Financial Management

HNDA - Fourth Year - 1st Semester

2016
Model Answers

Answer 01
(i) Briefly explain the types of decisions which are made by 5 Financial Manager.

The basic financial decisions include long-term investment decision, capital structure
decision (i.e., financing decision), profit allocation decision (i.e., dividend distribution
decision), and liquidity decision. Each and every investment decision would yield
benefits in future. To evaluate the investment criteria, the firm will estimate the future
profitability, and probable rate of return on proposed investment, and compare the
same with the cut-off rate (i.e., the generally accepted minimum level of return on
investment). Because of uncertain future, investment decisions involve risk. An
investor will expect higher return from an investment if risk is high. For a lower risk
investment, the expected return will be lower. This is referred to the risk-return
trade-off. The financial decisions jointly affect the market value of shares by
influencing the return and risk of the firm.
(Students need to explain at least 4 important decisions) 1 x 4

(ii) Differentiate Money Market and Capital Market.

 Money Market - Money market as the activity involved with the supply of
short term funds (usually less than a year) in the country. Short term funds are
supplied to meet the working capital requirements. This market is divided into
two sectors as the formal sector and the informal sector.
Instruments are Treasury Bills, Commercial Papers, Bankers’ Acceptance and
short term debt securities.

 Capital Market - The market which provides long term funds required by the
business men and investors is known as the capital market. This market
consists of the following institutions are the share market, long term and
medium term market of the commercial banks, medium term and long term
debt market of the development banks, Finance and leasing companies, unit
trusts, enterprise capital companies, insurance institutions.
Instruments are Ordinary Shares, Preference Shares, Treasury Bonds,
Corporate debentures and other long term debt securities.
(2 Marks 1 x 2)
(iii) State the core functions and services of the Colombo Stock Exchange (CSE) in Sri
Lanka.

 Listing companies to raise debt and equity capital, convertible, warrants,

assets securitizations.
 Providing trading facilities for the secondary trading of all securities that ae
listed.
 Providing on-line market data and other market related products.
 Posting trade clearing. settlement, and registration and depository facilities for
all secondary market transactions.
 Transferring of technology to other exchanges, and training.

1 mark for 1 point (1 x 4)

(iv) Briefly explain the important characteristics of financial instruments in the financial
market.

 Risk: The future outcome affecting the instruments is not known with
certainty. The uncertainty outcome may be changes in the price of the security,
or the default with respect to repayment of capital or income stream. The
measure of risk is the standard deviation of the probability distribution.
 Liquidity: It refers to the ease and speed at which a financial instrument can
be turned into cash without any loss, A bank sight deposit can be withdrawn or
redeemed on. demand and is therefore very liquid. Listed shares can be sold
on a stock exchange but the amount of cash obtained depends on the market
valuation at the time of sale. Hence, these are less liquid.
 Real Value certainty: It refers to the susceptibility to loss due to a rise in the
general level of prices. Share price tends to increase in line or above the rise in
the general price level.
 Terms of maturity: Financial instruments vary widely according to their
characteristics terms of maturity. Sight deposits at bank have zero term to
maturity, as they can be withdrawn on demand.
 Currency denomination: This adds a further component to the return on
non-domestic instruments in the form of the appreciation or depreciation of
the relevant exchange rate.
 Divisibility: It reflects the degree to which the instruments can be subdivided
into small units for transaction purposes. A saving deposit is fully divisible.
Treasury bills are sold minimum denomination and hence are not divisible.

1 mark for 1 point (1 x 4)

 (v) The role of financial system in an economy is to provide the mechanism by which
funds can be transferred from those with surplus units to deficit units. Evaluate the
flow of funds through financial system

The financial system accts as an intermediary between surplus and deficits;

Flow of Funds through the Financial System

Governments have been net demanders of funds and the household sectors the major supplier
of funds in financial system. As the business firms become more sophisticated, investment
requires larger amount of accumulated funds. Therefore, those investors or lenders that did
not spend all their current income on consumption, that are, saved some of their income,
could lend these funds to borrowers, which could use these funds to finance investment.
These household sector savings are usually channelled to demanders of funds through
financial institutions such as commercial banks, savings and, loans, mutual funds, credit
unions. Other intermediaries in the flow-of-funds process include mutual funds, pension
plans, and insurance firms. International investors are also a very important supplier of
capital. However, the business firms involve in this process specially in raising funds for their
required investment. Eventually, in exchange for these funds, firms would issue claims
refereed as financial instruments (for example, share certificates, Treasury bills, Treasury
bond, and corporate bonds).
1 mark for 1 point (1 x 4)
Answer 02
(i) What are the factors that determine working capital requirements?

 Nature and size of the business

 Manufacturing cycle
 Sales growth
 Demand condition, production policies
 Firm’s credit policy
 Operating efficiency & performance
1/2 mark for 1 point

(ii) Explain briefly the spontaneous working capital

It is the additional current assets required for temporary period, and it is above
permanent WC

A firm is required to maintain an additional current asset temporarily over and above
the permanent working capital to satisfy cyclical demands. Any additional working
capital apart from permanent working capital required to support the changing
production and activities is referred to as temporarily or variable working capital.

In other works, an amount over and above the permanent level of working capital is
temporary fluctuating or variable working capital.

At times, additional working capital is required to meet the unforeseen events like
floods, strikes, additional production and price like tendencies contingencies.

1 mark for 1 point

 (iii) Days
Days
Raw material holding period 365 × 320 27 01
4,400
WIP 365 × 350 13 01
1000
Finished goods holding period 365 × 260 09 01
10,500
Debtor's collection period 365 × 480 11 01
16,000
Gross operating cycle 60 01
Credit payment period (16) 01

Answer 03
(i) Explain the following risk which are associated with bonds.

(a) Interest Rate Risk

(b) Default Risk
(c) Inflation Risk

 The market value of the bonds all be changed due to the fluctuations of the
interest rate. That is called interest rate risk or market risk. 02
 If the bond issued institution does not pay the agreed interest rate and the bond
value to the investor that is called default risk. 01
 Due to the inflation situation the future economic value of the bond will be
reduced. That I called inflation risk. 01

1 mark for 1 point (1 x 4)

(ii) A 10 year bond of Rs.1000 has an annual rate of 12%. The interest is paid half yearly.
What is the value of the bond if the required rate of return is 12 percent?

= 1000 (1 / (1.045^40)) + 60 ((1-(1-/1.045^40))/0.045) 02

= 439.18 + 600.87 01

= 1040.05 01

(04 marks)
 (iii) Gihan Fashion Ltd issued debenture at 14.5% interest rate with a nominal value of
Rs.1000. The maturity period is 6 years and the market value of the debentures is
Rs.900. Calculate the Yield to Maturity (YTM).

6(1.14^1) = 6.84 4.48/1.15^1 = 5.94

6(1.14^2) = 7.79 5.02/1.15^2 = 5.89

6(1.14^3) = 8.88 5.62/1.15^3 = 5.84

6(1.14^4) = 10.13 5.62/1.15^4 = 5.79

(02) (02)
5.79(1.12) = 6.48
6.48/(0.15-.12) = 216.3 (01) 216.3/1.15^4 = 123.67

Total = 147.13 (01)

(iv) Last Earning Per Share (EPS) of the company was Rs.16 and the dividend payout
ratio was 50% from EPS. The market value of the share is Rs.50 and the dividend
growth rate is 11%. Calculate the cost of equity.

( (8 (1+0.11)) / 50) + 0.11 (02)

0.2876

0.2876 × 100 (02)

Ke = 28.76% (02)

Answer 04
(i) Briefly explain the importance of calculating the cost of capital of a company.

 Effective evaluation of capital budgeting decision

 Effective evaluation of long-term investment decision
 Effective evaluation of working capital decision
 Evaluate the financial performance of the company
 For maximizing the value of the firm
1 mark for any 3 point (1 x 3)
(ii)
(a) Ke = D1 / Po + g (01)

= 7 (1+0.04) / 55 + 0.04 (01)

= 0.1723

= 17.23% (01)

(b) Kp = D / Po (01)

= 1.5 / 13.5 (01)

= 0.1111

= 11.11% (01)

(c)

As we discussed in the lectures to calculate cist of Redeemable Debentures

you can use,
(i) Approximate YTM Formula or (ii) calculate IRR, for both after tax
adjustment (1-t) should be done for final answer.

(ii) To calculate he IRR, use the below mentioned Net Cash flow and
discount with two different rates and then use IRR formula using the
calculate two values of NPV.

Cost of debentures Kd
Year 0 1 2 3 4 5 6
Investment -95
Interest 12 12 12 12 12 12
Maturity value 100
Net cash flow -95 12 12 12 12 12 112

IRR = Kd before tax 13.26%

Kd after tax 13.26 (1-t) 9.55%

(05 marks for 5 points)

 (d)
Capital Structure No of MV Total Weight Cost of WACC
Shares Per Value Capital
(MN) Share
Ordinary Shares 100 80 8000 0.825 17.23 14.21
Irredeemable 30 30 900 0.093 11.11 1.03
Preference
Debentures 10 80 800 0.082 9.55 0.79
9700 16.03

(01) (01) (01) (01) (01) (01)

WACC = 16.03% (01)

Answer 05
(i) Define the following financial strategies

(a) Merger (02)

(b) Acquisition (02)
(c) Takeover (02)
A merger is said to occur when two or more companies combine into one company.
One or more companies may merge with an existing company or they may merge to
form a new company. In merge, there is complete amalgamation of the assets and
liabilities as well as shareholder’s interest and business of the merging companies.
There is yet another mode of merger. Here one company may purchase another
company without giving proportionate ownership to the shareholder’s of the acquire
company or without continuing the business of the acquired company. Laws in India
use the term amalgamation for merger. When an acquisition is a “forced” or
“unwilling” acquisition, it is called a takeover.

(ii) Explain the following types of merger with example.

(a) Horizontal merger (02)

(b) Vertical merger (02)
(c) Conglomerate merger (02)
Horizontal merger: This is a combination of two or more firms in similar type of
production, distribution or are of business. Example would be combining of two book
publishers or two luggage manufacturing companies to gain dominant market share.
Vertical merger: This is a combination of two or more firms involved in different
stages of production or distribution.. Joining of a TV manufacturing (assembling)
company and TV marketing company or the joining of a spinning company and a
 weaving company are examples of vertical merger. Vertical merger may take the form
of forward or backward merger. When a company combines with the supplier of
material, it is called backward merger and when it combines with the customer, it is
known as forward merger.
Conglomerate merger: This is a combination of firm engaged in unrelated lines of
business activity. A typical example is merging of different business like
manufacturing of cement products, fertilizers products, electronic products, insurance
investment and advertising agencies. Voltas Limited is an example of a conglomerate
company.

(iii)
(d) After merger number of shares

Number of shares paid to Beta’s shareholders = 5 × 0.8

= 4 (01)

Number of shares of the combined company = 15 + (5 × 0.8)

= 15 + 4

= 19 (01)

(a) Combined profit after tax = 80 + 20 (01)

= 100

Combined EPS = Combined profit after tax/No of

shares of the combined company
= 100/19

= 5.26 (01)

(b) Combined P/E Ratio = (7.5×80/100)+(6×20/100) (01)

= 6 + 1.2

= 7.2 (01)
 (c) Market value per share = P/E ratio × No of Shares

= 7.2 × 19

= 136.8 (01)

(e) Total market capitalization = MVPS × No of shares

= 136.8 × 19
= 2599.2 (02)
(f) Premium paid
Value of each share in Delta 0.8 × 40 = 32

(-) Value of Beta’s share before merger = 24

Premium = 8 (01)

Answer 06
(i) What is a spot exchange rate? How is it different from a forward rate? How will you
calculate forward premium or discount?

The spot exchange rate is the rate at which a currency can be bought or sold for
immediate delivery which is within two business days after the day of the trade. The
forward exchange rate is the rate that is currently paid for the delivery of a currency at
some future date. In terms of the volume of currency transactions, the spot exchange
market is much larger than the forward exchange market. The forward rate may be at
a premium or at a discount. Forward rate premium or discount may be shown as an
annualised percentage deviation from the spot rate. For example, if forward dollars
are more expensive than spot collars, the dollar is said to be trading at a premium
relative to the Indian rupee.
(06 Marks)

(ii) Explain each of the following parity condition briefly

(a) Interest rate parity (IRP) (b) Purchasing power parity (PPP)
(c) Forward rates and future spot rate parity (d) International Fisher Effect (IFE)
It states that the exchange rate of two countries will be affected by their interest rate
differential, In other works, the currency of a high-interest-rate will be at a forward
discount relative to the currency of a low-interest-rate-country, and vice versa. This
implies that the exchange rate (forward and spot) differential wall be equal to the
interest rate differential between the two countries. That is interest differential =
Exchange rate (forward and spot) (02 marks)
 In absolute terms, purchasing power parity states that the exchange rate between the
currencies of two countries. equals the ratio between the prices of goods in these
countries. Further, the exchange rate must change to adjust to the change in the prices
of goods in the two countries. In relative terms, purchasing power states that the
exchange rate between the currencies of the two countries will adjust to reflect
changes in the inflation rates of the two countries, In formal terms, it implies that the
expected inflation differential equals to the current spot rate and the expected spot rate
differential. Thus: Inflation rate differential = Current spot rate and expected
spot rate differential. (02 marks)

The expectation theory of forward exchange rates states that the forward rate provides
the best and unbased forecast of the expected future spot rate. In formal terms, it
means that the forward rate and the current rate differential must be equal to the
expected spot rate and the current spot rate differential. Thus: Forward and current
spot rate differential = Expected and current spot rate differential (02 marks)
In formal terms, the International Fisher Effect states that the nominal interest rate
differential must equal to the expected inflation rate differential in two countries.
Thus: Nominal interest rate differential = Expected inflation rate differential

(iii) The differences in the expected inflation rates should equal to the differences in the
interest rates. Thus,

(1+Isl) / (1+It) = (1+rsl) / (1+rt) (02)

1.065 / 1.085 = 1.145 / (1+rt) (02)
rt = (1.085 × 1.145) / 1.065 – 1 (02)