Name Roll No Course Assignment Study centre

Raghavendra.P 510828309 MBA-Semester 2 MB0029-Financial Management Set-1 and Set-2 2787 (NIMS)

MBOO29 Financial Management Set 1

Q.1 . Explicit cost and Implicit cost are the two dimensions of cost. What role does cost
play in financial decisions

Answers: Financing Decisions relate to the acquisition of funds at the least cost. Here cost has two dimensions viz Explicit cost and Implicit cost.
Explicit Cost refers to the cost in the form of coupon rate, cost of floating and issuing the

securities etc.,
Implicit cost is not a visible cost but it may seriously affect the companys operation

especially when it is exposed to the business and financial risks. For example, implicit cost is the failure of organization to pay to its lenders or debenture holders loan installments on due date on account of fluctuations in cash flow attributes to the firms business risks. In India if the company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as mean of financing, normally faces this risk especially when its operations are exposed to high degree of business risks. In all financing decisions a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deduction in computing taxable income on which the company is liable to pay income tax to the government of India. For example, if the interest rate on loan taken is 12%, tax rate applicable to the company is 50% and then when the company pays Rs.12 as interest to the lender, taxable income of the company will be reduced by Rs.12. In other words when actual cost is 12% with the tax rate of 50% the effective cost becomes 6% therefore, debt is cheap. But, every installment of debt brings along with it corresponding insolvency risk. Another thing notable in this connection is that the firm cannot avoid its obligation to pay interest and loan installments to its lenders and debentures. On the other hand, a company does not have any obligation to pay dividend to its shareholders. A company enjoys absolute freedom not to declare dividend even its profitability and cash positions are comfortable. However, shareholders are one of the stakeholders of the company. They are in reality the owners of company. Therefore, well managed companies cannot ignore the claims of shareholders for dividend. Dividend yields is an important determinant for stock prices. Dividend yield refers to the dividend paid with reference to the market price of the shares of the company. An investor in companys shares has to objectives for investing: a. Income from capital appreciation (i.e., capital gains on sale of shares at market price) b. Income from dividends It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys shares. The most important goal financial management is the maximization of wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. But, dividend is declared out of the profit earned by the company after paying income tax to the govt. of India.

For Example, let us assume the fallowing facts: Dividend = 12% on paid up value Tax rate applicable to the company = 30% Dividend tax =10% When company pays Rs 12 on paid up capital of Rs 100 as dividend the profit that the company must earn before tax is: since the payment of dividend by an Indian company attracts dividend tax, the company when it pays Rs 12 to shareholders, must pay to the Govt, of India. 10% of Rs 12 = Rs 1.2as dividend tax. Therefore dividend and dividend tax sum up to 12 +1.2 = Rs 13.2. since this paid out of the post tax profit, in the question, the company must earn: Post tax dividend paid/(1-tax rate) = Pre-tax profit required to declare and pay dividend. 13.2/(1-0.3) = 13.2/0.7 = Rs 19 approx. Therefore, to declare a dividend of 12% company has to earn pre-tax profit of 19%. On the other hand, to pay an interest of 12% company has to earn only 8.4%. this leads to conclusion that every Rs 100 procured through debt, it costs 8.4% where as the same amount procured in the form of equity(share capital) costs 19%. This confirms the established theory that equity costly but debt is cheap but risky source of the funds to the corporate. The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions which would attain an optimal structure of the capital. An optimal structure is one that arrives at the least cost structure, keeping in mind the financial risk. Besides, financing decision involved the consideration of managerial control, flexibility and legal aspects. As such it involves quite a lot of regulatory and managerial elements in financing decisions. ******************************************************************************************* ******

Q.2. Assume you are newly appointed as Finance Executive in a Manufacturing firm. What guidelines you need to follow in financial planning? Answers: Financial planning is a process by which funds required for each course of action is decided. It must consider expected business scenario and develop appropriate course of action. A financial plan has to consider capital structure, capital expenditure and cash flow. In this connection decision of the composition of debt and equity must be taken.
Benefits that accrue to a firm out of the financial planning:

1. Effective utilization of funds. 2. Flexibility in capital structure is given adequate consideration. 3. Formulation of policies and instituting procedures for elimination of all types of wastages in the process of execution of strategic plans. 4. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets. 5. Integration of long range plans with the shortage plans

Guidelines for financial planning:

1. Never ignore the coordinal principle that fixed asset requirements be met from the long term sources 2. Make maximum use of spontaneous sources of finance to achieve highest productivity of resources. 3. Maintain the operating capital intact by providing adequately out of the current periods earnings. Due attention to be given to physical capital maintenance or operating capability. 4. Never ignore the need for financial capital maintenance in units of constant purchasing power. 5. Employ current cost principle whenever required. 6. Give due weightage to cost and risk in using debt and equity. 7. Keeping the need for finance for expansion of business, formulate plough back policy of earnings. 8. Exercise through control over overheads 9. Seasonal peak requirements to be met from short term borrowings from banks
Steps in financial planning

1. Establish corporate objectives: Corporate objectives could be grouped into qualitative and quantitative . 2. Next stage is formulation of strategies for attaining the objective set. In this connection, corporate develop operating plans. Operating plans are framed with a time horizon. It could be a five year plan or ten year plan. 3. Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench marks, profit target etc., 4. Forecast the various financial variables such as sales, asset required, flow of funds. Cost to be incurred and then translate the same into financial statements. 5. Develop a detailed plans for funds required for the plan period under various heads of expenditure. 6. From the funds required plan, develop a forecast of funds that can be obtained from the internal as well as external sources during the time horizon for which plans are developed. 7. Develop a control mechanism for allocation of funds and their effective use. 8. At the time of formulating the plans certain assumptions need to be made about the economic environment. But when plans are implemented economic environment may change. To manage such situation, there is need to incorporate an building mechanism which would scale up down the operations accordingly.

Factors affecting Financial plans: Nature of industry we must consider whether it is a capital intensive or labor intensive industry. Size of company the size of company greatly influences the availability of funds from different sources. Status of company in the industry- a well established company enjoys a good market share, for its products normally commands investors confidence. Source of finance available sources of finance could be grouped into debt and equity. The capital structure of company is influenced by the desire of the existing management of the company to retain control over the affairs of the company. Matching sources with the utilization the prudent policy of any good financial plan is to match the term of the source with the term of investment. Flexibility the financial plan of a company should possess flexibility so as to affect changes in the composition of capital structure when ever need arise. Government policy SEBI guidelines, finance ministry circulars, various clauses of standard listing agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs influences the financial plan of the corporate today.

******************************************************************************************* ***** Q.3. Due to over capitalization the company may collapse which would certainly affect its employees, society, consumers and its shareholders. What remedies you would suggest? Give suitable example Answers A company said to be over capitalized, when its total capital (both equity and debt) exceeds the true value of assets. It is wrong to identify overcapitalization with excess of capital because most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of overcapitalization is the earning capacity of the firm. If the earning of the firm are less than then that of the market expectation, it will not be in position to pay dividends to its shareholders as per the expectations. It is a sign of overcapitalization. It is also possible that a company has more funds than a requirements based on the current operation levels and yet have low earnings. Over capitalization may be on account of any of the following: 1. Acquiring assets at inflated rates 2. Acquiring unproductive assets. 3. High initial cost of establishing the firm 4. Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalization once the boom condition subside. 5. Total funds requirement have been over estimated. 6. Unpredictable circumstances (like change in import export policy in market rate of interest, changes in the international economic and political environment) reduce substantially the earning capacity of the firm. For example rupee appreciation against US dollar has affected earning capacity of firms suggested mainly in export business because they invoice their sales in US dollar 7. Inadequate provision for depreciation adversely affects the earning capacity of company, leading to overcapitalization of the firm. 8. Existence of idle funds
Effects of over capitalization

a. b. c. d.

Decline in the earnings of the company. Fall in dividend rates Market value of companys share fails and company loses investors confidence. Company may collapse at any time because of anemic financial conditions it will affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company engaged in the production and marketing of certain essential goods and services to society, the collapse of the company will cause social damage.

Remedies for overcapitalization: Restructuring the firm is to be executed to avoid the situation of company becoming sick. It involves 1. Reduction of debt burden 2. Negotiation with term lending institutions for reduction in interest obligation. 3. Redemption of preference shares through a scheme of capital reduction 4. Reducing the face value and paid up value of equity shares 5. Initiating merger with well managed profit making companies interested in taking over ailing company.

Example: An over capitalized company can be like a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Unless the condition of overcapitalization is corrected, the company may find itself in great difficulties.

Thus if a company earns Rs. 1,50,000 with the general expectation at 10 per cent, capitalisation at Rs. 15,00,000 would b proper. But if the company, somehow, issues shares and debentures to the extent of Rs. 25,00,000, the rat of earning will be only 6 per cent because with surplus but idle funds profits will still remain Rs. 1,50,000. This company is over-capitalized.

When the promoters underestimate the capitalisation rate, the capitalisation may not support the expected rate of earnings and over-capitalisation may result. Suppose, a company's regular profit of rs. 50,000 is capitalized at 5% (i.e., capitalisation is Rs. 10,00,000), the rate which the promoters consider sufficient to induce investors to buy the offered securities. If it is later on found that such companies cannot command capital at less than 10% the correct capitalisation of the profit of 10,000 will work out at 100 50,000 x ------, i.e., Rs. 5,00,000. 10 ******************************************************************************************* *****

Q.4a. Mr. Avinash aged 40 years, needs 50000 after 5 years. If the interest rate is 10% how much should he save now to get Rs.50000 at the end of 5 years Answers: The problem is solved using Present Value of a future cash flow method PV = FVn /(1 +i)n Where PV =present Value FVn = future value after n years = Rs 50000 i=interest rate per annum = 10% n = number of years =5

So. PV =50000/(1+0.10)5 =50000/1.61051 PV =Rs 31046/- therefore, Mr. Avinash needs to save Rs of 31046 ******************************************************************************************* *****

Q. 4b. A Senior citizen intents to deposit Rs.1000 annually in ICICI bank for 3 years. The prevailing interest rate is 10%. What is the maturity value of the deposit? Answers: The problem can solved using Future Value of An Annuity method The future value of a regular annuity for a period of n years at i rate of interest can be summed up as under: FVAn = A {(1+i)n-1}/ i Where FVAn = Accumulation at the end of n years i = Rate of Interest =10% n = Time horiaon or no. of years = 3 years A =Amount deposit/invested at the end of every year for n years = Rs 1000 The expression {(1+i)n-1}/i Annuity(FVIFA) is called the Future Value Interest Factor For

FVAn =1000 * FVIFA (10%, 3y) = 1000 * 3.3100 (from FVIFA table) FVAn =Rs 3310.00 maturity value of deposit ******************************************************************************************* ****** Q5. Explain various types of bonds. Answers:
Bonds are of three types:

a. Irredeemable Bonds (also called perpetual bonds) b. Redeemable Bonds (i.e., bonds with finite maturity period) and c. Zero coupon bonds 1.Irredeemable Bonds or Perpetual Bonds: Bonds which will never mature are known as Irredeemable or perpetual bonds. Indian companies acts restricts the issue of such bonds and therefore these are very rarely used by corporates these days. In case of these bonds the terminal value or maturity value does not exist because they are not redeemable. The face value is known; the interest

received on such bond is constant and received at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the intrinsic value) is calculated as : Vo = I/id If a company offers to pay Rs.70 as interest on a bond of Rs 1000 par value. And the current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs.875.
2.Redeemable Bonds:

There are two types viz., bonds with annual interest payments and bonds with semi annual interest payments Bonds with annual interest payments:
Basic Bond Valuation Model:

The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principal repayment at the time of maturity. The intrinsic value or the present value of bond can be expressed as: Vo or Po =n
t=1

I/(I +kd)n +F/(I +kd)n

Which can also be stated as follows: Vo = I*PVIFA(kd, n) + F *PVIF(kd,n) Where Vo =Intrinsic value of the bond Po =Present value of the bond I =Annual interest payable on the bond F =Principal Amount(par value) repayable at the maturity time n =Maturity period of the bond kd= Required rate of return
Bond Values with Semi Annual Interest Payments

In reality, it is quite common to pay interest on bonds semi-annually. With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with annual interest payments. Hence, the bond Vo or Po = n
t=1

(I/2)(I+kd/2)n + F/(I +kd/2)2n

Where Vo =intrinsic value of the bond Po =Present value of the bond I/2 =Semi-annual interest payable on the bond F =Principal amount(par value) repayable at the maturity time 2n=Maturity period of the bond expressed in half yearly periods kd/2 =Required rate of return semi-annual

3.Valuation of Zero Coupon Bond: In India Zero Coupon bonds are alternatively known as Deep Discount Bonds. For Close to Declare, these bonds become very popular in India because of issuance of such bonds at regular intervals by IDBI and ICICI. Zero Coupon bonds have no coupon rate. i.e., there is no interest to be paid out. Instead, these bonds are issues at a discount at their face value. And the face value is the amount payable to the holders of the instrument on maturity. The difference between the discounted issue price and face value is effective interest earned by the investor. They are called deep discount bonds because these bonds are long term bonds whose maturity some time extend up to 25 to 30 years.

******************************************************************************************* *** Q.6. Sushma Industries wishes to issue bonds with Rs.100 as par value, 5 years to maturity, coupon rate 11% a. If YTM of 11%.What is the value of the bond? b. If the YTM is 10% what would be the value of the bond? c. If the YTM is 13% what is the value of the bond Answers: The problem is solved using Basic Bond Valuation Method: The Value of Bond can be calculated as Vo or Po = I*PVIFA(kd, n) + F *PVIF(kd,n) Where Vo =Intrinsic value of the bond Po =Present value of the bond I =Annual interest payable on the bond = 11%- coupon rate F =Principal Amount(par value) repayable at the maturity time=Rs 100 n =Maturity period of the bond =5 years kd= Required rate of return

a. If kd is 11%
Vo = 11*PVIFA (11%, 5y) +100*PVIF(11%, 5y) = 11*3.6959 +100*0.5935 (From PVIFA and PVIF tables)
Vo = 100.0049 or Rs 100 The value of Bond

b.If kd is 10% Vo = = Vo = 11*PVIFA(10%, 5y) +100*PVIF(10%, 5y) 11*3.7908 +100*0.6209 (From PVIFA and PVIF tables) Rs. 103.79- The value of Bond

c.If kd is 13% Vo Vo = 11*PVIFA(13%, 5y) +100*PVIF(13%, 5y) = 11*3.5172 +100 *0.5428 (From PVIFA and PVIF tables) = Rs 92.97- The value of Bond

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MBOO29 Financial Management Set 2

Q.1 . Is Equity Capital Free of cost? Substantiate your statement Answers:
Cost of Equity Capital

Equity shareholders do not have fixed rate of return on their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular dividends to them. Measuring the rate of return to equity holders is difficult and complex exercise. There are many approaches for estimating return-the dividend forecast approach, capital asset pricing approach, realized yield approach etc., according to dividend forecast approach, the intrinsic value of equity share is the sum of present values of dividends associated with it.
Ke = (D1/Pe) + g

This equation is modified from the equation Pe = {D1/Ke-g}. Dividends cannot be accurately forecast as they may sometimes be nil or have a constant growth or supernormal growth periods.
Is Equity Capital free of cost ?

Some people are of the opinion that equity capital is free of cost for the reason that a company is not legally bound to pay dividends and also the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciations. Dividends enhance the market value of shares and therefore equity capital is not free of cost. Example: Suraj Metals are expected to declare a dividend of Rs.5 per share and the growth rate in dividends is expected to grow @10% p.a. the price of one share is currently at Rs 110 in the market. What is the equity capital to the company ?

Solution:

Ke =(D1/Pe) + g = (5/110) +0.10

Ke = 0.1454 or 14.54%

******************************************************************************************* ***** Q 2.a. What is the rate of return for a company if the is 1.25, risk free rate of return is 8% and the market rate of return is 14%. Use CAPM model Answer: Capital Asset Pricing Model Approach The model establishes a relationship between the required rate of return of a security and its systemic risks expresses as . According to this model Ke =Rf + (Rm Rf) Where Ke = rate of return on share Rf = risk free rate of return 8% =beta of security -1.25 Rm =return on market portfolio -14% Therefore:Ke = 0.08 +1.25 (0.14-0.08) = 0.08 +0.075 Ke = 0.155 or 15.5% -Rate of return ******************************************************************************************* ****** Q.2.b. Sundaram Transports has the following capital structure. Equity capital Rs.10 par value 12% preference share capital Rs.100 each Retained earnings 12% Debentures (Rs.100 each) 14% Term loan from SBI Total 250 lakhs 100 lakhs 150 lakhs 350 lakhs 150 lakhs 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare a dividend per share of Rs.2 per share and there will be a growth of 10% in the dividends for the next 5 years. The preference shares are redeemable at a premium of Rs.5 per share after 8 years. The current market price of preference share is Rs.92. Debenture redemption will take place after 7 years at a discount of 2% and the current market price is Rs.91 per debenture. The corporate tax rate is 40%. Calculate WACC. Answers: Weighted Average Cost of Capital (WACC)It follows four steps

Step1: is to determine the cost of each component

Ke= (D1/Po) + g

= (2/54) +0.1
Ke =0.1370 or 13.70% Kp =[D +{(F-P)/n}] /{F + P}/2

=[12+(105-92)/8] /(105+92)/2
Kp = 0.1383 or 13.83%

Kr=Ke which is 13.70

Kd =[I(1-T) +{(F-P)/n}] /(F+P)/2 Kd = 0.094 or 9.4% Kt = I (1-T)

= [12(1-0.4)+(105-91)/7] /(105+91)/2

= 0.14(1-0.4)

Kt =0.084 or 8.4%

Step 2: To calculate the weights of each Source We =250/1000 =0.25 Wp =100/1000 =0.1 Wr = 150/1000 = 0.15 Wd =350/1000 = 0.35 Wt =150/1000 = 0.15 Step3: Multiply the costs of various sources of finance with corresponding weights WeKe =0.25 *0.1370= 0.034 WpKp =0.1*0.1383 = 0.014 WrKr = 0.15*0.1370 = 0.021 Wd*Kd =0.35*0.094 =0.033 Wt*Kt =0.15*0.084 = 0.013 Step4: WACC =WeKe +WpKp +WrKr +WdKd +WtKt = 0.034 +0.014 +0.021 +0.033 +0.013 WACC = 0.1141 or 11.41% ******************************************************************************************* *****

Q.3.The effective cost of debt is less than the actual interest payment made by the firm. Do you agree with this statement? If yes/no substantiate your views Answers: Any organisation requires funds to run its business. These funds may be acquired from short-term or long term sources. Long term funds are raised from two important sources capital (owners fund) and Debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable as debt holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the optimum capital structure. Optimum capital structure refers to the mix of different sources of ling term funds in the total capital of the economy.

Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilized for further activities. Retained earnings are the only internals source to fund the companys future plans. Weighted average coat of capital is the overall cost of all sources of finance. The debentures carry a fixed rate of interest. Interest qualifies foe tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm. The cost of term loan is computed keeping in mind the tax liability The cost of preference share is similar to debenture interest. Unlike debentures interest, dividends do not qualify for tax deductions. The calculation of cost of equity is slightly different as the returns to equity are not constant. The cost of retained earnings as the same as the cost of equity funds. ******************************************************************************************* ****

Q.4. Why capital budgeting decision very crucial for finance managers Answers: There are many reasons that make the capital budgeting decisions the most crucial for finance managers: 1. These decisions involve large outlay of funds now in anticipation of cash flow in future. For example, investment in plant and machinery. The economic life of such asset has long periods. The most crucial variable is the sales forecast. a. For Example, metal box spent large sum of money on expansion of its production facilities based on its own sales forecast. b. Equally we have empirical evidence of companies which took decision on expansion through the addition of new products and adoption of the latest technology creating wealth for shareholders. The best example is the Reliance Group. c. Any serious error in forecasting sales and hence the amount of capital expenditure can significantly affect the firm. An upward bias may lead to situation of the firm crating idle capacity laying the path for the cancer of sickness. d. Any downward bias in forecasting may lead the firm to a situation of losing it market to its competitors. Both are risky fraught with grave consequences. 2. A long term investment of funds some time may change the risk profile of the firm. A FMCG company with its source competencies in the business decided to enter the risk profile of the business of the company. Investors perception of the risk of the new business to be taken up by the company will change his required rate of return to invest in the company. In this connection it is to be noted that the power pricing is politically sensitive area affecting the profitability of organisation. 3. Most of the capital budgeting decision involve huge outlay. The funds requirements during the phase of execution must be synchronised with flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time

over run and cost over run. These two problems have to be prevented from occurring in the beginning of execution of the project.
4. Capital budgeting decisions involve assessment of market for companys products

and services, deciding on the scale of operations, selection of the relevant technology and finally procurement of costly equipment. If a firm were to realize after committing itself considerable sums of money in the process of implementing the capital budgeting decision taken that the decision to diversify or expand would become a wealth destroyer to the company. Then the firm would have experienced a situation of inability to sell the equipment bought.
5. The most difficult aspect of capital budgeting decisions is the influence of time. A

firm incurs capital expenditure to build up the capacity in anticipation of the expected boom in the demand for its products. The timing of the capital expenditure decision must match expected boom in demand for companys products. If it plans in advance it may effectively manage the timing and quality of asset acquisition. 6. All capital budgeting decisions have three strategic elements. These three elements are cost, quality and timing. Decision must be taken at the right time which would enable the firm to procure the assets at the least cost for producing the products of required quality for customer. Any lapse on the part of time in understanding the effect of these elements on implementation of capital expenditure decisions taken, will strategically affect the firms profitability.
7. Liberalization and globalisation gave birth to economic institution like world trade

organisation. General electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar electric company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored. Therefore the growth and survival of any firm in todays business environment demands a firm to proactive. proactive firms cannot avoid the risk of taking challenging capital budgeting decision for growth. 8. The social, political, economical and technological forces generate high level of uncertainty in future cash flows streams associated with capital budgeting decisions. These factors make these decisions highly complex. 9. Capital expenditure decisions are very expensive. To implement these decisions, firms will have to tap the capital market fir funds. The composition of debt and equity must be optimal keeping in view the expectation of investors and risk profile of the selected project. ******************************************************************************************* ******** Q.5. A road project require an initial investment of Rs.10,00,000. It is expected to generate the following cash flow in the form of toll tax recovery. Year 1 2 3 Cash Inflows 4,50,000 4,25,000 3,00,000

3,50,000

What is the IRR of the project? Answer:

IRR-Internal Rate of Return Is the rate of return (i.e., Discount rate)which makes the Net

Present Value (NPV) of any project equal to zero. IRR is the rate of interest which equates the PV (present value) of cash inflows with PV of cash flows. Step 1: Compute the average of Annual cash flows Year 1 2 3 4 Total Cash Inflows 450000 425000 300000 350000 1525000

Average = 1525000/4 =Rs 381250 Step2: Divide the initial investment by the average of annual cash inflow: = 1000000/381250 =2.623

Step 3: From PVIFA table for 4 years, the annuity factor very near 2.623 is 19%. Therefore the first initial rate is 19%. Year 1 2 3 4 Cash flows 450000 425000 300000 350000 PV factor at 19% 0.8403 0.7062 0.5934 0.4987 Total PV of cash flows 378151 300120 178025 174534 1030830

Since the initial investment Rs 1000000 is less than the computed value at 19% of Rs 1030830 the next trial rate is 20% Year Cash flows PV factor at 20% PV of cash flows 1 450000 0.8333 375000 2 425000 0.6944 295139 3 300000 0.5787 173611 4 350000 0.4823 168789 Total 1012539 The next trial rate is 21% Year Cash flows 1 450000 2 425000 PV factor at 21% 0.8264 0.6830 PV of cash flows 371901 290281

3 4

300000 350000

0.5645 0.4665 Total

169342 163278 994801

Since the initial investment of Rs 1000000 lies between 994801 (21%)and 1012539 (20%) the IRR by interpolation: IRR = 20+{(1012539-1000000)/(1012539-994801)}*1 = 20 +(12539/17738)*1 = 20 +0.707 IRR =20.707 =20.71 % ******************************************************************************************* ****** Q.6. What is sensitivity analysis? Mention the steps involved in it Answers: Sensitivity Analysis There are many variables like sales, cost of sales, investments, tax rates etc which affect the Net Present Value (NPV) and Internal Rate of Return (IRR) of a project. Analysing the change in the projects NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis. It is a technique that shows the change in NPV given a change in one of the variables that determine cash flows of a project. It measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.

The reliability of the NPV depends on the reliability of cash flows. If forecasts go wrong on account of changes in assumed economic environments, reliability of NPV and IRR is lost. Therefore, forecast are made under different economic conditions viz pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions. Following steps are involved in sensitivity analysis: 1. Identification of variables that influence the NPV and IRR of the project. 2. Examining and defining the mathematical relationship between the variables. 3. Analysis of the effect of the change in each of the variables on the NPV of the project. ******************************************************************************************* **