Unit 4 Business Finance PYQ’s 25th Dec 2021 Shift 1

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

The correct match is given below:

Important Points 

Market risk: 

Market risk refers to the probability that an individual or other entity would suffer losses as a result of factors affecting the overall performance of financial market investments.

Financial risk:

The risk of losing money on an investment or business endeavour is referred to as financial risk. Credit risk, liquidity risk, and operational risk are some of the more prevalent and distinct financial hazards. Financial risk is a sort of danger that might cause interested parties to lose money.

External business risk:

Economic events that occur outside of the business structure are frequently considered external risks. External occurrences that result in external risk are impossible for a corporation to manage or predict with high accuracy. Therefore, it is hard to reduce the associated risks.

Internal Business Risk:

Internal risks are those that emerge from within a company’s organisation and occur during routine business activities. Because these risks can be predicted with some accuracy, a corporation stands a fair chance of lowering internal business risk.

The correct answer is Present value of all expected future profits

Key Points Wealth Maximisation:

Wealth maximisation refers to maximising shareholder wealth through growing the company’s market capitalisation through a rise in share price.

Example:

Typical examples of wealth maximisation can be the cases where the shareholders have benefited from investing. 

A very practical example can be an investment made in 1996 for a US-based company called Havells. It is observed that any investor who has invested in Havells to a tune of $1500 in this stock in 1996 and has retained the stock till now have seen a massive gain from a mere $1500 to $4,000,000.

Important Points Wealth Maximisation objective:

• Value of the firm is measured by calculating present value of cost flows of profits of the firm over a number of years in the future.  
• To do so, profits of future years must be discounted because money value a rupee of profit in a future year is worth less than a rupee of profit in the present.
• Therefore, the value of the firm or shareholder’s wealth is given by the present value of all expected future profits of the firm.
   

 Profit Maximisation Objective

• All activities that raise profits should be pursued, while those that diminish profits should be avoided, according to this approach.
• Profit maximisation indicates that financial decisions should be based on a single criterion: pick profitable assets, projects, and decisions while rejecting those that are not.

The correct answer is Asymmetric information between managers and investors

Key Points 

Pecking Order Theory:

According to the pecking order principle, a corporation should seek to finance itself first through retained earnings. If this source of funding is unavailable, a corporation should consider borrowing money. Finally, and as a last resort, a business should fund itself by issuing equity.

• Important Points
• The pecking order theory (or pecking order model) in corporate finance states that asymmetric knowledge increases the cost of funding.
• Pecking order theory is based on asymmetric knowledge, which means that managers have a better understanding of their company’s prospects, dangers, and value than outside investors.
• Asymmetric information influences the decision to use internal or external finance, as well as whether to issue debt or equity. As a result, there is a ranking system for new project finance.

The correct answer is Self-liquidating structure

Key Points 

Securitisation:

• Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors.
• The process leads to the creation of financial instruments that represent an ownership interest in, or are secured by a segregated income producing asset or pool of assets. The pool of assets collateralises securities.
• These assets are generally secured by personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit card debt, consumer loans).

Important Points Self liquidating Structure:

• In securitisation, when an asset is not acquired and the collateral is fixed for the entire duration of the asset, such a structure is called a self-liquidating structure.
• It is a short-term loan, which is repaid with the money generated by the property to be used to buy it.
• These loans are intended to finance purchases that will generate cash quickly and reliably.

Additional Information Revolving structure: It means an issuing entity that is set up to issue multiple series, classes, subclasses, or tranches of asset-backed securities on multiple issuance dates, all of which are collateralised by a common pool of securitized assets that will change in composition over time and do not monetize excess interest and fees from those assets.

Amortized structure: Amortizing securities are debt-backed, which means they are made up of a loan or a group of loans that have been securitized. Nothing has changed from the initial loan agreement in terms of the borrower’s perspective, but the payments paid to the bank flow through to the investor who holds the security generated by the loan.

Collateralised structure: Any secured loan is referred to as “collateralised.” To put it another way, the lender has some type of security. If the loan is not returned, the debt is secured by a specified asset possessed by the debtor. Real estate, which is represented by a mortgage, could be used as collateral.

The correct answer is (A), (B), (C), (E), (D)

Key Points

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. 

 Important Points

Stages of capital budgeting are:

(A) Identification of potential investment opportunities: 

• The process starts with a search for available options.
• A corporation will most likely have several options to choose for each given effort.
• For example, if a corporation wants to expand its warehouse facilities, it can either add on to its existing structure or buy a larger facility in a new site.

(B) Assembling of proposed investments: 

• A standard capital investment proposal firm is used to submit investment proposals identified by the production department and other departments.
• Most proposals are routed via numerous people before they reach the capital budgeting committee or someone who puts them together.

(C) Decision-making: 

• A capital budgeting decision involves both a financial and an investment commitment.
• By taking on a project, the company is not only making a financial commitment, but it is also investing in its long-term strategy, which will likely affect future projects.

(D) Preparation of capital budget and appropriations: 

• After the decision-making step, the next step is to classify the investment outlays into the higher value and the smaller value investment.
• When the value of an investment is lower, and it is approved by lower management, it is usually covered by blanket appropriations in order to get quick actions. However, if the investment outlay is higher in value, it will be included in the capital budget after the relevant approvals are obtained. The purpose of these funds is to assess the investment’s performance during its implementation.

(E) Implementation and performance review:

• The investment plan under consideration is implemented, or turned into a tangible project, after all the preceding processes have been completed.
• The management professionals may confront a number of problems while carrying out the jobs, as they might be time-consuming.

The correct answer is Statement I is correct, but Statement II is incorrect.

Important Points

Statement I : Modified Internal rate of return is based on reinvestment assumption. 

This statement is true because:

• According to the modified internal rate of return (MIRR), positive cash flows are reinvested at the firm’s cost of capital, while new outlays are financed at the firm’s financing cost.
• MIRR is used to rank investments or projects a firm or investor may undertake.
• MIRR is designed to generate one solution, eliminating the issue of multiple IRRs.

Statement II : Value-additivity principle is not applicable in NPV.

This statement is false because:

• Value-additivity principle is applicable in NPV.
• According to the Value Additivity Principle in NPV, the value of the entire NPV of a larger project is equal to the sum of all smaller NPVs of projects.
• In other words, the larger NPV of an investment project is the sum of all smaller NPVs.
• The NPV of a collection of independent projects will equal the NPV of all independent projects.
• NPV (A+B) = NPV (A) + NPV (B)

The correct answer is 16%

Key Points 

Accounting Rate of Return:

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

ARR=AverageIncomeAverageInvestmentARR=AverageIncomeAverageInvestmentx100

Important Points 

Calculation of ARR:

Depreciation is calculated on straight line basis 

Therefore, Depreciation = 40000/5 = 8000 per year

Book Value of Investment

Average rate of Return = AverageIncomeAverageinvestmentAverageIncomeAverageinvestmentx 100

Average rate of Return = 320020000320020000×100

Average rate of Return = 16%

The correct answer is Residual Theory

Key Points

Residual Theory of dividends:

• According to the residual dividend principle, dividends should be distributed when expenditure for capital expenditure and working capital has been done, and even after that profit remains.
• A firm should adopt its investment strategy in such a way that as many positive net present value projects as possible are accepted and the dividend is paid only when funds are available.
• It keeps zero additional cash in the dividend policy business. The excess cash, if any, must be reinvested in the business or redistributed among shareholders.

For example:

The firm generates ₹1,40,000 in earnings for the month and spends ₹1,00,000 on CapEx. The remaining income of ₹40,000 is paid as a residual dividend to shareholders, which is ₹20,000 less than was paid in each of the last three months.