Neelam Aswal MBA Sem-2 fin.mngmnt.

Master of Business Administration - MBA Semester 2

MB0045 Financial Management - 4 Credits (Book ID: B1134) Assignment Set- 1

Q.1What are the 4 finance decisions taken by a finance manager. Ans.

The 4 finance decisions taken by a finance manager are1-Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are: (a) The evaluation of the prospective profitability of new investments, and (b) The measurement of a cut-off rate against that the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. 2-Financing Decision Financing decision is the second important function to be performed by the financial manager. Broadly, her or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firms capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk.

Neelam Aswal MBA Sem-2 fin.mngmnt. 3-Dividend Decision Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability, bonus shares and cash dividends in practice. 4-Liquidity Decision Current assets management that affects a firms liquidity is yet another important finances function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firms profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets.

Neelam Aswal MBA Sem-2 fin.mngmnt. Q.2What are the factors that affect the financial plan of a company? Ans.

Factors Affecting Financial Plan Nature of industry: The nature of the industry in which the company is performing is a major factor which affects financial plans. A labor- intensive industry requires less capital than a capital-intensive industry. Status of the company in the industry: The status of the company is a factor which has to be considered while drawing a financial plan. If the company is a well-recognized and a reputed one, it will have no problems in raising finance at short notices. But on the other hand, if the company is a new entrant into the field, it will need time to establish self and therefore raising money is slightly difficult, especially so if the company wants to go public. New firms may find it easier and better to take loans and function rather than going public. Alternative sources of finance: The Finance Manager will assess the alternative sources of funds and get the cheapest source of funds. He should also verify the conditions attached to the funds he procures, that are the contractual restrictions placed by the lenders. Attitude of management towards control: If the management wants to have control over the firm, it may not go in for the equity form of finance for control vests with equity shareholders and it gets diluted with every new issue of equity shares. Such companies prefer to raise additional amounts by debenture issue or bond issue. Extent of working capital requirements: The Finance Manager formulates his plan considering the short and long term financial needs of the firm. Short term funds required to finance working capital needs are to be procured through short term sources only. It is always a prudent policy to use short term avenues for short term requirements and long term needs can be funded by the issue of shares and debentures. Capital structure: Capital of a firm has two components debt and equity. The proportion of these should be so decided that the company gets the advantage of leverage. Running the company with loans and debentures will certainly help equity shareholders to get more income but the company is also functioning under a great risk. Flexibility: This is one important factor that should be kept in mind while planning. The financial plan should be flexible enough to adjust to the needs of the changing conditions. There should be flexibility to raise the amount from any source and similarly the repayments may be done any time the company has excess funds. The firm should also have the flexibility of substituting one form of financing with another if the need arises. Government policy with regard to financial controls, statutory provisions and controls should be considered. The SEBI guidelines should be strictly adhered to wherever applicable and necessary permissions from concerned authorities should be taken if necessary.

Neelam Aswal MBA Sem-2 fin.mngmnt. Q.3 Show the relationship between required rate of return and coupon rate on the value of a bond. Ans. Required Rate of ReturnThe time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It is called the risk-free rate. For example, if an individuals time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 are equivalent in value. But in reality this is not the only factor he considers. There is an amount of risk involved in such investment. He therefore requires another rate for compensating him with this which is called the risk premium. Required rate of return=Risk free rate + Risk Premium Coupon rate- Coupon rate is the specified rate of interest in the bond. The interest payable at regular intervals is the product of the par value and the coupon rate broken down to the relevant time horizon. If the coupon rate is lower, the bond is selling at a discount. If the coupon rate is the same, the bond is selling at a face value If the coupon rate is higher, the bond is selling at a premium

So coupon has an inverse relationship with required rate of return.

Neelam Aswal MBA Sem-2 fin.mngmnt. Q.4 Discuss the implication of financial leverage for a firm. Ans. Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of EBIT. It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity. Example: The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest @ 5% on debentures worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of outstanding shares as 1000.

Interpretation: 1. A 50 % increase in EBIT from Rs. 10000 to Rs. 15000 results in 74% increase in EPS. 2. A 50 % decrease in EBIT from Rs. 10000 to Rs. 5000 results in 74% decrease in EPS. This example shows that the presence of fixed interest source funds leads to a more than proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage DFL is a more precise measurement. It examines the effect of the fixed sources of funds on EPS.

Neelam Aswal MBA Sem-2 fin.mngmnt. Q.5 The cash flows associated with a project are given below: Ans.

Year
0 1 2 3 4 5

Cash Flow
(100.000) 25000 40000 50000 40000 30000

Calculate the -- a) payback period. b) Benefit cost ratio for 10% cost of capital Ans. a) Table Cash Flow and Cumulative Cash Flows EAR 1 2 3 4 5 CASH FLOW 25000 40000 50000 40000 30000 COMULATIVE CASH FLOW 25000 65000 115000 155000 185000

-----------------------------------------------------------------------------------------------------------------------------------------From the cumulative cash flows column. A recover the initial cash out tag of Rs. 1000,00 at the end of the third year. Therefore payback period of project is 2 years. Therefore payback period= 2 + 100000 65000/50000 = 2 + 35000/50000 = 2.7 years

Neelam Aswal MBA Sem-2 fin.mngmnt. Ans. b) Benefit cost ratio for 10% cost of capital. YEAR 1 2 3 4 5 CASH FLOW 25000 40000 50000 40000 30000 10%PV FACTOR 0.909 0.826 0.751 0.683 0.621 PV OF CASH FLOW 22725 33040 37550 27320 18630 COMULATIVE 22725 55765 93315 120635 139265

----------------------------------------------------------------------------------------------------------------------------------------= 3 + 100000 93315/27320 = 3 + 6685/27320 = 3 + .244 =3.244

Neelam Aswal MBA Sem-2 fin.mngmnt. q6. A compAnys eArnings And dividends Are growing At the rAte of 18% pA. the growth Ans. rate is expected to continue for 4 years. After 4 years, from year 5 onwards, the growth rate will be 6% forever. If the dividend per share last year was Rs. 2 and the investors required rate of return is 10% pa, what is the intrinsic price per share or the worth of one share.

Ans. n = 4 Years, growth = 6 % , Ke = 10% required rate of return, D0=18. The Present value of this flow of dividends will be Pn = (D n+1) / (Ke-g) P 4 = D5 / K e g = D5(1 + gn) / Ke g = 5(1.25)4 + (1 + 0.05) / (0.15 0.08) = 16.48 / 0.07 = 235.42 The intrinsic price is 235.42

Neelam Aswal MBA Sem-2 fin.mngmnt.

Master of Business Administration - MBA Semester 2

MB0045 Financial Management - 4 Credits
(Book ID: B1134)

Assignment Set- 2 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1

Discuss the objective of profit maximization vs. wealth

maximization.
Answer. Superiority of Wealth Maximization over Profit Maximizations 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 cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. 3. In todays competitive business scenario corporates play a key role. In company form 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 markets 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

Neelam Aswal MBA Sem-2 fin.mngmnt. must meet the wealth maximization criterion.

4. When a firm follows wealth maximization goal, it achieves maximization of market value of share. When a firm practices wealth maximization goal, it is possible only when it produces quality goods at low cost. On this account society gains because of the societal 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 as 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 enhances consumer welfare 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 held 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 market value of shares will lead to maximization of The net wealth of shareholders. Therefore, we can conclude that maximization of wealth is the appropriate of goal of financial management in todays context.

Neelam Aswal MBA Sem-2 fin.mngmnt.

Q.2

Explain the Net operating approach to capital structure.

Answer .This theory is propounded by Durand and is totally opposite of the Net Income Approach. He says any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalization rate is the same for all degrees of leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke As per the NOI approach the overall capitalization rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalization rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity Shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is Ke = Ko +[ (Ko Kd)(B/S)]

Neelam Aswal MBA Sem-2 fin.mngmnt.

Q.3

What do you understand by operating cycle?

Answer . Operating cycle of a firm has the following elements. 1. Acquisition of resources from suppliers. 2. Making payments to suppliers. 3. Conversion of raw materials into finished products. 4. Sale of finished products to customers. 5. Collection of cash from customers for the goods sold. The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle. These five phases occur on a continuous basis. There is no synchronization between the activities in operating cycle. Cash out flows occur before the occurrences of cash inflows in operating cycle cash out flows are certain. On the other hand cash in flows are uncertain because of uncertainty associated. With effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day today business operations. Therefore, the firm has to assess the operating cycle time Of its operation for providing adequately for its working capital requirements. Operating cycle = IC period + RC period IC period = Inventory conversion period

Neelam Aswal MBA Sem-2 fin.mngmnt. RC period = Receivables conversion period

Q.4

What is the implication of operating leverage for a firm.

Answer . Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorized into three main sections: 1. Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and volume of sales and generally cannot be reduced. 2. Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activity will have a direct effect on such types of costs incurred. 3. Semi variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.

Neelam Aswal MBA Sem-2 fin.mngmnt.

Q.5

A company is considering a capital project with the following

information:
The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant machinery and Rs.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million ad the net working capital will be liquidated at par. The project will increase revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project. Answer. Cost of Project 200 million 150 million 50 million Pv factor (10%) .909 .826 .751 Pv of Cash inflow 181.8 123.9 37.55

Neelam Aswal MBA Sem-2 fin.mngmnt.

Q.6

Given the following information, what will be the price per share

using the Walter model?

Earnings per share Rs. 40 Rate of return on investments 18% Rate of return required by shareholders 12% Payout ratio being 40%, 50%, or 60%. Ans. Walter Mode Formula P = D / Ke + [r(E-D) / ke] / ke

P is the market price per share, D is the dividend per Share, Ke is the cost of capital g is the growth rate of earnings, E is earning of share = 40, r is IRR = 18 %, Dpratio = 40 %, 50%, 60% P= D/Ke + [r (E-D)/Ke]/Ke 40%= 0.4/Ke + [0.18(40 - 0.4)/0.12] / 0.12 = 0.4 + [0.18(40-0.4)/0.12] /0.12

Neelam Aswal MBA Sem-2 fin.mngmnt. = Rs. 498.33 50% = 0.5/0.12 + [0.18(40-0.5)/0.12]/0.12 = 0.5 + [0.18(40-0.5) / 0.12]/0.12 = Rs. 497.91 60% = 0.6/0.12 + [0.18(40-0.6)/0.12]/0.12 = 0.6 + [0.18(40-0.6)/0.12] / 0.12 = Rs. 497.91