Unit 4 Business Finance PYQ’s 7th Dec 2023

The correct answer is Forward hedge.

Key Points

A forward hedge is a strategy used to mitigate or protect against the risk of fluctuations in foreign currency exchange rates. Given the context of protecting the value of a foreign currency denominated transaction, here’s how a forward hedge functions in alignment with its designation as the correct answer:

• Hedging Strategy: A forward hedge involves entering into a forward contract or using financial instruments in a way that will offset potential losses in a foreign currency transaction due to currency exchange rate movements. The aim is to lock in the exchange rate for a future transaction.
• Forward Contracts in Hedging: Even though the term “forward contract” is mentioned separately as option 1, it’s worth noting that forward contracts are commonly used as a part of forward hedging strategies. The distinction in this context is that “forward hedge” encompasses a strategy or objective (hedging risk), whereas “forward contract” is a specific instrument that can be used to achieve that strategy.
• Protection Against Exchange Rate Risk: For businesses or individuals involved in transactions that require converting one currency to another at a future date, the value of the transaction can significantly vary with changes in the exchange rate. By using a forward hedge, the parties agree on an exchange rate initially, thus protecting the transaction from becoming more expensive (or less profitable) due to unfavorable exchange rate movements.
• Why not the others?: While “forward swap” and “forward premium” relate to financial instruments and terms within the foreign exchange and hedging domain, they don’t directly describe a strategy aimed at protecting the value of a foreign currency denominated transaction in the way that “forward hedge” does. “Forward swap” involves exchanging financial instruments or cash flows between parties in different currencies for a specified period, and “forward premium” refers to a condition where the forward or future price of a currency is higher than the spot price. These don’t capture the comprehensive approach of mitigating currency risk for a transaction as the term “forward hedge” does.

The correct answer is Lifetime Value.

Key Points

• The Lifetime Value (LTV), also known as Customer Lifetime Value (CLV), is a prediction of the net profit attributed to the entire future relationship with a customer or segment.
• This financial metric is an important part of marketing and customer relationship management because it helps a company understand the economic value that a customer would offer over the course of their business relationship.
• LTV is calculated by predicting the net profit from the entire future relationship with a customer, then discounting it to present value.
• The present value is the current value of a future sum of money assuming a certain rate of return.
• LTV allows companies to understand what they should spend to acquire new customers or retain existing ones.
• An increase in lifetime customer value represents a positive outcome, as it implies that a company would profit more from a customer over their lifetime.
• Strategies that help in increasing LTV include improving customer service, personalizing customer experience, and launching customer loyalty programs.

The correct answer is  A, B, and C Only

Key Points

• The trilemma of international finance, also known as the impossible trinity, is a concept in economics that suggests it is impossible for a country to simultaneously achieve all three of the following objectives in its monetary policy: (A), an independent monetary policy (B)., and free capital movement (C).

• Fixed exchange rate: This refers to a situation where a country’s currency is pegged to the value of another currency or a basket of currencies, and the exchange rate remains constant. This is often desired for stability in international trade and investment.
• Independent monetary policy: This means that a country’s central bank has the ability to control its monetary policy, including interest rates and money supply, without being constrained by external factors. Independent monetary policy is crucial for addressing domestic economic conditions such as inflation, unemployment, and economic growth.
• Free mobility of capital: This implies that capital can flow in and out of a country’s economy without significant restrictions, such as capital controls or barriers to investment. Free mobility of capital facilitates international investment, diversification of portfolios, and efficient allocation of resources across borders.

Additional Information

• If a country chooses to have a fixed exchange rate and free mobility of capital, it would have to give up independent monetary policy. This is because capital mobility can put pressure on the exchange rate, forcing the central bank to adjust its monetary policy to maintain the fixed exchange rate.
• If a country prioritizes independent monetary policy and free mobility of capital, it would have to allow its exchange rate to float, meaning it cannot maintain a fixed exchange rate.
• Alternatively, if a country decides to have a fixed exchange rate and independent monetary policy, it would have to impose restrictions on capital flows to prevent speculative attacks on its currency. This would violate the principle of free mobility of capital.

The correct answer is Pacman defense 

Key Points 

• When a target company makes a counter bid for the stock of the bidder, the defensive strategy in reference is called Pacman defense 
• The Pacman defense is a strategic maneuver employed by a target company to lend off a hostile takeover bid by turning the tables on the would-be acquirer.
• The term is derived from the popular arcade game Pac-Man, where the titular character turns the tables on its pursuers by consuming them instead. Similarly, in the context of corporate takeovers, the target company attempts to “devour” or acquire the entity that initially sought to acquire it.

• Initially, a company (the bidder) launches a hostile takeover bid to acquire the target company.
• In response to the hostile takeover attempt, the target company adopts the Pacman defense strategy.
• By making a counter bid, the target company gains several strategic advantages
• Implementing a Pacman defense requires careful consideration of legal and regulatory implications.
• The Pacman defense can lead to negotiation and dialogue between the target company and the bidder.
• Both parties may seek to reach a mutually beneficial agreement, such as a merger or acquisition on favorable terms, to resolve the standoff.

Additional Information 

• Greenmail is a defensive strategy where a target company repurchases its own stock from a potential acquirer at a premium, thus making the takeover attempt less financially attractive for the acquirer.
• A poison pill is a strategy used by a target company to defend itself against an unwanted takeover bid. It involves the issuance of new shares or rights to existing shareholders, which dilutes the ownership stake of the acquirer, making the acquisition more expensive and less attractive.
• Golden parachute refers to a compensation package offered to top executives of a company in the event of a change in ownership or control, typically following a merger or acquisition. This package provides lucrative benefits to key executives if they are terminated or if there is a change in control of the company.

The correct answer is The Static Theory

Key Points 

• The theory of capital structure that articulates that a firm borrows up to the point where the tax benefit from extra debt is exactly equal to the cost that comes from the increased probability of financial distress is known as the “static theory.”
• The static theory, also known as the trade-off theory, suggests that there is an optimal capital structure for a firm where the tax advantage of debt is balanced against the costs of financial distress.
• In other words, a firm will continue to add debt until the marginal tax benefit of debt equals the marginal cost of financial distress.
• Debt provides tax shields in the form of interest expense deductions, which reduce the taxable income of the firm, resulting in lower tax payments.
• As the firm increases its debt level, the tax benefit from interest payments also increases.

Additional Information

• However, as the firm takes on more debt, it also faces increased financial distress costs, such as bankruptcy costs, agency costs, and the potential for loss of reputation and business opportunities.
• These costs rise with higher levels of debt due to increased risk of default.
• According to the static theory, the firm’s optimal capital structure is achieved when the tax benefit of debt is precisely offset by the costs associated with financial distress.
• At this point, further increases in debt would not provide any net benefit to the firm.

Correct answer is Rs. 40

Key Points

• Dividend theory = The important aspect of the dividend policy is to determine the amount of earnings to be distributed to shareholders and the amount to be retained by the firm. On the relationship between the dividend policy and the value of the firm, different theories have been given such as Walter’s model, Gordon’s model and MM hypothesis.
• Walter’s model = It is a dividend relevance model means the the policy of the dividend affects the value of the firm. It was given by Prof. James E. Walter. He argues that the choice of the dividend policy always almost affects the value of the firm. The theory shows the relationship between the firm’s rate of return and the cost of capital in determining the dividend policy and that will maximize the wealth of shareholders.
• Assumptions of Walter’s model theory
  • Constant return and cost of capital.
  • The firm finances all the the investment through retained earning. 
  • There is 100% payout and retention ratio.
  • The firm has a very long and infinite life.
  • Perfect capital market, no tax and no transaction cost.
• Growth firm = Growth firm means those firms in which the internal rate of return is more than the opportunity cost of capital. These type of company can maximize their growth by retaining all the earnings for internal investment. Thus, the optimal payout ratio for a growth firm is zero. The market value per share increases as payout ratio declines.
• Normal firms = Normal firms are those which have internal rate of return and the cost of opportunity are equal. The dividend policy has no effect on the market value of the share in Walter’s model. Thus, there is no optimum payout ratio for a normal firm.
• Declining firm = Declining firms are those which have internal rate of return less than the opportunity cost of capital. The market value per share of the declining firm will be maximum when it does not retain all the earnings. Optimum payout ratio of the declining firm is 100%. The market value per shares increases as payout ratio increases.
• To calculate the price per share according to the Walter model in an easy and simple way, we’ll use the Walter formula:
  P = [D + (E-D) ( r/k )] / k.
  Where:
  • ( P ) = Price per share
  • ( D ) = Dividend per share
  • ( k ) = Required rate of return by its shareholders
  • ( r ) = Rate of return on investments
  • ( E ) = Earnings per share
• Given in the question:
  • Earnings per share (( E )) = Rs. 4.0
  • Rate of return on investments (( r )) = 16% or 0.16
  • Required rate of return by its shareholders (( k )) = 12% or 0.12
  • Payout ratio = 40%, which means 40% of earnings are paid as dividends. Since ( E ) = Rs. 4.0, Dividend per share (( D )) = ( 4.0 \times 0.40 = Rs. 1.6 )
  • Now, plugging these values into the Walter formula:
    P = [D + (E-D) ( r/k )] / k
  • Now, plugging these values into the Walter formula:
    • P = [D + (E-D) ( r/k )] / k.
    •  
      P = [1.6 + (4.0 – 1.6) (0.16/0.12)]/0.12
      [ P = 13.33 + 26.67 ]
       
      [ P = Rs. 40 ]

Correct answer is A – IV, B – I, C – III, D – II

Key Points