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Question Paper

Treasury & Forex Management (MB3H1F) : January 2009


Section A : Basic Concepts (30 Marks)

• This section consists of questions with serial number 1 - 30.

• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.
1. Medwin Corp Ltd. has taken a loan of Rs.5 lakh from Secunderabad Bank at an interest rate of 12% per <Answer >
annum compounded monthly. If the loan is to be repaid along with interest in 60 equated monthly
installments (where the first installment is to be paid after one month from today and the interest is calculated
on the diminishing balances), the amount of installment will be
(a) Rs.14,213.22
(b) Rs.13,232.23
(c) Rs.12,253.21
(d) Rs.11,122.22
(e) Rs.10,203.32 .
2. The sinking fund factor is the inverse of >

(a) Capital Recovery Factor

(b) Future Value Interest Factor
(c) Future Value Interest Factor for Annuity
(d) Present Value Interest Factor for Annuity
(e) Present Value Interest Factor.
3. The stock of Excellent Housing Ltd., a housing finance company, sells for Rs.50 per share. The dividend <Answer >
likely to be paid after one year is Rs.2.50 per share and the price of the share after one year is expected to be
Rs.55. The return at the end of one year on the basis of the likely dividend and price per share will be
(a) 5%
(b) 10%
(c) 15%
(d) 20%
(e) 25%.
4. Beta Ltd. has recently paid a dividend of Rs.1.50 per share. If the required rate of return is 12% and the >
growth rate is 7%, the intrinsic value of the shares of Beta Ltd. is approximately
(a) Rs.28
(b) Rs.30
(c) Rs.32
(d) Rs.34
(e) Rs.36.
5. Consider the following data: >

Face value of a bond Rs.1,00,000

Issued at a discount of 10%
Time period of redemption 20 years
Coupon rate 12% p.a.
Redemption price Rs.1,10,000
The yield to maturity of the bond as per the approximation method is
(a) 10.0%
(b) 11.0%
(c) 11.9%
(d) 13.0%
(e) 13.7%.

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6. Which of the following is a leverage ratio? >

(a) Debt-assets ratio

(b) Current ratio
(c) Quick ratio
(d) Earning power
(e) Inventory turnover ratio.
7. Ferroiron Alloys Limited is planning for a new plant in Orissa with an initial outlay of Rs.45 billion. This <Answer
plant has a life of 5 years. Expected cash inflows from this project are as follows:
(Rs. in billion)
Year 1 2 3 4 5
Cash inflows 11.00 13.50 15.50 13.00 16.50

If the opportunity cost of capital of the company is 14%, the net present value (NPV) of the project is
(a) – Rs. 9.16 billion
(b) Rs. 1.77 billion
(c) Rs. 7.31 billion
(d) Rs.15.96 billion
(e) Rs.24.50 billion.
8. The current ratio and quick ratio of JC industries Ltd., are 1.2 and 0.8 respectively. The net working capital of <Answer
the firm is Rs.5,00,000 with an inventory of
(a) Rs. 7.50 lakh
(b) Rs. 9.20 lakh
(c) Rs.10.00 lakh
(d) Rs.12.10 lakh
(e) Rs.14.55 lakh.
9. Which of the following is not an assumption of the theory of absolute advantage? >

(a) The trade between two countries take place only in those situations where both countries enjoy
absolute advantage in the production of at least one product
(b) The transportation cost involved in selling a commodity are either non-existent or insignificant
(c) The prices are comparable across countries
(d) The exchange rates are stable
(e) Labor is not mobile between products.
10 According to the dynamic view of working capital >
I. Gross working capital is defined as the total of all current assets.
II. Net working capital is the difference between total current assets and total current liabilities.
III. Working capital is the amount of capital required for the smooth flow of the normal business operations
of the company.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
11.Which of the following is true when the level of inventory is increased? >

(a) Ordering costs decrease but carrying costs increase

(b) Carrying costs increase but ordering costs remain the same
(c) Both ordering and carrying costs increase
(d) Both ordering and carrying costs decrease
(e) Carrying costs decrease but ordering costs increases.

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12 Which of the following is/are the objective(s) of companies making credit sales? >
I. Increasing total sales.
II. Increasing profits as a result of increase in sales.
III. To ward off competition.
IV. To increase market share.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) (I), (II) and (III) above
(e) All (I), (II), (III) and (IV) above.
13 Other things remaining the same, which of the following will generally result as a consequence of making the <Answer
. credit standards more stringent?

(a) More bad debt losses

(b) Increase in the number of customers
(c) Higher sales turnover
(d) Reduction of the outstanding debtors in the balance sheet
(e) Incremental cost of collection of the receivables.
14 The market value of debt of a firm is Rs.40 lakh, that of equity is Rs.60 lakh and the costs of equity and debt >
. are 16% and 14% respectively. The net operating income for the firm, if the firm has 100% dividend payment
and no taxes is
(a) Rs.13.8 lakh
(b) Rs.14.2 lakh
(c) Rs.15.2 lakh
(d) Rs.15.8 lakh
(e) Rs.16.2 lakh.
15 Which of the following capital budgeting methods measures how long it takes to recover the initial <Answer
. investment in a project?

(a) Payback period

(b) Net present value
(c) Internal rate of return
(d) Accounting rate of return
(e) Annual capital charge.
16 Which of the following is not a common assumption in the Walter’s model and Gordon’s model on dividend <Answer
. policy?

(a) Retained earnings represent the only source of financing for the firm
(b) The rate of return on the firm’s investment is constant
(c) The cost of capital of the firm remains constant
(d) The firm has an infinite life
(e) The cost of capital is greater than the growth rate.
17 If a company appoints a number of skilled managers with a very high amount of compensation package, <Answer
. which of the following conditions may occur immediately after the appointment?

(a) The operating break-even point of the company will come down
(b) The company will be able to reach the financial break-even point easily
(c) The degree of operating leverage will be zero
(d) The degree of total leverage will reduce to zero
(e) The degree of total leverage will increase.

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18 Consider the following data: >
Opening stock of finished goods = Rs.2,82,000
Closing stock of finished goods = Rs.2,50,000
Cost of production = Rs.5,16,800
Selling, administration and financial expenditure = Rs. 2,950
Custom and excise duty = Rs. 5,000
Finished goods storage period for the company is (assuming 360 days in a year) approximately
(a) 39 days
(b) 153 days
(c) 172 days
(d) 192 days
(e) 365 days.
19 Anmole Dairy Products Ltd. was offered credit on the terms 4/20, net 45. What is the cost of trade credit if payment <Answer
. is made after 20th day but before 45th day? (Assuming 360 days in a year)

(a) 25%
(b) 44%
(c) 60%
(d) 68%
(e) 72%.
20 Which of the following statements is not true with respect to repo? >
(a) The amount of activity in the repo market will increase the turnover of the money market, resulting in
an enhanced liquidity and depth in the market
(b) As a tool of financing the repo would cause an increase in the turnover in the debt market
(c) Repo enables the traders to take convenient positions to go short or long in the market, which results
in incresed activity of the debt market
(d) Institutions and corporates see repo as an expensive way of financing
(e) Repo is also useful to the Central Bank in the way they can use them as a part of their open market
21 Which of the following statements is/are true with respect to European Options? >
I. In these options writer’s liability is limited.
II. These options can be exercised at a specified time only.
III. These options can be exercised at any time.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
22 Coalmines Ltd., is a popular mining company whose iron ore reserves are being depleted and the cost of <Answer >
. recovering is rising each year. As a sequel to it, the company’s earnings and dividends are declining at a rate
of 8% p.a. If the previous year’s dividend was Rs.12 and the required rate of return is 16%, the current price
of equity share of the company is
(a) Rs.40
(b) Rs.46
(c) Rs.50
(d) Rs.55
(e) Rs.60.

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23 Radon Ltd., is planning to employ total assets of Rs.100 crore next year, 50% of assets being financed by <Answer
. borrowed capital at an interest rate of 15% p.a. The direct costs for the next year are estimated at Rs.50 crore
and all other operating expenses are estimated at Rs.80 lakh. The goods will be sold to customers at 150% of
direct costs. Income tax rate is assumed to be 45%. The net profit margin of company is
(a) 12.25%
(b) 11.02%
(c) 10.11%
(d) 9.32%
(e) 8.10%.
24 The following information is available for Beco Ltd.: >
EBIT Rs.20,00,000
Profit before Tax Rs.5,00,000
Fixed costs Rs.10,00,000
If the sales of the company are expected to increase by 7%, the percentage change in EPS will be
(a) 35%
(b) 42%
(c) 48%
(d) 52%
(e) 57%.
25 The following are the exchange rates quoted in New York: >
HK$/US$ : 7.7891/94
DKr/US$ : 5.8517/20
The synthetic rates of DKr/HK$ are
(a) 11.9714/16
(b) 11.8171/73
(c) 0.7512/15
(d) 0.7512/13
(e) 0.7510/13.
26 Consider the following: >
One year euro interest rate is 3% (compounded quarterly)
One year dollar interest rate is 5% (compounded quarterly)
The forward six months exchange rate is $1.2788/€.
According to interest rate parity, the spot exchange rate is
(a) $1.2725/€
(b) $1.2915/€
(c) $1.2824/€
(d) $1.2919/€
(e) $1.2722/€.
27 Which of the following statements is/are false regarding the assumptions of standard Economic Order <Answer
. Quantity (EOQ) model?

I. The demand for a given period is known.

II. There may be delays in placing and receiving order.
III. There are two costs associated with inventories i.e. carrying cost and ordering cost and the cost per order
is constant.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.

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28 Which of the following statements is false with respect to determination of costs and benefits of a project? >
(a) The cash flows must be determined in incremental terms
(b) All costs and benefits must be measured in terms of cash flows
(c) Interest on long term funds must be excluded from the determination of net cash flows
(d) All accrued revenues and costs must be considered as benefits and costs respectively
(e) Cash flows are to be defined by duly considering the impact of taxes.
29 Which of the following is an example of a tariff barrier? >
(a) Quota
(b) Transit duty
(c) Embargo
(d) Voluntary Export Restraint
(e) Subsidies to local goods.
30 Which of the following guarantees is issued by Export Credit Guarantee Corporation, at the option of the <Answer>
. bank, either to cover political risk alone or moratorium which may delay or prevent the transfer of funds to
the bank in India are covered?
(a) Export finance guarantee
(b) Export performance guarantee
(c) Export production finance guarantee
(d) Export finance (overseas lending) guarantee
(e) Transfer guarantee.
Treasury & Forex Management (MB3H1F) : January 2009
Section B : Problems/Caselet (50 Marks)

• This section consists of questions with serial number 1 – 6.

• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanation should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. Mr. Sameer is planning to purchase a house which costs Rs.8,00,000. He has contacted two
housing finance companies viz, Best Finance Ltd. (BFL) and Parag Finance Ltd. (PFL). BFL has
offered 100% financing for a period of 7 years. Mr. Sameer has to repay the loan along with
interest in equated monthly installments of Rs.18,500 each, payable at the end of every month
over a period of 7 years.
PFL has offered to provide 90% finance for a period of 8 years. Mr. Sameer has to bring in 10%
of the cost of the house at the time of purchase. He will borrow the amount of his contribution
from one of his relatives and will pay back his relative Rs.40,000 and Rs.50,000 (which include
the amount borrowed and the interest) at the end of the first year and the second year respectively.
The amount borrowed from PFL has to be repaid along with interest in equated monthly
installments of Rs.12,800 each, payable at the end of every month over a period of 8 years.
You are required to find out the effective rates of interest for both the financing alternatives and
advise Mr. Sameer accordingly. ( 10marks)
2. Pallavi Saree Ltd. is considering a project which will entail the following revenues and expenses:
(Rs. in lakh)
Year 1 2 3 4 5
Sales 75 75 100 100 100
Operating cost 25 30 50 50 55
Depreciation 5 5 5 5 5
Interest on short term bank loan 5 5 5 5 5
Interest on term loan 1.30 1.04 0.78 0.52 0.26
The tax rate applicable to the company is 30%. The project involves the following outlays:

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(Rs. in lakh)
Plant and Machinery 80.00
Working capital 45.00
Total outlay 125.00
The proposed scheme of financing is given below:
(Rs. in lakh)
Equity capital 80.00
Term loan 10.00
Short term bank loan 35.00
Total financing 125.00
At the end of 5 years the net salvage value of the current assets will be equal to their book value
and the net salvage value of the fixed assets will be equal to Rs.5 lakh. The short term bank loan
will be repaid at the end of 5 years and the term loan will be repaid over the life of the project in
equal installments. The cost of capital for the project is 20%.
You are required to derive the net cash flows relating to the long term funds invested in the
1 marks
project. (0 )
3.The capital structure of Electrum Ltd., consists of ordinary share capital of Rs.10,00,000 (shares
of Rs.100 each) and Rs.10,00,000 of 10% debentures. The selling price is Rs.10 per unit, variable
cost amounts to Rs.6 per unit and fixed expenses amount to Rs.2,00,000. The income tax rate is
assumed to be 45%. The sales level is expected to increase from 1,00,000 units to 1,20,000 units.
You are required to calculate:
i. The percentage increase in earnings per share.
ii. The degree of financial leverage at 1,00,000 units and 1,20,000 units.
iii. The degree of operating leverage at 1,00,000 units and 1,20,000 units. ( 6 marks)
4.An Indian importer has a payable of £2 million. The seller has given the Indian importer the
following two options:
i. Pay immediately with a cash discount of 1% on the payable.
ii. Pay after 3 months with interest at 5% p.a.
The borrowing rate for the importer in rupees is 12% p.a. The following are the exchange rates as
on January 02, 2009:
Rs/£ Spot 80.90 / 92
3 months forward 80 / 82 paise
Which of the above two options is advisable for the importer? ( 6 marks)

Read the caselet carefully and answer the following questions:
5.The international flows of capital have become everyday fact of life in the international economy
and most of the capital flows are in the form of Foreign Direct Investment (FDI). Explain the
major determinants that influence the flow of FDI into a country. ( 9 marks)
6.Today FDI has become most important source of private development financing for developing
countries. In this context, discuss the various benefits offered by FDI to the host country. ( 9 marks)
Developing countries, emerging economies and countries in transition increasingly view Foreign
Direct Investment (FDI) as a source of economic development and modernization, income growth
and employment. Countries are on a spree to relax rules and regulations in order to attract more
Foreign Direct Investment. FDI is the investment made in physical assets by a domestic investor
in a foreign country, solely guided by the long term prospects for making profits by exercising the
managerial control over the investment. While portfolio investment is made by the investor in
financial assets, often motivated by short-term profit considerations FDI is of long-term
investment. Developing countries evince interest to tap FDI to promote economic growth.
When China was admitted into the WTO in December 2001, it accepted to liberalize trade rules
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and regulations. The liberalization process initiated by China yielded handsome gains to the
country in the form of huge FDI inflows. Besides this, Chinese authorities aptly and rightly
imposed one-child-per family norm in 1978 which increased the middle class segment in the
population and the disposal incomes. It is said that this policy has prevented 250 million births
approximately giving rise to, what is known as ‘little emperor’ syndrome. Every child is
supported by parents and grand parents. It is fair to expect that the next generation of Chinese
will grow up healthy and better educated than their elders. This helps to have more disposal
incomes. Availability of skilled labor at low cost is the key to success of China to attract more
FDI, since liberalization alone can not help to attract FDI.
Some of the top MNCs in China are doing exceedingly well in their operations and this prompted
other MNCs to look to China for business development. These MNCs are:
Company Headquarters
Wal-Mart USA
Proctor & Gamble USA
Gillette USA
Eastern Kodak USA
Unilever Netherlands
Heineken Netherlands
Metro A.G. Germany
Carretons France
80% of Wal-mart suppliers are in China. Wal-Mart spends $15 billion in China and it has 31
stores in 15 Chinese cities. China continues to maintain its position as the number one in
attracting FDI in the world, while US and India could occupy number two and three positions

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 7 - 8.

• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on Section C.
7. Any investor facing the foreign exchange risk would like to remove or at
least cut down the size of risk. This can be done by using certain hedging
techniques like currency hedging. Explain various techniques that commonly
used to hedge the currency exposure.
( 10 marks)
8. The total sales of a Biopharma Ltd. at the end of the year are Rs.200 Crore
and operating expense are Rs.170 Crore. Suppose, on an average the
company has approximately Rs.10 lakh surplus cash per day in its accounts.
Discuss various avenues that are available to Biopharma where such excess
cash can be deployed to earn profits while meeting the objectives of liquidity.
( 10 marks)
Suggested Answers
Treasury & Forex Management (MB3H1F) : January 2009
Section A : Basic Concepts
Answer Reason

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1. D The amount of equated half yearly installment will be < TOP >

Rs.500, 000 Rs.500, 000

= = Rs.11,122.22
= PVIFA(1%, 60months) 44.955 .
2. C i < TOP >
Sinking Fund Factor = (1 + i) − 1 = FVIFA .

i(1 + i)n

Capital recovery factor = (1 + i)n − 1

Therefore capital recovery factor is the inverse of Present value interest factor for
Future value interest factor = (1 + i) .

(1 + i)n − 1

Present value interest factor for annuity = (1 + i)n × i

Present value interest factor = (1 + i) , i.e. present value interest factor is the inverse
of the Future value interest factor.
3. C P −P +D < TOP >
t t −1 t
Holding period return is given as r = t −1
Here Pt = Rs.55, Pt-1 = Rs.50, Dt = Rs.2.50
55 − 50 + 2.50
r= × 100 = 15 percent
So, 50
4. C D D (1 + g) < TOP >
1 = 0 (1.50) (1.07)
k −g k −g (0.12 − 0.07)
Intrinsic value of a share = e e =
= Rs.32.10 ≅ Rs.32.
D0 = Current year dividend
D1 = Expected dividend after year
G = Growth rate
Ke = Cost of capital

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5. D I + (F − P) / n < TOP >

Approximate YTM is calculated as (F + P) / 2

I is the interest paid during the year
F is the redemption price
P is the Issue Price, and
n is the maturity period.
In the given case, approximate YTM
1, 00, 000 × 0.12 + (1,10, 000 − 1, 00, 000 × 0.9) / 20
= (1,10, 000 + 1, 00, 000 × 0.9) / 2

12, 000 + (1,10, 000 − 90, 000) / 20

= (1,10, 000 + 90, 000) / 2

13, 000
= 1, 00, 000 = 0.13 = 13%.

6. A Leverage ratios indicate the long term solvency of the firm. Leverage ratio may be < TOP >
expressed as a ratio between the amount of debt and the amount of assets; hence (a) is
the answer. (b) and (c) represent liquidity ratios – current ratio and quick ratio; hence
(b) and (c) are not the answer. Earning power is the ratio of EBIT to the amount of
assets and it is a measure of the operating profitability; hence (d) is not the answer.
Inventory turnover ratio is a liquidity ratio which measures the efficiency with which
the inventories are used; Hence (e) is not the answer.
7. B 11.00 13.50 15.50 13.00 16.50 < TOP >
+ + + +
1.14 2 3 4 5
NPV = – 45 + (1.14) (1.14) (1.14) (1.14)
= – 45 + 9.65 + 10.39 + 10.46 + 7.70 + 8.57
= Rs.1.77 billion approximately.
8. C Given CA/CL = 1.2 and (CA – Inventory)/CL = 0.8 < TOP >
Net working capital = CA – CL = Rs.5,00,000
1.2 CL – CL = 5,00,000
CL = Rs.25,00,000
CA = 1.2 x 25,00,000 = Rs.30,00,000
Now, (30,00,000 – Inventory)/25,00,000 = 0.8
30,00,000 – Inventory = 0.8 x 25,00,000
Inventory = Rs.10,00,000.
9. E One of the major assumptions of the theory is mobility and adaptability of labor < TOP >
between products.
The others are also assumptions of the theory.
10. C According to the Dynamic View, working capital can be viewed as the amount of < TOP >
capital required for smooth and uninterrupted functioning of the normal business
operations of a company ranging from the procurement of raw materials, converting
the same into finished products for sale and realizing cash along with profit from the
accounts receivables that arise from the sale of finished goods on credit.
11. A When the level of inventory is increased the ordering costs decrease as the number of < TOP >
orders come down but the carrying cost increase as a larger quantity of inventory has
to be maintained.
12. E All the given alternatives are objectives of companies making credit sales. < TOP >

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13. D Making the credit standards more stringent one will result in lower volume of sales < TOP >
turnover thereby decreasing the collection costs due to the reduced number of
customers which in turn reduces the bad debt losses. As a consequence of the above
event, the outstanding debtors in the balance sheet will also come down.
14. C Ko = O/V = Net operating income/Market value of the firm. < TOP >
Also, Ko = Kd(B/B  +  S) + Ke (S/B + S) = 0.14 (40/100) + 0.16 (60/100) = 0.056 + 0.096
= 0.152
Net operating income = Ko x Market value of the firm = 0.152 x 100 lakhs = 15.2
15. A Payback period method of capital budgeting measures how long it takes to recover the < TOP >
initial investment in a project.
16. E Only Gordon model assumes that the cost of capital is greater than the growth rate. < TOP >

17. E Appointment of the managers at a very high compensation package will increase the < TOP >
fixed cost of the company thereby decreasing the denominator of the DOL, DFL and
DTL. As a result of this, these leverages will go up. So, the operating break even
point and the financial break even point will increase.
18. C Rs.2,82, 000 + 2,50, 000 < TOP >

Average stock of finished goods = 2

= Rs.2,66,000
Cost of sales = Opening stock of finished goods + Cost of production + Selling
administration of financial expenditure + Custom and Excise
duly – Closing stock of finished goods.
= 2,82,000 + 5,16800 + 2,950 + 5,000 – 2,50,000
= Rs.5,56,750
Daily cost of sales = 360 = Rs.1546.53
Average stock of finished goods
The finished goods storage period = Daily cos t of sales

2, 66, 000
= 1546.53 = 172 days approximately.
19. C < TOP >
Rate of discount Number of days in a year
Cost of trade credit = 1-Rate of discount (Credit period-Discount period)

0.04 360
x = 0.60 = 60%
= 1-0.04 (45-20)

20. D Following statements are true with respect to repos: < TOP >
• The amount of activity in the repo market will increase the turnover of the
money market, resulting in the enhanced liquidity and depth in the market
• As a tool of financing the repos would cause an increase in the turnover in the
debt market
• Repos enable the traders to take convenient positions to go short and or long in
the market and the activity of the debt market increases
• Institutions and corporates see repos an inexpensive way of financing and can
borrow and invest at market rates
• Repos are also useful to the Central Bank in the way they can use them as apart
of their open market operations.
21. B European Options options can be exercised at a specified time only whereas < TOP >
American options options can be exercised at any time

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22. B g = -0.08 < TOP >
D = 12 (1-0.08 ) = Rs.11.04
D 11.04 11.04
P = 1 = = = Rs.46
0 K − g 0.16 − (−0.08) 0.24
23. A (Rs. Crore) < TOP >
Sales (150% of 50 Crore) 75.00
Less: Direct Costs 50.00
Gross profit 25.00
Less operating expenses 0.80
EBIT 24.20
Less: Interest (15% on Rs. 50 Crore) 7.50
PBT 16.70
PAT 9.185
= 0.1225 = 12.25%
Net Profit Margin = 75
24. B Operating Leverage (OL) = < TOP >
Contribution 20, 00, 000 + 10, 00, 000 30, 00, 000
= = = 1.5
EBIT 20, 00, 000 20, 00, 000
EBIT 20, 00, 000
= =4
Financial Leverage (FL) = PBT 5, 00, 000
Combined leverage = OL × FL = 1.5 × 4 = 6
Therefore, percentage change in EPS = 7 × 6 = 42%

25. D DKr 1 1 < TOP >

DKr (bid) = 5.8517 × = 0.7512
HK$ bid = US$ × HK$ / US$ (ask) 7.7894

DKr DKr 1 1
ask = ask × US$ ( bid ) = 5.8520 × = 0.7513
HK$ US$ HK$ 7.7891
26. E 2 2 < TOP >
⎛ 0.05 ⎞ 1 ⎛ 0.03 ⎞
⎜1 + ⎟ ⎜1 + ⎟ × 1.2788
⎝ 4 ⎠ = S⎝ 4 ⎠
S = Spot exchange rate

⎛ 0.03 ⎞
⎜1 + ⎟
⎝ 4 ⎠
× 1.2788
⎛ 0.05 ⎞
⎜1 + ⎟
S= ⎝ 4 ⎠
× 1.2788 = $1.2725
S = 1.0125
S = $1.2725 €.
27. B The assumptions of standard EOQ are: < TOP >
• The demand for a given period usually one year is known.
• Inventory orders can be replenished immediately i.e. there are no delays in
placing and receiving orders.
• There are two costs associated with inventories i.e. carrying cost and ordering
cost and the cost per order is constant.

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28. D According to the principles followed for the determination of the costs and benefits of < TOP >
a project, only the cash inflows and outflows are taken as benefits and costs. All
revenues generated from the implementation of the project may not lead to the actual
cash inflows while all expenses to be incurred may not result in actual cash outflows
due to the project. The other statements as mentioned in the other options are correct
for determining the costs and benefits of a project.
29. B Options in (a), (c), (d) and (e) are examples of non-tariff barriers. Transit duty is a < TOP >
tariff barrier.
30. E Transfer guarantee is issued at the option of the bank either to cover political risk < TOP >
alone or moratorium which may delay or prevent the transfer of funds to the bank in
India are covered.

Treasury & Forex Management (MB3H1F) : January 2009

Section B : Problems/Caselet
1. Cost of house = Rs.8,00,000 <
Financing by BFL: TOP
Let the interest rate per month be ‘r’
Number of months for which payments have to be made to BFL = 7 × 12 = 84
Amount payable at the end of every month to BFL = Rs.18,500
∴ 8,00,000 = 18,500 PVIFA(r, 84)
or PVIFA = 18500 = 43.243
(1.017)84 − 1
For, r = 1.7%, PVIFA = 0.017(1.017) = 44.548
(1.018)84 − 1
For, r = 1.8%, PVIFA = 0.018(1.018) = 43.141
(1.8 − 1.7)
1.7 + × (43.243 − 44.548)
∴ r= (43.141 − 44.548) = 1.793%
Effective interest rate = (1 + r) – 1 = (1.01793)12 – 1 = 23.77% p.a. (approx.)

Financing by PFL and relative of Mr. Sameer :

Let the interest rate be ‘r’.
Amount of finance from PFL = 8,00,000 × 0.90 = Rs.7,20,000
Amount of finance from relative = Rs.80,000
Total amount of financing = Rs.7,20,000 + Rs.80,000 = Rs.8,00,000
Amount payable at the end of every month to PFL = Rs.12,800
Number of months for which payments have to be made to PFL = 8 × 12 = 96 months
Amount payable to relative :
At the end of one year (i.e. 12 months) = Rs.40,000
At the end of two years (i.e. 24 months) = Rs.50,000
40, 000 50, 000
12,800 PVIFA (r, 96) + (1 + r) (1 + r) 24
∴ 8,00,000 =
(1.012)96 − 1 40000 50000
+ +
Let r = 1.2%, ∴ RHS = 12800 × 0.012(1.012) (1.012)12 (1.012) 24
= 12800 × 56.818 + 34665.2 + 37552.4

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= Rs.7,99,488
(1.011)96 − 1 40000 50000
+ +
r = 1.1% ∴ RHS = 12800 × 0.011(1.011) (1.011)12 (1.011) 24
= 12800 × 59.104 + 35078.9 + 38454.1 = Rs.830064.2
(1.2 − 1.1)
∴ r = 1.1 + (799488 − 830064.2) × (800000 – 830064.2) =
∴ Effective interest rate per annum = (1 + r)12 – 1 = (1.01198)12 – 1 = 0.1536 i.e. 15.36%.
We find from above that if Mr. Sameer borrows 90% of the cost of the house from PFL and
borrows the remaining amount from his relative he faces a lesser effective rate of interest
(15.36% per annum) than the effective rate of interest (23.77% per annum) he faces if he
borrows 100% of the cost of the house from BFL. Hence he should borrow 90% of the cost of
the house from MFL and the remaining amount from his relative.
2. <
Year 0 1 2 3 4 5 TOP
A Investment1 (90) >
B Profit before tax2 40 35 40 40 35
C Tax (30%) (12) (10.5) (12) (12) (10.5)
D Profit after tax 28 24.5 28 28 24.5
E Net salvage value of fixed assets 5
F Net salvage value of current assets 45
G Repayment of short term bank loan (35)
H Initial flow (90)
I Operating flow 3 33 29.5 33 33 29.50
J Terminal flow (E + F – G) 15
K Net cash flow (H + I + J) (90) 33 29.5 33 33 44.5
Working notes:
1. Investment = Total long term funds invested in the project
= Equity capital + Term loan = 80 + 10 = Rs.90 lakh.
2. Profit before tax = Sales – Operating cost – Depreciation – Interest on short term bank
Interest on term loan has been excluded from the calculation of profit before tax (PBT) and
profit after tax (PAT) because the post tax cost of long term funds which is used for
discounting the net cash flows relating to long term funds, includes the post-tax cost of
term loan.
3. Operating flow = PAT + Depreciation
Depreciation = 5
∴ Operating flow = PAT + 5
3. <
Particulars 1,00,000 units 1,20,000 units TOP
(Amount in Rs.) (Amount in Rs.)
Sales at Rs.100 per unit 10,00,000 12,00,000
Less: variable costs at Rs. 10 per unit 6,00,000 7,20,000
Contribution 4,00,000 4,80,000
Less: fixed expenses 2,00,000 2,00,000
EBIT 2,00,000 2,2,80,000
Less: Interest on Debenturs 1,00,000 1,000,00
PBT 1,00,000 1,80,000
Less: Tax at 45% 45,000 22181,000
PAT 55,000 99,000
= Rs.5.50
i. EPS (10,000 shares) = 10000 (1,00,000 units)

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= Rs.9.90
EPS (10,000 shares) = 10000 (1,20,000 units)
9.9 − 5.50
= 0.80 = 80%
Therefore, %age increase = 5.50
ii. Degree of Financial leverage = 100000 ……for…….. (1,00,000 units)
= 1.56
Degree of Financial leverage = 180000 …for……(1,20,000 units)
iii. Degree of Operating leverage = 200000 ……for……… (1,00,000 units)
= 1.71
Degree of Operating leverage = 280000 …for……… (1,20,000 units)
4. Payable : £ 2 million <
Option 1 : Pay now, by availing a cash discount of 1% on the payable TOP
Amount payable is (1 – 0.01) × 2 = £ 1.98 million
Borrow at 12% for 3 months.
Amount to be borrowed
= 1.98 × 80.92 = Rs.160.2216 million
⎛ 0.12 ⎞ 2
⎜1 + ⎟ a +b

Rupee outflow after 3 months = 160.2216 ⎝ 4 ⎠

= Rs.165.0282 million
Option 2: Pay after 3 months.
⎛ 0.05 ⎞
⎜1 + ⎟
Payment = £ 2 million × ⎝ 4 ⎠
= £ 2.025 million
If covered in the forward market rupee outflow after 3 months will be
£2.025 × 80.82
= Rs.163.6605 millions.
Option 1 is beneficial to the Indian importer as the rupee outflow is lower. So the importer should
pay now by availing a cash discount of 1% on the payable.
5. The major determinants that influence the flow of FDI into a country are as follows: <
i. Repatriation of capital and profits TOP
Repatriation of capital and profits plays an important role in determining FDI inflows. If the
investor easily transfers the profit to the home country, then obviously the FDI flow will be
more and vice versa.
ii. Political and social stability
The political and social risk plays an important role in deciding FDI inflow. Even the host
country possesses abundant natural resources, if there is no political and social stability, FDI
will be less to the country. In general, so long as the foreign company is confident of being able
to operate profitably without undue risk to its investment, it will continue to invest.
iii. Rules regarding entry and operations
‘Open’ economies encourage more foreign investment. One indicator of openness is the relative
size of the export sector. Exports, particularly manufacturing exports, are a significant
determinant of FDI flows.
iv. Policies on functioning and structures of the market
There exist a well-established relationship between FDI and the size of the market (proxied by
the size of GDP) as well as some of its characteristics (for example, average income levels and
growth rates). For the majority of low-income countries which fail to attract large FDI flows,
their small domestic markets are often cited as the main deterrent. Given other economic and
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political shortcomings, most investors are doubtful about the value of installing a factory unless
they can achieve a `critical mass' for their products.
v. Privatization policy
Privatization has attracted foreign investment flows to countries. For low developed countries, a
number of structural problems are constraining the process of privatization. Financial markets in
most low- income countries are less competitive. They are characterised by inefficiencies, lack
of depth and transparency and the absence of regulatory procedures. They continue to be
dominated by government activity and are often protected from competition. Existing stock
markets are thin and illiquid and securitised debt is virtually non-existent. An under-developed
financial sector of this type inhibits privatisation and discourages foreign investors.
vi. Trade policy (tariff and non-tariff barriers)
If a country imposes high tariff and non-tariff barriers, then FDI flows into the country will be
less and vice-versa.
vii. Tax policy
Lower taxes have no major impact on FDI, particularly when they are seen as compensation for
continuing comparative disadvantages. On the other hand, removing restrictions and providing
good business operating conditions are generally believed to have a positive effect. The lack of
a clear-cut policy with respect to foreign investment and excessive delays in approval
procedures are amongst the most important deterrents.
viii. Labor policy and laws governing employment
If the trade union activities and rules related to labor laws are modest, then FDI inflows will be
The other macro economic variables which influence the FDI flows into a country include (i)
interest rates, (ii) exchange rates, (iii) inflation rate, (iv) quality of financial intermediation,
(v) availability of skilled labor at low cost.
6. FDI offers the following benefits to the host country. <
i. Expansion of trade and investment: TOP
FDI integrates the host economy more closely to the world economy due to substantial growth
in exports and imports. Consumers benefit from imports as it results in lower prices. As a
result it increases domestic consumption. Producers benefit from exports as it results in higher
prices. As a result it reduces domestic consumption.
ii. Transfer of sophisticated technology:
FDI aids in securing latest technology as MNCs spend huge-amounts on research and
development. This is beneficial to host country through technological spill overs.
iii. Enrichment of human capital:
FDI enhances human capital as MNCs provide training and on the job training to the employees
This in long run increases the human capital in the host country.
iv. Increases Competition:
The inflow of FDI makes a competitive environment in the host economy. This leads to higher
productivity, lower prices and efficient allocation of resources.
v. Builds a conducive environment for enterprise development:
FDI stimulates enterprise development in the host country. Further it helps to raise efficiency
and reduce costs in the targeted enterprise and the development of new activities. In addition,
efficiency gains may also arise in unrelated enterprises through demonstration effects and other
spill overs similar to those that lead to technology and human capital spill overs.
vi. Increases revenue to the host country as profits generated by MNCs are taxable.

Section C: Applied Theory

7. Some of the most common techniques to hedge the currency exposure using forward, futures, < TOP >
currency options and swaps are:
Using Currency Forwards
Foreign exchange exposure of any international investor can be hedged using forward
contracts. For example, assume that an investor has invested in German bonds and would like
to hedge his long position in bonds using the forward market. He can achieve this by buying
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forward contracts worth his investment in the forward market at a predetermined rate. In fact,
no exchange of money is required for this kind of hedging. The forward rate that he is paying
to the bank consists of the required commission on forward delivery of the currency.
Using Currency Futures
A futures contract is generally regarded as a guarantee to buy or sell a specified amount of a
specific currency or any other commodity at a fixed price by a particular fixed date. Now, for
example, a fund manager in the US is managing a fund, which has invested in Euro bonds
worth Euro 500,000 and wants to hedge his/her long position using the futures contract.
Assume that he/she is expecting to receive the maturity amount after 3 months and to hedge
his/her receivable exposure, he/she should sell $/e futures contract worth 500,000 Euro. For
this he/she will have to purchase four contracts as the standardized size of the futures is
125,000. If the three month e futures contract is selling at the rate of $1.15/6, the fund manager
can lock his/her receivables amount at the rate of $1.15/e by purchasing four contracts.
Irrespective of the rate of the $/e at the end of the 3 months, the fund manager will be sure of
getting $5,75,000 from his/her receivables from the investment in bonds. On the other hand, in
case the fund manager is required to pay a certain amount in foreign currency after a specified
time, he/she will have to purchase the specific currency futures contract so that his/her
obligation remains locked for a specific time.
Using Currency Options
While forwards and futures are the most effective instruments used to minimize the volatility
of an exposed foreign currency transaction, they may not be appropriate for all types of foreign
exchange risk management. Their biggest limitation is the fact that they do not provide the
opportunity to benefit from favorable foreign exchange movements. Currency options give the
holder the right, but not the obligation, to buy or sell a fixed amount of foreign currency at a
specified price, 'American' options are exercisable at any time prior to the expiry date, while
'European' options are exercisable only on the expiry date. Most currency options have
'American' exercise. Two kinds of foreign currency options can be used for the purpose of
hedging, namely call option which gives its buyer the right to buy a specified amount of
currency and put option which provides the owner the right to sell a specified amount of a
particular currency. It is important to understand the two characteristics of currency options.
Firstly, a call option with an exercise price specified in dollar which provides the right to buy
British pounds is almost equivalent to the put option on dollars with an exercise price quoted in
pounds. Secondly, the put-call parity principle applicable to the foreign currency option is
nothing but an extension of the interest rate parity principle.
Now, assume that an investor has invested in German bonds and is expecting g 500,000 three
months from now. He could buy a put option of Euro. Since Euro is standardized and one
contract value is equal to 125,000 per contract, he should buy four contracts of put options on
Euro. Just like option on other underlying securities, foreign currency options have different
strike prices and expiry dates. If the spot rate is 1.15, he can choose at the money option with a
strike price 1.15 and the expiry date for the option should be nearer to the bond maturity date.
The main drawback of using a currency option as a hedging instrument is that he has to pay for
the option he buys which may prove to be costly if forex rates fluctuate unfavorably. It is
possible that the three-month option described above may not give any benefit if it has a
premium of 0.0057 Euro. The actual cost of 4 Euro contracts would cost (125000 x 4 x
0.0057/e) = $2850. The portfolio manager has to think whether the exchange risk would cost
more than the payment for hedging it with currency options. However, many international
investment firms use the currency option to hedge their currency risk because futures are not
always preferable to options since options provide more flexibility and accuracy in changing
the characteristics' portfolios and returns. Moreover, there are various option strategies to
hedge the same kind of exposure.
Using Currency Swaps
The motivation behind the currency swap is the actual need for funds denominated in a
different currency. In a typical currency swap there are three steps involved.
They are:
i. Exchange of principal amount.
ii. Periodic interest payments to each other on the principal amount borrowed.
iii. Re-exchange of the principal amount borrowed.
A currency swap need not involve an initial exchange of principal if the parties involved are

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concerned about only periodic requirements of different currencies. In such a situation the
principal involved will be notional and only periodic interest payments will be exchanged
between the two parties concerned.
Assume that there are two firms A and B who are in need of dollar funds and sterling funds
respectively. A wants $100 million and B wants 65 million sterling.
The exchange rate is 0.65 £/S. They have access to the foreign currency market at the
following interest rates:
Firms Dollars Sterling
A 10.5% 11.8%
B 8.5% 11%
The above table shows that the firm B has an absolute advantage in both dollar and sterling
markets. But A has a comparative advantage in sterling market in relation to the dollar, as it has
to pay only 0.8% more in the sterling market as compared to 2.0% more in the dollar market.
Assume that A wants dollar funds and B wants sterling funds, a currency swap can be arranged
between them using the comparative advantage principle. So that A and B can reduce their
effective cost of borrowing to the extent of the available spread in different currency markets.
The spread can be calculated as follows:
The spread in the dollar market is 2% and that in the sterling market is 0.8%. The effective
swap spread is (2 - 0.8) = 1.2%. This is called quality spread differential. The two parties can
share this spread to their advantage in reducing their effective cost of borrowing in a number of
ways depending on the creditworthiness of each of them. If the spread is equally shared
between them, the effective cost of borrowing of each of them is reduced by 0.6% in the
respective markets in which they wish to borrow. Since A wants $ funds and its cost is 10.5%
by going in for a swap agreement with B, the cost can be reduced to 9.9%. Similarly, B's cost
of borrowing pounds can be reduced to 10.4%. The steps involved in the swap will be as
i. B borrows dollar funds at 8.5% and lends it to A at 9.9% (10.5- 0.6).
ii. A borrows sterling at 11.8% and lends it to B at 11.8%.
B is gaining 1.4% on dollar payments from A which can be used to pay the sterling borrowing
to A and hence the effective cost of B works out to be 10.4%.
The above example assumed that there was no intermediary, i.e., a swap dealer. But in practice,
a swap dealer arranges the swap agreement between the two potential parties. Assume that
there was a swap dealer who arrange the swap. The dealer charges a fee as commission for the
arrangement initiated by him. The spread differential worked out earlier will be shared between
the two parties and the dealer. A currency swap helps both the parties to achieve lower funding
rates in the desired markets.
8. The excess cash which is generated in the day-to-day operations of the firm could be invested < TOP >
in safe and easily marketable instruments like treasury bills, certificates of deposits,
commercial papers, units of UTI, etc. depending on the time horizon and safety requirements.
Treasury Bills
These are highly liquid in nature and Government of India guarantees their repayment. The
RBI acts as an agent for issuing T-bills and is always willing to discount them.
Based on the nature of the issue T-bills can be categorized into
a. On Tap Treasury Bills
b. Auctioned Treasury Bills.
On tap T-Bills are issued by RBI on tap to investors on any working day. These are issued at
a discount and redeemed at face value and the amount to be invested is unlimited. The bills
rediscounted by the RBI could be resold to the banks. However, an additional early
rediscounting fee was imposed on 91-day T-Bills, if the banks rediscounted them within 14
days of purchase. The 364-day T-Bills have higher yield coupled with liquidity and safety.
These are auctioned fortnightly but the amount is not specified in advance. The yield on
auctioned T-Bills is determined by the market on the basis of bids tendered and accepted at
the auction.
Certificates of Deposit (CDs)
CDs are short-term deposits, issued by banks, by way of usance promissory notes, having
maturity period between one month and one year. They are negotiable in nature, issued at a
Page 18 of 19
discount rate which is freely determined by the issuing bank, depending on the market.
Financial Institutions can issue CDs ranging from one year to three years. They are issued in
multiples of Rs.5 lakh subject to a minimum issue size of Rs.5 lakh.
Commercial Paper (CP)
CPs are short-term, unsecured promissory notes issued at a discount to the face value by well-
known companies enjoying a high credit rating. They have flexible maturities tailored to the
requirements of the borrowers and investors. The maturity varies from one month to one year
and are issued in multiples of Rs.5 lakh but the amount should not be less than Rs.25 lakh
by any single issuer. Neither prior approval from the RBI nor underwriting is mandatory for
their issue. The stamp duty on primary issue is 0.25% for all other investors and 0.05% for
banks. Their secondary market transactions do not attract any stamp duty.
CPs are freely transferable by endorsement and delivery.

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