Unit 4 Business Finance PYQ’s 3rd Sept 2024 Shift 1

The correct answer is 4.9%.

Key Points

Given:

• Coupon rate (interest rate): 7% or 0.07
• Corporate tax rate: 30% or 0.30

Steps for Computation:

1. Calculate the pre-tax interest:
   Pre-tax interest = Coupon rate = 0.07
2. Calculate the after-tax interest:
   After-tax interest = 0.07 × (1 – 0.30)
3. Simplify:
   After-tax interest = 0.07 × 0.70
4. Final Calculation:
   After-tax interest = 0.049 or 4.9%

        Answer: 4.9%

 The correct answer is The firm is unable to forecast its cash needs with certainty.

Key Points

• The firm is unable to forecast its cash needs with certainty:
  • This statement is not an assumption of Baumol’s model of cash management. The Baumol model assumes that the firm has predictable and stable cash flow requirements.
  • The model aims to minimize the total cost of holding cash and the transaction costs of converting securities to cash, which relies on the predictability of cash needs.
  • If a firm cannot forecast its cash needs, it would not be able to effectively apply the Baumol model to manage its cash holdings.

Additional Information

• The opportunity cost of holding cash is known:
  • This is a correct assumption of Baumol’s model. The opportunity cost represents the return that could be earned if the cash were invested in marketable securities instead.
• The firm will incur the same transaction cost whenever it converts securities to cash:
  • Baumol’s model assumes a constant transaction cost for converting securities to cash, which simplifies the calculation of the optimal cash balance.
• The firm’s cash payments occur uniformly over a period of time:
  • This is another assumption of Baumol’s model. The uniform distribution of cash outflows allows for a more straightforward application of the model to calculate the optimal cash balance.

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

Key Points

• Systematic Risk (A) matches with Increase in corporate tax rate (II).
  • Systematic risk, also known as market risk, affects the entire market or economy and cannot be eliminated through diversification.
  • An increase in the corporate tax rate is an example of a systematic risk because it impacts all businesses operating within the same economic environment.
  • Other examples of systematic risk include changes in interest rates, inflation, and political instability.
• Beta (B) matches with Sensitivity coefficient (III).
  • Beta is a measure of a stock’s volatility in relation to the overall market. It indicates how much a stock’s price is expected to move in response to market changes.
  • As a sensitivity coefficient, beta helps investors understand the risk associated with a particular stock compared to the market.
  • A beta greater than 1 indicates that the stock is more volatile than the market, while a beta less than 1 means it is less volatile.
• Risk-free Rate (C) matches with Compensation for time (I).
  • The risk-free rate represents the return on an investment with zero risk, typically associated with government bonds.
  • It serves as a benchmark for the minimum return investors require for any investment, compensating them for the time value of money.
  • In financial models, the risk-free rate is used as a baseline to evaluate the attractiveness of other investments.
• Unsystematic Risk (D) matches with Competitor enters the market (IV).
  • Unsystematic risk, or specific risk, is unique to a particular company or industry and can be reduced through diversification.
  • A competitor entering the market is an example of unsystematic risk, as it directly affects the competitive landscape and profitability of the existing company.
  • Other examples include company management decisions, product recalls, and regulatory changes specific to an industry.

 The correct answer is Modigliani and Miller (MM) Approach.

Key Points

• Modigliani and Miller (MM) Approach:
  • The MM approach to capital structure was developed by Franco Modigliani and Merton Miller in 1958.
  • They proposed that, under certain conditions (e.g., no taxes, no bankruptcy costs, efficient markets), the value of a firm is unaffected by its capital structure.
  • One key aspect of their theory is the arbitrage process, which suggests that if two firms are identical in every way except their capital structure, investors can create leverage on their own to achieve the same returns, thus neutralizing any advantage of one capital structure over another.
  • This arbitrage process implies that the market value of a firm is determined by its earning power and the risk of its underlying assets, not by how it finances its operations.

Additional Information

• Traditional Approach:
  • This approach suggests that there is an optimal capital structure where the cost of capital is minimized and the firm’s value is maximized.
  • It assumes that the cost of debt remains constant up to a certain level of leverage, after which it starts to increase, reflecting the increasing risk of bankruptcy.
• Net Operating Income (NOI) Approach:
  • According to the NOI approach, the value of the firm is determined by the capitalization of its net operating income, and this value is independent of its capital structure.
  • It assumes that the cost of equity increases linearly with leverage, offsetting the benefits of cheaper debt.
• Net Income (NI) Approach:
  • This approach posits that a firm can increase its value and decrease its overall cost of capital by increasing the proportion of debt in its capital structure, given that debt is usually cheaper than equity.
  • It assumes that the cost of debt and equity remain constant regardless of the level of leverage.

 The correct answer is A, D & E only.

Key PointsLet’s analyze each assumption:

• No Taxes
  • One of the assumptions of Gordon’s dividend-capitalization model is that there are no taxes.
  • This simplification helps in focusing on the relationship between dividends, growth rates, and discount rates without the complications introduced by taxes.
• Cost of Capital is Less Than the Growth Rate
  • This assumption is not correct. In Gordon’s model, the growth rate (g) is assumed to be less than the cost of capital (k), because if the growth rate were higher than the cost of capital, the model would yield negative or non-feasible values.
  • Hence, this assumption is incorrect as per Gordon’s original framework.
• No Internal Financing
  • This assumption is not a part of Gordon’s model.
  • Rather, the model works under the scenario where retained earnings (internal financing) are considered, as they contribute to the growth rate of dividends.
• Constant Retention
  • An important assumption of Gordon’s model is that the retention ratio (the portion of earnings not paid out as dividends) is constant.
  • This influences the growth rate of dividends, which is assumed to remain steady.
• Constant Cost of Capital
  • Another assumption of the Gordon model is that the cost of capital (discount rate) remains constant over time.
  • This allows the model to simplify the valuation of the firm’s stock by maintaining a steady discount factor for future dividends.

Based on the evaluation above, the correct assumptions of Gordon’s dividend-capitalization model are No Taxes, Constant Retention, and Constant Cost of Capital. Therefore, the correct answer is option 4: A, D & E only. This option accurately identifies the assumptions that align with Gordon’s model, excluding the incorrect or non-related assumptions.

 The correct answer is ₹9.

Key Points

• The price of the company’s share is ₹80, and the value of growth opportunities is ₹20.
• This means that the price without growth is ₹80 – ₹20 = ₹60.
• The company’s capitalisation rate is 15%.
• The formula to find EPS (Earnings Per Share) without growth is EPS = Price without growth × Capitalisation rate.
• Thus, EPS = ₹60 × 15% = ₹9.

The correct answer is ‘A, C & D only.

Key Points

• Tax loss on short-term capital gains (A):
  • This refers to the financial loss that occurs when the selling price of a short-term asset is less than its purchase price.
  • Such losses can be used to offset other capital gains, thereby reducing the overall tax liability.
• Release of net working capital (C):
  • At the end of a project, any working capital that was tied up in the project becomes available for other uses.
  • This release positively impacts cash flows by providing additional liquidity.
• Tax saving on short-term capital loss (D):
  • When a company incurs a short-term capital loss, it can use this loss to offset other short-term capital gains.
  • This tax saving helps in reducing the overall tax burden on the company.

Additional Information

• Capital Budgeting Decisions:
  • Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the goal of the investor’s wealth maximization.
  • It involves planning the investment of resources in high-value projects and deciding which ones will provide the best returns.
• Terminal Year Cash Flows:
  • These are the final cash flows associated with the termination of a project.
  • They include the recovery of working capital, disposal value of assets, and any other residual cash inflows or outflows.

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

Key Points

• Profitability Index (A) matches with Ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment (IV).
  • The Profitability Index (PI) is a measure that calculates the ratio of the present value of future cash flows generated by an investment to the initial investment cost.
  • It helps in determining the attractiveness of an investment; a PI greater than 1 indicates that the net present value (NPV) is positive and the investment is likely to be profitable.
  • PI is particularly useful for comparing projects of different sizes and for making capital budgeting decisions.
• Accounting Rate of Return (ARR) (B) matches with Rate that is computed by dividing the average profit after tax with the average investment (III).
  • The Accounting Rate of Return (ARR) is a financial metric used to assess the expected profitability of an investment.
  • It is calculated by dividing the average annual accounting profit by the average investment in the project.
  • ARR is simple to compute and understand, but it doesn’t take into account the time value of money or cash flows.
• Internal Rate of Return (IRR) (C) matches with Rate that equates the investment outlay with the present value of cash inflow received after one period (I).
  • The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
  • IRR is used in capital budgeting to evaluate the profitability of potential investments.
  • Projects with an IRR greater than the cost of capital are considered good investments.
• Modified Internal Rate of Return (MIRR) (D) matches with Compound average annual rate that is calculated with a reinvestment rate different than the project’s IRR (II).
  • The Modified Internal Rate of Return (MIRR) is an improvement over the traditional IRR, addressing some of its limitations by incorporating a more realistic assumption about the reinvestment rate of intermediate cash flows.
  • MIRR assumes that positive cash flows are reinvested at the firm’s cost of capital rather than the IRR itself.
  • It provides a better measure of an investment’s attractiveness by considering the cost of capital and the final value of cash flows.