6. 
(a) 
Using suitable structural relationship, explain the impact of financial leverage. 
4+12=16 

(b) 
XYZ company is contemplating to undertake the following investment proposals: (i) expansion of existing capacity, and (ii) setting up a new project not related with the present business. The company's shares are regularly traded in stock exchanges, the recent estimate of share beta is 1.2. The debtequity ratio of the company at present is 2 : 1. However, the new project, if undertaken, can be financed with a debtequity ratio of 1 : 1, since the company has adequate internal accruals. To assess business/financial risk of the proposed new project, the XYZ company has identified a comparable company with debtequity ratio of 1.5 : 1 and estimated share beta of 1.5. The comparable company is subject to an effective tax rate of 20 per cent, whereas effective tax rate of XYZ company is 30 per cent.
You are required to estimate (with necessary calculations) the following: 

 
(i)  Cost of capital to be used as cutoff rate to evaluate the expansion project, assuming that its debtequity ratio will be 2 : 1. 
(ii)  Cost of capital to be used as cutoff rate to evaluage the new project. 
(iii)  Based on your calculations in (i) and (ii) above, would you recommend different cutoff rates or single cutoff rate for the expansion and new projects? Give reasons. 
You may further like to consider the following information while answering the above questions: 
(a)  The company will be able to negotiate loan at 15 per cent: 
(b)  The present yield on longdated government securities is around 7 per cent: 
(c)  Expected spread between return on stock index and government securities (i.e., market premium) 6 per cent: 
(d)  Estimated liquidity premium in the government securities is 1 per cent. 
(e)  Effective corporate tax rate of XYZ company will continue to be 30n per cent even after the projects being undertaken. 


7. 
(a) 
Define exposure differentiating between accounting and economic exposure. 
6+10=16 

(b) 
A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $ 10 unit, the yearly revenue from this investment equals $ 10 million. At present rate of exchange, dollar costs of local production equal to $ 6 per unit. A 10% devaluation is expected to lower unit costs by $ 0.30, while a 15% devaluation will reduce these costs by an additional $ 0.15. Suppose a devaluation of either 10% or 15% is likely, with respective probabilities of 0.4 and 0.2 (the probability of no currency change is 0.4). Depreciation at the current exchange rate equals $ 1 million annually, while the local tax rate is 40%. 

 
(i)  What will annual dollar cash flows (aftertax) be under each exchange rate scenario? 
(ii)  What is the expected value of annual aftertax dollar cash flows assuming no repatriation of profits to the United States? 
(iii)  Considering that the project involves a total investment of $ 25 million on plant and working capital, would you recommend the investment? Answer this question assuming that expected annual dollar cash flows, as worked out in (ii) above, would continue in perpetuity and dollar cash flows grow at an inflation rate of ever 2 percent. Also assumed that the minimum required return on investment is 12 per cent. 
 
8. 
(a) 
An Indian exporter has sold handicrafts items to an American business house. The exporter will be receiving US $ 1,00,000 in 90 days. Premium for a dollar put option with a strike price of Rs. 48 and a 90 days settlements is Re. 1. The exporter anticipates the spot rate after 90 days to be Rs. 46.50. 
5+11 
 
(i)  Should the exporter hedge its account receivable in the option market? 
(ii)  If the exporter is anticipating the spot rate to be Rs. 47.50 or Rs. 48.50 after 90 days, how would it effect the exporter's decision. 



(b) 
'Just Born' is a newly formed firm providing garments for babies and children. It has forecast its total fund requirements for the coming year as follows: 

 
Month  Total funds requirements Rs. (lakh)  Permanent requirements Rs. (lakh)  Seasonal requirements Rs. (lakh) 
January February March April May June July August September October November December 
8,500 8,000 7,500 7,000 6,900 7,150 8,000 8,350 8,500 9,000 8,000 7,500 
6,900 6,900 6,900 6,900 6,900 6,900 6,900 6,900 6,900 6,900 6,900 6,900 
1,600 1,100 600 100 0 250 1,100 1,450 1,600 2,100 1,100 600 
 11,600 
 


The firm's cost of shortterm and longterm financing is expected to be 10% and 15% respectively.
Calculate the cost of financing, using
(i)  hedging approach, 
(ii)  conservative approach, and 
(iii)  tradeoff approach. 


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