Mid-Term Examination, Winter 2010
Level: Masters
Program: MBAe Section B
Course: Financial Management
Term: III
Full Marks: 100
Pass Marks: 60
Time: 3 Hrs.
Candidates are required to be original and fair in the presentation of their answers.
The figures in the parenthesis indicate the marks for respective question.
Attempt all the questions
Section A
Attempt all questions
Each question carries 6 marks [5 x 6 =30]
1. You have to pay $12,000 a year in school fees at the end of each of the next six years. If the
interest rate is 8%, how much do you need to set aside today to cover these bills?
[3]
Answer:
Find out the PV of $ 12,000 as 6 years annuity. Answer – $ Rs 55476
You have invested $60,476 at 8%. After paying the above school fees, how much would remain at
the end of the six years?
[3]
Answer:
$ 60,476 and $ 55476 are at the same point of time and hence law of subtraction applies
Difference is $ 5,000. Find out the FV of $ 5000 after 6 years.
Answer - $ 7934.37
2. Jill has $40,000 on hand and expects her income next year to be $48,000. She would like to
consume $50,000 today by borrowing the additional $10,000 from a bank at the market rate of
20%. A friend, however, suggests that she should instead borrow $15,000 from the bank and
invest the additional $5,000 in an investment project that will return $12,000 in one year. The
friend believes that this will make Jill better off. What should Jill do?
Answer:
If Jill borrows $10,000 at 20 % to satisfy her consumption plan, then next year she will pay back
$12,000 (=$10,000 × 1.20) and have $36,000 (=$48,000 - $12,000) to consume. On the other hand, if
she follows her friend's advise and borrows $15,000 and invests $5,000 in the project, then next year
she will pay back $18,000 (=$15,000×1.20) and will be able to consume $42,000 (=$48,000 +
1|Page
$12,000 - $18,000). Thus, by investing in the project Jill can consume the same today and an
additional $6,000 next year.
3. A 10 year, 12 % semiannual coupon bond, with a par value of Rs 1,000 may be called in 4 years at a
call price of Rs 1,060. The bond sells for Rs 1,100 (Assume that the bond has just been issued)
a) What is the bond’s approx YTM ?
[2]
b) What is the bond’s current yield?
[1]
c) What is the bond’s capital gain or loss yield?
[1]
d) What is the bond’s approx yield to call?
[2]
Answer:
M-P 

C  n 
a) Approx YTM  
to get AYTM = 10.31%
M  2P 


3


b) Current Yield = C / P = 120/1100 = 10.91%. Or find out semiannual current yield by using C
= 60 and later multiplying the rate by 2 to make it annual.
c) Capital Gain/Loss Yield = YTM – Current Yield = 10.31% - 10.91% = (0.79%) Loss.
Capital gain or loss yield should also be always reported on annual form.
d)
Call Price - P 

C



n
= 10.12%
Approx YTC  
Call price  2P 


3


Alternatively, you can find YTM by using semiannual data, C = 60, n = 20 and then report the answer
in annual form by multiplying the semiannual YTM by 2. Same can be done in case of YTC using C=
60, n = 8 and them multiplying the rate by 2 to make it annual percentage rate.
4. Phoenix Company borrows Rs 500,000 at an interest rate of 14 %. The loan is to be repaid in 4
equal installments payable at the end of each of the next 4 years. Prepare a loan amortization
schedule.
Answer:
Equated annual installment
= 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585
Loan Amortisation Schedule
Beginning
2|Page
Annual
Principal
Remaining
Year
1
2
3
4
amount
500000
398415
282608
150588
installment
171585
171585
171585
171585
Interest repaid
70000
55778
39565
21082
balance
101585
115807
132020
150503
398415
282608
150588
85*
(*) rounding off error
5. Parnelli Product’s stock is currently selling for Rs 45 a share. The firm is earning Rs 5 per share
and is expected to pay a year-end dividend of Rs 1.80.
a) If investors require a 12% return, what rate of growth must be expected for Parnelli ? [3]
Answer:
Price = 45, D1 = 1.80, Ke = 0.12. Use constant growth model of stock valuation.
Answer – 8%
b) If Parnelli reinvests retained earnings to yield the expected rate of return, what will be the
next year’s EPS ?
[3]
Answer:
Dividend Payout Ratio being constant, EPS growth rate will be equal to dividend growth rate.
Next year’s EPS = 8% more than Rs 5. Answer = Rs 5.4
Alternative way,
EPS 1 = EPS 0 + Retained earning per share x Rate of return
EPS 1 = Rs 5 + 3.2 x 0.12 = Rs 5.4
Section B
Attempt any three questions
Each question carries 15 marks [3 x 15 = 45]
6. The Tanner Company’s cost of equity is 18%. Tanner’s before tax cost of debt is 12%, and its tax
rate is 40%. Using the following balance sheet, calculate Tanner’s after tax weighted average cost
of capital. (Assume that this accounting balance sheet also represents Tanner’s target capital
structure) – All figures are in Ten thousands.
Assets
Amount Liabilities
Amount
3|Page
Cash
Accounts Receivables
Inventories
Plant and Equipment, net
Total Assets
Rs 100
200
300
1800
Rs 2400
Accounts Payable
Accrued taxes due
Long term debt
Equity
Total Liabilities
Rs 200
200
400
1600
Rs 2400
Answer:
While computing D/E ratio or D/V and E/V ratio, we always use only long term capital (debt, pref
stock, equity). So D = 400 and E = 1600 in this case and V = sum of both = 2000
Thus, we get Wd = 0.2 and We = 0.8. This will be used in all of the three problems, since its not
changing with question.
Kdat = 7.2 %, Ke = 18%. Hence we get WACC = 15.84%

Find out the average cost of capital of Tanner if it has Rs 2 million requirement of capital
and 20% of the equity is coming from retained earnings. Assume that the cost of retained
earnings is 18% and cost of new equity is 20% more than the cost of retained earnings.
Take all other things same as above.
Answer:
Here equity has two parts, retained earnings and new equity. Cost of retained earnings is 18% and
cost of new equity is 1.2 x 18% = 21.6 %. Part of retained earnings in equity is 20% and part of new
equity is 80%. Hence average cost of equity will be 20.88%.
Now use
Wd = 0.2 and We = 0.8 , Kdat = 7.2 %, Ke average = 21.6 %
To get the WACC = 18.144%

Find out the average cost of capital of Tanner if it has Rs 2 million requirement of capital
and Rs 0.3 million of the equity is coming from retained earnings. Assume that the cost of
retained earnings is 18% and cost of new equity is 20% more than the cost of retained
earnings. Take all other things same as above.
Answer:
Here also equity has two parts, retained earnings and new equity. Cost of retained earnings is 18%
and cost of new equity is 1.2 x 18% = 21.6 %. Part of retained earnings in equity is 0.3/1.6 and part of
4|Page
new equity is 1.3/1.6 while 1.6 million is the part of equity. Hence average cost of equity will be
20.925%.
Now use
Wd = 0.2 and We = 0.8 , Kdat = 7.2 %, Ke average = 20.925 %
To get the WACC = 18.18%
7. Microtech Corporation is expanding rapidly, and it currently needs to retain all of its earnings.
Hence, it does not pay any dividends. However, investors expect Microtech to begin paying
dividend, with the first dividend of Rs 1.00 coming 3 years from today. The dividend should grow
rapidly at a rate of 50% per year during years 4 and 5. After year 5, the company should grow at a
constant rate of 8% per year. If the required return on the stock is 15%, what is the value of the
stock today?
Answer:
Here, D3 = 1, D4 = 1.5, D5 = 2.25 and D6 = 2.43. Using D6, find P5 (constant growth model with g
= 8% and r = 15%) = Rs 34.71.
Discount D3, D4, D5 and P5 with relevant PVIF (15%, n) to get P0 = Rs 19.89
[Note n =3, 4, 5 and 5, while discounting D3, D4, D5 and P5]

What is the value of the stock if first dividend next year is Rs 1.00 and it grows at 50%
per year for first two years, after two years, the company should grow at a constant
rate of 8% per year, and the required rate of return on the stock is 15%.
Answer:
Here, D1 = 1, D2 = 1.5 and D3 = 1.62. Using D3, find P2 = Rs 23.14.
Discount D1, D2 and P2 with relevant PVIF (15%, n) to get P0 = Rs 19.50

What is the value of the stock if the dividend paid two years ago was Rs 1.00 and it
has been growing at 50% rate since last five years, which will continue till next two
years. After two years, the company should grow at a constant rate of 8% per year, and
the required rate of return on the stock is 15%.
Answer,
Here, D-2 = 1, D-1 = 1.5, D0 = 2.25, D1 = 3.375, D2 = 5.0625, D3 = 5.4675.
Using D3, find P2 = Rs 78.107
Discount D1, D2 and P2 with relevant PVIF (15%, n) to get P0 = Rs 65.82
[Remember, the price of stock or any security means price at point 0 and its found out by only
discounting the future cash flows. Past cash flows has nothing to do with the present price. Past cash
flows can only serve as guide as in 2nd question, to find out the future cash flow pattern]
8. You are provided with the information below:
5|Page
Sales
Less: Variable costs
Less: Fixed Costs
EBIT
Less: Interest
EBT
Less: Tax
Net Income After
Tax
EPS
Rs 430,000
107,500
150,000
172,500
11,000
161,500
64,600
96,900
9.69
Required:
a. Calculate Degree of Operating Leverage, Financial Leverage and Combined Leverage [6]
Answer,
Use the normal formulae of DOL, DFL and DCL to find out the values of each as 1.869, 1.068 and
1.996 (lets say 2). Remember DCL = DOL x DFL
b. By how much the Sales should be increased, if EPS is to be doubled?
[2]
Measure of leverage that links EPS with Sales is DCL. DCL is 2 in this case. EPS to be doubled
means increase in EPS required is 100%. DCL = 2 means, 1% change in Sales brings 2% change in
EPS. Hence, to bring 100% increase in EPS, sales need to increase by 50% i.e. by Rs 215,000.
c. By how much the Sales should be increased, if EBIT is to be trippled ?
[2]
Measure of leverage that links EBIT with Sales is DOL. DOL is 1.869 in this case. EBIT to be
trippled means increase in EBIT required is 200%. DCL = 1.869 means, 1% change in Sales brings
1.869 % change in EPS. Hence, to bring 200% increase in EPS, sales need to increase by 107% i.e.
by Rs 890100.
d. What would be the impact of increasing fixed cost proportion in cost structure of the firm
on the operating leverage ? Show demonstration. And also show what would be the
percentage increased required in sales to double the EPS.
[2+3]
Answer:
Fixed cost proportion in cost structure is linked with operating leverage. Higher the fixed cost
proportion in cost structure, higher will be the operating leverage. Show one example of it.
9. Answer the followings:
a) What are the factors to be taken into consideration by Finance Manager in order to
maximize the wealth of shareholders ? Explain with examples.
b) What is agency problem and agency cost ? What can be the ways to prevent agency costs
in a profit making company ?
6|Page
Section C
The question carries 25 marks.
10. As an investment advisor, you have been approached by a client called Peter for advice on his
investment plan. He is 30 years old and has Rs.300,000 in his bank. He plans to work for 20 years
and retire at the age of 50, so that he can pursue his hobbies and travel widely in his postretirement period. His present salary is Rs.600,000 per year. He expects his salary to increase at
the rate of 12 percent per year until his retirement.
Peter has decided to invest his bank balance and future savings in a balanced mutual fund scheme
which he believes will provide a return of 10 percent per year. You concur with his assessment.
Peter seeks your help in answering several questions given below. In answering these questions,
ignore the tax factor.
(i)
Once he retires at the age of 50, he would like to withdraw Rs. 1,000,000 per year for his
consumption needs for the following 30 years (His life expectancy is 80 years). Each
annual withdrawal will be made at the beginning of the year. How much should be the
value of his investments be when he turns 50, to meet his retirement need?
[5]
(ii)
How much should Peter save each year for the next 20 years to be able to withdraw
Rs.1,000, 000 per year from the beginning of the 21st year for a period of 30 years?
Assume that the savings will occur at the end of each year. Remember that he already has
some bank balance. ( Approximate it to the nearest ‘000)
[10]
Peter needs 10,369,700 when he reaches the age of 50. His bank balance of Rs 300,000
will grow to:
300,000 (1.10)20 = 2,018,400
7|Page
(iii)
Suppose Peter wants to donate Rs.800,000 per year in the last 10 years of his life to a
charitable cause. Each donation would be made at the beginning of the year. Further, he
wants to bequeath Rs. 3,000,000 to his son at the end of his life. How much should he
have in his investment account when he reaches the age of 50 to meet this need for
donation and bequeathing? (Approximate it to the nearest ‘000.)
[10]
One more question:
Peter wants to find out the present value of his lifetime salary income. For the sake of simplicity,
assume that his current salary of Rs 600,000 will be paid exactly a year from now, and his salary is
paid annually. What is the present value of his lifetime salary income, if the discount rate applicable
to the same is 8 percent? Remember that Peter expects his salary to increase at the rate of 12 percent
per year until retirement.
[This is the case of Growing Annuity – Finite Time. The formula and example of such case can be
seen in the lecture slide of time value of money]
8|Page
Best of Luck
9|Page