CA FINAL

STRATEGIC FINANCIAL
MANAGEMENT

CHALLENGER SERIES
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 Strategic Financial Management

PROBLEM - 1

The risk free rate of interest rate in USA is 8% p.a. and in UK is 5% p.a. The
spot exchange rate between US $ and UK £ is 1$ = £ 0.75.
Assuming that is interest is compounded on daily basis then at which forward
rate of 2 year there will be no opportunity for arbitrage.
Further, show how an investor could make risk-less profit, if two year forward price is
1 $ = 0.85 £. Given e0.-06 = 0.9413 & e-0.16 = 0.852, e0.16 = 1.1735, e-0.1 = 0.9051

Solution :

2 year Forward Rate will be calculated as follows:

F  Se uk us 
r r t

Where F = Forward Rate

S = Spot Rate
rUK = Risk Free Rate in UK
rUS = Risk Free Rate in US
t = Time
Accordingly,

F  0.75e
0.050.08 2

= 0.75 х 0.9413
= 0.706
Thus,
1 US $ = £ 0.706
If forward rate is 1 UK $ = 0.85$ then an covered interest arbitrage
opportunity exists. Take following steps.
Step 1 - Should borrow UK £, say pound 100000 at 5% p.a. for 2 years.
Therefore, Outflow after 2 years = 1,00,000*e^(0.05*2) = 1,10,517
Step 2 - Convert the borrowed amount that is Pound 1,00,000 spot, getting
1,00,000/0.75 = $1,33,333
Step 3 - Invest $1,33,333 at 8% p.a. for 2 years, getting 1,33,333*e^(0.08*2) =
$1,56,468.
Step 4 - Sell $ Forward at 0.85, getting 1,56,468*0.85 = $1,32,998

Hence, Riskless Profit = $1,32,998 - 1,10,517 = 22,481.

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 Challenger Series Class - 3

PROBLEM - 2

True view Ltd. a group of companies controlled from the United Kingdom includes
subsidiaries in India, Malaysia and the United States. As per the CFO's forecast that ,
at the end of the June 2010 the position of inter-company indebtedness is as follows:
i. The Indian subsidiary will be owned or will receive `1,44,38,100 by the Malaysian
subsidiary and will to owe or will pay the US subsidiary US$ 1,06,007.
ii. The Malaysian subsidiary will be owed or will receive MYR 14,43,800 by the US
subsidiary and will owe it or will pay US$ 80,000
Suppose you are head of central department of the group and you are required to
net off inter-company balances as far as possible and to issue instructions for
settlement of the net balance. For this purpose, the relevant exchange rates may be
assumed in term of £1 are US$ 1.415; MYR 10.215; `68.10. What are the net
payments to be made in respect of the above balances?

Solution :
Indian Subsidiary :
1. Receipt from Malaysia = Rs. 1,44,38,100, i.e. Pound 2,12,013
2. Payment to US = $ 1,06,007,i.e. Pound 74,917
Therefore, Net Amount to be received by India = Pound 1,37,096

Malaysian Subsidiary :
1. Receipt from US = MYR14,43,800, i.e. Pound 1,41,341
2. Payment to India = Rs. 1,44,38,100, i.e. Pound 2,12,013
3. Payment to US = $80000,i.e. Pound 56,537
Therefore, net Amount to be paid by Malaysia = Pound 1,27,209

US Subsidiary :
1. Receipt from India = $ 1,06,007,i.e. Pound 74,917
2. Receipt from Malaysia = $80000,i.e. Pound 56,537
3. Payment to Malaysia = MYR14,43,800, i.e. Pound 1,41,341
Therefore, Net Amount to be paid by US Subsidiary = Pound 9887
Instruction from UK head office – Malaysia to pay India Pound 127209 and US to pay
India Pound 9887.

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 Strategic Financial Management

PROBLEM - 3
OJ Ltd. Of UK is supplier of leather goods to retails in the UK and other Western
European countries. The company is considering entering into a joint venture with a
manufacturer in South America. The two companies will each own 50% of the limited
liability company JV(SA) & will share profits equally. £450,000 of the initial capital is
being provided by OJ Ltd. and the equivalent in South American dollars (SA$) is being
provided by the foreign partner. The managers of the joint venture expect following
cash flows :
SA$ 000 Forward rates of exchange to the £ Sterling [SA$/£]
Year 1 4,250 10
Year 2 6,500 15
Year 3 8,350 21

For tax reasons JV(SA) the company to be formed for the joint venture, will be
registered in South America. Ignore taxation in your calculations Requirements :

Assume you are financial adviser retained by OJ Limited to advise on the proposed
joint venture.
i. Calculate NPV of the project under the two assumptions explained below. Use a
discount rate of 16% for both assumptions.
Assumption 1 : The South American country has exchange controls which
prohibit the payment of cash flows above 50% of the annual cash flows for the
first three years of the project. The accumulated balance can be repatriated at
the end of the third year.
Assumption 2 : The government of the South American country is considering
removing exchange controls and restriction on repatriation of profits. If this
happens all cash flows will be distributed to the partner companies at the end of
each year.

ii. Comment briefly on whether or not the joint venture should proceed based on
these calculations.

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Solution :
i. With Exchange Controls
Year Profit O.J. 50% div. OJ Share PVF @ Present
After Share ER[£/$] in £000 16% Value
Tax 50% SA$ 000 £000
SA$000 SA$0000
0 - (450) 1.000 (450)
1 4,250 2,125 1,062 .1 106 0.862 91
2 6,500 3,250 1,625 .067 108 0.743 80
3 8,350 4,175 2,088 .0476 100 0.641 64
3 - - 4,775 .0476 227 0.641 146

Net Present Value (69)

Exchange controls removed and all earnings distributed as divide

Year Profit OJ Share ER[£/$] OJ Share PVF @ Present

After SA$0000 S in £000 16% Value
Tax flow
SA$000 £000
0 (450) (1.000) (450)
1 4,250 2,125 .1 212 0.862 183
2 6,500 3,250 .067 217 0.743 161
3 8,350 4,175 .0476 199 0.641 127
Net Present Value 21

ii. Decision :
If exchange controls exist in the South American Country the project has a
negative and NPV should not be undertaken.

If exchange control are removed then project may be undertaken as then the
project has a positive NPV. Investing in countries with a history of high inflation
and political volatility adds to the risk of the project and OJ Ltd. Should proceeds
with caution.

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 Strategic Financial Management

PROBLEM - 4

A multinational company has surplus fund of £ 300,000 in UK for 90 days. The

company is planning to invest the fund for 90 days. The company is considering to
invest the fund in 90-day deposit in banks or invest in CDs for 90 days. The interest
rate offered by a British bank on 90-day deposit is 6.5%. The interest rate on CD is
10%, but the minimum size of investment in CD is £ 500,000 and in multiples of £
500,000. The overdraft charges applicable to the company is 14%. You are required
to
i. Find out the break-even size of investment in CD and suggest the bank whether to
invest in CD or not.
ii. Compare the gain/loss if the company have decided to invest in a CD against the
investment in bank deposits.

Solution :

i. Let x be breakeven size of Investment

[x = owned fund].
Alternative 1 Bank Deposit
3
Int. income =  6.5% of x   0.01625x
12
Alternative 2 Invest 5,00,000 in C.D by borrowing [5,00,000 - x]
3 3
Net Int. Income  10% of 5,00,000   14% of  5,00,000  x  
12 12
 70000  0.14x 
 12,500   
 4 
= 12,500 - 17,500 + 0.035x
= 0.035x - 5000
At break even, 0.01625x = 0.035x - 5000
5000
x  2,66,666.67
00.1875
= 2,66,667
Since the Co. has owned fund of ` 3,00,000 (> 2,66,667)
It should choose Alternative 2 i.e. invest in C.D.

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ii. Int income on bank deposit = 0.1625x = 0.01625 × 3,00,000

= £ 4875
Net Int. income in CD = 0.035x - 5000
= 0.035 × 3,00,000 - 5000 = £ 5,500
 Gain to company = £ 625
Due to CD investment.

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 Strategic Financial Management

PROBLEM - 5

A multinational company based in Germany has its subsidiaries in UK, Singapore,

Hongkong and Japan. The cash position of these subsidiaries for the month of
February 2003 is as follows:
UK. Cash surplus of £1 million
Singapore Cash deficit of S$1 million
Hongkong Cash deficit of HK$2 million
Japan Cash surplus of JPY 50 million
The current exchange rates are given below:
Euro/£ 1.5025
S$/Euro 1.8910
Euro/HK$ 0.1190
JPY/Euro 130
You are required to determine the cash requirement of the MNC if it adopts:
i. Centralized cash management.
ii. Decentralized cash management.

Solution :

i. Total cash requirement under centralized cash management

=+£1 million + JP ¥50 million - S$1 million - HK$2 million
=Euro 1  1.5025  
50 1
  2  0.119 
 130 1.8910 
=Euro [1.5025+0.3846-0.5288-0.2380]
=Euro 1.1203 million.

ii. Total cash requirement under decentralized cash management

=S$1 million +HK$2 million
=Euro  
1
 2  0.119 
 1.8910 
= Euro 0.7668 million
Surplus available at U.K subsidiary and Japan subsidiary is not available for
adjustment against the deficit of the other subsidiaries.

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 Challenger Series Class - 3

PROBLEM - 6

The covered after tax lending and borrowing rates for three unit of a Multinational
corporation located in the United States and having Subsidiaries in Singapore and
Hongkong are :
Lending (%) Borrowing (%)
United States 4.9 5.0
Singapore 2.70 3.9
Hong Kong 2.75 3.3

Currently, the Singapore and Hong Kong units owe $25,00,000 and $35,00,000,
respectively to their US parent. The Singapore unit also has $10,00,000 in receivables
from is Hong Kong affiliate. The timing of these payment can be changed by up to 60
days in either direction. If US Parent is borrowing funds, while both the Singapore
and Hong Kong subsidiaries have surplus cash available, you are required to
i. Determine the MNC's optimal leading and lagging strategies
ii. Calculate the net profit impact of these adjustments
iii. Indicate the change in the MNC's optimal strategy, if the US parents has surplus
cash available.

Solution :

i. The entire situation is shown below

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Optimum leading an lagging strategies

I. Singapore should pay US $ 25,00,000 today.
II. Hongkong should pay US $ 3,500,000 today.
III. Hongkong should pay Singapore 10,00,000 after 60 days.

Self Note: Always decide in favour of the entity which has higher opportunity
cost. The word favour means -
If the entity is suppose receive/ pay, we advice leading/lagging.
ii. Profit as a result of 1st strategy
= $2,500000 × ( 5-2.7) % × 2/12
= $2,500000 × 2.30 % × 2/12
= $9583.33
Profit due to 2nd strategy
=$ 3,500000 × ( 5% - 2.75 ) % × 2/12
=$ 3,500000 × 2.25 % × 2/12
= $13,125
Profit due to 3rd advice
= $ 10,00,000 × (2.75 - 2.70) % × 2/12
=$10,00,000 × 0.05% × 2/12
=$ 83.33
Overall profit = $ [ 9583.33+13,125+83.33] = $ 22,791.66

iii. If US has surplus its opportunity cost is 4.9% that is stillmore than Opportunity
Cost of the other two firms. So, there is no change in advice.

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 Challenger Series Class - 3

PROBLEM - 7

An Indian company is planning to set up a subsidiary in South Africa. The initial

project cost is estimated to be ZAR 500 million; Working Capital required is estimated
to be ZAR 30 million. The finance manager of company estimated the data as follows:

Variable Cost of Production (Per Unit Sold) ZAR 5.20

Fixed cost per annum ZAR 4 million
Selling Price ZAR 15
Production capacity 16 million units
Expected life of Plant 5 years
Method of Depreciation Straight Line Method (SLM)
Salvage Value at the end of 5 years NIL
The subsidiary of the Indian company is subject to 40% corporate tax rate in the
South Africa and the required rate of return of such types of project is 15%. The
current exchange rate is ` 5/ZAR and the rupee is expected to depreciate by 3% per
annum for next five years.
The subsidiary company shall be allowed to repatriate 60% of the CFAT every year
along with the accumulated arrears of blocked funds at the end of 5 years, the
withholding taxes are 10%. The blocked fund will be invested in the South African
money market by the subsidiary, earning 6% (free of taxes) per year.
Determine the feasibility of having a subsidiary company in the South Africa,
assuming no tax liability in India on earnings received by the parent company from
the South Africa subsidiary.

Solution :
Step - 1 Calculation of CFAT (Cash flow After Tax)
Selling Price ` 15
(-) V. cost 5.2
Contribution 9.8
Quantity 16m
Annual cost 156.8
(- ) Cash Flow Cost 4

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 Strategic Financial Management

EBDIT 152.8
(-) Dep (500/5) 100
EBIT 52.8
NOPAT @ 60% 31.68
+ Dep 100
CFAF 131.68

Step - 2 PV of Repatriated amount each year

Years Repatriated Amount E(S) Repatriated ` PV @ 15%
(60% of CFAT)
1 79.01 5.15 406.90 353.83
2 79.01 5.30 418.75 316.64
3 79.01 5.46 431.39 283.65
4 79.01 5.62 444.04 253.88
5 79.01 5.79 457.47 227.44

After applying 10% withholding tax, PV = 1435.44  0.9 = 1291.90

Step - 3 PV of the blocked funds Repatriated at the end

Blocked funds each year = 40% of CFAT = 52.67
Years Blocked fund Reinvested @ 6%
1 52.67 66.49
2 52.67 62.73
3 52.67 59.18
4 52.67 55.83
5 52.67 52.67
FV of Reinvested 296.9
(-) CF withholding Tax @ 10% 29.69
267.21
E (Ss) 5.82
Expected ` proceeding ` 1555.16
PV @ 15% 773.19

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Step - 4 We assume that working capital of 30m is received in full. No withholding tax
is charged on its repatriation.
So, amount repatriated = 30 × 5.82 = ` 174.6m
PV @ 15% = 86.81 m

NPV = Step 2 + Step 3 + Step 4 - Initial Investment

= 1291.90 + 773.19 + 86.81 - (530 × 5)
= 2151.9 - 2650
= (498.1)
Project is not viable.

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 Strategic Financial Management

PROBLEM - 8
On 1st March. 2008, A Inc, a US company bought certain products from Tapland. The
currency of Tapland is Tapa. The price agreed was Tapa 900000 payable on 31st May,
2008.
The spot price on 1st March, 2008 was 10 Tapa per US $. The expected future spot
rate was 8 Tapa per US $ : and the 3-months forward rate is 9 Tapa per US$. The US
and Tapland annual interest rate are 12% and 8% respectively. The tax rate for both
countries is 40%. A Inc., is considering three alternatives to deal with the risk of
exchange rate fluctuations.

i. To enter the forward market to buy Tapa 9,00,000 a 3 months forward rate
ii. To borrow appropriate amount in $ to buy Tapa at current spot rate and to invest
the Tapa purchased for 3 months
iii. To wait until May 31, 2008, and buy Tapas at whatever spot rate prevailing at that
time.
Which alternative the A Inc. should follow in order to minimize its cost of future
payment of Tapas.

Solution :

Alternative A

Forward Contract
900000÷9 = 100000
$ Outflow = $100000
Alternative B
Step 1:
Invest the PV of Tapa 900000 at 8% p.a. for 3 months.
∴ Amount to be invested = 900000 ÷ (1+ 0.08/4)= 882352.94 Tapa
Step 2:
Buy Tapa spot @ 10 requiring,
882352.94 ÷ 10 = 88235.29 $

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Step 3:
Borrow $ 88235.29 at 12% p.a for 3 months.
So, outflow after 3 months = 88235.29  (1+ 0.12/4)= $90882.35
Alternative C
Outflow after 3 months = 900000/8 = $112500
 Outflow is least in Alternative (B),
∴ A Inc. should go for Alternative (B) to minimize the cost of future payment.

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 Strategic Financial Management

PROBLEM – 9
Wenden Co is a Dutch-based company which has the following expected
transactions.
One month: Expected receipt of £2,40,000
One month: Expected payment of £1,40,000
Three months: Expected receipts of £3,00,000
The finance manager has collected the following information:
Spot rate (£ per €) : 1.7820 ± 0.0002
One month forward rate (£ per €) : 1.7829 ± 0.0003
Three months forward rate (£ per €) : 1.7846 ± 0.0004
Money market rates for Wenden Co:
Borrowing Deposit
One year Euro interest rate 4.9% 4.6
One year Sterling interest rate 5.4% 5.1

Assume that it is now 1 April.

Required:
a. Calculate the expected Euro receipts in one month and in three months
using the forward market.
b. Calculate the expected Euro receipts in three months using a money-market
hedge and recommend whether a forward market hedge or a money market
hedge should be used.

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Solution :
a. Forward market evaluation
Net receipt in 1 month = £2,40,000 – £1,40,000 = £1,00,000
WendenCo needs to sell Sterlings at an exchange rate of
(1.7829 + 0.0003) = £1.7832 per €
Euro value of net receipt = 1,00,000/ 1.7832 = €56,079
Receipt in 3 months = £3,00,000
Wenden Co needs to sell Sterlings at an exchange rate of
1.7846 + 0.0004 = £1.7850 per €
Euro value of receipt in 3 months = 3,00,000/ 1.7850 = €1,68,067

b. Evaluation of money-market hedge

Expected receipt after 3 months = £300,000
Sterling interest rate over three months = 5.4/ 4 =
1.35%
Sterlings to borrow now to have £300,000 liability
after 3 months = 300,000/ 1.0135 = £296,004
Spot rate for selling Sterling = 1.7820 + 0.0002 = £1.7822 per €
Euro deposit from borrowed Sterling at spot = 296,004/ 1.7822 = €166,089
Euro interest rate over three months = 4.6/ 4 = 1.15%
Value in 3 months of Euro deposit = 166,089 x 1.0115 = €167,999
The forward market is marginally preferable to the money market hedge for the
Sterling receipt expected after 3 months.

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 Strategic Financial Management

PROBLEM – 10
Opus Technologies Ltd., an Indian IT company is planning to make an investment
through a wholly owned subsidiary in a software project in China with a shelf life of
two years. The inflation in China is estimated as 8 percent. Operating cash flows are
received at the year end.

For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in land.
The land will be sold after the completion of project at estimated value of CN¥
35,00,000. The project also requires an office complex at cost of CN¥ 15,00,000
payable at the beginning of project. The complex will be depreciated on
straight-line basis over two years to a zero salvage value. This complex is
expected to fetch CN¥ 5,00,000 at the end of project.

The company is planning to raise the required funds through GDR issue in Mauritius.
Each GDR will have 5 common equity shares of the company as underlying security
which are currently trading at ` 200 per share (Face Value = `10) in the
domestic market. The company has currently paid the dividend of 25% which is
expected to grow at 10% p.a. The total issue cost is estimated to be 1 percent of issue
size.

The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The
price of unit is expected to rise at the rate of inflation. Variable operating costs
are 40 percent of sales. Fixed operating costs will be CN¥ 22,00,000 per year and
expected to rise at the rate of inflation.

The tax rate applicable in China for income and capital gain is 25 percent and as per
GOI Policy no further tax shall be payable in India. The current spot rate of CN¥
1 is ` 9.50. The nominal interest rate in India and China is 12% and 10% respectively
and the international parity conditions hold

You are required to

i. Identify expected future cash flows in China and determine NPV of the project in
CN¥.

ii. Determine whether Opus Technologies should go for the project or not
assuming that there neither there is restriction on the transfer of funds
from China to India nor any charges/taxes payable on the transfer of funds.

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SOLUTION :

Working Notes:

1. Calculation of Cost of Capital (GDR)

Current Dividend (D0) 2.50
Expected Divedend (D1) 2.75
Net Proceeds (Rs. 200 per share – 1%) 198.00
Growth Rate 10.00%

2.75
ke   0.10  0.1139 i.e. 11.39%
198
2. Calculation of Expected Exchange Rate as per Interest Rate Parity
Year Expected Rate

9.50 
1  0.12   9.67
1
1  0.10 
1  0.12   9.85
2

2 9.50 
1  0.10 
2

3. Realization on the disposal of Land net of Tax

CN¥
Sale value at the end of project 3500000.00
Cost of Land 3000000.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax 3375000.00

4. Realization on the disposal of Office Complex

(CN¥)
Sale value at the end of project 500000.00
WDV 0.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax (A) 375000.00

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5. Computation of Annual Cash Inflows

Year 1 2
Annual Units 10000 10000
Price per bottle (CN¥) 540.00 583.20
Annual Revenue (CN¥) 5400000.00 5832000.00
Less: Expenses
Variable operating cost (CN¥) 2160000.00 2332800.00
Depreciation (CN¥) 750000.00 750000.00
Fixed Cost per annum (CN¥) 2376000.00 2566080.00
PBT (CN¥) 114000.00 183120.00
Tax on Profit (CN¥) 28500.00 45780.00
Net Profit (CN¥) 85500.00 137340.00
Add: Depreciation (CN¥) 750000.00 750000.00
Cash Flow 835500.00 887340.00

i. Computation of NPV of the project in CN¥

(CN¥)
Year 0 1 2
Initial Investment -4500000.00
Annual Cash Inflows 835500.00 887340.00
Realization on the disposal of Land net 3375000.00
of Tax
Realization on the disposal of Office 375000.00
Complex
Total -4500000.00 835500.00 4637340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -4500000.00 750279.00 3737696.00
NPV -12,025

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ii. Evaluation of Project from Opus Point of View

a. Assuming that inflow funds are transferred in the year in which same are
generated i.e. first year and second year.

Year 0 1 2
Cash Flows (CN¥) -4500000.00 835500.00 4637340.00
Exchange Rate (`/ CN¥) 9.50 9.67 9.85
Cash Flows (`) -42750000.00 8079285.00 45677799.00
PVF @ 12% 1.00 0.893 0.797
-42750000.00 7214802.00 36405206.00
NPV 870008.00

b. Assuming that inflow funds are transferred at the end of the project i.e.
second year.

Year 0 2
Cash Flows (CN¥) -4500000.00 5472840.00
Exchange Rate (Rs./ CN¥) 9.50 9.85
Cash Flows (Rs.) -42750000.00 53907474.00
PVF 1.00 0.797
-42750000.00 42964257.00
NPV 214257.00
Though in terms of CN¥ the NPV of the project is negative but in Rs. it has
positive NPV due to weakening of Rs. in comparison of CN¥. Thus Opus can accept
the project.

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PROBLEM – 11
Place the following strategies by different persons in the Exposure
Management Strategies Matrix.
Strategy 1: Kuljeet a wholesaler of imported items imports toys from China to
sell them in the domestic market to retailers. Being a sole trader, he is always so
much involved in the promotion of his trade in domestic market and
negotiation with foreign supplier that he never pays attention to hedge
his payable in foreign currency and leaves his position unhedged.
Strategy 2: Moni, is in the business of exporting and importing brasswares to
USA and European countries. In order to capture the market he invoices the
customers in their home currency. Moni enters into forward contracts to sell
the foreign exchange only if he expects some profit out of it other-wise he
leaves his position open.
Strategy 3: TSC Ltd. is in the business of software development. The company
has both receivables and payables in foreign currency. The Treasury Manager of
TSC Ltd. not only enters into forward contracts to hedge the exposure but
carries out cancellation and extension of forward contracts on regular basis to earn
profit out of the same. As a result management has started looking Treasury
Department as Profit Centre.
Strategy 4: DNB Publishers Ltd. in addition to publishing books are also in the
business of importing and exporting of books. As a matter of policy the movement
company invoices the customer or receives invoice from the supplier
immediately covers its position in the Forward or Future markets and hence
never leave the exposure open even for a single day.

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Solution:
Strategy 1: This strategy is covered by High Risk: Low Reward category and worst as it
leaves all exposures unhedged. Although this strategy does not involve any time and
effort, it carries high risk.
Strategy 2: This strategy covers Low Risk: Reasonable reward category as the
exposure is covered wherever there is anticipated profit otherwise it is left.
Strategy 3: This strategy is covered by High Risk: High Reward category as to
earn profit, cancellations and extensions are carried out. Although this strategy
leads to high gains but it is also accompanied by high risk.
Strategy 4: This strategy is covered by Low Risk : Low Reward category as
company plays a very safe game.
Diagrammatically all these strategies can be depicted as follows:

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