Birla Institute of Technology & Science, Pilani

Hyderabad Campus, I Semester 2018-19

Course Title: Financial Management Test: Mid Semester Exam Date:
09/10/2018
Course No.: ECON F315/FIN F315 Max. Marks: 30 Duration:
90 Min.
PART-A (Closed Book) (75 Mins)

Q: 1/ You have been asked to analyze GenCorp, a corporation with food and tobacco
subsidiaries. The tobacco subsidiary is estimated to be worth $ 15 billion and the
food subsidiary is estimated to have a value of $ 10 billion. The firm has a debt to equity
ratio of 1.00. You are provided with the following information on comparable firms:

Business Average Beta Average D/E Ratio

Food 0.92 25%
Tobacco 1.17 50%

All firms are assumed to have a tax rate of 40%.

A. If the current long-term bond rate is 6%, estimate the current cost of equity of
GenCorp. Assume now that GenCorp divests itself of the food division for its
estimated value of $10 billion.
B. Estimate the beta for GenCorp if the cash is used to pay down debt.
C. Estimate the beta for GenCorp if the cash is retained in the firm and invested
in government Securities.
[2+2+1 = 5]

Solution:

Q: 2/ The chief financial officer of Adobe Systems, a growing software manufacturing firm, has
approached you for some advice regarding the beta of his company. He subscribes to a
service which estimates Adobe System's beta each year, and he has noticed that the beta
estimates have gone down every year since 1991 - 2.35 in 1991 to 1.40 in 1995. He
would like the answers to the following questions.
 A. Is this decline in beta unusual for a growing firm?
B. Why would the beta decline over time?
C. Is the beta likely to keep decreasing over time? [1+1+1 = 3]

Q: 3/ Ranbaxy and Glenmark operate in healthcare industry. However, their cost structures
and financing structures differ substantially. Their financial performance is as follows.

Rs. (Crore) Ranbaxy Glenmark

Sales 750 1,100
Variable Cost 300 500
Fixed Cost 250 200
Operating Profit (EBIT) 200 400
Interest 75 80
Profit Before Tax (PBT) 125 320

Find out the following for the above companies.

A. Business risk (Degree of Operating Leverage – DOL)

B. Financial risk (Degree of Financial Leverage – DFL)
C. Total Risk (Degree of Total Leverage – DTL)
What is your analysis about the business risk and the financial risk of the company?
[ Note: DOL = Contribution / (Contribution – Fixed Cost), DFL = EBIT / (EBIT – I)]

[1+1+2= 4]

Q 5:/

Lotus Corporation is contemplating replacement of its existing milling machine with an

improved version that would increase the production from 12,000 components per
month to 18,000. Due to improved design the new component would also fetch a better
price of Rs 90 as against existing price of Rs 85 per piece. New machine costs Rs 12 lacs
with additional amount on installation and training of Rs 1.50 lacs to be spent. If
purchased, the existing milling machine would be sold for Rs 3.5 lacs that has a book
value of Rs 4 lacs. The remaining life of the existing machine is 5 years and the firm
follows a policy of SLM for depreciation of fixed assets. The life of the new machine too
is 5 years. Installation of new machine would entail some extra recurring cost. The
operator salary would be increased from Rs 50,000 to Rs 70,000 per month. However it
would save the cost on maintenance and power. While the production would increase by
50% the rise in maintenance cost would be 20% from existing Rs 10,000 per month.
 Similarly the power consumption would increase by 25% only from existing Rs 6,000
per month. There would be no change in any other cost. Increase in working capital may
be ignored.

Assuming 40% taxes and cost of capital at 10%. Examine whether Lotus Corporation
should buy the new milling machine or not.
[5]

Q:6/ Radiant Technology has a project costing Rs. 15 crores for making high-end microchips
on hand.
It shall provide the earning level of Rs. 4 crores annually. With a view to decide the
desired capital structure the firm compiled following data with respect to cost of debt
and cost of equity for debt levels of 20% to 70% of the cost of the project, as follows:

Plan I II III IV V VI
Debt Ratio 20% 30% 40% 50% 60% 70%
Amount of Debt (Rs lac) 300 450 600 750 900 1050
Cost of Debt (%) 8% 8% 8% 9.50% 10% 10.50%
Cost of Equity (%) 15.50% 15.50% 16% 18% 21% 25%

Examine which of the capital structure is best for Radiant Technology.

[4]

Q 6:/
You have run a regression of monthly returns on Amgen, a large biotechnology
firm, against monthly returns on the S&P 500 index, and come up with the
following output

Rstock = 3.28% + 1.65 RMarket R2 = 0.20

The current one-year treasury bill rate is 4.8% and the current thirty-year bond
rate is 6.4%, and the market risk premium is 8,5%. The firm has 265 million
shares outstanding, selling for $ 30 per share.
 A. What is the expected return on this stock over the next year?
B. Would your expected return estimate change if the purpose was to get a
discount rate to analyze a thirty-year capital budgeting project?
C. An analyst has estimated, correctly, that the stock did 51.10% better than
expected, annually, during the period of the regression. Can you estimate
the annualized risk free rate that she used for her estimate?
D. The firm has a debt/equity ratio of 3%, and faces a tax rate of 40%. It is
planning to issue $2 billion in new debt and acquire a new business for
that amount, with the same risk level as the firm's existing business. What
will the beta be after the acquisition?
[Marks 4]

PART-B (Open Book)

Q.7/ Analyze the risk and return profile of your selected organization from investor and
organization’s perspective. (Hint: Do a critical analysis of various indicators of market
risk and company risk). [5]