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OBJECTIVE TYPE QUESTIONS

FOR PRACTICE (COVERS ALL MODULES)

Net Interest income is

(i) Interest earned on advances

(ii) Interest earned on investments(iii) Total interest earned on advances and investment

(iv) Difference between interest earned and interest paid

Interest rate risk is a type of

(i) Credit risk

(ii) Market risk (iii) Operational risk

(iv) All the above

European opinion can be exercised on any day at the option of the buyer on orbefore the expiry of the option.

(i) True

(ii) False

What is the beta factor for corporate finance under Standardized approach ?

(i) 15%

(ii) 18%

(iii) 12%

(iv) None of the above

A bank suffers loss due to adverse market movement of a security. The security

was however held beyond the defeasance period. What is the type of therisk that the bank has suffered ?

(i) Market Risk

(ii) Operational Risk

(iii) Market Liquidation Risk

(iv) Credit Risk

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The June 1999 Basle Committee on Banking Supervision issued proposals for

reform of its 1988 Capital Accord (the Basle II Proposals). These

proposals contained MAINLY.

(I) Settlement risk management

(II) Capital requirements(III) Supervisory review

(IV) The handling of hedge funds

(V) Contingency plans(VI) Market discipline

(i) I, III and VI

(ii) II, IV and V(iii) I, IV and V

(iv) II, III and VI

Which of the following is not a type of credit risk ?

(i) Default risk

(ii) Credit spread risk

(iii) Intrinsic risk

(iv) Basis risk

8% Government of India security is quoted at RS 120/- The current yield on thesecurity, will be----

(i) 12%(ii) 9.6%

(iii) 6.7%

(iv) 8%

Risk of a portfolio with over exposure in steel sector will be

(i) More than systematic risk

(ii) Equal to intrinsic risk

(iii) Less than intrinsic risk

(iv) None of these

A company declares RS 2/- dividend on the equity share of face value of RS 5/-.

The share is quoted in the market at RS 80/- the dividend yield will be----

(i) 20%

(ii) 4%

(iii) 40%

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(iv) 2.5%

How many accounts have suffered rating migration in the following table

Rating Migration of 100 A Rated Accounts

Migration between 31.03.06 and 31.03.07

Last

Rating

No. of

Accounts

Present Rating

A++ A+ A B+ B C Default

A 100 1 1 79 10 4 3 2

(i) 2

(ii) 19

(iii) 21(iv) 25

The risk that arises due to worsening of credit quality is

(i) Intrinsic Risk

(ii) Credit spread Risk

(iii) Portfolio risk

(iv) Counterparty risk

A debenture of face value of As. 100 carries a coupon of 15%. If the current yield

is 12.5%. What is the current market price ?

(i) Rs.100

(ii) Rs.120

(iii) Rs.150(iv) Rs.125

In order to develop an capability to actively manage an credit portfolio one musthave in place the following:

(a) Credit Rating Model (or models for different categories of loans andadvances)

(b) Develop and maintain necessary data on defaults of borrowers rating

category wise, i.e., Rating Migration.

(i) Both 1 and 2 are required

(ii) Only 1 is required

(iii) Only 2 is required(iv) None of the above

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An increase in cash reserve ratio will cause yield curve to

(i) Shift downward(ii) Remain unchanged

(iii) Become steeper

(iv) Become flatter

The model that combines five financial ratios using reported accountinginformation and equity values to produce on objective measure of

borrowers financial health is

(i) Altmans 2 score

(ii) Credit Metrics

(iii) Credit Risk +


A bank holds a security that is rated A+. The rating of the security migrates to A.What is the risk that the bank has faced ?

(i) Market risk (ii) Operational risk

(iii) Market liquidation risk

(iv) Credit risk

When interest rates go up, prices of fixed interest bonds

(i) Go up

(ii) Go down

(iii) Remain unchanged

VaR is not enough to assess market risk of a portfolio. Stress testing is desirable

because

(i) It helps in calibrating VaR module

(ii) It helps as an additional risk measure

(iii) It helps in assessing risk due to abnormal movement of market

parameters

(iv) It is used as VaR measure is not accurate enough

STUDY THE FOLLOWING STATEMENTS AND ANSWER

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(COVERS ALL MODULES)

(a) Bond with BBB rating will carry lower interest rate than one with AArating

i. Falseii. True

iii. Difficult to say

(b) Fall in interest rate cause the rate causes the bond prices also to fall.

i. False

ii. Trueiii. Difficult to say

(c) A normal yield curve is sloping upward.

i. Falseii. Trueiii. Difficult to say

(d) Stamp duty on transfer of dematted shares is lower.

i. False

ii. True


(e) Large Government borrowing can cause yield curve to shift upward.

i. False

ii. True


(f) Growth Funds assure growth in return.

i. False


(g) If short term interest rates remain higher than the long term interest rates,the yield curve will be inverted.

i. False

ii. True


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(h) Credit rating agencies determine interest rates on debt securities.

i. False

ii. True


(i) The shares of software companies carry high P/E ratio.

i. False

ii. True


(j) Closed end mutual funds are trading at discount to NAV.

i. False

ii. True


(k) In a rising interest rate phase Zero coupon bond will be traded at apremium

i. False

ii. True


(l) A sharp decline in short term interest rates will cause yield curve to besteeper

i. False

ii. True


(m) A fall in interest rates reduces the demand for bonds in the secondary

market

i. False

ii. True


(n) Increase in the cash reserve ratio can cause the yield curve going

temporarily inverted.

i. False

ii. True


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(o) Dematerialization of stocks has increased turnover on the stock market.

i. False

ii. True


(p) Tight money and credit policy will cause bond prices to fall.

i. False

ii. True


(q) Increasing Government borrowing will raise interest rates.

i. False


(r) Bond carrying AA rating will carry highest interest rate than one

carrying BBB rating.

i. False

ii. True


(s) Mutual fund redemption bring bearish influence on the stock market.

i. False

ii. True


(t) Decline in the interest rates on long dated Govt. bonds will cause yield

curve to be steeper.

i. False

ii. True


(u) Demat shares carry lower stamp duty on transfer than physical shares.

i. False

ii. True


(v) Increase in interest rates will cause bond prices to fall.

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i. False

ii. True


(w) Growth fund is a mutual fund that invests primarily in equity shares.

i. False

ii. True


(x) Stamp duty on transfer of demated shares is lowest.

i. False

ii. True


(y) Large Government borrowing in the market can make the yield curve shift

upward.

i. False

ii. True


(z) Bond with A rating will carry higher interest rate than one carrying

BBB rating.

i. False




When the interest rates fall, the market price of a fixed rate bond

(i) falls

(ii) rises

(iii) does not change

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A transaction where financial securities are issued against the cash flow generated

from a pool of assets is called

(i) Securitization

(ii) Credit Default Swaps

(iii) Credit Linked Notes(iv) Total Return Swaps

Growth Fund is a mutual fund that

(i) assures growth in income

(ii) invests in fixed income securities

(iii) gives fixed return

(iv) invests primarily in equities

Operational Risk arises from

1) Inadequate or failed internal processes

2) People and systems3) External Events

4) Defaults

Which of the following is true ?

(i) All of them

(ii) None of them

(iii) (a) , (b) and (c)

(iv) (a) , (b) and (e)

A decline in cash reserve ratio will cause the yield curve to

(i) shift upward

(ii) shift downward

(iii) become flatter

(iv) remain unchanged

The third consultative paper recommended for

(a) Cause based classification(b) Effect based classification

(c) Event based classification

For operational risk. Which of the following is true

(i) (a)

(ii) None of them

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(iii) (c)

(iv) (b)

12% Government of India security is quoted at Rs.120. If interest rates go down

by 1%, the market price of the security will be.....

(i) Rs. 120

(ii) Rs.133.3

(iii) Rs. 109(iv) Rs. 140

Benefits of integrated risk frame work are:

(a) To relate capital and reserves more effectively to their

actual level of risk exposure.(b) To evaluate pricing decisions and product profitability.

(c) In making risk transfer decisions.


(i) All of them

(ii) None of them(iii) (a) and (b)

(iv) (b) and (c)

Rewards of proper management of operational risks are

(a) Lesser risk capital

(b) Cost reductions in operations

(c) Competitive edge


(i) All of them

(ii) None of them

(iii) (a) , (b) and (c)

(iv) (a) and (b)

A fall in long term interest rates on Government securities will make the yield

curve become

(i) flatter

(ii) steeper (iii) shift downward

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A bank expects fall in price of a security if it sells it in the market. What is the

risk that the bank is facing ?

(i) Market risk

(ii) Operational risk

(iii) Asset Liquidation risk(iv) Market liquidity risk

(i) An 8-year 8% semi-annual bond has a BPV of Rs.125. The yield

on the bond has

11% Government of India security is quoted at Rs. 110, the yield will be

(i) 11%

(ii) 10%

(iii) 9%(iv) None of these

1 day VaR of a portfolio is Rs.500,000 with 95% confidence level. In a period of

six months (125 working days) how many times the loss on the portfolio

may exceed Rs.500,000 ?

(i) 4 days

(ii) 5 days

(iii) 6 days

(iv) 7 days

A fall in interest rates will make prices of Government Securities -

(ii) Go down

(iii) Go up

(iv) Remain unchanged

(v) None of these

Systemic risk the risk of

(i) Failure of a bank, which is not adhering to regulations

(ii) Failure of two banks simultaneously due to bankruptcy of one bank(iii) Where a group of banks fail due to contagion effect

(iv) Failure of entire banking system

If the yield on long dated Govt. securities falls, then the yield curve will became:-

(i) Steeper

(ii) Flatter

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(iii) Shift downward

11% Govt. of India security is quoted at Rs.110. If the interest rates go down by

1% the market price of the security will be

(i) Rs.110

(ii) Rs.109

(iii) Rs.122.2

(iv) Rs.130

Balanced fund is a mutual fund that

(i) Assures income

(ii) Invests in debt and equity

(iii) Assure growth

(iv) Gives fixed returns

Back testing is done to

(i) Test a model

(ii) Compare model results and actual performance

(iii) Record performance


Under Basel II, Capital requirement under the accord is

(i) The maximum Capital that is required to be maintained

(ii) The minimum Capital that is required to be maintained

(iii) The capital as specified by the regulatory authority is required

to be maintained


STUDY THE FOLLOWING STATEMENTS AND ANSWER

(COVERS ALL MODULES)

(aa) Fall in interest rates cause the prices of Govt. securities to go up.

i. False

ii. True


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(bb) Steeper yield curve means long term interest rates are much lower than

short term interest rates.

i. False


(cc) Mutual fund mobilization has bearish influence on the stock market.

i. False

ii. True


(dd) Convertible debentures carry an element of equity shares.

i. Falseii. Trueiii. Difficult to say

(ee) Credit Rating agencies fix interest rates on bonds or debentures issued by

companies.

i. False

ii. True


(ff) Mutual Funds invest only in equity shares.

i. False

ii. True


(gg) Favorable monsoon brightens the prospects for stock market.

i. False

ii. True


(hh) Large Government borrowings cause debt securities prices to rise.

i. False

ii. True


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(ii) Falling interest rates have benefited investors in debt securities mutual

funds.

i. False

ii. True


(jj) Large government borrowing would cause interest rates to go down.

i. False

ii. True


(kk) Falling interest rates cause NAVs of debt mutual fund to go down.

i. False


(ll) Bond with BBB rating will carry lower interest rates than one with A

rating.

i. False

ii. True


(mm) Money market mutual funds do not invest in equity shares.

i. False

ii. True


(nn) SEBI gives credit rating to securities issued in the capital market.

i. False


(oo) Mutual funds can offer guaranteed returns.

i. False

ii. True


(pp) Large government borrowings will cause interest rates to go up.

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i. False

ii. True


(qq) A mutual fund scheme; with a entry load will have its sale price higherthan its NAV.

i. False

ii. True


(rr) Security with A rating will carry higher interest rate than one with BBrating.

i. False




A fall in the interest rates causes Govt. Securities to

(i) Remain stable

(ii) Fall

(iii) Rise

Capital charge for credit risk requires input for PD, LGD, EAD and M. Underadvanced IRB approach, who provide the input for LGD.

(i) Bank

(ii) Supervisor

(iii) Function provided by BCBS


A debenture of Rs.100 carrying 15% coupon rate is quoted in the market at

Rs.135/-. The current yield on this debenture will be

(i) 13.5%

(ii) 15%

(iii) 11.11%

(iv) 10%

Investment in Post Office time deposit is

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(i) Zero risk investment

(ii) Low risk investment

(iii) Medium risk investment(iv) High risk investment

If the short term interest rates are temporarily higher than the long term interestrates, the yield curve will be

(i) Sloping upward

(ii) Inverted

(iii) Zigzag

(iv) Horizontal

Premature payment of a term loan will result in interest rate risk of type

(i) Basis risk

(ii) Yield curve risk(iii) Embedded option risk(iv) Mismatch risk

A company with equity capital of Rs.50 crores (Face Value of Rs.10/- per share)

makes gross profit of Rs.70 crores and net profit after tax of Rs.25 crores.

If the market price of its equity share is Rs.50, the PE ratio will be

(i) 50

(ii) 5

(iii) 10

(iv) 20

Daily volatility of a stock is 1%. What is its 10 days volatility approximately ?

(i) 3%

(ii) 10%(iii) 1%

(iv) 4%

If call money rates are temporarily higher than the long term interest rates, theyield curve will be

(i) Slopping upwards(ii) Zigzag

(iii) Inverted

(iv) Horizontal

Capital charge component of pricing accounts for

1) Cost of capital

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2) Internal generation of capital

3) Loss provision

Which of the following is true.?

(i) All the statements are correct(ii) Statements 1 and 2 are correct(iii) Statements 2 and 3 are correct

(iv) Statements 3 and 1 are correct

Equity oriented mutual funds

(i) Assure income(ii) Assure growth

(iii) Invest in debentures

(iv) Invest in shares

A bank funds its assets from a pool of composite liabilities. Apart from credit and

operational risks, it faces

(i) Basis risk

(ii) Mismatch risk(iii) Market risk

(iv) Liquidity risk

A branch sanctions Rs.1 core loan to a borrower, which of the following risks the

branch is taking

1) Liquidity risk

2) Interest rate risk

3) Market risk4) Credit risk

5) Operational risk

(i) All of them(ii) 1,2 and 3 only

(iii) 1,4 and 5 only

(iv) 1,2,4 and 5 only

A rise in Government securities prices will make yield curve

(i) Slope upward

(ii) Shift downward

(iii) Remain stable

(iv) Shift upward

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Risk mitigation measures result in

1) Reducing downside variability

2) Reducing upside potential which of the following is true

(i) Both the statements are correct

(ii) Both the statements are not correct

(iii) Statement 1 is correct

(iv) Statement 2 is correct9% Government of India security is quoted at Rs.120. The current yield on the

security will be

(i) 12%(ii) 9%

(iii) 7.5%

(iv) 13.3%

Financial Risk is defined as

(i) Uncertainties resu1ting in adverse variation of profitability or

outright losses

(ii) Uncertainties that result in outright losses(iii) Uncertainties in cash flow

(iv) Variations in net cash flows

Strategic Risk is a type of

(i) Interest Rate Risk

(ii) Operation Risk

(iii) Liquidity Risk


Objective of liquidity management is to:

(i) Ensure profitability(ii) Ensure liquidity

(iii) Either of two

(iv) Both

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A mutual fund charges 1% entry load and no exit load. Its NAV is Rs.16; its sale

and repurchase price will -----

(i) Rs.16 and Rs.15.80

(ii) Rs.16.16 and Rs.15.84

(iii) Rs.15.84 and Rs.16(iv) Rs.16.16 and Rs.16

Banks need liquidity to:

(i) Meet deposit withdrawal

(ii) Fund loan demands

(iii) Both of them

(iv) None of them

OBJECTIVE TYPE QUESTIONSFOR PRACTICE (COVERS ALL MODULES)

A fall in interest rate of long dated government securities with the short term

interest rates remaining unchanged will make the yield curve.

(i) Steeper

(ii) Slop downward

(iii) Shift downward

(iv) Flatter

Adequacy of banks liquidity position depends upon:

(i) Sources of funds

(ii) Anticipated future funding needs

(iii) Present and future earnings capacity

(iv) All of the above

Current yield on a government security is 5%. If the market price of the bond is

Rs.160, the coupon rate on the bond will ----

(i) 6%

(ii) 5%

(iii) 8%

(iv) 10%

Assets represent source of funds where as liabilities denote the use of funds in a

balance sheet.

(i) True

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(ii) False

(iii) Difficult to say

Deregulated environment has narrowed spreads of the banks.

(i) True

(ii) False


Asset Liability management is only management of maturity mismatch and has no

bearing on profit augmentation.

(i) True

(ii) False


A rise in the short term interest rates with the long term interest rates remainingunchanged will make the yield curve -----.

(i) Steeper (ii) Shift upward

(iii) Flatter

(iv) Slope upward

Net Interest Margin is also known as Spread.

(i) True

(ii) False


A scheme of mutual fund has units with face value of Rs.10 and NAV of Rs.37.

The Fund declares a dividend of 35% in the scheme. The ex-dividend

NAV will be ------- per unit.

(i) Rs.37

(ii) Rs.2

(iii) Rs.33.50

(iv) Rs.35.5

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

will be ----------.

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(i) 8.55%

(ii) 6.25%

(iii) 7.75%(iv) 7%

A company with equity capital of Rs.15 crores makes PBIDT of Rs.15 crores andPAT of Rs.10 crores. The face value of its share is Rs.5 and PE is 10, the

market price will be ---------.

(i) Rs.50

(ii) Rs.66

(iii) Rs.33

(iv) Rs.100

CASE STUDIES(COVERS ALL MODULES)

1. A company with equity of Rs.10 crore, earns PBIDT of Rs.30 crore. It incurs

interest cost of Rs.35 crore depreciation of Rs.5 crore and pays Rs.10 crore as tax.

It has reserve of Rs.30 crore (excluding current years profits) and long terms debtof Rs.35 crore. It pays 50% dividends and transfer remaining profit to reserves. Its

share of Rs.10 face value is quoted at Rs.150/-

Find the following----

(i) Earning per share

PAT

= ----------------- x 10

Equity

30 (5 + 5 + 10) 10

= -------------------- x 10 = ------- x 10 = Rs.10

10 10

(ii) Book value of share

= Equity + Reserves

= 10 + 30 + 5

= Rs.45

(iii) Return on Net worth

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PAT

= ----------------NW

10= -------------- x 100

45

= 22.2%

(iv) Debt-equity ratio

= 35: 45 = 7:9

(v) P/E ratio

PE = MP / EPS = 150 / 10 = 15

(vi) Payout ratio

Dividend 5

= ----------- x 100 = -------- x 100 = 50%

PAT 10

2. A company with equity of Rs. 10 crore earns PBIDT of Rs. 40 crore. It incurs

interest of Rs.5 crore, depreciation of Rs. 5 crore and pays tax of Rs. 10 crore. Ithas reserves of Rs. 30 crore (Excluding current years profits) and long term debt

of Rs. 50 crore. It pays 100% dividend and transfers remaining profit to reserves.

Its share of Rs. 10 face value is quoted at price of Rs. 200. Find the following :

(i) Book value of share after current year's profit transferred to reserves.

Book Value = Equity + Reserves + Current years (PAT Div)

= 10 + 30 + (20 10) = Rs..50

(ii) Earning per share

40 ( 5+5+10)

EPS = PAT / Equity = ------------------ x 1010

20

--- x 10 = Rs.20

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10

(iii) Return on net worth

PAT x 100 2040% Return on net worth = ------------ = ------- x 100 = 40%

NW 50

(iv) Debt-equity ratio

50

1:1 Debt equity ratio = ------ = 1:150

(v) P/E ratio

10 M.P. = EPs x PE200 = 20 x PE

PE = 10

(vi) Payout ratio

50%

Dividend 10

----------- = ---- = 50%PAT 20

IMPORTANT KEY WORDS FOR PRACTICE

Appreciation:

An increase in the market value of an asset.

Arbitrage:

(i) Dealing between two centres to take advantage in the rate due to a temporary

difference in the rates between two places.

(ii) The simultaneous trading (purchase/sale OR sale/purchase) of assets to take advan-

tage of price differentials.

Asset creation:

Acquisition of assets/ investments

Balance sheet:

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A Financial Statement that indicates the type and amount of assets, liabilities and Capital

of a firm as on a particular date.

Base currency:

The currency against which another currency is quoted. [Eg. INR 39.4880/USDwherein

INR is quoted currency and USD is base currency]

B R:

Bankers Receipt. This is a receipt issued by the Bond/ security selling bank when the

original scrip/ Bond is not immediately deliverable for settlement.

Bid:

The price quoted by someone to buy the asset or borrow funds.

Broker:

Intermediaries who match buyers and sellers Or borrowers and lenders and receive a

commission (brokerage) for such intermediation.

Concurrent auditor:

A professional, generally an external guy (not a staff), who checks/ audits the day to day

transactions and reports. His main task is to check whether the laid down

systems/procedures/policy has been complied with, in each transaction and report the

discrepancies to the Management.

Cover:

To take out forward contracts to protect against exchange fluctuation between todays

date and due payment date.

Deal:

A transaction undertaken by the Dealer in the domestic market or Foreign Exchange

market binding the Bank.

Deal confirmation:

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Written advice from one counterparty in a deal to the other in which the main terms and

conditions of the deal are confirmed.

Fixed rate currency:

Currency having a fixed rate of exchange within narrow limits versus another reference

currency, usually the dollar.

Floating rate currency:

Currency having its exchange rate determined by market forces including Central Bank

intervention.

Forex:

Foreign Exchange.

Forward contract:

Any contract for settlement later than spot date.

Forward-Forward deal:

Simultaneous purchase and sale of one currency for different forward value dates.

Funding of assets:

Borrowing done, when assets are more than the Liabilities of the bank.

Hedge:

Action taken by the Bank to reduce or eliminate a risky exposure.

Intra day position:

Open position run by a dealer within the day. This is generally reduced to square or

nearly so before close of business.

Keeping arms length:

Not to influence/interfere or get influenced/interfered.

Liquidity risk:

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The variation in net income and market value of bank equity caused by the banks

difficulty in obtaining immediate funds, either by borrowing or selling assets.

LIBOR:

London Interbank Offered Ratethe rate at which major Banks in London offer to lend

in the interbank market.

Nostro account:

A Banks account with a foreign Bank.

NSE:

National Stock Exchange

NSE terminals:

Computer nodes through which screen driven trading can be conducted in the NSE.

Offer:

Rate at which the Bank/dealer sells or lends.

Open position:

Difference between total purchases and total sales in a given currency on which an

exchange risk is run.

Premium:

Difference between spot price and price for forward settlement.

Proactive:

One who acts in advance before others react, anticipating the market move.

Reserves:

Qualifying assets to meet the statutory reserve requirements.

Settlement of deals:

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Verification of the deal terms/calculations, obtention of Deal confirmation from the

counterparty, Brokers contract, documentation of the transaction and arranging the

delivery of the documents.

SGL account:

Subsidiary General Ledger Account maintained with RBI for Govt. Securities

transactions.

Spot deal:

A deal for currency for delivery two business days from today.

Spot next:

A deal from the spot date until the next day, either as a deposit or a swap.

Spread:

Difference between the cost of funds and return from the funds.

Volatile market:

Market wherein the prices/rates are fluctuating in a wide band/ range

Vostro account:

A foreign Banks account with a local Bank.

Wire agency:

News reporters, which are transmitting the information/news instantaneously through

tele-net work.

Reserves:

Assets qualifying to meet statutory requirements.

CRR:

Cash Reserve Ratio

SLR:

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Statutory Liquidity Ratio

AssetLiability Maturity Mismatches:

Case when either gross Financial Assets outgrows Capital & Liabilities or vice versa

Demand and Time Liabilities (DTL):

Sum of Demand Deposits and Fixed deposits including inter bank deposits

Government Stock/Loan/Securities/Gilts:

Loans raised by Government to meet its fiscal deficits. These are issued in the form of

tradable bonds.

NDTL for SLR:

Gross DTL less Inter Bank Deposits.

NDTL for CRR:

NDTL for SLR less exempted categories of liabilities.

Delivery versus Payment (DVP) System:

System where the securities are delivered against simultaneous payment. As both the legs

of delivery and payment are simultaneous Settlement Risk is avoided.

SGL Transfer Form:

RBI prescribed format printed on semi security paper for effecting security transactions

in the SGL account of the bank.

Authorized Signatories:

Officials (generally back office staff) who are authorized to execute/ sign SGL Transfer

Forms and other documents and whose specimen signatures are lodged with RBI andother counterparts in the market.

Bank Rate:

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Interest rate at which RBI lends to Sch. Comm. Banks. Refinance Rates and penalty on

default of CRR are pegged to Bank Rate. RBI is using Bank Rate as a tool to send

interest rate signals to the market.

Local Bank Account:

Account with SBI and/or such other Bank, which is managing the Clearing house,

through which the Clearing net proceeds are and where the Bank is maintaining a current

account for passing the Clearing inflows and outflows.

Cash Surplus Branch:

Branch which collecting and holding cash more than its stipulated limit/ normal payment

requirement.

Purchased Funds:

Funds sourced at the at market determined rates (different from rates offered to the

public).

Repoable Securities:

Securities which are approved for Repo transactions.

Discretionary Liabilities:

Liabilities/resources raised at the discretion of the borrower.

Buyers Market:

Market where the demand is less and supply is more. Buyer has better choice for

selection/negotiation since sellers (supply) outnumbers the buyers (demand).

CAR:

Capital Adequacy Ratio.

DVP System:

Delivery versus Payment (DVP) system is the Settlement system wherein delivery of

the Stock/security and Payment of consideration are made simultaneous. In case if one

side of the transaction doesnt go through (say, for want of good delivery), the RBI holds

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back the other side of the transaction (payment of consideration). By this, settlement risk

is totally hedged.

Derivative Usance Promissory Note (DUPN):

Usance Promissory note drawn by the discounting Bank against the underlying Bills.While rediscounting the Bills, actual endorsement and delivery of these Bills are not

necessary. Instead this Promissory Note is delivered. Since this Note derives its value

from the underlying Bills, this is called Derivative Usance Promissory Note.

Maximization of Spreads:

Difference between the Total cost of funds and total return from it gives the spread.

Spreads can be maximized either by reducing the cost and/or increasing the return from

it.

Maximization of Net worth:

Increasing the profits of the business so that maximum profits can be ploughed back to

Reserves. This maximizes the Net worth of the Company and thereby increases the

Shareholders value.

GAP:

It is the difference between the Rate Sensitive Assets (RSA) and Rate Sensitive

Liabilities (RSL). GAP is said to be positive when RSA > RSL.

Duration GAP:

Difference between the aggregate duration of Assets and aggregate duration of Liabilities

is Duration Gap.

Market Interest Rate:

The interest rate, or discount rate, or yield to maturity is an interest rate which changes

constantly, depending on various factors like demand/supply of the Financial asset, future

economic outlook, etc.

Face Value:

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The principal value or the Maturity value of the Bond, which is printed on the bond and

which is fixed throughout the bonds life.

Coupon Rate:

The fixed rate of interest which is printed on the Bond certificate is called Coupon rate.

Coupon rates are contractual rates that cannot be changed after the bond is issued.

Time Value of Money:

In order to understand this concept, it is important that we are familiar with discounted

cash flow analysis.

It is known that:

a. People have a positive time preference for money;

b. A rupee today is worth more than a rupee received in the future;

c. People postpone their current consumption and save only if their future

consumption opportunities will be more because of their savings;

d. Since money earns interest, it takes more future rupees to equal the value of a rupee

today.

The above show that money has a time value.

Future Value:

The process of going from todays value or Present Value (PV) to Future Value (FV) is

called compounding. To understand this, consider the case where an investor put Rs 100

in the Bank at 10 per cent p.a.

This means that Rs 100 today is equivalent to its Future value of Rs 100 x (1 + 0.10) = Rs

110 one year from now.

Future Value at the end of second year is Rs110 x (1 + 0.1) = Rs 121.

This can be expressed by the formula:

FV = PV (1+i) n

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Where: i = interest rate and n is number of years

Present Value:

The process of calculation from Future Value to todays value (Present Value) is called

discounting. In the above quoted example the Present value of Rs 121 to be received from

the Bank at an interest rate of 10 per cent is Rs 100.00. The process of discounting is

simply the inverse process of compounding. Accordingly, the Present Value (PV) can be

found out as follows:

PV = FV / (1+i) n

Net Present Value:

Suppose an investment of Rs.100 generates a net cash flow of Rs 115 from one year fromnow and if the cost of funds for the Bank is 10 per cent, the investment is worth doing.

To find out how much wealth does the investment creates for the capital, the future value

of Rs 115 is discounted at the cost of capital, i.e.,10 per cent.

115

PV of Rs 115 = = Rs 104.55

(1 + 0.1)

Since the initial cost of investment is only Rs 100, the Net Present Value, i.e., the wealthcreated for the shareholders, is found out as.

NPV = PV of the future revenue initial cost = 104.55 100 = Rs 4.55

The net present value (NPV) approach can be extended to more complex situations.

Using the same logic as above, to find the NPV of an asset with an initial investment of

cost of C and net cash flows at subsequent dates from year 1 to year n is:

cash flow 1 cash flow 2 cash flow n

NPV = () C + + + ................ +

(1+r)1 (1+r)2 (1+r) n

Bond Valuation:

Bond is a contractual obligation to pay:

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i. Coupon/interest specified on the Bond;

ii. at fixed intervals;

iii. Principal amount with or without premium, if specified any, at maturity.

The Present value or price of the Bond is therefore:

i. PV of the future stream of cash flows (interest payments and Principal) discounted

at prevailing market interest rates;

ii. At the time of new issue, coupon interest and market interest are ideally the same

and expressed as follows:

C1 C2 C3 (Cn + M)

Bond Value (VB) = + + + +

(1+i) (1+i)2

(1+i)3

(1+i)n

n C + M

=

t =1 (1+i)t (1+i) n

Where:

C1.. Cn = period coupon payment from year 1 to n

i = market interest rates, prevailing

n = period to maturity

M = Principal with / without redemption premium

The value of the Bond will change if there is a change in the market interest rate (i). If

market interest rate goes up beyond the coupon rate, the value of the bond will fall so that

the new investor (buyer) would earn market interest rate despite the fact that the coupon

of the Bond would continue to give fixed lower income. Likewise if market interest rate

declines below the coupon rate, the value of the bond will appreciate so that the new

investor (buyer) earn only lower market interest rate despite the fact that the coupon of

the Bond would continue to give fixed higher income. Such equilibrating adjustment in

bond price/ value is knows as bond dynamics.

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We learnt that the value of the Bond depends on the coupon rate vis--vis prevailing

market interest rates. We can summarize the above as follows:

i. Whenever the market interest rate rise above the coupon rate of the bond, the price

of the bond will fall;

ii. if the market interest rate falls below the coupon rate of bond, the price of bond will

appreciate;

iii. if there is no change in the market interest rate from bond coupon rate, the price of

bond will remain the same.

Annuity:

This is a series of equal payments made at fixed intervals for a specified number of

periods. If the payments are made at the end of the period, it is known as ordinary annuity

or deferred annuity. If payments are made at beginning of period, then it is an annuity

due.

Formula for Future value of an ordinary /deferred annuity is:

FVAn = A (1+r) + A (1+r) +......+A

Where FVAn = Future value of an annuity with n periods

A = Constant/regular cash flow

r = Interest rate

n = Duration of the annuity

YIELD:

Yield is defined as an overall return to an investor on his investment. With respect to

yield on Bonds/GOI securities, three types of yields are discussed:

Nominal yield:

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This is the annual interest rate specified on the Bonds, irrespective of its price (i.e.,

whether quoted at a premium or at a discount). This is also known as Coupon of the

Bond.

Current yield:

This is the effective yield an investor earns keeping in mind the current market price of

the Bond. This is given by the formula:

Nominal yield or Coupon

Current Yield = x 100

Current market Price

Yield to maturity:

This term popularly known as YTM connotes redemption yield and is very useful for

Treasury Managers whose investment horizon is long term. YTM can be interpreted as

the bonds average compounded rate of return if the bond is bought at the current asked

price and held until it matures and the face value is repaid. That is, YTM can be defined

as the discount rate that equates present value of all cash flows to the present market price

of the Bond. Future cash flows includes interest and capital gain/loss. This can be

algebraically expressed as follows: Let the Bond with a face value of A of coupon C

with a term to maturity of n years is quoted/traded at a market price of P, then

C C C (C + A)P = + + + +

(1+y)1 (1+y)2 (1+y)3 (1+y)n

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Where y is the discount rate (to be found by trial & error method ) at which the cash

flows are discounted so that the right hand side of the above equation tallies/equates with

the Price P (left hand side) of the Bond.

The 'y' so derived would be the Yield to maturity (YTM) of the bond. It implies that, ifthe Bond is held till maturity and the Coupons/Cash flows received are reinvested at the

'y' rate itself, the overall yield on the Bond will be 'y', which is its YTM.

An example would further help to understand the mechanics of the YTM. Suppose the

market value of Rs 100 (face value) bond carrying coupon of 13 per cent p.a. maturing

after 7 years is quoted Rs 109.45 in the market. The YTM of the bond is found by

discounting the yearly coupon flows of Rs 13 in the next 6 years and Rs 113 (Principal of

Rs 100 + coupon of Rs 13) at the end of 7 year at a rate (to be found by trial & errormethod), say r so that the Present value of such cash flows sums to Rs 109.45 Rs 13

(PVIFA) + Rs 100 (PVIF) = Rs 109.45 PVIFA being the Price Value Interest Factor for

the 7 year Annuity and PVIF the Price Value Interest Factor for 7 years to be taken from

the PVIFA table and PVIF table (available in all standard Finance Text Books) for a 7

year term, by trial and error method.

Accordingly for 7 years (PVIFA) at 11% = 4.712

and for 7 years (PVIF) at 11% = 0.482

Then LHS of the equation becomes 13 x (4.712) + 100 x (0.482) = Rs 109.45

Then 11 per cent is said to be the YTM of the bond, also described as the Internal Rate of

Return, (IRR). In other words, in the above example, if the above bond is held by the

buyer till maturity the overall return from the Bond will be 11 per cent. However as the

above process will be time consuming, YTM can be found by approximation as follows.

C + (A P)/nYTM = X 100

(A + P) /2

Where C = coupon

A = Face Value/maturity Value

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P = Price paid for the Bond

n = term to maturity

Applying this in the above example,

13 + (100 109.45)/ 7 13 + ( 9.45/7)

YTM = =

(100 + 109.45)/ 2 104.725

13 1.35

= X 100 = 11.12%

104.725

However underlying assumption in the YTM concept is that the coupons/cash flows

received during the tenure of the bond is reinvested at YTM rate, which may not be true

since the market interest rates will always be changing from time to time.

Holding Period/Realized Yield:

When the holder/investor is going to disinvest the Bond before its maturity, the overall

yield earned by him from the Bond is known as Holding Period Yield or Realized Yield.

Let us understand this with the help of an example:

Suppose you are holding a 10 year Bond with a Face value of Rs 100 and coupon 8 per

cent. After 3 years, when the interest rates move up to 10 per cent for 7 years term, you

want to sell this Bond. As the interest rates have moved up, naturally you may have to

sell the Bond at a discount. The selling price for the Bond by using the Bond Valuation

Formula as follows:

8 8 8 108

+ + + + = 90.25

(1.10) (1.10)2 (1.10)3 (1.10)7

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This shows that the Bond have to be sold at a below par value of Rs 90.25, thereby

incurring a capital loss of

(100 90.25) = Rs 9.75.

Now to find the Realized yield on the 8 per cent bond for the period of 3 years held and

with a redemption value of Rs 90.25 (as the sale proceeds of the Bond), the YTM

formula is used as follows:

8 8 (8 + 90.25)

+

+ = 100

(1+r) 1 (1+r) 2 (1+r) 3

Where r is the Realized or Holding Period Yield.

Accordingly, we get the Realized yield r = 4.9 per cent.

However as it is much lower than the promised yield of 8 per cent, the seller incurs a loss

of (8 4.9) = 3.1 per cent returns on his Bond.

Yield Spreads:

Yield spreads are the differences between the yields of any pair of bondsusually a zero

risk bond and another risky bondof same maturity.

{Yield on risky bond} {Yield on zero risk bonds} = {yield spread}

Yield spreads are also called risk-premiums because they measure the additional yield

that risky bonds pay to induce investors to buy more-risky bonds rather than less risky

bonds.

Yield on Discounted instruments:

The issue price of a discounted instrument is calculated as follows:

F

D =

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1 + {( r x n)/36500}

where,

D = Discounted value of the instrument

F = Maturity Value

r = Effective rate of interest per annum

n = Tenure of the instrument ( in days)

Conversely to find out the yield from a discounted instrument, the following formula can

be derived from the above one,

(F D) 365

r = X X 100

D nwhere,

D = Discounted value of the instrument

F = Maturity Value

r = Effective rate of interest per annum

n = Tenure of the instrument ( in days)

REPO Transactionscalculations:

Assume Bank A borrows from Bank B an amount of Rs 10 crores for a period of 14

days from 10.10.2005 to 24.10.2005, at an interest rate of 8 per cent against its holding of

11.50 per cent GOI 2007 (Interest Payment dates of this stock are 5th April and 5th

October of the year). As already stated earlier, the transaction involves 2 legsFirst

leg/Ready leg and Second leg/Forward leg. The calculation for both legs are explained

below:

Working

(Note: While calculating interest accrued on Government securities, 360 days are

considered for an year.)

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FIRST LEG/READY LEG on 10.10.2005: (Bank A sold 11.50 per cent GOI 2007 to

Bank B)

Calculation for first leg is as if Bank A is selling the security (11.5 per cent GOI 2007)

outright to Bank B at the market price of Rs 100. This is as follows:

Principal (Rs 10 crs. @ 100.00) = Rs 10,00,00,000.00

Accrued int.on the stock

= (10 crs x 11.5% x 5/360) = Rs 1,59,722.22

First/Ready leg settlement amount...(1) = Rs 10,01,59,722.22

(It may be understood from the above transaction, that Bank A borrowed Rs

10,01,59,722.22 from Bank B)

FORWARD/SECOND LEG on 24.10.2005: (Bank A bought back the stock from Bank

B)

Though the second leg transaction is to be calculated as if Bank A is buying outright the

security from Bank B, to arrive at the buying rate/price, the calculation has to be done on

the reverse way, as follows:

1. Calculate the settlement amount Bank A has to pay Bank B which is = Amount

borrowed + interest @ 8% for 14 days (Repo rate)

= Rs 10,01,59,722.22 + Rs 3,07,339.42

Settlement amount = Rs 10,04,67,061.64

2. From this subtract accrued interest on the stock till date.

Accrued interest on the stock

= 10,00,00,000 x 11.5% x 19

---------

360

= Rs 6,06,944.44

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Settlement amt. Accrued interest = 10,04,67,061.64

6,06,944.44

Rs 9,98,60,117.20

3. Resulting amount of Rs 9,98,60,117.20 is the principal amount for the Rs 10 crore

value stock. Hence to get rate of repurchase, divide this value by nominal value

i.e. 9,98,60,117.20

------------------ = 99.860117

10,00,00,000

Now based on this rate, the accounting is done as follows:

Principal (Rs 10 crs. @99.860117) = Rs 9,98,60,117.20

Accrued int. on the stock

= (10 crs x 11.5% x19/360) = Rs 6,06,944.44

Forward/second leg settlement amt

= (1) + int @ 8% for 14 days = (2) = Rs 10,04,67,061.64

STUDY MATERIAL:-

FINANCIAL MANAGEMENT

VERY SHORT QUESTIONS ( 1 MARK)1 Define Financial Management.

Ans financial management is that specialized activity which is responsible for

obtaining and affectively utilizing the funds for the efficient functioning of the

business and, therefore, it includes financial planning, financial administrationand financial control.

2 State the primary objective of Financial management.

Ans. To maximize the shareholders wealth.3 State the decisions involved in Financial management.

Ans.. a) Investment decision b) Financing decision c) Dividend decision

4 What is meant by Financial Planning?Ans.. Financial planning means deciding in advance, the financial activities to

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be carried on to achieve the basic objective of the firm. The basic objective of the

firm is to get maximum profits out of minimum efforts.

5 What are the objectives of financial planning?Ans.. a) to ensure availability of fund whenever required.

b) to see that the firm does not raise funds unnecessarily.

6 What is Working Capital ?Ans.. The capital required for day to day operations of the business is called

Working capital.

7 State the difference between gross working capital and net workingcapital.

Ans.. Gross working capital is the sum/ aggregate of the current assets,

whereas

Net working capital = Current assets current liabilities.8 What is meant by capital budgeting decision?

Ans.. A long term Investment decision is called capital budgeting decision.

9. When is financial leverage considered favorable?

Ans) Financial leverage is considered favorable when return on investment ishigher than the cost of debt.

10. How does production cycle effect working capital?Ans) working capital requirement is higher with longer production cycle. 11. What do

you mean by floatation cost?

Ans) Cost incurred for raising funds.12. What is capital structure of a company?

Ans.. Capital structure is the relative proportion of different sources of long

term finance. In other words Capital structure of a company refers to the make

up of its capitalizationSHORT ANSWER QUESTIONS (3 / 4 MKS)

1. Are the share holders of a company likely to gain with a debt component in

the capital employed ? Explain with the help of an example?Ans) The shareholders of a company are very likely to gain with debt component

in the capital employed by way of trading

On equity as it increases the earning per share(EPS) of the share holders.2 Define current assets and Give four examples.

Ans. Current assets also called as floating assets or fluctuating assets are short

term assets whose value fluctuates in the short period. These assets are required to

pay off the current liabilities. For e.g. cash in hand/Bank, Inventory, Debtors.Bills receivable, Marketable securities etc.

3 To avoid the problem of shortage and surplus of funds, what is required

in Financial management? Name the concept and explain four points ofimportance.

Ans.Financial Planning is required to avoid shortage or surplus of finance.

Importance of financial planning is:a) By planning utilization of finance, it reduces waste ,duplication of efforts

and

gaps in the planning.

b) It helps in coordinating the various business activities such as sales,

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purchases, production, finance etc.

c) It is a technique of control. It helps in setting up standard and compare

with the actual performance. The deviations, if any are then analysed.Causes found out and corrective measures are taken.

(d)It helps in avoiding shocks and surprises as proper provision regarding

Shortage or surplus is made in advance by anticipating future receipts andPayments.

.

4 Explain the role of Operational efficiency in the determination ofworking capital requirement.

Ans. The firm with a better operational efficiency has to invest less in working

capital because-

a) they convert raw materials quickly into finished goods, and sell them at theirearliest. i.e. converts stock into sales quickly.

b) Promptly collects debts from debtors and bills receivable. 5 Discuss how Working

capital affects both the liquidity and profitability of

a business.Ans. Short term Investment decisions are concerned with the decisions about the

level of cash, inventory and debtors etc. (working capital)Efficient cash management, Inventory management and receivable management

are essential ingredients of sound working capital management.

The working capital should be neither more or less than required. Boththe situations are harmful. If the amount of working capital is more than required,

it will no doubt increase the liquidity but decrease the profitability. Similarly if

there is a shortage of working capital, it will face the problem of meeting day to

day requirements.Thus optimum amount of current assets and current liabilities should

be determined so that the profitability of the business remains intact and there is

no fall in the liquidity.6 How does Interest coverage ratio affects the capital structure.

Ans. The interest coverage ratio refers to the number of times earnings before

interest and taxes of a company covers the interest obligations.Interest coverage ratio = EBIT/Interest

Higher the ratio, better is the position of the firm to pay its interest

obligations, so

it should issue debt. On the other hand if it is low, the firm should avoid usingdebt as

interest is to be paid irrespective of profits.

7 Why Capital budgeting decisions are more important?.Ans. The long term Investment decision is called capital budgeting. It is more

important due to the following reasons-

a) Long term growth and affects : As capital budgeting decisions involveinvestment in long term fixed assets, it affects the long term growth.

b) Large amount of funds involved : As huge amount of fund is blocked for a

long period, the decision should be taken rationally.

c) Risk involved : As such a decision affects the returns of the firm as a whole, it

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involves more risk.

d) Irreversible decisions : These long term decisions taken once cannot be

reversed back, without incurring heavy losses. It will lead to waste of fund, ifreversed.

Thus capital budgeting decisions should be taken after careful study and deep

analysis.8 What is Financial risk? How does it arise?

Ans. It refers to the risk of the company not being able to cover its fixed financial

cost. Fixed financial cost includes payment of interest that is to be paidirrespective of profit.

The higher level of risk are attached to higher degrees of financial leverage. If

EBIT(Earnings before interest and tax) decreases, financial risk increases as the

firm is not in a position to pay its interest obligations. Thus the risk of default is calledFinancial risk. The firm should overcome the situation accordingly or will

be forced towards liquidation.

LONG QUESTIONS ( 5/6 MKS)

1.What are the determinant of capital structure of a company?OR

Determination of capital structure of a company is influenced by a number offactors explain six such factors.

Ans. Capital structure refers to the relative proportion of different sources of long

term finance. Following factors are to be considered before determining capitalstructure.

a) Cash flow position: The cash available with the company should be enough to

meet the fixed interest liabilities. Interest on debt is to paid irrespective of

profits. A company has to meet working capital requirements, invest in fixedassets and also pay the interest and principal amount of debt after a particular

stipulated period. If cash position is sound, debt van be raised, and if not

sound debt should be avoided.b) Interest coverage ratio : it is the ratio that expresses the number of times the

Net profit before interest and tax covers the interest liabilities. Higher the

ratio, better is the position of the firm to raise debt.c) Control : Issue of Equity shares dilutes the control of the existing shareholders

, whereas issue of debt does not as the debenture holders do not participate in

the management decisions as they are not the owners of the fir. Thus if control

is to be retained, equity should be avoided.d) Stock market conditions : If the stock market is bullish, the investors are

adventurous and are ready to invest in risky securities, equity can be issued

even at a premium whereas in the Bearish phase, when the investors becomecautious, debt should be issued as there is a demand for fixed cost security.

e) Regulatory framework : Before determining the capital structure of a company

, the guidelines of SEBI and concerned regulatory authority is to beconsidered. For e.g companies Act, Banking regulation Act etc are to

considered.

f) Tax rate : As interest on debt is treated as an expense, it is tax deductable.

Dividend on equity is the distribution of profit so is not tax deductable. Thus

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if the tax rates are high, issue of debt is an attractive means as it is economical

in nature.

2. Explain briefly five factors determining the amount of fixed capital.Ans. Fixed capital refers to the capital which is used for the purchase of fixed assets,

such as land, building, machinery etc.

Following factors are to be considered before determining its requirement.a) Nature of Business: If a firm is a manufacturing fir, it requires to purchase

fixed assets for the production process. It needs investment in fixed assets, so

require more fixed capital. Similarly if it is a Trading firm where the finishedgoods are only traded i.e purchased and sold, it needs less fixed capital.

b) Scale of operations larger the size and scale of operations larger is the

requirement of the fixed capital and vice versa. c) Choice of technique: The

Manufacturing firm using the modern, latesttechnology machines has to invest more funds in the fixed assets, so they

require more fixed capital. On the other hand, firms using the traditional

method of production where the task is performed manually by the labourers,

it requires less fixed capital.d) Diversification : There are few firms and organizations who deal in a single

product. These investment in fixed assets is low, whereas the firms dealing innumber of products ( Diversification) requires more investment in purchasing

different fixed assets, it requires more fixed capital.

e) Financing alternatives: If the manufacturing firm actually buys the assets andblocks huge funds in the fixed assets, it requires more fixed capital. The

companies who acquire the fixed asset and use them by obtaining leasing

facilities, it requires less fixed capital. Leasing is suitable in high risk lines of

business where huge funds should not be blocked in the fixed assets.3. What is meant by Working capital? How is it calculated? Explain the

determinants of working capital requirements.

Ans. Working capital is the capital required for meeting day to dayrequirements/operations of the business.

Net working capital= current assets current liabilities.

Following factors are to be considered before determining the requirement of workingcapital.

a) Scale of operations: There is a direct link between the scale of business and

working capital. Larger business needs more working capital as compared to

the small organizations.b) Nature of Business: The manufacturing organizations are required to purchase

raw materials, convert them into finished goods, maintain the stock of raw

materials, semi finished goods and finished goods before they are offered forsale. They have to block their capital for labour cost, material cost etc, so they

need more working capital. In the trading firm processing is not performed.

Sales are affected immediately after receiving goods for sale. Thus they do notblock their capital and so needs less working capital.

c) Credit allowed: If the inventory is sold only for cash, it requires less working

capital as money is not blocked in debtors and bills receivable. But due to

increased competition, credit is usually allowed. A liberal credit policy results

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in higher amount of debtors, so needs more working capital.

d) Credit availed: If goods are purchased only for cash, it requires more working

capital. Similarly if credit is received from the creditors, the requirement ofworking capital decreases.

e) Availability of Raw materials: If the raw materials are easily available in the

market and there is no shortage, huge amount need not be blocked ininventories, so it needs less working capital. But if there is shortage of

materials, huge inventory is to be maintained leading to larger amount of

working capital. Similarly if the lead time is higher, higher amount of workingcapital is required.

4. Every Manager has to take three major decisions while performing the

finance function briefly explain them. Ans. The three important decisions taken by the

finance manager are as follows 1) Investment decision: It refers to the selection of the assets in which investment

is to be made by the company. Investment can be made in Long term fixed

assets and short term current assets. Thus Investment decision is divided in

two parts :(a) Long term Investment decisions: Such decisions are also called Capital

Budgeting decisions. It relates to the investment in long term fixed assets.As such decisions affects the growth of the firm, it involves huge fund to be

blocked for a long period, and such decisions are irreversible in nature, they

should be taken carefully after making a comparative study of variousalternatives available.

(b) Short term Investment decision (Working capital decision): It refers to

investment in short term assets such as cash, inventory, debtors etc. Finance

manager has to ensure that enough working capital is available to meet theday to day requirements. It should also ensure that unnecessarily high

reserve of working capital should not be retains as it decreases the

profitability. Thus profitability and Liquidity are to be compared andappropriate amount kept as working capital.

2. Financing decision: There are various sources of obtaining long term finance

such as Equity shares, preference shares, term loans, Debentures etc. For takingfinancing decision and deciding the capital structure various factors are to be

considered and an analysis of cost and benefit is made.

3. Dividend decision: It refers to the decision related to the distribution of profit.

The finance manager has to decide as to how much amount of profit is to bedistributed as Dividend and how much to be retained in the business. If too

much retained earnings are maintained, it dissatisfies the shareholders as they

receive less dividend. Similarly if a liberal dividend policy is followed, thoughthe shareholders are satisfies, but the firm does not have enough reserve for

future growth, expression, meeting contingency etc.

5. What is meant by Financial management Explain its importance..Ans. Financial management refers to that part of the management which is concerned

with the efficient planning and controlling the financial affairs of the enterprise.

Financial management plays the following role.-

a) Determination of fixed assets : Fixed assets have an important contribution in

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increasing the earning capacity of the business. Long term investment decisions also

called capital budgeting decision raise the size of fixed assets..

b) Determination of current assets : Current assets are needed to meet the day to daytransactions of the business. The total investment in current assets is to be determined

and the split up into its elements is required. For e.g. if it is decided to maintain

current assets of Rs 10 lakh, further decision is to be made as to how much cash isrequired, how much amount to be invested in debtors, stock etc.

c) Determination of long term and short term finance: Under this a Finance manager

has to maintain a proper ratio of short term and long term sources of finance afterestimating its requirement. d) Determination of Capital Structure: A balanced decision

related to capital structure

is to be made . The proportion of debt and equity is to be determined.

e) Determination of various items in the Profit and loss account-The financialdecisions affect the various items to appear in the profit and loss account. For e.g

depreciation on fixed assets, interest on debt etc.STUDY MATERIAL:-

CASH FLOW STATEMENT

Qus:1 Why is the cash flow statement not a suitable judge ofprofitability ?

Ans: Cash Flow statement is prepared on cash basis of accounting butprofit is calculated on accrual basis.So cash flow statement is not a

judge of profitability.

Qus:2 Under which accounting standard , cash flow statement isprepared ?

Ans: Under accounting standard-3(Revised).

Qus:3 Why do we add back non cash items to net profit while

calculating cash flow from operating activities.Ans: Non cash items reduce the net profit without reducing the cash

balance.

Qus:4 How will you classify loans given by HDFC whilepreparing cash flow statement.

Ans: As Operating Activities.

Qus:5 How will you classify deposits by customers in SBI whilepreparing cash flow statement.

Ans: Operating Activities

Qus:6 Where will you show purchase of furniture in cash flow

statement ?Ans: As Outflow under Investing Activities.

Qus:7 Give examples of non cash transactions.

Ans: Give any two examples-(i) Acquisition of fixed asset by issue of debentures or

shares.

(ii) Conversion of debentures into shares.Qus:8 A company receives a dividend of Rs. 5 Lakhs on its

investment in other companys share will it be Cash inflow from

operating or investing activities in case of a.

(i) Finance Company.

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(ii) Non-Finance Company. Ans: It will be operating activities in case of a finance

company and

investing activities in case of non-Financing Company.Qus:9 Give four example of movement between cash and cash

equivalents.

Ans: Cash deposited into bank, Cash withdrawn from bank foroffice use, purchase of short term marketable securities, , sale of

short term marketable securities

Qus:10 How are various activities classified as per AS-3(Revised) ?

Ans: (i) Operating Activities.

(ii)Investing Activities.

(iii)Financing Activities.Qus:11 Give one example each of an extra ordinary item under

operating, investing and financing activity.

Ans: Examples of extraordinary items under:-

(a) Operating activity claim received from insurance companyagainst loss of stock.

(b) Investing activity amount of compensation received againstacquisition of land belonging to the enterprise.

(c) Financing activity payment for buy-back of equity shares of

the company.Qus:11 Cash flow from operating Activities + Cash flow from

Investing Activities + Cash flow from Financing

Activities =

Ans: = Net Increase /Decrease in cash and Cash Equivalents.Qus:12 What are the two methods which can be employed to

calculate net cash flow from operating activities ?

Ans: Direct Method and Indirect Method.Qus:13 Modern Toys Ltd. Purchased a machinery of

Rs.20,00,000 for manufacturing toys. State giving reason

Whether the cash flow due to the purchase of machinerywill be cash flow from operating activities,

Investing activities or Financing activities ?

Ans: Investing Activities Because .

Qus:14 M/s.Lakshmi Electrical Appliances furnish thefollowing information - Calculate net cash flow from financing activities:-

Particulars

31.12.2007 31.12.2008Equity share capital 2,00,000 4,50,000

10% debentures 1,00,000 -

6% preference shares - 3,00,000Additional information

(a) Interest paid on debentures Rs.5,000/-.

(b) Dividend paid on equity shares Rs.40,000/-.

(c) Bonus shares were issued to existing shareholders in the

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ratio of 4:1 during the year.

Ans.: CALCULATION OF NET CASH FLOW FROM

FINANCING ACTIVITIESParticulars

Rs.

Cash proceeds from issue of 3,00,000Pref. Shares + equity shares 2,50,000

Redemption of 10% debentures (1,00,000)

Interest paid (5,000)Dividend paid on equity shares (40,000)

Net cash flow from financing activity

4,05,000

Qus:15 A company had the following balance -Particulars

Rs.

Investment at the beginning of the period 3,40,000

Investment at the end of the period 2,80,000During the year, the company sold 40% of investments at the

beginning at a profit of 84,000. Calculate cash fro, investingactivities

Particulars

Rs.Inflow from sale of investment

Cost of investment Gold 2,20,000 (40% of Rs.340000) = 136000

Add profit on sale = 84000

Out flow on purchase of investment (76,000)Net cash flow from investing activities 1,44,000

Investment A/c.

To balance b/d. 3,40,000 By Cash sale ofinvestment

2,20,000

To profit on sale 84,000To bank a/c.

(purchase)

76,000 By balance c/d. 2,80,000

5,00,000 5,00,000Practice numerical:

Qus:16 From the following profit or loss account find out the

flow of cash from operating activities of Mohan Ltd.Profit and Loss Account

Dr. Cr.

Particulars Amount Particulars AmountTo Rent Paid 14,000

Less: Prepaid 2,000

To Salaries

To Depreciation

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To Loss on sale of Furniture

To Goodwill written Off

To Bad DebtsTo Office Expenses

To Discount allowed

To Proposed DividendTo Provision for Tax

To Net Profit

(Rs)12,000

25,000

15,000

10,0008,000

3,000

18,000

7,00030,000

22,00052,800

2,02,800

By Gross ProfitBy Profit on Sale of Machine

By Tax Refund

By Rent received 4,000

Add: Rent accrued 1,000(Rs)

1,82,000

12,0003,800

5,000

2,02,800Note: There was increase in Closing stock by Rs. 25,000.

Ans: Cash from Operating Activities Rs.1,03,800. Qus:17 Prepare Cash flow Statement

from the following

information of LOYD PVT. LTD. For the year ended March31,2004.

BALANCE SHEETS OF LOYD PVT.

LTD. AS ON MARCH 31,2004Liabilities

2003 2004 Assets 2003 2004

Sharecapital

Profit &

Loss

Account

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General

Reserve

TaxProvision

Creditors

BillPayables

Depreciation

Provision(Rs)

3,00,000

1,20,000

60,00070,000

50,000

30,000

25,0006,55,000

(Rs)4,00,000

2,60,000

95,00080,000

90,000

10,000

40,0009,75,000

Goodwill

Machinery12%

Investments

StockDebtors

Cash at

Bank

Short termInvestment

(Rs)

70,0003,00,000

1,50,000

35,00050,000

30,000

20,000

6,55,000

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(Rs)

30,000

3,20,0003,00,000

1,85,000

70,00040,000

30,000

9,75,000Additional Information :

1.Investment costing Rs.50,000 were sold for Rs. 48,000 during

the year.

2.Tax paid during the year Rs.70,000.3.Interest received on Investment Rs. 12,000.

Ans: (i) Cash Inflow From Operating Activities Rs.80, 000.

(ii)Cash Outflow on Investing Activities Rs.1, 60,000.

(iii) Cash Inflow from Financing Activities Rs. 1, 00,000.

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