ASSIGNMENT-01

Name:

Registration No:

Learning Centre:

Learning Centre Code:

Course: MBA

Subject: Financial Management

Semester: 2ND Semester

Module No: MB0045

Date of Submission:

Marks Awarded:

Director of Distance Education

Sikkim Manipal University

II Floor, Syndicate House

Manipal-576 104

Signature of Coordinator Signature of Center Signature of Evaluator

Q.1 Show the relationship between required rate of return and coupon rate on the value of a bond.

Answer:

The relation between the required rate of interest (Kd ) and coupon rate on the value of a bond are displayed below.

• When required rate of interest (Kd ) is equal to the coupon rate, the intrinsic value of the bond is equal to its face value.

• When required rate of interest (Kd ) is greater than the coupon rate, the intrinsic value of the bond is less than its face value.

• When required rate of interest (Kd ) is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value.

Number of years of maturity

• When required rate of interest (Kd ) is greater than the coupon rate, the discount on the bond declines as maturity approaches.

• When required rate of interest (Kd ) is less than the coupon rate, the premium on the bond declines as the maturity increases.

Example

To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years.

If Kd is 13%, then,

V0 = I*PVIFA (Kd , n) + F*PVIF (Kd , n)

= 11*PVIFA (13%, 7) + 100*PVIF (13%, 7)

= 11*4.423 + 100*0.425

= 48.65 + 42.50

= Rs.91.15

After 1 year, the maturity period is 6 years, the value of the bond is

V0 = I*PVIFA (Kd , n) + F*PVIF (Kd , n)

= 11*PVIFA (13%, 6) + 100*PVIF (13%, 6)

= 11* 3.998 + 100*0.480

= 43.98 + 48

= Rs. 91.98.

We see that the discount on the bond gradually decreases and value of the bond increases with the passage of time as required rate of interest (Kd) is higher than the coupon rate.

Continuing with the same problem above, let us see the effect on the bond value if the required rate is 8%.

If Kd is 8%,

V0 = I*PVIFA (Kd , n) + F*PVIF (Kd , n)

= 11*PVIFA (8%, 7) + 100*PVIF (8%, 7)

= 11*5.206 + 100*0.583

= 57.27 + 58.3

= Rs. 115.57

One year later, with Kd at 8%,

V0 = I*PVIFA (Kd , n) + F*PVIF (Kd , n)

= 11*PVIFA (8%, 6) + 100*PVIF (8%, 6)

= 11*4.623 + 100* 0.630

= 50.85 + 63

= Rs. 113.85

For a required rate of return of 8%, the bond value decreases with passage of time and premium on bond declines as maturity approaches

Q2. What do you understand by operating cycle?

Answer:

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 synchronization between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in 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. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements.

Operating cycle = IC period + RC period

IC period = Inventory conversion period

RC period = Receivables conversion period

Inventory conversion period is the average length of time required to produce and sell the product.

Inventory Conversion period = (Average Inventory * 365) / Annual Cost of goods sold

Receivables conversion period is the average length of time required to convert the firm’s receivables into cash.

Receivables conversion period = Average Accounts Receivables *365 / Annual Sales

Accounts payables period is also known as payables deferral period.

Accounts payables period = Average Creditors / Purchases per day

(Payables deferral period)

Purchases per day = Total Purchases for year / 365

Cash conversion cycle is the length of time between the firm’s actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets.

Cash Conversion Cycle is

CCC = ICP + RCP – PDP

CCC = Cash Conversion Cycle

ICP = Inventory Conversion Period RCP = Receivables Conversion Period PDP = Payables deferral period

Q3. What is the implication of operating leverage for a firm?

Answer:

Operating leverage is associated with the asset purchase activities, while financial leverage is associated with the financial activities. However, combined leverage is the combination of operating leverage and the financial leverage.

Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows. A company’s operating costs can be categorized into three main sections as shown in figure fixed costs, variable costs and semi-variable costs.

Classification of operating costs

• Fixed costs

Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.

For example, consider that a firm named XYZ enterprise is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as ―fixed costs.

• Variable costs

Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred.

For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as ―Variable costs, as these costs are not fixed and keep changing depending upon the conditions.

• Semi-variable costs

Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as ―Semi-variable costs.

The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage

occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.

As operating leverage can be favorable or unfavorable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards.

The applications of operating leverage are as follows:

Business Rick Measurement Production Planning Measurement of Business Risk

Risk refers to the uncertain conditions in which a company performs. A business risk is measured using the degree of operating leverage (DOL) and the formula of DOL is:

DOL = {Q(S–V)} / {Q(S–V)–F}

Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa. Production planning

A change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

Q4. Explain the factors affecting Financial Plan.

Answer:

Factors affecting Financial Plan

• Nature of the indu s try

The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns.

• Si z e of the c o m pany

The size of the company greatly influences the availability of funds from different sources. A small company normally finds 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

• Status of the c ompany in the indu s try

A well established company enjoys a good market share, for its products normally commands investors’ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment

• Sour c es of finan c e a v ailable

Sources of finance could be grouped 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 finance is closely linked to the firm’s capability to manage the risk exposure.

• The c apital s tru c ture of a c ompany

The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain 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.

• Mat c hing the s our c es with utili s a ti on

The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset – investments are to be financed by long term sources, which is a cardinal principle of financial planning.

• Fle x ibility

The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market.

• Go v er n m e nt poli c y

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 corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

Q5. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%?

Solution :

Amount deposit/invested at the end of every year for n years= A = Rs 30000

Time horizon or no. of years= n = 20 years

Rate of interest = i = 9% p.a

Value of PF amount at end of 20 years=

= A * FVIFA(i,n)

where FVIFA(i,n) = {(1+i)n -1}/i}

= 30000 * FVIFA (9%, 20Y)

= 30000 * 51.160

= Rs. 1534800

Q6. Mr. Anant purchases a bond whose face value is Rs.1000, and which has a nominal interest rate of 8%. The maturity period is 5 years. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond?

Solution:

Interest payable= 100*8% = Rs. 8

Principal repayment = Rs. 1000

Required rate of return = 10%

Therefore,

Value of the bond = 8*PVIFA(10%,5y)+1000*PVIF(10%,5y)

= 924.28