Unit 4 Business Finance PYQ’s 14th Oct 2022 Shift 1

The correct answer is Rs. 4

Key Points

The correct answer is 24.9%

Key Points Average Rate of Return:

• The average annual amount of cash flow produced over the course of an investment is the average rate of return.
• This rate is derived by adding up all anticipated cash flows and dividing it by the anticipated lifespan of the investment. Investors frequently use it to choose whether to invest in a particular asset.

Important Points

Average Income = 36,875/5 = Rs. 7,375

Average Investment = 

⇒ Salvage Value + ½ (Cost of Machine – Salvage Value)

⇒ 3,000 + ½ ( 56,125 – 3,000)

⇒ Rs. 29,562.50

Now, ARR = 7,375 / 29,562.5

⇒ 24.9%

The correct solution is option 1

Higher dividend yield and high rate of capital appreciation 

Key points

Domestic equity investment 

• Domestic Equity Funds are index funds, mutual funds, or other types of funds that invest only in U.S. domestic stocks and not bonds

Foreign equity investment

• Foreign portfolio investment (FPI) involves holding financial assets from a country outside of the investor’s own. FPI holdings can include stocks, ADRs, GDRs, bonds, mutual funds, and exchange-traded funds. 

Important Points

Capital Appreciation & dividend Yield:

• A dividend is the distribution of a company’s profits to its shareholders. 
• Capital appreciation is an increase in the value of shares while the investor still holds them.
• Combined, dividend income and capital appreciation give the total return delivered by equity shares.

In comparison to domestic equity investment, foreign equity investment would be preferred if it offers higher dividend yield and high rate of capital appreciation.

The correct answer is Translation exposure. 

 Key points

Translation exposure

• It is the type of risk that arise due to the fluctuation of currency exchange rates fluctuation in the exchange rate that may cause changes in the value of the company’s assets, liabilities.
• It occurs when a company has operations or subsidiaries in other nations and must convert the financial statements of these companies into its own currency for consolidation reasons.

Important Points Example: 

• Consider a US-based business with a Japanese subsidiary,
• The assets and revenues of the subsidiary will increase in value when converted into US dollars if the yen strengthens versus the dollar.
• This will result in an increase in the parent company’s consolidated financial statements, which could result in a beneficial influence on its financial performance.
• The value of the assets and revenues of the subsidiary would, however, decline if the yen appreciates against the US dollar, which will have a detrimental effect on the parent company’s financial performance.

 Important information

• Economic exposure – is a measure of the change in the future cash flows of a company as a result of unexpected changes in foreign exchange rates. it is also known as operating exposure.
• Transaction exposure – Transaction exposure is the risk of loss from a change in exchange rates during the course of a business transaction. This exposure is derived from changes in foreign exchange rates between the dates when a transaction is booked and when it is settled.

The correct answer is Factoring 

Key Points

Factoring:

• The process of converting a non-productive, inactive asset into a productive asset by selling receivables to a company that specializes in their collection and administration is described as factoring.
• It is a kind of financial service in which a business organization sells its accounts receivable to another person called a factor at a discount in order to raise money.

Important Points

A factoring transaction involves the following three parties:

• The factor who provides the factoring services,
• The client, who is actually availing the services,
• The customers, who purchase the goods and services on credit

Here, factoring means an arrangement between a factor and his client that includes at least two of the following services to be provided by the factor.

• Finance
• Maintenance of debt
• Collection of debts
• Protection against credit risk

Additional Information

• Bill discounting is a form of short-term finance for traders wherein they can sell unpaid invoices due on a future date to financial institutions in lieu of a commission. The bank purchases the bill (promissory note) before its due date and credits the bill’s value after a discount charge to the customer’s account.
• Underwriting is the process through which an individual or institution takes on financial risk for a fee. This risk most typically involves loans, insurance, or investments.
• Guaranteeing is defined as promising to do something or that something will happen.

3 (A), (B), (C), (E) Only is correct answer.

Key Points

Currency option –

• A currency option is a type of derivative contract that gives the buyer the right, but not the obligation, to sell or buy currencies at a predetermined exchange rate within a predetermined time frame.
• Currency options are used to protect against unfavourable currency movements.

Important PointsSpot exchange rate –

• The spot exchange rate is the current value of one currency in relation to another at a given point in time.
• The open market price at which a trader will pay to purchase another currency.
• The foreign exchange market and government entities both have an impact on the spot exchange rate.

Exercise rate –

• The underlying in a Currency Option is the exchange rate of the specific currency.
• The exchange rate is directly proportional to the premium pricing of the Call option and inversely proportional to the premium pricing of the Put option.
• Any increase in the underlying currency’s exchange rate raises the premium of the Call Option.
• The premium of the PUT option decreases as the underlying’s exchange rate rises.

Strike Price-

• The premium price is inversely proportional to the strike price.
• As a result, increasing the strike price lowers the premium for a Call option.
• In the case of a Put Option, the premium rises as the strike price rises.

Time to maturity-

• Call & Put options lose value as the time to maturity decreases.
• The premium for a currency option increases as the expiration date approaches.
• It also decreases as the option’s expiration date approaches.

Volatility-

• An increase in volatility indicates a high degree of uncertainty about the currency’s exchange rate, which affects the value of an option.
• The price of the Call option rises as volatility rises, while the price of the Put option falls.

Foreign risk – 

• A foreign currency option grants the holder the right, but not the obligation, to buy or sell currency at a predetermined price (known as the strike price) on or before a specific date.
• The buyer pays an upfront premium to the seller in exchange for this right. Foreign currency options are used to protect against potential losses caused by fluctuations in exchange rates.

Hence, option 3 (A), (B), (C), (E) Only is correct answer.

Key Points

Exchange rate – 

• An exchange rate is the cost of exchanging one currency for another between nations or economic zones.
• It is used to determine the relative value of various currencies and is crucial in determining trade and capital flow dynamics.

Important Points

1. Current/Non-Current method – 

• Current assets and liabilities with maturities of one year or less are translated at the current exchange rate.
• Noncurrent assets and liabilities are converted using the previous exchange rate that was in effect at the time the asset or liability was recorded in the books.
• If the local currency appreciates, a foreign subsidiary with current assets in excess of current liabilities will incur a translation gain.

2.Monetary/Non-monetary method – 

• All monetary balance sheet accounts of a foreign subsidiary, such as cash, notes payable, accounts payable, and marketable securities, are converted at the current exchange rate using this method.
• The remaining nonmonetary balance sheet accounts and shareholder equity are converted at the exchange rate in effect at the time the account was recorded.
• This method is based on the idea that monetary accounts are similar in that their value is equivalent to a sum of money, the value of which varies with changes in exchange rates.

3.Temporal method – 

• The temporal method converts current and noncurrent monetary accounts, such as receivables, payables, and cash, at the current exchange rate.
• The other balance sheet accounts are converted at the current rate if they are carried out on the books at current value.
• If they are performed in the past, they are converted into the historical rate of exchange that existed at the time.

4.Current Rate method – 

• Except for stockholder’s equity, all balance sheet accounts are converted at the current exchange rate using this method.
• On the dates the items are recognized, the income statement items are converted at the current exchange rate.

Hence, option 3 (A), (B), (C), (D) Only is correct answer.

Key Points

Capital structure – A company’s capital structure is the specific combination of debt and equity used to fund its overall operations and growth.

The M&M Theorem of capital structure:

• The Modigliani-Miller Theorem, also known as the M&M Theorem, is one of the most important theorems in corporate finance.
• In 1958, economists Franco Modigliani and Merton Miller proposed the theorem.
• The M&M theory’s central premise is that a company’s capital structure has no bearing on its overall value.
• According to the Modigliani-Miller capital structure theory, a firm’s market value is unrelated to its capital structure, i.e., the market value of a levered firm equals the market value of an unlevered firm if they are in the same class of business risk.
• This approach holds that there is no optimal capital structure, and that the firm’s valuation is determined by its operating income.

Important Points

The Modigliani-Miller capital structure theory, developed in 1958, is predicated on the following assumptions:

• Perfect capital markets
• There are no transaction expenses.
• The stock price is not affected by any of the investors.
• Any investor can access both public and private information.
• There are no restrictions on purchasing or selling stock.
• Same expectation of firm’s EBIT with which to evaluate the value of a firm
• All companies within the same class have the same business risk
• Borrowing costs are fixed (kd) and always less than the required rate of return on equity (ke), i.e., kd < ke.
• Every investor believes the expected return for each stock is the same.
• Companies pay out all of their net income as dividends.
• There are no fees associated with filing for bankruptcy.
• There are no taxes.

Hence, the correct answer is (A), (C), (D), (E) Only.

The correct answer is (A) – (IV), (B) – (I), (C) – (II), (D) – (III).

Key Points 

Important Points Leveraged Lease:

• A leveraged lease is a lease agreement that is financed through the lessor with help from a third-party financial institution. In a leveraged lease, an asset is rented with borrowed funds.
• Leverage leases can be more complex than basic operating lease because leverage is involved.
• The structure of the leveraged lease terms will depend on the lessor and their financing relationships.
• The lessor may also be the financing institution that provides the loan in which case they approve the loan for the borrower.

Direct Lease:

• A direct lease is a contractual agreement under which the lessor uses the existing asset or purchases it directly to lease it to the lessor.
• The lessor’s business is to purchase the specific asset, lease it to customers, and make a profit.

Wet Lease:

• Aircraft leases are leases used by airlines and other aircraft operators for servicing and fuel.
• Airlines lease aircraft from other airlines or leasing companies for two main reasons: to operate aircraft without the financial burden of buying them, and to provide a temporary increase in capacity.
• The industry has two main leasing types: wet leasing, which is normally used for short-term leasing, and dry-leasing which is more normal for longer-term leases.
• The industry also uses combinations of wet and dry.
• For example, when the aircraft is wet-leased to establish new services, then as the airline’s flight or cabin crews become trained, they can be switched to a dry lease.

Update Lease:

• Lease accounting is the process organizations use to record the financial impact of their leases.
• Entities are now required to record the majority of their leases on the balance sheet following the release of the new lease accounting standards.
• It protects the lessee from obsolescence as upgrading the lease is helpful in keeping up with the trends.

Key Points

 NPV Method

• Net present value (NPV) is a financial metric that seeks to capture the total value of an investment opportunity.
• The goal of NPV is to forecast all potential future cash inflows and outflows related to an investment, discount each one to the present and then tally them all up. The investment’s net present value (NPV) is the sum of all the positive and negative cash flows.
• A positive NPV indicates that, after taking into account the time value of money, making the investment will result in a profit.

Important Points

1. Forecasting cash flows

• The NPV method is based on estimating project-related cash flows during a timespan covering both the project’s delivery and benefits realization periods.
•  In the very first step, one needs to estimate the timing and amount of future cash flows.

2. Identify an appropriate discount rate:

• in the next step, one needs to find out the discount rate.
• The discount rate is the rate of return that the investors expect or the cost of borrowing money.
• If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV. If the firm pays 4% interest on its debt, then it may use that figure as the discount rate.

3. Calculate the present value of cash flows:

• After estimating the timing and amount of future cash flows and picking a discount rate equal to the minimum acceptable rate of return now calculate the present value of cash flows.
• The present value of cash flows is the sum of all future cash flows over the investment’s lifetime which is discounted to the present value rate.

4. Compute the net present value:

• Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
• NPV is used in capital budgeting and investment planning to analyse the profitability of a projected investment or project.
• Using the appropriate discount rate, computations are performed to determine the current value of a stream of future payments or NPV.
• Projects that have a positive NPV are generally worthwhile pursuing, whereas those that have a negative NPV are not.

5. Rank the projects as per NPV:

• If a company has the option of more than one project, then the company needs to decide which project should be accepted based on NPV
• If the NPV of one project is greater than the NPV of the other project, accept the project with the higher NPV. If both projects have a negative NPV, reject both projects.

Hence, the correct sequence is (C), (B), (A), (E), (D).