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Question
Paper
Strategic
Financial Management (MB361F) : April 2007
Section A
: Basic Concepts (30 Marks)
•
This
section consists of questions with serial number 1 - 30.
•
Answer
all questions.
•
Each
question carries one mark.
•
Maximum
time for answering Section A is 30 Minutes.
1. Which of the following statements is/are true with respect to survival
strategies? < Answer >
I.
A company
might pursue a non-growth strategy if its non-economic objectives are more
important than its economic objectives.
II.
A
non-growth strategy is bound to be a corrective strategy.
III.
A company
can adopt a negative strategy in pursuit of withdrawing from less profitable
areas of business.
IV. A
corrective strategy cannot be used in conjunction with, or as one component of,
a growth strategy.
(a)
Only
(III) above
(b)
Both (I)
and (II) above
(c)
Both (II)
and (III) above
(d)
(I), (II)
and (III) above
(e)
All (I),
(II), (III) and (IV) above.
2. Which of the following is not a part of the internal governance
groups of a firm? < Answer >
(a)
Shareholders
(b)
The Board
of Directors
(c)
Media
(d)
Managerial
hierarchy
(e)
Internal
capital markets.
3.
Which of
the following factors does not
figure in when assessing the present value of an investment by the risk<
Answer > adjusted
discount rate method?
(a)
Projected
future cash flows from the investment
(b)
Beta of
the investment in question
(c)
Expected
return from the tangency portfolio
(d)
Expected
return from the equity shares of the firm
(e)
Risk free
return.
4.
Which of
the following is used by the ratio comparison approach to the valuation of
projects or commercial real< Answer > estate?
(a)
Ratio of
total debt to equity
(b)
Ratio of
total debt to total assets
(c)
Ratio of
price to earnings
(d)
Ratio of
net income to revenues
(e)
Ratio of
revenues to total assets.
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5. Which of the following statements with
respect to the real options are not true? < Answer >
I.
Investment
timing option allows the firm to delay the project until at a later point of
time when more information is available.
II
Growth
options allow the firm to alter operations depending on how the conditions
change during the life of the project.
III. Abandonment options give the firms an option
to abandon a project if not profitable.
IV. Flexibility options allow a company to increase
its capacity of operation if the market conditions are better than expected.
(a)
Both (I)
and (II) above
(b)
Both (I)
and (III) above
(c)
Both (II)
and (III) above
(d)
Both (II)
and (IV) above
(e)
(I), (II)
and (IV) above.
6.
According to the trade-off theory
of capital structure, the firm attempts to arrive at a trade-off between which
of the< Answer >
following?
(a)
Between
agency cost and bankruptcy cost
(b)
Between
agency cost and financial cost
(c)
Between
bankruptcy cost and financial cost
(d)
Between
size of the tax shield and bankruptcy costs
(e)
Between
size of the tax shield and agency cost.
7.
Consider
the following data relating to a company:
|
Degree of
leverage |
Overall
capitalization rate |
|
0.50 |
10.00% |
|
0.75 |
9.25% |
|
1.00 |
8.75% |
|
1.25 |
8.25% |
|
1.50 |
8.00% |
|
1.75 |
8.25% |
|
2.00 |
8.75% |
|
2.25 |
9.25% |
Which approach to capital structure defines the
above pattern?
(a)
Net
income approach
(b)
Net
operating income approach
(c)
Traditional
approach
(d)
M & M
approach
(e)
Walter
approach.
8.
The term
agency costs in the context of capital structure means
(a)
The
commission payable by a company to its purchasing agents
(b)
The
commission payable by a company to its selling agents
(c)
The
expenses incurred in distribution of the products of the company
(d)
The cost
on account of restrictive covenants imposed on a company by its lenders
(e)
The
dividends paid by a company to its shareholders.
< Answer >
< Answer >
9.
For a firm, if the current ratio
remains constant and the quick ratio decreases during the same period, then,
which of< Answer > the following is indicated for the firm
(a)
The
proportion of total debt relative to total assets is decreasing
(b)
The
proportion of total debt relative to net worth is decreasing
(c)
The
proportion of net worth relative to total assets is increasing
(d)
The
liquidity is decreasing
(e)
The
profitability is increasing.
10.
Which of the following statements is/are false with respect to different model
for maximizing shareholders’ value? <
Answer >
I.
According
to Marakon model, a firm’s value is measured by the ratio of its book value to
the economic value.
II.
According
to Alcar model, for ascertaining the value generating capability of a strategy,
the value of firm’s equity without the strategy is compared to the value of the
firm’s equity if the strategy is implemented.
III. McKinsey model focuses on the identification
of key value drivers at various levels of the organization.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Both (I)
and (II) above
(d)
Both (II)
and (III) above
(e)
All (I),
(II) and (III) above.
11.
Kohinoor
Steel earns 10% on the equity and the growth rate of dividends and earnings is
5%. The book value per< Answer > share is Rs.80. If the market price of the shares
of Kohinoor Steel is Rs.70, according to the Marakon model, the
cost of equity is approximately
(a)
9.67%
(b)
10.71%
(c)
12.45%
(d)
13.78%
(e)
14.67%.
12.
Which of
the following is a ‘value driver’ that affects the value of a firm according to
Alcar Model?
(a)
Dividend
payout
(b)
Value
growth duration
(c)
Sales
(d)
Growth
rate of dividends
(e)
Book
value of the firm.
13.
Which of
the following is/are the assumptions of multiple discriminant analysis?
I.
There are
two discrete groups to be analyzed.
II.
The
independent variables can be combined in a linear manner for discriminating
between the two groups.
III. The values of the variables are
distributed lognormally.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (II) above
(e)
All (I),
(II) and (III) above.
14. Which of the following statements is false with respect to Dutch Auction
Tender Offer for share repurchases?
(a)
The firm
does not fix any predetermined price
(b)
The firm
may indicate a price band, consisting of floor price and a ceiling price, for
the tender offer
(c)
The
tender offer is open for all the shareholders of the firm
(d)
It is a
financial hybrid combining some features of open market and fixed price tender
offer
(e)
Dutch
auction is more risky to the management than fixed price premium offers.
<
Answer >
<
Answer >
< Answer >
15.
There are two firms, A Ltd. and B
Ltd. They are similar in all respects except that A Ltd. is unlevered, while B
Ltd.< Answer > has Rs.4 crore of 11% debentures outstanding. Both companies have a net
operating income of Rs.1 crore each. The
tax rate applicable to both the companies is 35%.
The discount rate for both the companies is 10% p.a. The value of firm B,
considering Modigliani-Miller position on leverage holds good is
(a)
Rs.1
crore
(b)
Rs.3.5
crore
(c)
Rs.6.5
crore
(d)
Rs.7.90
crore
(e)
Rs.8.30
crore.
16.
Rohan
Industries Ltd.(RIL) follows a strict residual dividend policy. The company has
a capital budget of< Answer > Rs.80,00,000 and it wants to maintain the present
D/E ratio even after the capital budget proposal. RIL forecasts that
its net income will be Rs.30,00,000. If it has the
dividend pay out ratio of 20%, what will be the targeted D/E ratio of the
company?
|
|
(a) |
2.33 |
|
|
|
|
(b) |
3.00 |
|
|
|
|
(c) |
3.33 |
|
|
|
|
(d) |
3.56 |
|
|
|
|
(e) |
4.67. |
|
|
|
17. |
Which of the following is true regarding the effect on return
on equity, others things remaining constant? |
|||
|
|
(a) |
Greater the amount of sales, lower the return on
equity |
||
|
|
(b) |
Lower the equity multiplier, lower the return on
equity |
||
|
|
(c) |
Higher the assets turnover, lower the return on
equity |
||
|
|
(d) |
Lower the debt-assets ratio, higher the return on
equity |
||
|
|
(e) |
Higher the return on assets, lower the return on
equity. |
||
|
18. |
Consider the following information of ABC Ltd.: |
|||
|
|
|
|
|
|
|
|
|
Dividend per share |
Rs.4 |
|
|
|
|
Dividend cover |
5 |
|
|
|
|
Number of outstanding shares |
10,000 |
|
|
|
|
Net profit margin |
10% |
|
|
|
|
Total assets |
Rs.10,00,000 |
|
|
|
The asset turnover ratio for the company is |
|
|
|
|
|
(a) |
1.25 |
|
|
|
|
(b) |
1.50 |
|
|
|
|
(c) |
2.00 |
|
|
|
|
(d) |
2.50 |
|
|
|
|
(e) |
4.00. |
|
|
<
Answer >
<
Answer >
19.
Aditya
Industries Ltd. is targeting at an EPS of Rs.3 per share for next year. The
firm has 1,00,000 shares< Answer > outstanding. It is expected to have the sales
revenue of Rs.12,00,000 for the next year. Its estimated fixed costs are
Rs.1,50,000 and it’s target D/E ratio is 2:1. It pays 12% interest on debt and
it falls under the tax bracket of 30%. It
has total assets of Rs.15,00,000. What should be
the percentage of its variable cost to sales to achieve its targeted EPS?
(a)
35.56%
(b)
38.58%
(c)
41.79%
(d)
45.77%
(e)
49.67%.
20.
Which of
the following models is based on numerical assessment of the firms’ weakness
which is classified as < Answer > defects, mistakes and symptoms?
(a)
Beaver
Model
(b)
The
Wilcox Model
(c)
Blum
Marc’s Failing Company Model
(d)
Altman’s
Z score Model
(e)
Argenti
Score Board.
21. High asset turnover ratio indicates < Answer >
(a)
Large
amount of investment in the fixed assets
(b)
Large
amount of investment in the current assets
(c)
Large
amount of sales value in comparison to total assets
(d)
Inefficient
utilization of the assets
(e)
High
debt-equity ratio.
22. Which of the following is/are not assumption(s) of the Baumol model? < Answer >
I.
The cash
requirement for the period under consideration is constant and known.
II.
Cash
expenses are incurred evenly over the period under consideration.
III. There are no transaction costs involved in
the conversion of securities into cash.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (II) above
(e)
Both (II) and (III) above.
23.
Jyothi
Industries Ltd. has annual sales of Rs.3,65,00,000 (Rs.1,00,000 a day on a
365-day basis). On average, the < Answer > company has Rs.1,20,00,000 in inventory and
Rs.80,00,000 in accounts receivable. The company is looking for
ways to shorten its net operating
cycle, which is calculated on a 365-day basis. Its CFO has proposed new
policies that would result in a 20% reduction in both average inventories and
accounts receivable. The company anticipates that these policies will also
reduce sales by 10%. Accounts payable will remain unchanged. What effect would
these policies have on the company’s net operating cycle? (Round off to the
nearest whole day)
(a)
–40 days
(b)
–32 days
(c)
–27 days
(d)
–22 days
(e)
–18 days.
24.
Which of
the following is not a determinant
of the capital structure of a company?
(a)
Type of
asset financed
(b)
Product
life cycle
(c)
Current
capital structure
(d)
Credit
rating
(e)
Type of
raw material used.
25.
Which of
the following statements is/are not true
with respect to the certainty equivalent approach?
I.
It
restricts decision makers from introducing their own risk preference directly
into the analysis.
II.
It is
preferable to use this approach whenever forward prices are available for
estimating future cash flows.
<
Answer >
<
Answer >
III.
Under
this method, each period’s cash flow can be adjusted separately to account for
the specific risk of those cash flows.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (II) above
(e)
Both (I)
and (III) above.
|
26. The
following information is available about |
Kun
United & Co.: |
<
Answer > |
||
|
|
||||
|
|
Rs. in crore |
|
|
|
|
Gross Fixed Assets |
= |
75 |
|
|
|
Accumulated Depreciation = |
25 |
|
|
|
|
Total current assets |
= |
150 |
|
|
|
Current liability |
|
= |
50 |
|
|
EBIT |
= |
30 |
|
|
Working Capital Leverage (WCL) for 20% increase in
current assets will be
(a)
0.238
(b)
0.313
(c)
0.588
(d)
0.652
(e)
0.885.
27.
M/S
Swapna Enterprises Ltd., an Indian company has a subsidiary in Germany and is
exposed to the risk of euro< Answer > weakening and the value of its assets,
liabilities, and profit contributions declining in rupee terms in its
consolidated financial statements. The company is exposed to which of the
following risks?
(a)
Transaction
risk
(b)
Translation
risk
(c)
Economic
risk
(d)
Interest
rate risk
(e)
Market
risk.
28. Which of the following are the tasks to be
performed by the risk managers while managing environmental risks? < Answer >
I.
Minimize
the probability of occurrence of an adverse event such as an accident.
II.
Cut the
cost when an accident occurs.
(a)
Both (I)
and (II) above
(b)
Both
(III) and (IV) above
(c)
(I), (II)
and (IV) above
(d)
(II),
(III) and (IV) above
(e)
All (I),
(II), (III), and (IV) above.
29.
According
to the Walter Model, if r is the
internal rate of return, g is the
growth rate and ke is the cost of capital,
< Answer > under
which of the following conditions the optimal payout ratio is 100%?
(a)
r = ke
(b)
r < ke
(c)
r > ke
(d)
g > ke
(e)
g = ke.
30. Which of the following statements regarding
bankruptcy models is/are true? < Answer >
I.
According
to Wilcox model, the net liquidation value of the firm is the best indicator of
the financial health of the firm.
II.
Blum
Marc’s failing company model is based on liquidity ratios only.
III.
According
to the Beaver model, the ratio of cash flow to total debt is the single best
predictor of corporate failure.
(a)
Only (I)
above
(b)
Only (II)
above
(c)
Only
(III) above
(d)
Both (I)
and (III) above
(e)
All (I),
(II) and (III) above.
END OF SECTION A
Section B
: Problems/Caselets (50 Marks)
•
This
section consists of questions with serial number 1 – 7.
•
Answer all questions.
•
Marks are
indicated against each question.
•
Detailed
workings/explanations should form part of your answer.
•
Do not
spend more than 110 - 120 minutes on Section B.
1.
The
information pertaining to the Hitech Industries Ltd.(HIL) for the year ending
on 31st March,
2007 is as follows:
|
Sales |
Rs.924.54 million |
|
Net profit |
Rs.384.84 million |
|
Net worth |
Rs.1593.25 million |
|
Dividend per share |
Re.1 |
|
Share capital (face value Rs.10 per share). |
Rs.587.5 million |
|
Cost of equity |
21.5% |
|
|
|
For the financial year 2007-2008,
the earnings per share and the dividend per share are anticipated to be consistent
with the sustainable growth rate. Current market price of the company is
consistent with P/E ratio derived from fundamentals.
You are required
to
a.
Calculate
the price of share as on 31st March 2007, assuming that perpetual dividend
growth model holds good.
b.
Determine
the post-issue share price, if during financial year 2007-08, the firm plans to
shift to the policy of 100 percent dividend payout and decides to issue
required shares for financing the increase in dividend expenses. The pre-issue
capital appreciation for the year 2007-08 is to the extent of current growth
rate. Dividend payment and new issue take place on 31st March 2008. Assume that
M & M hypothesis on dividend policy holds good.
c.
Determine
the growth rate that is consistent with the P/E ratio of the company’s post
issue price as on 31st March 2008 derived in part (b), if perpetual
dividend growth model holds good.
(4 + 6 +
2 = 12 marks)
2.
L.C.
Gupta’s model was the first Indian model proposed to predict failure. From the
following Income statement and Balance sheet of Moti Labs Ltd. for the year
2005-06 and 2006-07, calculate the
profitability ratios and balance sheet ratios of the company for both years as
per the L.C. Gupta model.
Financial
Statements of Moti Labs Ltd.
Income Statement
for the year ending on
(Rs.
|
in Millions) |
|
|
|
|
|
|
|
|
31st March, 2007 |
31st March, 2006 |
|
Income |
|
|
|
Net Sales |
18421.85 |
14372.65 |
|
Other Income |
808.44 |
230.01 |
|
A. Operating Income |
19,230.29 |
14,602.66 |
|
Expenses |
|
|
|
Material Consumed |
10,136.62 |
7,419.47 |
|
Manufacturing Expenses |
1,528.18 |
1,234.44 |
|
Personnel Expenses |
952.49 |
734.63 |
|
Selling Expenses |
1,382.16 |
1,171.15 |
|
Administrative Expenses |
1,007.04 |
848.86 |
|
B. Cost Of Sales |
15,006.49 |
11,408.55 |
|
Operating Profit (A-B) |
4,223.80 |
3,194.11 |
|
Other Recurring Income |
218.23 |
130.87 |
|
PBDIT |
4,442.03 |
3,324.98 |
|
Interest Expenses |
134.75 |
44.84 |
|
Depreciation |
402.84 |
283.56 |
|
Other Write offs |
0.99 |
0.66 |
|
PBT |
3,903.45 |
2,995.92 |
|
Tax Charges |
877.50 |
647.50 |
|
Non Recurring gains |
40.96 |
129.02 |
< Answer >
< Answer >
|
|
0.00 |
|
|
0.00 |
|
|
|||
|
Reported PAT |
|
3,066.91 |
|
|
2,477.44 |
|
|
||
|
Appropriations: |
|
|
|
|
|
|
|
|
|
|
Equity Dividend |
|
899.58 |
|
|
599.72 |
|
|
||
|
Preference Dividend |
|
0.00 |
|
|
0.00 |
|
|
||
|
Retained Earnings |
|
1,941.07 |
|
|
1,800.88 |
|
|
||
|
|
|
Balance Sheet as on |
|
|
|
||||
|
|
|
|
|
|
|
|
(Rs. in
Millions) |
||
|
|
|
|
|
|
|
|
|
||
|
|
|
|
|
31st March, 2007 |
31st March, 2006 |
||||
|
|
SOURCES OF FUNDS |
|
|
|
|
|
|
|
|
|
|
Owner's Fund |
|
|
|
|
|
|
|
|
|
|
Equity Share Capital (Face Value Rs.10) |
|
599.72 |
599.72 |
|||||
|
|
Share Application Money |
|
0.02 |
0.00 |
|||||
|
|
Preference Share Capital |
|
0.00 |
0.00 |
|||||
|
|
Reserves & Surplus |
|
11,938.95 |
9,997.88 |
|||||
|
|
Loan Funds |
|
|
|
|
|
|
|
|
|
|
Secured Loans |
|
305.99 |
288.86 |
|||||
|
|
Unsecured Loans |
|
1,799.85 |
658.97 |
|||||
|
|
Total |
|
14,644.53 |
11,545.43 |
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|
USES OF FUNDS |
|
|
|
|
|
|
|
|
|
|
Fixed Assets |
|
|
|
|
|
|
|
|
|
|
Gross Block |
|
7,407.91 |
|
5,169.83 |
|
|||
|
|
Less : Revaluation Reserve |
|
101.83 |
|
103.19 |
|
|||
|
|
Less: Accumulated Depreciation |
|
1,932.30 |
|
1,459.35 |
|
|||
|
|
Net Block |
|
5,373.78 |
|
3,607.29 |
|
|||
|
|
Capital Work-in-progress |
|
560.11 |
|
288.35 |
|
|||
|
|
Investments |
|
1,803.69 |
|
1,265.94 |
|
|||
|
|
Net Current Assets |
|
|
|
|
|
|
|
|
|
|
Current Assets, Loans & Advances |
|
14,362.30 |
|
12,910.99 |
|
|||
|
|
Less : Current Liabilities & Provisions |
|
7,455.35 |
|
6,528.13 |
|
|||
|
|
Total Net Current Assets |
|
6,906.95 |
|
6,382.86 |
|
|||
|
|
Miscellaneous expenses not written off |
|
0.00 |
|
0.99 |
|
|||
|
|
Total |
|
14,644.53 |
|
11,545.43 |
|
|||
|
|
|
|
|
|
|
|
(6 marks) |
|
|
3. Excel Products Ltd. is a manufacturer of
household goods. Presently it is planning to manufacture an automatic |
<
Answer > |
|||||||
|
|
||||||||
|
dishwasher.
The investment required for manufacturing and marketing the new product is
Rs.250 lakh. The |
|
|||||||
|
investment-planning
horizon is five years at the end of which it is estimated that the project
will have a salvage |
|
|||||||
|
value
of Rs.20 lakh. The projected unlevered operating cash flows from the project
are: Rs.200 lakh at the end of |
|
|||||||
|
each of
the first and second years respectively, and Rs.300 lakh at the end of each
of the third, fourth and fifth years |
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respectively.
However these operating cash flows as well as the salvage value are uncertain
and the actual unlevered |
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cash
flows may be less than the projections, especially in the later years. The
uncertainty of the cash flows is to be |
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factored
in by the certainty equivalent method and the certainty equivalent factors
for the various years are as |
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Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
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1.0 |
0.90 |
0.80 |
0.70 |
0.60 |
0.50 |
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•
The
project enhances the debt capacity of the firm in the first year as well as the
second year by Rs.75 lakh, and in the third, fourth and fifth years by Rs.50
lakh. The interest rate on the borrowings of the company is expected to be 8%
and the tax rate applicable is 36% for the entire investment horizon. The
interest rate on risk free securities is 6%. It is assumed that the company
will utilize all its tax shields with certainty.
•
You are required to calculate the NPV of the
investment.
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Caselet 1
Read the caselet carefully and
answer the following questions:
4.
The
caselet says that the target costing can yield important benefits to the
success of the new product/service development efforts. Explain the benefits of
target costing.
(7 marks)
5.
As
mentioned in the caselet, after the determination of target cost, the
achievement of the same is central to the success of new products and services.
In this context, explain the various steps involved in the process of achieving
the target cost.
(7 marks)
<
Answer >
<
Answer >
Target costing is different from
a simple spending control mechanism, in so far as you determine market-based
prices for envelopes of features based upon market and competitive conditions,
in which price/volume relationships are examined, then subtract the required
margin to determine the product or service level target cost. Such aggregate
level target costs can be useful in designing your value delivery processes and
determining the relative cost contribution of people, process and technology
elements in such a manner to achieve your target cost before costs are
incurred.
Managing target costs can be
viewed at a unit level and from the framework of product life-cycle costs, as
well as from a portfolio perspective. It is this central algorithm (market
price minus margin = target cost), which contributes to the definition of
target costing as a profit and cost planning system. In this regard, cost
becomes a dependent variable.
Target costing can yield
important benefits to the success of new product/service development efforts.
Target costing also provides a way for your company to target cost reductions
in its major cost categories by focusing on major "design drivers"
that influence costs and on the cost of support processes. Frequently the
benefits of such efforts can be applied across product lines.
The most robust target costing
processes seamlessly integrate strategic business and profit planning,
competitive research and analysis, market research and customer requirements,
research and development, technology advances and product development. These
processes establish product and service strategies, which help to determine
market niches, market share objectives and market volumes. Product portfolio
and profit plans developed in business planning cycle can provide strategic
summary schedules for product development, introduction and replacement, and
capital investments.
The target costing process is a
logical outgrowth of determining the causes of cost and seeking ways to reduce
or eliminate those costs before production costs were incurred, while
simultaneously looking to improve quality and customer satisfaction. The target
costing process is based upon systems theory and can be integrated into your
New Product Development (NPD) process. It is an important contributor to NPD
success.
Determining the product or
service concept and the relevant market niche is the first phase of the
process. Key determinants of the concept include the business focus of the
enterprise (strategy articulation), understanding the competitive conditions
(competitive research), understanding customers' preferences as well as
economic conditions in relevant markets (market research).
After determining the target
cost, achieving target cost is central to the success of new products and
services. Key to the process is creating development plans which interact with
the multi-year product and service, profit and cost plans. Design teams focus
on the concurrent design of products or services and processes. Frequent checks
of the parameters of the plan based upon anticipated, simulated and/or actual
results are applied during the development process. Design reviews which focus
on quality, cost and profitability are included in the check cycle.
In conclusion, it can be said
that although target costing in its simplest form is merely a calculation i.e.,
market price minus margin; today's competitive environment can make target
costing an indispensable, strategic management technique. It can be
successfully integrated into your current NPD and portfolio management processes
to provide your firm with economic and strategic benefits. A key element to
consider is the benefit of abandoning projects, which will not be economically
viable in today’s competitive markets, and focusing typically limited resources
on those opportunities, which will provide adequate returns to the company.
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Caselet 2
Read the caselet carefully and
answer the following questions:
6. What is Enterprise Risk Management (ERM)?
What does it aim to achieve? < Answer >
(6 marks)
7. What
are the attributes involved in the discipline of managing risk? < Answer >
(5 marks)
A major reason the managers are frustrated with
their progress on Enterprise Risk Management (ERM) is because they believe they
don’t have adequate tools. This is particularly the case when it comes to risk
modeling, developing probability distributions of outcomes that represent the
uncertainty associated with specific risk factors. Illustration to explain the
linkages between risk, risk management, risk capital and ERM consider the
classic statistical example of a cookie jar full of white and black marbles. If
there is a penalty for drawing a black marble from the jar, the draw of a black
marble is risk. Risk management seeks to understand the full penalty for
drawing the black marble as well as the likelihood that such a draw will occur.
Risk capital calculations assure that if you draw a black marble or perhaps
several in a row, you will survive the events. ERM finds the best way to put
your hand into the cookie jar, so to speak.
ERM, taking the pillars of a Basel II approach,
then looks at the interaction of business lines, through dynamic,
forward-looking scenarios and seeks to structure a firm in a manner to maximize
its performance relative to its risk appetite. Achieving this requires both an
understanding of how business lines operate as well as how they interact with
each other and their competitive space.
ERM would analyze the likely impact on both
revenues and capital to determine if the merger made sense. This would then
lead to an analysis of what the optimal combination of the three businesses
might be going forward, if any and allocating risk-taking authority (risk
capital) in such a fashion as to maximize the firm's anticipated risk -adjusted
performance. It is quite conceivable that the three entities would produce a
better risk-adjusted return for the merged entity if their sizes towards going
forward were quite different. In other words, ERM helps to not only determine
if a merger makes sense, but where the combined capital of the three entities
is best deployed.
This is exactly the same analysis that is done at
any business with multiple existing business lines. Again, the goals of ERM are
no different than those of existing managerial sciences, but are a vast
improvement because of the emphasis on improving the understanding of one's own
business through modeling, discipline and education.
END OF
SECTION B
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Section C : Applied Theory (20
Marks)
8
9
• This
section consists of questions with serial number 8 - 9.
• Answer
all questions.
• Marks
are indicated against each question.
• Do not
spend more than 25 -30 minutes on section C.
A corporate body can face risks arising out of a
variety of sources in the dynamic business environment. In order < Answer > to achieve its objective of maximizing the wealth
of the shareholders every corporate body must effectively manage the risks it
faces. Explain the various approaches to risk management that may be adopted by
a corporate body.
(10
marks)
|
Though the use of real options had brought in
significant advantages in creating a project, still there exist some |
<
Answer > |
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pitfalls in their usage. Discuss. |
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(10
marks) |
|
END OF SECTION C
END OF
QUESTION PAPER
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Suggested
Answers
Strategic
Financial Management (MB361F) : April 2007
Section A : Basic Concepts
1.
Answer :
(d)
Reason : A company might pursue a
non-growth strategy if its non-economic objectives are more important than its
economic objectives. Statement (I) is true.
A non-growth strategy is bound to be a corrective
strategy. Statement (II) is true.
A company can adopt a negative strategy in pursuit
of withdrawing from less profitable areas of business. Statement (III) is true.
A corrective strategy can be used in conjunction
with, or as one component of, a growth strategy.
Statement (IV) is not true.
Hence (d) is the answer.
2.
Answer :
(c)
Reason :
Media is part of external governance groups of a firm. Hence (c) is the
answer.
3.
Answer :
(d)
Reason : Expected return from the
equity shares of the firm does not figure out when assessing the present value
of an investment by the risk adjusted discount rate method.
4.
Answer :
(c)
Reason : Ratio of price to
earnings is used by the ratio comparison approach to the valuation of projects
or commercial real estate.
5.
Answer :
(d)
Reason : Investment Timing Option
allows the firm to delay the project until at a later point of time when more
information is available.
Growth options allow a company to increase its
capacity of operation if the market conditions are better than expected.
Abandonment Options give the firms an option to
abandon a project if not profitable.
Flexibility options allow the firm to alter
operations depending on how the conditions change during the life of the
project.
Hence (d) is the answer.
6.
Answer :
(d)
Reason : According to the
trade-off theory of capital structure the firm attempts to arrive at a
trade-off between size of the tax shield and bankruptcy costs.
7.
Answer :
(c)
Reason : The above trend shows
that the overall capitalization rate first decreased and then increased. This
is according to the traditional approach. According to net income approach, the
overall capitalization rate steadily decreases and reaches a point – but does
not increase while according to net operating income approach, it remains constant.
Finally, according to MM approach, the overall capitalization rate is
independent of the degree of leverage.
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8.
Answer :
(d)
Reason : Agency cost are cost on
account of restriction imposed by creditors on the firm in the form of some
protective covenants. Commission payable by the company to its purchasing and
selling agents , the expenses incurred in distribution of the products of the
company, or the dividends paid by the company does not come under the agency
cost.
9.
Answer :
(d)
Reason : Current ratio is defined
as the ratio between the current assets and current liabilities. While Quick
Ratio is calculated by dividing current assets minus inventories by current
liabilities. Now, among the components of the current assets, inventories are
the least liquid instruments. So, a decreasing quick ratio and same value of
the current ratio implies the increasing volume of inventory, thereby
indicating the decreasing level of liquidity.
10.
Answer :
(a)
Reason : Statement I is not
correct. According to Marakon model, a firm’s value is measured by the ratio of
its market value to the book value. Other both statements are correct with
respect to different models of maximizing value of shareholders.
Hence the correct answer is (a).
11.
Answer :
(b)
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B( r − g) |
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12. |
Answer : (b) |
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Reason : |
Of the given factors, value growth duration only
is a value driver as per Alcar Model all other are |
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financial factor determining firm’s value as per
Marakon Model. |
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13. |
Answer : (d) |
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Reason : |
The assumptions of multiple discriminant analysis
are : |
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(1)
There are
two discrete groups to be analysed
(2)
The
independent variables can be analysed in a linear manner for discriminating
between two groups.
(3)
The
values of the variables are distributed normally.
Hence statement III is not an assumption of
multiple discriminant analysis. So the correct option is (d).
14.
Answer :
(e)
Reason: Dutch auction are less
riskier to the management than fixed price premium offers. All the shares
repurchased receive a uniform price may induce some shareholders to submit
their offers at very low ask prices to ensure their accepteance in the auction.
This would benefit the firm by reducing the final repurchase price. It
eliminates those shareholders who assign relatively lower valuatoins to the
stock. All other options are true with respect to Dutch option tender offer.
15.
Answer :
(d)
O(1 − t)
Reason: Value of B Ltd. = k + B × t
1×0.65
=
0.10 + 0.35 × 4
=
6.50 +
1.40
=
Rs.7.90
crores
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16.
Answer :
(a)
Reason :
Dividend pay out ratio
Dividends = Rs.30,00,000 × 20% = Rs.6,00,000
Income retained = Rs.30,00,000 – Rs.6,00,000 =
Rs.24,00,000
Capital budget = Rs.80,00,000
Capital
budget proposal to be financed with debt =
Rs.80,00,000 - Rs.24,00,000 = Rs.56,00,000
D/E ratio = Rs.56,00,000/ Rs.24,00,000 = 2.33
17.
Answer :
(b)
Reason: Du
Pont equation for return on equity is:
|
Return on Equity (ROE) = |
Net profit |
× |
Sales |
× |
Average assets |
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Sales |
Average
assets |
Average equity |
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The third component of the equation is called
equity multiplier.
Thus, higher the assets turnover
ratio, higher the equity multiplier, higher the debt-assets ratio, higher the
return on assets, higher will be the return on equity. Hence, (c), (d) and (e)
are not correct and (b) is correct. Return on equity does not depend on sales.
Hence, (a) is also not true.
18.
Answer: (c)
Reason: Dividend cover = EPS/DPS
Therefore EPS = 20
Asset turnover ratio = (20)(10,000)/0.10 = 2
10,00,000
Therefore, Option (c) is the correct answer.
19.
Answer :
(c)
Reason : EPS = [(Sales – Variable
costs – Fixed costs – Interest ) × (1 – tax
rate)] / Number of shares outstanding.
Step 1:
Calculate interest expense.
Amount of debt = 2/3 × 15,00,000 = Rs.10,00,000
Interest expense = 10,00,000 × 0.12 = Rs.1,20,000.
Step 2:
Solve for EPS
EPS = 3 = [(12,00,000 – Variable cost – 150,000 –
1,20,000) × (1 – 0.3)]/1,00,000 3 =
[(6,51,000 – 0.7 Variable cost)]/1,00,000 3,00,000 = 6,51,000 – 0.7 Variable
cost
3,51,000 = 0.7 Variable cost
Variable cost = 3,51,000/0.7= Rs.5,01,428.57
% of Variable cost to Sales =
(Rs.5,01,428.57/Rs.12,00,000) ×100
=41.79%.
20.
Answer :
(e)
Reason:
Argenti Score Card is classified in three weakness namely defects,
mistakes and symptoms.
21.
Answer :
(c)
Reason : Asset turnover of a
company is defined as the ratio between the sales value and total assets. High
asset turnover is possible only when a company can generate a high sales volume
in comparison to the amount invested in the fixed assets and current assets.
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22.
Answer :
(c)
Reason : There are two costs
involved - Holding costs and transaction costs. Holding costs are in the form
of interest forregone on cash balance held, and trasaction costs are costs
incurred in converting securities into cash. Hence, statement (III) is wrong as
there are transaction costs involved in the converting securities into cash.
Hence, option (c) is the correct answer.
23.
Answer :
(d)
Reason : Net operating cycle =
Inventory conversion period + Receivables collection period – Payables deferral
period
For this problem, we are only interested in the
change in the net operating cycle. We may therefore ignore the payables
deferral period, since it is assumed to remain unchanged.
Old operating cycle (ignore payables)
= Rs.1,20,00,000/Rs.1,00,000 +
Rs.80,00,000/Rs.1,00,000
= 120 + 80 = 200 days.
New operating cycle =
Rs.96,00,000/Rs.90,000 + Rs.64,00,000/Rs.90,000 = 106.67 + 71.11 = 177.78 days.
Change in operating cycle = New operating cycle –
Old operating cycle
= 177.78 – 200
= -22.22 days. Round off to 22 days shorter.
24.
Answer :
(e)
Reason : Type of asset financed,
product life cycle, current capital structure and credit rating are all direct
determinants of capital structure of a company while the type of raw material used
does not have any direct relationship with it.
25.
Answer :
(a)
Reason : The certainty equivalent
approach provides a clear basis for making decisions, because the decision
maker can introduce their own risk preference directly into the analysis.
Hence, statement (I) is false. Whenever there is the availability of the
forward prices for estimating the future cash flows it is preferable to use the
certainty equivalent method. Hence, statement (II) is true. Under this method,
each period’s cash flow can be adjusted separately to account for the specific
risk of those cash flows. Hence, statement (III) is true.
Hence, option (a) is the correct answer.
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26. |
Answer : (d) |
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Reason : WCL= |
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TA + ∆CA |
NFA + CA + ∆CA |
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= 0.652 . |
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27.
Answer :
(b)
Reason : The example given in the
question is of translation risk. The risk arises from the translation of
balance sheets and income statements in foreign currencies to the currency of
the parent company for financial reporting purposes.
Hence (b) is the answer.
28.
Answer :
(e)
Reason : All
the four tasks have to be performed by the risk managers while managing
environmental risks.
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29.
Answer :
(b)
Reason : According to Walter
model on dividend policy, if the internal rate of return is less then the cost
of capital then the optimal payout ratio is 100%.
30.
Answer :
(d)
Reason : The Wilcox model
considers the net liquidation value of the firm as the best indicator of a
firm’s financial health. Blum Marc’s failing company model is based on a set of
12 ratios divided into liquidity, profitability and variability ratios. The
Beaver model identifies the cash flow to total debt as the single best
indicator of a firm’s financial health.
Section B : Problems
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1. |
a. |
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384.84 |
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Net Pr ofit m arg in = 924.54 |
= 41.63% |
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Re turn on equity = |
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384.84 |
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= 24.15% |
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1593.25 |
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= 384.84 =
EPS Rs. 6.55
58.75
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Dividend pay out ratio = |
1 |
= 15.27% |
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6.55 |
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Retention ratio = 1-0.1527 = 0.8473 |
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g = ROE × b = 0.2415 × 0.8473 = 20.46% |
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P/E ratio of the company as on 31st March 2007 = |
(1 − b ) (1+ g ) |
= |
0.1527×1.2046 |
= 17.68 |
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K e − g |
0.215 − 0.2046 |
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The estimated price of share as on 31st March 2007 = 17.68 × 6.55 = 115.8
b. As given, the firm will have to issue new
shares to finance its growth if it switches to a cent percent payout policy.
The growth rate of dividends tends to decline when the amount of retained
earnings decreases every year. On the basis of the current dividend payout
policy, the price of the stock for the subsequent year can be obtained by
multiplying the growth rate of 20.46 percent with the intrinsic value of
Rs.115.804, which gives Rs.139.50. At March 2008, if the number of original
shares outstanding is taken to be n1, the market value of the company shall be Rs
139.50n1.
As per the revised policy, new shares numbering n2 will be
issued to compensate for the amount distributed out of retained earnings. This
compensation will be equivalent to the Rs 6.69 (5.55 × 1.2046) per original share (the difference of Rs.
7.89 and Rs 1.2046), an aggregate loss of Rs 6.69n1. The
quantity of the new shares being n2 and with P1 as the price of the share at 31st March
2008 under the revised policy n2P1 = 6.69n1…(1)
At the same time, as the total value of the firm
does not get changed, i.e 139.5n1 = P1(n1 + n2)…(2)
These two equations are to be solved to give the
value of P1.
By substituting P1 = 6.69n1/n2 in the other equation, we get,
139.50n1 = 6.69n1/n2 (n1 + n2),
139.50n2 = 6.69(n1 + n2) = 6.69n1+ 6.69n2,
20.855n2 = n1 + n2, n1 = 19.85n2
When this relation between n1 and n2 is again substituted in n2P1 = 6.69n1, we get n2P1 = 6.69 x 19.85n2,
∴ P1 = Rs 132.80.
c.
P/E ratio
of the company as on 31st March
2008 = 132.80 / 7.89 = 16.83
∴ 16.83 = 1(1 + g)
0.215 − g
∴ 3.6185 – 16.83g = 1+g
∴ g = 14.69%.
2.
Profitability ratios:
i.
EBDIT/
NET SALES =
for the year 2006 = 3324.98/
14372.65 = 0.231 for the year 2007 = 4,442.03/ 18421.85 =0.241
ii.
OCF/
SALES
= ( Net profit + depreciation + other write offs)/net
sales
for the year 2006 = ( 2,477.44 + 283.56 + 0.66)/
14372.65 = 0.192 for the year 2007 = (3,066.91 + 402.84 +0.99)/ 18421.85 = .188
iii.
EBDIT /
(TOTAL ASSETS +ACCUMULATED DEPRECIATION) = for the year 2006 = 3324.98/
(18073.56+1,459.35) = 0.1702
for the year 2007 = 4,442.03 /( 22099.88+ 1932.30)
=0.1848
iv.
OCF/
TOTAL ASSETS = ( Net profit + depreciation + other write offs) / Total assets
for the year 2006 = (2477.44 +283.56+.66) / 18073.56 = 0.152.
for the year 2007 = 3,066.91 + 402.84
+0.99/22099.88 =0 .157
v.
EBDIT /
(INTEREST +0.25 DEBT) =
for the year 2006 = 3324.98/ 281.80 = 11.80 for the
year 2007 = 4442.03 / 661.21 = 6.71
Balance
sheet ratios:
i. NET
WORTH / TOTAL DEBT
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for the year 2006 = 10597.6 /7475.96 = 1.42 |
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for the year 2007 = 12538.69 / 9561.19 = 1.31 |
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ii
ALL OUTSIDE LIABILITIES/
TANGIBLE |
ASSETS |
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for the year 2006 = 7475.96 / 18072.58 = 0.414 |
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for the year 2007 = 9561.19 / 22099.88 = 0.43. |
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3. |
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Year |
1 |
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3 |
4 |
5 |
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A. |
Debt capacity (increase) |
75 |
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75 |
50 |
50 |
50 |
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B. |
Interest (@ 8%) |
6 |
|
6 |
4 |
4 |
4 |
|
C. |
Interest tax shield |
3.84 |
|
3.84 |
2.56 |
2.56 |
2.56 |
|
|
= B(1 – 0.36) |
|
|
|
|
|
|
|
D. |
Projected operating cash flows |
200 |
|
200 |
300 |
300 |
300 |
|
E. |
Certainty equivalent |
0.90 |
|
0.80 |
0.70 |
0.60 |
0.50 |
|
F. |
CE cash flows = D × E |
180 |
|
160 |
210 |
180 |
150 |
|
G. |
Total CE operating cash flows = C + F |
183.84 |
|
163.84 |
212.56 |
182.56 |
152.56 |
|
H. |
CE salvage value = 20 × 0.50 |
|
|
|
|
|
10 |
|
I. |
Total CE cash flows = G + H |
183.84 |
|
163.84 |
212.56 |
182.56 |
162.56 |
|
|
|
|
|
|
|
|
|
<TOP>
<TOP>
|
183.84 |
+ |
163.84 |
+ |
212.56 |
+ |
182.56 |
+ |
162.56 |
− 250 |
|||||
|
|
|
|
|
|
|
|
|
|
||||||
|
NPV= 1.06 |
1.062 |
1.063 |
1.064 |
1.065 |
||||||||||
|
|
|
|
|
= Rs.513.8 lakh. |
||||||||||
|
||||||||||||||
As the NPV arrived at after adjusting for
uncertainty and tax shields is positive the project can be accepted.
4.
1. The
process of target costing provides detailed information on the costs involved
in producing a new product, as well as a better way of testing different cost
scenarios through the use of ABC.
2.
Target
costing reduces the development cycle of a product. Costs can be targeted at
the time when the product is being designed, by including the functional
personnel from the manufacturing and finance departments to ensure that all
avenues of cost reduction are explored and that the product is designed for
manufacturability at an early stage of development.
3.
The
internal costing model, using ABC, can provide an excellent understanding of
the dynamics of production costs and can detail ways to eliminate waste, reduce
non-value-added activities, improve quality, simplify the process, and attack
the root causes of costs (cost drivers). It can also be used for measuring
different cost scenarios to ensure that the best ideas available are
incorporated from the outset into the production design.
4.
The
profitability of new products is increased by target costing through promoting
reduction in costs while maintaining or improving quality. It also helps in
promoting the requirements of consumers, which leads to products that better
reflect consumer needs and find better acceptance than existing products. This
helps the company to achieve its target market share goals.
5.
Target
costing is also used to forecast future costs and to provide motivation to meet
future cost goals.
6.
Target
costing is very attractive because it is used to control costs before the
company even incurs any production costs, which save a great deal of time and
money.
5.
• Prepare
Development Plan
One of the first steps in
developing new products or services is to develop a plan including such
elements as identification of key customers and suppliers or partners, project
management and organization, budgets, information and tooling required and any
other required changes in infrastructure.
•
Check Feasibility
Once these efforts are complete, initial cost,
quality and cycle time estimates are prepared. Then the plan is reviewed to
ensure the product or service is still viable. If not, plans are revised and
checked again.
•
Design product, service and processes
Target cost is achieved through
the design of product or service elements and processes that satisfy quality,
cost, and time targets. Target cost goals are achieved by evaluating the entire
cost structure of the company or value chain. For manufacturing companies, this
is accomplished by applying value engineering to influence design-related cost
drivers and process improvement methods to influence the cost and quality of
other processes in the company or value chain. Activity-Based Costing (ABC) can
be used to better understand the true costs of processes. Outsourcing options
may also be considered to reduce the total cost of products and services.
•
Establishing a market value for new product or
service features, functions and quality levels is not easy. Conjoint analysis can be applied to
understand perceived customer value and then translate these into an
engineering view of the product or service. One of the ways that product or
service level target cost can be decomposed to the elements of the product or
service is through the proportional use of perceived value from customers.
•
Pre-production/delivery preparation
This preparation process is
important to identify and eliminate problems before they occur in the
full-scale product production or service delivery. Production schedules and
sales, distribution and service plans are finalized. Members of the value chain
are trained in pertinent new processes, techniques and control methods. Tests
may be conducted and processes checked to ensure that they satisfy requirements
for quality, cost and cycle time.
•
Produce/deliver products or services
This process provides the
intended products or services to the market place. In the production phase of
the product or service life cycle, target costing and its supporting tools can
be applied to focus cost reduction efforts. Frequently this effort is also
referred to as kaizen costing. This can be particularly valuable when such
efforts may provide cost reductions across multiple models or services through
new technology or new process
<TOP>
<TOP>
•
Check results
Production process results are
monitored to control quality and cycle time. Market place results such as
sales, unit cost, customer satisfaction, etc., are evaluated. If results do not
match expectations, remedial efforts are examined and implemented.
6.
Businesses
face a lot of risks. Risks range from those arising due to changes in interest
rates and exchange rates to risks like terrorist attacks. ERM is a tool that
allows organizations to examine all the risk they face, measure the potential
impact of those risks on the long-term viability of the company, and take
appropriate steps to manage or mitigate those risks. Managing all the risks the
organization has to face in an integrated manner is the essence of enterprise
risk management (ERM). In addition to the coherence in risk management for the
organization as whole, ERM offers other advantages. It helps in identifying the
risks that may offset each other and need not be hedged for individually in
reducing the costs. To deal proactively with financial, operational and
strategic risks, organizations can adopt ERM.
The range of risks most business
face include hazard risk, such as property damage and theft; financial risks,
such as interest rate and foreign exchange fluctuations; operational risks,
such as supply chain problems or cost overruns; and strategic risks, such as
misaligned products. The ERM is trying to address all those risks in an
integrated fashion. It greatly expands the company’s definition of risk to
include anything that threatens the organization’s continuity. This approach
also divides the concept of risk into those risks that can help a company to
grow and those that will only lead to loss.
7.
Managing
risk demands more intuitive inklings of uncertainty, threats and opportunities.
Managing risk well requires
1.
Insight
assessments of threatened losses and potential gains.
2.
Awareness
of strategies for dealing with these threats and opportunities.
3.
Ability
to choose and implement the most promising of these strategies.
4.
And
objectivity in reviewing results and adapting to change.
These four qualities are
attributes that most persons naturally possess to some degree. The discipline
called risk management seeks to refine these qualities and to identify and
enhance specific skills so that they can be taught and passed across continents
and from one generation to the next.
<TOP>
<TOP>
Section C: Applied Theory
8. Approaches to risk Management < TOP >
The following are the different approaches to
managing risks :
•
Risk
avoidance
•
Loss
control
•
Combination
•
Separation
•
Risk
transfer
•
Risk
retention
•
Risk
sharing.
Risk
Avoidance
An extreme way of managing risk is to avoid it
altogether. This can be done by not undertaking the activity that entails risk.
For example, a corporate may decide not to invest in a particular industry
because the risk
involved
exceeds its risk bearing capacity. Though this approach is relevant under
certain circumstances, it is more of an exception rather than a rule. It is
neither prudent, nor possible to use it for managing all kinds of risks. The
use of risk avoidance for managing all risks would result in no activity taking
place, as all activities involve risk, while the level may vary.
Loss Control
Loss control refers to the
attempt to reduce either the possibility of a loss or the quantum of loss. This
is done by making adjustments in the day-to-day business activities. For
example, a firm having floating rate liabilities may decide to invest in
floating rate assets to limit its exposure to interest rate risk. Or a firm may
decide to keep a certain percentage of its funds in readily marketable assets.
Another example would be a firm invoicing its raw material purchases in the
same currency in its which invoices the sales of its finished goods, in order
to reduce its exchange risk.
Combination
Combination refers to the
technique of combining more than one business activities in order to reduce the
overall risk of the firm. It is also referred to as aggregation or
diversification. It entails entering into more than one business, with the
different businesses having the least possible correlation with each other. The
absence of a positive correlation results in at least some of the business
generating profits at any given time. Thus, it reduces the possibility of the
firm facing losses.
Separation
Separation is the technique of
reducing risk through separating parts of businesses or assets or liabilities.
For example, a firm having two highly risky businesses with a positive
correlation may spin-off one of them as a separate entity in order to reduce
its exposure to risk. Or, a company may locate its inventory at a number of
places instead of storing all of it at one place, in order to reduce the risk
of destruction by fire. Another example may be a firm sourcing its raw
materials from a number of suppliers instead of from a single supplier, so as
to avoid the risk of loss arising from the single supplier going out of
business.
Risk Transfer
Risk is transferred when the firm
originally exposed to a risk transfer it to another party which is willing to
bear the risk. This may be done in three ways. The first is to transfer the
asset itself. For example, a firm into a number of businesses may sell-off one
of them to another party, and thereby transfer the risk involved in it. There
is a subtle difference between risk avoidance and risk transfer through
transfer of the title of the asset. The former is about not making the
investment in the first place, while the latter is about disinvesting an
existing investment.
The second way is to transfer the
risk without transferring the title of the asset or liability. This may be done
by hedging through various derivative instruments like forwards, futures, swaps
and options.
The third way is through
arranging for a third party to pay for losses if they occur, without
transferring the risk itself. This is referred to as risk financing. This may
be achieved by buying insurance. A firm may insure itself against certain risks
like risk of loss due to fire or earthquake, risk of loss due to theft, etc.
Alternatively, it may be done by entering into hold harmless agreements. A hold-harmless
agreement is one where one party agrees to bear another party’s loss, should it
occur. For example, a manufacturer may enter into a hold-harmless agreement
with the vendor, under which it may agree to bear any loss to the vendor
arising out of stocking the goods.
Risk Retention
Risk is retained when nothing is
done to avoid, reduce, or transfer it. Risk may be retained consciously because
the other techniques of managing risk are too costly or because it is not
possible to employ other techniques. Risk may even be retained unconsciously
when the presence of risk is not recognized. It is very important to
distinguish between the risk that a firm is ready to retain and the ones it
wants to offload using risk management techniques. This decision is essentially
dependent upon the firm’s capacity to bear the loss.
This technique is a combination
of risk retention and risk transfer. Under this technique, a particulars risk
is managed by retaining a part of it and transferring the rest to a party willing
to bear it. For example, a firm and its supplier may enter into an agreement,
whereby if the market price of the commodity exceeds a certain price in the
future, the seller foregoes a part of the benefit in favor of the firm, and if
the future market price is
lower
than a predetermined price, the firm passes on a part of the benefit to the
seller. Another example is a range forward, an instrument used for sharing
currency risk. Under this contra ct, two parties agree to buy/sell a currency
at a future date. While the buyer is assured a maximum price, the seller is
assured a minimum price. The actual rate for executing the transaction is based
on the spot rate on the date of maturity and these two prices. The buyer takes
the loss if the spot rate falls below the minimum price. The seller takes the
loss if the spot rate rises above the maximum price. If the spot rate lies
between these two rates, the transaction is executed at the spot rate.
9. Drawbacks of using Real Option Analysis < TOP >
Though the use of real options
had brought in considerable advantages in creating a project, still there
exists some pitfalls in their usage.these pitfalls can broadly be categorized
under the following:
-
Using the
real option analysis when one should not use them.
-
Framing a
wrong model for the purpose of valuation.
-
Using
incorrect data and biased judgments in the model.
-
Miscalculation
in the process of valuation.
a.
Using real option analysis when one should not
Real
option analysis takes into account a number of assumptions. One basic
assumption of real option is that the relevant uncertainties are random walks
and as a result are unforeseeable. Coupled with this, it also states that the
consumer is the price taker, and decision taken by the consumer can change the future
course of the random walk. Such assumptions are in fact violated if there
exists a small number of leading competitors. In this case the decisions may
not be random. Each player’s action can influence the price of all the players
who will take decisions with full knowledge of what the possible counter moves
will be for every other player. The other assumption the option theory makes is
that the risks of an option can be hedged away. If hedging is feasible the
option will be priced as if it had been hedged, in which case the risk is
risk-free. If it is given that hedging is indeed possible it does not matter
whether any one option is actually hedged or not.
b.
Using the wrong real option model
It is
easy to wrongly assume that the actual decisions pertaining to the project is
“Like” a given real option model while in reality it is “Unlike” so. Thus
picking up a wrong model can be disastrous. Say for example, if one has assumed
that the interest rates are fixed, should it change the decisions to a large
extent if the interest rates were truly variable. If one bases his assumption
that the prices of oil and gas are independent of each other, how can it, in
any way, influence the decision if they were linked by some economic mechanism.
c.
Miscalculation in the data inputs
It is
important to understand the drivers of the option value in any specific real
option model. One needs to check the model for sensitivity to the associated
variables, try to understand how the errors in the variables could result in
based results. Say for example, the value of the call option is increased in
the time to expiry and the volatility of the underlying asset is increased. As
far as this is concerned it is important to note that one has over-estimated
the length of the available time, or what could be the smallest possible
estimate one could use for volatility?
d.
Getting both the models of the data right, but
making mistakes in the solution
It may sometimes happen, that while
using the complete mathematical algorithm, one can easily miss an important
variable. While calculating the option value, one may notice that the
calculated option values are exploding towards plus or minus infinity, or are
oscillating between the two. The results of option valuation are sometimes in
conflict with common sense approach. Nevertheless, it is important to make as
many logical checks as possible to ensure that these results are commensurate
with the economic rationality.
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