Unit 4 Business Finance PYQ’s 17th Oct 2020 Shift 2

The correct answer is – Rs. 5

Right offering:

1. A rights offering is when a company issues to its existing shareholders a right to buy additional shares in the company.
2. The company offers its shareholder a specific number of shares at a special price.
3. The company will also set a time limit for the shareholder to buy these shares.
4. The shares are often offered at a discounted price to the existing shareholders.
5. In a rights offering, the subscription price at which each share may be offered is generally at a discount to the current market price.
6. Rights are often transferable, allowing the holder to sell them in the open market.

Key Points

Number Of Right Shares: 1

Total Shares= Existing + New share = 5+1= 6

Value Of Right = (Number Of Right Shares / Total Shares) x (Market Value – Issue Price)

Value Of Right = (1/6) x (150-120)

∴ Value Of Right = 0.166667 x 30

∴ Value Of Right = Rs. 5

Alternatively,

Market Value Of 5 Existing Holdings = Rs. 150 x 5 = Rs. 750

Add: Issue Price Of 1 New Holding = Rs. 120 x 1 = Rs. 120

∴ Value Of Total Holdings = 750 + 120 = Rs. 870

Value Of Each Share = 870/6 = Rs. 145

Value Of Right = Market Price – Average Price

Value Of Right = 150 – 145

∴Value Of Right = Rs. 5

Thus, option 1 is the correct answer.

The correct answer is – Multinational capital budgeting

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.

Key Points

1. As part of capital budgeting, a company might assess a prospective project’s lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.
2. The original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions.’
3. The specific project, as well as reinvestment decisions – should be justified by traditional financial analysis.
4. Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.
5. Multinational capital budgeting is capital budgeting for a foreign project using the same theoretical framework as domestic capital budgeting.

Important Points

1. Political risk management comes in the ambit of Multinational capital budgeting.

2. For each project, political risk must be evaluated, because the cash flows can be severely affected by the changes in the political environment.
3. The changes in the government would change the political philosophy thereby leading to a new economic environment.
4. An extreme form of risk is the ‘risk of expropriation’ and repatriation. In the case of expropriation, the projects and the parent’s cash flows tend to change drastically because in this case the funds are blocked in the country of the project.
5. The political stability of a country directly impacts borrowing costs, taxes, and regulation for businesses.
6. Kickbacks and other forms of corruption have serious repercussions for MNCs. For example, Turkey has experienced a number of economic and political setbacks that raised the cost of borrowing for the national government. Corruption allegations, tight lending conditions, and financial volatility within the country made it more challenging for corporate entities to operate there effectively.

Thus, option 4 is the correct answer.

The correct answer is – Value maximization

Financial Management means planning, organizing, directing, and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to the financial resources of the enterprise.

Value maximization is the most pervasive and sustaining objectives of financial decision making.

Key Points

1. Value maximisation is the administrative activity concerned with determining an organization’s long-term market value.

2. All of an organization’s financial assets, including equity, debt, preference shares, and warrants, make up its overall value.
3. When a company’s stock price rises on the market, its overall value rises as well.

Thus, option 3 is the correct answer.

The correct answer is – Rs. 29.87

Walter’s Model: Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise. His model shows clearly the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximize the wealth of shareholders.

Key Points

The formula to determine the market value of share as suggested by Prof. Walter is as under :

P = (D/K_e) + [r(E – D)/K_e] / K_e

where,

P = Market Price Per Share

D = Dividend Per Share

r = Internal Rate Of Return

E = Earnings Per Share

K_e = Cost Of Equity Capital or Capitalization Rate

Therefore,

P = (1.6/0.15) + [0.18(4-1.6)/0.15] / 0.15

∴ P = 10.67 + 19.2

∴ P = Rs. 29.87

29.87 Rupees will be the price per share as per Walter model if the payout ratio is 40%.

Thus, option 1 is the correct answer.

Hint

D = 4 x 0.40 = 1.6

The correct answer is – 14%

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt.

Key Points

The cost of each type of capital is weighted by its percentage of total capital and they are added together.

WACC = (10 x 0.20) + (15 x 0.80)

∴ WACC = 2 + 12

∴WACC = 14%

The overall cost of capital is 14%.

Thus, option 4 is the correct answer.

The correct answer is – A, B and C only

Key Points

The Fisher Effect:

• The Fisher Effect refers to the relationship between both the nominal interest rate, real interest rate, and inflation expectations.
• It is an economic theory described by Irving Fisher in 1930.
• The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected rate of inflation.
• i.e. Real interest rate = Nominal interest rate – An expected rate of inflation.
• Therefore, the Nominal rate is equal to a real interest rate plus an expected inflation rate.
• The Fisher Effect has been extended to the analysis of the money supply and international currencies trading.

• The International Fisher Effect expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nation’s nominal interest rates.
• In other words, exchange rate differential between two currencies is explained by interest – inflation rate differential.

Therefore, Statements A, B, and C only describe Fisher (Irving) effect.

The correct answer is – A, B, D and C

Capital budgeting is a process of evaluating investments and huge expenses in order to gain the best returns on investment. it includes the decision to invest the current funds for addition, modification, disposition, or replacement of fixed assets.

Key Points

Capital budgeting process sequence:

A. Cash flow estimation:

• Cash flow estimates are used to determine the economic viability of long-term investments.
• Cash flow estimation is an integral part of the valuation and capital budgeting process.
• It is necessary for assessing investment decisions of any kind.
• Project cash flows consider all kinds of cash inflows.

B. Identify discounting rate:

• A discount rate is the rate of return to discount future cash flows back to their present value.
• A discount rate expresses the change in the value of money as it is invested in a business over a period of time.
• Many companies calculate their WACC and use is it as a discount rate when budgeting for a new project.
• A discount rate helps in determining the NPV as when discount rates are large, cash flows in the future affect NPV less than when rates are small.

C. Determination of NPV:

• Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows.
• NPV is used in the capital budget to analyze the profitability of a projected investment.
• A positive NPV indicates that the projected earnings generated by investment exceed the anticipated costs.

D. Project selection decision:

• When making a project selection decision, one with a higher NPV is preferred.
• The advantage of considering NPV over the Payback Period is that it takes into consideration the future value of money.
• There are mainly two project selection methods:

1. Benefit measurement methods
2. Constrained optimization methods.

Therefore, Option 2) is the correct sequence in the capital budgeting process.