Test Series: April, 2021

MOCK TEST PAPER 2

FINAL (OLD) COURSE: GROUP – I
PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT
SUGGESTED ANSWERS/HINTS
1. (a)
12 Months 24 Months
1. Total Annual Rs. 3,800 X 12 – Rs.40,000 (Rs. 2,140X24 – Rs. 40,000)/2 =
Charges for Loan = Rs. 5,600 Rs. 5,680
2. Flat Rate of `5,600 ` 5,680
Interest (F)  100 14%  100 14.20%
` 40,000 ` 40,000
3. Effective Interest n 12 n 24
Rate  2F =  28 = 25.85%  2F =  28.40 = 27.26%
n1 13 n1 25

Alternatively
12 Months 24 Months
(a) Principal to be repaid Rs.40,000 Rs. 40,000
(b) EMI Rs.3,800 Rs.2,140
(c) PVAF (a) ÷ (b) 10.5263 18.6916
(d) Per month Interest Rate 2.05+ 2.10+
using Interpolation (10.5429-10.5263) (18.7014-18.6916)
×(0.05) ×(0.02)
10.5429-10.5107 18.7014-18.6593
= 2.076% = 2.105%
(e) Effective Interest Rate (1.02076) 12 – 1 (1.02105) 12 – 1
= 1.2796 – 1 = 1.2840 – 1
= 0.2796 i.e. 27.96% = 0.2840 i.e. 28.40%
Or 2.076 x 12 = 24.91% 2.105 x 12 = 25.26%
(b)
A When dividend is paid
(i) Price per share at the end of year 1
1
100 = (` 5  P 1)
1.10
110 = Rs. 5 + P1
P1 = 105
(ii) Amount required to be raised from issue of new shares
Rs. 10,00,000 – (Rs. 5,00,000 – Rs. 2,50,000)
Rs. 10,00,000 – Rs. 2,50,000 = Rs. 7,50,000
(iii) Number of additional shares to be issued

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 7,50,000 1,50,000
 shares or say 7143 shares
105 21
(iv) Value of ABC Ltd.
(Number of shares × Expected Price per share)
i.e., (50,000 + 7,143) × Rs. 105 = Rs. 60,00,015
B When dividend is not paid
(i) Price per share at the end of year 1
P
100 = 1
1.10
P1 = 110
(ii) Amount required to be raised from issue of new shares
Rs. 10,00,000 – Rs. 5,00,000 = Rs. 5,00,000
(iii) Number of additional shares to be issued
5,00,000 50,000
 shares or say 4545 shares.
110 11
(iv) Value of ABC Ltd.,
(50,000 + 4,545) × Rs.110
= Rs. 59,99,950
Thus, as per M.M. approach the value of firm in both situations will be the same.
(c) (i) Dirty Price
= Clean Price + Interest Accrued
10 262
= 99.42 + 100 × × = 106.70
100 360
(ii) First Leg (Start Proceed)
Dirty Price 100 - Initial Margin
= Nominal Value x ×
100 100
106.70 100 - 2
= Rs.8,00,00,000 x × = Rs.8,36,52,800 or, rounded off to Rs.8,36,53,000
100 100
No. of day s
Second Leg (Repayment at Maturity) = Start Proceed x (1+ Repo rate × )
360
14
= Rs. 8,36,53,000 x (1 + 0.0565 × ) = Rs.8,38,36,804
360
or
14
= Rs. 8,36,52,800 x (1 + 0.0565 × ) = Rs.8,38,36,604
360
(d) VALUATION BASED ON MARKET PRICE
Market Price per share Rs. 400
Thus value of total business is (Rs. 400 x 1.5 Cr.) Rs. 600 Cr.

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 VALUATION BASED ON DISCOUNTED CASH FLOW
Present Value of cash flows
(Rs. 250 cr x 0.893) + (Rs. 300 cr. X 0.797) + ( Rs. 400 cr. X 0.712 ) = Rs. 747.15 Cr.
Value of per share (Rs. 747.15 Cr. / 1.5 Cr) Rs. 498.10 per share
RANGE OF VALUATION
Per Share Total
Rs. Rs. Cr.
Minimum 400.00 600.00
Maximum 498.10 747.15

2. (a) Bank will buy from customer at the agreed rate of Rs. 70.40. In addition to the same if bank will
charge/ pay swap difference and interest on outlay/inlay in funds.
(i) Swap Difference
Bank Sells at Spot Rate on 28 th November 2019 Rs. 70.22
Bank Buys at Forward Rate of 31 December 2019 (70.27 - 0.10) Rs. 70.17
Swap Gain per US$ Rs. 00.05
Swap Gain for US$ 1,00,000 Rs. 5,000
(ii) Interest on Outlay Funds
On 28th November Bank sells at Rs. 70.22
It buys from customer at Rs. 70.40
Outlay of Funds per US$ Rs. 00.18
Interest on Outlay fund for US$ 1,00,000 for 31 days Rs. 153.00
(US$100000 x 00.18 x 31/365 x 10%)
(iii) Gain on early delivery
Swap Gain Rs. 5,000.00
Interest on Outlay fund for US$ 1,00,000 for 31 days (Rs. 153.00)
Rs. 4,847.00
(iv) Net Inflow to Mr. X
Amount received on sale (Rs. 70.40 x 1,00,000) Rs. 70,40,000
Add: Gain on early delivery received by bank Rs. 4,847
Rs. 70,44,847
(b) (i) For finding expected market price first we shall calculate Intrinsic Value of Bond as follows:
PV of Interest + PV of Maturity Value of Bond
Forward rate of interests
1st Year 12%
2nd Year 11.62%
3rd Year 11.33%
4th Year 11.06%
5th Year 10.80%
Rs. 90 Rs. 90 Rs. 90 Rs. 90 Rs. 90
PV of interest = +
2
+
3
+
4
 5
(1+0.12) (1+0.1162) (1+0.1133) (1+0.1106) (1+0.1080)

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 = Rs. 90 x 0.8929 + Rs. 90 x 0.8026 + Rs. 90 x 0.7247 + Rs. 90 x 0.6573 + Rs. 90 x 0.5988
= Rs. 80.36 + Rs. 72.23 + Rs. 65.22 + Rs. 59.16 + Rs. 53.89
= Rs. 330.86
Rs. 1000
PV of Maturity Value of Bond = 5
(1+0.1080)
= Rs. 1,000 x 0.5988 = Rs. 598.80
Intrinsic value of Bond = Rs. 330.86 + Rs. 598.80 = Rs. 929.66
Expected Price = Intrinsic Value x Beta Value
= Rs. 929.66 x 1.10 = Rs. 1,022.63
(ii) The given yield curve is inverted yield curve.
The main reason for this shape of curve is expectation for forthcoming recession when
investors are more interested in Short-term rates over the long term.
3. (a) Working Notes:
(i) The Earnings of S Ltd.
Rs. lakh
Earnings of C Ltd. 10000
Earnings of D Ltd. 5800
15800
Growth 0.08
Earnings of S Ltd. (15800 X 1.08) 17064
(ii) Market Value of S Ltd.
Rs. lakh
Earnings of S Ltd. 17064
P/E Ratio (10+9)/2 9
Market Value of S Ltd. 153576
(iii) No. of shares in S Ltd.
No. of shares of C Ltd. 4000
No. of shares issued to P Ltd. 3000
No. of shares of C Ltd. 7000
Gain to Shareholders of P Ltd.
Share of Shareholders of P Ltd. in S Ltd. Rs. 65818.29 lakh
(3000/7000) x 153576
Market Value of P Ltd. before merger Rs. 58000.00 lakh
(5800 X 10)
Gains to Shareholders Rs. 7818.29 lakh
No. of Shares (before merger) 1000 lakh
Gain Per Share Rs. 7.82

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 (b)
Shares No. of shares Price Amount (Rs.)
Nairobi Ltd. 25,000 20.00 5,00,000
Dakar Ltd. 35,000 300.00 1,05,00,000
Senegal Ltd. 29,000 380.00 1,10,20,000
Cairo Ltd. 40,000 500.00 2,00,00,000
4,20,20,000
Less: Accrued Expenses 2,50,000
Other Liabilities 2,00,000
Total Value 4,15,70,000
No. of Units 10,00,000
NAV per Unit (4,15,70,000/10,00,000) 41.57

4. (a) (i) To compute perfect hedge we shall compute Hedge Ratio (Δ) as follows:
C1  C2 150  0 150
Δ    0.50
S1  S2 780  480 300

Mr. Dayal should purchase 0.50 share for every 1 call option.
(ii) Value of Option today
If price of share comes out to be Rs.780 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x Rs. 780) Rs. 390
Loss on account of Short Position (Rs. 780 – Rs. 630) Rs. 150
Rs. 240
If price of share comes out to be Rs. 480 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x Rs. 480) Rs. 240
Accordingly, Premium say P shall be computed as follows:
(Rs. 300 – P) 1.025 = Rs. 240
P = Rs.65.85
(iii) Expected Return on the Option
Expected Option Value = (Rs. 780 – Rs. 630) × 0.60 + Rs. 0 × 0.40 = Rs. 90
90  65.85
Expected Rate of Return =  100 = 36.67%
65.85
(b) (i) Working for calculation of WACC
Orange Grape Apple
Total debt 80,000 50,000 20,000
Post tax Cost of debt 10.40% 8.45% 9.75%
Equity Fund 20,000 50,000 80,000
Cost of equity 26% 22% 20%

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 WACC
Orange: (10.40 x 0.8) + (26 x 0.2) = 13.52%
Grape: (8.45 x 0.5) + (22 x 0.5) = 15.225%
Apple: (9.75 x 0.2) + (20 x 0.8) = 17.95%
Orange Grape Apple
WACC (%) 13.52 15.225 17.95
EVA [EBIT (1-T)-(WACC x Invested Capital)] 3,770 1,350 -1,050
Alternatively, it can also be computed as follows:
Orange Grape Apple
Net Income (Rs.) 8,970 12,350 14,950
Pre Tax Income (Rs.) (A) 13,800 19,000 23,000
Debt Amount (Rs.) 80,000 50,000 20,000
Interest (Rs.) (B) 12,800 6,500 3,000
EBIT (Rs.) 26,600 25,500 26,000
Tax 35% (Rs.) 9,310 8,925 9,100
EAT 17,290 16,575 16,900
Less: WACC X Invested Capital 13,520 15,225 17,950
EVA (Rs.) 3,770 1,350 -1,050
(iii) Orange would be considered as the best investment since the EVA of the company is
highest and its weighted average cost of capital is the lowest
(iv) Estimated Price of each company shares
Orange Grape Apple
EBIT (Rs.) 26,600 25,500 26,000
Interest (Rs.) 12,800 6,500 3,000
Taxable Income (Rs.) 13,800 19,000 23,000
Tax 35% (Rs.) 4,830 6,650 8,050
Net Income (Rs.) 8,970 12,350 14,950
Shares 6,100 8,300 10,000
EPS (Rs.) 1.4705 1.488 1.495
Stock Price (EPS x PE Ratio) (Rs.) 16.18 16.37 16.45
Since the three entities have different capital structures they would be exposed to different
degrees of financial risk. The PE ratio should therefore be adjusted for the risk factor.
Alternative Answer
Orange Grape Apple
Net Income (Given) (Rs.) 8,970 12,350 14,950
Shares 6,100 8,300 10,000
EPS (Rs.) 1.4705 1.488 1.495
Stock Price (EPS x PE Ratio) (Rs.) 16.18 16.37 16.45

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 (v) Market Capitalisation
Estimated Stock Price (Rs.) 16.18 16.37 16.45
No. of shares 6,100 8,300 10,000
Estimated Market Cap (Rs.) 98,698 1,35,871 1,64,500
5. (a) (i) (a) Borrow and Buy Option
Year 0 Year 1 Year 2 Year 3
Purchase Price Rs. 80,00,000 - - -
Maintenance Cost - Rs. 4,00,000 Rs. 4,00,000 Rs. 4,00,000
Residual Value - - - (Rs. 20,00,000)
Total Rs. 80,00,000 Rs. 4,00,000 Rs. 4,00,000 (Rs. 16,00,000)
PVF@8% 1.00 0.926 0.857 0.794
PV Rs. 80,00,000 Rs. 3,70,400 Rs. 3,42,800 (Rs. 12,70,400)
Present Value of Outflow Rs. 74,42,800
(b) Leasing Option
PV of Cash Outflow = Rs. 27,50,000 (1 + 0.926 + 0.857) = Rs. 76,53,250
Decision: Since PV of cash outflow is least in case of Borrowing and Buying option it
should be acquired by borrowing.
(ii) To make choice between normal maintenance and upgraded maintenance we shall compute
EAC in each of Replacement Cycle.
(A) 3-year Replacement Cycle – Normal Maintenance
Year 0 Year 1 Year 2 Year 3
Initial Cost Rs. 80,00,000 - - -
Maintenance Cost - Rs. 4,00,000 Rs. 4,00,000 Rs. 4,00,000
Residual Value - - - (Rs. 20,00,000)
Rs. 80,00,000 Rs. 4,00,000 Rs. 4,00,000 (Rs. 16,00,000)
PVF@10% 1 0.909 0.826 0.751
PV Rs. 80,00,000 Rs. 3,63,600 Rs. 3,30,400 (Rs. 12,01,600)
Total Value of Outflow Rs. 74,92,400
PVAF@10% 2.486
Equivalent Annual Cost (Rs. 74,92,400/2.486) Rs. 30,13,837
(B) 4-year Replacement Cycle – Upgraded Maintenance
Year 0 Year 1 Year 2 Year 3 Year 4
Initial Cost Rs. 80,00,000 - - - -
Maintenance - Rs. 6,00,000 Rs. 6,00,000 Rs. 6,00,000 Rs. 6,00,000
Cost
Residual - - - - (Rs. 5,50,000)
Value
Rs. 80,00,000 Rs. 6,00,000 Rs. 6,00,000 Rs. 6,00,000 Rs. 50,000
PVF@10% 1 0.909 0.826 0.751 0.683
PV Rs. 80,00,000 Rs. 5,45,400 Rs. 4,95,600 Rs. 4,50,600 Rs. 34,150
Total Value of Outflow Rs. 95,25,750
PVAF@10% 3.169
Equivalent Annual Cost (Rs. 74,92,400/2.486) Rs. 30,05,917
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 In case machine with upgraded maintenance is bought the EAC will be less and hence same
should be opted for.
(b) Net Issue Size = $15 million
$15 million
Gross Issue = = $15.306 million
0.98
Issue Price per GDR in Rs. (300 x 3 x 90%) Rs. 810
Issue Price per GDR in $ (Rs. 810/ Rs. 60) $13.50
Dividend Per GDR (D 1) = Rs. 2 x 3 = Rs. 6
Net Proceeds Per GDR = Rs. 810 x 0.98 = Rs. 793.80
(1) Number of GDR to be issued
$15.306 million
= 1.1338 million
$13.50
(2) Cost of GDR to Odessa Ltd.
6.00
ke = + 0.20 = 20.76%
793.80
6. (a) (i) Do Nothing
We shall compute the cross rates in Spot Market on both days and shall compare the
amount payable in INR on these two days.
On 1st February 2020
Rupee – Dollar selling rate = Rs. 75.50
Dollar – SKW = SKW 1190.00
Rupee – SKW cross rate = Rs. 75.50 / 1190.00
= Rs. 0.0634
Amount payable to Importer as per above rate (1190 Million x Rs. 0.0634) Rs. 754.4600 Lakh
On 1st March 2020
Rupee – Dollar selling rate = Rs. 75.75
Dollar – SKW = SKW 1188.00
Rupee – SKW cross rate = Rs. 75.75 / 1188.00
= Rs. 0.0638
Amount payable to Importer as per above rate (1190 Million x Rs. 0.0638) Rs. 759.2200 Lakh
Thus, Exchange Rate Loss = (Rs. 759.2200 Lakh - Rs. 754.4600 Lakh) Rs. 4.7600 Lakh
(ii) Hedging in NDF
Since company needs SKW after one month it will take long position in SKW at quoted rate
of SKW 1190/ USD and after one-month it will reverse its position at fixing rate of SKW
1187/USD. The profit/ loss position will be as follows:

8
 Buy SKW 1190 Million and sell USD (1190 Million/ 1190) USD 1,000,000
Sell SKW 1190 Million and buy USD at Fixing Rate (1190 Million/ USD 1,004,219
1185)
Profit USD 4,219

Final Position
Amount Payable in Spot Market (as computed earlier) Rs. 759.2200 Lakh
Less: Profit form NDF Market USD 4219 x 75.50 Rs. 3.1853 Lakh
Rs. 756.0347 Lakh

Thus, Exchange Rate Loss = (Rs. 756.0347 Lakh - Rs. 754.4600 Lakh) Rs. 1.5747 Lakh
Decision: Since Exchange Loss is less in case of NDF same can be opted for.
(b) (i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for the
same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.
Alternatively, three securities can also be found as follows:

Since securities other than A, E and C are not on Efficient Frontier they are rejected.
(ii) The average values for A and C for a proportion of 3 : 1 will be :
(3  4)  (1 12)
Risk = = 6%
4

(0.75)2 ×(4)2 +(0.25)2 ×(12)2 +2×0.75×0.25×4×12×1

or = 6%
(3  8)  (1 12)
Return = = 9%
4

9
 Therefore: 75% A E
25% C _
Risk 6 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.
7. (a) The given statement is true to a certain extent in reference to Mutual Funds where the concept of
Quant Fund is becoming popular day by day.
Quant Fund follows a data-driven approach for stock selection or investment decisions based on
a pre-determined rules or parameters using statistics or mathematics based models.
Contrary to an active fund Manager who selects the quantum and timing of investments i.e. entry
or exit, this fund completely rely on an automated programme for making decision for quantum of
investment as well as its timings.
It does not mean that there is no human intervention at all, the Fund Manager usually focuses on
the robustness of the Models in use and also monitors their performance or some modification is
required.
Sometime a Quant Fund manager is confused with Index Fund Manager but it is not so as the
Index Fund Manager may entirely hands off the investment decision purely based on Index, while
Quant Fund Manager often designs and monitors models that throw up the choices.
The main advantage of Quant Fund is that it eliminates the human biasness and subjectivity.
Further using model based approach also ensures consistency in strategy across the market
conditions.
Also since the Quant Fund normally follows passive strategy, the exposure ratio tends to be
lower.
Since Quant Fund uses highly sophisticated strategies investors who well understand Stock
Valuation methods, different stock picking styles, the market sentiments and derivatives etc.
should invest in the same. Further since Quant Fund are tested on the basis of historical data
and past trends though cannot altogether be ignore but also cannot be used blindly as good
indicators.
Thus, overall it can be said that whether it is human or a machine it is not easy to beat the
market.
(b) The key decisions falling within the scope of financial strategy include the following:
1. Financing decisions: These decisions deal with the mode of financing or mix of equity
capital and debt capital.
2. Investment decisions: These decisions involve the profitable utilization of firm's funds
especially in long-term projects (capital projects). Since the future benefits associated with
such projects are not known with certainty, investment decisions necessarily involv e risk.
The projects are therefore evaluated in relation to their expected return and risk.
3. Dividend decisions: These decisions determine the division of earnings between payments
to shareholders and reinvestment in the company.
4. Portfolio decisions: These decisions involve evaluation of investments based on their
contribution to the aggregate performance of the entire corporation rather than on the
isolated characteristics of the investments themselves.

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(c) A very important phenomenon witnessed in the Mergers and Acquisitions scene, in recent times
is one of buy - outs. A buy-out happens when a person or group of persons gain control of a
company by buying all or a majority of its shares. A buyout involves two entities, the acquirer and
the target company. The acquirer seeks to gain controlling interest in the company being
acquired normally through purchase of shares.
There are two common types of buy-outs: Leveraged Buyouts (LBO) and Management Buy-outs
(MBO).
LBO is the purchase of assets or the equity of a company where the buyer uses a significant
amount of debt and very little equity capital of his own for payment of the consideration for
acquisition.
MBO is the purchase of a business by its management, who when threatened with the s ale of its
business to third parties or frustrated by the slow growth of the company, step-in and acquire the
business from the owners, and run the business for themselves. The majority of buy-outs is
management buy-outs and involves the acquisition by incumbent management of the business
where they are employed. Typically, the purchase price is met by a small amount of their own
funds and the rest from a mix of venture capital and bank debt.
Internationally, the two most common sources of buy-out operations are divestment of parts of
larger groups and family companies facing succession problems. Corporate groups may seek to
sell subsidiaries as part of a planned strategic disposal programme or more forced reorganisation
in the face of parental financing problems. Public companies have, however, increasingly sought
to dispose of subsidiaries through an auction process partly to satisfy shareholder pressure for
value maximisation.
In recessionary periods, buy-outs play a big part in the restructuring of a failed or failing
businesses and in an environment of generally weakened corporate performance often represent
the only viable purchasers when parents wish to dispose of subsidiaries.
Buy-outs are one of the most common forms of privatisation, offering opportunities for enhancing
the performances of parts of the public sector, widening employee ownership and giving
managers and employees incentives to make best use of their expertise in particular sectors.
(d) Re-investment Risk: This risk is again akin to all those securities, which generate intermittent
cash flows in the form of periodic coupons. The most prevalent tool deployed to measure returns
over a period of time is the Yield-to-Maturity (YTM) method. The YTM calculation assumes that
the cash flows generated during the life of a security is reinvested at the rate of YTM. The risk
here is that the rate at which the interim cash flows are reinvested may fall thereby affecting the
returns.
Thus, reinvestment risk is the risk that future coupons from a bond will not be reinvested at the
prevailing interest rate when the bond was initially purchased.
Default Risk: The event in which companies or individuals will be unable to make the required
payments on their debt obligations. Lenders and investors are exposed to default risk in virtually
all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of
return that correspond the debtor's level of default risk. The higher the risk, the higher the
required return, and vice versa. This type of risk in the context of a Government security is
always zero.
(e) It is increasingly realised that commercial evaluation of projects is not enough to justify
commitment of funds to a project especially when the project belongs to public utility and
irrespective of its financial viability it needs to be implemented in the interest of the society as a
whole. Huge amount of funds are committed every year to various public projects of all types –
industrial, commercial and those providing basic infrastructure facilities. Analysis of such projects
has to be done with reference to the social costs and benefits since they cannot be expected to

11
yield an adequate commercial rate of return on the funds employed at least during the short
period. A social rate of return is more important. The actual costs or revenues do not necessarily
reflect the monetary measurement of costs or benefits to the society. This is because the market
price of goods and services are often grossly distorted due to various artificial restrictions and
controls from authorities, hence a different yardstick has to be adopted for evaluating a particular
project of social importance and its costs and benefits are valued at 'opportunity cost' or shadow
prices to judge the real impact of their burden as costs to the society. Thus, social cost benefit
analysis conducts a monetary assessment of the total cost and revenues or benefits of a project,
paying particular attention to the social costs and benefits which do not normally feature in
conventional costing.
United Nations Industrial Development Organisation (UNIDO) and Organisation of Economi c
Cooperation and Development (OECD) have done much work on Social Cost Benefit analysis. A
great deal of importance is attached to the social desirability of projects like employment
generation potential, value addition, foreign exchange benefit, living standard improvement etc.
UNIDO and OECD approaches need a serious consideration in the calculation of benefits and
costs to the society. This technique has got more relevance in the developing countries where
public capital needs precedence over private capital.

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