DECEMBER 2010 EXAMINATION

FM12
FINANCIAL MANAGEMENT

Time: Three Hours Maximum Marks: 100

NOTE: The paper is divided into two sections: Section A and Section B. There are seven
questions in Section A. Students are required to attempt four questions from Section A.
Question No. 8 (Section B) is compulsory. Each question carries 20 Marks.

Section-A

1. (i) (a) What is Operating Cycle and Cash Conversion Cycle of a service firm.
(b) Also explain the methodology of calculating it and its uses with the help of an
example. (7+7)
(ii) Maheshwari & Maheshwari Limited, a large EOU has a working capital cycle below the
industry average. What strategy should it follow for its working capital and sources of
funding they can depend on? (6)

2. (i) What impact will each of the following events have on a firms’ WACC, giving brief
reason:
(a) if firm increases its leverages
(b) if corporate tax rate is lowered
(c) if stamp duty are imposed
(d) if firm sells a risky strategic business unit
(e) if CRR, SLR are increased by 25 basis points by RBI (2+2+2+2+2)
(ii) What is agency problem and how they can affect the wealth of the firm. (10)

3. (i) Is the fact that the EVA is negative, necessarily an indication of poor project choices?
Why or why not? (10)
(ii) Synfosys Ltd. is equity based company with a Current Market Price at Rs. 165. The
dividend has been paid at 15% an year. The dividend is expected to grow at 10%. A new
investment proposal requires an initial outlay of Rs. 20 Lacs, which has estimated inflows
of Rs. 10 Lacs over a period of 3 years.

What is the Cost of Equity if the project is (a) entirely financed through retained earnings,
(b) entirely financed through a fresh issue in the market, where the floatation cost comes
to 5%. (10)
4. Does the dividend policy of company changes its market value? Give reasons for your
answer taking a real life company and applying dividend models. (20)

5. (i) Vrijesh Kumar, CFO of Venco Ltd., is trying to figure out the cost of debt and cost of
equity.

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 (a) Venco’s balance sheet has a total debt of Rs. 200 crore and Venco’s total interest
burden for the forthcoming year will be Rs. 24 crore. Vrijesh argues, “We owe Rs.
200 crore and we will pay Rs. 24 cr. interest. So the cost of our debt is 12 percent.”
What is the flaw in this argument?
(b) Venco’s equity currently sells for Rs. 100 per share and the dividend per share will
probably be Rs. 6. Vrijesh reasons, “Since we plan to pay a dividend of Rs. 6 per
share which has a market price of Rs. 100, our cost of equity is 6 percent.” What is
the error in this reasoning? (10)
(ii) Comment on following:
(a) Diversification will have no value if the returns of all risky assets are perfectly co-
correlated
(b) Shareholders wealth remains unaffected by scrip dividends. (5+5)

6. (i) You are 20 year old today and you are planning for savings to settle at the time of your
retirement. You expect to retire at 50 years and will live for 25 years after retirement.
You have to buy a house at the time of retirement costing Rs. 50 lacs(cost at the time of
retirement). You also expect annual living expenses of Rs. 6 lacs / year for your expected
life after retirement. How much you need to have saved by your retirement date. Assume
rate of interest at 8%. Also calculate how much you need to save each year till retirement
to reach at the amount you have to save as per your retirement plan. (10)

(ii) Write a note on JIT and FSN system of inventory control. (5+5)

7. Write short on the following :

(i) Reasons for reverse split
(ii) Weighted Marginal Cost of Capital
(iii) SEBI guidelines on ESOPs
(iv) Callable bonds (5+5+5+5)

Section - B
8. CASE STUDY
Orange Manufacturing Company has an opportunity to replace an existing piece of
equipment with a new machine that performs, a particular manufacturing operation more
efficiently. The purchase price of the new machine is Rs. 16500. Shipping charges will be
Rs. 1200 and installation is Rs. 600. Because of a high rate of technical obsolescence, the
machine is expected to have a life of only three years; no salvage value is expected at the end
of the three-year period. Operating savings are expected to be Rs. 9600 in the first year and
Rs. 8400 in each of the next two years. The existing machine has a remaining book value of
Rs. 2100 and is being depreciated at the rate of Rs. 700 a year. Its remaining useful life is
three years, after which it will have no salvage value. Orange can get Rs. 4000 for the
existing machine if it sells it now. The applicable tax rate is 40 percent, and Orange uses
straight-line depreciation for tax purposes. If the firm has a required return of 15 percent,
should the existing piece of equipment be replaced? (20)

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