the effects of depreciation and other carrying cost factors.
Since carrying cost will now be smaller, the calculated EOQ and hence the average inventory
will increase. However, if rate of inflation is higher the interest rates will also be higher, and
this will cause carrying cost to increase and thus lower the EOQ and average inventories.
Question36
The forward rate is an accurate predictor of the future spot rate. Do you agree?
In the absence of any control in the financial market,
Answer Forward Rate is accurate predictor of Future Rate.
Theoretically, in the efficient market and in the absence of intervention or control in the
exchange or financial markets, the forward rate is an accurate predictor of the future spot rate.
These requirements are, generally, satisfied if the following three conditions are found:
Interest Rate Parity : According to interest rate parity principle, the forward premium (or
discount) on currency of acountry vis-à-vis the currency of another country will be exactly offset
by the interest rate differential between the countries. The currency of the country with lower
interest rate is quoted at a forward premium andvice-versa.
(i) Purchasing Power Parity (PPP) : According to the PPP Principle, the currency of a
country will depreciate vis-à-vis the currency of another country on the basis of
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differential in the rates of inflation between them. The rate of depreciation in the
currency of a country would roughly be equal to the excess inflation rate in the
country over the other country.
(ii) International Fisher Effect : The interest rate differential between two countries,
according to the Fisher effect, will reflect differences in the inflation rates in them. The
high interest country will experience higher inflation rate.
However, even if these conditions are satisfied, the future spot rate might not be identical to
the forward rate. Random differences between the two rates may be found.
Question.37
What is the role of Company Secretary as a forex manager?
Answer
Company Secretary as a forex manager
The developments in international trade have resulted in the emergence of a new brand of
manager called the forex manager. The forex manager is a category apart from the finance
manager or the treasury manager. He has to transact with dealers, brokers and bankers in the
foreign exchange market. He has to face special kind of risk. Yet his vocation is full of
opportunities and challenges. For effective management of forex transactions, the forex
manager is expected to have awareness of historical development of world trade, ability to
forecast future trends in exchange movements, have comparative analysis skills, have in- depth
knowledge of forex market and movement of interest rates,. He should also be able to hedge
his position. By virtue of their training and education, a company secretary is competent in
dealing with all these situations
Question38
“A firm’s stock price is not related to its mix of debt and equity financing.” Do you agree with
the statement? Give reasons.
Answer
According to theory of modern financial management by Modigliani and Miller, the value of a
firm depends solely on its future earnings stream, and hence its value is unaffected by its
debt/equity mix. They concluded that a firm’s value stems from its assets, regardless of how
those assets are financed.
MM Hypothesis was based on restrictive set of assumptions, including perfect capital markets
(which implies zero taxes). They used an arbitrage proof to demonstrate that capital structure is
irrelevant. If debt financing resulted in a higher value for the firm than equity financing, then
investors who owned shares in a leveraged (debt-financed) firm could increase their income by
selling those shares and using the proceeds, plus borrowed funds, to buy shares in an
unleveraged (all equity-financed) firm. The simultaneous selling of shares in the leveraged firm
and buying of shares in the unleveraged firm would drive the prices of the stocks to the point
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where the values of the two firms would be identical. Thus, according to MM Hypothesis, a
firm’s stock price is not related to its mix of debt and equity financing.
However, according to according to Net income approach the capital structure decision is
relevant to the valuation of the firm. As such a change in the capital structure causes an overall
change in the cost of capital and also in the total value of the firm. A higher debt content in the
capital structure means a high financial leverage and this result in decline in the overall or
weighted average cost of capital. This results in increase in the value of the firm and also
increase in the value of the equity shares. In an opposite situation, the reverse condition
prevails. Assumptions of this approach are:
1. Corporate taxes do not exist
2. Debt content does not change the risk perception of the investors.
3. Cost of debt is less than cost of equity i.e., debt capitalization rate is less than the equity
capitalization rate.
Question.39
What are business risk and financial risk? How does each of them influence the firm’s capital
structure decisions?
Answer
BUSINESS RISK
Business risk is inherent in any company’s operations. If a firm is unable to cover its operating
costs, it is exposed to business risk. In general, the greater the firm's operating leverage- the
use of fixed operating costs-the higher its business risk. Although operating leverage is an
important factor affecting business risk, two other factors also affect it.
i) revenue stability and
ii) cost stability
Revenue stability reflects the relative variability of the firm's sales revenues. Firms with stable
levels of demand and product prices tend to have stable revenues. The result is low levels of
business risk. Firms with highly volatile product demand and prices have unstable revenues that
result in high levels of business risk. Cost stability reflects the relative predictability of input
prices such as those for labour and materials. The more predictable and stable these input
prices are, the lower the business risk; the less predictable and stable they are, the higher the
business risk.
Business risk varies among firms, regardless of their lines of business, and is not affected by
capital structure decisions. The higher a firm's business risk, the more cautious the firm must be
in establishing its capital structure. Firms with high business risk therefore tend toward less
highly leveraged capital structures, and firm with low business risk tend toward more highly
leveraged capital structures.
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FINANCIAL RISK
If a firm is unable to cover its required financial obligations, it is exposed to financial risk. In
general, the greater the firm's financial leverage- the use of fixed charge source of funds - the
higher its financial risk.
The firm's capital structure directly affects its financial risk which is the risk to the firm of being
unable to cover required financial obligations. The penalty for not meeting financial obligations
is bankruptcy. The more fixed cost financing-debt (including financial leases) and preferred
stock firm has in its capital structure, the greater its financial leverage and risk. Financial risk
depends on the capital structure decision made by the management and, that decision is
affected by the business risk the firm faces.
Question 40
What do you mean by capital rationing? Illustrate some of its advantages.
Answer
Capital rationing is a common practice in most of the companies as they have more profitable
projects available for investment as compared to the capital available. In theory, there is no
place for capital rationing as companies should invest in all the profitable projects. However,
majority of companies follow capital rationing as a way to isolate and pick up the best projects
under the existing capital restrictions.
Capital rationing is a technique of selecting the projects that maximizes the firm’s value when
the limited budget of company/firm is allocated optimally between different projects. This aims
in choosing only the most profitable investments for capital investment decision.
This can be accomplished by putting restrictive limits on the budget or selecting a higher cost of
capital as the hurdle rate for all the projects under consideration.
There are few advantages of practicing capital rationing:
 Budgeting: The first and an important advantage is that capital rationing introduces a
sense of strict budgeting of corporate resources of a company. Whenever there is an
injunction of capital in the form of more borrowings or stock issuance capital, the
resources are properly handled and invested in profitable projects.
 Less wastage: Capital rationing prevents wastage of resources by not investing in each
and every new project available for investment.
 Fewer projects: Capital rationing ensures that limited number of projects are selected
by imposing capital restrictions. This helps in keeping the number of active projects to
minimum and thus manages them well.
 Higher returns on investments: Through capital rationing, companies invest only in

projects where the expected return is high, thus eliminating projects with lower
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returns on capital.
Stability: As the company is not investing in every project, the finances are not over-extended.
This helps in having adequate finances for tough times and ensures more stability and increase
in the stock price of the company Thus, there is no evidence as to whether inflation raises or
lowers the optimal level of inventories of firms in the aggregate.
Question.41
A higher financial leverage is better than higher operating leverage. Comment.
Answer
Operating leverage indicates the proportion of fixed operating charges. Higher operating
leverage indicates higher quantum of fixed operating charges. If a business firm has a lot of
fixed costs as compared to variable costs, then the firm is said to have high operating leverage.
The financial leverage indicates the proportion of fixed financial charges, in the form of interest
cost. Higher financial leverage indicates higher quantum of fixed financial charges.
T
he company can differ or somewhat convince the financial institution and banks, to accept the
delay in payment, which cannot be possible in the case of provider of operating activities.
Hence we can say that higher financial leverage is better than higher operating leverage.
Question.42
Write short note on effect of a Government imposed freeze on dividends on stock prices and
the volume of capital investment in the background of Miller-Modigliani (MM) theory on
dividend policy.
Answer
According to MM theory, under a perfect market situation, the dividend decision of any firm is
irrelevant as it does not affect the value of firm. Thus, under MM’s theory, the government
imposed freeze on dividends should make no difference on stock prices. Firms not paying
dividends will have higher retained earnings and will either reduce the volume of new stock
issues, repurchase more stock from market or simply invest extra cash in marketable securities.
In all of the above cases, the loss by investors of cash dividends will be made up in the form of
capital gains.
Whether the Government imposed freeze on dividends has an effect on volume of capital
investment in the background of MM theory on dividend policy fetches two arguments. First
argument is that if the firms keep their investment decision separate from their dividend and
financing decision, then the freeze on dividend by the Government will have no effect on
volume of capital investment. If the freeze restricts dividends the firm can repurchase shares or
invest excess cash in marketable securities e.g. in shares of other companies.
Other argument is that the firms do not separate their investment decision from dividend and
financing decisions. Rather, they prefer to make investment from internal funds. In this case,
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the freeze of dividend by government could lead to increased real investment.
Question.43
Describe the logic underlying the use of target weights to calculate the WACC, and compare
and contrast this approach with the use of historical weights. What is the preferred weighting
scheme?
Answer
First, we have to understand the concept of book value weight and market value weight to
calculate WACC.
Book value weights use accounting values to measure the proportion of each type of capital in
the firm’s financial structure. Market value weights measure the proportion of each type of
capital at its market value. Market value weights are appealing because the market values of
securities closely approximate the actual Rupees to be received from their sale. Moreover,
because firms calculate the costs of the various types of capital by using prevailing market
prices, it seems reasonable to use market value weights. In addition, the long-term investment
cash flows to which the cost of capital is applied are estimated in terms of current as well as
future market values. Market value weights are clearly preferred over book value weights.
HISTORICAL VERSUS TARGET WEIGHT
Historical weights can be either book or market value weights based on actual capital structure
proportions. For example, past or current book value proportions would constitute a form of
historical weighting, as would past or current market value proportions. Such a weighting
scheme would therefore be based on real—rather than desired—proportions. However,
Target weights, which can also be based on either book or market values, reflect the firm’s
desired capital structure proportions. Firms using target weights establish such proportions on
the basis of the “optimal” capital structure they wish to achieve. Considers the somewhat
approximate nature of the calculation of weighted average cost of capital, the choice of weights
may not be critical. However, from a long term perspective, the preferred weighting scheme
should be target market value proportions.
Question44
The scope of financial services in India is very wide. Discuss the various activities covered under
financial services.
Answer
Scope of Financial Services
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(i) Traditional Activities

Traditionally, the financial intermediaries have been rendering a wide range of
services encompassing both capital and money market activities. They can be
grouped under two heads:
(a) Fund based activities : The traditional services which come under fund based
activities are the following:
o Underwriting or investment in shares, debentures, bonds, etc. of new issues
(primary market activities).
o Dealing in secondary market activities.
o Participating in money market instruments like commercial Papers, certificate of
deposits, treasury bills, discounting of bills etc.
o Hire purchase
o Leasing
o Venture capital
(b) Non-fund based activities : Financial intermediaries provide services on the basis of
non-fund activities also. This can be called ‘fee based’ activity. They include:
o Merchant banking
o Broking service
o Credit rating
o Portfolio management
o Underwriting etc.
Question.45
‘Loan syndication is one of the project finance services. ’Discuss.
Answer
Loan syndication involves obtaining commitment for term loans from the financial institutions
and banks to finance the project. Basically it refers to the services rendered by merchant
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bankers in arranging and procuring credit from financial institutions, banks and other lending
and investment organisation or financing the client project cost or working capital
requirements.
Loan syndication is infact a tie up of term loans from the different financial institutions. The
process of loan syndication involves various formalities such as:
 Preparation of project details,

 Preparation of loan application,
 Selection of financial institutions for loan syndication,
 Issue of sanction letter of intent from the financial institutions,
 Compliance of terms and conditions for the availment of the loan,
 Documentation, and
 Disbursement of the loan.
Question46
Explain the process of securitization of debt and the participants involved in the process.
Answer
Securitisation of debt is a technique by which identified receivables and other financial assets
can be packaged into transferable securities and sold to investors. The instruments issued
under a securitisation deal derive their value from the cash flows (current or future) or
collateral value of a specified financial asset or pool of financial assets, general debt obligations
or other financial receivables.
Participants of the securitization process
The following parties are involved in a typical securitization deal:
1. Originator: This is the entity that requires the financing and hence is the driver of the
deal. Typically the Originator owns the assets or cash flows around which the
transaction is structured.
2. SPV (Special Purpose Vehicle): An SPV is typically used in structured transaction for
ensuring bankruptcy remoteness from the Originator. The SPV is the issuer of securities
or the entity through which the financing is channeled. Typically the ownership of the
cash flows or assets around which the transaction is structured is transferred from the
Originator to the SPV at the time of execution of the transaction. The SPV is typically a
marginally capitalized entity with narrowly defined purposes and activities and usually
has independent trustees/directors.
3. Investors : The investors are the providers of funds and could be individuals or
institutional investors like banks, financial institutions, mutual funds, provident funds,
pension funds, insurance companies, etc.
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4. Obligor(s) : The Obligor is the Originator’s debtor. The amount outstanding from the
Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is
of paramount importance in a structured finance transaction.
5. Guarantor/Credit Enhancement Provider/Insurer : These are entities that provide

protection to the Investor for the finance provided and the returns thereon against
identified risks. Typically, on the happening of pre-identified events, affecting the
underlying assets or cash flows or the payment ability of the Obligors, these entities pay
moneys, which are passed on, to the Investor.
Besides these primary parties, the other parties involved in a deal are given below:
1. Rating Agency: Since structured finance deals are generally complex with intricate
payment structures and legal mechanisms, rating of the transaction by an independent
qualified rating agency plays an important role in attracting Investors.
2. Administrator or Servicer: The Servicer performs the functions of collecting the cash
flows, maintaining the assets, keeping records and general monitoring of the Obligors. In
many cases, especially in the Indian context, the Originator also performs the role of the
Servicer.
3. Agent and Trustee: The Trustee is the manager of the SPV and plays a key role in the
transaction. The Trustee generally administers the transaction, manages the inflow and
outflow of moneys, and does all acts and deeds for protecting the rights of the Investors
including initiating legal action against various participants in case of any breach of
terms and triggering payment from various credit enhancement structures.
4. Structurer: Normally, an investment banker acts as the structurer and designs and
executes the transaction. The Structurer also brings together the Originator, Credit
Enhancement Provider, the Investors and other parties to a deal. In some cases (like
ICICI), the Investor also acts as the Structurer.
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A securitisation deal normally has the following stages:-

1. The originator issues loan to the obligors
2. The cash flows (principal + interest) on the loan are collected by the collection agent
on behalf of the originator.
3. Support mechanisms (or credit enhancements) are appointed in the structure in
order to minimise or mitigate potential credit risks.
4. The loan pool is selected and credit rating is taken.
5. A structure, generally, a merchant banker is appointed.
6. The SPV is formed. It acquires the receivables under an agreement at their
discounted value.
7. The SPV pays the purchase consideration to the originator.
8. & 9. The SPV funds the purchase by issuing class A (senior) Pass Through Certificates
(PTCs) and class B (Subordinated)PTCs.
9. The collection agent collects the receivables, usually in an escrow mechanism, and
pays off the collection to the SPV.
The SPV either passes the collection to the investors, or reinvests the same to pay off to
investors at stated intervals.
Question47
What is Social Cost benefit analysis (SCBA) of project? Explain the approaches for SCBA.
Answer
Social cost-benefit analysis is a systematic and cohesive method to survey all the impacts
caused by a project. It comprises not just the financial effects (investment costs, direct benefits
like tax and fees, etc), but all the social effects, like: pollution, safety, indirect (labour) market,
legal aspects, etc. The main aim of a social cost benefit analysis is to attach a price to as many
effects as possible in order to uniformly weigh the abovementioned heterogeneous effects. As
a result, these prices reflect the value a society attaches to the caused effects, enabling the
decision maker to form a statement about the net social welfare effects of project.
Two approaches for SCBA

– UNIDO Approach: - This approach is mainly based on publication of UNIDO (United
Nation Industrial Development Organisations) named Guide to Practical Project Appraisal
in1978.
The UNIDO guidelines provide a comprehensive framework for appraisal of projects and
examine their desirability and merit by using different yardsticks in a step-wise manner. The
desirability is examined from various angles, such as the impact on
(a) Financial profitability of utilization of domestic resources,
(b) Savings and consumption pattern,
(c) Income distribution, and
(d) Production of merit and demerit goods.
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– L-M Approach :- The seminal work of Little and Mirrlees on benefit-cost analysis
systematically develops a theoretical basis for the analysis and its underlying assumptions and
lays down step-wise procedure for undertaking benefit-cost studies of public projects. The
mathematical formulation is identical to the UNIDO method except for differences in assigning
value to discount rates and accounting for imperfections and other market failures and social
considerations.
Like UNIDO guidelines, the Little-Mirrlees method also suggests valuation of project investment
at opportunity cost (shadow prices) of resources to correct distortions due to market
imperfections.
Question48
“In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend
action does provide a clear-cut means of ‘making a statement’ that speaks louder than
thousand words.”Explain.
Answer
In an uncertain environment, verbal statements about the performance of the company may
not be significant but changes in dividends cannot be ignored as they contain information vital
to the investors. The payment of dividend conveys to the shareholders information relating to
the profitability of the firm. An increase in the amount of dividend signify that the firm expects
its profitability to improve in future or vice versa. The dividend policy is likely to cause a
changes in the market price of the shares.
Although Modigliani and Miller they still maintain that dividend policy is irrelevant as dividends
do not determine the market price of shares. However, empirical studies have proved that
changes in dividends convey more significant information than what earnings announcements
do. Further, the market reacts to dividend changes – prices rise in response to a significant
increase in dividends and fall when there is a significant decrease or omission in payment of
dividend Modern activities
Thus from above it is proved that dividend action provide a clear cut mean of making a
statement.
Question49
State with reason whether the investment, financing and dividend decisions are inter-related.
Answer
Financial Management, to be more precise, is concerned with investment, financing and
dividend decisions in relation to objectives of the company, in the ultimate analysis; such
decisions have to take care of the interest of the shareholders. Investment ordinarily means
profitable utilization of funds. Investment decisions are concerned with the question whether
adding to capital assets today will increase the net worth of the firm. Financing is next step in
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financial management for executing the investment decision once taken. Finance decision
making is concerned with the question as to how funds requirements should be met keeping in
view their cost and how far the financing policy influences cost of capital. This would provide a
cut off rate whether corporate fund be committed to or withheld from certain projects and
how the expected returns on projects be measured. The dividend decision is another major
area of financial management. The financial manager helps in deciding whether the firm
should distribute all profits or retain them or distribute a portion and retain the balance.
Thus, from the point of view of a corporate unit, financial management is related not only to
‘fund raising’ but encompasses wider perspective of investing and distributing the finances of
the company efficiently. As such it is true to stay that investment, financing and dividend
decisions are inter- related.
Question50
Define scenario analysis.
Answer
Scenario analysis is a process of analyzing possible future events by considering alternative

possible outcome. Thus, the scenario analysis, which is a main method of projection, does not
try to show one exact picture of the future. Instead it presents consciously several alternatives
future development consequently a scope of possible future outcomes observable, also the
development paths leading to the outcomes. It does not rely on historical data & does not
expect past observations to be still valid in the future. Instead it tries to consider possible
developments & turning points. In short several scenarios are demonstrated in a scenario
analysis to show possible future outcomes.
Question51
Define sensitivity analysis
Answer.
Capital budgeting remain unrealistic in the circumstances when despite a set of reliable
estimates of return, outlays, discount rate and project life time uncertainty surrounds some of
all of these figures. Sensitivity analysis is helpful in such circumstances.
It is a computer based device. Sensitivity analysis has been evolved to treat risk and uncertainty
in capital budgeting decisions. The analysis is comprised of the following steps: (1) Identification
of variables; (2) Evaluation of possibilities for these variables; (3) Selection and combination of
variables to calculate NPV or rate of return of the project; (4) substituting different values for
each variables in turn while holding all other constant to discover the effect on the rate of
return; (5) Comparison of original rate of return with this adjusted rate to indicate the degree
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of sensitivity of the rate to change in variables; (6) subjective evaluation of the risk involved in
the project.
The purpose of sensitivity analysis is to determine how varying assumptions will effect the
measures of investment worth. Ordinarily, the assumptions are varied one at a time i.e. cash
flows may be held constant with rate of discount used to vary; or discount rate is assumed
constant and cash flow may vary with assumed outlay; or the level of initial outlay may change
with discount rate and annual proceeds remaining the same.
In the context of NPV, sensitivity analysis provides information regarding the sensitivity of the
calculated NPV to possible estimation errors in expected cash flows, the required rate of return
and project life.
Question 52
Risk and uncertainty are quite inherent in capital budgeting decisions.
Answer
 Risk and uncertainty are quite inherent in capital budgeting decision.
 Capital budgeting involves various elements which have uncertainties.
 This is so because capital budgeting are actions of today which bears fruits in future
which is unforeseen. Future is uncertain and involve risk.
 The estimations of cash inflows may not hold true.
 The cost of capital which offers cut off rates may also be inflated or deflated under
business cycle conditions.
 Besides all these, technological developments are other factors that enhance the degree
of risk and uncertainty by rendering plant & equipments obsolete and the projects out
of date.
Question 53
Define capital structure and its kind.
Answer
Meaning of Capital Structure
By the term capital structure we mean the structure or constitution or break-up of the capital
employed by a firm. The capital employed consists of both the owners’ capital and the debt
capital provided by the lenders. Debt capital is understood here to mean the long term debt
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which has been deployed to build long term assets. Apart from the elements of equity and debt
in the capital structure, a firm could have quasi equity in the form of convertible debt.
Capital Structure of a firm is a reflection of the overall investment and financing strategy of the
firm. It shows how much reliance is being placed by the firm on external sources of finance and
how much internal accruals are being used to finance expansions etc. Capital structure can be
of various kinds as described below:
1. Horizontal Capital Structure

In a Horizontal capital structure, the firm has zero debt components in the structure mix. The
structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or
retained earning only. The absence of debt results in the lack of financial leverage. Probability
of disturbance of the structure is remote.
2. Vertical Capital Structure

In a vertical capital structure, the base of the structure is formed by a small amount of equity
share capital. This base serves as the foundation on which the super structure of preference
share capital and debt is built. The incremental addition in the capital structure is almost
entirely in the form of debt. Quantum of retained earnings is low and the dividend pay-out ratio
is quite high. In such a structure, the cost of equity capital is usually higher than the cost of
debt. The high component of debt in the capital structure increases the financial risk of the firm
and renders the structure unstable. The firm, because of the relatively lesser component of
equity capital, is vulnerable to hostile takeovers.
3. Pyramid shaped Capital structure

A pyramid shaped capital structure has a large proportion consisting of equity capital and
retained earnings which have been ploughed back into the firm over a considerably large period
of time. The cost of share capital and the retained earnings of the firm is usually lower than the
cost of debt. This structure is indicative of risk averse conservative firms.
4. Inverted Pyramid shaped Capital Structure

Such a capital structure has a small component of equity capital, reasonable level of retained
earnings but an ever increasing component of debt. All the increases in the capital structure in
the recent past have been made through debt only. Chances are that the retained earnings of
the firm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable
to collapse.
Question 54
Write a short note on capital Asset pricing Model.
Answer
CAPM is defined as an economic theory that describes relationship between risk and expected
return and serves as a model for the pricing of risky securities. The CAPM asserts that the only
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risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated.
The CAPM sys that expected return of a security or a portfolio is equal to rate on a risk free
security plus a risk premium multiplied by asset’s systematic risk. The CAPM is calculated
according to the following formula
Desired return= Risk free+ β(Rm - Rf)
The General idea behind CAPM is that investors need to be compensated for investing their
cash in two ways (i)Time value of Money (ii) Risk
The time value of money is represented by risk free rate (Rf) & it compensates investors for
placing money in any investment over period of time. Risk calculates the amount of
compensation the investor needs for taking additional Risk. This is calculated by taking a risk
measure (beta) that compares return of the asset to the market over a period of time & to the
market premium (Rm--Rf).
Question 55
What are assumption of CAPM?
Answer
Assumptions of CAPM
(1) All investors ASIM to Maximize Economic utilities
(2) All investors are rational and Risk averse
(3) All investors can lend and borrow unlimited amount under the risk free rate of interest.
(4) All Investor trade without transaction or taxation cost
(5) All investor has all information at same time
Question 56
Leasing VS Hire purchase

Answer
Leasing Hire Purchase

Ownership In leasing it is only financial In hire purchase, agreement
lease ownership will get is entered for transfer of
transferred, while in ownership after a fixed
operating lease the period
ownership is not transferred.
Depreciation In leasing Depreciation is Depreciation is claimed by
claimed by lessor in lease purchase hire in a hire
agreement purchase
Buyer count In operating lease lessor can In hire purchase the goods
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transfer asset to more than property is sold once & there

one lessee can’t be more than one
buyer
Relationship Relationship in lease Relationship between seller
agreement is that of lessor & & buyer will be owner &
lessee hirer in a hire purchase
Question 57
Write short note on venture capital financing.
Answer
Venture capital is regarded as risk capital. Venture capital financing refers to financing of new
high-risk ventures promoted by qualified entrepreneur who lack experience and funds to give
shape to their ideas. A venture capitalist invests in equity or debt securities floated by such
entrepreneurs who under take highly risky venture with a potential of success. It is an
investment in securities of new and unseasoned enterprises by way of private placement. It
plays an important role not only in financing high technology projects but also helps to turn
research and development into commercial production. Common methods of venture capital
financing include:
(1) Equity financing: The venture capital undertaking generally requires funds for a longer
period but may not be able to provide returns to the investors during the initial stages.
Therefore, the venture capital finance is generally provided by way of equity share
capital. The equity contribution of venture capital firm does not exceed 49% of the total
equity capital of venture capital undertaking so that the effective control and ownership
remains with the entrepreneur.
(2) Conditional loan: A conditional loan is repayable in the form of a royalty after the
venture is able to generate sales. No interest is paid on such loans. In India venture
capital financers charge royalty ranging between 2% to 15% actual rate depends on
other factors of the venture such as gestation period, cash flow patterns, riskiness etc.
Some venture capital financers give a choice to the enterprise of paying a high rate of
interest (which could be well above 20%) instead of royalty once it becomes
commercially sound.
(3) Income note: It is a hybrid security which combines the features both conventional loan
and conditional loan. The entrepreneur has to pay both interest and royalty on sales but
at substantially low rates.
(4) Participating Debenture: Such security carries charges in three phases in the start up
phase, no interest is charged, next stage a low rate of interest is charged upto a
particular level of operations, after that, a high rate of interest is required to be paid.
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Venture capital funds have been promoted in India by both the private and public sector.
Some of the examples are:
Private Sector
 India Investment Fund (ANZ Grindlays BANK)
 Credit Capital Venture Fund (India) Ltd.
 20th Century Venture Capital Corporation Ltd.
 Indus Venture Capital Fund.
Public Sector
 Technology Development and Information Company of India Ltd. (TDICI promoted by
ICICI)
 Industrial Development Bank of India (IDBI) Venture Capital Fund Division
 Risk Capital and Technology Finance Corporate (RCTS)
 Canfina Venture Capital Fund Division
State Financial Institutions

 Gujarat Venture Finance Ltd.
 APIDC Venture Capital Ltd. (Promoted by Andhra Pradesh Industrial DEVELOPMENT
AND Investment Corporation).
The problems areas facing the industry are:

 There is insufficient understanding of venture capital as a commercial activity
 The support to the venture capital industry, by the government is inadequate;
 The exit options available to the venture capitalists are limited;
 Market limitations hinder the growth of venture capital industry; and
 The inadequacy of the legal framework for venture capital industry.
Question 58 -Write a short note on domestic resource cost?

Answer
- Domestic resource cost refers to the resource cost involved in manufacturing a
particular product rather than importing the same.
- It reflects the competitive edge the country has in producing the good.
- It helps in maintain favourable balance of payment.
- By calculating the domestic resource cost (DRC) a judicious can be made whether or not
it is feasible to produce the good or is it better to out rightly purchase (import) the
goods under consideration.
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Question 59 Write a short note on ERR.
Answer
ERR is a rate of discount which equates the real economic cost of project outlay to its economic
benefits during the life of the project. ERR is an attempt in find out the rate of return to the
economy or society and not the private promoters or various agencies involved in promoting a
project. The need for ERR arises because current market prices and costs taken into account to
determine the financial ability of the project do not represent the true value from the national
or economic view point. ERR is based on shadow prices. Shadow prices reflect the real cost of
inputs to the society and real benefits of the output instead of market prices.
Question 60 Write a short note on ERP.
Answer
The effective rate of protection offered to a particular stage of manufacture of a product is an
important consideration in the determination of competitive strength of the product. In the
calculation of ERP, the basic parameter is value added which is the difference of selling prices of
a product and the cost of the material inputs. If measures of protections are absent
domestically and abroad theoretically , value added computed at domestic prices will be equal
to the value added at international or cross border prices. The difference in the value added in
two sets of prices reflect a measure of protection.
ERP= Value added at domestic prices- Value added at international prices.
Question 61. Write a short note on project appraisal under inflationary conditions.
Answer
Timing for project appraisal is most important consideration for all types of appraisers. A
project under normal circumstances is appraised from different angles viz. technical feasibility,
managerial aspects, commercial aspects financial viability and economic and social aspects.
Under the normal conditions when prices are generally stable, demand pattern as projected in
the project report is unchangeable, the project cost described in the project report remains
unchanged at current prices and as such there is not much danger of any sudden escalation in
project cost or over run in the projected resource.
There is practically no risk involved of either business or financial nature and evaluation of the
project could be done from different angles without providing for any change in project cost
and planning for additional financial resources to meet the over run or escalations.
Nevertheless, project appraisal can't avoid inflationary pressures as normal conditions for a
project do not exist as the project is to be implemented over a period of time ranging upon the
size and magnitude of project.
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In a developing economy like India, inflation grow at a planned steady rate because of the
economic development activities and as such provision for a probable escalation in the
project cost is generally provided as a cushion to inflationary pressures
However, during inflationary conditions the project cost is affected in magnitude of parameters.
Cost of project on all heads viz. Labour wage, raw material, fixed assets, equipments, plant and
machinery, building material, remuneration of technicians and managerial personnels undergo
a change. The financial institution and banks revise their rate of lending and their financing
cost further escalate during inflationary conditions. Under such conditions, the appraisal of the
project generally be done keeping in view the following guidelines which are usually followed
by the Government agencies, banks and financial institutions:
1. Make provisions for delay in project implementation, escalation in project cost as per
the forecasted rate of inflation in the economy particularly on all heads of cost.
2. Sources of finance should be carefully scrutinized with reference to revision in the rate
of interest to be made by lender and the revision which could be followed in the interest
bearing securities. All these factors will push up the cost of financial resources for the
corporate unit.
3. Profitability and cash flow projections as made in the project report require revision and
adjustment should be made to take care of the inflationary pressures affecting
adversely future projections
4. In inflationary times, early pay back projects should be prepared. Because projects with
long pay back are more subjected to inflationary pressures and the cash flow generated
by the project will bear high risk.
Question 62 Project reviews is a very important aspect of entire project life. Comment?
Answer
Even project that are well designed, comprehensively planned, fully resourced and meticulously
executed will face challenges. These challenges can take place at any point in the life of the
project and the project team must work to continually revisit the design, planning and
implementation of the project to confirm they are valid and to determine whether corrective
actions need to be taken when the project's performance deviates significantly from its design
and its plan. This is the purpose of the Project Monitoring, Evaluation and Control.
Not surprisingly, the three principle categories of activities taking place during the Monitoring,
Evaluation and
Control Phase are:
 Project Monitoring,
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 Project Evaluation
 Project Control
These activities are intended to occur continuously through the entire life of the project. For
example, the earliest procedure of the project indicators are already being developed during
the Project identification and Design Phase, the Monitoring Plan is developed during the
Planning Phase; monitoring visits are conducted during the implementation phase.
Project monitoring: - It tracks the operational work of the project. It answer questions like”
Have Activities been completed a planned”? Have outputs been produced as anticipated? Is the
work of project progressing as projected?
Project Evaluation: - It tends to focus on tracking progress at the higher level, Evaluation tends
to Explore Questions like, “is the project successful at archiving its outcome”? “Is project
contributing to its ultimate goal”?
Project Control: - It involves establishing the systems & decision-making process to manage
variances between project plans & the realities of project implementation. It also involves
establishing how project variances and changes are managed, documented and communicated
with stake holders.
Question 63
Write a short note on stable dividend policy
Answer
Stable dividend policy: here the payment of certain sum of money is regularly paid to the
shareholders. It is of three types:
(a) Constant dividend per share: here reserve fund is created to pay fixed amount of
dividend in the year when the earning of the company is not enough. It is suitable for
the firms having stable earning.
(b) Constant payout ratio: it means the payment of fixed percentage of earning as dividend
every year.
(c) Stable rupee dividend + extra dividend: it means the payment of low dividend per
share constantly + extra dividend in the year when the company earns high profit.
Merits of stable dividend policy:

– It helps in creating confidence among the shareholders.
– It stabilizes the market value of shares.
– It helps in marinating the goodwill of the company.
– It helps in giving regular income to the shareholders.
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Question 64
Define Working Capital Leverage.
Answer
 The term working capital leverage, refers to the impact of level of working capital on
company’s profitability.
 Higher level of Investment in current Assets than is actually required means increase in
the cost of interest charges on the short term loans and working capital finance raised
from bank etc. and will result in lower return on capital employed and vice versa.
Working capital leverage measures the responsiveness of ROCE (Return on capital
employed) for changes in current assets.
 It is calculated by using the following formula:
𝐶.𝐴
 Working capital leverage =𝑇.𝐴.−𝐷.𝐶.𝐴.
C.A= Current Assets
T.A.= Total assets (i.e., net fixed assets + current assets)
D.C.A. = change in current assets.
Question 65
Define tools of option Derivatives.
Answer
Tools of Options Derivatives
These four tools are known as options derivatives. They are:
1. Delta
An options delta is used to measure the anticipated percentage of change in the premium in
relation to a change in the price of the underlying security. If a particular call option had a delta
of 60% we would expect the option premium to vary by 60% of the change in the underlying
stock. If that stock rose 1 point, the option premium should rise approximately 6/10 (60%) of 1
point.
2. Gamma
Gamma measures the expected change in the delta factor of an option when the value of the
price of the underlying security rises. If a particular option had a delta of 60% and a gamma of
5%, an increase of 1 point in the value of the stock would increase the delta factor by 5% from
60% to 65%.
3. Theta
The theta derivative attempts to measure the erosion of an option’s premium caused by the
passage of time. We know that at expiration an option will have no time value and will be
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worth only the intrinsic value if, in fact, it has any. Theta is designed to predict the daily rate of
erosion of the premium.
Naturally other factors, such as changes in the value of the underlying stock will alter the
premium. Theta is concerned only with the time value. Unfortunately, we cannot predict with
accuracy changes in a stock’s market value, but we can measure exactly the time remaining
until expiration.
4. Vega
The fourth derivative, Vega is concerned with the volatility factor of the underlying stock. We
have pointed out that the volatility varies among different securities. Vega measures the
amount by which the premium will rise when the volatility factor of the stock increase.
Vega measures the sensitivity of the premium to these changes in volatility.
Question 66
What is credit derivative & its types?
Answer
Credit derivatives are financial contracts that provide insurance against credit-related losses.
These contracts give investors, debt issuers, and banks new techniques for managing credit risk
that complement the loan sales and asset securitization methods. The general credit risk is
indicated by the happening of certain events, called credit events, which include bankruptcy,
failure to pay, restructuring etc. There is a party trying to transfer credit risk, called protection
seller.
A credit derivative being a derivative does not require either of the parties, the protection seller
or protection buyer to actually hold the reference asset. When a credit event takes place, there
are two ways of settlement – cash and physical. Cash settlement means the reference asset will
be valued, and the difference between its par and fair value will be paid by the protection
seller. Physical settlement means the protection seller will acquire the defaulted asset, for its
par value.
Types of credit Derivatives.

(1) Credit default swaps (CDS)
A swaps designed to transfer the credit exposure of fixed income products between parties. A
credit default swap is also referred to as a credit derivative contract, where purchaser of swap
makes payment until the maturity date of contract. Payments are made to seller of swaps. In
return seller agrees to pay off a third party debt. If this party defaults on loan.
A CDS is considered as an insurance against non-payment. The buyer of a CDS might be
speculating on the possibility that the third party will indeed default.
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The buyer of CDS receives credit protection, where as seller of CDS of guarantees the credit.
Worthiness of debt security. In this way risk of default is transferred from holder of fixed
income security to swap.
(2) Total Return Swap (TRS)

A swap agreement in which one party makes payment based on a set rate either fixed or
variable, while the other party makes payment based on return of underlying assets, which
includes both the income it generates & any capital gains. In total return swaps, the underlying
asset, referred to as the reference asset, is usually an equity index. Loans, bonds. This is owned
by party receiving the set rate payment.
Total return swaps allow the party receiving the total return to gain exposure & benefit from a
reference asset without actually having to own it.
In a total return swap the party receiving the total will receive any income generated by the
asset as well as benefit if the price of asset appreciate over the life of the swap. In return the
total receiver must pay the owner of asset the set rate over the life of swap. If the price of asset
fall over swaps life the total return receiver will be required to pay the asset owner the amount
by which the asset has fallen in price.
Bank A
(Protection Bank B
buyer) (Protection
Seller)
Interest payment (Libor + spread)
Loss in value of refer asset
Interest rate payment Interest rate payment
Increase in value of reference asset
Interest payment
Reference
Asset
(3) Credit Link Notes (CLN)

A credit linked note (CLN) is a form of funded credit derivative. It is structured as
a security with an embedded credit default swap allowing the issuer to transfer a specific credit
risk to credit INVESTORS. The issuer is not obligated to repay the debt if a specified event
occurs. This eliminates a third-party insurance provider.
It is issued by a special purpose company or trust, designed to offer INVESTORS par value at
maturity unless the referenced entity defaults. In the case of default, the INVESTORS receive a
recovery rate.
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The trust will also have entered into a default swap with a dealer. In case of default, the trust
will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed
on to the INVESTORS in the form of a higher yield on their note.
The purpose of the arrangement is to pass the risk of specific default onto investors willing to
bear that risk in return for the higher yield it makes available. The CLNs themselves are typically
backed by very highly rated collateral, such as U.S. Treasury securities.
Explanation
A bank lends money to a company, XYZ, and at the time of loan issues credit-linked notes
bought by investors. The interest rate on the notes is determined by the credit risk of the
company XYZ. The funds the bank raises by issuing notes to investors are INVESTED in bonds
with low probability of default. If company XYZ is solvent, the bank is obligated to pay the notes
in full. If company XYZ goes bankrupt, the note-holders/investors become the creditor of the
company XYZ and receive the company XYZ loan. The bank in turn gets compensated by the
returns on less-risky bond INVESTMENTS funded by issuing credit linked notes.
CLN Solvent
Investor XYZ Comp
Money B Lend insolvent
a
Money
n
k
B
o
(Risk – free with low coupen)
n
d
Question 67
State the main features of Commodity Exchanges in India.
Answer
Features of Commodity Exchanges
A commodities exchange is an exchange where various commodities and derivatives
products are traded. Most commodity markets across the world trade in agricultural
products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa,
coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them.
A commodity exchange is considered to be essentially public because anybody may trade

through its member firms. The commodity exchange itself regulates the trading
practices of its members while prices on a commodity exchange are determined by
supply and demand.
There are four commodity exchanges in India:
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(i) National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai;

(ii) Multi Commodity Exchange of India Limited (MCX) Mumbai; and
(iii) National Multi- Commodity Exchange of India Limited (NMCEIL), Ahmadabad;
(iv) Indian Commodity Exchange Limited (ICEX), Gurgaon.
The unique features of commodity exchanges are:

(i) They are demutualized, meaning thereby that they are run professionally and there
is separation of management from ownership. The independent management does
not have any trading interest in the commodities dealt with on the exchange.
(ii) They provide online platforms or screen based trading as distinct from the openout-
cry systems (ring trading) seen on conventional exchanges. This ensures
transparency in operations as everyone has access to the same information.
(iii) They allow trading in a number of commodities and are hence multi-commodity
exchanges.
(iv) They are national level exchanges which facilitate trading from anywhere in the
country.
Question 68
Fixed exchange rate and flexible exchange rate.
Answer
Difference between fixed exchange rate and flexible exchange rate
Fixed Exchange Rate : The exchange rate which the government sets and maintains as the
official exchange rate, called fixed exchange rate. A set price will be determined
against a major world currency. In order to maintain the local exchange rate, the
central bank buys and sells its own currency on the foreign exchange market in return
for the currency to which it is pegged.
Flexible Exchange Rate : A flexible exchange rate is determined by the private market
through supply and demand. A flexible rate is often termed "self-correcting," as any
differences in supply and demand will automatically be corrected in the market. A
flexible exchange rate is constantly changing.
Question 69
Leading and lagging
Answer
Difference between Leading and Lagging
Leading is the payment of an obligation before due date. It is attractive for the company.
This technique is used when there is apprehension that in future foreign currency will
be dearer.
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Lagging is delaying the payment of an obligation past due date. There is possibility to incur
loss due to increase in exchange rate.
The purpose of these techniques is for the company to take advantage of expected
devaluation or revaluation of the appropriate currencies. Lead and lag payments are
particularly useful when forward contracts are not possible. This technique is used
when there is apprehension that in future foreign currency will be cheaper.
Question 70
Intrinsic Value of Option
Answer
Intrinsic Value
This is simply the difference between the exercise (strike) price and the underlying stock
price. Warrants are also referred to as in-the-money or out-of-the-money, depending
on where the current asset price is in relation to the warrant’s exercise price. Thus, for
instance, for call warrants, if the stock price is below the strike price, the warrant has
no intrinsic value (only time value - to be explained shortly). If the stock price is above
the strike, the warrant has intrinsic value and is said to be in-the-money.
The following equations will allow you to calculate the intrinsic value of call and put
options:
 Call Options : Intrinsic value = Underlying Stock’s Current Price - Call Strike Price
 Put Options : Intrinsic value = Put Strike Price - Underlying Stock’s Current Price
Question 71
Time Value of Option
Answer
Time Value
Time value can be considered as the value of the continuing exposure to the movement in
the underlying security that the warrant provides. Time value declines as the
expiration of the warrant gets closer. This erosion of time value is called time decay. It
is not constant, but increases rapidly towards expiration. Time value is affected by
time to expiration, volatility, dividends and interest rates.
Time value is the amount by which the price of an option exceeds its intrinsic value.
Also referred to as extrinsic value, time value decays over time.
Time Value = Put Premium - Intrinsic Value
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Time Value = Call Premium - Intrinsic Value
Question 72
“Buying a call option is risky because the holder commits to purchase a share at a later
date.” Discuss.
Answer
A call option gives its owner the right to buy the underlying asset at a predetermined price
at a future date.
The striking price (also called the exercise price) is the price stated in the option contract
at which the call (put) owner can buy (sell) the underlying asset up to the expiration
date, the final calendar date on which the option can be traded.
Selling a call option is riskier than buying a call option. This is because the maximum loss
for selling a call option is unlimited if the underlying stock price keeps soaring.
The advantage to buying a call option is that it gives the underlying asset its limited risk.
For a call option the most a purchaser can lose is the initial investment, the option
premium.
So far as the buyer of call is concerned he is not oblige to buy share if it is available in the
market at a price below exercise price.
So it is wrong to say that buying a call option is risky because the holder commits to
purchase a share at a later date.
Question 73
“Internal treasury control is a process of self-improvement”. Explain
Answer
All economic units have the goal of profit maximization or wealth maximization.
This objective is achieved by short-term and long-term planning for funds. The plans are
incorporated in the budget in the form of activities and corresponding targets are fixed
accordingly. The next step in the process is the control function to see that the budgets
are being implemented as per plans. Control is thus part of planning and budgeting in
any organization.
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Control is a process of constant monitoring to ensure that the activities are being carried
out as per plans. It is also noticed whether there is any divergence from the plans,
what are the reasons for the divergence and what remedial action can be suggested.
The control aims at operational efficiency and removal of wastages and inefficiencies and
promotion of cost effectiveness in the firm. The control is exercised under phases of
planning and budgeting. These phases include setting up of targets, laying down
financial standards, evaluation of performance as per these norms and reporting in a
standard format.
The quarterly and annual budgets would set the targets for each department and financial
standards are set out for each activity. Monthly budgets are evaluated by the
performance sheets maintained daily and regular reports go to the financial controller.
Reporting and evaluation go together and on the basis of information system built in the
past, plans are prepared for the next period.
Internal treasury control concerned with all flows of funds, cash and credit and all financial
aspects of operations. From time to time and on regular basis, the internal treasury
control is exercised on financial targets. The financial aspects of operations include
procuring of inputs, paying creditors, making arrangement for finance against
inventory and receivables. The gaps between inflows and outflows are met by planned
recourse to low cost mix of financing.
Hence it is true to say “Internal treasury control is a process of self improvement”.
Question 74
“Stability in payment of dividends has a marked bearing on the market price of the shares
of a corporate firm.” Explain the statement
Answer
The dividend decision should reflect the different factors already mentioned above as well
as company’s present operating and financial position. In this total framework, the
firm will find that it has a choice of several dividend policies to follow, viz.:
Steady dividend, dividend fluctuating, low regular dividend plus extra dividends;
elimination of dividend entirely.
Profit of the firm fluctuates considerably with changes in the level of business activity.
Most companies seek to maintain a target dividend per share. However, dividend increase
with a lag after earnings rise and this increase in earnings appear quite sustainable and
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relatively permanent. When dividends are increased strenuous efforts are made to
maintain them at increased new level. This stability could take three forms:
1) keep dividends at a stable rupee amount but allow its payout ratio to fluctuate, or
2) maintain stable payout ratio and let the rupee dividend fluctuate, or
3) set low regular dividend and then supplement it with year end “extras” in years when
earnings are high.
As earnings of the firm increase the customary dividend will not be altered but a year end
“extras” will be declared.
The dividend policy has to be adopted to the nature and environments of the firm,
industry and economy. If the company is operating in highly cyclical industry, like the
machine tools industry, its management cannot create through regular dividends as
stability does not exist. A low pay out in boom period cannot be off set by continuing
dividends in prolonged period of large losses. It is better to relate dividends to
earnings and not unduly attempt to protect shareholders from large fluctuations in
earnings so inherent in business. Failure to pay dividends in one year may shock the
market price of share and remove the security from the approved list of the
investments used by institutional investors.
A stable Dividend policy may lead to higher stock prices because it sustains investors
confidence as they value more the dividend which are certain to be received. If
dividends fluctuate investors may discount with some percentage probability factor
i.e. the likelihood of receiving any particular amount of dividend. Hence it is better to
keep a consistent dividend payment policy.
Question 75
Treasury management has both macro and micro aspects. Discuss
Answer
Government sector, business sector and the foreign sector are the major sectors of
country’s economy. For macro operations of these sectors, there is requirement of
cash, currency and credit. In broader terms, all financial resources including foreign
exchange are to be made available to the industrial or business units. Similarly, at the
macro level return flow of funds in the form of taxes and repayment of loans is
needed.
Such to and from movement of funds is part of the financial functioning.

Any business enterprise requires finance to start business operations. The first
requirement is in the form of capital for setting up of the project. Project finance
needs long term funds.
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These funds can be obtained from equity and debt both. Equity and internal accruals are
considered the owners’ contribution whereas debt is treated as the outsiders’ stake in
the project. Once the company starts operations of production and manufacture, it
needs working capital funds also. These funds are required to meet the payments for
raw materials and other inputs, spares, utilities etc. The quantum of funds needed for
working capital depends upon nature of the company’s business and nature of its
products or services.
The function of treasury management is concerned with both macro and micro facts of the
economy. At the macro level, the pumping in and out of cash, credit and other
financial instruments are the functions of the government and business sectors, which
borrow from the public. These two sectors spend more than their means and have to
borrow in order to finance their ever-growing operations. They accordingly issue
securities in the form of equity or debt instruments. The latter are securities including
promissory notes and treasury bills which are redeemable after a stipulated time
period. Such borrowings for financing the needs of the government and the business
sector are met by surplus funds and savings of the household sector and the external
sector. These two sectors have a surplus of incomes over expenditure. The micro units
utilize these surpluses and build up their capacities for production of output and this
leads to the productive system and distribution and consumption systems.
Question 76
Social cost-benefit analysis.
Answer
In Social Cost-Benefit Analysis, a project is analyzed from the point of view of the benefit it
will generate for the society as a whole.
There are three principal measures which may be employed to select projects that would
best sub-serve the goal of economic development of a nation. These are as follows:
1) Maximum social benefits— Which is equal to the present value of total project benefits
minus present value of total costs;
2) Benefit cost ratio — present value of total benefits divided by present value of total
costs;
3) Internal rate of return — it is the discount rate which makes the present net worth of a
project equal to zero, it represents the average earning power of the money used in the
project over the project life and the higher it is, the more profitable for the nation.
The important questions in making cost benefit analysis are what cost to be included,
what benefit to be sought, what are the main and immediate objectives of the project,
how to value them, what rate of interest will be appropriate at which these are to be
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discounted, what are the relevant constraints etc. Some of the answers to these
queries are that costs are to interpreted in economic terms. Further, costs are to be
calculated in terms of the opportunities foregone for employing factors of production
for a particular project. Similarly, labour costs are not to be calculated at the existing
rate in places where serious unemployment or under employment exist, because
existing rate may be artificial due to minimum wage legislation. Therefore, shadow
price of labour will have to be calculated. Based on these guidelines, cost-benefit
analysis is done to assess the following gains:
1) impact on national income
2) impact on government finance
3) impact on immediate beneficiaries.
Question 77
Depreciation is a non-cash item of an expense and it is said that it is a source of finance.” –
Discuss.
Answer
Depreciation is the funds set apart for replacement of worn-out assets. Depreciation is a
deduction out of profits of the company calculated as per accounting rules on the basis
of estimated life of each assets each year to total over the life of the assets to an
amount equal to original value of the assets. Although depreciation is meant for
replacement of particular assets but generally it creates a pool of funds which are
available with a company to finance its working capital requirements and sometimes
for acquisition of new assets including replacement of worn-out plant and machinery.
Depreciation is an expenditure recorded in the accounting system of a company and is
allowed to be deducted while arriving at the net profits of the company subject
provisions of the tax laws.
Amongst all the sources of internal finance, main source is depreciation on an average as
revealed by some research studies done by research scholars. The second source is
reserves and surplus and lastly the bonus issue of preference shares or equity shares.
There exists a controversy whether depreciation should be taken as a source of funds.

Whatever may be the outcome of such controversy, the fact remains that the
depreciation is a sum that is set apart out of profits and retained within the business
and finance the capital needs in the normal business routine, and as such depreciation
in true academic sense be deemed as a source of internal finance.
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Question 78
Describe the meaning of ‘index futures’.
Answer
Index Futures: Futures contracts in which underlying assets is based on indexes such as
the S & P 500, SENSEX, NIFTY or Value Line Index. An index future entitles the buyer to
any appreciation in the index over and above the index futures price and the seller to
any depreciation in the index from the same benchmark. Index future represents to
buy /sell a set/basket of securities. Since index cannot be purchased or delivered
hence these are the cash settlement contracts.
Question 79
What are the steps taken by financial institutions while appraising the project?
How do the financial institutions monitor the projects financed by them?
Answer
Project appraisal is a process whereby a lending financial institution makes an
independent and objective assessment of the various aspects of an investment
proposal, for arriving at a financing decision.
Appraisal exercises are aimed at determining the viability of a project, and sometimes
reshape the project so as to upgrade its viability Steps in Appraisal : Major steps
undertaken by Financial Institutions under project
appraisal are —
(a) Promoters’ Capacity : Promoters capacity and competence is examined, with reference
to their Management Background,
 Traits as entrepreneurs,
 Business or industrial experience,
 Past performance, etc.
Different considerations are applied in the case of new entrepreneurs.
(b) Project Report : Project report must be complete in all aspects so that its appraisal
becomes easy and relevant. For this purpose, the project report should be a self-
contained study with necessary feasibility report, market surveys, etc.
(c) Viability Test : Viability test of a project is to be carried out by examining the project
from different aspects viz. technical, economic, financial, commercial, management,
social and other related aspects as discussed below :-
(i) Technical Feasibility
It involves consideration of technical aspects like location and size of the project,
availability, quality and cost of services, supplies of raw materials, fuel, power, land,
labour, housing, transportation, etc.
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(ii) Economic Viability

It is done on the basis of market analysis of the product or service with particular
reference to the size of the market, projected growth in market demand, and the
market share expected to be captured.
(iii) Financial Viability
It involves evaluation of project cost in the light of period of construction work, provision
for cost escalation, timing of raising funds, projected cost of production and
profitability, and cash flow projections, to ensure the potentiality of the project to
meet the current and long-term obligations.
(iv) Commercial Viability
This is assessed in terms of the potential demand for the product, estimated sales price,
cost structure, the ability of the Firm to achieve the target sales at competitive price,
and the intensity of competition.
(v) Management Capability
It is an examination of the track record of Promoters, their background and capabilities,
and competence of the management team.
(vi) Social Relevance
Social relevance of a project like conformity with national policies and plant priorities are
also important factors to be considered in project appraisal.
(d) Appraisal in Inflationary and Deflationary Situations : Project Appraisal during
inflationary and deflationary conditions does not differ materially from that of an
appraisal during normal conditions, except that the financial, economic and commercial
aspects require to be taken care of:-
 Inflationary Situations
 Deflationary Situations
(i) Project Cost, prices of raw materials and labour cost will go up. Hence, there would
be a decline in the profitability, as the prices of end products are controlled by the
Government or market.
(ii) Market may not be prepared to pay a higher price during an inflationary period.
Such a situation impairs the financial viability of the project.
(iii) During a recessionary period, the stock of finished goods tends to accumulate
resulting in the blocking up of working capital, and thereby contributing to the
sickness of the project.
(iv) It is important to take into consideration the economic conditions while appraising a
project.
Question 80
“Economic value added (EVA) concept is in conformity with the objective of wealth
maximization”. Explain.
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Answer
Economic value added (EVA) is the after tax cash flow generated by a business minus the
cost of the capital it has deployed to generate that cash flow. Representing real profit
versus paper profit, EVA underlines shareholder value, increasingly the main target of
leading companies strategies. Shareholders are the players who provide the firm with
its capital; they invest to gain a return on that capital.
There are two key components to EVA. The net operating profit after tax (NOPAT) and the
capital charge, which is the amount of capital times the cost of capital. In other words,
it is the total pool of profits available to provide cash return to those who provided
capital to the firm. The capital charge is the product of the cost of capital times the
capital tied up in the investment. In other words, the capital charge is the cash flow
required to compensate investors for the riskiness of the business given the amount of
capital invested. On the one hand, the cost of capital is the minimum rate of return on
capital required to compensate debt and equity investors for bearing risk-a cut-off rate
to create value and capital is the amount of cash invested in the business, net of
depreciation (Dierks and Patel, 1997). In formula form,
EVA = (Operating Profit) - (A Capital Charge)
EVA = NOPAT - (Cost of Capital x Capital)
There is growing evidence that EVA, not earnings, determines the value of a firm.
There is difference between EVA, earnings per share, return on assets, and discounted
cash flow, as a measure of performance.
Earnings per share tells nothing about the cost of generating those profits. If the cost of
capital (loans, bonds, equity) as say, 15 per cent, then a 14 per cent earning is actually
a reduction, not a gain, in economic value. Profits also increase taxes, thereby reducing
cash flow.
Return on assets is a more realistic measure of economic performance, but it ignores the
cost of capital. Leading firms can obtain capital at low costs, via favourable interest
rates and high stock prices, which they can then invest in their operations at decent
rates of return on assets. That tempts them to expand without paying attention to the
real return, economic value-added.
Discounted cash flow is very close to economic value-added, with the discount rate being
the cost of capital.
Hence it is true that “Economic value added (EVA) concept is in conformity with the
objective of wealth maximization.”
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Question 81
Lockers Pvt. Ltd. is considering the use of a lockbox system to handle its daily collections.
The company’s credit sales are Rs.160 crore per year, and it currently processes 1,300
cheques per day. The cost of the lockbox system is Rs.95,000 per year. The system
allows for up to 1,000 cheques per day. Any additional cheques are processed at an
additional charge of Rs.1.50 per cheque. The company estimates that the system will
reduce its float by 3 days. The firm’s discount rate for equally risky projects is 15 per
cent, its tax rate is 40 per cent, and its cost of short-term capital is 12 per cent.
(Assume a 360-day year).
(a) How much cash will be released for other uses if the lockbox system is used ?
(b) What net benefit will Lockers Ltd. gain from using lockbox system ?
(c) Should Lockers Ltd. adopt the proposed lockbox system ?
(d) Assume now that the institution that offers the lockbox system requires a Rs.7,00,000
compensating balance to be held for the complete year in a non-interest-bearing
account. Should Lockers Ltd. adopt the system ?
Answer
1) Credit sales per day = 160 croe / 360 days = 44,44,444
2) Cost if lock box system is adopted
Cost of lock box = Rs.95,000
Additional cost for cheques = 300 cheque x Rs.1.5 x 360 = Rs. 1,62,000
Opportunity cost = 2,57,000 x 12% = 30,840
Total cost = 257,000 + 30,840 = 2,87,840.
3) Cost of Funds = 7,00,000 x 12% = 84,000.
4) Reduction in float days = 3
a) Cash that will be released for other use = 44,44,444 x 3 days = 1,33,33,332.
b) Cost of locker = 2,87,840.
Gain on release of fund = 1,33,33,332 x 15% = 20,00,000 Apprx.
Hence net benefit from use of lock box = 20,00,000 - 287,840 =17,12,160.
c) Lockers Ltd. should adopt the lock box system.
d) Total cost if Rs. 7,00,000 to be deposited = 84,000 + 2,87,840 = 3,71,840.
Net gain = 20,00,000 - 371,840 = 16,28,160. Still Lockers Ltd. should adopt the lock box
system.
9899259817, 9811059817 Page 55

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CA ARUN SETIA CLASSES

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(a) Conservation of cash for meeting profitable investment opportunities.

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2. To Company: Stock dividends are costlier to administer than cash dividend. It is

What are the different motives for holding cash?

– Purchase of Capital Goods like plant and machinery

– Capital inflows from promoters’ capital and borrowed funds

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 Higher returns on investments: Through capital rationing, companies invest only in

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the freeze of dividend by government could lead to increased real investment.

HISTORICAL VERSUS TARGET WEIGHT

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(i) Traditional Activities

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 Preparation of project details,

The following parties are involved in a typical securitization deal:

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5. Guarantor/Credit Enhancement Provider/Insurer : These are entities that provide

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A securitisation deal normally has the following stages:-

Two approaches for SCBA

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Scenario analysis is a process of analyzing possible future events by considering alternative

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 The estimations of cash inflows may not hold true.

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1. Horizontal Capital Structure

2. Vertical Capital Structure

3. Pyramid shaped Capital structure

4. Inverted Pyramid shaped Capital Structure

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What are assumption of CAPM?

Leasing VS Hire purchase

Leasing Hire Purchase

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transfer asset to more than property is sold once & there

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State Financial Institutions

The problems areas facing the industry are:

Question 58 -Write a short note on domestic resource cost?

- It helps in maintain favourable balance of payment.

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Question 59 Write a short note on ERR.

Question 60 Write a short note on ERP.

ERP= Value added at domestic prices- Value added at international prices.

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Write a short note on stable dividend policy

Merits of stable dividend policy:

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 It is calculated by using the following formula:

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Vega measures the sensitivity of the premium to these changes in volatility.

Types of credit Derivatives.

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(2) Total Return Swap (TRS)

(3) Credit Link Notes (CLN)

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