OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) Net Interest income is (i) (ii) (iii) (iv)

Interest earned on advances Interest earned on investments Total interest earned on advances and investment Difference between interest earned and interest paid

Interest rate risk is a type of (i) (ii) (iii) (iv) Credit risk Market risk Operational risk All the above

European opinion can be exercised on any day at the option of the buyer on or before the expiry of the option. (i) (ii) True False

What is the beta factor for corporate finance under Standardized approach ? (i) (ii) (iii) (iv) 15% 18% 12% None of the above

A bank suffers loss due to adverse market movement of a security. The security was however held beyond the defeasance period. What is the type of the risk that the bank has suffered ? (i) (ii) (iii) (iv) Market Risk Operational Risk Market Liquidation Risk Credit Risk

The June 1999 Basle Committee on Banking Supervision issued proposals for reform of its 1988 Capital Accord (the Basle II Proposals). These proposals contained MAINLY. (I) (II) (III) (IV) (V) (VI) (i) (ii) (iii) (iv) Settlement risk management Capital requirements Supervisory review The handling of hedge funds Contingency plans Market discipline

I, III and VI II, IV and V I, IV and V II, III and VI

Which of the following is not a type of credit risk ? (i) (ii) (iii) (iv) Default risk Credit spread risk Intrinsic risk Basis risk

8% Government of India security is quoted at RS 120/- The current yield on the security, will be---(i) (ii) (iii) (iv) 12% 9.6% 6.7% 8%

Risk of a portfolio with over exposure in steel sector will be (i) (ii) (iii) (iv) More than systematic risk Equal to intrinsic risk Less than intrinsic risk None of these

A company declares RS 2/- dividend on the equity share of face value of RS 5/-. The share is quoted in the market at RS 80/- the dividend yield will be---(i) (ii) (iii) 20% 4% 40%

(iv)

2.5%

How many accounts have suffered rating migration in the following table Rating Migration of 100 A Rated Accounts Migration between 31.03.06 and 31.03.07 Last Rating A No. of Accounts 100 (i) (ii) (iii) (iv) 2 19 21 25 A++ 1 A+ 1 A 79 Present Rating B+ B 10 4 C 3 Default 2

The risk that arises due to worsening of credit quality is (i) (ii) (iii) (iv) Intrinsic Risk Credit spread Risk Portfolio risk Counterparty risk

A debenture of face value of As. 100 carries a coupon of 15%. If the current yield is 12.5%. What is the current market price ? (i) (ii) (iii) (iv) Rs.100 Rs.120 Rs.150 Rs.125

In order to develop an capability to actively manage an credit portfolio one must have in place the following: (a) Credit Rating Model (or models for different categories of loans and advances) (b) Develop and maintain necessary data on defaults of borrowers rating category wise, i.e., Rating Migration. (i) (ii) (iii) (iv) Both 1 and 2 are required Only 1 is required Only 2 is required None of the above

An increase in cash reserve ratio will cause yield curve to (i) (ii) (iii) (iv) Shift downward Remain unchanged Become steeper Become flatter

The model that combines five financial ratios using reported accounting information and equity values to produce on objective measure of borrowers financial health is (i) (ii) (iii) (iv) Altmans 2 score Credit Metrics Credit Risk + None of the above

A bank holds a security that is rated A+. The rating of the security migrates to A. What is the risk that the bank has faced ? (i) (ii) (iii) (iv) Market risk Operational risk Market liquidation risk Credit risk

When interest rates go up, prices of fixed interest bonds (i) (ii) (iii) Go up Go down Remain unchanged

VaR is not enough to assess market risk of a portfolio. Stress testing is desirable because (i) (ii) (iii) (iv) It helps in calibrating VaR module It helps as an additional risk measure It helps in assessing risk due to abnormal movement of market parameters It is used as VaR measure is not accurate enough

STUDY THE FOLLOWING STATEMENTS AND ANSWER

4

(COVERS ALL MODULES) (a) Bond with BBB rating will carry lower interest rate than one with AA rating i. False ii. True iii. Difficult to say (b) Fall in interest rate cause the rate causes the bond prices also to fall. i. False ii. True iii. Difficult to say A normal yield curve is sloping upward. i. False ii. True iii. Difficult to say (d) Stamp duty on transfer of dematted shares is lower. i. False ii. True iii. Difficult to say (e) Large Government borrowing can cause yield curve to shift upward. i. False ii. True iii. Difficult to say (f) Growth Funds assure growth in return. i. False ii. True iii. Difficult to say (g) If short term interest rates remain higher than the long term interest rates, the yield curve will be inverted. i. False ii. True iii. Difficult to say

(c)

(h)

Credit rating agencies determine interest rates on debt securities. i. False ii. True iii. Difficult to say

(i)

The shares of software companies carry high P/E ratio. i. False ii. True iii. Difficult to say

(j)

Closed end mutual funds are trading at discount to NAV. i. False ii. True iii. Difficult to say

(k)

In a rising interest rate phase Zero coupon bond will be traded at a premium i. False ii. True iii. Difficult to say

(l)

A sharp decline in short term interest rates will cause yield curve to be steeper i. False ii. True iii. Difficult to say

(m)

A fall in interest rates reduces the demand for bonds in the secondary market i. ii. iii. False True Difficult to say

(n)

Increase in the cash reserve ratio can cause the yield curve going temporarily inverted. i. ii. iii. False True Difficult to say

(o)

Dematerialization of stocks has increased turnover on the stock market. i. ii. iii. False True Difficult to say

(p)

Tight money and credit policy will cause bond prices to fall. i. ii. iii. False True Difficult to say

(q)

Increasing Government borrowing will raise interest rates. i. ii. iii. False True Difficult to say

(r)

Bond carrying AA rating will carry highest interest rate than one carrying BBB rating. i. ii. iii. False True Difficult to say

(s)

Mutual fund redemption bring bearish influence on the stock market. i. ii. iii. False True Difficult to say

(t)

Decline in the interest rates on long dated Govt. bonds will cause yield curve to be steeper. i. ii. iii. False True Difficult to say

(u)

Demat shares carry lower stamp duty on transfer than physical shares. i. ii. iii. False True Difficult to say

(v)

Increase in interest rates will cause bond prices to fall.

i. ii. iii. (w)

False True Difficult to say

Growth fund is a mutual fund that invests primarily in equity shares. i. ii. iii. False True Difficult to say

(x)

Stamp duty on transfer of demated shares is lowest. i. ii. iii. False True Difficult to say

(y)

Large Government borrowing in the market can make the yield curve shift upward. i. ii. iii. False True Difficult to say

(z)

Bond with A rating will carry higher interest rate than one carrying BBB rating. i. ii. iii. False True Difficult to say

OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) When the interest rates fall, the market price of a fixed rate bond (i) (ii) (iii) falls rises does not change

A transaction where financial securities are issued against the cash flow generated from a pool of assets is called (i) (ii) (iii) (iv) Securitization Credit Default Swaps Credit Linked Notes Total Return Swaps

Growth Fund is a mutual fund that (i) (ii) (iii) (iv) assures growth in income invests in fixed income securities gives fixed return invests primarily in equities

Operational Risk arises from 1) 2) 3) 4) Inadequate or failed internal processes People and systems External Events Defaults

Which of the following is true ? (i) (ii) (iii) (iv) All of them None of them (a) , (b) and (c) (a) , (b) and (e)

A decline in cash reserve ratio will cause the yield curve to (i) (ii) (iii) (iv) shift upward shift downward become flatter remain unchanged

The third consultative paper recommended for (a) Cause based classification (b) Effect based classification (c) Event based classification For operational risk. Which of the following is true (i) (ii) (a) None of them

(iii) (iv)

(c) (b)

12% Government of India security is quoted at Rs.120. If interest rates go down by 1%, the market price of the security will be..... (i) (ii) (iii) (iv) Rs. 120 Rs.133.3 Rs. 109 Rs. 140

Benefits of integrated risk frame work are: (a) To relate capital and reserves more effectively to their actual level of risk exposure. (b) To evaluate pricing decisions and product profitability. (c) In making risk transfer decisions. Which of the following is true ? (i) (ii) (iii) (iv) All of them None of them (a) and (b) (b) and (c)

Rewards of proper management of operational risks are (a) Lesser risk capital (b) Cost reductions in operations (c) Competitive edge Which of the following is true ? (i) (ii) (iii) (iv) All of them None of them (a) , (b) and (c) (a) and (b)

A fall in long term interest rates on Government securities will make the yield curve become (i) (ii) (iii) flatter steeper shift downward

10

A bank expects fall in price of a security if it sells it in the market. What is the risk that the bank is facing ? (i) (ii) (iii) (iv) (i) Market risk Operational risk Asset Liquidation risk Market liquidity risk An 8-year 8% semi-annual bond has a BPV of Rs.125. The yield on the bond has

11% Government of India security is quoted at Rs. 110, the yield will be (i) (ii) (iii) (iv) 11% 10% 9% None of these

1 day VaR of a portfolio is Rs.500,000 with 95% confidence level. In a period of six months (125 working days) how many times the loss on the portfolio may exceed Rs.500,000 ? (i) (ii) (iii) (iv) 4 days 5 days 6 days 7 days

A fall in interest rates will make prices of Government Securities (ii) (iii) (iv) (v) Go down Go up Remain unchanged None of these

Systemic risk the risk of (i) (ii) (iii) (iv) Failure of a bank, which is not adhering to regulations Failure of two banks simultaneously due to bankruptcy of one bank Where a group of banks fail due to contagion effect Failure of entire banking system

If the yield on long dated Govt. securities falls, then the yield curve will became:(i) (ii) Steeper Flatter

11

(iii)

Shift downward

11% Govt. of India security is quoted at Rs.110. If the interest rates go down by 1% the market price of the security will be (i) (ii) (iii) (iv) Rs.110 Rs.109 Rs.122.2 Rs.130

Balanced fund is a mutual fund that (i) (ii) (iii) (iv) Assures income Invests in debt and equity Assure growth Gives fixed returns

Back testing is done to (i) (ii) (iii) (iv) Test a model Compare model results and actual performance Record performance None of the above

Under Basel II, Capital requirement under the accord is (i) (ii) (iii) (iv) The maximum Capital that is required to be maintained The minimum Capital that is required to be maintained The capital as specified by the regulatory authority is required to be maintained None of the above

STUDY THE FOLLOWING STATEMENTS AND ANSWER (COVERS ALL MODULES) (aa) Fall in interest rates cause the prices of Govt. securities to go up. i. ii. iii. False True Difficult to say

12

(bb)

Steeper yield curve means long term interest rates are much lower than short term interest rates. i. ii. iii. False True Difficult to say

(cc)

Mutual fund mobilization has bearish influence on the stock market. i. ii. iii. False True Difficult to say

(dd)

Convertible debentures carry an element of equity shares. i. ii. iii. False True Difficult to say

(ee)

Credit Rating agencies fix interest rates on bonds or debentures issued by companies. i. ii. iii. False True Difficult to say

(ff)

Mutual Funds invest only in equity shares. i. ii. iii. False True Difficult to say

(gg)

Favorable monsoon brightens the prospects for stock market. i. ii. iii. False True Difficult to say

(hh)

Large Government borrowings cause debt securities prices to rise. i. ii. iii. False True Difficult to say

13

(ii)

Falling interest rates have benefited investors in debt securities mutual funds. i. ii. iii. False True Difficult to say

(jj)

Large government borrowing would cause interest rates to go down. i. ii. iii. False True Difficult to say

(kk)

Falling interest rates cause NAVs of debt mutual fund to go down. i. ii. iii. False True Difficult to say

(ll)

Bond with BBB rating will carry lower interest rates than one with A rating. i. ii. iii. False True Difficult to say

(mm) Money market mutual funds do not invest in equity shares. i. ii. iii. (nn) False True Difficult to say

SEBI gives credit rating to securities issued in the capital market. i. ii. iii. False True Difficult to say

(oo)

Mutual funds can offer guaranteed returns. i. ii. iii. False True Difficult to say

(pp)

Large government borrowings will cause interest rates to go up.

14

i. ii. iii. (qq)

False True Difficult to say

A mutual fund scheme; with a entry load will have its sale price higher than its NAV. i. ii. iii. False True Difficult to say

(rr)

Security with A rating will carry higher interest rate than one with BB rating. i. ii. iii. False True Difficult to say

OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) A fall in the interest rates causes Govt. Securities to (i) (ii) (iii) Remain stable Fall Rise

Capital charge for credit risk requires input for PD, LGD, EAD and M. Under advanced IRB approach, who provide the input for LGD. (i) (ii) (iii) (iv) Bank Supervisor Function provided by BCBS None of the above

A debenture of Rs.100 carrying 15% coupon rate is quoted in the market at Rs.135/-. The current yield on this debenture will be (i) (ii) (iii) (iv) 13.5% 15% 11.11% 10%

Investment in Post Office time deposit is

15

(i) (ii) (iii) (iv)

Zero risk investment Low risk investment Medium risk investment High risk investment

If the short term interest rates are temporarily higher than the long term interest rates, the yield curve will be (i) (ii) (iii) (iv) Sloping upward Inverted Zigzag Horizontal

Premature payment of a term loan will result in interest rate risk of type (i) Basis risk (ii) Yield curve risk (iii) Embedded option risk (iv) Mismatch risk A company with equity capital of Rs.50 crores (Face Value of Rs.10/- per share) makes gross profit of Rs.70 crores and net profit after tax of Rs.25 crores. If the market price of its equity share is Rs.50, the PE ratio will be (i) (ii) (iii) (iv) 50 5 10 20

Daily volatility of a stock is 1%. What is its 10 days volatility approximately ? (i) (ii) (iii) (iv) 3% 10% 1% 4%

If call money rates are temporarily higher than the long term interest rates, the yield curve will be (i) (ii) (iii) (iv) Slopping upwards Zigzag Inverted Horizontal

Capital charge component of pricing accounts for 1) Cost of capital

16

2) Internal generation of capital 3) Loss provision Which of the following is true.? (i) (ii) (iii) (iv) All the statements are correct Statements 1 and 2 are correct Statements 2 and 3 are correct Statements 3 and 1 are correct

Equity oriented mutual funds (i) (ii) (iii) (iv) Assure income Assure growth Invest in debentures Invest in shares

A bank funds its assets from a pool of composite liabilities. Apart from credit and operational risks, it faces (i) (ii) (iii) (iv) Basis risk Mismatch risk Market risk Liquidity risk

A branch sanctions Rs.1 core loan to a borrower, which of the following risks the branch is taking 1) 2) 3) 4) 5) (i) (ii) (iii) (iv) Liquidity risk Interest rate risk Market risk Credit risk Operational risk

All of them 1,2 and 3 only 1,4 and 5 only 1,2,4 and 5 only

A rise in Government securities prices will make yield curve (i) (ii) (iii) (iv) Slope upward Shift downward Remain stable Shift upward

17

Risk mitigation measures result in 1) Reducing downside variability 2) Reducing upside potential which of the following is true (i) Both the statements are correct (ii) Both the statements are not correct (iii) Statement 1 is correct (iv) Statement 2 is correct 9% Government of India security is quoted at Rs.120. The current yield on the security will be (i) (ii) (iii) (iv) 12% 9% 7.5% 13.3%

Financial Risk is defined as (i) (ii) (iii) (iv) Uncertainties resu1ting in adverse variation of profitability or outright losses Uncertainties that result in outright losses Uncertainties in cash flow Variations in net cash flows

Strategic Risk is a type of (i) (ii) (iii) (iv) Interest Rate Risk Operation Risk Liquidity Risk None of the above

Objective of liquidity management is to: (i) (ii) (iii) (iv) Ensure profitability Ensure liquidity Either of two Both

18

A mutual fund charges 1% entry load and no exit load. Its NAV is Rs.16; its sale and repurchase price will ----(i) (ii) (iii) (iv) Rs.16 and Rs.15.80 Rs.16.16 and Rs.15.84 Rs.15.84 and Rs.16 Rs.16.16 and Rs.16

Banks need liquidity to: (i) (ii) (iii) (iv) Meet deposit withdrawal Fund loan demands Both of them None of them OBJECTIVE TYPE QUESTIONS FOR PRACTICE (COVERS ALL MODULES) A fall in interest rate of long dated government securities with the short term interest rates remaining unchanged will make the yield curve. (i) (ii) (iii) (iv) Steeper Slop downward Shift downward Flatter

Adequacy of banks liquidity position depends upon: (i) (ii) (iii) (iv) Sources of funds Anticipated future funding needs Present and future earnings capacity All of the above

Current yield on a government security is 5%. If the market price of the bond is Rs.160, the coupon rate on the bond will ---(i) (ii) (iii) (iv) 6% 5% 8% 10%

Assets represent source of funds where as liabilities denote the use of funds in a balance sheet. (i) True

19

(ii) (iii)

False Difficult to say

Deregulated environment has narrowed spreads of the banks. (i) (ii) (iii) True False Difficult to say

Asset Liability management is only management of maturity mismatch and has no bearing on profit augmentation. (i) (ii) (iii) True False Difficult to say

A rise in the short term interest rates with the long term interest rates remaining unchanged will make the yield curve -----. (i) (ii) (iii) (iv) Steeper Shift upward Flatter Slope upward

Net Interest Margin is also known as Spread. (i) (ii) (iii) True False Difficult to say

A scheme of mutual fund has units with face value of Rs.10 and NAV of Rs.37. The Fund declares a dividend of 35% in the scheme. The ex-dividend NAV will be ------- per unit. (i) (ii) (iii) (iv) Rs.37 Rs.2 Rs.33.50 Rs.35.5

7.5% coupon interest Government Security is quoted at Rs.120. Its current yield will be ----------.

20

(i) (ii) (iii) (iv)

8.55% 6.25% 7.75% 7%

A company with equity capital of Rs.15 crores makes PBIDT of Rs.15 crores and PAT of Rs.10 crores. The face value of its share is Rs.5 and PE is 10, the market price will be ---------. (i) (ii) (iii) (iv) Rs.50 Rs.66 Rs.33 Rs.100

CASE STUDIES (COVERS ALL MODULES) 1. A company with equity of Rs.10 crore, earns PBIDT of Rs.30 crore. It incurs interest cost of Rs.35 crore depreciation of Rs.5 crore and pays Rs.10 crore as tax. It has reserve of Rs.30 crore (excluding current years profits) and long terms debt of Rs.35 crore. It pays 50% dividends and transfer remaining profit to reserves. Its share of Rs.10 face value is quoted at Rs.150/Find the following---(i) Earning per share PAT = ----------------- x 10 Equity = (ii) 30 (5 + 5 + 10) -------------------- x 10 = 10 10 ------- x 10 = Rs.10 10

Book value of share = Equity + Reserves = 10 + 30 + 5 = Rs.45

(iii)

Return on Net worth

21

PAT = ---------------NW 10 = -------------- x 100 45 = 22.2% (iv) Debt-equity ratio = 35: 45 = 7:9 (v) P/E ratio PE = MP / EPS (vi) Payout ratio Dividend = ----------PAT x 100 = 5 -------- x 100 = 50% 10 = 150 / 10 = 15

2. A company with equity of Rs. 10 crore earns PBIDT of Rs. 40 crore. It incurs interest of Rs.5 crore, depreciation of Rs. 5 crore and pays tax of Rs. 10 crore. It has reserves of Rs. 30 crore (Excluding current years profits) and long term debt of Rs. 50 crore. It pays 100% dividend and transfers remaining profit to reserves. Its share of Rs. 10 face value is quoted at price of Rs. 200. Find the following : (i) Book value of share after current year's profit transferred to reserves. Book Value = Equity + Reserves + Current years (PAT Div) = 10 + 30 + (20 10) = Rs..50 (ii) Earning per share EPS = PAT / Equity 20 --- x 10 40 ( 5+5+10) = ------------------ x 10 10

= Rs.20

22

(iii)

10 Return on net worth 40% Return on net worth = PAT x 100 -----------NW 50 ------ = 50 20 = ------- x 100 = 40% 50

(iv)

Debt-equity ratio 1:1 Debt equity ratio = 1:1

(v)

P/E ratio 10 M.P. = EPs x PE 200 = 20 x PE PE = 10

(vi)

Payout ratio 50% Dividend ----------PAT 10 = ---- = 50% 20

IMPORTANT KEY WORDS FOR PRACTICE Appreciation: An increase in the market value of an asset. Arbitrage: (i) Dealing between two centres to take advantage in the rate due to a temporary difference in the rates between two places. (ii) The simultaneous trading (purchase/sale OR sale/purchase) of assets to take advantage of price differentials. Asset creation: Acquisition of assets/ investments Balance sheet:

23

A Financial Statement that indicates the type and amount of assets, liabilities and Capital of a firm as on a particular date. Base currency: The currency against which another currency is quoted. [Eg. INR 39.4880/USDwherein INR is quoted currency and USD is base currency] B R: Bankers Receipt. This is a receipt issued by the Bond/ security selling bank when the original scrip/ Bond is not immediately deliverable for settlement. Bid: The price quoted by someone to buy the asset or borrow funds. Broker: Intermediaries who match buyers and sellers Or borrowers and lenders and receive a commission (brokerage) for such intermediation.

Concurrent auditor: A professional, generally an external guy (not a staff), who checks/ audits the day to day transactions and reports. His main task is to check whether the laid down systems/procedures/policy has been complied with, in each transaction and report the discrepancies to the Management. Cover: To take out forward contracts to protect against exchange fluctuation between todays date and due payment date. Deal: A transaction undertaken by the Dealer in the domestic market or Foreign Exchange market binding the Bank. Deal confirmation:
24

Written advice from one counterparty in a deal to the other in which the main terms and conditions of the deal are confirmed. Fixed rate currency: Currency having a fixed rate of exchange within narrow limits versus another reference currency, usually the dollar. Floating rate currency: Currency having its exchange rate determined by market forces including Central Bank intervention. Forex: Foreign Exchange. Forward contract: Any contract for settlement later than spot date. Forward-Forward deal: Simultaneous purchase and sale of one currency for different forward value dates. Funding of assets: Borrowing done, when assets are more than the Liabilities of the bank. Hedge: Action taken by the Bank to reduce or eliminate a risky exposure. Intra day position: Open position run by a dealer within the day. This is generally reduced to square or nearly so before close of business. Keeping arms length: Not to influence/interfere or get influenced/interfered. Liquidity risk:

25

The variation in net income and market value of bank equity caused by the banks difficulty in obtaining immediate funds, either by borrowing or selling assets. LIBOR: London Interbank Offered Ratethe rate at which major Banks in London offer to lend in the interbank market. Nostro account: A Banks account with a foreign Bank. NSE: National Stock Exchange NSE terminals: Computer nodes through which screen driven trading can be conducted in the NSE.

Offer: Rate at which the Bank/dealer sells or lends. Open position: Difference between total purchases and total sales in a given currency on which an exchange risk is run. Premium: Difference between spot price and price for forward settlement. Proactive: One who acts in advance before others react, anticipating the market move. Reserves: Qualifying assets to meet the statutory reserve requirements. Settlement of deals:

26

Verification of the deal terms/calculations, obtention of Deal confirmation from the counterparty, Brokers contract, documentation of the transaction and arranging the delivery of the documents. SGL account: Subsidiary General Ledger Account maintained with RBI for Govt. Securities transactions. Spot deal: A deal for currency for delivery two business days from today. Spot next: A deal from the spot date until the next day, either as a deposit or a swap. Spread: Difference between the cost of funds and return from the funds.

Volatile market: Market wherein the prices/rates are fluctuating in a wide band/ range Vostro account: A foreign Banks account with a local Bank. Wire agency: News reporters, which are transmitting the information/news instantaneously through tele-net work. Reserves: Assets qualifying to meet statutory requirements. CRR: Cash Reserve Ratio SLR:
27

Statutory Liquidity Ratio Asset Liability Maturity Mismatches: Case when either gross Financial Assets outgrows Capital & Liabilities or vice versa Demand and Time Liabilities (DTL): Sum of Demand Deposits and Fixed deposits including inter bank deposits Government Stock/Loan/Securities/Gilts: Loans raised by Government to meet its fiscal deficits. These are issued in the form of tradable bonds. NDTL for SLR: Gross DTL less Inter Bank Deposits. NDTL for CRR: NDTL for SLR less exempted categories of liabilities. Delivery versus Payment (DVP) System: System where the securities are delivered against simultaneous payment. As both the legs of delivery and payment are simultaneous Settlement Risk is avoided. SGL Transfer Form: RBI prescribed format printed on semi security paper for effecting security transactions in the SGL account of the bank. Authorized Signatories: Officials (generally back office staff) who are authorized to execute/ sign SGL Transfer Forms and other documents and whose specimen signatures are lodged with RBI and other counterparts in the market. Bank Rate:

28

Interest rate at which RBI lends to Sch. Comm. Banks. Refinance Rates and penalty on default of CRR are pegged to Bank Rate. RBI is using Bank Rate as a tool to send interest rate signals to the market. Local Bank Account: Account with SBI and/or such other Bank, which is managing the Clearing house, through which the Clearing net proceeds are and where the Bank is maintaining a current account for passing the Clearing inflows and outflows. Cash Surplus Branch: Branch which collecting and holding cash more than its stipulated limit/ normal payment requirement. Purchased Funds: Funds sourced at the at market determined rates (different from rates offered to the public). Repoable Securities: Securities which are approved for Repo transactions. Discretionary Liabilities: Liabilities/resources raised at the discretion of the borrower. Buyers Market: Market where the demand is less and supply is more. Buyer has better choice for selection/negotiation since sellers (supply) outnumbers the buyers (demand). CAR: Capital Adequacy Ratio. DVP System: Delivery versus Payment (DVP) system is the Settlement system wherein delivery of the Stock/security and Payment of consideration are made simultaneous. In case if one side of the transaction doesnt go through (say, for want of good delivery), the RBI holds

29

back the other side of the transaction (payment of consideration). By this, settlement risk is totally hedged. Derivative Usance Promissory Note (DUPN): Usance Promissory note drawn by the discounting Bank against the underlying Bills. While rediscounting the Bills, actual endorsement and delivery of these Bills are not necessary. Instead this Promissory Note is delivered. Since this Note derives its value from the underlying Bills, this is called Derivative Usance Promissory Note. Maximization of Spreads: Difference between the Total cost of funds and total return from it gives the spread. Spreads can be maximized either by reducing the cost and/or increasing the return from it. Maximization of Net worth: Increasing the profits of the business so that maximum profits can be ploughed back to Reserves. This maximizes the Net worth of the Company and thereby increases the Shareholders value.

GAP: It is the difference between the Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL). GAP is said to be positive when RSA > RSL. Duration GAP: Difference between the aggregate duration of Assets and aggregate duration of Liabilities is Duration Gap. Market Interest Rate: The interest rate, or discount rate, or yield to maturity is an interest rate which changes constantly, depending on various factors like demand/supply of the Financial asset, future economic outlook, etc. Face Value:
30

The principal value or the Maturity value of the Bond, which is printed on the bond and which is fixed throughout the bonds life. Coupon Rate: The fixed rate of interest which is printed on the Bond certificate is called Coupon rate. Coupon rates are contractual rates that cannot be changed after the bond is issued. Time Value of Money: In order to understand this concept, it is important that we are familiar with discounted cash flow analysis. It is known that: a. b. c. People have a positive time preference for money; A rupee today is worth more than a rupee received in the future; People postpone their current consumption and save only if their future consumption opportunities will be more because of their savings; d. Since money earns interest, it takes more future rupees to equal the value of a rupee today. The above show that money has a time value. Future Value: The process of going from todays value or Present Value (PV) to Future Value (FV) is called compounding. To understand this, consider the case where an investor put Rs 100 in the Bank at 10 per cent p.a. This means that Rs 100 today is equivalent to its Future value of Rs 100 x (1 + 0.10) = Rs 110 one year from now. Future Value at the end of second year is Rs110 x (1 + 0.1) = Rs 121. This can be expressed by the formula: FV = PV (1+i) n

31

Where: i = interest rate and n is number of years Present Value: The process of calculation from Future Value to todays value (Present Value) is called discounting. In the above quoted example the Present value of Rs 121 to be received from the Bank at an interest rate of 10 per cent is Rs 100.00. The process of discounting is simply the inverse process of compounding. Accordingly, the Present Value (PV) can be found out as follows: PV = FV / (1+i) n Net Present Value: Suppose an investment of Rs.100 generates a net cash flow of Rs 115 from one year from now and if the cost of funds for the Bank is 10 per cent, the investment is worth doing. To find out how much wealth does the investment creates for the capital, the future value of Rs 115 is discounted at the cost of capital, i.e.,10 per cent. 115 PV of Rs 115 = = Rs 104.55 (1 + 0.1) Since the initial cost of investment is only Rs 100, the Net Present Value, i.e., the wealth created for the shareholders, is found out as. NPV = PV of the future revenue initial cost = 104.55 100 = Rs 4.55 The net present value (NPV) approach can be extended to more complex situations. Using the same logic as above, to find the NPV of an asset with an initial investment of cost of C and net cash flows at subsequent dates from year 1 to year n is:
cash flow 1 (1+r)1 cash flow 2 ................ + (1+r)2 cash flow n (1+r) n

NPV = () C + + +

Bond Valuation: Bond is a contractual obligation to pay:

32

i. ii. iii.

Coupon/interest specified on the Bond; at fixed intervals; Principal amount with or without premium, if specified any, at maturity.

The Present value or price of the Bond is therefore: i. PV of the future stream of cash flows (interest payments and Principal) discounted at prevailing market interest rates; ii. At the time of new issue, coupon interest and market interest are ideally the same and expressed as follows:
C1 Bond Value (VB) = C2 + (1+i) (1+i)2 (1+i)3 (1+i)n C3 + + (Cn + M) +

n = t =1

C (1+i)t

M (1+i) n

Where: C1.. Cn = i = n = M = period coupon payment from year 1 to n market interest rates, prevailing period to maturity Principal with / without redemption premium

The value of the Bond will change if there is a change in the market interest rate (i). If market interest rate goes up beyond the coupon rate, the value of the bond will fall so that the new investor (buyer) would earn market interest rate despite the fact that the coupon of the Bond would continue to give fixed lower income. Likewise if market interest rate declines below the coupon rate, the value of the bond will appreciate so that the new investor (buyer) earn only lower market interest rate despite the fact that the coupon of the Bond would continue to give fixed higher income. Such equilibrating adjustment in bond price/ value is knows as bond dynamics.
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We learnt that the value of the Bond depends on the coupon rate vis--vis prevailing market interest rates. We can summarize the above as follows: i. Whenever the market interest rate rise above the coupon rate of the bond, the price of the bond will fall; ii. if the market interest rate falls below the coupon rate of bond, the price of bond will appreciate; iii. if there is no change in the market interest rate from bond coupon rate, the price of bond will remain the same.

Annuity: This is a series of equal payments made at fixed intervals for a specified number of periods. If the payments are made at the end of the period, it is known as ordinary annuity or deferred annuity. If payments are made at beginning of period, then it is an annuity due. Formula for Future value of an ordinary /deferred annuity is: FVAn = A (1+r) + A (1+r) +......+A Where FVAn = A= r= n= YIELD: Yield is defined as an overall return to an investor on his investment. With respect to yield on Bonds/GOI securities, three types of yields are discussed: Nominal yield: Future value of an annuity with n periods Constant/regular cash flow Interest rate Duration of the annuity

34

This is the annual interest rate specified on the Bonds, irrespective of its price (i.e., whether quoted at a premium or at a discount). This is also known as Coupon of the Bond. Current yield: This is the effective yield an investor earns keeping in mind the current market price of the Bond. This is given by the formula: Nominal yield or Coupon Current Yield = Current market Price x 100

Yield to maturity: This term popularly known as YTM connotes redemption yield and is very useful for Treasury Managers whose investment horizon is long term. YTM can be interpreted as the bonds average compounded rate of return if the bond is bought at the current asked price and held until it matures and the face value is repaid. That is, YTM can be defined as the discount rate that equates present value of all cash flows to the present market price of the Bond. Future cash flows includes interest and capital gain/loss. This can be algebraically expressed as follows: Let the Bond with a face value of A of coupon C with a term to maturity of n years is quoted/traded at a market price of P, then

C P = + (1+y)1

C (1+y)2 +

C (1+y)3

(C + A) (1+y)n

+ +

35

Where y is the discount rate (to be found by trial & error method ) at which the cash flows are discounted so that the right hand side of the above equation tallies/equates with the Price P (left hand side) of the Bond. The 'y' so derived would be the Yield to maturity (YTM) of the bond. It implies that, if the Bond is held till maturity and the Coupons/Cash flows received are reinvested at the 'y' rate itself, the overall yield on the Bond will be 'y', which is its YTM. An example would further help to understand the mechanics of the YTM. Suppose the market value of Rs 100 (face value) bond carrying coupon of 13 per cent p.a. maturing after 7 years is quoted Rs 109.45 in the market. The YTM of the bond is found by discounting the yearly coupon flows of Rs 13 in the next 6 years and Rs 113 (Principal of Rs 100 + coupon of Rs 13) at the end of 7 year at a rate (to be found by trial & error method), say r so that the Present value of such cash flows sums to Rs 109.45 Rs 13 (PVIFA) + Rs 100 (PVIF) = Rs 109.45 PVIFA being the Price Value Interest Factor for the 7 year Annuity and PVIF the Price Value Interest Factor for 7 years to be taken from the PVIFA table and PVIF table (available in all standard Finance Text Books) for a 7 year term, by trial and error method. Accordingly for 7 years (PVIFA) at 11% and for 7 years (PVIF) at 11% = = 4.712 0.482

Then LHS of the equation becomes 13 x (4.712) + 100 x (0.482) = Rs 109.45 Then 11 per cent is said to be the YTM of the bond, also described as the Internal Rate of Return, (IRR). In other words, in the above example, if the above bond is held by the buyer till maturity the overall return from the Bond will be 11 per cent. However as the above process will be time consuming, YTM can be found by approximation as follows. C + (A P)/n YTM = X 100 (A + P) /2 Where C A = coupon = Face Value/maturity Value

36

P n

= Price paid for the Bond = term to maturity

Applying this in the above example, 13 + (100 109.45)/ 7 YTM = = (100 + 109.45)/ 2 13 1.35 = X 100 = 11.12% 104.725 However underlying assumption in the YTM concept is that the coupons/cash flows received during the tenure of the bond is reinvested at YTM rate, which may not be true since the market interest rates will always be changing from time to time. 13 + ( 9.45/7) 104.725

Holding Period/Realized Yield: When the holder/investor is going to disinvest the Bond before its maturity, the overall yield earned by him from the Bond is known as Holding Period Yield or Realized Yield. Let us understand this with the help of an example: Suppose you are holding a 10 year Bond with a Face value of Rs 100 and coupon 8 per cent. After 3 years, when the interest rates move up to 10 per cent for 7 years term, you want to sell this Bond. As the interest rates have moved up, naturally you may have to sell the Bond at a discount. The selling price for the Bond by using the Bond Valuation Formula as follows:

8 (1.10)2

8 (1.10)3

108 + = (1.10)7 90.25

+ + + (1.10)

37

This shows that the Bond have to be sold at a below par value of Rs 90.25, thereby incurring a capital loss of (100 90.25) = Rs 9.75. Now to find the Realized yield on the 8 per cent bond for the period of 3 years held and with a redemption value of Rs 90.25 (as the sale proceeds of the Bond), the YTM formula is used as follows: 8 + + = 100 (1+r) 1 (1+r) 2 (1+r) 3 8 (8 + 90.25)

Where r is the Realized or Holding Period Yield. Accordingly, we get the Realized yield r = 4.9 per cent. However as it is much lower than the promised yield of 8 per cent, the seller incurs a loss of (8 4.9) = 3.1 per cent returns on his Bond.

Yield Spreads: Yield spreads are the differences between the yields of any pair of bondsusually a zero risk bond and another risky bondof same maturity. {Yield on risky bond} {Yield on zero risk bonds} = {yield spread} Yield spreads are also called risk-premiums because they measure the additional yield that risky bonds pay to induce investors to buy more-risky bonds rather than less risky bonds. Yield on Discounted instruments: The issue price of a discounted instrument is calculated as follows: F D =

38

1 + {( r x n)/36500} where, D F r n = = = = Discounted value of the instrument Maturity Value Effective rate of interest per annum Tenure of the instrument ( in days)

Conversely to find out the yield from a discounted instrument, the following formula can be derived from the above one, (F D) r = D where, D F r n = = = = Discounted value of the instrument Maturity Value Effective rate of interest per annum Tenure of the instrument ( in days) 365 X X n 100

REPO Transactionscalculations: Assume Bank A borrows from Bank B an amount of Rs 10 crores for a period of 14 days from 10.10.2005 to 24.10.2005, at an interest rate of 8 per cent against its holding of 11.50 per cent GOI 2007 (Interest Payment dates of this stock are 5th April and 5th October of the year). As already stated earlier, the transaction involves 2 legsFirst leg/Ready leg and Second leg/Forward leg. The calculation for both legs are explained below: Working (Note: While calculating interest accrued on Government securities, 360 days are

considered for an year.)

39

FIRST LEG/READY LEG on 10.10.2005: Bank B)

(Bank A sold 11.50 per cent GOI 2007 to

Calculation for first leg is as if Bank A is selling the security (11.5 per cent GOI 2007) outright to Bank B at the market price of Rs 100. This is as follows: Principal (Rs 10 crs. @ 100.00) Accrued int.on the stock = (10 crs x 11.5% x 5/360) First/Ready leg settlement amount...(1) = = Rs 1,59,722.22 Rs 10,01,59,722.22 = Rs 10,00,00,000.00

(It may be understood from the above transaction, that Bank A borrowed Rs 10,01,59,722.22 from Bank B)

FORWARD/SECOND LEG on 24.10.2005: (Bank A bought back the stock from Bank B) Though the second leg transaction is to be calculated as if Bank A is buying outright the security from Bank B, to arrive at the buying rate/price, the calculation has to be done on the reverse way, as follows: 1. Calculate the settlement amount Bank A has to pay Bank B which is = Amount borrowed + interest @ 8% for 14 days (Repo rate) = Rs 10,01,59,722.22 + Rs 3,07,339.42 Settlement amount = Rs 10,04,67,061.64 2. From this subtract accrued interest on the stock till date. Accrued interest on the stock = 10,00,00,000 x 11.5% x 19 --------360 = Rs 6,06,944.44

40

Settlement amt. Accrued interest = 10,04,67,061.64 6,06,944.44 Rs 9,98,60,117.20 3. Resulting amount of Rs 9,98,60,117.20 is the principal amount for the Rs 10 crore value stock. Hence to get rate of repurchase, divide this value by nominal value i.e. 9,98,60,117.20 -----------------10,00,00,000 Now based on this rate, the accounting is done as follows: Principal (Rs 10 crs. @99.860117) = Rs 9,98,60,117.20 = 99.860117

Accrued int. on the stock = (10 crs x 11.5% x19/360) Forward/second leg settlement amt
= (1) + int @ 8% for 14 days = (2) = Rs 10,04,67,061.64

Rs 6,06,944.44

STUDY MATERIAL:FINANCIAL MANAGEMENT VERY SHORT QUESTIONS ( 1 MARK) 1 Define Financial Management. Ans financial management is that specialized activity which is responsible for obtaining and affectively utilizing the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial administration and financial control. 2 State the primary objective of Financial management. Ans. To maximize the shareholders wealth. 3 State the decisions involved in Financial management. Ans.. a) Investment decision b) Financing decision c) Dividend decision 4 What is meant by Financial Planning? Ans.. Financial planning means deciding in advance, the financial activities to

41

be carried on to achieve the basic objective of the firm. The basic objective of the firm is to get maximum profits out of minimum efforts. 5 What are the objectives of financial planning? Ans.. a) to ensure availability of fund whenever required. b) to see that the firm does not raise funds unnecessarily. 6 What is Working Capital ? Ans.. The capital required for day to day operations of the business is called Working capital. 7 State the difference between gross working capital and net working capital. Ans.. Gross working capital is the sum/ aggregate of the current assets, whereas Net working capital = Current assets current liabilities. 8 What is meant by capital budgeting decision? Ans.. A long term Investment decision is called capital budgeting decision. 9. When is financial leverage considered favorable? Ans) Financial leverage is considered favorable when return on investment is higher than the cost of debt. 10. How does production cycle effect working capital? Ans) working capital requirement is higher with longer production cycle. 11. What do you mean by floatation cost? Ans) Cost incurred for raising funds. 12. What is capital structure of a company? Ans.. Capital structure is the relative proportion of different sources of long term finance. In other words Capital structure of a company refers to the make up of its capitalization SHORT ANSWER QUESTIONS (3 / 4 MKS) 1. Are the share holders of a company likely to gain with a debt component in the capital employed ? Explain with the help of an example? Ans) The shareholders of a company are very likely to gain with debt component in the capital employed by way of trading On equity as it increases the earning per share(EPS) of the share holders. 2 Define current assets and Give four examples. Ans. Current assets also called as floating assets or fluctuating assets are short term assets whose value fluctuates in the short period. These assets are required to pay off the current liabilities. For e.g. cash in hand/Bank, Inventory, Debtors. Bills receivable, Marketable securities etc. 3 To avoid the problem of shortage and surplus of funds, what is required in Financial management? Name the concept and explain four points of importance. Ans.Financial Planning is required to avoid shortage or surplus of finance. Importance of financial planning is: a) By planning utilization of finance, it reduces waste ,duplication of efforts and gaps in the planning. b) It helps in coordinating the various business activities such as sales,

42

purchases, production, finance etc. c) It is a technique of control. It helps in setting up standard and compare with the actual performance. The deviations, if any are then analysed. Causes found out and corrective measures are taken. (d)It helps in avoiding shocks and surprises as proper provision regarding Shortage or surplus is made in advance by anticipating future receipts and Payments. . 4 Explain the role of Operational efficiency in the determination of working capital requirement. Ans. The firm with a better operational efficiency has to invest less in working capital becausea) they convert raw materials quickly into finished goods, and sell them at their earliest. i.e. converts stock into sales quickly. b) Promptly collects debts from debtors and bills receivable. 5 Discuss how Working capital affects both the liquidity and profitability of a business. Ans. Short term Investment decisions are concerned with the decisions about the level of cash, inventory and debtors etc. (working capital) Efficient cash management, Inventory management and receivable management are essential ingredients of sound working capital management. The working capital should be neither more or less than required. Both the situations are harmful. If the amount of working capital is more than required, it will no doubt increase the liquidity but decrease the profitability. Similarly if there is a shortage of working capital, it will face the problem of meeting day to day requirements. Thus optimum amount of current assets and current liabilities should be determined so that the profitability of the business remains intact and there is no fall in the liquidity. 6 How does Interest coverage ratio affects the capital structure. Ans. The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligations. Interest coverage ratio = EBIT/Interest Higher the ratio, better is the position of the firm to pay its interest obligations, so it should issue debt. On the other hand if it is low, the firm should avoid using debt as interest is to be paid irrespective of profits. 7 Why Capital budgeting decisions are more important?. Ans. The long term Investment decision is called capital budgeting. It is more important due to the following reasonsa) Long term growth and affects : As capital budgeting decisions involve investment in long term fixed assets, it affects the long term growth. b) Large amount of funds involved : As huge amount of fund is blocked for a long period, the decision should be taken rationally. c) Risk involved : As such a decision affects the returns of the firm as a whole, it

43

involves more risk. d) Irreversible decisions : These long term decisions taken once cannot be reversed back, without incurring heavy losses. It will lead to waste of fund, if reversed. Thus capital budgeting decisions should be taken after careful study and deep analysis. 8 What is Financial risk? How does it arise? Ans. It refers to the risk of the company not being able to cover its fixed financial cost. Fixed financial cost includes payment of interest that is to be paid irrespective of profit. The higher level of risk are attached to higher degrees of financial leverage. If EBIT(Earnings before interest and tax) decreases, financial risk increases as the firm is not in a position to pay its interest obligations. Thus the risk of default is called Financial risk. The firm should overcome the situation accordingly or will be forced towards liquidation. LONG QUESTIONS ( 5/6 MKS) 1.What are the determinant of capital structure of a company? OR Determination of capital structure of a company is influenced by a number of factors explain six such factors. Ans. Capital structure refers to the relative proportion of different sources of long term finance. Following factors are to be considered before determining capital structure. a) Cash flow position: The cash available with the company should be enough to meet the fixed interest liabilities. Interest on debt is to paid irrespective of profits. A company has to meet working capital requirements, invest in fixed assets and also pay the interest and principal amount of debt after a particular stipulated period. If cash position is sound, debt van be raised, and if not sound debt should be avoided. b) Interest coverage ratio : it is the ratio that expresses the number of times the Net profit before interest and tax covers the interest liabilities. Higher the ratio, better is the position of the firm to raise debt. c) Control : Issue of Equity shares dilutes the control of the existing shareholders , whereas issue of debt does not as the debenture holders do not participate in the management decisions as they are not the owners of the fir. Thus if control is to be retained, equity should be avoided. d) Stock market conditions : If the stock market is bullish, the investors are adventurous and are ready to invest in risky securities, equity can be issued even at a premium whereas in the Bearish phase, when the investors become cautious, debt should be issued as there is a demand for fixed cost security. e) Regulatory framework : Before determining the capital structure of a company , the guidelines of SEBI and concerned regulatory authority is to be considered. For e.g companies Act, Banking regulation Act etc are to considered. f) Tax rate : As interest on debt is treated as an expense, it is tax deductable. Dividend on equity is the distribution of profit so is not tax deductable. Thus

44

if the tax rates are high, issue of debt is an attractive means as it is economical in nature. 2. Explain briefly five factors determining the amount of fixed capital. Ans. Fixed capital refers to the capital which is used for the purchase of fixed assets, such as land, building, machinery etc. Following factors are to be considered before determining its requirement. a) Nature of Business: If a firm is a manufacturing fir, it requires to purchase fixed assets for the production process. It needs investment in fixed assets, so require more fixed capital. Similarly if it is a Trading firm where the finished goods are only traded i.e purchased and sold, it needs less fixed capital. b) Scale of operations larger the size and scale of operations larger is the requirement of the fixed capital and vice versa. c) Choice of technique: The Manufacturing firm using the modern, latest technology machines has to invest more funds in the fixed assets, so they require more fixed capital. On the other hand, firms using the traditional method of production where the task is performed manually by the labourers, it requires less fixed capital. d) Diversification : There are few firms and organizations who deal in a single product. These investment in fixed assets is low, whereas the firms dealing in number of products ( Diversification) requires more investment in purchasing different fixed assets, it requires more fixed capital. e) Financing alternatives: If the manufacturing firm actually buys the assets and blocks huge funds in the fixed assets, it requires more fixed capital. The companies who acquire the fixed asset and use them by obtaining leasing facilities, it requires less fixed capital. Leasing is suitable in high risk lines of business where huge funds should not be blocked in the fixed assets. 3. What is meant by Working capital? How is it calculated? Explain the determinants of working capital requirements. Ans. Working capital is the capital required for meeting day to day requirements/operations of the business. Net working capital= current assets current liabilities. Following factors are to be considered before determining the requirement of working capital. a) Scale of operations: There is a direct link between the scale of business and working capital. Larger business needs more working capital as compared to the small organizations. b) Nature of Business: The manufacturing organizations are required to purchase raw materials, convert them into finished goods, maintain the stock of raw materials, semi finished goods and finished goods before they are offered for sale. They have to block their capital for labour cost, material cost etc, so they need more working capital. In the trading firm processing is not performed. Sales are affected immediately after receiving goods for sale. Thus they do not block their capital and so needs less working capital. c) Credit allowed: If the inventory is sold only for cash, it requires less working capital as money is not blocked in debtors and bills receivable. But due to increased competition, credit is usually allowed. A liberal credit policy results

45

in higher amount of debtors, so needs more working capital. d) Credit availed: If goods are purchased only for cash, it requires more working capital. Similarly if credit is received from the creditors, the requirement of working capital decreases. e) Availability of Raw materials: If the raw materials are easily available in the market and there is no shortage, huge amount need not be blocked in inventories, so it needs less working capital. But if there is shortage of materials, huge inventory is to be maintained leading to larger amount of working capital. Similarly if the lead time is higher, higher amount of working capital is required. 4. Every Manager has to take three major decisions while performing the finance function briefly explain them. Ans. The three important decisions taken by the finance manager are as follows 1) Investment decision: It refers to the selection of the assets in which investment is to be made by the company. Investment can be made in Long term fixed assets and short term current assets. Thus Investment decision is divided in two parts : (a) Long term Investment decisions: Such decisions are also called Capital Budgeting decisions. It relates to the investment in long term fixed assets. As such decisions affects the growth of the firm, it involves huge fund to be blocked for a long period, and such decisions are irreversible in nature, they should be taken carefully after making a comparative study of various alternatives available. (b) Short term Investment decision (Working capital decision): It refers to investment in short term assets such as cash, inventory, debtors etc. Finance manager has to ensure that enough working capital is available to meet the day to day requirements. It should also ensure that unnecessarily high reserve of working capital should not be retains as it decreases the profitability. Thus profitability and Liquidity are to be compared and appropriate amount kept as working capital. 2. Financing decision: There are various sources of obtaining long term finance such as Equity shares, preference shares, term loans, Debentures etc. For taking financing decision and deciding the capital structure various factors are to be considered and an analysis of cost and benefit is made. 3. Dividend decision: It refers to the decision related to the distribution of profit. The finance manager has to decide as to how much amount of profit is to be distributed as Dividend and how much to be retained in the business. If too much retained earnings are maintained, it dissatisfies the shareholders as they receive less dividend. Similarly if a liberal dividend policy is followed, though the shareholders are satisfies, but the firm does not have enough reserve for future growth, expression, meeting contingency etc. 5. What is meant by Financial management Explain its importance.. Ans. Financial management refers to that part of the management which is concerned with the efficient planning and controlling the financial affairs of the enterprise. Financial management plays the following role.a) Determination of fixed assets : Fixed assets have an important contribution in

46

increasing the earning capacity of the business. Long term investment decisions also called capital budgeting decision raise the size of fixed assets.. b) Determination of current assets : Current assets are needed to meet the day to day transactions of the business. The total investment in current assets is to be determined and the split up into its elements is required. For e.g. if it is decided to maintain current assets of Rs 10 lakh, further decision is to be made as to how much cash is required, how much amount to be invested in debtors, stock etc. c) Determination of long term and short term finance: Under this a Finance manager has to maintain a proper ratio of short term and long term sources of finance after estimating its requirement. d) Determination of Capital Structure: A balanced decision related to capital structure is to be made . The proportion of debt and equity is to be determined. e) Determination of various items in the Profit and loss account-The financial decisions affect the various items to appear in the profit and loss account. For e.g depreciation on fixed assets, interest on debt etc.STUDY MATERIAL:CASH FLOW STATEMENT Qus:1 Why is the cash flow statement not a suitable judge of profitability ? Ans: Cash Flow statement is prepared on cash basis of accounting but profit is calculated on accrual basis.So cash flow statement is not a judge of profitability. Qus:2 Under which accounting standard , cash flow statement is prepared ? Ans: Under accounting standard-3(Revised). Qus:3 Why do we add back non cash items to net profit while calculating cash flow from operating activities. Ans: Non cash items reduce the net profit without reducing the cash balance. Qus:4 How will you classify loans given by HDFC while preparing cash flow statement. Ans: As Operating Activities. Qus:5 How will you classify deposits by customers in SBI while preparing cash flow statement. Ans: Operating Activities Qus:6 Where will you show purchase of furniture in cash flow statement ? Ans: As Outflow under Investing Activities. Qus:7 Give examples of non cash transactions. Ans: Give any two examples(i) Acquisition of fixed asset by issue of debentures or shares. (ii) Conversion of debentures into shares. Qus:8 A company receives a dividend of Rs. 5 Lakhs on its investment in other companys share will it be Cash inflow from operating or investing activities in case of a. (i) Finance Company.

47

(ii) Non-Finance Company. Ans: It will be operating activities in case of a finance company and investing activities in case of non-Financing Company. Qus:9 Give four example of movement between cash and cash equivalents. Ans: Cash deposited into bank, Cash withdrawn from bank for office use, purchase of short term marketable securities, , sale of short term marketable securities Qus:10 How are various activities classified as per AS-3 (Revised) ? Ans: (i) Operating Activities. (ii)Investing Activities. (iii)Financing Activities. Qus:11 Give one example each of an extra ordinary item under operating, investing and financing activity. Ans: Examples of extraordinary items under:(a) Operating activity claim received from insurance company against loss of stock. (b) Investing activity amount of compensation received against acquisition of land belonging to the enterprise. (c) Financing activity payment for buy-back of equity shares of the company. Qus:11 Cash flow from operating Activities + Cash flow from Investing Activities + Cash flow from Financing Activities = Ans: = Net Increase /Decrease in cash and Cash Equivalents. Qus:12 What are the two methods which can be employed to calculate net cash flow from operating activities ? Ans: Direct Method and Indirect Method. Qus:13 Modern Toys Ltd. Purchased a machinery of Rs.20,00,000 for manufacturing toys. State giving reason Whether the cash flow due to the purchase of machinery will be cash flow from operating activities, Investing activities or Financing activities ? Ans: Investing Activities Because . Qus:14 M/s.Lakshmi Electrical Appliances furnish the following information - Calculate net cash flow from financing activities:Particulars 31.12.2007 31.12.2008 Equity share capital 2,00,000 4,50,000 10% debentures 1,00,000 6% preference shares - 3,00,000 Additional information (a) Interest paid on debentures Rs.5,000/-. (b) Dividend paid on equity shares Rs.40,000/-. (c) Bonus shares were issued to existing shareholders in the

48

ratio of 4:1 during the year. Ans.: CALCULATION OF NET CASH FLOW FROM FINANCING ACTIVITIES Particulars Rs. Cash proceeds from issue of 3,00,000 Pref. Shares + equity shares 2,50,000 Redemption of 10% debentures (1,00,000) Interest paid (5,000) Dividend paid on equity shares (40,000) Net cash flow from financing activity 4,05,000 Qus:15 A company had the following balance Particulars Rs. Investment at the beginning of the period 3,40,000 Investment at the end of the period 2,80,000 During the year, the company sold 40% of investments at the beginning at a profit of 84,000. Calculate cash fro, investing activities Particulars Rs. Inflow from sale of investment Cost of investment Gold 2,20,000 (40% of Rs.340000) = 136000 Add profit on sale = 84000 Out flow on purchase of investment (76,000) Net cash flow from investing activities 1,44,000 Investment A/c. To balance b/d. 3,40,000 By Cash sale of investment 2,20,000 To profit on sale 84,000 To bank a/c. (purchase) 76,000 By balance c/d. 2,80,000 5,00,000 5,00,000 Practice numerical: Qus:16 From the following profit or loss account find out the flow of cash from operating activities of Mohan Ltd. Profit and Loss Account Dr. Cr. Particulars Amount Particulars Amount To Rent Paid 14,000 Less: Prepaid 2,000 To Salaries To Depreciation

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To Loss on sale of Furniture To Goodwill written Off To Bad Debts To Office Expenses To Discount allowed To Proposed Dividend To Provision for Tax To Net Profit (Rs) 12,000 25,000 15,000 10,000 8,000 3,000 18,000 7,000 30,000 22,000 52,800 2,02,800 By Gross Profit By Profit on Sale of Machine By Tax Refund By Rent received 4,000 Add: Rent accrued 1,000 (Rs) 1,82,000 12,000 3,800 5,000 2,02,800 Note: There was increase in Closing stock by Rs. 25,000. Ans: Cash from Operating Activities Rs.1,03,800. Qus:17 Prepare Cash flow Statement from the following information of LOYD PVT. LTD. For the year ended March 31,2004. BALANCE SHEETS OF LOYD PVT. LTD. AS ON MARCH 31,2004 Liabilities 2003 2004 Assets 2003 2004 Share capital Profit & Loss Account

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General Reserve Tax Provision Creditors Bill Payables Depreciation Provision (Rs) 3,00,000 1,20,000 60,000 70,000 50,000 30,000 25,000 6,55,000 (Rs) 4,00,000 2,60,000 95,000 80,000 90,000 10,000 40,000 9,75,000 Goodwill Machinery 12% Investments Stock Debtors Cash at Bank Short term Investment (Rs) 70,000 3,00,000 1,50,000 35,000 50,000 30,000 20,000 6,55,000

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(Rs) 30,000 3,20,000 3,00,000 1,85,000 70,000 40,000 30,000 9,75,000 Additional Information : 1.Investment costing Rs.50,000 were sold for Rs. 48,000 during the year. 2.Tax paid during the year Rs.70,000. 3.Interest received on Investment Rs. 12,000. Ans: (i) Cash Inflow From Operating Activities Rs.80, 000. (ii)Cash Outflow on Investing Activities Rs.1, 60,000. (iii) Cash Inflow from Financing Activities Rs. 1, 00,000.

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