Gyan Sagar Classes

Test Series
FINAL EXAMINATION
Syllabus 2022
Paper 14: STRETEGIC FINANCIAL MANAGEMENT (SFM)
Time Allowed: 3 Hours Full Marks: 100
The figures in the margin on the right side indicate full marks.
Working Notes should form part of your answers.
Wherever necessary, candidates may make appropriate assumptions and clearly state them.
No present value factor table or other statistical table will be provided in addition to this question paper
This paper contains two sections. A and B. Section A is compulsory and contains questions
(Answer Key)
No.1 for 30 marks. Section B contains question Nos. 2 to 8, each carrying 14 marks.
Answer any five questions from Section B.
(Phase – II)
SECTION – A
Answer all the question. Each question carries two marks.
1. Choose the correct option from the four alternatives given : (1 mark is for the correct
choice and 1 mark is for the justifications/workings. You may present only the Roman
numeral, your choice and the reasons/workings, without copying the question).
2×15=30

(i) The following information is available for a mutual fund:

Return 13%
Risk (S.D. i.e. σ) 16%
Beta (β) 0.90
Risk Free Rate 10%
Treynor's Ratio of the mutual fund is:
(A) 3.85
(B) 4.43
(C) 3.33
(D) 3.73

Please Turn Over

P-14(SFM) (2)
Syllabus 2022
(ii) The 90 day interest rate is 1.85% in USA and 1.35% in the UK and the current spot exchange
rate is $ 1.6/£. The 90-day forward rate is
(A) $ 1.607893
(B) $ 1.901221
(C) $ 1.342132
(D) $ 1.652312

(iii) A project has a 10% discounted pay back of 2 years with annual after tax cash inflows
commencing from year end 2 to 4 of ₹ 400 lacs. How much would have been the initial cash
outlay which was fully made at the beginning of year 1?
(A) ₹ 400 lacs
(B) ₹ 452 lacs
(C) ₹ 633.80 lacs
(D) ₹ 497.20 lacs
(Use p.v. factors only up to 3 decimal places.)

(iv) BLC Ltd. a valued customer engaged in import business, is in need to remit EURO 1 million to
his European exporter. The spot rate of ₹/US$ is ₹ 65.47/65.57 and that of US$/EURO is $
0.8053/0.8057. What rate will a banker quote to BLC Ltd. if the bank's margin is 0.50%?
(A) ₹ 53.09
(B) ₹ 53.067
(C) ₹ 53.01
(D) ₹ 52.99

(v) A project had an equity beta of 1.4 and is to be financed by a combination of 25% Debt and 75%
Equity. Assume Debt Beta as zero, Rf = 12% and Rm = 18%.
Hence, the required rate of return of the project is
(A) 16.72%
(B) 18.30%
(C) 17.45%
(D) 12.00%

(3) P-14(SFM)
 Syllabus 2022
(vi) Which of the following investment avenues has the least risk associated with it?
(A) Corporate Fixed Deposits
(B) Deposits in commercial banks
(C) Public Provident Fund
(D) Non-convertible zero coupon bonds

(vii) MS Ltd. is planning to invest in USA. The annual rates of inflation are 8% in India and 3% in
USA. If spot rate is currently ₹ 75-50/$, what spot rate can the company expect after 3 years?
(A) ₹ 65.49
(B) ₹ 79.16
(C) ₹ 87.04
(D) ₹ 72.00

(viii) There are 4 investments

X Y Z U
The standard deviation is 37,947 44,497 42,163 41,997
Expected net present value (₹) 90,000 1,06,000 1,00,000 90,000
Which investment has the highest risk?
(A) X
(B) Y
(C) X
(D) U

(ix) The following is not a feature of Capital Market Line:

(A) There is no unsystematic risk.
(B) The individual portfolio exactly replicates market portfolio in terms of risk and reward.
(C) Estimates portfolio return based on market return.
(D) Diversification can minimize the individual portfolio risk.

(x) ‘Bank rate’ published by the Reserve Bank refers to

(A) the repo rate transacted by RBI.
(B) the rate at which housing or other long term loans shall be sanctioned by scheduled banks to
their customers.
(C) The rate at which RBI is willing to buy or rediscount bills of exchange or other
commercial paper.
(D) the rate which RBI uses as cut-off for auction of Government securities.

Please Turn Over

P-14(SFM) (4)
Syllabus 2022
(xi) Bond volatility is inversely related to:
(A) Term to maturity
(B) Yield to maturity
(C) Coupon rate
(D) Both (b) and (c)

(xii) Which among the following increases the NAV of a mutual fund scheme?
(A) Value of investments
(B) Receivables
(C) Accrued income
(D) All of (a), (b) and (c)

(xiii) Plain vanilla interest rate swaps involved:

(A) Fixed to fixed rate swap
(B) Fixed to floating rate swap
(C) Floating to floating rate swap
(D) Currency swap

(xiv) The 6-month forward rate for US dollar against Rupee is quoted as ₹49.50 as opposed to a spot
price of ₹48.85. The forward premium on US dollar is:
(A) 1.50 %
(B) 3.08 %
(C) 3.05 %
(D) None of the above.

(xv) The sterling is trading at $1.6400 today. Inflation U.K. is 3.8% and that in U.S.A. is 2.9%. What
would be the spot rate ($/£) after 2 years?
(A) $1.6117
(B) $1.615
(C) $1.625
(D) None of the above

(5) P-14(SFM)
 Syllabus 2022
Section – B
Answer any five questions out of the following seven questions.
Each question carries 14 marks.

2 (a) Company A wishes to raise $10m and to pay interest at a floating rate, as it would like to be able
to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or
at a floating rate of 1% above LIBOR. (8 Marks)
Company B also wishes to raise $10m. They would prefer to issue fixed rate debt because they
want certainty about their future interest payments, but can only borrow for one year at 13%
fixed or LIBOR + 2% floating, as it has a lower credit rating than company A.
Required:
Calculate the effective swap rate for each company – assume savings are split equally.
Ans
Before solving the problem we can summarize the problem as under:
Company A B
Fixed rate 10 % 13 %
Floating rate L+1% L+2%

Step: 1 Identify absolute advantage party if any and calculate comparative advantage for such party.
Absolute advantage party means party who can obtain cheaper loan under both market.
Here, Company A is absolute advantage party
Company A‘s advantage in fixed market = 3 %
Company A‘s advantage in floating market = 1%
Step: 2 Identify the market for each party. Select the market for absolute advantage party where
comparative gain is higher and the other party‘s market will automatically decide.
Hence,
Company A should borrow fixed rate loan
Company B should borrow floating rate loan
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap:
Due to swap A pays B L + 2 %
Company A Company B

Due to swap B pays A 10 %

Bank Bank

Loan obtain @ 10 % from Loan obtain @ L + 2 %

Bank
Step: 4 Prepare a statement showing gain / loss due to swap and its allocation:
Particulars Company A Company B
Cost due to IRS:
Company A pays B L+2% -
Company B pays A - 10 %
Cost without IRS:
Company A pays L+1%
Company B pays - 13 %
Gain / (Loss) due to IRS (1 %) 3%
Net gain 2%
Share of each party 1% 1%

Step: 5 Prepare a statement showing effective cost of borrowing for each party:
Particulars Company A Company B
Paid to bank 10 % L+2%
Paid to other party due to swap L+2% 10 %
Receive from other party due to swap (10 %) (L + 2 %)
Share in loss (0.50 %) 0.50
Share in gain (1.50 % ) 1.50
Effective cost L 12 %

2 (b) The following are the data on Five mutual funds — (6 Marks)
Fund Return Standard deviation Beta
Raksha 16 8 1.50
Varsha 12 6 0.98
Vredhi 14 5 1.40
Mitra 18 10 0.75
Laheri 15 7 1.25

What is the reward-to-variability / volatility ratio and the ranking if the risk - free rate is 6 %?
Ans

3 (a) X Limited has contracted to borrow Rs.500 lakhs after 6 months for 3 months period at a spread
of 100 basis point over the 3 month LIBOR. 6 X 9 FRA is quoted at 8 % / 9 %. Find out the
 annual cost of borrowing when hedged through FRA if 3 months LIBOR after 6 months happens
to be –
(a) 11 % (b) 7 % (7 Marks)
Ans
(a) FRA rate: 9 %
Borrowing rate: L + 1 %
Step: 1 Calculate settlement amount at t = 1
Notional principal X Interest Rate differential X t /12
Settlement amount =
1+(Interest rate X t /12)
3
500lakhs X ( 11%−9 % ) X
12
Settlement amount =
3
1+(11 X )
12
2. 50
Settlement amount = = 2.43 lakhs
1. 0275
Step: 2 Calculate amount to be borrowed at t =1
500 lakhs – 2.43 lakhs = 497.57 lakhs
Step: 3 Loan repayment in 3 month with interest of L + 1 % i.e. 12 %
Repayment = 497.57 + 497.57 * 12 % * 3/12
= 497.57 + 14.93 = 512.50 lakhs
Step: 4 Calculate effective cost
Repayment of amount−Fund enjoyed 12
Effective cost = X 100 X
Fund enjoyed Period
512. 50−500 12
Effective cost = X 100 X = 10%
500 3
(b) FRA rate = 9 %
Borrowing rate = L + 1
Step: 1 Calculate settlement amount at t = 1
Notional principal X Interest Rate differential X t /12
Settlement amount =
1+(Interest rate X t /12)
3
500lakhs X ( 7 %−9 % ) X
12
Settlement amount =
3
1+(7 X )
12
2. 50
Settlement amount = = 2.46 lakhs
1. 0175
Step: 2 Calculate amount to be borrowed at t = 1
500 lakhs + 2.46 lakhs = 502.46 lakhs
Step: 3 Repayment of loan with interest after 3 months
502.46 + 502.46 * 8 % * 3/12
= 502.46 + 10.05 = 512.51 lakhs
Step: 4 Calculate effective cost of borrowing
Repayment of amount−Fund enjoyed 12
Effective cost = X 100 X
Fund enjoyed Period
 512. 50−500 12
Effective cost = X 100 X = 10%
500 3

3 (b) The historical rates of return of two securities over the past ten years are given.
Calculate the Covariance and the Correlation coefficient of the two securities; (7 Marks)
Years 1 2 3 4 5 6 7 8 9 10
Security a : (Return %) 12 8 7 14 16 15 18 20 16 22
Security B: (Return %) 20 22 24 18 15 20 24 25 24 18

Ans

4 (a) Investor’s Weekly, a news magazine on the happenings at cloudy Street, publishes the following
information in its July edition for Security D - equilibrium Return = 20%, market Portfolio
Return = 20%, 6% treasury Bills (Rs.100) at Rs.120. covariance of the Security with the market
portfolio is 225% and correlation is 0.85. determine risk (of market Portfolio) and security risk.
(7 Marks)
Ans
4 (b) An investor holds two stocks X and Y. an analyst prepared ex-ante probability distribution for
the possible economic scenarios and the conditional returns for the two stocks and the market
index as shown below:
Economic Scenario Probability Conditional Returns %
X Y Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

The risk free rate during the next year is expected to be around 9%. determine whether the
investor should liquidate his holdings in stocks X and Y or on the contrary make fresh
investments in them. CAPM assumptions are holding true. (7 Marks)
Ans
5 (a) Welsh Limited is faced with a decision to purchase or acquire on lease a mini car. The cost of the
mini car is Rs. 1,26,965. It has a life of 5 years. The mini car can be obtained on lease by paying
equal lease rentals annually. The leasing company desires a return of 10% on the gross value of
the asset. Welsh Limited can also obtain 100% finance from its regular banking channel. The
rate of interest will be 15% p.a. and the loan will be paid in five annual equal instalments,
inclusive of interest. The effective tax rate of the company is 40%. For the purpose of taxation it
 is to be assumed that the asset will be written off over a period of 5 years on a straight line basis.
(a) Advise Welsh Limited about the method of acquiring the car. (8 Marks)
(b) What should the annual lease rental to be charged by the leasing company to match the loan
option? (3 Marks)
For your exercise use the following discount factors:
Discount rate Years
1 2 3 4 5
10 % 0.91 0.83 0.75 0.68 0.62
15 % 0.87 0.76 0.66 0.57 0.49
9% 0.92 0.84 0.77 0.71 0.65

Ans
(a) Alternative: 1 Lease option
Amount of annual lease rent = 1,26,965
3.79
= 33,500
Statement showing present value of net cash flow:
Annual lease rent 33,500
Less: Tax benefit @ 40 % 13,400
Lease rent (after tax) 20,100
Cumulative present value factor (at 9 %) 3.89
Present value of lease cash flow 78,189
Alternative: 2 Buying option
Annual installment (At 15 % for 5 years) = 1,26,965
3.35
= 37,900
Statement showing calculation of interest:
Opening Principal Closing
Year Installment Interest
balance repayment balance
1 1,26,965 37,900 19,045 18,855 1,08,110
2 1,08,110 37,900 16,217 21,683 86,427
3 86,427 37,900 12,964 24,936 61,491
4 61,491 37,900 9,224 28,676 32,815
5 32,815 37,900 5,085 32,815 -

Statement showing tax saving on interest cost:

Year Interest cost Tax benefit
1 19,045 7,618
2 16,217 6,487
3 12,964 5,186
4 9,224 3,689
5 5,085 2,034
Calculation of tax benefit of depreciation = 1,26,965
5
= 25,393
Tax benefit @ 40 % = 10,157
Statement showing present value of net cash flow:
Tax benefit Present
Tax benefit of Net cash Present
Year Installment of value
interest flow value
depreciation factor
1 37,900 7,618 10,157 20,125 0.92 18,515
2 37,900 6,487 10,157 21,256 0.84 17,855
 3 37,900 5,186 10,157 22,557 0.77 17,369
4 37,900 3,689 10,157 24,054 0.71 17,078
5 37,900 2,034 10,157 25,709 0.65 16,711
87,528

Decision: Lease option should be preferred.

(b) Let lease rent per annum =x
Therefore after tax lease rent = 0.60 x
Present value of after tax lease rent = 0.60 x * 3.79 = 2.274 x
So, 2.274 x = 87,528
87528
x= = 38491
2.274

5 (b) Ram invested in a Mutual Fund when the Net Asset Value was Rs.12.65. 60 Days later the Asset
Value per unit of the fund was Rs.12.25. In the meantime, Ram had received a cash dividend of
Re.0.50 and a Capital Gain distribution of Re.0.30. Compute the monthly return. (3 Marks)
Ans

6 (a) Saptarshi Ltd. has just installed Machine- M at a cost of Rs. 2,10,000. The machine has a five
year life with no residual value. The annual volume of production is estimated at 150000 units,
which can be sole at Rs. 6 per unit in the first two years and at Rs. 7,8 and 9 in the third, fourth
and fifth years. The first year’s operating costs are estimated at Rs. 2,00,000 (excluding
depreciation) at this output level. Fixed costs are estimated at Rs. 3 per unit for the same level of
production. The second year’s cost will be the same as in the first year. Thereafter, costs
(operating and fixed) will increase over the first year’s cost by 10%, 20% and 25% respectively
in the third, fourth and fifth years.
Saptarshi Ltd. has just come across another model called Machine-N capable of fiving the same
output at the same fixed and operating costs as in the first year of Machine- M.
There will be no change over the first year’s costs in the next four years also. Capital cost of this
machine is Rs. 2,50,000 and the estimated life is five years with nil residual value.
The company has an offer for sale of Machine- M at Rs.1,10,000. But the cost of dismantling
 and removal will amount to Rs.40,000. As the company has not yet commenced operations, it
wants to sell Machine- M and purchase Machine- N.
Saptarshi Ltd. will be a zero-tax company for seven years in view of several incentives and
allowances available.
The cost of capital is 15%.
(i) Advise whether the company should opt for the replacement. Present calculations
of discounted annual cash flows to the nearest rupee without netting off.
(ii) Will there be any change in your view, if machine-M has not been installed, but the company
is in the process of selecting one or the other machine ?
Support your view with necessary workings. Cash flows of revenue and cost may be taken at
year ends. (8 Marks)
Ans

Replacement :
Rs.
Cash outflow on Machine – N 1,10,000
2,50,000
Less : Sale value of Machine- M
Less : Cost of Dismantling and Removal = 40,000 70,000

Net outflow = 1,80,000

P.V. of incremental cash inflows = (From (ii) workings below)
13,32,200 (N) – 11,34,308 (M) = 197892

NPV of Machine – N = 1,97,892 – 1,80,000 = 17,892

Rs. 210000 spent on Machine – M is a sunk cost and hence not relevant for deciding the
replacement.
Decision : Since NPV of Machine – N is positive, replacement is advised.
(ii) Independent evaluation :
Machine- M
Total Cost
Sale Value Net C/I PV Total Inflow
(Op + Fixed)
Y1 6,50,000 9,00,000 2,50,000 0.870 2,17,500
Y2 6,50,000 9,00,000 2,50,000 0.756 1,89,000
Y3 7,15,000 10,50,000 3,35,000 0.658 2,20,430
Y4 7,80,000 12,00,000 4,20,000 0.572 2,40,240
Y5 8,12,500 13,50,000 5,37,500 0.497 2,67,138
Less : Cash NPV --------------
outflow 11,34,308
2,10,000
--------------
9,24,308
 -------------

Machine- N
Y1 6,50,000 9,00,000 2,50,000 0.870 2,17,500
Y2 6,50,000 9,00,000 2,50,000 0.756 1,89,000
Y3 6,50,000 10,50,000 4,00,000 0.658 2,63,200
Y4 6,50,000 12,00,000 5,50,000 0.572 3,14,600
Y5 6,50,000 13,50,000 7,00,000 0.497 3,47,900
--------------
13,32,200
Less : Cash 2,50,000
NPV
outflow --------------
10,82,200
-------------

As the NPV of Machine – N is higher than that of Machine – M, the choice should fall on
Machine – N.
Note : As the company is a zero tax company depreciation and the tax effect on the
same are not relevant for consideration.

6 (b) The equity shares of MNB Ltd. are being sold at ₹ 315. A 3-month call option is available
for a premium of ₹ 9 per share and a 3 month put option is available for a premium of ₹
8 per share. Find out the net pay off of the holder of the call option and put option given
that:
(i) The strike price in both cases is ₹ 330 and
(ii) The share price on the exercise day is ₹ 300 or ₹ 315 or ₹ 345 or ₹ 360. (6 Marks)
Ans
Call option holder
Exercise Price 330 330 330 330
Spot Price 300 315 345 360
Option Lapse Lapse Exercise Exercise
Gain - - 15 30
Premium -9 -9 -9 -9
Net Pay off (9) (9) +6 +21

Put option holder

Option Exercise Exercise Lapse Lapse

Gain 30 15 - -
Premium -8 -8 -8 -8
Net Pay off +22 +7 (8) (8)
7 (a) JASPAL Ltd. is currently considering two mutually exclusive projects, A and B. The
following are some of the information concerning the two projects:
Project A Project B
Initial investment ₹ 15,000 ₹ 20,000
Project life 3 years 3 years
Annual cash inflow ₹ 7,000 ₹ 10,000
Risk index 0.4 1.8

In addition, the firm uses two different techniques to adjust for the different risk levels of
projects: certainty equivalent factors and risk adjusted discount rate. Additional information is
provided below:
Certainty equivalent factors
Year Project A Project B
0 100 100
1 0.95 0.90
2 0.90 0.85
3 0.90 0.70

Risk index RADR (%) Risk index RADR (%)

0.0 7.0 1.0 12.0
0.2 8.0 1.2 13.0
0.4 9.0 1.4 14.0
0.6 10.0 1.6 15.0
0.8 11.0 1.8 16.0

The company’s cost of capital is 10%.

(i) Calculate the NPV of Project A and Project B at 10% discount rate.
(ii) Determine the NPV of Project A and Project B using certainty equivalent (CE) to
account for Risk.
(iii) Determine the NPV of Project A and Project B using Risk Adjusted Discount Rate
(RADR) to account for Risk.
(iv) Compare and explain your findings in (i), (ii) and (iii) (9 Marks)
Ans
Ans (i) NPV at 10% Discount rate
Cash flows
End of year PV factor PV Proj A Cash flows B PV Proj B
A
0 1 -15,000 -15,000 -20,000 -20,000
1-3 2.487 +7,000 +17,409 +10,000 +24,870
NPV +2,409 +4,870
 B is preferred
(ii) Rf = 7%
Cash flow A Cash flow B
End of PV factor (Certainty Eq) (Certainty Eq)
PV Proj A PV Proj B
year 7% C/I x CE C/I x CE
Factor Factor
0 1 -15,000 -15,000 -20,000 -20,000
1 0.935 +6,650 +6,218 +9,000 +8,415
2 0.873 +6,300 +5,500 +8,500 +7,421
3 0.816 +6,300 +5,141 +7,000 +5,712
NPV +1,858 +1,548

A is preferred

(iii) RADR. Discount factor for A is 9% and for B 16%

End of PV factor Cash PV factor Cash flows
PV Proj A PV Proj B
year 9% flows A 16% B
0 1 -15,000 -15,000 1 -20,000 -20,000
1-3 2.531 7,000 +17,717 2.246 10,000 +22,460
NPV +2,717 +2,460

A is better.
(iv) When we ignore risk we see that both projects give NPV of greater than zero. Since they
are mutually exclusive, we need to select the project which gives higher NPV. Therefore, we select
Project B. When we apply the certainty equivalent approach, we see that Project A is better with a
higher NPV. Similarly even under RADR method, Project A gives higher NPV. The choice is therefore
obvious that we should select Project A as it gives a higher NPV even after adjusting for risk under both
the methods.

7 (b) Given the following -

$/£ 1.3670/1.3708
S.Fr/DEM 1.0030/1.0078
$/S.Fr 0.8790 / 0.8803
And if DEM / £ in the market are 1.5560 /1.5576
Find out if any arbitrage opportunity exists. (5 Marks)
If so, show how $10,000 available with you can be used to generate risk - less profit.
Ans
8. Answer the following questions:
(a) What are the tools and techniques used by RBI to maintain financial stability? (5 Marks)
(b) Advantages of Digital Financial Services. (3 Marks)
(c) Participatory Notes. (3 Marks)
(d) Sale and Lease back. (3 Marks)
Ans
8. (a) Tools and Techniques
The Reserve Bank makes use of a variety of tools and techniques to assess the
build
up of systemic risks in the economy and to provide critical inputs in this respect to its
policy making departments. The tools include:
 A Financial Stress Indicator - a contemporaneous indicator of conditions in
financial markets and in the banking sector;
 Systemic Liquidity Indicator for assessing stresses in availability of systemic liquidity;
 A Fiscal Stress Indicator for assessing build up of risks from the fiscal;
 A Network Model of the bilateral exposures in the financial system - for assessing
the inter-connectedness in the system;
 A Banking Stability Indicator for assessing risk factors having a bearing on the
stability of the banking sector; and
 A series of Banking Stability Measures for assessing the systemic importance of
individual banks.
(b)

(c)

(d)