MB0029 Set 1 and Set 2 completed

8/14/2019 MB0029 Set 1 and Set 2 completed

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Name: Falguni Pandit Registration No.: 520966021MBA II SEM

Financial Management - MB0029

Set 1

QN.1a. Explain why wealth maximization is superior over profit maximization.

Answer:

Maximization of profits is regarded as the proper objective of the firm, but it is not asinclusive a goal as that of maximizing stockholder wealth. For one thing, total profits are notas important as earnings per stock. Therefore, wealth maximization is superior in a way thatit is based on cash flow, not on the accounting profit.

Wealth maximization is superior because it values the duration of expected returns. Sincedistant flows are uncertain, converting them into comparable values at base period facilitatedbetter comparison of financial projects. This can be achieved by for example; by discounting

all future earnings to establish their net present value.

When a firm follows wealth maximization goal, it achieves maximization of market value ofshare. When a firm practices wealth maximization goal, it is possible only when it producesquality goods at low cost. On this account therefore, society gains because of the societalwelfare.

1b. Briefly explain the steps involved in financial plan.

Answer:

The financial planning process turns your own personal objectives into specific plans and

outlines methods and strategies to implement these plans.Establish Financial Goals and Objectives: Your Financial Consultant will assist you inidentifying your objectives. For example, you may be asked the following questions: At whatage and income level would you like to retire? What level of income would you like to provideto your surviving spouse? How would you like your estate to be distributed?

Gather Data: Information reviewed may include, for example, tax returns, brokeragestatements, insurance policies, wills, trusts, estate planning documents, or businessagreements. The more information that is available, the more accurate your financial planwill be.Process and Analyze Information: Appropriate advisors will consider various alternatives tomeet your objectives.

Adopt a Comprehensive Financial Plan: Illustrations and analyses showing you strategies toconsider meeting your goals.

Implement the Plan: You choose to implement the strategies with which you feelcomfortable.Monitor the Plan: Periodically, you and your Financial Consultant will review your financialplan. Circumstances change and you may need to make revisions to your plan.

QN.2a. Explain the two theories of capitalization.

Answer:

Page No: 2 Name: Falguni Pandit |Registration No.: 520966021


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Financial Management - MB00291. Cost Theory: According to the cost theory of capitalization, the value of a company isarrived at by adding up the cost of fixed assets like plants, machinery patents, etc., thecapital regularly required for the continuous operation of the company (working capital), thecost of establishing business and expenses of promotion. The original outlays on all these

items become the basis for calculating the capitalization of company. Such calculation ofcapitalization is useful in so far as it enables the promoters to know the amount of capital tobe raised. But it is not wholly satisfactory. On import objection to it is that it is based o afigure (i.e., cost of establishing and starting business) which will not change with variation inthe earning capacity of the company. The true value of an enterprise is judged from itsearning capacity rather than from the capital invested in it. If, for example, some assetsbecome obsolete and some others remain idle, the earnings and the earning capacity of theconcern will naturally fall. But such a fall will not reduce the value of the investment made inthe company's business.

2. Earnings Theory: The earnings theory of Capitalization recognizes the fact that the truevalue (capitalization) of an enterprise depends upon its earnings and earning capacity.

According to it, therefore, the value or Capitalization of a company is equal to the capitalizedvalue of its estimated earnings. For this purpose a new company has to prepare anestimated profit and loss account. For the first few year of its life, the sales are forecast adthe manager has to depend upon his experience for determining the probable cost. Theearnings so estimated may be compared with the actual earnings of similar companies in theindustry and the necessary adjustments should be made. Then the promoters will study therate at which other companies in the same industry similarly situated are earnings. The rateis then applied to the estimated earnings of the company for finding out the capitalization. Totake an example a company estimates its average profit in the first few years at Rs. 50,000.Other companies of the same type are, let us assume, earnings a return of 10 per cent ontheir capital. The Capitalization of the company will then be 50,000x100=Rs.500,000.

QN. 2b. A customer wants to deposit Rs.10,000 in ICICI bank for 5 years. Theprevailing interest rate is 9.50% what will be the value of the deposit on maturity.

Answer:

FV = PV (1+i) ^n

FV = 10000(1+0.095) ^5

FV= Rs.15, 742.39

QN.3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5 years hence. Howmuch should it deposit annually in sinking fund account so that it can accumulate Rs.30 million at the end of 5 years.

Answer:



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FV = installment * PVIFA (i, y)

30,000,000 = installment * PVIFA (12%, 5)

30,000,000 = installment *3.60530,000,000 3.605 = installment.Installment = 8,321,775.31

QN.3b. Road Transport Corporation issued deep discount bonds in 1996 which has aface value of Rs. 2, 00, 000 maturing after 25 years. The bond was issued at Rs. 5300.What is the effective interest rate earned by the investor from this bond?

Answer:

A = Po (1+i) n

200,000 = 5300(1+i) 25

Solving for r, 200,000/5300 = (1+i) 2537.7358 = (1+i) 25

37.73581/25 = (1+i)

i = 15.63% is the effective interest rate per annum.

QN.4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10% maturing after10 years. If the YTM is 12% what is the market value of the bond? If the YTM isincrease to 14%, what is the market value of the bond? Compare and give theinference.

Answer:

Interest payable = 1000*10% = Rs 100Principal payment = 1000YTM = 12%

Vo = I*PVIFA (kd, n) + F*PVIF (kd, n)

Vo =100*5.650 (12%, 10y) + 1000*0.322 (12%, 10y)

Vo = Rs 887

Using YTM as 14%

Vo =100*5.216 (14%, 10y) + 1000*0.270 (14%, 10y)

Vo = Rs 791.6

Compare and give inference.



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Financial Management - MB0029When the YTM is low the market value of the bond is high and when the YTM is high themarket value of the bond is low.

The inference is that, the bonds value moves inversely proportional to its YTM.

As the YTM increases by from 12% to 14% the value of the bond falls from Rs 887 to Rs791.6.

QN.5. ABC Ltd, produced and sold Rs 100,000 of a product at the rate of Rs 100.forproduction of Rs.1,00,000 units, it has spent a variable cost of Rs.6,00,000 at the rateof Rs.6 per unit and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs. 50,000at the rate of 5 percent and Rs.1,00,000 debts. Calculate operating leverage.

Answer:

Operating Leverage = % Change in EBIT / % Change in Sales

Operating Leverage = (100 6)100000 / [(100 6)100000]-250000

Operating Leverage = 1.03

b) Explain the importance of capital budgeting.

Answer:

Capital budgeting (or investment appraisal) is the planning process used to determinea firms expenditures on assets whose cash flows are expected to extend beyond one year

such as new machinery, equipments, etc. It is also the process of identifying, analyzing andselecting investment projects whose cash flows are expected to extend beyond one yearsuch as research and development project.

Capital expenditures can be very large and have a significant impact on the firmsfinancial performance. Besides, the investments take time to mature and capital assets arelong-term, therefore, if a mistake were done in the capital budgeting process, it will affect thefirm for a long period of time. Basically, the importance of capital budgeting are as follow:

Capital budgeting helps to avoid forecast error.The future success of a business largely depends on the investment decisions thatcorporate managers make today. Investment decisions may result in a major departure from

what the company has been doing in the past. Through making capital investments, firmacquires the long-lived fixed assets that generate the firms future cash flows and determineits level of profitability. Thus, this decision greatly influences a firms ability to achieve itsfinancial objectives. For example, if the firm invests too much it will cause higherdepreciation and expenses. On the other hand, if the firm does not invest enough, the firmwill face a problem of inadequate capacity and thus, lose its market share to its competitors.

Capital budgeting helps a firm to plan its financing. Proper capital budgeting analysis iscritical to a firms successful performance because capital investment decisions can improvecash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distressand even to bankruptcy.

While working with capital budgeting, a firm is involved in valuation of its business. Byvaluation, cash flow is identified and discounted at the present market value. In capital



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Financial Management - MB0029budgeting, valuation techniques are undertaken to analyze the impact of assets instead offinancial assets.

The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is

the varying key involved in forecasting cash flow. The importance of capital budgeting is notonly its mechanics, but also the parameters of forecasting the incurrence of cash in thebusiness.

QN.6. Financial planning: Assume you are working for an investment banker. A clientaged 30 has approached you on investment planning. His present salary isRs.6,00,000 per year and his current savings is Rs.1,50,000.(a) How much does this current saving grow to in 3 years if the interest rate is12%compounded annually.

Answer:

(a) FVAn = A [(1+i) ^n 1/i]FVAn = 150000[(1+0.12) ^3 1/ 0.12]FVAn = Rs 506,160

(b) Assume he plans to save Rs.60000 at the end of every year for 5 years, what wouldbe the amount at the end of 5 years if the interest being 10% compounded annually.

Answer:

FVAn = A [(1+i) ^n 1/i]FVAn = 60000[(1+0.10) ^5 1/ 0.10]

FVAn = Rs 366,306 Set 2

Q1: Compare and contrast NPV with IRR.

ANS 1.

Net present value methodThe cash inflow in different years are discounted (reduced) to their present valueby applying the appropriate discount factor or rate and the gross or total presentvalue of cash flows of different years are ascertained. The total present value ofcash inflows are compared with present value of cash outflows (cost of project)and the net present value or the excess present value of the project and thedifference between total present value of cash inflow and present value of cashoutflow is ascertained and on this basis, the various investments proposals areranked.

Cash inflow = earnings / profits of an investment after taxes but beforedepreciation

The present value of cash outflows = initial cost of investment and the commentof project at various points of time ^



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Financial Management - MB0029Decision rule After ranking various investments proposals on basis on netpresent value, projects with negative net present value (net present value ofcash inflows less than their original costs) are rejected and projects with positiveNPV are considered acceptable. In case of mutually exclusive alternative

projects, projects with higher net present value are selected. Net present valuemethod is suitable for evaluating projects where cash flows are uneven.

Merits

1. The most significant advantage is that it explicitly recognizes the time value ofmoney, e.g., total cash flows pertaining to two machines are equal but the netpresent value are different because of differences of pattern of cash streams.

The need for recognizing the total value of money is thus satisfied.

2. It also fulfills the second attribute of a sound method of appraisal. In that itconsiders the total benefits arising out of proposal over its life time.

3. It is particularly useful for selection of mutually exclusive projects.4. This method of asset selection is instrumental for achieving the objective offinancial management, which is the maximization of the shareholder's wealth. Inbrief the present value method is a theoretically correct technique in theselection of investment proposals.

Demerits

1. It is difficult to calculate as well as to understand and use, in comparison withpayback method or average return method.

2. The second and more serious problem associated with present value methodis that it involves calculations of the required rate of return to discount the cashflows. The discount rate is the most important element used in the calculation ofthe present value because different discount rates will give different presentvalues. The relative desirability of a proposal will change with the change ofdiscount rate. The importance of the discount rate is thus obvious. But thecalculation of required rate of return pursuits serious problem. The cost of capitalis generally the basis of the firm's discount rate. The calculation of cost of capitalis very complicated. In fact there is a difference of opinion even regarding theexact method of calculating it.

3. Another shortcoming is that it is an absolute measure. This method will acceptthe project which has higher present value. But it is likely that this project mayalso involve a larger initial outlay. Thus, in case of projects involving differentoutlays, the present value may not give dependable results.

4. The present value method may also give satisfactory results in case of twoprojects having different effective lives. The project with a shorter economic lifeis preferable, other things being equal. It may be that, a project which has ahigher present value may also have a larger economic life, so that the funds willremain invested for longer period while the alternative proposal may haveshorter life but smaller present value. In such situations the present value

method may not reflect the true worth of alternative proposals. This method issuitable for evaluating projects whose capital outlays or costs differ significantly.



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Internal rate of return methodThe technique is also known as yield oninvestment, marginal efficiency value of capital, marginal productivity of capital,rate of return, time adjusted rate of return and so on. Like net present value,

internal rate of return method also considers the time value of money fordiscounting the cash streams. The basis of the discount factor however, isdifficult in both cases. In the net present value method, the discount rate is therequired rate of return and being a predetermined rate, usually cost of capitaland its determinants are external to the proposal under consideration. Theinternal rate of return on the other hand is based on facts which are internal tothe proposal. In other words, while arriving at the required rate of return forfinding out the present value of cash flows, inflows and outflows are notconsidered. But the IRR depends entirely on the initial outlay and cash proceedsof project which is being evaluated for acceptance or rejection. It is thereforeappropriately referred to as internal rate of return. The IRR is usually, the rate ofreturn that a project earns. It is defined as the discount rate which equates theaggregate present value of net cash inflows (CFAT) with the aggregate presentvalue of cash outflows of a project. In other words it is that rate which gives thenet present value zero. IRR is the rate at which the total of discounted cashinflows equals the total of discounted cash outflows (the initial cost ofinvestment). It is used where the cost of investment and its annual cash inflowsare known but the rate of return or discounted rate is not known and is requiredto be calculated.

Accept / Reject decisionThe use of IRR as a criterion to accept capital investment decision involves acomparison of actual IRR with required rate of return, also known as cut off rate

or hurdle rate. The project should qualify to be accepted if the internal rate ofreturn exceeds the cut off rate. If the internal rate of return and the required rateof return be equal, the firm is indifferent as to accept or reject the project. Incase of mutually exclusive or alternative projects, the project which has thehighest IRR will be selected provided its IRR is more than the cut off rate. In casethere are budget constraints, the projects are ranked in descending order of theirIRR and are selected subject to provisions.

Evaluation of IRR

1. Is a theoretically correct technique to evaluate capital expenditure decision. Itpossesses the advantages which are offered by the NPV criterion such as, it

considers the time value of money and takes into account the total cash inflowsand outflows.

2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than theyunderstand the concept of NPV. For instance, Business X willunderstand the investment proposal in a better way if it is said that the total IRRof Machine B is 21% and cost of capital is 10% instead of saying that NPV ofMachine B is Rs. 15,396.3. It itself provides a rate of return which is indicative of profitability of proposal.

The cost of capital enters the calculation later on.



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Financial Management - MB00294. It is consistent with overall objective of maximizing shareholders wealth.According to IRR, the acceptance / rejection of a project is based on acomparison of IRR with required rate of return. The required rate of return is theminimum rate which investors expect on their investment. In other words, if the

actual IRR of an investment proposal is equal to the rate expected by theinvestors, the share prices will remain unchanged. Since, with IRR, only suchprojects are accepted which have IRR of the required rate, therefore, the shareprices will tend to rise. This will naturally lead of maximization of shareholderswealth. ^

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicated computation problems.

2. It produces multiple rates which can be confusing. This situation arises in thecase of non-conventional projects.

3. In evaluating mutually exclusive proposals, the project with highest IRR wouldbe picked up in exclusion of all others. However in practice it may not turn out tobe the most profitable and consistent with the objective of the firm i.e.,maximization of shareholders wealth.

4. Under IRR, it is assumed that all intermediate cash flows are reinvested at theIRR. It is rather ridiculous to think that the same firm has the ability to reinvestthe cash flows at different rates. The reinvestment rate assumption under theIRR is therefore very unrealistic. Moreover it is not safe to assume always thatintermediate cash flows from the project may be reinvested at all. A portion of

cash inflows may be paid out as dividends, a portion may be tied up with currentassets such as stock, cash, etc. Clearly, the firm will get a wrong picture of theproject if it assumes that it invests the entire intermediate cash proceeds.

Further it is not safe to assume that they will be reinvested at the same rate ofreturn as the company is currently earning on its capital (IRR) or at the currentcost of capital (k).

NPV versus IRR NPV indicates the excess of the total present value of futurereturns over the present value of investments. IRR (or DFC rate) indicates on theother hand the rate at which the cash flows (at present values) are generated inthe business by a particular project.

Both NPV and IRR iron out the difference due to interest factor or say higherreturns in earlier years and higher returns in later years (though the total returnsin absolute terms may be around the same for several projects).Between the two, IRR or DFC rate is the more sophisticated method a popularas well, since:

(a) IRR method -mostly subjective decision regarding discounting rate. ^

(b) Whilst under NPV the main basis of comparison is between different NPV's ofdifferent projects, under IRR or DFC rate approach a number of basis is available.For example



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Financial Management - MB0029DFC rate Vs Discount rate of return (on normal operations) ^ DFC rate Vs Cut

off rate of the company DFC rate Vs Borrowing rate (on cost of capital) DFCrates between different projects

(c) The results under DFC rate approach are simpler for the management tounderstand and appreciate. We should however be very careful in applying thedecision rules properly when NPV and IRR calculation shows divergent results.

The rules are

(i) the projects be the basis of decision when mutually exclusive in character;

(ii) there is capital rationing situation

(d) IRR should be a better guide when there are plenty of project situations (as itis there in a long enterprise) and no major constraints (for example, in respect ofmacro projects).



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Financial Management - MB0029Q2: Zodiac Ltd is considering purchase of investment worth Rs. 40lakhs. The estimated life and the new cash flow fir 3 years are as under.

Machines

A

B C

Estimated life 3 Years 3 Years 3yearsCash inflows(in lakhs)1 Year 27 06 122 Year 18 21 803 Year 55 33 30

Ans 2

A) Payback period

Machine A. Rs.27 lakhs will be recovered in 1st year & the balance 13 lakhs (40 27) will be recovered in 2nd year of 18 lakhs

Payback period = 1year +(13/18*12month) or =1year +13/181 year 8.6 month = 1year + 0.72

1.72year

machine B. Rs.06 lakhs will be recovered in 1st year & the balance 34 lakhs(40 6) will be recovered in 2nd year of 21 lakhspayback period = 1year +(35/21*12month) or =1year + 35/21

= 1year 20 month = 1year +1.66

2.66year

machine c. Rs.12 lakhs will be recovered in 1st year & the balance 28 lakhs(40 12) will be recovered in 2nd year of 80 lakhspayback period = 1year + (28/80*12month) or =1year + 28/80= 1year + 4.2 month = 1year + 0.35

= 1.35year



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machine A. Rs. 35.4546 will be recovered in 2nd year & balance 4.5454(40-35.4546) will be recovered in 3rd year out of 39.149

=2year + (4.5454/39.149)=2year + 0.1161

=2.11year

machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(40-22.0968) will be recovered in 3rd year out of 23.489

=2year + (17.9032/23.489)=2year +0.7621=2.76year

machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936(40- 74.4936) will be recovered in 3rd year out of 95.8436

=2year + (-34.4936/95.8436)=2year + -0.3598

= 1.64year



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Financial Management - MB00295. market risk

1. project specific risk: the source of this risk could be traced to somethingquite specific to the project. Managerial deficiencies or error in estimation of

cash flow or discount rate may lead to a situation of actual cash flow relisedbeing less than that projected.2. competitive risk or competition risk: unanticipated of a firms competitors willmaterially affect the cash flows expected from a project. Because of this theactual cash flow from a project will be less than that of the forecast.3. industry- specific : industry specific risks are those that affect all the firms inthe industry. It could be again grouped in to technological risk, commodity riskand legal risk. All these risks will affect the earnings and cash flows of theproject. The changes in technology affect all the firms not capable of adaptingthemselves to emerging new technology. The best example is the case of firmmanufacturing motors cycles with two stroke engines. When technologicalinnovation replaced the two stroke engines by the four stroke engines thosefirms which could not adapt to new technology had to shut down theiroperations. Commodity risk is the arising from the affectof price changes on goods produced and marketed. Legal risk arise fromchanges in laws and regulations application to the industry to which the firmbelongs. The best example is the imposition of service tax on apartments by thegovernment of India when the total numberof apartments built by a firm engaged in that industry exceeds a prescribed limit.Similarly changes in import export policy of the government of India have ledto the closure of some firms or sickness of some firms.4. international risk : these types of risk are faced by firms whose businessconsists mainly of exports or those who procure their main raw material from

international markets. For example, rupee dollar crisis affected the software andBPOs because it drastically reduce their profitability. Another best example isthat of the textile units in Tirupur in Tamilnadu, exporting their major part of thegarments produces. Rupee gaining and dollar weakening reduced theircompetitiveness in the global markets.



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Q4: The expected cash flow of Tejaswini Ltd, are an follow. (5 Marks)

Year Cash flow

0 (50000)1 9000

2 8000

3 7000

4 12000

5 21000

The certainty equivalent factor balance as per the following equation t=1-05.05t. Calculate the

NPV of the project if the risk free rate of return is 9%.

Ans 4:



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Q5: From the following information prepare cash budgets for VSI Co. Ltd.:

Particulars Jan Feb March April

Opening cash balanceCollection from customerPayments :Raw materials purchaseSalary and WagesOther expensesIncome TaxMachinery

20,0001,30,00025,0001,00,00015,0006,000---

1,60,00045,0001,05,00010,000--------

1,65,00040,0001,00,00015,000----20,000

2,30,000632001,14,20012,000------

The firm wants to maintain a minimum cash balance of Rs.25000 foreach month. Creditors are allowed one-month credit. There is no lag in

payment of salary, other expenses.

Ans 5:

For JAN:Bank over Draft 21,000 for maintain minimum cash balance for

month of

February 21000+4000=25000.

For FEB:No need to take bank over Draft because closing balance 25,000.

For MARCH:Bank over Draft 10,000 for maintain minimum cash balance for

month ofApril 15,000+10,000=25000.

At last closing balance month of April 65,600 so return to bank 31,000form month

of april , 65,600 31,000= 34,400



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Case StudyAssume you are an external financial consultant. You have beenapproached by a client M/s Technotron Ltd to give a presentation on

Credit Policy adopted by Information technology companies. You arespecifically asked to deal with credit standards, credit period, cashdiscounts and collection programme. For the sake of simplicity take anytwo information technology companies and analyze the credit policyfollowed by them.

ANS:-Credit policy Variables1. Credit standards.2. Credit period.3. Credit discount and

4. Collection programme.

1. Credit standards : The term credit standards refer to the criteria forextending credit to customers. The bases for setting credit standards are.a. Credit ratingb. Referencesc. Average payment periodd. Ratio analysis

There is always a benefit to the company with the extension of credit to itscustomers but with the associated risks of delayed payment or non payment,funds blocked in receivables etc. The firm may have light credit standards. It

may sell on cash basis and extend credit only to financially strong customers.Such strict credit standards will bring down bad debt losses andreduce the cost of credit administration. But the firm may not be able to increaseits sales. The profit on lost sales may be more the costs saved by the firm. Thefirm should evaluate the trade off between cost and benefit ofany creditstandards.

2. Credit period: Credit period refer to the length of time allowed to itscustomers by a firm to make payment for the purchase made by customers ofthe firm. It is generally expressed in days like 15 days or 20 days. Generally,firms give cash discount if payment are made within the specified period. If afirm follows a credit period of net 20 it means that it allows to itscustomers 20 days of credit with no inducement for early payments. Increasingthe credit period will bring in additional sales from existing customers and newsales from new customers. Reducing the credit period will lower sales, decreaseinvestments in receivables and reduce the bad debt loss. Increasing the creditperiod increases the incidence of bad debt loss. The effect of increasing thecredit period on profits of the firm are similar to that of relaxing the creditstandards.

3. Cash discount: Firms offer cash discount to induce their customer to makeprompt payments. Cash discount have implications on sales volume, averagecollection period, investment in receivables, incidence of bad debt and profits. A

cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the



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Financial Management - MB0029payment is made by the tenth day; other wise full payment will have to be madeby 20th day.4. Collection programme : The success of a collection programme depends onthe collection policy pursued by the firm. The objective of a collection policy is to

achieve. Timely collection of receivable, there by releasing funds locked inreceivables and minimize the incidenceof bad debts. The collection programmes consists of the following.

1. Monitoring the receivables2. Reminding customers about due date of payment3. On line interaction through electronic media to customers about the paymentsdue around the due date.4. Initiating legal action to recover the amount from overdue customer as thelast resort the dues from defaulted customers. Collection policy formulated shallnot lead to bad relationship with customers.


MB0029 Set 1 and Set 2 completed

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