MBA- Semester 2 Assignment - Marks 60 (6X10=60) MB0045 Financial Management - 4 Credits

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Subject Code - MB0045

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Q.1 Considering the following information, what is the price of the share as per Gordons Model?

Details of the Company Net sales Net profit margin Outstanding preference shares No. of equity shares Cost of equity shares Retention ratio Rate of interest (ROI) Rs.120 lakhs 12.5% Rs.50 lakhs@ 12% dividend 25, 000 12% 40% 16%

GORDONS MODEL: Gordons model assumes investors are rational and risk averse. They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. The shareholders therefore prefer current dividends to avoid

risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected. Gordon explains his theory with preference for current income. Investors prefer to pay higher price for stocks which fetch them current dividend income. Gordons model can be symbolically expressed as: P = E (1 - b) / Ke br Where, P is the price of the share, E is Earnings Per Share, b is Retention ratio, (1 b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment. According to question, E = (12000000*12.5%)= 1500000 b = 40% (1 - b) = (1 - 40%) = 0.60 Ke = (250000*12%)= 30000 br = 16% = 0.16 Therefore, P = (1500000 x 0.60) / (30000 0.16) = 29.84 = 30.00 (rounded-off) Q.2 Examine the components of working capital & also explain the concepts of working capital.

Working capital management is concerned with managing the different components of current assets and current liabilities. Components of current assets: o Inventories o Sundry debtors o Bills receivables o Cash and bank balances o Short-term investments o Advances such as advances for purchase of raw materials, components and consumable stores and pre-paid expenses

The components of current liabilities are: o Sundry creditors

o Bills payable o Creditors for out-standing expenses o Provision for tax o Other provisions against the liabilities payable within a period of 12 months

A firm must have adequate working capital, neither excess nor inadequate. Maintaining adequate working capital is crucial for maintaining the competitiveness of a firm.

Concepts of Working Capital The four most important concepts of working capital are (see figure 11.1) Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Gross Working Capital: Refers to the amounts invested in various components of current assets. This concept has the following practical relevance. Management of current assets is the crucial aspect of working capital management Gross working capital helps in the fixation of various areas of financial responsibility Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets

Net working capital: Refers to the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance.

 Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms short term solvency is measured through the net working capital position it commands

Permanent working capital: It is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firms business. This minimum level of current assets has been given the name of core current assets. Permanent working capital is also known as fixed working capital.

Temporary working capital: It is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital. Q.3 Internal capital rationing is used by firms for exercising financial control. How does a firm achieve this? Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control. The various factors relating to the internal constraints imposed by the management are (see figure) Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints.

Private owned company

Under internal constraint, the management of the firms might decide that expansion of the company might be a problem and not worth taking. This kind of condition arises only when the management of a firm fears losing the control in the company. Divisional constraints Another constraint might lead to the allocation of fixed amount for each division in a firm by the upper management. This procedure can also be considered as an overall corporate strategy. These situations arise mainly from the point of view of a department. The cost of capital or the cost structure of the management, the budget constraints imposed by the senior officials or decisions coming from the headoffice and wholly owned subsidiary decisions relate to the internal constraints. Human Resource limitations The management of the firm or the company should see that excessive labour is being used for the project. Lack of proper man-power can become an internal constraint. Dilution Dilution refers to the dilution of the company. This constraint occurs mainly when a reluctance in the issuing of further equity takes place, due to the fear of management losing the control over the company. Debt constraints Debt constraints also constitute to the internal constraints in capital rationing. This constraint occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to a certain level. These are the methods by which various factors are effecting the capital rationing of a particular firm or a management. Let us now look at the different types of capital rationing in the following topic. Q.4 What are the objectives of working capital management? Briefly explain the various elements of operating cycle. A firm must earn sufficient returns from its operations to ensure the realisation of this objective. There exists a positive co-relation between sales and firms return on its investment. Firms make sales on credit. There is always a time gap between sale of goods on credit and the realisation of earnings of sales from the firms customers. Therefore, objective of working capital management is to ensure smooth functioning of the normal business operations of a firm. The firm has to decide on the amount of working capital to be employed.

The firm may have a conservative policy of holding large quantum of current assets to ensure larger market share and to prevent the competitors from snatching any market for their products. However such a policy will affect the firms returns on its investment. The firm will have returns higher than the required amount of investment in current assets. This excess funds locked in current assets will reduce the firms profitability on operating capital. Credit obtained by a firm from its suppliers is known as spontaneous finance. Here a firm will try to reduce its investments in current assets as much as possible but checks that they are not affecting the firms ability to meet working capital needs for sales growth targets. Such a policy will ensure higher return on its investment as the firm will not be locking in any excess funds in current assets. However, any error in forecasting can affect the operations of the firm unfavourably if the error is fraught with the down side risk. There is also another risk of firm losing on maintaining its liquidity position. Objective of working capital management is achieving a tradeoff between liquidity and profitability of operations for the smooth conduct of normal business. The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties 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 to day business operations. Inventory conversion period is the average length of time required to produce and sell the product. Receivables conversion period is the average length of time required to convert the firms receivables into cash. Accounts payables period is also known as payables deferral period. Accounts payables period = (Payables deferral period) Purchases per day = Cash conversion cycle is the length of time between the firms actual cash expenditure and its own cash receipt. Q.5 Define risk. Examine the need for assessing the risks in a project.

Risk in capital budgeting may be defined as the variation of actual cash flows from the expected cash flows. Every business decision involves risk. Risk exists on account of the inability of a firm to make perfect forecasts of cash flows. The inability can be attributed to factors that affect forecasts of investment, cost and revenue. Some of these are as follows: The business is affected by changes in political situations, monetary policies, taxation, interest rates and policies of the central bank of the country on lending by banks Industry specific factors influence the demand for the products of the industry to which the firm belongs Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect companys cost and revenue positions Types and Sources of Risk in Capital Budgeting Stand alone risk: In a project it is considered when the project is in isolation. Stand-alone risk is measured by the variability of expected returns of the project. Portfolio risk : A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on: The co-variance of return from the new project The return from the existing portfolio of the projects Market risk: It is defined as the measure of the unpredictability of a given stock value. However, market risk is also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate. Corporate risk: Focuses on the analysis of the risk that might influence the project in terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm. Sources of risk The five different sources of risk are: Project specific risk Competitive or Competition risk Industry specific risk International risk Market risk Technological risk

Commodity risk Legal risk International risk Market risk

There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned. Q.6 Briefly examine the significance of identification of investment opportunities in capital budgeting process A firm is in a position to identify investment proposal only when it is responsive to the ideas of capital projects emerging from various levels of the organisation. The proposal may be to: Add new products to the companys product line, Expand capacity to meet the emerging market at demand for companys products Add new technology based process of manufacture that will reduce the cost of production. Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the capital budgeting decisions. Proactive organisations encourage a continuous flow of investment proposals from all levels in the organisation. In this connection following points deserve to be considered: Analysing the demand and supply conditions of the market for the companys product could be a fertile source of potential investment proposals. Market surveys on customers perception of companys product could be a potential investment proposal to redefine the companys products in terms of customers expectations. Companies which invest in Research and Development constantly get exposure to the benefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic business environment. Reports emerging from R & D section could be a potential source of investment proposal. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities in existing firms. These new business opportunities could be potential investment ideas. Public awareness of their rights compels many firms to initiate projects from environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertained at the Supreme Court and High courts. Therefore project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and customer welfare, are accepted by well managed firms. Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could

not succeed in forecasting the demand for the product on a realistic basis. Capital budgeting process involves three steps Financial appraisal, Technical appraisal and Economic appraisal.