Master of Business Administration-MBA Sem.

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 market

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

5. Maximization of wealth demands on the part of corporate to develop new products or

render new services in the most effective and efficient manner. This helps the
consumers all it will bring to the market the products and services that 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
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

Q3. What factors affect financial Plan?

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

Factors Affecting Financial Plan

1. Nature of the industry:- Here, we must consider whether it is a capital intensive of

labour intensive industry. This will have a major impact on the total assets that the
firm owns.

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

3. Status of the company in the industry:- A well established company enjoying a

good market share, for its products normally commands 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 influenced

by the desire of the existing management of the company to remain control over the
affairs of the company. The promoters who do not like to lose their grip over the
affairs of the company normally obtain extra funds for growth by issuing preference
shares and debentures to outsiders.

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

7. Flexibility:- The financial plan of company should possess flexibility so as to effect

changes in the composition of capital structure when ever need arises. If the capital
structure of a company is flexible, it will not face any difficulty in changing the
 sources of funds. This factor has become a significant one today because of the
globalization of capital market.

8. Government Policy:- SEBI guidelines, finance ministry circulars, various clauses of

Standard Listing Agreement and regulatory mechanism imposed by FEMA and
Department of Corporate Affairs (Govt of India) influence the financial plans of
corporate today. Management of public issues of shares demands the companies with
many status in India. They are to be compiled with a time constraint.
Q4. Suppose you buy a one-year government bond that has a maturity value of
Rs.1000. The market interest rate is 8 per cent. (a) How much will you pay for the
bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you earn from
this investment?

Answer:- A.

Bond value maturity = 1000

Market interest rate = 8%

Period of maturity = 1Yrs

Maturity value
Valu of bond = 1 + rate of
return

1000
=
1 + 0.08

= 926

Pay for the bond = 926

Answer:- B.

904.9
Purchase price of bond = 8

Maturity value = 1000

Maturity value - Purchase price

Interest earning = of bond

= 1000 - 904.98

= 95.02

Interest
Rate of interest = Current Price of X 100
bond

95.02
= X 100
904.98

10.50
= %
Interest rate earn
from this 10.50
investment = %
 Case Study

Deepak Hand tools Private Limited

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

Questions:

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

Answer 1. Investment in New Equipment : 250000000

Life of machine : 10 Years

Salvage : 55000000

Year Cash PV factors at PV of cash

s inflows 14 % inflows
45,000 39,47
1 ,000 0.877 3,684
45,000 34,62
2 ,000 0.769 6,039
45,000 30,37
3 ,000 0.675 3,718
68,000 40,26
4 ,000 0.592 1,459
68,000 35,31
5 ,000 0.519 7,069
68,000 30,97
6 ,000 0.456 9,885
68,000 27,17
7 ,000 0.400 5,338
68,000 23,83
8 ,000 0.351 8,016
30,000 9,22
9 ,000 0.308 5,238
30,000 8,09
10 ,000 0.270 2,314
Salva 55,000 14,83
ge ,000 0.270 5,910
PV of cash 294,1
inflows 98,670
 Initial cash out 250,00
flow 0,000
44,1
NPV 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
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

ks = D1 + g;
P0 c) Discounted
Cash Flow
where: ApproachAlso
D1 = next years dividend known as the
g = firms constant growth rate dividend
P0 = price yield plus
growth
approach.
Q3. Explain Miler and 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.

I(1-T)+{(F-P)/N}
Kd =
(F+P)/2

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

= 6.48+0.03
 1.9

6.51
=
1.9

= 3.43% or 343

Cost of debenture 3.43

B.

I(1-T)+{(F-P)/N}
Kd =
(F+P)/2

13.5(1-.52)+(2.2-1.8)/4
=
(2.2+1.8)/2

6.48+0.1
=
2

6.58
=
2

= 3.29% or 329

Cost of debenture 3.29

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

Rs. In
Items
crore
Net worht 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding
interest) 118.23

You are required to calculate:

A. Debt equity ratio

B. Operating leverage

C. Financial leverage

D. Combined leverage.

Interpret your results and components of incremental cash flows?

Answer:

980.2
Sale 0
Less Variable
cost ?
161.4
Contribution 0
118.2
Less Fixed Cost 3
EBIT 43.17
Less interest 34.39
PBT 8.78

Contribution = Sale Variable cost

Variable cost not given so Contribution = EBIT + Interest

= 43.17 + 118.23

= 161.40

A. Debt equity ratio

Debt
Debt equity ratio =
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

EBIT
Financial leverage =
PBT (Profit before tax)

43.17
=
8.78

= 4.92
D. Combined leverage

Cobined leverage = Operating leverage X Financial leverage

Contribution EBIT
= X
EBIT PBT

161.40 43.17
= X
43.17 8.78

= 3.74 X 4.92

= 18.38

Ratio of debt to equity is 1.09 it means that on every Rupees (Net worth) there is Rs.1.09
external liability. Hence the company has over burden of external liability is his capital.
Hence the risk is excess and shareholders require return is also higher.
Q3. Explain Miler and Modigliani Approach to capital structure theory?

Answer: Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a
reasonable limit and Ko being constant at all degrees of leverage. They state that the
relationship between leverage and cost of capital is elucidated as in NOI approach. The
assumptions for their analysis are:

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

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

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

Taxes: There is no corporate or personal income tax.

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

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

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

Expected NOI

Expected overall capitalization rate

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

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

Where V is the market value of the firm,

S is the market value of the 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.

Cost of Capital

K
Ke
o

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 shares
are being purchased and lowering the shares price of those share which are being sold.
This switching operation will continue till the market price of identical firms becomes
identical.
 Proposition II: The expected yield on equity is equal to discount rate (capitalization
rate) applicable plus a premium.

Ke = Ko + [ ( Ko Kd ) D/S ]

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

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

Answer: Estimation of cash flows

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

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

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

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

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

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

1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is

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

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

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

Q5. What are the steps involved in capital rationing?

Answer: Steps involved in Capital Rationing are:

1. Ranking of different investment proposals

2. Selection of the most profitable investment proposals

Ranking of different investment proposal

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

Profitability index as the basis of Capital Rationing

The following details are

Cash Inflows

Proje Initial Cash

ct outlay Year 1 Year 2 Year 3

10 60, 50, 40,

A 0,000 000 000 000

20, 40, 20,

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

Cost of Capital is 15%

Computation of NPV

Project
A

Cash PV factors at PV of Cash

Year Inflows 15% inflows

60,0 52
1 00 0.870 ,200

50,0 37
2 00 0.758 ,800

40,0 26
3 00 0.658 ,320

PV of cash 1
inflows 16,320

Initial cash 100

outlay ,000

NPV 16,320

PV of Cash inflows
Profitability index
= PV of Cash
outflows

1,16,000
=
1,00,000

= 1.1632
Project
B

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

2
1 0,000 0.870 17,400

4
2 0,000 0.758 30,320

2
3 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

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

2
1 0,000 0.870 17,400

3
2 0,000 0.758 22,740

3
3 0,000 0.658 19,740

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

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

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

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

Answer:

NPV of Project A

Yea Cash PV factors at PV of cash PV factors at PV of cash

rs inflows 11 % inflows 16 % inflows
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 PV of cash
inflows 84611 inflows 73695
Initial cash out Initial cash out
flow 75000 flow 75000
NPV 9611 NPV -1305

NPV at lower rate

Lower (different in
IRR = + NPV at lower rate - NPV at X
rate rate)
higher rate
 9611
= 11 + X (16-11)
9611 - (1305)

= 11 + 4.4

IRR = 15.40%

NPV of Project B

Yea Cash PV factors at PV of cash PV factors at PV of cash

rs inflows 11 % inflows 18 % inflows
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 PV of cash
inflows 59228 inflows 48966
Initial cash out Initial cash out
flow 50000 flow 50000
NPV 9228 NPV -1034

NPV at lower rate

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

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

= 11 + 6.29

IRR = 17.29%

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

___________________________________________________________________________