Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Paper-12: FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Time Allowed: 3 Hours Full Marks: 100

Answer Question No. 1 from Part A which is compulsory and any five questions from Part B.
Working notes should form a part of the answer
“Wherever necessary, suitable assumptions should be made and indicated in answers by the
candidates”

PART A (25 Marks)

1. (a) (i) High proportion of gearing will increase: [10 x 2 = 20]

(a) Financial risk
(b) Business risk
(c) Cost of funds
(d) Shareholders equity
(ii) The financial data furnished for A Ltd. for the year ended 31st March, 2013, as
follows:
Operating leverage = 3 : 1; Financial leverage = 2 : 1; Interest charges p.a. is ` 12
lakhs, Corporate tax rate is 40%. The variable cost as % of sales is 60%. The EBIT of
the company is:
(a) ` 24 lakhs
(b) ` 22. Lakhs
(c) ` 32 lakhs
(d) ` 18 lakhs
(iii) Modern Ltd.‟s share beta factor is 1.40. The risk free rate of interest of government
securities is 9%. The expected rate of return on the company equity shares is 16%.
The cost of equity capital based on CAPM is:
(a) 9%
(b) 16%
(c) 18.8%
(d) 15.8%
(iv) If EBIT is less than financial break-even point then:
(a) EPS will be positive
(b) EPS will be negative
(c) there will be no impact on EPS
(d) Cost of debt raises
(v) BKC Ltd. has profits before interest and taxes of ` 3,00,000. The applicable tax rate is
40%. Its required rate of return on equity in the absence of borrowing is 18%. In the
absence of personal taxes, the value of the company in an MM world with no
leverage is:
(a) ` 10,00,000
(b) ` 11,60,000
(c) ` 12,60,000
(d) ` 14,00,000
(vi) The dividend decisions are concerned with:
(a) determination of quantum of profits to be distributed to the owners
(b) the frequency of such payments
(c) the amounts to be retained by the firm
(d) all of the above
(vii) A financial lease is preferred in the situation:
(a) when the long-term stability of asset is uncertain

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

(b) When the lessee want to own the asset but does not have enough funds to
invest
(c) when the asset is subject to rapid obsolescence
(d) none of the above
(viii) About 50 items are required every day for a machine. A fixed cost of ` 50 per order
is incurred for placing an order. The inventory carrying cost per item amounts to `
0.02 per day. The lead period is 32 days. Compute reorder level.
(a) 1,200 items
(b) 1,400 items
(c) 1,600 items
(d) 1,800 items
(ix) The stock of Pioneer company sells for ` 120. The present value of exercise price
and the value of a call option are ` 108.70 and ` 19.80 respectively. Hence the
value of the put option is:
(a) ` 8.50
(b) ` 9.00
(c) ` 11.00
(d) ` 8.25
(x) Currency swap is a method of:
(a) speculating the foreign exchange
(b) hedging against foreign exchange risk
(c) making money by banks
(d) exchanging one currency for another

(b) State if each of the following sentences is T (=true) or F (= false): [5 x 1=5]

(i) Corporate tax rate does not affect cost of debt.
(ii) IRR and NPV always give the same profitability ranking.
(iii) If Profitability Index is 1, cash inflow and cash outflow would be equal.
(iv) An investor expecting a fall in interest rates buys a floor and also a cap.
(v) Commercial paper introduced by RBI in early 1990, is „a secured promissory note‟
tied to any specific transaction.

Answer:

1. (a) (i) (a) Financial risk

(ii) (a) ` 24 lakhs
Financial leverage = 2 (given)
EBIT
=2
EBIT - Interest
EBIT
=2
EBIT - 12
2 EBIT – 24 = EBIT
EBIT = ` 24 lakhs
(iii) (c) 18.8%
Ke = 9% + 1.40 (16% - 9%) = 18.8%
(iv) (b) EPS will be negative
(v) (a) ` 10,00,000
`3,00,000 x 0.6
Company Value = = ` 10,00,000
0.18
(vi) (d) all of the above

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

(vii) (b) When the lessee want to own the asset but does not have enough funds to
invest
(viii) (c) 1,600 items
Reorder level
= Maximum usage per day x Maximum lead time
= 50 items per day x 32 days = 1,600 items
(ix) (a) ` 8.50
Value of put option
= Value of call option + P.V. of exercise price – Stock price
= ` 19.80 + ` 108.70 – 120
= ` 8.50
(x) (b) hedging against foreign exchange risk

(b) (i) False:

Debt may be perpetual or redeemable debt, while calculating cost of debt, the
corporate tax rate effect the formula as follows-
(a) Perpetual /irredeemable debt:
Kd (after tax) = 1/P(1-t)
Where, t= tax rate,
P = net proceeds and kd = Cost of debt, I= Interest
(b) Redeemable debt : (after tax)
I 1 / n( P NP )
Kd = x(1 t )
1 / 2( P NP )
(ii) False:
When evaluating mutually exclusive projects, the one with the highest IRR may not
be the one with best NPV. The conflict between NPV and IRR for evaluation of
mutually exclusive projects is due to reinvestment assumption:
(a) NPV assumes Cash flows reinvested at the Cost of Capital.
(b) IRR assumes Cash flows reinvested at the internal rate of return.
(iii) True:
We know that Profitability Index (PI) = PV of Cash Inflow/ PV of Cash Outflow. So, if
P1 is 1, then cash inflow and cash outflow would be equal.
(iv) True:
A Cap provides variable rate borrowers with protection against raising interest rates
while also retaining the advantages of lower or falling interest rate. Floors are used
to obtain certainty for investments and budgeting by setting minimum interest rate
on investments
(v) False:
Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise
funds for a short period, generally varying from a few days to a few months

PART B (75 MARKS)

2. A company proposes to introduce a new product. The market study information suggests
that the company can set a price of `36 or ` 38 or `40 per unit. The company intends to hire
a machinery to manufacture the product at ` 400000 per annum but if the annual production
exceeds 60,000 units additional cost of `1,60,000 per annum will be incurred on the hire of
machinery. The variable cost is `10 or `12 per unit produced. The following estimate of sales
at each possible selling price has been prepared:

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Selling Price `36 `38 `40

Units Probability Units Probability Units Probability
Pessimistic 70,000 0.3 60,000 0.1 30,000 0.4
Most Likely 80,000 0.5 70,000 0.7 60,000 0.5
Optimistic 90,000 0.2 90,000 0.2 70,000 0.1
The probability of unit costs is 0.6 for variable cost of ` 10 per unit and 0.4 for variable costs of
`12 per unit. The company has committed an advertisement expenditure of `80,000 per
annum.
You are required to analyze and advise which selling price will be appropriate from the point
of view of maximization of profits. [15]

Answer:

2. Since the combined effect of three variables (selling price, variable cost and hire charges of
machinery) have to be taken into account, separate calculations are needed for each
possible combination with respect to a particular selling price.
Units Contribution Total HMA Net Probability Expected
Contribution (` 000) Contribution Value
(` 000) (` 000) (` 000)
Selling Price `36
26 1,820 640 1,180 0.3 × 0.6 212.4
Units (400+160+80) (1,820-640) = 0.18 (1180×0.18)
70,000 24 1,680 640 1,040 0.3 × 0.4 124.8
= 0.12
26 2,080 640 1,440 0.5 × 0.6 432
Units = 0.30
80,000 24 1,920 640 1,280 0.5 × 0.4 256
= 0.20
26 2,340 640 1,700 0.2 × 0.6 204
Units = 0.12
90,000 24 2,160 640 1,520 0.2 × 0.4 121.6
= 0.08
1,350.80

Units Contribution Total HMA Net Probability Expected

Contribution (` 000) Contribution Value
(` 000) (` 000) (` 000)
Selling Price `38
28 1,680 480 1,200 0.1 × 0.6 72
Units (400+80) (1,680-480) = 0.06
60,000 26 1,560 480 1,080 0.1 × 0.4 43.2
= 0.04
28 1,960 640 1,320 0.7 × 0.6 554.4
Units (400+160+80) = 0.42
70,000 26 1,820 640 1,180 0.7 × 0.4 330.4
= 0.28
28 2,520 640 1,880 0.2 × 0.6 225.6
Units = 0.12
90,000 26 2,340 640 1,700 0.2 × 0.4 136
= 0.08
1,361.60

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Units Contribution Total HMA Net Probability Expected

Contribution (` 000) Contribution Value
(` 000) (` 000) (` 000)
Selling Price `40
30 900 480 420 0.4 × 0.6 100.8
Units (400+80) (900-480) = 0.24
30,000 28 840 480 360 0.4 × 0.4 57.6
= 0.16
30 1,800 480 1,320 0.5 × 0.6 396
Units = 0.30
60,000 28 1,680 480 1,200 0.5 × 0.4 240
= 0.20
30 2,100 640 1,460 0.1 × 0.6 87.6
Units (400+160+80) = 0.06
70,000 28 1,960 640 1,320 0.1 × 0.4 52.8
= 0.04
934.80
Note: Contribution per unit with variable cost per unit of `10 or `12

Analysis – Selling price of `40 should not be set. Out of `36 and `38, selling price `38 is
suggested to fix, since the expected value of contribution is greater than other alternative
price of `36 and `40.

3. (a) The earnings per share of a company is ` 10 and the rate of capitalisation applicable to it
is 10 per cent. The company has three options of paying dividend i.e. (i) 50%, (ii) 75% and
(iii) 100%. Calculate the market price of the share as per Walter's model if it can earn a
return of (a) 15, (b) 10 and (c) 5 per cent on its retained earnings. [3+3+3]
(b) Enumerate the main features of Venture Capital. [6]

Answer:

r
D (E D)
3. (a) P ke
ke
Where
P = Price of Share
R = rate of Earning
Ke = rate of Capitalisation or Cost of Equity

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

(i) (ii) (iii)

DP ratio 50% DP ratio 75% DP ratio 100%
(a) Price of Share if r =15% .15 .15 .15
5 (10 5) 7.5 (10 7.5) 10 (10 10)
.10 .10 .10
.10 .10 .10

12.5 11.25 10
.10 .10 .10
`125 `112.5 `100
.10 .10
5 (10 5) 7.5 (10 7.5)
.10 .10 .10
10 (10 10)
(b) Price of Share if r = 10% .10 .10 .10
.10
10 10 10
= `100 = `100 = `100
.10 .1 .1
.05 .05 .05
5 (10 5) 7.5 (10 7.5) 10 (10 10)
(c) Price of Share if r = 5% .10 .10 .10
.10 .10 .10
7. 5 10
= `75 = `100
.10 8.75 .1
= `87.5
.10

(b) The main features of Venture Capital are enumerated below:

(i) High Degree of risk: Venture capital financing is, invariably, an investment in a highly
risky project with the objective of earning a high rate of return.
(ii) Equity Participation: Venture Capital financing is, invariably, an actual or potential
equity participation wherein the object of venture capital is to make capital gain by
selling the share once the project become profitable.
(iii) Long term investment: Venture capital financing is a long term investment. It
generally takes a long period to encash the investment in securities made by the
venture capitalists.
(iv) Participation in Management: In addition to provide capital, venture capital funds
take an active interest in the management of the form that of a traditional lender or
banker. It is also different from that of accompany stock market investor who merely
trades in the shares of a company without participating in their management. It has
been rightly said, “Venture capital combines the qualities of banker, stock market
investor and entrepreneur in one”.
(v) Achieve Social Objectives: It is different from the development capital provided by
several central and state level government bodies in that the profit objective is the
motive behind the financing. But venture capital profits generate employment, and
balanced regional growth indirectly due to setting up successful new business.
(vi) Investment is Illiquid: A venture capital is not subject to repayment on demand as
with an overdraft or following a loan repayment schedule. The investment is realized
only when the company is sold or achieves a stock market listing. It is lost when the
company goes into liquidation.

4. (a) The data relating to two companies are as given below:

Company A Company B
Equity Capital `6,00,000 `3,50,000

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

12% Debentures `4,00,000 `6,50,000

Output (units) per annum 60,000 15,000
Selling price/unit `30 `250
Fixed Costs per annum `7,00,000 `14,00,000
Variable Cost per unit `10 `75
You are required to calculate the Operating leverage, financial leverage and combined
leverage of two companies. [3+3]

(b) Sun Ltd. discounts its cash flows at 16% and is in the tax bracket of 35%. For the
acquisition of a machinery worth `10,00,000, it has two options - either to acquire the
asset by taking a bank loan @ 15% p.a. repayable in 5 yearly installments of `2,00.000
each plus interest or to lease the asset at yearly rentals of `3,34,000 for five (5) years. In
both the cases, the installment is payable at the end of the year. Depreciation is to be
applied at the rate of 15% using 'written down value' (WDV) method. You are required to
advise which of the financing options is to be exercised and why.
Year 1 2 3 4 5
P.V factor @16% 0.862 0.743 0.641 0.552 0.476
[9]
Answer:

4. (a) Computation of degree of Operating leverage, financial leverage and combined

leverage of two companies
Company A Company B
Output units per annum 60,000 15,000
` `
Selling price/unit 30 250
Sales revenue (S) 18,00,000 37,50,000
(60,000 units × `30) (15,000 units × `250)
Less: Variable Costs(VC) 6,00,000 11,25,000
(60,000 units× `10) (15,000 units × `75)
Contribution(C=S-VC) 12,00,000 26,25,000
Less: Fixed Costs(FC) 7,00,000 14,00,000
EBIT(C-FC) 5,00,000 12,25,000
Less: Interest 2 12% on debentures 48,000 78,000
PBT 4,52,000 11,47,000

Company A Company B
C 2.4 2.14
DOL (`12,00,000 /`5,00,000) (`26,25,000/`12,25,000)
EBIT
EBIT 1.11 1.07
DFL (`5,00,000/`4,52,000) (`12,25,000/`11,47,000)
PBT
DCL= DOL × DFL 2.66 2.29
(2.4 × 1.11) (2.14 1.07)

(b) Alternative I: Acquiring the asset by taking bank loan:

Years 1 2 3 4 5
(a) Interest (@15% p.a., on 1,50,000 1,20,000 90,000 60,000 30,000
opening balance)
Depreciation (@15%WDV) 1,50,000 1,27,500 1,08,375 92,119 78,301

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3,00,000 2,47,500 1,98,375 1,52,119 1,08,301

(b) Tax shield (@35%) 1,05,000 86,625 69,431 53,242 37,905

Interest less Tax shield (a)-(b) 45,000 33,375 20,569 6,758 (-)7,905
Principal Repayment 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Total cash outflow 2,45,000 2,33,375 2,20,569 2,06,758 1,92,095
Discounting Factor @ 16% 0.862 0.743 0.641 0.552 0.476
Present Value 2,11,190 1,73,398 1,41,385 1,14,130 91,437
Total P.V of cash outflow = `731,540

Alternative II: Acquire the asset on lease basis

Year Lease Rentals Tax Shield Net Cash Discount Present
(`) @35% Outflow Factor Value
1 3,34,000 1,16,900 2,17,100 0.862 1,87,140
2 3,34,000 1,16,900 2,17,100 0.743 1,61,305
3 3,34,000 1,16,900 2,17,100 0.641 1,39,161
4 3,34,000 1,16,900 2,17,100 0.552 1,19,839
5 3,34,000 1,16,900 2,17,100 0.476 1,03,340
Present value of Total Cash out flow 7,10,785

Advice -By making Analysis of both the alternatives, it is observed that the present value
of the cash outflow is lower in alternative II by `20,755(i.e. `731,540 - `7,10,785) Hence, it is
suggested to acquire the asset on lease basis.

5. JKL Ltd. has the following book-value capital structure as on March 31, 2013.

`
Equity share capital (2,00,000 shares) 40,00,000
11.5% preference shares 10,00,000
10% debentures 30,00,000
80,00,000

The equity share of the company sells for `20. It is expected that the company will pay next
year a dividend of ` 2 per equity share, which is expected to grow at 5% p.a. forever.
Assume a 35% corporate tax rate.

Required:
(i) Compute weighted average cost of capital (WACC) of the company based on the
existing capital structure.
(ii) Compute the new WACC, if the company raises an additional `20 lakhs debt by issuing
12% debentures. This would result in increasing the expected equity dividend to `2.40
and leave the growth rate unchanged, but the price of equity share will fall to `16 per
share.
(iii) Comment on the use of weights in the computation of weighted average cost of capital.
[15]
Answer:

5.
(i)

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Weighted Average Cost of Capital of the Company

(Based on Existing Capital Structure)
After Weights Weighted
tax cost (Refer to working note 4) cost
(a) (b) (a) X (b)
Equity share capital cost 0.15 0.50 0.075
(Refer to working note 1)
Cost of preference share capital @11.5% 0.115 0.125 0.014375
(Refer to working note 2)
Cost of debentures 0.065 0.375 0.02437
(Refer to working note 3)
Weighted average cost of capital 11.375%

Working Notes:
1. Cost of equity capital:
Dividend
Ke = g
Current market price of share
`2
= 5% = 15% or 0.15
` 20
2. Cost of preference share capital:
Annual preferenceshare dividend
=
Net proceeds in the issue of preferenceshare
`1,15,000
= = 0.115
`10,00,000
3. Cost of Debentures:
1
= (Interest Tax)
Net proceeds
1
= (`3,00,000 – `1,05,000)
` 30,00,000
= 0.065
4. Weights of equity share capital, preference share capital and debentures in total
investment of `80,00,000:
Total equity share capital
Weight of equity share capital =
Total investments
` 40,00,000
= = 0.50
` 80,00,000
Total preference share amount
Weight of preference share capital =
total investments
`10,00,000
= = 0.125
` 80,00,000
Total debentures
Weight of debentures =
Total investments
` 30,00,000
= = 0.375
` 80,00,000
(ii) New Weighted Average Cost of Capital of the Company
(Based on new capital structure)

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

After tax Weights Weighted

cost (Refer to working note 4) cost
(a) (b) (a) x (b)
Cost of equity share capital 0.20 0.40 0.080
(Refer to working note 2)
Cost of preference share 0.115 0.10 0.0115
Cost of debentures @10% 0.065 0.30 0.0195
Cost of debentures @12% 0.078 0.20 0.0156
Weighted average cost of capital 12.66%

Working Notes:
1. Weights of equity share capital, preference share and debentures in total investment
of `100,00,000
` 40,00,000
Weight of equity share capital = = 0.4
`1,00,00,000
`10,00,000
Weight of preference share capital = = 0.1
`1,00,00,000
` 30,00,000
Weight of debentures @ 10% = = 0.30
`1,00,00,000
` 20,00,000
Weight of debentures @12% = = 0.20
`1,00,00,000
2. Cost of equity capital:
Dividend ` 2.40
Ke = g= + 5% = 20%
Current market price of share `16

(iii) Comment: In the computation of weighted average cost of capital weights are
preferred to book value. For example, weights representing the capital structure under a
corporate financing situation, its cash flows are preferred to earnings and market.
Balance sheet is preferred to book value balance sheet.

6. (a) How is Economic Value Added (EVA) different from Market Value Added (MVA) ? [5]
(b) The management of MNP Company Ltd. is planning to expand its business and consults
you to prepare an estimated working capital statement. The records of the company
reveal the following annual information:
`
Sales – Domestic at one month‟s credit 24,00,000
Export at three month‟s credit (sales price 10% below domestic price) 10,80,000
Materials used (suppliers extend two months credit) 9,00,000
Lag in payment of wages - ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four installments of which one falls in the new 2,25,000
financial year

Rate of gross profit is 20%.

Ignore work-in-progress and depreciation.
The company keeps one month‟s stock of raw materials and finished goods (each) and
believes in keeping ` 2,50,000 available to it including the overdraft limit of ` 75,000 not
yet utilized by the company.

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

The management is also of the opinion to make 12% margin for contingencies on
computed figure.
You are required to prepare the estimated working capital statement for the next year.
[10]
Answer:

6. (a) MVA is the excess of market value of the firm as reflected in share price and the value of
the debt, over the book value of the capital employed. This book value of the capital
employed includes the value of reserves and surplus. The MVA is considered a better
measure of corporate performance than the market capitalization.
Mathematically, MVA = Market value of the firm – Capital Employed
EVA can be defined from two perspectives – (a) Accounting and (b) Finance
From the accounting perspective, EVA is defined as the difference between the firm’s
net operating profits after tax (NOPAT) and its weighted average rupee cost of capital
Since EVA fully accounts for the firm’s overall capital costs, it differs from the traditional
metrics of financial performance such as EBIT, EBITDA, EAT etc.
Mathematically, EVA = NOPAT – Capital Cost
= NOPAT – (WACC X Capital Employed)
= (r x Capital Employed – c x Capital Employed)

Thus, EVA = (r-c) x Capital Employed

(b)
Preparation of Statement of Working Capital Requirement for MNP Company Ltd.
Estimated Working Capital Statement

(A) Current Assets in terms of Cash Costs `

1
Debtors: Domestic Sales x 19,20,000 1,60,000
12
3 2,40,000
Export Sales x 9,60,000
12
Prepaid Sales promotion expenses 37,500
1 75,000
Stock of Raw materials x 9,00,000
12
2,40,000
1
Stock of finished goods x 28,80,000
12
Cash at Bank and in Hand 1,75,000
Total Current Assets 9,27,500
(B) Current Liabilities in terms of Cash Costs `

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Creditors for:
2
Material x 9,00,000 1,50,000
12
1 30,000
Wages x 7,20,000
24
1 90,000
Manufacturing expenses x 10,80,000
12
20,000
1
Administrative expenses x 2,40,000
12
Income Tax Payable 56,250
Total Current Liabilities 3,46,250
(C) `
Net Current Assets (A-B) 5,81,250
Add: 12% margin for contingencies 69,750
Required Working Capital 6,51,000

Working Notes:
Cash cost of sales is calculated as under: ` `
Domestic Sales 24,00,000
Less: Gross profit @ 20% 4,80,000 19,20,000
Expert Sales 10,80,000
10,80,000
` = 12,00,000 @ 10% 1,20,000 9,60,000
90
28,80,000

7. (a) The spot rate is $ 1.65 / £. The expected inflation rates in UK and USA for the next three
years are given below:
Year UK Inflation (%) US Inflation (%)
1 3.0 2.0
2 3.5 2.5
3 3.0 2.0
Calculate the expected $/£ spot after three years. [4]

(b) On November 17, Mr. X bought one future contract for CAD 1,00,000 each, at a rate of
USD/CAD 0.8657. A 5% initial margin was deposited and no maintenance margin is
available. The subsequent settlement prices are shown in the table below.
November 18 19 20 21 24 25 26 27
Futures Rate 0.84 0.83 0.84 0.86 0.87 0.88 0.89 0.90
(i) What are the daily cash flows from marking to market?
(ii) What is the total cash flow from marking to market? [1+4]

(c) A company in UK sends 2000 pieces to its subsidiary in US, each piece worth £ 5000.The
payment in £ would have to be made by the subsidiary at the end of 3 months. The
finance manager of the subsidiary wishes to have protection against the uncertainty. It is
given that:
Spot £ 1 = $ 1.8306; 90 days forward £ 1= $ 1.8350.
90 days $ interest = 5.25%, 90 days £ 1interest=4.75%

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 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

Call option on £ with a strike of 1.8347 is available with a premium of 1.5324%. The
expected spot rate at expiry would be 1.8405. What are the options available to the
financial manager, including remaining un-hedged. [6]

Answer:

7. (a) Today, £1 and $ 1.65 can both buy the same basket of goods if we apply Purchasing
Power Parity (PPP).
The same basket of goods will have the following price after three years.
In UK – (1) (1.030) (1.035) (1.030) = £ 1.098.
In USA – (1.65) (1.020) (1.025) (1.020) = $ 1.760.
If we apply PPP again, £ 1.098 = $ 1.760.
So, £1 = $ 1.603.
Hence, the expected spot rate after three years is $ 1.603 / £.

(b) Original Trade: Buy One CAD Futures at 0.8657[ each contract = 1,00,000]
November Futures Rate Mark to Market Loss/ Gain Gain/ Loss In value Balance
18 Deposit of initial
margin =100000×0.8657×5% 4328.50
18 0.84 -0.0257 -2570 1758.50
19 0.83 -0.01 -1000 758.50
20 0.84 +0.01 +1000 1758.50
21 0.86 +0.02 +2000 3758.50
24 0.87 +0.01 +1000 4758.50
25 0.88 +0.01 +1000 5758.50
26 0.89 +0.01 +1000 6758.50
27 0.90 +0.01 +1000 7758.50
Total cash flow from Marking to Market +3430

(c) Option I (Remain un-hedged)

If the expected spot rate after 90 days is 1.8405, the total outgo for the subsidiary
= 2000 × 5000 × 1.8405
= $ 18.405 million
Option II (Hedge using forwards)
The given forward rate £ 1= $ 1.8350
The outlay for the subsidiary
= 2000 × 5000 × 1.8350
= $ 18.350 million
Option III (Hedge using options)
Since the subsidiary has to make payment of pounds, it will buy a call option on pounds
at a strike of 1.8347. Premium = 1.5324% of 1.8347 = 0.02811/pound. If the expected spot
rate at expiry would be 1.8405, then the call option would be exercised and the profit
=1.8405-1.8347-0.0811= -0.02231. Obviously going for call option, results in a loss.

8. (a) Write short note on GATT. [5]

(b) State the two components of value of currency option. Show a relationship between
volatility of currency and option value. [5]
(c) How does “Risk Adjusted Discount Rate” differ from “Certainty Equivalent Approach” As
techniques of risk analysis in capital budgeting? [5]

Answer:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 13
 Answer to MTP_Final_Syllabus 2008_Jun2014_Set 2

8. (a) (i) GATT was a treaty, not an organization.

(ii) Main objective of GATT was the reduction of barriers to international trade through
the reduction of tariff barriers, quantitative restrictions and subsidies on trade through
a series of agreements.
(iii) It is the outcome of the failure of negotiating governments to create the International
Trade Organization (ITO).
(iv) The Bretton Woods Conference had introduced the idea for an organization to
regulate trade as part of a larger plan for economic recovery after World War II. As
governments negotiated the ITO, 15 negotiating states began parallel negotiations
for the GATT as a way to attain early tariff reductions. Once the ITO failed in 1950,
only the GATT agreement was left.
(v) The functions of the GATT were taken over by the World Trade Organization which
was established during the final round of negotiations in early 1990s.

(b) Relationship between volatility of currency and option value may be explained as
follows:
(i) The intrinsic value: The amount by which an option is in the money. A call option
whose exercise price is below the current spot price of the underlying instrument, or a
put option whose exercise price is above the current spot price of the underlying
instrument, is said to be in the money.
(ii) The extrinsic value: It is the total premium of an option less the intrinsic value. It is also
known as the time value or volatility value. As per the expiry time increases, the
premium of an option also increases. However, with each passing day, the rate of
increase in the premium decreases. Conversely, as an option approaches expiry, the
rate of decline in its intrinsic value increases. This decline is known as the time decay.
Therefore, the more volatile a currency, the higher will be its option value.

(c) Both the Risk Adjusted Discount Rate (RADR) and the Certainty Equivalents (CE)
Approaches attempt to incorporate project risk. However, the way of approach differs.
The RARD is concerned with the denominator- it increases the discount rate of the NPV
formula. The CE deflates the cash flows and deals with the numerator of the NPV
formula.
For RADR the discount rate is a constant one over the life of the project, for CE different
degrees of risk are taken care of the different years of the project life. The RARD tends to
club together the risk free rate, the risk involved and the risk premium, while the CE
approach maintains a distinction between the risk free rate and the risk. In CE the
discount rate is risk free as the risk is adjusted by reducing the numerator- the cash flow.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 14