File MB0045-Financial Management Solved

Q1. Why wealth maximization is superior to profit maximization in today’s context? Justify you answer?

Answer: Superiority of Wealth Maximization over Profit Maximization:

1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it takes care of the quality of cash flows. Distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associate with cash flows. These risk are adequately considered when present values of cash of any project.

3. In today’s competitive business scenario corporate play a key role. In company from of organization, shareholders own the company but the management of the company rests with the board of directors. Directors are elected by shareholders and hence agents of the shareholders. Company management procures funds for expansion and diversification from Capital Markets. In the liberalized set up-, the society expects corporate to tap the capital market effectively for their capital requirements. Therefore to keep the investors happy through the performance of value of shares in the market, management of the company must meet the wealth maximization criterion.

4. When a firm follows wealth maximization goal, it achieve maximization of market value of share. When a firm pact wealth maximization goal, it is possible only when procedures quality goods at low cost. On this account society gains became of the society welfare.

5. Maximization of wealth demands on the part of corporate to develop new products or render new services in the most effective and efficient manner. This helps the consumers all it will bring to the market the products and services that consumer’s need.

6. Another notable features of the firms committed to the maximization of wealth is that to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhance consumer and hence the benefit to the society.

7. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximization could be considered a superior goal compared to profit maximization.

8. Since listing ensures liquidity to the shares help by the investors shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximization of the net wealth of shareholders.

Therefore we can conclude that maximization of wealth is the appropriate of goal of financial management in today’s context.

Q2. Your grandfather is 75 years old. He has total savings of Rs.80,000. He expects that he live for another 10 years and will like to spend his savings by then. He places his savings into a bank account earning 10 per cent annually. He will draw equal amount each year- the first withdrawal occurring one year from now in such a way that his account balance becomes zero at the end of 10 years. How much will be his annual withdrawal?

Answer:-

Present Value(PV) =80000/-Amount (A) =?Interest Rat e(I) =10%No. of Year(N) =10

PVAn = A {1+i)n-1} /{ i(1+i)n}

80000=A{1+.10)10 }/{.10(1+.10)10}

80000=A{ 1.593742/0.259374}

Annual withdrawal =80000/ 6.144567

Annual withdrawal = 13019.63 Yrly

Q3. What factors affect financial Plan?

Answer:- We live in a society and interact with people and environment. What happens to us is not always accordance to our wishes. Many things turn out in our live are uncontrollable by us. Many decisions we take are the result of external influences. So do our financial matters. There are many factors affect our personal financial planning. Range from economic factors to global influences. Aware of factors affecting your money matters below will certainly benefit your planning.

Factors Affecting Financial Plan

1. Nature of the industry:- Here, we must consider whether it is a capital intensive of labour intensive industry. This will have a major impact on the total assets that the firm owns.

2. Size of the company: - The size of the company greatly influences the availability of funds from different sources. A small company normally finals it difficult to raise funds from long term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates.

3. Status of the company in the industry:- A well established company enjoying a good market share, for its products normally commands investor’s confidence. Such a company can tap the capital market for raising funds in competitive term for implementation new projects to exploit the new opportunity emerging from changing business environment.

4. Sources of finance available:- Sources of finance could be group into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finances us closely linked to the firms capacity to manage the risk exposure.

5. The capital structure of a company:- Capital structure of a company is influenced by the desire of the existing management of the company to remain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization:- The product policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed assets-investment are to be finance by long term sources. It is a cardinal principal of financial planning.

7. Flexibility:- The financial plan of company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market.

8. Government Policy:- SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of Corporate Affairs (Govt of India) influence the financial plans of corporate today. Management of public issues of shares demands the companies with many status in India. They are to be compiled with a time constraint.

Q4. Suppose you buy a one-year government bond that has a maturity value of Rs.1000. The market interest rate is 8 per cent. (a) How much will you pay for the bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you earn from this investment?

Answer:- A.

Bond value maturity = 1000

Market interest rate = 8%

Period of maturity = 1Yrs

Valu of bond = Maturity value1 + rate of return

= 10001 + 0.08

= 926

Pay for the bond = 926

Answer:- B.

Purchase price of bond = 904.98

Maturity value = 1000

Interest earning = Maturity value - Purchase price of bond

= 1000 - 904.98

= 95.02

Rate of interest =Interest

X 100Current Price of bond

= 95.02 X 100904.98

= 10.50%

Interest rate earn from this investment = 10.50%

Case Study

Deepak Hand tools Private LimitedDHPL is a small sized firm manufacturing hand tools. It manufacturing plan is situated in Haryana. The company’s sales in the year ending on 31st March 2007 were Rs.1000 million (Rs.100 crore) on an asset base of Rs.650 million. The net profit of the company was Rs.76 million. The management of the company wants to improve profitability further. The required rate of return of the company is 14 percent. The company is currently considering an investment proposal. One is to expand its manufacturing capacity. The estimated cost of the new equipment is Rs.250 million. It is expected to have an economic life of 10 years. The accountant forecasts that net cash inflows would be Rs.45 million per annum for the first three years, Rs.68 million per annum from year four to year eight and for the remaining two years Rs.30million per annum. The plant can be sold for Rs.55 million at the end of its economic life. The company would need to raise debt to the extent of Rs.200 million. The company has the following options of borrowing Rs.200 million: a. The company can borrow funds from a nationalized bank at the interest rate of 14 percent for 10 years. It will be required to pay equal annual installment of interest and repayment of principal. b. A financial institution has offered to lend money to DHPL at 13.5 per annum but it needs to pay equated quarterly installment of interest and repayment of principal.

Questions:

1. Should the company expand its capacity? Show the computation of NPV 2. What is the annual installment of bank loan? 3. Calculate the quarterly installments of the Financial Institution loan 4. Should the company borrow from the bank or from the financial institution?

Answer 1. Investment in New Equipment : 250000000

Life of machine : 10 Years

Salvage : 55000000

Years Cash inflows PV factors at 14 % PV of cash inflows

1 45,000,000 0.877 39,473,684 2 45,000,000 0.769 34,626,039 3 45,000,000 0.675 30,373,718 4 68,000,000 0.592 40,261,459 5 68,000,000 0.519 35,317,069 6 68,000,000 0.456 30,979,885 7 68,000,000 0.400 27,175,338 8 68,000,000 0.351 23,838,016 9 30,000,000 0.308 9,225,238

10 30,000,000 0.270 8,092,314 Salvag

e 55,000,000 0.270 14,835,910 PV of cash inflows 294,198,670 Initial cash out flow 250,000,000 NPV 44,198,670

Here NPV is positive it is advisable to the company to expand its capacity.

Answer 2.

Loan Amount : 200000000

Interest rate : 14 %

No of Year(N) : 10 Years

Installment X PVIFA (14%,10) =20,00,00,000

Installment = 20,00,00,000 / 5.216

= 3,83,43,558

Answer 3.

Loan Amount : 20,00,00,000

Interest rate : 13.5 %

No of Year(N) Quarterly : 10 Years

Installment X PVIFA (13.5% / 4, 40) =20,00,00,000

Installment = 20,00,00,000 / 5.176

= 3,86,39,876

Answer 4. Should the company borrow from the bank because payback by the company less then financial institution .

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Q1. A. What is the cost of retained earnings?

Answer:- Cost of Retained Earnings

Cost of retained earnings (ks) is the return stockholders require on the company’s common stock.

There are three methods one can use to derive the cost of retained earnings:a) Capital-asset-pricing-model (CAPM) approachb) Bond-yield-plus-premium approach c) Discounted cash flow approach

a) CAPM Approach To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company’s beta (bi), which is an estimate of the stock’s risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of

retained earnings.

b) Bond-Yield-Plus-Premium ApproachThis is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm’s long-term debt and add a risk premium (typically three to five percentage points):

ks = long- term bond yield + risk premium

c) Discounted Cash Flow ApproachAlso known as the “dividend yield plus growth approach”. Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

ks = D1 + g; P0

where:D1 = next year’s dividendg = firm’s constant growth rateP0 = price

Q3. Explain Miler and

Q1. B. A company issues new debentures of Rs. 2 million, at par; the net proceeds being Rs. 1.8 million. It has a 13.5 per cent rate of interest and 7 years maturity. The company’s tax rate is 52 per cent. What is the cost of debenture issue? What will be the cost in 4 years if the market value of debentures at that time is Rs. 2.2 million?

Answer:-

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate,

F is the redemption price per debenture,

P is the net amount realized per debenture,

N is maturity period

A.

Kd =I(1-T)+{(F-P)/N}

(F+P)/2

=13.5(1-.52)+(2-1.8)/7

(2+1.8)/2

=6.48+0.03

1.9

=6.511.9

= 3.43% or 343

Cost of debenture 3.43

B.

Kd =I(1-T)+{(F-P)/N}

(F+P)/2

=13.5(1-.52)+(2.2-1.8)/4

(2.2+1.8)/2

=6.48+0.1

2

=6.58

2

= 3.29% or 329

Cost of debenture 3.29

Q2. Volga is a large manufacturing company in the private sector. In 2007 the company had a gross sale of Rs.980.2 crore. The other financial data for the company are given below:

Items Rs. In crore

Net worht 152.31Borrowing 165.47EBIT 43.17Interest 34.39Fixed cost (excluding interest) 118.23

You are required to calculate:

A. Debt equity ratio

B. Operating leverage

C. Financial leverage

D. Combined leverage. Interpret your results and components of incremental cash flows?

Answer:

Sale 980.20Less Variable cost ?Contribution 161.40Less Fixed Cost 118.23EBIT 43.17Less interest 34.39PBT 8.78

Contribution = Sale – Variable cost

Variable cost not given so Contribution = EBIT + Interest

= 43.17 + 118.23

= 161.40

A. Debt equity ratio

Debt equity ratio =Debt

Equity

=165.47152.31

= 1.09

B. Operating leverage

Operating leverage = ContributionEBIT (Operating Earning)

=161.4043.17

= 3.74

C. Financial leverage

Financial leverage =EBIT

PBT (Profit before tax)

=43.178.78

= 4.92

D. Combined leverage

Cobined leverage = Operating leverage X Financial leverage

=Contribution

XEBIT

EBIT PBT

=161.40

X43.17

43.17 8.78

= 3.74 X 4.92

= 18.38

Ratio of debt to equity is 1.09 it means that on every Rupees (Net worth) there is Rs.1.09 external liability. Hence the company has over burden of external liability is his capital. Hence the risk is excess and shareholders require return is also higher.

Q3. Explain Miler and Modigliani Approach to capital structure theory?

Answer: Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko being constant at all degrees of leverage. They state that the

relationship between leverage and cost of capital is elucidated as in NOI approach. The assumptions for their analysis are:

Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities( both shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities infinitely divisible, availability of all required information at all times.

Investors behave rationally, that is, they choose that combination of risk and return that is most advantageous to them.

Homogeneity of investors risk perception that is all investors have the same perception of business risk and returns.

Taxes: There is no corporate or personal income tax.

Dividend pay-out is 100%, that is, the firms do not retain earnings for future activities.

Basic propositions: The following three propositions can be derived based on the above assumptions:

Proposition I: The market value of the firm is equal to the total market value of equity and total market value of debt and is independent of the degree of leverage. It can be expressed as :

Expected NOI

Expected overall capitalization rate

V + (S + D) = which is equal to O/Ko which is equal to NOI/Ko

V + (S + D) = O/Ko = NOI/Ko

Where V is the market value of the firm,

S is the market value of the firm’s equity,

D is the market value of the debt,

O is the net operating income,

K/o is the capitalization rate of the risk class of the firm.

▲

Cost

of

Capi

tal

Ko

Ke

►Leverage D/S

The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism. Arbitrage is the process of buying security at lower price in one market and selling it in another market at higher price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of firm whose value is higher will sell their share and in return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower the share prices risk.. Such behaviours are expected to increase the share price of whose shares are being purchased and lowering the shares price of those share which are being sold. This switching operation will continue till the market price of identical firms becomes identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization rate) applicable plus a premium.

Ke = Ko + [ ( Ko – Kd ) D/S ]

Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing decision are independent.

Q4. How to estimate cash flows? What are the components of incremental cash flows?

Answer: Estimation of cash flows

Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. It is the result of the team work of many professionals in an organization.

1. Capital outlays are estimated by engineering department after examining all aspects of production process.

2. Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions.

3. Operating cost is estimated by cost accountants and production engineers.

4. Incremental cash flows and out flows statement is prepared by the cost accountant on the basis of details generated in the above steps. The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the implementation of any capital expenditure decision.

Investment (Capital budgeting) decision required the estimation of incremental cash flow stream the life of the investment. Incremental cash flow are estimated on after tax basis.

1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is determined after considering any post tax cash inflows if any. In replacement decision existing old machinery is disposed of and new machinery incorporating the latest technology is installed in its place. On disposed of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on disposal on the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment.

2. Operating Cash inflows: Operating cash inflows are estimated for the entire economic life of investment. Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any saving in cost on installation of new machinery in the place of the old machinery will have to be accounted to on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new project over the existing position.

3. Terminal Cash inflows: At the end of the economic life of the project, the operating assets installed now will be disposed off. It is normally known as salvage value of equipments. These terminal cash inflows are computed on post tax basis.

Q5. What are the steps involved in capital rationing?

Answer: Steps involved in Capital Rationing are:

1. Ranking of different investment proposals

2. Selection of the most profitable investment proposals

Ranking of different investment proposal

The various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV. Profitability index or IRR in the descending order.

Profitability index as the basis of Capital Rationing

The following details are

Cash Inflows

Project Initial Cash outlay Year 1 Year 2 Year 3

A 100,000 60,000 50,000 40,000

B 50,000 20,000 40,000 20,000

C 50,000 20,000 30,000 30,000

Cost of Capital is 15%

Computation of NPV

Project A

Year Cash Inflows PV factors at 15% PV of Cash inflows

1 60,000 0.870 52,200

2 50,000 0.758 37,800

3 40,000 0.658 26,320

PV of cash inflows 116,320

Initial cash outlay 100,000

NPV 16,320

Profitability index =PV of Cash inflows

PV of Cash outflows

=1,16,000

1,00,000

= 1.1632

Project B

YearCash

Inflows PV factors at 15% PV of Cash inflows

1 20,0

00 0.870 17,4

00

2 40,0

00 0.758 30,3

20

3 20,0

00 0.658 13,1

60


80


00

NPV 10,8

80


PV of Cash outflows

=60880

50000

= 1.2176

Project C

YearCash

Inflows PV factors at 15% PV of Cash inflows

1 20,0 0.870 17,4

00 00

2 30,0

00 0.758 22,7

40

3 30,0

00 0.658 19,7

40


80


00

NPV 9,8

80


PV of Cash outflows

=59880

50000

= 1.1976

Ranking of Project

Project NPV Profitability Index

Absolute Rank Absolute Rank

A 16320 1 1.1632 3

B 10880 2 1.2176 1

C 9880 3 1.1976 2

If the firm has sufficient funds and no capital rationing restriction, then all the projects can be accepted because all of them have positive NPVs.

Let us assume that the firm is forced to resort to capital rationing because the total funds available for execution of project is only Rs. 1, 00,000.

In this case on the basis of NPV Criterion, Project A will be cleared. It incurs an initial cash outlay of Rs. 1,00,000. After allocating Rs.1, 00,000 to project A, left over funds is nil. Therefore, on the basis of NPV criterion other projects i,e B & C cannot be taken up for execution by the firm. It will increase the net wealth of the firm by Rs, 16,320.

On the other hand on the basis of profitability index, project B and C can be executed with Rs. 1,00,000 because both of the incur individually an initial outlay of Rs. 50,000. Therefore, with the execution of projects B and C, increase in net wealth of the firm will be Rs. 10880 + 9880 = Rs. 20760.

The objective is to maximize NPV per rupees of capital and project should be ranked on the basis of the profitability index. Funds should be allocated on the basis ranks assigned by profitability.

Q6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20,000 per year for six years. A substitute B would cost Rs.50,000 and generate net cash flow of Rs.14,000 per year for six years. The required rate of return of both equipments is 11% . Calculate the IRR and NPV for the equipments. Which equipment should be accepted and why?

Answer:

NPV of Project A

Years

Cash inflows PV factors at 11 %

PV of cash inflows PV factors at 16 %

PV of cash inflows

1 20000 0.901 18018 0.862 172412 20000 0.812 16232 0.743 148633 20000 0.731 14624 0.641 128134 20000 0.659 13175 0.552 110465 20000 0.593 11869 0.476 95226 20000 0.535 10693 0.410 8209 PV of cash inflows 84611 PV of cash inflows 73695

Initial cash out

flow 75000Initial cash out

flow 75000 NPV 9611 NPV -1305

IRR = Lower rate + NPV at lower rate X (different in rate)NPV at lower rate - NPV at higher rate

= 11 + 9611 X (16-11)9611 - (1305)

= 11 + 4.4

IRR = 15.40%

NPV of Project B

Years

Cash inflows PV factors at 11 %

PV of cash inflows PV factors at 18 %

PV of cash inflows

1 14000 0.901 12613 0.847 118642 14000 0.812 11363 0.718 100553 14000 0.731 10237 0.609 85214 14000 0.659 9222 0.516 72215 14000 0.593 8308 0.437 61206 14000 0.535 7485 0.370 5186 PV of cash inflows 59228 PV of cash inflows 48966

Initial cash out

flow 50000Initial cash out

flow 50000 NPV 9228 NPV -1034

IRR = Lower rate + NPV at lower rate X (different in rate)NPV at lower rate - NPV at higher rate

= 11 + 9228 X (18-11)9228 - (1034)

= 11 + 6.29

IRR = 17.29%

Equipment A has positive NPV where as equipment B negative NPV hence equipment A should be accepted.

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File MB0045-Financial Management Solved

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