Unit 4 Business Finance PYQ’s 17th Oct 2020 Shift 1

The correct answer is – 3,600 units

Option1 is correct.

Key Takeaways

Monthly Demand = 1,350 units (Given)

Annual demand = 1350 x 12=16200 (monthly units x 12)

Ordering Cost = 2400 (given)

Price paid = Rs. 20 per unit.

Carrying Cost = 30% x 20 = 0.03 x 20 = 6 (As carrying cost of inventory being 30 percent of the price paid)

where:

• AR– Consumption of the article concerned (in units) during a year;
• OC = Cost of placing one order including the cost of receiving the goods or ordering cost; and
• C = Interest payment per unit per year including another variable cost of storing it (carrying cost per unit per annum)

= √2 × 16200 × 24006

EOQ= 3600 Units

The correct answer is – Rule of 72

In continuous compounding, the time it takes to double the sum grossly follows ‘Rule of 69’. If it is changed to discrete compounding. the relevant rule of thumb is Rule of 72.

Key Takeaways

• The Rule of 72 is a simplified way to estimate the doubling of an investment’s value, based on a logarithmic formula.
• The Rule of 72 can be applied to investments, inflation, or anything that grows, such as GDP or population.
• The formula is useful for understanding the effect of compound interest.

Additional Notes

The Formula for the Rule of 72 Is

Years to Double= 72/ Interest Rate

where: Interest Rate=Rate of return on investment.

The correct answer is – Unsystematic risk

The portfolio theory articulates diversification to reduce Unsystematic risk.

Key Takeaways

1. The portfolio diversification theory used today was first established by economist Harry Markowitz.
2. Labeled the modern portfolio theory, this particular set of equations and principles helps investors better understand how to create a diversified portfolio that mitigates against volatility and risk.
3. Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. However, no matter how diversified your portfolio is, risk can never be eliminated completely.
4. We can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes.

Important Note

1. Investors confront two main types of risk when they invest.

• The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.
• The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Therefore, option 3 is the correct answer.

The correct answer is – Natural hedge

A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset.

Key Takeaways

Natural Hedge:

1. Natural Hedging is the balancing act by adding assets that have a negative correlation.
2. A company can also go for a natural hedge by using its normal operating procedures.

1. For instance, incurring expenses in the same currency in which the company generates revenues. This lowers exchange rate risk.
2. For instance, an oil company may relocate its refining operations in the United States to naturally hedge against the cost of crude oil. The reason being that the cost of crude oil is denominated in U.S. dollars.

1. Another example of a natural hedge is that a company’s suppliers, production, and customers belong to the same country. This will allow the company to set costs and prices in the same currency. For example, Apple producing and selling iPhone SE in India. This results in foreign currency assets and liabilities to match in terms of the amount of exposure and timing of maturity, thereby reducing any kind of foreign exchange risk.

Thus, option 2 is the correct answer.

Additional Notes

Financial Hedge:

1. Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
2. The reduction in risk provided by hedging also typically results in a reduction in potential profits.
3. Hedging strategies typically involve derivatives, such as options and futures contracts.
4. Even though hedging does not eliminate risks completely, it can successfully mitigate losses.
5. If the hedge works effectively, the investor’s profits will be protected or losses reduced, at least in part.

Perfect Hedge:

1. A perfect hedge is a position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio.
2. In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found.

Netting:

1. Netting is a method of reducing risks in financial contracts by combining or aggregating multiple financial obligations to arrive at a net obligation amount.
2. Netting is used to reduce settlement, credit, and other financial risks between two or more parties.

The correct answer is – External Commercial Borrowings (ECB)

Long term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds and it is done for usually big projects financing and expansion of the company and such long term financing is generally of high amount.

External Commercial Borrowings is a long term source of finance.

Key Takeaways

External Commercial Borrowings:

1. An external commercial borrowing (ECB) is an instrument used in India to facilitate Indian companies to raise money outside the country in foreign currency.
2. The government of India permits Indian corporates to raise money via ECB for expansion of existing capacity as well as for fresh investments.
3. ECBs allow corporates to borrow a large volume of funds for a relatively long term.

Thus, option 2 is the correct answer.

Additional Notes

1. Short term loans are called such because of how quickly the loan needs to be paid off. In most cases, it must be paid off within six months to a year. Any loan for a longer loan term than that is considered a medium-term or long-term loan.
2. Commercial Paper: Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities.
3. Factoring: A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company. The practice is also known as factoring, factoring finance, and accounts receivable financing.
4. Line Of Credit: It is a kind of short-term loan. A line of credit is much like using a business credit card. A credit limit is set and the business is able to tap into the line of credit as needed. It makes monthly installment payments against whatever amount has been borrowed. Therefore, monthly payments due vary in accordance with how much of the line of credit has been accessed.

The correct answer is – (B), (C) and (D) only

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 analyze the profitability of a projected investment or project.

The internal rate of return is a metric used in financial analysis to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR is the annual rate of growth investment is expected to generate. IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of annual return over time.

Key Takeaways

Conflicts Between NPV vs IRR:

In the case of mutually exclusive projects that are competing such that acceptance of either blocks acceptance of the remaining one, NPV and IRR often give contradicting results. NPV may lead the project manager or the engineer to accept one project proposal while the internal rate of return may show the other as the most favorable. Such a kind of conflict arises due to a number of problems.

1. For one, conflicting results arise because of substantial differences in the amount of capital outlay of the project proposals under evaluation.
2. Sometimes, the conflict arises due to issues of differences in cash flow timing and patterns of the project proposals or differences in the expected service period of the proposed projects.
3. When faced with difficult situations and a choice must be made between two competing projects, it is best to choose a project with a larger positive net value by using a cutoff rate or a fitting cost of capital.
4. The reason the two above-mentioned options works is because a company’s objective is maximizing its shareholder’s wealth, and the best way to do that is choosing a project that comes with the highest net present value. Such a project exerts a positive effect on the price of shares and the wealth of shareholders.
5. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.

Thus, option 4 is the correct answer.

The correct answer is – (A) and (C) only

Payback period method:

1. The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven.
2. Account and fund managers use the payback period to determine whether to go through with an investment.

1. Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.

1. The payback period is calculated by dividing the amount of the investment by the annual cash flow.
2. The payback period, as a tool of analysis, is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor.

Key Takeaways

The payback period is an effective measure of investment risk. It is widely used when liquidity is an important criterion to choose a project.

• A business is said to be overleveraged when it is carrying too much debt when compared to its operating cash flows and equity.
• An overleveraged company has difficulty in paying its interest and principal payments and is often unable to pay its operating expenses because of excessive costs due to its debt burden, which often leads to a downward financial spiral. In short, the company faces a liquidity crisis.
• Thus, the payback period method is advised for the evaluation of investment opportunities in the situation of an overleveraged business.
• In an uncertain market, one thing is certain: market declines are an inevitable part of investing.
• Thus, a company should use payback analysis to get an overview of the life of their investment and its returns.
• Projects with a longer payback period should be avoided during uncertain market conditions as they can pose a severe impact on the liquidity of the firm.

Thus, option 2 is the correct answer.

The correct answer is – (C), (B), (A)

Arbitrage pricing theory (APT):

• Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk.
• Unlike the CAPM, which assumes markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the market eventually corrects and securities move back to fair value.
• Using APT, arbitrageurs hope to take advantage of any deviations from fair market value.

Calculating the Expected Rate of Return of an Asset Using Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory Formula – E(x) = rf + b1 * (factor 1) +b2 *(factor 2) + ….+ bn *(factor n)

Where,

• E(X) = Expected rate of return on the risky asset
• Rf = Risk-free interest rate or the interest rate that is expected from a risk-free asset
• B = Sensitivity of the stock with respect to the factor; also referred to as beta factor 1, 2.
• N = Risk premium associated with respective factors

Therefore, The logical sequence of APT is:

1. Identify the Macroeconomic Factors
2. Estimate the Risk Premium for Factor(s).
3. Estimate the Factor Sensitivities

Thus, Option 3 is the right answer.

The correct answer is – (A), (C), (B)

The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity.

Additional Notes

This pecking order is important because it signals to the public how the company is performing:

1. If a company finances itself internally, that means it is strong.
2. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations.
3. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.

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

Key Takeaways

Therefore, it is clear from the above explanation that option 3) is the correct answer.

The correct answer is – Both (A) and (R) are correct but (R) is NOT the correct explanation of (A)

Firms opt for buying an asset if the equivalent annual cost of ownership and operation is less than the best lease rate it can get and

Operating leases are attractive to equipment users if the lease payment is less than the user’s equivalent annual cost of buying the equipment.

Both (A) and (R) are correct but for the assertion, the reason given does not satisfy. Hence option2 is correct.

Key Takeaways

1. Equivalent annual cost (EAC) is the annual cost of owning and maintaining an asset determined by dividing the net present value of the asset purchase, operations, and maintenance cost by the present value of the annuity factor.

1. It is a capital budgeting tool used by companies to compare assets with unequal useful lives.
2. The same concept can be applied to analyze projects which have unequal useful lives.
3. An operating lease is a contract that allows for the use of an asset but does not convey ownership rights of the asset.
4. Operating leases are considered a form of off-balance-sheet financing—meaning a leased asset and associated liabilities (i.e. future rent payments) are not included on a company’s balance sheet.
5. Historically, operating leases have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets, thereby keeping their debt-to-equity ratios low.

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

Key Takeaways

Therefore, it is clear from the above explanation that option 2) is the correct answer.