MGT201 Final Term Subjective Paper Solved with references March (2014)

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Firms increases financial risk in two ways. Explain these.

Answer:- Page no : 135

 Increase in Risk faced by Common Stock Holders (or Equity Holders or

Owners) when a Firm takes on moreDebt or Financial Leverage.
 Increase in debt shifts morerisk on common stock holders and risk per
share increases.

Briefly describe as how lease can be treated as a collateralized loan?

Answer:-

Like Collateralized Loan (where the leased asset is the collateral).

Lease Contract is just as serious as a loan agreement. Failure to pay lease rental
is just like failure to pay interest. Canbankrupt the Lessee (Borrowe r).
Lessor(LenderorLeasingCompany) can seize the leased asset and, if the claimis
larger, also demandup to 1 yearlease rental.

What are some strategies to protect the firm against exchange rate risk?

Answer:-

1) Inflation

2) Fiscal Deficit (if government expenditures exceed their revenues through taxes
etc.)

Diversify and Reduce Sovereign (Country-Specific Political) Risk

• Portfolio of Subsidiary Companies, Divisions, Projects, Investments diversified

across different countries can reduce the Sovereign (or Country-Specific
Political) Risk

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• Manage Foreign Exchange Rate Exposure. If your home currency is very weak or
Depreciating (because of Inflation, Deficits, Political Turmoil etc. ) then
invest abroad

• Take advantage of Lower Costs of Debt (interest rates) in foreign

countries or

lower Taxes.

Briefly describe conclusions of the capital structure theory along with the areas
ignored therein.

Answer:

• Capital Structure has no affect on value of a FIRM! Capital

Structure is Irrelevant!

• It does NOT matter how a firm finances its operations, how much
debt it has because it has no bearing on a Firm’s Overall Value as calculated
using NPV!

• Corporate Financing & Capital Structure Decisions have no bearing on

Investment(or Capital Budgeting) Decisions.

• Capital Budgeting can be carried out without knowing the exact

Capital structure of a Firm - youcan assume 100% Equity (Un-levered) Firm.

XYZ industuries has a project N which is finanaced by issuing :

6000 common stocks at par value of RS.120 per sha re. company is currently
paying dividend of rs 2.25 and it is expected to grow at constant rate of 5%
intrinsic value of the share is rs. 105.

Two thousands preferred stock. Dividend on preferred share RS.5 and its
intrinsic value and par value of share is RS.100.

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Bonds to NTN company of RS. 715000 at 9% required rate of return and
coperate tax rate is 35%.

Calculate weighted cost of common equity.

6000 common stocks at par value of RS.120 per sha re. company is currently
paying dividend of rs 2.25 and it is expected to grow at constant rate of 5%
intrinsic value of the share is rs. 105.

Answer:

Div=2.25, g=5%, par value=120 , Po=105

rEXE

r=DIV1/Po+ g =(2.25/105)+0.05=0.715

XE=120/6000=0.02

rEXE=0.715x0.02=1.43

Two thousands preferred stock. Dividend on preferred share RS.5 and its
intrinsic value and par value of share is RS.100.

Answer:

rEXE

r=DIV1/Po =5/100 =0.05

XE=prefferred stock value/total capital = 100 /2000 =0.05

rEXE =0.05x0.05 =0.25

Bonds to NTN company of RS. 715000 at 9% required rate of return and

coperate tax rate is 35%.

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Answer:

ReXe

Re=re* (1 - TC)

=0.09*(1-0.35)=0.0585

Briefly describe conclusions of the capital structure theory along with the areas
ignored therein.

Securities Expected Return S.D

Y 25% 20%

Z 15% 18%

1. Calculate Cofficient of variance (CV) for each security with the help of above
data

2. Which security will be selected by a risk lover investor?

3. What security will be selected by a risk averse investor ?

Answer:

1. Calculate Cofficient of variance (CV) for each security with the help of above
data

CV(Y) = 20/25% = .8%

CV(Z) = 18/15%=1.2%

2. Which security will be selected by a risk lover investor?

Z security will be seleceted.

3. What security will be selected by a risk averse investor ?

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Y security will be selected.

2-stock portfolio amount 1000 in column stock A' return 1300 & probability .50
& stock's B return 1,200 & probability were also same as A's stocks which 's .50
.....requirement was to calculate std. deviation. 5

Answer:

Probability Expected return <ri>=pi*ri

Stock A 0.50 1300 650
Stock B 0.50 1200 600

σ= √ ( r i- <r i > )2 p i

σ=√ (1300-650)2x.50+(1200-600)2x.50= √211250+180000 = 625.49

Lease & advantages of financial lease. 5

Answer:

Leasing Company (Lessor) Buys/Owns the Asset and the Lessee (Borrower)
Controls, Operates, and Uses it. Lesser receives a regular and fixed
Lease Rental. Lifespan of lease is limited (few months to several years).

Advantages:

– Less risky than investing own large amount of money in expensive fixed assets in
a new

businesses that suffer from Cyclicality i.e. Airplanes

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– More suitable for hi-tech assets that become Obsolete quickly.

– When product demand and hence equipment life is uncertain.

– Lender has to share portion of operational risk and maintenance costs

100% equity ratio & add debt equity ratio in it then what’ll be the effect of this
on debt ? 5

Answer:

If Business is 100% Equity (or un-levered firm)

No Debt and No Interest.

Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity Firm,
Total Assets =Equity. So Overall ROR= Net Income / Equity= ROE!

Note: Net Income is also called Earnings.

Note: ROE does not equal rE (Required Rate of Return). ROE is

Expected book return on Equity.

Used in Stock Valuation Formula to calculate “g” & “PVGO”

Fluctuations in ROE = “Basic Business Risk”

Postulates of signaling theory? 5

Answer:

Practically speaking, Firms should maintain LESS Leverage than the

Optimal Level from Tradeoff Theory.

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• Firms Should Save Some Reserve Debt Financing Capacity in case they find a
Great Project or

Investment Opportunity. They should finance the Project using Debt for 2
reasons:

– They don’t have to share the Financial Gains with more shareholders and

– They give the Right Signal to the Market of Investors about the good health of
their Firm !

– Debt Financing brings Financial Discipline and tighter cash control on some
Managers

that waste Shareholders’ money

• News of New Equity Financing Signals bad news: It indicates shortfall in

cash flows through profit, Investors will sell stock and Market Price
(Po) of Stock will fall. Therefore, Required ROR (r = DIV/ (Po + g)) will
Rise and WACC will Increase. Now more difficult for Projects and
Investments to meet this Firm’s Capital Budgeting Criterion by showing
positive NPV (=Sum of Cash Flows /(1+r)t).

Variable investment portfolio can reduce the risk. U agree r not.

Answer:

It states that don’t put all your eggs in one basket. Diversification
can reduce risk. By spreading your money across many different Investments,
Markets, Industries, countries you can avoid the weakness of each. Make sure
that they are Uncorrelated so that they don’t suffer from the same bad news.
Due to certain change in the interest rates some of the investments in your
portfolio may go up and the others go downward.

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Advantages and disadvantages of short term financing (5M)
Answer:
Advantages of Short Term Debt or Loan
– Speed of getting finance as they are short run
– Flexibility (not locked in)
– Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)
• Disadvantage of Short Term Debt is that cost of debt is uncertain and
variable in long run.
Non-renewable.

What is the financial derivative "option" .Explain it "option" in your words: (3M)
Answer:
Options are not obligations. It is cheaper to buy an Option to buy a
house than to
Buy the house! Same for F/x. Also, you can decide not to buy and let the option
expire.
• Call Option – Right to Buy something at a fixed Strike Price for a limited time
in the future
• Put Option – Right to sell something at a fixed Strike Price for a limited time in
the future
• Valuation or Pricing of Options using famous BLACK & SCHOLES MODEL or
simpler Binomial Model.

Q: Price of stocks find

Data was as required of return is 12% for both stock
D1V1 76
stock A= 5% and stock B = 6%
Answer:
Note: Question seems incomplete.
Well price of stock can be calculated by following formula.
PV = Po*= DIV1 / (1+ rCE) + DIV1 / (1+ rCE)2

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Q:Find the market value of a levered firm
Data
Amount of debt = 150,000
EBIT = 115975
interest debt = 9%
Return on Equity = 21%
Corporate tax =35%

Answer:
Sequence of Steps:
(1) Calculate NI = EBIT - Interest -Tax
NI=115975-0.09-0.35=115974.56
(2) Calculate E = NI / rE
E = 115974.56/ 0.21=552259.80
(3) Calculate VL = Equity+ Debt
VL =552259.80+150,000=702259.80

Q:
Data
Dividend Growth = 10%
Face value = 12
Dividend value for next year = 3 per share
Lawyer and fee commission = 1 per share
Floated price 18Rs (premium 6Rs)
Is data k WACC calculate krna tha(Net stock issuance approch) 5M

Answer: page no 126

Net Proceeds = Flotation Price - Flotation Costs = 18 - 1 = 17
r =(DIV1/NP) + g= 3/17 + 0.10 =0.276=27.6%

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100% equity k sath abc comapny ne kam start kia us ka batana tha k uski EBIT,
EBT, aur income pe kia effect ho ga
Answer:
Breakeven Point is the point or quantity of sales at which Earnings before
Interest and Taxes (EBIT)=0.
If Business is 100% Equity (or un-levered firm)

No Debt and No Interest.

Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity Firm,
Total Assets =Equity. So Overall ROR= Net Income / Equity= ROE!

Note: Net Income is also called Earnings.

Note: ROE does not equal rE (Required Rate of Return). ROE is

Expected book return on Equity.

Used in Stock Valuation Formula to calculate “g” & “PVGO”

Fluctuations in ROE = “Basic Business Risk”

Forward market aur spot market:-

Answer: Page no: 182
F/x Spot Market : “Current” exchange rate for Delivery within 2 Days
F/x Forwards Market: Make contract today for Delivery in future.
Forward Price Determined by Interest Rate Yield Curve and Spot Rate.
Contract size and delivery date negotiated privately with banks.

Common stock ki value mallom karni thi

ROI 17%
g 7%
DIV1 Rs. 12 (New year's dividend rate)
Share price 125 rupees thi

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Answer: Page no : 81
PV = Po* = DIV1 / (rCE-g) =12/(.17-.7) =120

100000 equity wala question tha is mei C.V maloom karni thi uski EBIT 175000
thi kai past papers mei bhi ye question h
a) full 100% equity k sath
b) half (50%) quity aur half (50%) debt k sath
(Assolli tor pe ye question galat h kiyu k equity ki value question mei 1000000
(10 lakh) di h aur sara question actuallly 100000 pe base karta h)
Answer: -

Question is not understandable.

Lean & Mean Policy

Answer: Page no : 163
“Zero Working Capital Policy”(Extreme form of Lean & Mean Policy)
It cannot be 0 in reality but its objective is to minimize.
• Japanese Just in Time(JIT) i.e. Toyota Motor Co. It means the spare parts reach
just a few hours ago from the assembly time.

Can Creditors affect dividend payout? Yes or No. Justify

Answer: #internet
Creditors of a financially constrained firm may fear that it may not be able to raise
enough cash to overcome the temporary financial distress that triggered the
violation of the financial covenant. As a result, creditors will force the firm to cut
dividends either to prevent tunneling or to allow the firm to invest it in
restructuring. On the contrary, creditors of a financially unconstrained firm may
be sufficiently confident about firm’s ability to raise funds necessary for an
improvement in the financial health of the firm, and will allow the firm to
maintain its dividend policy.

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5. One numerical question related to find Expected return. Equity and Debt
capital financing values were given.
Answer:
Expected return on Equity :- rE = div/po

Expected return on Debt :- rD = div/po + g

6. If opening firm and need computers. Should we buy or lease? Advantages of

leasing?
Answer:-
NAL = Net Advantage of Leasing = PV (Cost of Owning Asset) – PV
(Cost of Leasing). If NAL>0 then Leasing is Better than Buying.

LSO had a project S with cost of Rs. 425,550 that is 49% debt financed at interest rate of
11.5% and reaming through equity. Corporate tax rate was 35%.
Required: Calculate after-tax cost of debt with the help of provided data. (3m)

Answer:

After Tax Cost of Debt = rD = rD* (1 - TC)= .49(1-.35) = 0.3185

ABC Company has decided to pay cash dividend and increased dividend from Rs. 10 per
share. How it will affect the following:
 Current Assets of the company
 Working capital of company (3m)
Answer:

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Stock B is being traded in the Karachi stock exchange (KSE) at a market price of Rs.25/-. You
need to calculate the expected theoretical fair price of a stock B before you can decide
whether to buy it or not. Relevant information is given below:
Forecasted dividend is Rs.4/- in the upcoming year on a share of face value= Rs.10/-

Forecasted constant growth rate in dividends is 10% pa. T-bill rate of return or PLS bank
account ROR is 10% pa. the Karachi stock exchange`s historical average ROR based on the
value of the KSE 100 index is 20% p.a. and stock B has historically been as volatile or risky
as the KSE 100 index has the beta 1.0. 5m

Answer:- page no : 114

DIV1 = Rs 4 (i.e. Forecasted Dividends in the upcoming year on a share of Face Value = Rs
10)

g = 10% pa (i.e. Forecasted Constant Growth Rate in Dividends)

rRF = 10%pa (i.e. T-Bill Rate of Return or PLS Bank Account ROR)

rM = 20% pa (i.e. The Karachi Stock Exchange’s historical average ROR based on
the value of the KSE100 Index)

Beta of Stock B = 1.0 (i.e. Stock B has historically been as volatile or risky
as the KSE 100 Index) //default

Use the Gordon-SML Equation to Estimate Fair Price of Stock A:

Po* = DIV1 / [ (rRF + (rM -rRF) A ) - g]

= 4/ [(10% + (20% -10%) (1.0)) - 10%]

= 4 / [20% - 10%] = 4 / 10% = Rs: 40

1. Sky flyers wants to purchase a new luxury bus; Rs. 7,300,000 will be required to
purchase a new bus; proposed income from this project is Rs. 2,400,000 Rs. 2,400,500
Rs. 2,500,850 and Rs. 2,605,200 respectively for the coming four years. Required rate
of return is 9%.
Evaluate the project with the help of profitability index that either the project is feasible
or not. (Support your answer with complete working) 5m

Answer:

PI = [Σ CFt / (1+ i)t ]/ IO

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 PI= [240,000 / (1.9)]+ [240,000 / (1.9)2]+ [250,850 / (1.9)3]+ [2,605,200 / (1.9)4]/7300,000

PI= solve by yourself.

Those projects with a profitability index ratio of more than one (PI >= 1.0)
are considered acceptable

2. What strategies can be used by the target firms to responds to hostile raid? 5m
Answer:

• Poison Pill – Target Firm takes on excessive short-term debt to appear

unhealthy. Because of high liabilities their balance sheet becomes unattractive.

• White Knight – a wealthy friendly investor who protects the Target Firm by

Making higher counter-tender offer against the corporate Raider.

• Fight Back: Target Firm makes counter-tender offer to shareholders

• Be Acquired (if Raider is offering much higher value than Firm is worth)

1. What does the term stable dividend policy means, explain with the help of an
example? 3m
Answer:

Stable Dividends signal financial stability and Less Risk.

If Cap Ex Budget = Rs.150 then shortfall of Rs.50 (=TotalFinancing–Budget=100–

150). Means Firm has to raise external financing. What kind and at what cost?
• Can NOT raise external Debt because Target Capital Structure will change.
• Must raise external Equity. But Cost of Equity will increase. Recall that
Transaction and Flotation Costs of External New Stock Issuance is more than
Opportunity Cost of Using Retained Earnings.
• Again, assuming that Dividend Payout would be zero because Firm would want
To use entire Earnings as source of cheapest capital to meet Capital Expenditure
Budget.

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 Firms increases financial risk in two ways. Explain these. 3m
Answer:

If the Company raises money using Debt or Bonds, then it will have to pay a
fixed amount of interest (or mark-up) regularly for a limited amount of time. Of
course, failure to pay interest can force company to close down.

If the Company raises money using Equity, then it is forced to bring in new
shareholders who are Owners & can interfere in the management and will get a share of
the net profits (or dividends) for as long as the company is in operation.

2. Define asset stripping. Briefly describe the idea behind asset stripping. 3m
Answer:

Asset Stripping: separate out the non-profitable and sell its assets individually

to generate cash and restore profitability.

Mechanism of Leveraged Buy-Outs (LBO’s) using Debt Financing: Acquiring Firm

borrows alot of money (from Debt Investors) to buy the shares of another
publicly traded Target Firm. The Public Firm thus becomes “Privatized” in the hands of
fewer shareholders and it also means less administrative costs. It then sells assets (Asset
Stripping) of the Target to make immediate interest payments. If Firm runs into
difficulty, then can raise more money by selling its own Junk Bonds. After
Restructuring, Cost Cutting, and Down-Sizing, the firm (now financially stronger)
again goes Public giving opportunity for its takeholders and deal-makers and
Investment Bank Advisers to recover their Investment and en cash Capital Gains.

3. Suppose a firm ABC has total assets of Rs. 1000 and is 100% equity based (i.e. un-
levered). There were 10 equal owners and 5 of them want to leave. So the firm takes a
bank loan of Rs. 500 (at 10% pa mark-up) and pays back the equity capital to the 5
owners who are leaving. Now, half of the equity capital has been replaced with a loan
from a bank (i.e. Debt). What impact does this have on ROE? 5m
Answer:

Assuming Business Risk is unchanged, and then risk per share rises because Equity
is halved.

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 So, more Risk is transferred to Common Shareholders.
• Debt Investors (i.e. Lenders and Bond Holders) face minimal risk because
(1) Guaranteed Regular Interest Income and
(2) 1st Claim on Assets in event of Bankruptcy

What are the securities? What is difference between the direct and indirect security? 5m
Answer:

Securities:

Security, also known as a financial asset, is a piece of paper representing a

claim on an asset. Securities can be classified into two categories.

• Direct Securities: Direct securities include stocks and bonds. While valuing direct
securities we take into account the cash flows generated by the underlying
assets. Discounted Cash Flow (DCF) technique is often used to determine the value of a
stock or bond.

• Indirect Securities: Indirect securities include derivatives, Futures and Options.

The securities do not generate any cash flow; however, its value depends on the
value of the underlying asset.

4. With the help of provided information, you are required to calculate portfolio return
(rP) by using CML equation.
Particulars

Risk of the market 0.9%

Risk free rate of return 10%

Expected rate of return for the market for all 25%

possible stock

Answer: not really sure about the answer because risk of stock isn’t given so I am
supposing here market risk as risk of stock according to the formula

CML Equation: rP* =rRF+[(rM-rRF) / σM] σP

rRF=risk free rate of return=10

rM=expected rate of return for the market of all possible stock=25

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 σM=risk of the market=.9

σP =risk of stock portfolio=

risk of stock= MarketRisk + Random Specific Unique Risk=.9%

rP* =rRF+[(rM-rRF) / σM] σP

rP* = 10+(25-10)]=25%

5. What is the difference between operating lease and financial lease? 5m

Answer:-

1- Financial Lease (or Capital Lease)

– Financial Lease is Fully Amortized: Lessor recovers BOTH the full Value of
Asset

(Principal amount) AND the Profit (in form of interest or mark-up). BOTH are
built

into the Lease Rental amount collected by the Lessor over the lifespan of the
Lease.

Fully Amortized Lease means the lessor recovers the principal amount plus interest
amount.

– Financial Lease is NOT Cancelable: If Lessee MUST Cancel or Terminate the

Lease

Prematurely then pays heavy penalty to Lesso.

2-Operating Lease (or Service Lease)

– Operating Lease offers Financing AND MAINTENANCE: often the Lessor is the

Supplier /Vendor of the Asset i.e. IBM

– Operating Lease is NOT FULLYAMORTIZED ANDIS CANCELLABLE

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 6. Mr. Rehan is a supplier of material to Textile Company. Management of the company
wants to purchase material from Mr. Rehan on credit basis and promises to pay within
three months. Existing current ratio and quick ratio for textile company are as follows:
Current ratio = Rs. 6,351/Rs. 3,850 = 1.65:1……………….5m

Answer:

Note: question isn’t complete.

Current Ratio= Current Assets /Current Liabilities

Quick Ratio= Quick Assets / Current Liabilities

Quick Assets = Current Assets – Inventory

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