Unit 4 Business Finance PYQ’s 6th Dec 2019 Shift 2

The following are the explanation for the correct match:

The operating cycle refers to the average time lapse between the acquisition of raw material and the final cash realization. This concept is used to ascertain the requirements of cash working capital to meet the operating expenses.

In the operating cycle the inventory period consists of:

1. Raw Material Conversion Period (RMCP), which is the time gap between purchase of raw material and the issuance of raw material for production.

2. Work in Progress Conversion Period (WIPCP), which is the time gap between issuance of raw material and the conversion of raw material into finished goods.
3. Finished Goods Conversion Period (FGCP), which is the time gap between sale of goods and the transfer of finished goods from shop floor to the warehouse.
4. Book Debt/Receivables Collection Period (BDCP), which is the time gap between sales and realization of cash.

Key Points

Now the length of the operating cycle for direct material can be calculated as follows:

Gross operating cycle = RMCP+WIPCP+FGCP+BDCP

Net Operating Cycle = Gross Operating Cycle – PDP = RMCP+WIPCP+FGCP+BPCP-PDP, Where PDP is the Payment Deferral Period. PDP is the credit time extended by suppliers to pay for the purchases.

The Capital Asset Pricing Model (CAPM) is developed by Sharpe, Linter, and Mossin. The CAPM describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return then the investment should not be undertaken.

The main insights of CAPM are :

1. Investors need to be rewarded for systematic risk (β) only because unsystematic risk can be reduced to zero through diversification of the investment portfolio.
2. A security’s systematic risk is measured by beta value.
3. The required rate of return on a security depends on the riskless rate of interest the market risk premium and the security’s beta value.

Formula: R = rf + ß (rm – rf)

where, R = Expected rate of return, rf = Risk free rate, rm = Market rate of return, ß = Project beta (systematic risk)

R = 6 + 1.5 (10 – 6) = 12%

Therefore, If the risk – free return (Rf) is 6%, Beta value (β) is 1.5 and market rate of return (Km) is 10%, the expected rate of return would be 12%

Before-Tax Cost Of Debt = I + [(FV – NP)/n] / (FV + NP)/2

Where, I = Interest, FV = Face Proceeds, NP = Net Proceeds, n = number of years

Interest (I)= 100 x 10% = Rs.10

Face Proceeds (FV) = Rs. 100

Net Proceeds (NP) = Face Value – Discount = 100 – 2% = Rs. 98

Number of years (n) = 10 years

Before-Tax Cost Of Debt = 10 + [(100 – 98)]/10 / (100+98)/2 = 10 + 0.2 / 99 = 10.2/99 = 10.30%

After-Tax Cost Of Debt = Before-Tax Cost Of Debt x (1 – t)

Where, t = Tax Rate

After-Tax Cost Of Debt = 10.30 (1 – 0.40) = 6.18%

Therefore, if a company raises Rs. 1,00,000 by issue of 1000, 10% debentures of Rs. 100 each at a discount of 2% redeemable after 10 years. If the corporate tax rate is 40%, the cost of capital will be 6.18%

Though the term risk has got different connotations from different angles, it can be defined as the potential that events, expected or unexpected may have an adverse impact on earnings or capital or both. Risk and expected return are positively related; higher the risk, higher the expected return, and vice versa.

Key Points

1. Transaction Exposure:

• This arises when a company is importing or exporting.
• If the exchange rate moves between agreeing on the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.
• For instance, An Indian person has to make a payment to a person residing in the US after 3 months.
• Now, since foreign exchange rates are volatile, there is a chance that the Indian currency will weaken or the US currency will strengthen on the day of payment causing a loss to the Indian person.
• Transaction exposure is inherent in all foreign currencies denominated contractual transactions.
• Thus, statement A is correct.

2. Translation Exposure

• It refers to the amount of risk facing the firm as a result of the need to translate financial statements prepared in one currency into statements in another currency.
• This is particularly true for multinational firms which must consolidate their financial results at the end of the year.
• The accounting framework is the legally required form in which companies must report operating results and financial condition to shareholders.
• The financial statements contain information of interest to various other parties viz lenders, debtors, regulators.
• Thus, the translation of subsidiary accounts for consolidation into parent accounts faces translation exposure and may pose serious implications for the parent company.
• For instance, If the subsidiary is in a country whose currency weakens, the subsidiary’s assets will be less valuable in the consolidated accounts.
• Thus, statement B is correct.

3. Economic exposure

• It relates to ‘cash flow‘ risks.
• Thus, economic exposure has an impact on the valuation of a firm.
• Economic (competitiveness) risk is concerned with threats from changes in real exchange rates to the competitiveness of costs.
• The sensitivity of a business to competitiveness risk depends on its elasticity of demand.
• Competitiveness risk is a long term problem. For example, the business is a single hotel, and the home currency becomes uncompetitive, fewer tourists will come and the hotel will lose business.
• Some authors like Adler and Dumas (1984) and Wihlborg (1987) treat currency risk as one element of the wider concept of macroeconomic threats to real (inflation-adjusted) cash flows.
• The economic risks may include exchange rate fluctuations, a shift in government policy or regulations, political instability, or the introduction of economic sanctions.
• Thus, statement C is correct.

4. Operational risk

• According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events.
• This risk is associated with human error, system failures, and inadequate procedures and controls.” According to Laylock (1998) “Operational risk is the potential for adverse fluctuations in the profit-and-loss statement or the cash flow of the firm due to effects that are attributable to customers, inadequately defined controls, system or control failures, and unmanageable events.”
• Since operating exposure has an impact on the firm’s future operating revenues or future operating costs, statement D is incorrect.

a) Pay – back period method considers all cash flows of a project: False

Explanation: The payback method simply projects incoming cash flows from a given project and identifies the break-even point between profit and paying back invested money for a given process.

b) Payback period method concerns more with the recovery of the cost than profitability: True

Explanation:

1. The payback period refers to the amount of time it takes to recover the cost of an investment.
2. Simply put, the payback period is the length of time an investment reaches a break-even point.
3. The desirability of an investment is directly related to its payback period.

4. Shorter paybacks mean more attractive investments.

5. Therefore, the Payback period method concerns more with the recovery of the cost than profitability.

c) Net Present Value represents net addition to the wealth of shareholders: True

Explanation:

1. The NPV technique measures the present value of the future cash flows that a project will produce.
2. A positive NPV means that the investment should increase the value of the firm and lead to maximizing shareholder wealth.
3. A positive NPV project provides a return that is more than enough to compensate for the required return on the investment.
4. Thus, using NPV as a guideline for capital investment decisions is consistent with the goal of creating wealth.

d) Accounting Rate of Return method incorporates risk as well as time value of money: False

Explanation:

1. Accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment’s cost.
2. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of the asset, or related project.
3. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

According to Gerstenberg, “ Capital structure refers to the makeup of a firm’s capitalization”. In other words, it represents a mix of different sources of long-term funds.

In general, the experts in finance define the term capital structure to include only long-term debt and total stockholders’ investment.

Key Points

Capital Structure Theories:

1. Net Operating Income (NoI) approach:

• This approach is propounded by Durand.
• According to this approach, the overall cost of capital and value of the firm is independent of capital structure decisions, and a change in the degree of financial leverage does not bring about and change in the value of the firm and cost of capital.
• The net operating income approach says that the value of a firm depends on operating income and associated business risk.

• The value of the firm will not be affected by a change in debt components.

• The average cost of capital remains constant with the increased use of leverage.

Thus, Option 1 is the correct answer.

Additional Information

1. Net Income (NI) Theory:

• According to this approach, capital structure decision is relevant to the valuation of the firm in as much as a change in the pattern of capitalization brings about a corresponding change in the overall cost of capital and the total value of the firm.
• This theory, also known as fixed Cost of Equity (ke) theory, was propounded by David Durand.
• The theory works like this: “As the proposition of cheaper debt funds in the capital structure increases, the weighted average cost of capital decreases and approaches the cost of debt”.
• This theory recommends 100% debt financing is optimal capital structure.
• Thus, the cost of capital decreases with an increase in leverage.

2.Traditional Approach:

• The traditional theory assumes changes in Ke at different levels of debt-equity rate.
• It is the middle of the two extremes of NI and NOI. Beyond a particular point of debt-equity mix, ke rises at an increasing rate.
• There are three stages:-
• Stage I – Introduction of debt-Net Income rises; the cost of equity capital rises because of risk but less than earnings rate leading to a decline in the overall cost of capital and an increase in Market value.
• Stage II – Further Application of debt: cost of equity capital rises- debt cost increases – value remains the same.
• Stage III – Further Application of debt – the cost of equity capital is very high because of high risk – value goes down.
• Thus, according to this approach, the cost of capital increases as leverage increases.

3. Walter’s Approach is associated with the dividend policies of the firm and not the capital structure of the firm.

a) Dividend payout ratio refers to that portion of total earnings which is distributed among equity shareholders of the company- True

Explanation: The payout ratio is a financial metric showing the proportion of earnings a company pays shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. On some occasions, the payout ratio refers to the dividends paid out as a percentage of a company’s cash flow.

b) ‘Bird in hand’ argument is given by Gordon’s model: True

Explanation:

• Myron Gordon and John Lintner developed the bird-in-hand theory as a counterpoint to the Modigliani-Miller dividend irrelevance theory.
• The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding stock arise from dividends or capital gains.
• Under the bird-in-hand theory, stocks with high dividend payouts are sought by investors and, consequently, command a higher market price.

c) MM model suggests that dividend payment is very relevant for the value of the firm- False

Explanation: Modigliani- Miller Theory on Dividend Policy. Modigliani – Miller’s theory is a major proponent of the ‘Dividend Irrelevance’ notion. According to this concept, investors do not pay any importance to the dividend history of a company and thus, dividends are irrelevant in calculating the valuation of a company.

d) Walter’s Model suggests that dividend payment does not affect the market price of the share: False

Explanation: Walter’s model provides a single framework to explain the relationship between dividend policy and the value of the firm. If the assumptions underlying the model hold good, the behavior of the market price of the shares in response to the dividend policy of this firm can be explained with the help of this model