b.v. patel institute of business management, computer...

B.V. Patel Institute of Business Management, Computer & Information

Technology, Uka Tarsadia University

Question Bank 030030610: Strategic Financial Management

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Chapter 1 Strategic Financial Management and Financial Planning

Answer the following. (1 Marks)

1. Where concept of strategic financial management is applied?

To applying financial management practices to strategic decision related to future

financial status

2. How strategic financial management help in optimal utilization resources?

To maximize the profitability and wealth creation of an enterprise strategically

3. Which techniques are used in analyze risk and return?

Capital budgeting techniques are available to analyze risk and return levels, using a

number of methods.

4. What are the sources of strategic financial information?

The major source of this strategic financial information is the analysis of financial

statements.

5. Which type of planning is involved in strategic financial management?

Strategic market expansion planning

6. Do the strategic financial management decisions have long term impacts?

Yes strategic financial management decisions have long term impacts.

7. Who can formulate a financial plan?

Finance manger formulate financial plan.

8. What is the first step of financial planning process?

Determining financial objectives is the first step of financial planning process.

9. What is the main aspect of financial planning?

The main aspects of financial planning are determining financial objectives

10. State any one characteristic of a sound financial plan.




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Simple and easy to understand

Future guide

Flexibility

Liquidity

Cost of funds

Ploughing back of profits

Less dependence on outside sources

Profitability

Optimum risk

Briefly answer the following. (2 marks)

1. Define strategic financial management.

Strategic Financial Management refers to both, the financial implications or aspects of

various business strategies, and the strategic management of finances. The author further

opines that finances are required to be managed strategically in order to accelerate profits

at a sustainable rate of growth. In order to accelerate wealth successfully, a strategic mix

of specifically three performance factors, namely, people, capital and technology should

be efficiently managed over a period of time.

2. State the scope of strategic financial management.

Strategic investment management decisions

Strategic financing management decisions

Strategic liquidity management decisions

Strategic approach to shareholder's wealth management and value of firm decisions

Strategic profitability management




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3. Write any four importance of strategic financial management.

Proactive planning and forecasting funding needs

Optimal utilization of resources

Strategic investment plans

Liquidity maintenance

Stakeholder interest

Value of firm

Perspective beyond working capital requirements

Encourages consistency in profitability

Incorporates impacts of economic and business environment

Promotes clarity on systems, requirements and goals

Converging efforts and financial resources

Risk hedging

4. Write any four success factors of strategic financial management.

Principled economic approach

Strategic approach to intrinsic competencies and costs

Structured system approach with' scope for flexibility

Strategic approach to cost management

Positive responsiveness to dynamic environment

Survival and sustainability

Adaptability

Financial control and prowess




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5. What is principled economic approach?

This factor relates to generating superior revenues within the constriction of ethics and

values of business without compromising on the quality of products and services.

Sometimes, a business may pursue short-term profitability by compromising on quality,

which negates sustainability and profitability. Long-term building of consistent profits

along with appropriate quality can be achieved through strategic financial planning.

6. How does strategic financial management encourage consistency in profitability?

The proactive approach follows the identification of problem areas well in time. This

avoids the sudden negative impacts on returns. Strategic financial management provides

corrective analysis and solutions to identify problems that adversely affect profitability,

facilitating appropriate strategies to defy financial distress situations.

7. How does strategic financial management maintain liquidity?

Strategic financial management provides for adequate funds, cash reserves ascertained in

advance and generation of required resources. Strategic financial management helps in

providing a cushion against economic, natural or situational contingencies. It forearms the

firm against unforeseen difficult circumstances.

8. How does strategic financial management help in planning for the organisation,

especially financial resources?

The investors are now aware of the avenues available for investing their funds to get

maximum returns. Organizations are striving to get optimum solutions to their funding

needs at viable costs. Business enterprises need to demonstrate consistent good

performance over a number of years to attract adequate investment as capital for future

ventures. Besides this, there is the companies' attempt to increase shareholders' wealth

and value of their firm in the markets. These requirements make it imperative for the

companies to sustain profitability over a long period of time. In a progressive business

arena, it is essential for investors to experience growth, future security, liquidity,

profitability and capital appreciation. In a nutshell, companies need to pursue the




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consistent and superior profitability and wealth maximization objectives to meet the

shareholders' and investors' expectations. On a long-term perspective, strategic approach

to finance management can be rewarding.

9. Define financial planning.

Financial planning is a process of analyzing the financing and investment choices,

projecting the future consequences of present decisions, deciding which alternatives to

undertake and measuring subsequent performance against the goals set in the financial

plan.

10. State the limitations of financial planning.

A sound financial plan of a firm is also subject to certain limitations which are given

below:

Difficulty in accurate forecasting

Lack of coordination

Rigidity

Rapid technological changes

Answer the following (limit 250 words). (5 marks)

1. Discuss the characteristics of strategic financial management.

Strategic Financial Management as a contemporary discipline has incorporated the practices,

methodologies and perspectives of strategic management and financial management. So, the

salient features and characteristics contain the contributions of both these fields of study to

promote sustenance and growth of enterprises. Various prominent features identified are as

follows:

1. Strategic Financial Management relates to long-term management of funds. It

incorporates management with a strategic perspective on finances, as to how they

are to be accumulated, allocated, invested and reaped back in multiples. Strategic




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Financial Management is an approach that takes a long-term view of financial

performance of the business enterprise.

2. It focuses on profitability and wealth maximization to facilitate better competitive

position of the firm in future and to invest funds to generate optimal returns over a

period of time.

3. It is result-oriented convergence of resources, especially of financial and economic

resources. They are directed towards the-visionary pursuits and objectives of the

organization. This field manoeuvres the scarce capital resources to generate

maximum benefits, and utilization is optimized.

4. It takes into account an integrated and holistic view of the organization at present

and decides its roadmap for future. While analyzing the inherent capabilities to

make them go with existing us well as anticipated business dynamics, this field

studies the organization in totality with inclusion of facts related to various

segments of the business organization. This approach is followed as the future

implications of decisions will be borne by the organization as a whole. Further, the

long-term strategic perspectives are achieved through integration of plans in the

short-term. Strategic financial planning of flexible nature can be empowering.

5. It establishes coherence between the organization's long-term objectives with the

financial prowess and capability to support such decisions in future. This can be

useful in corporate restructuring decisions.

6. It promotes growth, profitability and sustainability of the organization in the long

haul. It involves visualizing the futuristic image of the firm in the market and

growth potential of the firm today. Strategic Financial Management maximizes

shareholders' wealth through consistent growth and profitability.

7. It is an evolving and perpetual process that engages constant revamping of strategies

to achieve strategic financial objectives, especially enhancing the value of the firm.

8. The concepts of Strategic Financial Management apply contemporary and

traditional financial evaluation techniques to enhance strategic decision making.




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9. It incorporates an innovative, creative, multi-dimensional and lateral thinking

oriented approach towards devising solutions to problems.

10. It is an amalgamation of analytical financial techniques along with qualitative and

quantitative judgement on factual information. A rational, logical and justified

approach of strategist may help gain better foresights into business situations.

11. It is structured as well as flexible in nature. Some methodologies for analysis are

structured, but decisions may be taken in a flexible manner, like exercising one out

of a number of feasible options (especially in case of capital budgeting).

12. There may be a number of solutions offered while analysing the organization in

context to Strategic Financial Management. The strategist is required to select the

most appropriate solution out of the available feasible solutions, generally trading

off risks and returns.

13. It anticipates repercussions of present decisions in the future. Strategic Financial

Management helps formulate appropriate strategies and facilitates constant

monitoring of the action plan to match the long-term aspirations, both financial and

non-financial.

14. It considers costs on a strategic basis. The benefits derived out of the investments in

short-term and long-term must be satisfactory. This may entail sustainable quality of

investments and capabilities as it focuses on availing lucrative opportunities in

given business circumstances in the most effective and efficient manner possible.

15. It strives to cater to the interests of all the stakeholders. Strategic Financial

Management aims to provide them with consistent, stable and progressive benefits

over time for being associated with the business enterprise. It may focus on wealth

creation and capital appreciation through a strategic approach to dividend policy.

Thus, strategic financial management is the field of study that is proactive in nature and

adopts a strategic approach to efficient management of funds to help companies survive

competition in business and sustain in the long run. It is a multi-faceted field and it can

include a number of decisions in its scope.




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2. Explain the scope of strategic financial management.

Strategic Financial Management is of recent origin. Challenges have necessitated the

requirement to adopt a multi-dimensional approach to the management of resources. The all-

pervasive management function is becoming comprehensive to include various combinations

of aspects spread across in the organization. Strategic Financial Management has a wide

scope and includes various management discipline inputs to provide for profitability and

sustenance to strengthen the financial status of the firm. Broadly, the scope of strategic

financial management extends to five main areas:

1. Strategic investment management decisions

2. Strategic financing management decisions

3. Strategic liquidity management decisions

4. Strategic approach to shareholder's wealth management and value of firm decisions

5. Strategic profitability management

First, the strategic investment management involves the decisions related to the long-term

benefits derived out of the capital invested today and its feasibility with the organization's

goals is ascertained. Capital budgeting techniques are available to analyse risk and return

levels, using a number of methods. Strategic investments are made if the returns are adequate

in the long run (considering many other factors).

Secondly, strategic financial management deals with the strategic financing management

decisions that take into account the amount of funds required in the long run. A firm cannot

anytime raise any amount of funds as it has to maintain a balance between *the costs to pay

for raising these funds like interest payments for raising debt, or payment of dividends to

shareholders, etc. over the long run. Inapt decisions may lead to financial imbalances within

the firm. For instance, excessive debt may cause financial burden and if a company in future

wishes to raise more funds, it will be seen as a risky firm. So, funds will be either inadequate

or raised at additional costs if financial status is not sound.




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Thirdly, strategic liquidity management decisions are important as a firm has to maintain cash

reserves for future and contingencies. If the liquidity is not there, then a firm may face

financial agony.

Fourthly, the strategic value creation of the firm enhances the market status of the firm.

Consistently well performing companies win the trust of existing as well as potential

shareholders or investors. This increases the worth of the company's shares in capital

markets, which creates wealth and value of the firm in the long run.

Finally, a company cannot sustain in the future unless and until consistent adequate profits

are planned and generated. The source of revenue has to be pre-decided to obtain profits in

future. It can be closely related to investment decisions as the revenue generation will be

from operations, investments, divestments, etc.

The scope of strategic financial management is expanding. With the increasing need to

manage funds more effectively and efficiently, to generate optimum returns in the future,

strategic financial management, as an academic discipline as well as a practical technique in

business, is gaining momentum. Recently, the business economic conditions have been

challenging and strategists tried to safeguard the interests of their stakeholders by utilizing

superior management techniques wherever possible. In such a business environment, sound

management of resources is crucial. For this, foresight and proactive approach are the

facilitators that form an integral part of strategic financial management.

3. Discuss the success factors to strategic financial management.

Strategic financial management can be a catalyst for superior financial status of the firms. A

business firm aspires to build harmonious, long-term relationships with its investors, creditors

and stakeholders. It also intends to establish itself as a socially responsible business entity.

There are various factors that help businesses succeed in establishing themselves as

successful organizations. Effective strategic financial management provides endurance to

firms to sustain business pressures. Strategic financial management offers various success

factors that may help a firm achieve optimum utilization of financial resources and improvise

financial status of the firm. The various factors are enlisted below:




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1. Principled economic approach This factor relates to generating superior revenues

within the constriction of ethics and values of business without compromising on

the quality of products and services. Sometimes, a business may pursue short-term

profitability by compromising on quality, which negates sustainability and

profitability. Long-term building of consistent profits along with appropriate quality

can be achieved through strategic financial planning.

2. Strategic approach to intrinsic competencies and costs Strategic financial

management facilitates focussing on central capabilities and intrinsic competencies

so that business becomes sustainable. It is further stressed that the costs be viewed

in the long-term perspective and not to constrict costs to generating superior returns

in short-term. It follows a wider perspective towards investments and return on

investments, through a balanced approach.

3. Structured system approach with' scope for flexibility Strategic financial

management follows a balanced approach towards the mechanisms of the

organization. The methods and systems are structured, automated, documented, and

still allow space for flexibility required due to dynamic changes. This makes

strategic financial management dynamic in nature. To be static is to be subjecting to

obsolescence.

4. Strategic approach to cost management Strategic financial management follows a

long-term perspective on managing costs. The short-term costs are perceived for

receiving benefits in the long run. The long-term impacts of the costs must not be

overlooked. It is tempting to cut costs and compromise on quality. This generally

puts the long-term image building in the market at stake. The long-term vision,

perspective and image should be kept in mind. Strategic cost benefit analysis may

be helpful in certain business conditions.

5. Positive responsiveness to dynamic environment The business must be prepared for

unexpected business changes. A proactive approach will facilitate positive

responsiveness to the environment. Strategic financial management facilitates

superior evaluation of projects and funds management, and provides for adequate




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resources to avail opportunities like corporate restructuring, technological prowess,

product developments, market expansions, etc.

6. Survival and sustainability Strategic financial management puts the organization in

a strong and capable financial position to survive competition, innovate, and sustain

the market leadership position strategically.

7. Adaptability Strategic financial management advocates a constant environmental

analysis and generates funds with futuristic approach. When the changing

dimensions can be identified well in time, then appropriate provisions can also be

created proactively. So, constant analysis, evaluation and match of internal

capabilities with external environs can be made. This would encourage better

adaptability of the organization.

8. Financial control and prowess Financial controls arrest wastage of financial

resources directly and other organizational resources indirectly. This helps in

investing resources in the most appropriate manner. The control measures build

expertise in the utilization of resources. Control does not imply deterioration of

quality or capabilities; it checks wastage and wasteful expenditure of funds.

In a nutshell, it is necessary to understand the strategic approach to funds management. The

basis of success factors is the ethical approach of the companies towards business and

stakeholders. The sustainability may rest on the idealism that the business leaders follow,

compatible with evolution.

4. What are the constraints to strategic financial management?

Strategic financial management requires technical expertise, knowledge, analytical skill,

wisdom, decisiveness, innovative approach, etc. to justify its academic capabilities. There are

certain constraints that come into picture when strategists have to make crucial decisions with

strategic impacts. Some major issues that pose constraints are discussed below.

1. Closely linked to personal attributes of strategists The attitude of the decision maker

or strategist will determine the quality of decisions and how the vision for the




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organization is followed. Their incapability may affect the overall direction of the

organization that can be detrimental. The preconceived biases must be dislodged.

2. Capability to have a panoramic view on situations The strategist as the decision

maker must follow a multi-dimensional, multifaceted, innovative, creative, and

visionary approach. It takes great level of maturity and competence to imbibe this

demanding approach. Any rigidity, bias, pre-conceived notions of the strategist on

personal grounds, restrictive thinking, suppression and autocratic approach can defy

the whole purpose of envisioning.

3. Technical know-how The strategist is required to have mastery over finance

methodologies, technical knowledge, inter-linkages of various issues, consequential

impacts, etc. The ability to make accurate deductions is challenging and requires

chiselled analytical skill. If the strategist falters to justify his competence, the

purpose of strategic financial management may be diluted.

4. Approach towards problems If problems are not perceived properly, they may

become insurmountable. A solution-oriented approach requires a great deal of

practicality and optimism. This combination may not be readily available in the

workforce.

5. Resource constraints Due to sudden environmental pressures, resources may not be

available to pursue the vision. There can be issues with vendors, distributors,

personal rivalries, etc. which may impede the pursuit of goal.

6. Conflict between owner's and strategist's vision The owners participating in decision

making may not agree with the strategist's devised direction for the company. This

may tug the organizational resources and productive inputs in conflicting directions.

This is counter-productive for the organization.

7. Inability to integrate The strategist may become biased towards certain segments or

notions. This may bring rigidity in planning and constrain the wider perspective.

This may not provide proper integration of various segments, systems and processes

in the organization. The inability to connect with the organization as a whole may

be impairing.




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Therefore, it is necessary to vest the decision making related to strategic moves in finance in

capable and competent leaders. The dexterity of the strategist is crucial. Further, the way

strategy is perceived and implemented also counts.

5. What is financial planning? Explain the characteristics of a sound financial plan.

Financial planning is a process of analyzing the financing and investment choices, projecting

the future consequences of present decisions, deciding which alternatives to undertake and

measuring subsequent performance against the goals set in the financial plan. It involves

analyzing the financial flows of a firm, forecasting the consequences of various investment,

financing and dividend decisions and weighing the effects of various alternatives. The main

objective is to determine where the firm has been, where it is now and where it is going.

A sound financial plan is one which follows the principles and practices of corporate finance.

The finance manager should consider the following principles while formulating a sound

financial plan:

1. Simple and easy to understand The financial plan should be easily understandable

by a layman. It should not create any suspicion in the minds of investors and should

be free from complicated statements, involving more types of securities leading to

confusion among investors!

2. Future guide A financial plan should be prepared after taking into consideration the

future requirements of funds. The plan which is prepared with some foresight

definitely helps the firm to meet its requirements.

3. Flexibility The financial plan of a firm should be flexible enough to meet the

changing requirements of funds of the firm. Financial plan should be flexible enough

to allow to raise additional funds and also to reduce the capital raised through issue of

equity shares, preference shares and bonds. The capital can be reduced by issue of

redeemable preference shares or loans or debentures.

4. Liquidity A sound financial plan helps the firm by maintaining adequate liquidity.

Liquidity ensures the creditworthiness and goodwill of the firm.




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5. Cost of funds The cost of procurement of funds is another important consideration

while formulating a financial plan. The funds should always be raised at minimum

cost. Cost can be minimized by proper selection of various sources of finance and

proper mix of debt and equity.

6. Ploughing back of profits A part of profits should always be ploughed back in the

business to meet future contingencies. Contingencies are unexpected. A financial

planner should always forecast which kind of contingencies the firm is likely to face

and how they can be managed.

7. Less dependence on outside sources A long-term financial plan should aim to

reduce dependence on outside sources. In the beginning, outside funds may be a

necessity, but financial planning should be such that dependence on such funds may

be reduced in due course of time.

8. Profitability A financial plan should adjust the securities in such a way that profits of

the firm are not affected at all. There should be a proper balance between interest

bearing securities and other liabilities so as to improve the profitability position of a

firm.

9. Optimum risk A financial planner should maintain a proper proportion between

long-term and short-term funds so as to minimize the risk and maximize the

profitability of a firm.

6. Explain the process of financial planning.

The process of financial planning involves the following steps given below:

1. Determining financial objectives: The first step in financial planning process is

determining financial objectives of a firm. The financial objectives may be both short

term and long term. The main aim of this plan is best possible utilization of financial

resources for achieving these objectives. Projection of financial statements is very

much needed, as it helps to analyze the effects of operating plan on projected profits

and various financial plans.

2. Determining the requirements of funds: After determining financial objectives, the

next step in financial planning process is to determine the requirements of funds,




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whether short term or long term. It is decided whether the funds are needed to be

invested on fixed assets as well as current or for research and development

programmes.

3. Availability of funds: The required funds may be generated from two sources, i.e.

internal and external. An estimation of funds to be generated from internal as well as

external sources is identified in advance.

4. Establish and maintain systems of controls: Planning and control are the two main

functions of management. Control system is required to establish to ensure the proper

and effective utilization of funds. It confirms that the basic financial plan is carried

out properly.

5. Formulating procedures: Procedures are formulated to ensure consistency of

actions. The procedures follow the formulation of policies. If the policy is to raise

funds from banks and financial institutions who are authorized to initiate such actions.

6. Flexibility: Financial planning should ensure proper flexibility in policies, objectives

and procedures so as to adjust according to changing economic situations. The

changing economic environment may offer new opportunities. The business should be

able to make use of such situations for the benefits of the concern.

7. Discuss the objectives of financial planning.

The following are the main objectives/importance of a good financial plan:

1. Determine financial objectives The main objective of a financial plan is to determine

the financial resources required to meet the company's financial objectives. It also

Flexibility

Formulating Procedures

Establish and Mantain Systems of Conytrols

Availability of Funds

Determining the Requirements of Funds

Determining Financial objectives




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ensures availability of sufficient funds to invest in feasible projects by achieving the

company goals.

2. Forecasting the sources of funds Another main objective of financial planning is to

forecast the extent to which the requirement of funds will be met by internal sources

and to what extent they will be met from external sources.

3. Balance in risk and costs The main consideration while raising the required funds is

to maintain a balance between risk and costs to protect the interests of investors.

4. Sound financial structure The financial structure should not be made complicated

by issuing a variety of securities. The company should issue very few securities to

make it simple and easily understandable.

5. Flexibility The financial plan should be flexible so as to adjust the plan as per the

changing business environment.

6. Liquidity It means the ability of a firm to meet its short-term obligations as and when

they become due. So, the main objective of a financial plan is to provide the funds in

the period of depression also.

7. Proper utilization of funds The main aim of a financial plan should be the proper

utilization of funds for genuine needs. It should not neither result in shortage of cash

or have excess funds which ultimately lead to wastage. So, the ultimate aim of a plan

should be to raise the funds according to the needs and requirements of business and

should be utilized properly.

8. Minimum cost The main objective of a financial plan is to raise the funds at

minimum possible cost. The cost should not be too high so as to put unnecessary

burden on the firm. It must ensure optimum debt-equity mix.




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Chapter 2 Capital Budgeting decision under Risk and Uncertainty


1. What is risk?

Risk is the potential for variability in returns.

2. State the elements of risk.

Systematic and unsystematic risks are the two components of total risk.

3. What is systematic risk?

Systematic risk is the risk which is directly related with the overall movement in general

market or economy.

4. What is uncertainty?

Uncertainty may be defined as "the unforeseen chance for future loss or damage".

5. What is financial risk?

Financial risk refers to the variability in return due to capital structure.

6. State the types of business risks

Internal business risk and external business risk are the types of business risks.

7. Write the full form of RADR.

Risk-Adjusted Discount Rate

8. Mention one limitation of decision tree analysis.

Its format is in the form of branches of a tree which may become unwieldy and

complex if the project has a long life with different probabilities of cash flows.

It is very time-consuming and difficult to apply to a project when the product or

service is new and the firm has less knowledge about the response of consumers.

It involves cumbersome calculations when its tree diagram becomes more and more

complicated due to more and more alternatives.




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Decision trees are difficult to apply when investments are gradually made over a

period of time rather than in a few well-defined stages.

9. What is certainty?

It means no risk.

10. What is risk premium?

Risk premium rate is the extra return expected by investors over the normal rate (i.e. risk-

free rate) on account of project being risky.


1. State the types of systematic risk.


market or economy. It is non-diversifiable and is associated with securities market as well

as the economic, sociological, political and legal considerations of prices of all securities

in the economy.

2. What is unsystematic risk?

Unsystematic risk refers to variability in returns caused by unique factors relating to that

firm or industry like management failure, labour strikes, and shortage of raw material.

When variation in returns occurs due to such firm-specific factors, it is unsystematic risk.

This risk is unique or specific to a company or industry.

3. State any one difference between risk and uncertainty.

Risk and uncertainty go together, but there is a difference between these two. Risk refers

to a situation in which the decision-maker knows the possible consequences of an

investment decision.

Whereas uncertainty involves a situation about which the likelihood of possible outcome

is not known. So, the word 'risk' includes all the elements of variability of returns,




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uncertainty of outcome, etc. Some of the risks can be controlled by the investors by

proper planning, but uncertainty has to be borne compulsory by investors.

4. State the types of uncertainty.

Uncertainty can be classified into the following categories:

Market uncertainty

Technical uncertainty

Competitive uncertainty

Technological uncertainty

Political uncertainty

5. List various sources of uncertainty.

The sources of uncertainty are discussed below in detail:

Information incomplete

Reliability of sources of information

Variability

Linguistic imprecision

6. What are the various types of investment decisions?

The decision situations with reference to risk can be divided into three types:

Certainty (no risk

Uncertainty

Risk

7. Write the merits of RADR.

It is easy to understand and very simple to calculate.

It gives some premium for risk as it gives psychological satisfaction to the decision

maker.

8. State the process of decision tree analysis.

The following steps are taken for constructing a decision tree:

Identification of problem




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Identifying various alternatives of investment

Preparing decision tree

Specification of data

Evaluation of alternatives

Selecting best alternative

9. State the techniques of investment decisions.

Risk Adjusted Discount Rate Method

Certainty Equivalent Method or Approach

Simulation Analysis

Sensitivity Analysis

Decision Tree Analysis

10. Define certainty equivalent approach.

Certainty equivalent method is a risk incorporation technique which adjusts the expected

cash flows, instead of adjusting discount rate. The estimated cash flows are reduced to

certain amount by applying a correction factor known as certainty equivalent coefficient.

This correction factor is the ratio of risk less (certain) cash flows and risky (uncertain)

cash flows.


1. Write a brief note on certainty equivalent approach.

Certainty equivalent method is a risk incorporation technique which adjusts the expected cash

flows, instead of adjusting discount rate. The estimated cash flows are reduced to certain

amount by applying a correction factor known as certainty equivalent coefficient. This

correction factor is the ratio of risk less (certain) cash flows and risky (uncertain) cash flows.

Riskless cash flows means the cash flow which the management is prepared to accept in case

there is no risk involved. For example, a project is expected to generate a cash flow of ?




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20000. The project is risky, but management feels that it will get at least a cash flow of ?

12000. It means that certainty equivalent coefficient is 0.6 (i.e. 12,000/20,000).

Certainty equivalent coefficient assumes a value between 0 and 1 and varies inversely with

risk. After calculating certainty equivalent coefficient, the next step is to calculate present

values using risk-free rate. There is no addition of risk premium, because uncertain cash

flows are converted into equivalent cash flow. We can use either NPV or IRR techniques.

1. In the case of NPV method:

If NPV of certainty equivalent cash flow > 0 (accept)

If NPV of certainty equivalent cash flow < 0 (reject)

If NPV of certainty equivalent cash flow = 0 (consider)

2. In the case of IRR method:

If IRR > risk-free rate (accept)

If IRR < risk-free rate (reject)

If IRR = risk-free rate (consider)

Merits of CE method

It is simple to understand and easy to calculate.

It is superior to the risk-adjusted discount rate method because it does not consider

that the risk increases with increases in time.

Demerits of CE method

It is difficult to consider increasing risk capacity.

It is inconvenient and difficult to allocate CE coefficients.

2. Write an essay on a simulation analysis.

Simulation method is David B. Hertz's contribution to evaluate risky investments. He

proposed a simulation model to obtain the expected return and dispersion about it for an

investment proposal. This is also known as method of statistical trials or Monte Carlo's




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simulation. Computer languages have been developed especially to facilitate Monte Carlo

simulation. It involves random selecting of an outcome for each variable or element,

combining of these outcomes with any fixed amounts and obtaining one trial outcome in

terms of the desired answer.

The main requirement of simulation method is that the outcomes of all variables of interest be

randomly selected, i.e. the probability of selection of all possible outcomes be in accordance

with their respective probability distributions. This is done through the use of tables of

random numbers and then relating these numbers to the distributions of variables. Random

numbers are generated in such a manner that there is an equal probability of every number

appearing each time. Simulation method is generally used to solve problems which cannot be

adequately represented by mathematical models or where solution of models is not possible

by analytical method.

Advantages or merits of simulation method

1. This method is used to investigate the behaviour of problems which are too complex

to be modelled mathematically.

2. The main advantage of this technique is that we now have normal distribution from

which we can get a mean and a standard deviation for use in other analysis to accept

or reject the project.

3. The basic principles of this method are fairly simple and so it is more attractive to

people who are not expert in quantitative techniques.

4. This method only refers to table model and results in saving of cost.

5. Time is saved in this method as the effects of ordering, advertising or other policies

over many months or years can be obtained by computer in a short time.

Disadvantages of simulation method

1. Reliable results are not possible keeping in view the complexity of estimating and

specifying the relationship between factors.

2. This method is very time-consuming and costly as it involves a lot of data and its

solution cannot be applied to other similar kinds^ of problems also.




23

3. Simulation methods are not as efficient as analytical methods.

4. Managers have to generate all the conditions and constraints for solution to get the

desired results.

5. To cope with the amount of calculation, a system is required.

3. Describe sensitive analysis.

Sensitivity analysis is concerned with judging the sensitivity of items of data which are

needed to make a decision. Sensitivity testing is the assessment of effect on results of the

decision if one or more items of data vary and also if the number of factors involved differs.

Risk is the degree of uncertainty about an outcome. Sensitivity analysis is an approach for

assessing risk. It provides several possible return estimates to obtain a sense of the variability

among outcomes.

Sensitivity analysis gives information about the sensitivity of estimated project parameters,

i.e. discount rate, selling price, units sold, economic life, etc. about estimation errors. As the

future is uncertain, the decision maker wants to properly review the viability of the project if

the project parameters deviate from its expected value. This is also known as what if analysis.

It provides a more precise idea about the variability of return.

Sensitivity analysis provides information about cash flows under three assumptions:

1. Pessimistic (the worst)

2. Most likely (expected)

3. Optimistic (the best)

The future cash inflows are discounted to find out the net present values under three different

situations. So, the risk of the project is measured by range of NPV. The range is calculated by

substituting the pessimistic outcomes from optimistic outcomes. The greater the range, the

more variability or risky is the project and vice versa. If the net present values under the three

situations differ widely, it implies that there is a great risk in the project and the investor's

decision to accept or reject a project will depend upon his risk bearing ability.

Merits of sensitivity analysis




24

Sensitivity analysis has the following merits:

1. It helps a decision maker in knowing the viability of a project in totality by

considering the variables which affect the forecast of cash flows.

2. It helps to find out inappropriate forecasts as it indicates the areas where

improvements are likely to have great impact on results.

3. It helps to frame alternative plans if there is a change in the basic assumptions.

Demerits of sensitivity analysis

The following are the demerits or limitations of sensitivity analysis:

1. There is an ambiguity in results or assumed possible outcomes. It means different

things to different people. So, the values provided by different possible outcomes may

be inconsistent.

2. It fails to focus on the interrelationship between variables.

3. It is very subjective in nature as same sensitivity analysis may lead one decision

maker to accept the project while another may reject it.

4. It ignores the chances associated with different possible values of variables.

4. Discuss different types of risks.

The risk in an investment is due to variability in its returns. The variability in returns is due to

a number of factors. The factors which contribute to variations in returns from an investment

constitute the elements of risk. The elements of risk are also the components of risk and can

be broadly classified into two groups or two types.

Total risk = Systematic risk + Unsystematic risk or General risk + Specific risk

Systematic Risk


market or economy.

Interest rate risk: Interest rate risk is the variation in the returns of a security resulting from

changes or fluctuations in the level of market interest rate. Mostly, interest rate risk affects




25

the prices of bonds, debentures and stocks. Interest rate risk is a systematic risk which

directly affects bonds and indirectly affects shares.

Market risk: Market risk is the risk which is caused due to variation in a security's return,

resulting from changes or fluctuations in the stock market.

Purchasing power risk: This risk arises out of change in the prices of goods and services

and covers both inflation and deflation period. In India, purchasing power risk is related with

inflation and rising prices in the economy.

Exchange rate risk: Exchange rate risk can be defined as the variability in returns on

securities due to currency fluctuations. This is also known as currency risk.

Unsystematic Risk

Unsystematic risk refers to variability in returns caused by unique factors relating to that firm

or industry like management failure, labour strikes, and shortage of raw material. When

variation in returns occurs due to such firm-specific factors, it is unsystematic risk. This risk

is unique or specific to a company or industry.

There are two sources of unsystematic or unique risk, i.e. business risk and financial risk. Let

us discuss each of them.

Business risk: Business risk is the variability in operating income due to operating

conditions of the company. This risk is sometimes external to the company due to changes in

government policy or strategies of competition or unforeseen market conditions. Business

risks also may be internal due to fall in production, labour problems, raw material problems

or inadequate supply of electricity etc.

Business risk can be divided into two types: Internal business risk and External business risk.

Financial risk: Financial risk refers to the variability in return due to capital structure.

Capital structure of the company consists of equity funds and borrowed funds. It is usually

measured by debt equity mix of the firm. The variance in return is the financial risk.




26

Chapter 3 Mergers and Acquisitions


1. What is synonym of Amalgamations?

Merger is the synonym of Amalgamations.

2. What is meant by merger?

Mergers mean merging, implying coming together of separate or similar things.

3. What are the main objectives of mergers?

The major objective is to embrace the opportunities available in the market places.

4. What is meant by horizontal merger?

A horizontal merger is the combination of two or more firms that produce the same

goods or service.

5. What is meant by reverse merger?

Reverse merger, in the Indian context, is the process when a smaller company initiates

merger with a larger company.

6. What is the time limitation for publication of an advertisement regarding merger

in newspapers?

Publication of an advertisement or notice regarding merger in at least two newspapers

within 21 days.

7. Who can issue NOC for a merged company?

Obtaining no objection certificate (NOC) from shareholders of both companies

(Under exceptional circumstances, this may be exempted from meeting to reduce time

and costs.)

8. What is the time limitation for submit the certified copy of high court order to

the registrar of the company?




27

Certified copy of High Court sanction order is submitted to the Registrar of

Companies within 30 days of issue of this order.

9. According to Companies Act how many shareholders agree to the proposal of

the merger?

Companies Act states that the 90% of shareholders (whether present or voting) of a

company must agree to the proposal of the merger. Let us understand it to gain clarity

about this mode of unification.

10. Mention the other term used for Acquisition.

Takeover is the other name of acquisition.

11. How are target companies identified?

Undervaluation of company

12. What is the main objective of acquisition?

The major aim of acquisitions is to avail growth opportunities and safeguard against

hostile takeovers in the future.


1. Define merger.

Mergers mean merging, implying coming together of separate or similar things. It can

also be called a happy blending of two or more organizations. Mergers are also known

as amalgamations in India. These bring together organizations with a mutual benefit

and in a friendly manner.

According to James C. Van Home, 'Merger is a combination of two companies in

which eventually only one survives as the merged company loses its existence.'

2. State any four characteristics of merger.




28

The terms 'merger or amalgamations' have distinctive characteristics which are as

follows:

Merging of companies by purchase of assets or stock.

Loss of entity of the merging company.

A friendly deal.

Mutual benefit.

Pooling the resources.

Impact on the value of the firm.

Compensation to.

3. Write any four objectives of merger.

The motives or purposes can be enlisted as follows:

Growth objective of an organization

Expansion

To compete better in intense competition

Synergies and economies of scale

A safeguard against future takeovers

Value chain

Surplus resources

Survival—the shark and fish syndrome

Turnaround strategy

Innovation for a mature company

Risk management

Retention of talented human capital

Tax planning

Revival and reconstruction

As a logical natural requirement

4. What is meant by congeneric merger?




29

A merger between firms of related industry. This means the firms are of similar nature

but do not manufacture the same products. It relates to a merger between firms of

general industry but not a buyer or seller. For instance, merger between a bank and a

leasing firm.

5. State the payment options available for merger.

Various modes of payment or compensation can be categorized into any of the four

forms, namely, cash, ordinary shares, loan stock and convertible loan stock.

6. What is the role of investment banker?

The role of investment bankers in mergers and acquisition is given in below:

Arrangement for merger and acquisition through specialized defence

group/identity firms

Devising or designing offensive and defensive tactic/ ^

Facilitate fair valuation of firms during merger transaction

Funding for mergers and acquisition

Arbitrary services

Other corporate alliances etc.

7. State the popular valuation methods for merger?

Capitalized earnings, Asset based valuation approach, market based valuation

approach and earnings per share approach.

8. What are the first two steps of a merger transaction in India?

Screening and investigation of a merger proposal.

Negotiation between the companies takes place.

9. State the constraints to a reverse merger.

Some possible constraints are identified and enlisted below.

Acceptability of reverse merger in markets

The pinch of salt




30

Valuation issues

10. Define acquisition.

The basis of a union based on acquisition is to acquire a controlling interest in the

target company to gain the decision making power and control. Acquisitions can be

either friendly or hostile. As said by James C. Van Home, 'Strategic acquisitions

involve one company acquiring another as a part of overall strategy.'

11. State the characteristics of acquisition.

The other characteristics are:

Acquiring a controlling interest or stock holding

Uninvited manoeuvre

Intention of invasion

Aggressive in nature

Unpredictability

12. What are the rules for successful acquisition?

Think what value can be added to the acquired business, not just synergies.

There should be some common ground for these businesses.

Genuine regard for the product offering of acquired firm.

Stability of top management of the acquired firm.

Career progress of personnel over a year or so.


1. Explain the characteristics of merger.

The concept of mergers and amalgamations relates to merging of two or more

companies to form a new entity with the purpose of fostering rapid growth of the firm.

The terms 'merger or amalgamations' have distinctive characteristics which are as

follows:




31

1. Merging of companies by purchase of assets or stock A merger takes place

when the assets of one company are purchased by another company fully or

partially and the payment is made in the form of cash or stock. The company

that has been merged loses its being and the assets become part of the

purchasing company. This company obtains assets and liabilities, but has to

pay off the shareholders.

2. Loss of entity of the merging company The merging company loses its

existence and entity to the procuring company along with transferring assets

and liabilities. Usually, the more established (or larger) company's name gets

carried forward in order to enhance market presence. So, in the end, only one

company's name exists.

3. A friendly deal The merger deal in most cases is relatively friendly and is

with consent to the merging company. No forceful means are used to strike the

deal. It is characterized by the harmonious and willing blending of the

companies.

4. Mutual benefit Mergers offer a win-win situation to both merging and

merged companies. They share the technical resources, funds, human resource

or human capital-skill, knowledge and experience of the manpower. They also

integrate their market networks to make use of one company's licence.

5. Pooling the resources As in the concept of teamwork, a combination of

different individuals with different skills and expertise is able to achieve the

output which is more than what they can achieve individually. This concept is

called synergy, where 2 + 2 (input) = 5 (superior output). Similarly, when

good companies combine their resources and are in a win-win situation, there

is a synergizing effect seen in the form of amplified profits, productivity and

greater market share.

6. Impact on the value of the firm Initially, the investor confidence may rise.

So it improves the image of the company in the eyes of the public and the

stakeholders. The perception of the competitors also changes and the position




32

of the company is enhanced. The period of sustenance of this image depends

on the performance levels of the company.

7. Compensation to shareholders It is mandatory to take care of the interests of

shareholders of all the companies that are merging. The usual end result of

party negotiations is done through determination of acceptable swap ratio or

similar benefits as compensation.

The weightage of these characteristics is situational in nature. Also, the terms and

negotiations bring forth newer dimensions to a merger deal and its end result.

2. Discuss the reasons behind merger.

Mergers have a strategic approach. There has to be lucrative returns. Only then such

strategic decisions are taken and resources are allocated to these pursuits. So, the

motives or purposes can be enlisted as follows:

1. Growth objective of an organization A company could be looking at

growth potential that is prevalent in the economy and existing industry as

well.

2. Expansion: Expansion relates to extension towards international markets,

inclusion of product lines, operational capacity and capability, etc.

3. To compete better in intense competition In order to capture the markets

in an opportune time and before the competitors, companies could look into

mergers as this may ideally expand the market presence and image, and help

counter competitive strategies by the rivals.

4. Synergies and economies of scale Synergies build up distinctive and

complimentary existence. The value of the two firms together should be far

greater than their value as individual companies.

5. A safeguard against future takeovers The organizations that perceive

themselves as soft targets for acquirers try to counter their intentions by

using mergers as a leeway to grow big enough such that possible takeover

becomes difficult for the prospective bidder.




33

6. Value chain The concept of value chain was given by Michael E. Porter. At

each step, the value is added to the existing processes in order to pursue

optimal quality of the end product in an efficient and effective manner.

7. Surplus resources In some of the situations, companies have very good

liquidity position along with additional reserves and surpluses.

8. Survival—the shark and fish syndrome As the survival rests on the theory

of evolution, 'survival of the fittest', the companies need to consolidate and

support each other.

9. Turnaround strategy During the phases of change happening all around,

many sick companies plan to overhaul their present conditions

10. Innovation for a mature company Companies have their life-cycles,

starting with its inception, growth, boom, maturity and degeneration.

11. Risk management In the unpredictable economic environment, companies

face numerous risks.

12. Retention of talented human capital In today's era, there is an increased

trend of employees of one organization moving to another in the same or

different industry.

13. Tax planning As companies generate more profits, they need to balance the

profit margins productively, else a heavy chunk of profits flow out of the

company in the form of taxes.

14. Revival and reconstruction benefits The Government of India encourages

the revival of sick units through merger with top-notch performers and offers

them tax benefits, exemptions and tax holidays, etc.

15. As a logical natural requirement/process Due to their perpetual existence,

it is a temperamental facet of organizations to nurture and develop

themselves over a period of time.

3. What is merger? Explain the types of merger.

Mergers mean merging, implying coming together of separate or similar things. It can

also be called a happy blending of two or more organizations. Mergers are also known




34

as amalgamations in India. These bring together organizations with a mutual benefit

and in a friendly manner.

Mergers may be of various types. Depending on the manner in which companies

come together, they are categorized into four main types by various academicians,

which may further have their extensions. We restrict our discussion to the four major

types.

1. Horizontal merger A horizontal merger is the combination of two or more

firms that produce the same goods or service. These are the existing firms

that wish to consolidate the resources to grow into a bigger company. This

merger may help reduce rivalry among the firms and bring harmony in the

relevant industry.

2. Vertical merger The vertical merger relates to the combining of firms that

are forward or backwards on the supply chain. So, a merger between a firm

and its supplier of raw material or the distributor of its products is known as

vertical merger.

3. Congeneric merger A merger between firms of related industry. This

means the firms are of similar nature but do not manufacture the same

products. It relates to a merger between firms of general industry but not a

buyer or seller. For instance, merger between a bank and a leasing firm.

4. Conglomerate merger A conglomerate merger is the merger of two firms

from entirely non-related industries. These firms have no similarity in their

product or service offering. For instance, a merger between a car

manufacturer and a fashion textile company

4. Write a short note on payment options available for a merger.

5. Discuss popular valuation methods in case of merger.

Valuation must be authentic and besides the negotiated values, valuation must include

the asset base existing in companies, earning capacity of respective firms in future,

value of existing assets at present value, amount of liabilities, analysis of capital




35

structures, the defaults if any, etc. Valuation is required in most of the corporate

restructuring techniques as well. An overview of the popular valuation methods is

given below:

1. Capitalized earnings or capital budgeting or discounted cash flows

approach The capitalized earnings method is based on the assumption that

the quoted price must include the present and potential earning capacity of

the business in future. The future earnings should be capitalized to arrive at

justified price for the firm. The compensation value for merger must

incorporate these factors. If the earnings are consistent, then experts will be

in a better position to make future estimates and arrive at the fair value of the

company.

2. Asset based valuation approach This approach rates the value of the firm

on the basis of asset base it owns and its worth. In this approach, the

physical assets may be taken only at their monetary quantification values or

sometimes the qualitative assets like goodwill, patents, innovative research,

and the like may be recommended to be included.

3. Market value based valuation approach This method intends to value the

firm on the basis of its stock performance in stock markets. The value is

derived on the basis that the price of security in open market, based on

demand and supply, will be the best determining factor.




36

4. Earnings per share (EPS) approach In this approach, the estimate is made

regarding the fact that if this merger comes through, then what will be the

increase or decrease in earnings per share of the firm. The method involves

supplementary information related to price earnings ratio, and studies the

impact of EPS on the value of the firm in stock markets.

6. Define reverse merger. Discuss constraints to reverse merger.

Reverse merger, in the Indian context, is the process when a smaller company initiates

merger with a larger company. In the international context, reverse merger relates to

the taking over of a public company by a private company with a major objective of

availing listing benefits.

Constraints to Reverse Merger

A reverse merger may seem lucrative as it provides cost benefits, synergies,

promising growth in earnings, etc. but it may suffer from certain constrictions that

may not help the companies to reap long-term strategic benefits. Some possible

constraints are identified and enlisted below.

1. Acceptability of reverse merger in markets A rough estimates of value

generation can be made prior to reverse merger, but in reality the investors of a

company and shareholders (especially short-term speculators) may become

doubtful about future returns post reverse merger. In case the shareholders start

to sell the share in bulk due to perceived low returns in future, then the value of

the firm will be adversely affected.

2. The pinch of salt If the smaller company has unfavourable historical issues, then

those will become an integral part of the merged company. This may impact the

public image.

3. Valuation issues The valuation and market worth of the smaller non-listed

company may not be accurate as the shares of this company are not traded in the

stock market. So, its market value may not be ascertained. This will crop up

issues regarding profit sharing at the end of the financial year.




37

7. What are the constraints to acquisition?

Even though the concept of mergers and acquisitions may offer a lot of advantages

and strategic foothold to the companies, there are many constraints or challenges to

such endeavours. Some of the constraints are discussed below.

1. Lost control The target company once taken over loses the decision making

power and control over its operations. This may not be in the best interest of the

target company's stakeholders because the acquiring firm may have its own

ways. It may even sell assets of the company in market piecemeal (at break-up

value).

2. Shareholders of the acquired company may not derive adequate satisfaction

When it is an acquisition, the acquiring company's management has the controls.

They may not provide any compensation to the existing shareholders of the

acquired company. These stakeholders may be left at a losing end.

3. Ego-centric pursuit may not assure long-run compatibility The decision for an

acquisition has to be made with diligence. If the target company has been

acquired out of the whim and ego-centric approach of top management, without

checking the strategic viability of the deal and resources invested, then it may

not sustain the test of time. This move may even imbalance the internal

resources of the acquiring firm.

4. New equity-liabilities must be balanced The acquisition deal brings in new

influx of resources, both assets and liabilities. The company should be in a

position to absorb them with least possible hick-ups. This aspect must be pre-

estimated and provisions should be created in advance to balance them.

5. Cost to tactics Generally, there is a cost associated with these tactics being

played during the pursuit. These may have hidden costs and implications. The

company may have struck the deal, but it will all come clear when all the costs

are attributed to decisions.

6. Alternative options forgone Once the resources get engaged in the acquisition,

they may become irreversible in nature. The company, in order to acquire its




38

target may have to pay way beyond budget. Once it gets into the vicious trap, it

is not easy to pull away. The resources way beyond estimations may get

engaged and committed which may otherwise be invested into more lucrative

avenues.

8. What are the motives of acquisition?

The reasons or motives behind the target company's easy surrender are enlisted below.

7. Non-lucrative existing business All of the existing businesses that a firm has

may not be generating the expected required returns.

8. Existing business offering low synergy or counterproductive core

competence It happens to be the most apt and lucrative segment of the business.

If any of the business in a company's diversified portfolio is not offering any

synergy to the group or core competency is not generated, then it may be

considered feasible to let the business segment go and the company may

welcome the offer from the bidder.

9. Generating cash flows for debt-ridden business portfolio In some cases,

companies resort to debt financing for tax shield purposes. But in course of they

are not able to generate cash flows to service debt, they may land into trouble,

and they may lose out on market valuation, further financing, credibility and

goodwill.

10. Extreme and intense competition from powerful players In a highly

competitive environment, the competition may become very intense which may

make it difficult for small players to exist in the market.

11. To counter stunted growth There are phases in life cycles of products,

industries, and economies that have "their distinctive impacts on organizations.

12. For striking best deal when no escape available This is a situation when a

company analyzes and understands that whatever tactics it may try, the merger

or takeover is inevitable.




39

Chapter 4 Foreign Exchange Management


1. Define domestic currency.

The currency of the home country for an entity is called domestic currency.

2. What is meant by foreign currency?

It means any currency other than the home currency.

3. What is forex market?

Forex Market is a market for buying and selling currencies.

4. Who is the major player in the forex market?

The major players in the forex market are banks.

5. Name the market for international level transaction.

The transactions at the international level take place in the foreign exchange (forex)

market.

6. Name two largest centers of the forex market.

The largest centers are in London (UK), New York (USA), Tokyo (Japan), Hong

Kong, Singapore and Frankfurt (Germany).

7. What is spread?

The difference in bid and ask prices is known as the spread.

8. What is forward premium?

When a currency is costlier in forward, it is said to be at premium.

9. What is forward discount?

When a currency is cheaper in forward, it is said to be at discount.

10. What is fisher equation?




40

Nominal rate of interest = real rate of interest + inflation

11. How may parties involved in bilateral netting?

Only two parties are involved in bilateral netting.

12. Write the full form of PPP.

Purchasing Power Parity


1. What is exchange rate?

Rate for which the currency of a country can be exchanged (bought or sold) for

another country's currency. For example, the exchange rate between Indian "Rupee

(INR) and the Australian Dollar (AUD) is Rs. 49 (Quoted on 1st Sept. 2011).

2. Write the types of quote.

There are two types of quotes, direct and indirect quote.

3. How spread can be calculated?

% age spread = 𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 −𝐵𝑖𝑑 𝑃𝑟𝑖𝑐𝑒

𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 X 100

4. What is forward rate?

It is the rate contracted today for exchange of currencies at a specified future date.

Thus, the price is decided today but the delivery and settlement is made on a specified

future date. Both the parties, i.e. customer and the dealer banker are obliged to

perform the contract on the specified date irrespective of the exchange rate prevailing

on that date.

5. Explain cross currency quotes.

Cross rates is the currency exchange rate between two currencies, both of which are

not the official currencies of the country in which the exchange rate quote is given in.




41

This phrase is also sometimes used to refer to currency quotes which do not involve

the U.S. dollar, regardless of which country the quote is provided in.

For example, if an exchange rate between the US$ and the Japanese Yen was quoted

in an Indian newspaper, this would be considered a cross rate in this context, because

neither the US$ or the yen is the standard currency of India.

6. When interest rate parity theory used?

Interest Rate Parity (IPR) theory is used to analyze the relationship between at the

spot rate and a corresponding forward (future) rate of currencies.

7. State the risk in forex transaction.

Transaction risk, Translation risk, Economic risk and political risk

8. State the hedging tools in forex market.

Home currency invoicing

Foreign currency accounts / EEFC account

Leads and lags

Netting

Money market hedge

Forward exchange rate contracts

Futures contract

Currency option

9. Write the limitations of PPP theory.

The theory places too much emphasis on purchasing power as a determining factor of

rate of exchange. The result may change with the change in the goods taken for

comparison. It also considers only trade merchandise but there are other factors also

like capital, unilateral transfers, etc, which affect the exchange rate.




42

10. Explain spot rate.

It is the rate that is applicable for immediate settlement (i.e. T+2 working days). For

example, if a spot transaction is done on a Friday, the settlement will be done on

Tuesday, since Saturday and Sunday are holidays and Monday is the first working

day.


1. Explain the factors which affect the exchange rate.

a. International trade: Trade of goods and services is the major reason for demand

and supply of foreign currencies. If a country's imports are high, the demand for

foreign currency will be high and vice versa.

b. Capital movements: Foreign Direct Investment (FDI) and Foreign Institutional

Investment (FII) are important factors affecting exchange rate. Large capital

inflows in the country will result into appreciation of the domestic country and

large capital outflow will result into depreciation of the domestic currency.

c. Speculations: When people speculate a fall in the value of a currency in the near

future, they will sell that currency and start buying the other currency that they

expect to appreciate. The selling will increase the supply of the former currency

and lead to its depreciation and the appreciation of the other currency.

d. Government policies: The Central bank of a country plays an important role in

case when there is fixed exchange rate system or managpdfloat. The Central Bank

influences the exchange rate by buying and selling of bills ana currencies.

e. Political stability: If the Political status of a country is uncertain, international

investors would stay away from such countries. Whereas, a stable political

environment leads to capital inflows in the country.

f. Balance of payments: A surplus in the Balance of payment would lead to a

strong currency and a deficit would lead to a weak currency. A deficit in the

current account shows the country is spending more on foreign trade than it is




43

earning, and that it is borrowing capital from foreign sources to make up the

deficit. In other words, the country requires more foreign currency than it receives

through sales of exports, and it supplies more of its own currency than foreigners

demand for its products. The excess demand for foreign currency lowers the

country's exchange rate

g. Inflation: As per the Purchasing Power Parity theory, high inflation in one

country as compared to the other will lead to depreciation in the currency of that

country.

h. Interest rate parity: When interest rates go up in a country, so do yields for

assets denominated in that currency; this leads to increased demand by investors

and causes an increase in the value of the currency of this country. If interest rates

go down, this may lead to a flight from that currency to another.

2. What are the different risks associated with foreign exchange transaction?

An entity dealing in forex transactions has to face many risks as follows:

(a) Transaction risk: It refers to the effect of exchange rate movement

associated with the time gap between the date of the transaction and the date

on which the consideration is settled. It is also referred as 'Transaction

exposure'. For example, a transaction takes place on 1st April 2011 but the

settlement (payment) takes place on 31st May 2011. The exchange rates may

be different on both the dates giving rise to transaction risk.

(b) Translation risk: It refers to the profit or loss associated with converting

foreign currency denominated assets/labilities, income/expenses into

reporting currency. It is also referred as 'Translation exposure'. The reporting

of foreign currency transactions are done as per Accounting Standard 11,

issued by ICAI. For example, XYZ Ltd. is an Indian company having branch

in Australia.

(c) Economic risk: It is an unanticipated change in exchange rate, which has an

impact on the potential of an organization to perform. It is also referred as

'Economic exposure'. For example, ABC Ltd. of USA invests large funds in




44

India, in manufacturing of medicines. If the rupee strengthens against US$,

and the margins turn out to be low, the project may ultimately have to be

wound up.

(d) Political risk: It refers to the effects that political activities in a country may

have on the forex transactions of an entity. For example, compulsory

acquisition of business by Government, tax related controls, discrimination

against foreign goods.

3. Explain various hedging tools that can be used by a business firm to manage

foreign exchange rate risk.

The above mentioned risks cannot be totally eliminated, but they can be managed. To

manage the exchange risks mentioned above, there are various options that are

available with the entity dealing in forex transactions.

1. Home currency invoicing: The business entity simply prices everything in

home currency. For example, an Indian exporter would invoice his bills in

INR and Indian importer would insist his supplier to invoice in INR.

2. Foreign currency accounts / EEFC account: An entity which engages into

both import and export can maintain account in the currency of trade,

through which all transactions are routed.

3. Leads and lags: Importers and exporters try to advance or delay their

payments or receipts according to their estimation of movement of exchange

rate. If the importer expects devaluation of the domestic currency, he will

hurry to pay his foreign currency obligation (if he waits, then he need more

of local currency to buy the foreign currency).

4. Netting: A process that enables business firms, dealing in foreign

transactions, to settle only their net positions with one another at the end of

the day, in a single transaction, not trade by trade. In this process, debit

balances are netted off against credit balances, so that only the net amounts

remain due to be paid in actual currency flows. There are two types of

netting listed below:




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(a) Bilateral netting: In this type, only two parties are involved. The

lower balances are netted off against higher balances, and the

remainder is paid or received.

(b) Multilateral netting: In this type, more than two parties are involved.

It is used by large companies to manage their intercompany payment

processes, involving many currencies. This has to be coordinated by

a treasury manager.

5. Money market hedge: Money market is a market for short term instruments.

In this market, borrowing and lending transactions are carried out with

foreign currencies so that home currency value is established at a specific

level, in a forex transaction.

6. Forward exchange rate contracts: An entity can enter into currency forward

contracts with banks. It is a negotiated agreement between two parties to

exchange specific amounts of currency at a set rate on a particular date in

future.

7. Futures contract: Futures currency contract are similar to forward contracts.

The futures contracts are traded on organized exchanges like, Chicago

Mercantile Exchange (CME), or London International Financial Futures

Exchange (LIFFE). Futures contract are not tailor made like forward

contracts. They are standard in terms of expiration time and lot sizes.

8. Currency option: A currency option gives the holder the right, but not the

obligation, to sell or buy a face amount of currency at a set price, on or

before a given date.

9. Currency swap: A Currency Swap involves exchange of principal and/or

interest payments on a loan or on an asset in one currency for principal

and/or interest payments on an equivalent loan or on an asset in another

currency, with a predetermined prevailing spot / predetermined forward rate

(for forward start swaps) as agreed on the date the transaction is entered into.

4. Write a short note on interest rate parity theory.




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Interest Rate Parity (IPR) theory is used to analyze the relationship between at the

spot rate and a corresponding forward (future) rate of currencies.

The IPR theory states interest rate differentials between two different currencies will

be reflected in the premium or discount for the forward exchange rate on the foreign

currency if there is no arbitrage - the activity of buying shares or currency in one

financial market and selling it at a profit in another.

The theory further states size of the forward premium or discount on a foreign

currency should be equal to the interest rate differentials between the countries in

comparison

Thus, Interest rate differential = Exchange rate differential

1 + 𝑟𝐷1 + 𝑟𝐹

= 𝑓𝐷/𝐹

𝑆𝐷/𝐹 =

𝑆𝐹/𝐷

𝑓𝐹/𝐷

Where,

r = Rate of interest

f = Forward rate

S = Spot rate

D/F = Exchange rate between direct and foreign currency

F/D - Exchange rate between foreign and direct currency

The exchange rate, a year later (also known as Future spot rate) can be computed as

follows:

𝑓𝐷/𝐹 = 𝑆𝐹/𝐷 1 + 𝑟𝐷1 + 𝑟𝐹

Arbitrage opportunity: It can be identified with the help of the above formula.

1. Compute the theoretical forward rate and compare it with the actual forward

rate. If the two are not equal, then there is arbitrage opportunity




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2. Compute the theoretical domestic interest rate and compare it with the actual

interest rate. If the two are not equal, then there is arbitrage opportunity.

Limitations of Interest Rate Parity Model

In recent years, there has been limited usefulness by using the interest rate parity

model. In many cases, countries with higher interest rates often experience it's

currency appreciate due to higher demands and higher yields and has nothing to do

with risk-less arbitrage.

5. Explain purchasing power parity theory.

The Purchasing Power Parity (PPP) Theory of Exchange Rate theory, establishes the

fact that the exchange rates between currencies are in equilibrium in the event of

equality in the purchasing power of each of the countries. It means that the exchange

rate between the currencies of two countries equals the ratio between the prices of

goods in these countries. The exchange rate must change to adjust to the change in the

prices of goods in the two countries. The PPP theory states that the expected inflation

differential equals to the current spot rate and expected spot rate differential.

If the inflation rate within a country's economy increases then the value of the

currency needs to depreciate to maintain the purchasing power parity. In the absence

of transportation and other similar expenses, the competitive market will equalize the

price of an identical object in two countries when the prices are expressed by the same

currency.

Thus, Inflation rate differential = current spot rate and expected spot rate differential

1 + 𝑖𝐷1 + 𝑖𝐹

= 𝐸(𝑆𝐷

𝐹

)

𝑆𝐷/𝐹 =

𝑆𝐹/𝐷

𝐸(𝑆𝐷

𝐹

)

Where,

i = inflation rate

E(S) = expected spot rate differential




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S = spot exchange rate

D/F = Exchange rate between direct and foreign currency

F/D = Exchange rate between foreign and direct currency

The spot exchange rate after a period (N) can be found out by using the following

formula

𝑆2,𝐴/𝐵 = 𝑆1,𝐴/𝐵 × 1 + 𝑟𝐴1 + 𝑟𝐵

𝑁

Where,

SI,A/B = Spot rate between domestic and foreign country

S2,A / B = Spot rate after N period between domestic and foreign country

rA = inflation rate in country A

rB = inflation rate in country B

N = No. of years

Calculation of PPP

The PPP is calculated by comparing the price of an identical good in both the

countries. The "Hamburger Index" in The Economist magazine presents the index by

comparing the price of a McDonald's hamburger around the world. But the calculation

is not free from problem because consumers in every country consume different types

of products. Another index is the iPOD Index. The iPOD is considered to be one of

the standard consumer products these days. Hence PPP can be calculated by

comparing its price.

Limitations of PPP theory

The theory places too much emphasis on purchasing power as a determining factor of

rate of exchange. The result may change with the change in the goods taken for

comparison. It also considers only trade merchandise but there are other factors also

like capital, unilateral transfers, etc, which affect the exchange rate.




49

6. Discuss international fisher effect.

It is an exchange rate model designed by economist Irving Fisher in the 1930s. The

Fisher hypothesis states that the real rate of interest is constant. Consequently, the

nominal rate moves with inflation.

The real rate of interest would be determined by the time preferences of the public

and technological constraints determining the return on real investment.

The fisher equation is simply:

Nominal rate of interest = real rate of interest + inflation

(1 + nominal rate) = (1 + real rate) X (1 + inflation rate)

If inflation rate is higher in a country, nominal interest rate is also higher and vice

versa. If the international capital markets are perfect, then the equivalent risk in two

countries should offer same expected real rate of return. If the expected real rate of

return is higher in one country than m another, capital would flow from the latter to

the former country and investors would have opportunity to make riskless arbitrage

profit. The arbitrage will exist till an equilibrium is established in the expected real

returns in the two countries.

Thus, nominal interest rates in the two countries would adjust for the change in the

inflation rates. The International Fisher Effect reinforces the Interest Rate Parity and

Purchasing Power Parity Theory, by considering the 'inflation' element in nominal

interest rates.

As per the theory,

a. A country with higher interest rate will also be inclined to have a higher

inflation rate.

b. The future exchange rate can be estimated based on the nominal interest rate

relationships

c. The free movement of capital across the borders will equalize the real interest

rate.




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Thus, nominal interest rate differential = Expected inflation rate differential

1 + 𝑟𝐷1 + 𝑟𝐹

= 𝐸(1 + 𝑖𝐷)

𝐸(1 + 𝑖𝐹)

Where,

rD = Rate of interest in domestic country

rF= Rate of interest in foreign country

E(1 + iD)= Expected inflation in the domestic country

E(1+ iF)= Expected inflation in the foreign country

b.v. patel institute of business management, computer...

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