Unit 4 Business Finance PYQ’s 4th March 2023 Shift 2

The correct answer is Within 30 days from the date of receipt

Key Points

FDI policy India

The Department for Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce & Industry, Government of India makes policy pronouncements on FDI through Consolidated FDI Policy Circular/Press Notes/Press Releases which are notified by the Department of Economic Affairs (DEA), Ministry of Finance, Government of India.

Investments can be made by non-residents in the equity shares/fully, compulsorily and mandatorily convertible debentures/fully, compulsorily and mandatorily convertible preference shares of an Indian company, through the Automatic Route orthe Government Route. Under the Automatic Route, the non-resident investor or the Indian company does not require any approval from Government of India for the investment

An Indian company receiving investment from outside India for issuing shares/convertible debentures/preference shares under the FDI Scheme should report the details of the inflow to the RBI Within 30 days from the date of receipt  

The correct answer is Increases first and then decreases 

Key Points 

• Traditional theory of capital structure:
  • The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value.
  • Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity. 
  • This theory depends on assumptions that imply that the cost of either debt or equity financing vary with respect to the degree of leverage.
  • The traditional theory of capital structure says that a firm’s value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing
  • In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increased value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital

The correct answer is 13.33%

Key Points

• Correct Option (13.33%):
  • The cost of preference shares is calculated as the dividend paid divided by the net proceeds after flotation costs.
  • Formula used: Cost of Preference Shares = (Dividend / Net Proceeds) * 100.
  • Here, the dividend is 12% of Rs. 110 (face value + premium), and the net proceeds after flotation costs is Rs. 95.
  • Calculation: (12% * 110) / 95 * 100 = 13.33%.
  • This option correctly factors in all elements including the premium, flotation costs, and sale price.
• Incorrect Options:
  • Options like 12%, 12.67%, and 13% do not accurately calculate the cost of preference shares using the correct formula or may omit factors such as flotation costs or sale price.
  • They may overlook the premium paid on redemption or misinterpret the calculation method.
  • For instance, 12% might only consider the coupon rate without incorporating the premium or flotation costs.
  • These options fail to match the precise calculation derived from considering all financial components involved.

The correct answer is Making loans to risky borrowers by attracting savings from the savers who are risk-averse. 

Important Points

•  Default-risk intermediation refers to the process by which financial institutions, such as banks or other lending institutions, assume the risk of loan default from borrowers in exchange for a fee or interest rate premium. 
• Default-risk intermediation involves the process of taking funds from risk-averse savers and using those funds to make loans to borrowers who may have a higher risk of defaulting on their obligations. 

Risk Aversion of Savers – 

• Savers typically prefer low-risk investment options to protect their savings.
• They may be hesitant to directly lend their money to risky borrowers who have a higher likelihood of defaulting.

Role of Intermediary –

• The intermediary plays a crucial role in this process.
• They act as a bridge between the risk-averse savers and the potentially risky borrowers.
• The intermediary is responsible for assessing and mitigating the risks associated with lending to these borrowers.

Lending to Risky Borrowers –

• The intermediary takes on the responsibility of assessing the creditworthiness of borrowers.
• They identify potential borrowers who may have a higher risk of default due to factors such as poor credit history, unstable income, or other financial vulnerabilities.

The correct answer is A and B only.

Key Points

• Inflation rate differential: Higher inflation in a country compared to its trading partners will tend to depreciate its currency. This means that the relative prices of its goods increase, thereby decreasing the demand for its goods and for its currency.
• Interest rate differential: Countries with higher interest rates often attract more foreign investors as they can get a higher return on their investments. This can lead to an appreciation of the currency. Conversely, if a country has lower interest rates relative to others, its currency is likely to depreciate.
• Growth rate differential: Strong economic growth attracts foreign investors to invest in a country, thus increasing the demand for its currency, leading to appreciation. While weak or negative growth can lead to outflows of foreign investors, decreasing the demand for the domestic currency, leading to its depreciation.
• Fiscal deficit differential: Large fiscal deficits can lead to the depreciation of a currency. The rationale is that large fiscal deficits have to be financed by borrowing from overseas, which increases the demand for foreign currency, resulting in relative depreciation of the domestic currency. However, the effect of fiscal deficits on exchange rates isn’t as direct or substantial as the effect of inflation and interest rates.
• Foreign exchange (Forex) reserve differential: Foreign exchange reserves do affect a currency’s value but the relationship is complex and not as direct as with inflation or interest rates. Increases in a country’s Forex reserves might indicate that the country’s central bank is trying to prevent the currency from appreciating. Conversely, a decrease in reserves might indicate an attempt to prevent the currency from depreciating.

The correct answer is A, B, C and D only.

Key Points

• The Internal Rate of Return (IRR) method is a capital budgeting technique that businesses use to determine whether a project is worth pursuing.
• Here are its advantages as per the options given:
  • It recognizes the time value of money: This is true. The IRR method calculates the discount rate at which the Net Present Value (NPV) of the cash inflows from a project equals the initial investment, thereby acknowledging the time value of money.
  • It is consistent with the shareholders’ profit-maximization objective also: This is true. If the IRR exceeds a company’s required rate of return, the project is expected to add value to the firm, thereby potentially increasing the company’s stock price.
  • It considers all cash flows occurring over the entire life of the project: This is true. The IRR calculation includes all project cash inflows and outflows, from start to finish.
  • It generally gives the same acceptance rule as the NPV method: This is often true. A project is acceptable if its IRR is greater than the required rate of return—the same criterion as accepting a project if its NPV is positive. However, there could be differences in certain situations, especially with mutually exclusive projects or non-ordinary cash flows.
  • It considers all positive NPV over the entire life of the project: This is not really relevant to IRR. IRR is a rate of return, a percentage, not an accumulation of net present values.

The correct answer is A, B, C and D only.

Key Points

• Off-balance sheet financing is a form of financing in which large capital expenditures are kept off a company’s balance sheet through various classification methods.
• This can help a company maintain lower debt-to-equity ratios.
• Here we look at the given options in that context:
  • Securitisation: This is a financial transaction in which a company sells its illiquid assets (like loans it has given out) to a third party in return for cash. The third party then packages these assets into securities and sells them to investors. It is not recorded on the balance sheet and is therefore considered an off-balance sheet source of finance.
  • Factoring: The sale of receivables to a financial institution (factor) is known as factoring. When a company sells its receivables outright to a factor, it gets immediate cash and transfers the credit risk to the factor. This does not appear on the balance sheet and so it is an off-balance sheet source of finance.
  • Forfaiting: It involves the sale of longer-term receivables (like bills of exchange or promissory notes) to a financial institution (forfait). The financial institution takes on all the risks associated with the receivables but receives a return higher than the interest rate. Similar to factoring, this is also considered an off-balance sheet source of finance as it similar doesn’t appear on the balance sheet
  • Operating lease: An operating lease doesn’t show up as an asset or a liability on a balance sheet. Instead, operating lease expenses are treated as operating expenses. Therefore, they are considered an off-balance sheet source of finance.
  • Credit rating: This is not a source of finance, but rather, it’s an assessment of a company’s ability to repay its debts. A credit rating does not provide financing, nor does it directly lead to obtaining finance — although it can influence the terms of loans or bonds a company may issue.

The correct answer is A, B, C and D only.

Key Points

• Correct options
  • Portfolio Size: Even though the size of a portfolio (total number of different investments) doesn’t directly affect portfolio beta (risk compared to the market), a larger portfolio usually consists of a diverse set of investments. This diversity can balance out risks, leading to a change in the overall beta of the portfolio.
  • Investment Longevity: This refers to how long you’re investing for. Although it doesn’t directly affect the beta, the duration of the investment might influence the data used to calculate the beta. For instance, if you calculate the beta using ten years of data instead of only five, the different market conditions over these periods could lead to a slightly different beta.
  • Trading Volume: This refers to how often stocks in the portfolio are bought and sold. While it doesn’t directly affect the calculation of beta, the idea here is that stocks that are traded more frequently might have lower price fluctuations and, by extension, a lower beta.
  • Return Interval (weekly vs. monthly): This is about how frequently you calculate returns (profits and losses) from the investment. Calculating returns more often can capture small changes and make the beta calculation more sensitive to those changes.
• Incorrect Option:
  • Portfolio leverage: This involves borrowing money to invest, which could potentially increase risk and thus theoretically could affect the beta. However, in this particular context, leverage isn’t being considered as something that influences the portfolio beta. This might be because it usually impacts another type of beta (known as equity beta) used to measure different kinds of risks.

The correct answer is A, C and D only.

Key Points

• Statement A: Increasing capital requirements on banks could reduce the likelihood of their failure.
  • This statement is accurate.
  • In the banking sector, higher capital requirements are designed to help absorb losses and protect depositors in the event of risky ventures or investments failing.
  • In short, more capital makes banks safer.
• Statement B: Open financial markets are solely influenced by the currency rate movements.
  • This statement is incorrect.
  • Although exchange rates play a significant role in financial markets, they are not the only influencing factor.
  • Other factors include interest rates, inflation, political stability, economic indicators, etc.
  • Hence, it’s a multifactorial system and not solely reliant on currency rate movements.
• Statement C: Financial inflow reflects the net flow of capital into one country in the form of increased purchases of domestic assets by foreigners.
  • This statement is correct.
  • Financial inflow does typically relate to the incoming capital acquired through foreign direct investment (FDI), which includes foreign investors purchasing domestic assets.
• Statement D: Tier II Capital for banks includes Perpetual Debt Instruments.
  • This statement is accurate.
  • Tier II capital, which serves as a secondary buffer for banks (alongside Tier I capital), can comprise various components, including the uncalled part of partly-paid shares and hybrid (debt/equity) capital instruments, which indeed include Perpetual Debt Instruments.
• Statement E: Only private banks in India have implemented Basel III guidelines.
  • This statement is incorrect.
  • The Basel III guidelines, which were introduced to strengthen bank capital requirements, are not limited to just private banks.
  • In India, all scheduled commercial banks, including public sector banks, have been mandated to implement these guidelines.

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

Key Points

• Euro Bonds:
  • A Eurobond is a debt instrument that’s denominated in a currency other than the home currency of the country or market in which it is issued.
  • They are commonly issued by international syndicates and sold to investors in countries other than the one in whose currency the bond is denominated.
  • For instance, a bond issued in US dollars in Europe by an American company would be a Eurobond.
• Global Bonds:
  • A Global bond is a type of bond issued and traded outside the country where the currency of the bond is denominated.
  • These bonds are simultaneously sold in multiple markets worldwide.
  • They provide an easy avenue for a company to raise capital from various global markets at a lower cost.
• Yankee Bonds:
  • Yankee bonds are foreign bonds issued in the United States by foreign banks and corporations, denominated in U.S. dollars.
  • These bonds are subject to the securities regulations of the U.S. Securities and Exchange Commission (SEC).
  • For a foreign company, issuing bonds in the U.S. market can potentially allow it to raise capital at lower cost if U.S. dollar interest rates are lower than in its home country.
• Samurai Bonds:
  • Samurai Bonds are yen-denominated bonds issued in Tokyo by non-Japanese companies and are subject to Japanese regulations.
  • These bonds provide an avenue for foreign companies to raise capital from Japanese investors.
  • The advantage for an issuer of Samurai Bonds may be the generally low funding costs in Japan’s capital markets.

The correct answer is 1. ‘A, C, B, E, D’

Key Points

• Identify an opportunity (A):
  • The first step in an international arbitrage operation is identifying a price discrepancy in different markets.
  • This involves spotting a potential gain from differences in exchange rates, asset prices, or market conditions between countries.
• Review the transaction cost (C):
  • Before making any transactions, it’s crucial to review and factor in the transaction costs.
  • These costs can significantly affect the net profit, so calculating them ensures the opportunity is genuinely profitable.
• Purchase the asset (B):
  • Once the opportunity and costs have been evaluated, the next step is to buy the asset in the market where it is cheaper.
  • This step involves executing the trade to acquire the asset at the lower price.
• Sell the asset (E):
  • After purchasing the asset, it is then sold in the market where the price is higher.
  • This step involves transferring the asset to the market with favorable conditions to complete the arbitrage process.
• Pocket the profit (D):
  • The final step is to calculate and secure the profit made from the difference in prices after accounting for transaction costs.
  • This is the net gain realized from the arbitrage operation.

Additional Information 

• C, A, D, B, E :
  • Starts with reviewing transaction costs, but without identifying an opportunity first, there’s no basis for this review.
  • Pocketing profit appears incorrectly at the third step before purchasing and selling the asset.
  • This sequence does not logically follow the natural order of an arbitrage operation.
• B, A, D, E, C :
  • Begins with purchasing the asset without identifying an opportunity, making it a non-strategic purchase.
  • Pocketing the profit comes before even selling the asset, which is illogical.
  • Reviewing costs at the end overlooks the importance of transaction cost assessment before making the initial purchase.
• B, D, A, C, E :
  • Like the previous option, it starts with purchasing the asset impulsively without any opportunity identification.
  • Pocketing the profit incorrectly comes before both identifying an opportunity and reviewing costs.
  • Selling the asset is placed after reviewing costs, which should logically follow the purchase step.

Correct answer is 3. B, C, A, E, D.

Key Points

 Risk management process in involves the following steps:

1. Identification of risk variable
   • The initial step in the risk management process is to identify the risks that the business is exposed to in its operating environment.
   • It is important to identify as many of these risk factors as possible. In a manual environment, these risks are noted down manually. If the organization has a risk management solution employed all this information is inserted directly into the system.
2. Determination of frequency and severity of risk
   • Once a risk has been identified it needs to be analyzed. The scope of the risk must be determined.
   • It is also important to understand the link between the risk and different factors within the organization.
   • To determine the severity and seriousness of the risk it is necessary to see how many business functions the risk affects.
3. Selection of appropriate risk model for analysis
   • Risks need to be ranked and prioritized. Most risk management solutions have different categories of risks, depending on the severity of the risk. A risk that may cause some inconvenience is rated lowly, risks that can result in catastrophic loss are rated the highest. It is important to rank risks because it allows the organization to gain a holistic view of the risk exposure of the whole organization. 
4.  Application of a suitable risk instrument
   • Every risk needs to be eliminated or contained as much as possible. This is done by connecting with the experts of the field to which the risk belongs. In a manual environment, this entails contacting each and every stakeholder and then setting up meetings so everyone can talk and discuss the issues.
5. Feedback on the risk management process
   • Not all risks can be eliminated – some risks are always present. Market risks and environmental risks are just two examples of risks that always need to be monitored.
   • Risk feedback is a structured process whereby the agency solicits, receives, and evaluates citizen input for inclusion in a risk-management plan.

​Therefore we can say that correct answer is B, C, A, E, D.