Mb0029 Financial Management Set 1 2 Revised (Ok)

8/9/2019 Mb0029 Financial Management Set 1 2 Revised (Ok)

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Master of Business Administration-MBA Sem.2

MB0029 - Financial Management - Assignment set-1

Q1. Why wealth maximization is superior to profit maximization in todays 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 todays 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 marketvalue 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 consumers

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


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management in todays 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


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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 offunds 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 investors 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 influencedby 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


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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.


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Q4. Suppose you buy a one-year government bond that has a maturity value ofRs.1000. The market interest rate is 8 per cent. (a) How much will you pay for thebond? (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

=1000

1 + 0.08

= 926

Pay for the bond = 926

Answer:- B.

Purchase price of bond =904.9

8

Maturity value = 1000

Interest earning =

Maturity value - Purchase price

of bond

= 1000 - 904.98

= 95.02

Rate of interest =Interest

X 100Current Price ofbond

= 95.02 X 100904.98

=10.50

%


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Interest rate earnfrom thisinvestment =

10.50%


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Case Study

Deepak Hand tools Private LimitedDHPL is a small sized firm manufacturing hand tools. It manufacturing plan is situated inHaryana. The companys 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.76million. The management of the company wants to improve profitability further. The requiredrate of return of the company is 14 percent. The company is currently considering aninvestment proposal. One is to expand its manufacturing capacity. The estimated cost of thenew equipment is Rs.250 million. It is expected to have an economic life of 10 years. Theaccountant forecasts that net cash inflows would be Rs.45 million per annum for the firstthree years, Rs.68 million per annum from year four to year eight and for the remaining twoyears Rs.30million per annum. The plant can be sold for Rs.55 million at the end of itseconomic life. The company would need to raise debt to the extent of Rs.200 million. Thecompany has the following options of borrowing Rs.200 million: a. The company can borrowfunds from a nationalized bank at the interest rate of 14 percent for 10 years. It will berequired to pay equal annual installment of interest and repayment of principal. b. A financialinstitution has offered to lend money to DHPL at 13.5 per annum but it needs to pay equatedquarterly 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

Cashinflows

PV factors at14 %

PV of cashinflows

145,000

,000 0.87739,47

3,684

245,000

,000 0.76934,62

6,039

345,000

,000 0.67530,37

3,718

468,000

,000 0.59240,26

1,459

568,000

,000 0.51935,31

7,069

668,000

,000 0.45630,97

9,885

768,000

,000 0.40027,17

5,338

868,000

,000 0.35123,83

8,016

9

30,000

,000 0.308

9,22

5,238

1030,000

,000 0.2708,09

2,314Salva

ge55,000

,000 0.27014,83

5,910PV of cash

inflows294,1

98,670


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Initial cash out

flow250,00

0,000

NPV44,1

98,670

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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Master of Business Administration-MBA Sem.2

MB0029 - Financial Management

Assignment set-2

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 companys common

stock.

There are three methods one can use to derive the cost of retained earnings:

a) Capital-asset-pricing-model (CAPM) approach

b) 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 companys beta (bi), which is an estimate of the stocks risk.

Inputting these assumptions into the CAPM equation, you can then calculate the cost of

retained earnings.

b) Bond-Yield-Plus-Premium Approach

This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the


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interest rate of the firms long-term debt and add a risk premium (typically three to five

percentage points):

ks = long-term bond yield + risk premium

c) DiscountedCash 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.

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

companys 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

ks = D1 + g;

P0

where:

D1 = next years dividend

g = firms constant growth rate

P0 =price

Q3. Explain Miler and


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1.9

=6.51

1.9

= 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


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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:

ItemsRs. Incrore

Net worht 152.31

Borrowing 165.47EBIT 43.17

Interest 34.39Fixed cost (excludinginterest) 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:

Sale980.2

0Less Variablecost ?

Contribution161.4

0

Less Fixed Cost118.2

3

EBIT 43.17

Less interest 34.39PBT 8.78

Contribution = Sale Variable cost


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Variable cost not given so Contribution = EBIT + Interest

= 43.17 + 118.23

= 161.40

A. Debt equity ratio

Debt equity ratio =Debt

Equity

=

165.4

7

152.3

1

= 1.09

B. Operating leverage

Operating leverage = Contribution

EBIT (Operating Earning)

=161.40

43.17

= 3.74

C. Financial leverage

Financial leverage =EBIT

PBT (Profit before tax)

=

43.17

8.78

= 4.92


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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.


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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 areasonable 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


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

Where V is the market value of the firm,

S is the market value of the firms 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.

CostofCapital

K

o

Ke

Levera

ge 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 sharesare 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.


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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 onthe 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 thelatest 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


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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

60,0

00 0.870

52

,200

2

50,0

00 0.758

37

,800

3

40,0

00 0.658

26

,320

PV of cash

inflows

1

16,320

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


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Project

B

Year

Cash

Inflows PV factors at 15% PV of Cash inflows

1

2

0,000 0.870

17,400

2

4

0,000 0.758

30,320

3

2

0,000 0.658

13,160

PV of cash inflows

60,880

Initial cash outlay

50,000

NPV

10,880

Profitability index

=

PV of Cash inflows

PV of Cash outflows

=60880

50000

= 1.2176

Project

C

Year

Cash

Inflows PV factors at 15% PV of Cash inflows

1

2

0,000 0.870

17,400

2

3

0,000 0.758

22,740

3

3

0,000 0.658

19,740

PV of cash inflows


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59,880

Initial cash outlay

50,000

NPV

9,880

Profitability index

=

PV of Cash inflows

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 ofNPV 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,


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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 NPVper 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 peryear 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

Cashinflows

PV factors at11 %

PV of cashinflows

PV factors at16 %

PV of cashinflows

1 20000 0.901 18018 0.862 17241

2 20000 0.812 16232 0.743 14863

3 20000 0.731 14624 0.641 12813

4 20000 0.659 13175 0.552 11046

5 20000 0.593 11869 0.476 9522

6 20000 0.535 10693 0.410 8209

PV of cash

inflows 84611PV of cash

inflows 73695

Initial cash out

flow 75000Initial cash out

flow 75000

NPV 9611 NPV -1305

IRR =Lowerrate

+NPV at lower rate

X(different inrate)NPV at lower rate - NPV at

higher rate


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= 11 +9611

X (16-11)9611 - (1305)

= 11 + 4.4

IRR = 15.40%

NPV of Project B

Years

Cashinflows

PV factors at11 %

PV of cashinflows

PV factors at18 %

PV of cashinflows

1 14000 0.901 12613 0.847 11864

2 14000 0.812 11363 0.718 10055

3 14000 0.731 10237 0.609 8521

4 14000 0.659 9222 0.516 7221

5 14000 0.593 8308 0.437 6120

6 14000 0.535 7485 0.370 5186

PV of cash

inflows 59228PV of cash

inflows 48966

Initial cash out

flow 50000Initial cash out

flow 50000

NPV 9228 NPV -1034

IRR =Lowerrate

+NPV at lower rate

X(different inrate)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 Bnegative NPV hence equipment A

should be accepted.

___________________________________________________________________________

Mb0029 Financial Management Set 1 2 Revised (Ok)

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Transcript of Mb0029 Financial Management Set 1 2 Revised (Ok)