Taxmann's Financial & Strategic Management (FSM | FM & SM) | MCQs

Preface to Seventh Edition

The Financial & Strategic Management is one of the most important subjects of the CS Executive Level. The legal aspects of finance are becoming increasingly important and a Company Secretary is expected to successfully and effectively handle, amongst other things, important aspects such as management of public issues, syndication of loans, obtaining project approvals, raising of finance through public deposits and debentures or bonds etc. This requires expert knowledge of diverse and complex procedures involved. Realizing that the services of a Company Secretary could be of immense use in this important area, the “Financial & Strategic Management” subject is introduced by the ICSI in its syllabus for CS Executive Level. Many CS Executive students find this subject complicated and tricky as other subjects mainly focus on Acts, Rules & Regulations.

The book is designed exclusively as per the requirements of CS Examination pattern as prescribed by ICSI. Each chapter covers, Problems & Solutions along with Multiple Choice Questions. The book is a comprehensive work, with lucid and systematic presentation for theory, practical questions & MCQs.

I assure you all that CS Executive students studying for “Financial & Strategic Management” paper from this book will come out with flying colours.

I shall be grateful for any of your suggestion to improve the book further.

I am really thankful to my family members for their blessings and support in my career journey.

I am also thankful to TAXMANN and their staff for their cooperation in presenting the book to students all over India. I thank you, one and all.

N.S. Zad

7

CHAPTER

PROBLEM & SOLUTIONS

Problem No. 1] A company’s capital structure consists of the following:

The company earns 12% on its employed capital. The tax rate is 35%. The company requires a sum of ` 25 lakhs to finance its expansion programme for which following plans are available to it:

(

i)Issue 20,000 equity shares of ` 100 each at a premium of ` 25 per share, or

(ii)Issue 10% preference shares, or

(iii)Issue 8% debentures.

It is estimated that the price earning ratio in case of equity shares, preference shares and debentures financing would be 20, 17 & 16 respectively. You are required to:

(1)Evaluate each proposal and recommend the best plan.

(2)Calculate indifference points between Plan I & Plan II; Plan I & Plan III.

Ans.: Capital structure for new finance:

Statement showing profit available for equity shareholder, EPS & Market Price:

2.6x - 13,55,000 = 3.9x - 28,12,500 - 1.3x = - 14,57,500

x = EBIT = 11,21,154

Problem No. 2] MC Ltd. is planning an expansion programme which will require ` 30 Crores and can be funded through one of the three following options:

(

a) Issue further equity shares of ` 100 each at par.

(

b) Issue loan at 15% interest.

(

c) Issue of preference shares at 12%.

Present paid up capital is ` 60 crores and average annual EBIT is ` 12 Crores. Assume income tax rate at 50%. After the expansion, EBIT is expected to be ` 15 Crores p.a.

Calculate EPS under the three financing options indicating the alternative giving the highest returns to the equity shareholder. Determine the point of indifference between equity shares capital and debt [i.e. options (a) & (b) above].

Calculation of indifferent point between Option (a) & (b):

0.3x = 0.45x - 2.025 - 0.15x = - 2.025

x = EBIT = 13.5 Crores

Problem No. 3] The Modern Chemicals Ltd. requires ` 25,00,000 for a new plant. This plant is expected to yield earnings before interest and taxes of ` 5,00,000. While deciding about the financial plan, the company considers the objectives of maximizing earnings per share. It has three alternatives to finance the project - by raising debt of ` 2,50,000 or ` 10,00,000 or ` 15,00,000 and the balance, in each case, by issuing equity shares. The company’s shares is currently selling at ` 150, but it is expected to decline to ` 125 in case the funds are borrowed in excess of ` 10,00,000. The funds can be borrowed at the rate of 10% up to ` 2,50,000 and 15% up to ` 10,00,000 and at 20% over ` 10,00,000. The tax rate applicable to the company is 50%. Which form of financing should company choose?

Ans.: No. of equity shares to be issued under each Option:

Statement showing profit available for equity shareholder and EPS:

Analysis: Since EPS is maximum at Option II, it should be selected. Problem No. 4] A Company earns a profit of ` 3,00,000 per annum after meeting its interest liability of ` 1,20,000 on 12% Debentures. The tax rate is 50%. The number of equity shares of ` 10 each are 80,000 and the retained earnings amount to ` 12,00,000. The company proposes to take up an expansion scheme for which a sum of ` 4,00,000 is required. It is anticipated that after expansion, the company will be able to achieve the same return on investment as at present. The funds required for expansion can be either through debt at the rate of 12% or by issuing equity shares at par.

Required:

(a) Compute the earning per share (EPS), if:

- The additional funds were raised as debt

- The additional funds were raised as equity shares.

(b) Advise the company as to which source of finance is preferable.

Capital structure for new finance:

EBIT after expansion = 34,00,000 × 14% = 4,76,000

Statement showing profit available for equity shareholder and EPS:

Analysis: EPS is high at Plan I, hence debt financing is preferred.

Problem No. 5] X Ltd. is considering the following two alternative financing plans:

The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%. Calculate the rate of dividend on preference shares.

of indifferent point between Plan I & Plan II:

1,51,200 = 1,68,000 - x

- 16,800 = - x

x = Preference Dividend = 16,800

Rate of Preference Dividend = 16,800 × 100 = 8.4% 2,00,000

Problem No. 6] NS Ltd. EBIT is 4,50,000. Which of the following capital structure will you recommend and why? Capital structureDebt in capital structureCost of debt (Kd)Cost

Ignore taxation.

Ans.: Determination of capital structure:

Analysis: Capital structure having debts of ` 4,50,000 is recommended as overall cost of capital is minimum.

Problem No. 7] Sun Ltd. and Moon Ltd. are identical in all respects including risk factors except for debt/equity mix. Sun Ltd. having issued 12% Debentures of ` 30 lakhs, while Moon Ltd. issued only equity capital. Both companies earn 24% before interest and taxes on their total assets of ` 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for an all-equity company.

Compute the value of Sun Ltd. and Moon Ltd. using:

(

i) Net Income Approach

(ii) Net Operating Income Approach

(iii) Using ‘Net Operating Income Approach’, calculate the overall ‘Cost of Capital’ for both the companies.

Calculation of overall cost of capital (market value basis):

Moon Ltd. has only one type of capital i.e. equity, hence cost of equity itself will be overall cost of capital.

Problem No. 8] Merry Ltd. has earnings before interest and taxes (EBIT) of ` 30,00,000 and 40% tax rate. It required rate of return on equity in the absence of borrowing is 18%. In the absence of personal taxes, what is the value of the company in an MM world (i) with ` 40,00,000 in debt and (ii) ` 70,00,000 in debt?

Ans.: Value of unlevered company: Particulars `

(-) Tax @ 40%(12,00,000)

Market value of equity (PAT/Capitalization rate) × 1001,00,00,000

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.

Value of unlevered firm + (Value of debt × Tax rate) = Total Value of levered firm

Value of the company with ` 40,00,000 in debt:

1,00,00,000 + (40,00,000 × 40%) = 1,16,00,000

Total value - Value of debt = Value of equity

1,16,00,000 - 40,00,000 = 76,00,000

Value of the company with ` 70,00,000 in debt:

1,00,00,000 + (70,00,000 × 40%) = 1,28,00,000

Total value - Value of debt = Value of equity

1,28,00,000 - 70,00,000 = 58,00,000

Problem No. 9] Sky Ltd. and Universe Ltd. are identical in every respect except that Sky Ltd. use only equity in its capital structure while Universe Ltd. has debt of ` 6,00,000 at 15% interest. Corporate tax rate is 35%. EBIT is ` 2,00,000. Equity capitalization rate is 20%. Assuming that all assumption of MM are met determine value of Sky Ltd. and Universe Ltd. also determine weighted average cost of capital of the both the companies.

Ans.: Value of unlevered company: (Sky Ltd.)

Particulars ` EBIT2,00,000

(-) InterestEBT2,00,000

(-) Tax @ 35%(70,000) PAT1,30,000

Capitalization rate 20%

Market value of equity (PAT/Capitalization rate) × 1006,50,000

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.

Value of unlevered firm + (Value of debt × Tax rate) = Total Value of levered firm

Value of the company with ` 6,00,000 in debt:

6,50,000 + (6,00,000 × 35%) = 8,60,000

Total value - Value of debt = Value of equity

8,60,000 - 6,00,000 = 2,60,000

Calculation of WACC of Sky Ltd.:

Since there is no debt cost of equity itself will be WACC.

K e = 1,30,000 = 20% 6,50,000

Calculation of WACC of Universe Ltd.:

Particulars `

EBIT2,00,000

(-) Interest(90,000)

EBT1,10,000

(-) Tax @ 35%(38,500)

PAT71,500

K e = D = 71,500 = 0.275 i.e. 27.5% P0 2,60,000

Cost of debt:

Kd = I (1 - t) = 15 (1 - 0.35) = 9.75%

Calculation of overall cost of capital (market value basis):

Problem No. 10] RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost of equity, Ke = 21%. The company wants to buyback equity shares worth ` 5,00,000 by issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model (with taxes), you are required to calculate:

(i) Market value of RES Ltd.

(ii) Cost of Equity Ke.

(iii) Weighted average cost of capital and comment on it.

Ans.: Computation of EBIT of the unlevered company:

Particulars `

EBIT7,50,000

(-) Interest-

EBT7,50,000

(-) Tax @ 30%(2,25,000) PAT5,25,000

Capitalization rate 21%

Market value of equity (PAT/Capitalization rate) × 100 (given) 25,00,000

Perform reserve calculation to find out EBIT.

Particulars All Equity Equity + Debt

EBIT7,50,0007,50,000

(-) Interest-(75,000)

EBT7,50,0006,75,000

(-) Tax @ 30%(2,25,000)(2,02,500)

PAT5,25,0004,72,500

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.

Value of unlevered firm + (Value of debt × Tax rate) = Total Value

Value of the company with ` 5,00,000 in debt: 25,00,000 + (5,00,000 × 30%) = 26,50,000

Total value - Value of debt = Value of equity

26,50,000 - 5,00,000 = 21,50,000

K e = D = 4,72,500 = 0.2198 i.e. 21.98% P0 21,50,000

Cost of debt: Kd = I (1 - t) = 15 (1 - 0.30) = 10.5%

Calculation of overall cost of capital (market value basis):

Problem No. 11] Following is the data relating to Azad Ltd. and Bharat Ltd. belonging to the same risk class:

Explain how under MM approach, an investor holding 10% shares and debentures in Azad Ltd. will be better of in switching his holding to Bharat Ltd. [CS (Professional) - June 2005] (10 Marks)

An investor owns 10% shares and debentures of Azad Ltd. He sells his shares and debentures for ` 14,30,000.

= (9,00,000 × 15 × 10%) = 13,50,000

= (8,00,000 × 10%) = 80,000.

He wishes to purchase 10% equity shares in Bharat Ltd. which will cost him ` 1,35,000 (1,50,000 × 9 × 10%)

Thus, the income of investor remains the same and at the time he is left with ` 12,95,000 (14,30,000 - 1,35,000) of funds which can be invested elsewhere for generating additional income.

Problem No. 12] Two companies: P Ltd. & Q Ltd. belong to the equivalent risk group. The two companies are identical in every respect except that Q Ltd. is levered, while P Ltd. is unlevered. The outstanding amount of debt of the levered company is ` 6,00,000 in 10% debentures. The other information for the two companies is as follows:

An investor owns 5% equity shares in Q Ltd. show the process and the amount by which he could reduce his outlay through the use of arbitrage process. Is there any limit to the process?

[CS (Professional) - June 2006] (10 Marks)

Ans.: An investor owns 5% shares of Q Ltd. He sells his shares for ` 22,500 (4,50,000 × 5%). He wishes to purchase 5% equity shares in P Ltd. which will cost him ` 50,000 (10,00,000 × 5%)

He borrows an amount of ` 27,500 @ 10% p.a. and invests ` 50,000 i.e. 5% equity shares in P Ltd.

Thus, the income of the investor increases by switching form Q Ltd. to P Ltd.

The above arbitrage process would continue till the price of the two companies comes to common equilibrium.

MCQ MCQs ON THEORY

1. _____ refers to the mix of a firm’s capitalization and includes long-term sources of funds.

(A) Leverage

(B) Capital structure

(C) Debt mix

(D) Owner’s equity

2. The term “capital structure” refers to:

(A) Current assets & current liabilities

(B) Long-term debt, preferred stock, and common stock equity

(C) Total assets minus liabilities

(D) Shareholders’ equity

3. The decisions regarding the forms of financing, their requirements and their relative proportions in total capitalization are known as -

(A) Equity decisions

(B) Equilibrium decisions

(C) Outright decisions

(D) Capital structure decisions

4. Which of the following statement is false?

I. In case the firm wants to grow at a faster pace, it would be required to incorporate debt in its capital structure to a greater extent.

II. If the firm has no long-term debt in its capital structure, it means that either it is risk averse or it has cost of equity capital or cost of retained earnings less than the cost of debt. Select the correct answer from the options given below:

(A) Statement I is true while Statement II is false.

(B) Statement I is false while Statement II is true.

(C) Both Statement I and Statement II are false.

(D) Both Statement I and Statement II are true.

5. While designing a capital structure a finance manager should choose a pattern of capital which -

(A) Minimizes cost of capital

(B) Maximizes the owners return.

(C) Maximizes cost of capital and minimizes the owners return.

(D) Both (A) and (B)

6. Which of the following changes in capital structure would you recommend for growth at faster rate?

(A) Incorporate more retained earnings out of profit and loss account.

(B) Incorporate debt in its capital structure to a greater extent.

(C) Merge with other companies.

(D) Pay more dividend to equity shareholders.

7. The manner in which an organization’s assets are financed is referred to as its -

(A) Capital structure

(B) Financial structure

(C) Asset structure

(D) Owners structure

8. Optimal capital structure consists of -

(A) Appropriate mix of fixed assets and current assets.

(B) Appropriate mix of long-term debts and fixed assets.

(C) Appropriate mix of sales and profit.

(D) Appropriate mix of debt and equity.

9. Which of the following is not included in capital structure?

(A) Long-term debt

(B) Preferred stock

(C) Current assets

(D) Retained earnings

10. Which of the following shows significance of capital structure?

(A) Capital structure reflects the overall strategy of the firm.

(B) One can get a reasonably accurate broad idea about the risk profile of the firm from its capital structure.

(C) The capital structure acts as a tax management tool.

(D) All of the above

11. Financial structure involves creation of -

(1) Long-term assets

(2) Short-term assets

Select the correct answer from the options given below:

(A) (2) only

(B) Neither (1) nor (2)

(C) (1) only

(D) Both (1) and (2)

12. Which of the following statement is incorrect?

1. High debt funds in capital structure increases EPS.

2. High debt funds increases the operating or business risk.

Select the correct answer from the options given below:

(A) Both Statement 1 and Statement 2 are correct.

(B) Statement 1 is correct while Statement 2 is incorrect.

(C) Statement 2 is correct while Statement 1 is incorrect.

(D) Both Statement 1 and Statement 2 are incorrect.

13. Financial structure is ______ concept while capital structure is _____ concept

(A) inappropriate; appropriate

(B) appropriate; inappropriate

(C) narrow; broader

(D) broader; narrow

14. Assertion (A):

The capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded.

Reason (R):

The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum.

Select the correct answer from the options given below:

(A) A is true but R is false

(B) A is false but R is true.

(C) Both A and R are true but R is not correct explanation of A.

(D) Both A and R are true and R is correct explanation of A.

15. Which of the following capital structure consist of zero debt components in the structure mix?

(A) Pyramid Shaped Capital Structure

(B) Inverted Pyramid Shaped Capital Structure

(C) Horizontal Capital Structure

(D) Vertical Capital Structure

16. Which of the following statement is false?

(A) The use of excessive debt threatens the solvency of the company.

(B) A firm having operating loss would find it worthwhile to incorporate debt in the capital structure in a greater measure.

(C) The capital structure should be flexible.

(D) None of the above

17. One can get a reasonably accurate broad idea about the risk profile of the firm from its -

(A) Dividend policy

(B) Capital structure

(C) Debt service ratio

(D) Earning yield

18. A critical assumption of the net operating income (NOI) approach to valuation is that:

(A) Debt and equity levels remain unchanged.

(B) Dividends increase at a constant rate.

(C) Ko remains constant regardless of changes in leverage.

(D) Interest expense and taxes are included in the calculation.

19. If the debt component in the capital structure is predominant -

(A) The fixed interest cost of the firm will be minimum thereby decreasing its risk.

(B) Earnings per share (EPS) will be very low.

(C) Dividend expectations of equity shareholders are also and P/E Ratio may decrease.

(D) The fixed interest cost of the firm increases thereby increasing its risk.

20. Capital structure relates to _____ capital deployment for creation of ______ assets.

(A) long-term; long-term

(B) long-term; short-term

(C) short-term; long-term

(D) short-term; short-term

21. Assertion (A):

The capital structure acts as a tax management tool also.

Reason (R):

Relatively lesser component of equity capital is vulnerable to hostile takeovers. Select the correct answer from the options given below:

(A) A is true but R is false

(B) A is false but R is true.

(C) Both A and R are true but R is not correct explanation of A.

(D) Both A and R are true and R is correct explanation of A.

22. Select which of the following statement is correct.

Horizontal capital structure -

1. is quite stable.

2. is formed by a small amount of equity share capital.

3. there is absence of debt.

4. have increasing component of debt. Select the correct answer from the options given below:

(A) 1, 2 & 4

(B) 2 & 3

(C) 1 only

(D) 1 & 4 only

23. One can design capital structure with proper proportions of equity, preference and debt mix. The choice of the combination of these sources is called -

(A) Structural mix

(B) Policy mix

(C) Capital structure mix

(D) Finance mix

24. In horizontal capital structure -

(A) Expansion of the firm takes place by issuance of debt securities.

(B) Expansion of the firm takes place by issuance of debt securities and preferred stocks.

(C) Expansion of the firm takes in a lateral manner, i.e. through equity or retained earning only.

(D) Expansion of the firm takes place by issuance of short-term and marketable securities.

25. According to Cost Principle an ideal pattern or capital structure is one that -

(A) Minimizes cost of capital structure

(B) Maximizes earnings per share (EPS).

(C) Both (A) and (B)

(D) None of the above

Financial & Strategic Management

(FSM | FM & SM) | MCQs

AUTHOR : N.S. ZAD

PUBLISHER : TAXMANN

DATE OF PUBLICATION : JULY 2023

EDITION : 7TH EDITION

ISBN NO : 9789357781381

NO. OF PAGES : 766

BINDING TYPE : PAPERBACK

Description

This book is prepared exclusively for the Executive Level of Company Secretary Examination requirement. Each chapter covers problems & solutions along with multiple-choice questions (MCQs).

The Present Publication is the 7th Edition for CS-Executive | Old Syllabus | Dec. 2023 Exam. This book is authored by CS N.S. Zad, with the following noteworthy features:

u [Comprehensive, Lucid & Systematic] presentation of theory, practical questions & MCQs

u [Coverage] of this book includes

 [2900+ MCQs] along with Problems & Solutions are covered in each chapter

 [Theory & Practical Based MCQs] with the following for complicated terms and mathematical calculations:

 Hints

 Working Notes

 Explanatory Notes

 [Fully Solved Questions of Past Exams], including:

 Solved Paper – June 2023 | Suggested Answers

 [Chapter-wise Marks Distribution] is included in this book from June 2019 onwards ORDER

Rs. 795 | USD 41