ASSIGNMENTS- MBA Sem-II

MB0029 – FINANCIAL MANAGEMENT

SMU
ASSIGNMENT
SEMESTER – 2
MBO029

FINANCIAL MANAGEMENT

SUBMITTED BY:
SIDHARTH RAMTEKE
MBA
ROLL NO.- 520918813

SET 1

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MB0029 – FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT

Q.1:- Why wealth maximization is superior to profit maximization in today’s context?

Justify your answer

Ans:- Profit maximization has been considered as the legitimate objective of a firm
because profit maximization is based on the cardinal rule of efficiency. Under perfect
competition allocation of resources shall be based on the goal of profit maximization.
A firm’s performance is evaluated in terms of profitability. Investor’s perception of
company’s performance can be traced to the goal of profit maximization. But, the goal of pro
fit maximization has been criticized on many accounts.

Wealth Maximization has, been accepted by the finance managers, because it

overcomes the limitations of profit maximisation. Wealth maximisation means maximizing
the net wealth of the Company’s share holders. Wealth maximisation is possible only
when the company pursues policies that would increase the market value of shares of the
company.

Superiority of Wealth Maximisation over Profit Maximisation

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 cash flows are uncertain. Converting distant uncertain cash flows into comparable
values at base period facilitates better comparison of projects. There are various ways of
dealing with risk associated with cash flows. These risks are adequately considered
when present values of cash flows are taken to arrive at the net present value of any project.

3. In today’s competitive business scenario corporates play a key role. In

company form 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 corporates to tap the capital markets 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 maximisation criterion.

4. When a firm follows wealth maximisation goal, it achieves maximization of

market value of share. When a firm practices wealth maximisation goal, it is possible only
when it produces quality goods at low cost. On this account society gains because of the
societal welfare.

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

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

6. Another notable features of the firms committed to the maximisation of wealth

is that to achieve this goal they are forced to render efficient service to their customers with
courtesy. This enhances consumer welfare 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 maximisation.

8. Since listing ensures liquidity to the shares held

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
market value of shares will lead to maximisation of the net wealth of shareholders

Q.2:- 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?

Ans:- 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}
A =80000/ 6.144567
A = 13019.63 Yrly

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Q.3:- What factors affect financial plan?

Ans:- Factors Affecting Financial Plan

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

or 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 finds it
difficult to raise funds from long X Ds X 1000 , 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 terms
for implementing new projects to exploit the new opportunities emerging from changing
business environment.

4. Sources of finance available 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 capacity to manage the risk exposure.

5. 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 obt
ain extra funds for growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization The prudent 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 terms finance. All fixed
assets financed investments are to be financial by long term sources. It is a cardinal
principle of financial planning.

7. Flexibility The financial plan of a 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.

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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
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.

9. Economic factors Many economic factors will significantly affect your financial
plan, i.e. supply and demand, various institutions, business, labor force, and government.
Supply and demand will form price. Price level will change your consumption pattern, so do
your investment and others. Labor force will determine your income. When unemployment
rate is high, it will be more difficult to find job. When job is rare, people are willing to work
for less money, and vice versa. Financial institutions and others business are the user of
labors. Their activities will shape the economic and eventually affect your financial.
Government will influence economic by monetary and fiscal policy. The steps government
take will affect you financially. When government raise the interest rate, economic will cool
down. When economic slow down, government will lower the interest rate. When interest
rate is low, invest your money in bank will not give you decent return. It means take longer
time for your investment to reach your financial goals. Therefore, in order to get higher return
people invest in stock market or business.

10. Global influence Since the advance of technology causes this globe to become
“smaller”, especially in the era of globalization. Now people do business cross the country
boundary, therefore what happen in other country will have an effect on people in another
country “Rain at Wall Street, drizzle around the world”. The economic of particular country
depend on foreign investment. When many foreign investors come, they will create new
businesses. New business will absorb many labors, therefore lowering unemployment rate
and increasing wages. However higher wage does not always guarantee the prosperity of
workers in certain country. When you earn high income but everything is so expensive there.
It is identical with make little, since your much money actually cannot buy many things. For
instance, average worker in Indonesia make approximately 1 million Rupiah monthly. Can
you imagine make 1 million dollars monthly here? Unfortunately, that 1 million Rupiah is
only around $ 108, since the currency exchange of Rupiah is around Rp. 9,200 to $ 1 USD.
Currency exchange surely will impact your purchasing power and your financial situation.
Currency of a country is usually base on its economic condition i.e. government’s budget,
balance trade, inflation level and growth. Foreign exchange is the biggest financial market in
the world, we definitely will learn about it in later articles.
11. Economic condition Consumer price, consumer spending, interest rate, money
supply, unemployment, house started, gross domestic product, trade balance and market
indication are among economic condition that affect your decision in handling your money
matters.

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12. Consumer price measure the value of your money through inflation rate. It
influences your personal financial planning because consumer price alter your money
purchasing power. When consumer price increase beyond your income, you will unable to
buy as much thing as you used to. Consumer spending measures the demand of good and
service by individuals and household. When consumer spending is up, more jobs will be
available and wage will be higher. Increase in consumer spending will drive consumer price
to increase and inflation level as well.

13. Interest rate measure cost of money or credit and return of investment. Increase in
interest rate will make credit more expensive and discourage borrowing. With high interest,
people are more likely to invest their money to earn interest than take higher risk to do
business. Excessive investment from investor with inability of bank lending to third party will
create over supply of fund. In which will drive down the interest rate eventually.

14. Money supply measures money available for spending in an economic. More
money make people have more to save. Therefore, increases in money supply tend to
decrease interest rate as more people save. Moreover, higher saving and lower spending will
reduce job opportunity. Unemployment measures number of people, who willing and able to
work, out of work. High unemployment rate reduce consumer spending and job opportunity.
It is wiser to setup higher emergency fund and reduce debt to cope with high unemployment
rate, since it is harder to get new job when unemployment rate are high. House started
measures the number of new house built. New house build is sign of economic expansion.
When new house build increase, it creates more jobs, higher wage and higher consumer
spending. Gross domestic product measures the total value produce within a country’s border.
GDP indicate country prosperity. High GDP will increase employment opportunity and
opportunity for personal financial wealth.

15. Trade balance measures different between export and import. Deficit happen,
when import exceed export. Large deficit over long run will hurt employment and GDP.
Surplus happen, when export exceed import. Large surplus will raise the value of the
currency, reducing the future opportunity of export, since commodity become more
expensive to foreigner. Market indication (stock market index) measures the relative value of
stocks. These indexes provide indication of the price movement of stocks. Since you will
invest your money in the market to help you reach your financial goals, understand how the
market work will benefit you.

Q.4:- 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

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bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you earn from
this 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 company’s 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?

Ans:-

SET 2

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FINANCIAL MANAGEMENT

Q.1:- A. What is the cost of retained earnings?

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
company’s 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?

Ans:-
A. Cost of Retained Earnings A company’s earnings can be reinvested in full
to fuel the ever-increasing demand of company’s fund requirements or they may be paid off
to equity holders in full or they may be partly held back and invested and partly paid off.
These decisions are taken keeping in mind the company’s growth stages. High growth
companies may reinvest the entire earnings to grow more, companies with no growth
opportunities return the funds earned to their owners and companies with constant growth
invest a little and return the rest. Shareholders of companies with high growth prospects
utilizing funds for reinvestment activities have to be compensated for parting with their
earnings. Therefore the cost of retained earnings is the same as the cost of shareholder’s
expected return from the firm’s ordinary shares. That is, Kr=Ke

There are three methods one can use to derive the cost of retained earnings:

(a) Capital-asset-pricing-model (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 company’s beta (bi), which is an estimate of
the stock’s 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 firm’s
long-term debt and add a risk premium (typically three to five percentage points):

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ks = long-term bond yield + risk premium

(c) Discounted cash flow approach Also known as the “dividend yield plus
growth approach”. Using the dividend-growth model, you can rearrange the terms
as follows to determine ks.

ks= D1 + g;
P0

where:
D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price

Q3. Explain Miler and

(F+P)/2
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
13.5(0.52) + (1.8)/ 13.5*.48+2/7
6.51
(2+1.8)/2 1.9
=3.43
(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4
(2+2.2)/2 2.1
=6.43/.21=3.06

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Q.2:- 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:

Items Rs. In crore

Net worth 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 comment on the Volga’s debt policy

Ans:-

Q.3:- Explain Miller and Modigliani Approach to capital structure theory.

Ans:- The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the
basis for modern thinking on capital structure. The basic theorem states that, in the absence of
taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of
a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is
raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is.
Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance

Principle Modigliani was awarded the 1985 Nobel Prize in Economics for this and other
contributions. Miller was awarded the 1990 Nobel Prize in Economics, along with Harry
Markowitz and William Sharpe, for their "work in the theory of financial economics," with
Miller specifically cited for "fundamental contributions to the theory of corporate finance."

Historical background Miller and Modigliani derived the theorem and wrote their path
breaking article when they were both professors at the Graduate School of Industrial
Administration (GSIA) of Carnegie Mellon University. In contrast to most other business
schools, GSIA put an emphasis on an academic approach to business questions. The story
goes that Miller and Modigliani were set to teach corporate finance for business students
despite the fact that they had no prior experience in corpora the finance. When they read the
material that existed they found it inconsistent so they sat down together to try to figure it out.
The result of this was the article in the American Economic Review and what has later been
known as the MM theorem.

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Propositions The theorem was originally proved under the assumption of no taxes. It is
made up of two propositions which can also b e extended to a situation with taxes. Consider
two firms which are identical except for their financial structures. The first (Firm U) is
unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed
partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of
the two firms is the same.

Without taxes

Proposition I: where VU is the value of an unlevered firm = price of buying a firm

composed only of equity, and VL is the value of a levered firm = price of buying a firm that
is composed of some mix of debt and equity.
To see why this should be true, suppose an investor is considering buying one of the two
firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the
shares of firm U and borrow the same amount of money B that firm L does. The eventual
returns to either of these i investments would be the same. Therefore the price of L must be
the same as the price of U minus the money borrowed B, which is the value of L's debt. This
discussion also clarifies the role of some of the theorem's assumptions. We have implicitly
assumed that the investor's cost of borrowing money is the same as that of the firm, which
need not be true in the presence of asymmetric information or in the absence of efficient
markets.

Q.4:- How to estimate cash flows? What are the components of incremental cash
flows?

Ans:- Cash flow estimation is a must for assessing the investment decisions of any
kind. To evaluate these investment decisions there are some principles of cash flow
estimation. In any kind of project, planning the outputs properly is an important task. At the
same time, the profits from the project should also be very clear to arrange finances in a
proper way. These forecasting are some of the most difficult steps involved in the capital
budgeting. These are very important in the major projects because any kind of fault in the
calculations would result in huge problems. The project cash flows consider almost every
kind of inflows of cash. The capital budgeting is done through the coordination of a wide
range of professionals who are going to be involved in the project. The engineering
departments are responsible for the forecasting of the capital outlays. On the other hand, there
are the people from the production team who are responsible for calculating the operational
cost. The marketing team is also involved in the process and they are responsible for
forecasting the revenue.

Next comes the financial manager who is responsible to collect all the data from the
related departments. On the other hand, the finance manager has the responsibility of using
the set of norms for better estimation. One of these norms uses the principles of cash flow
estimation for the process.

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There are a number of principles of cash flow estimation. These are the consistency
principle, separation principle, post-tax principle and incremental principle. The separation
principle holds that the project cash flows can be divided in two types named as financing
side and investment side. On the other hand, there is the consistency principle. According to
this principle, some kind consistency is necessary to be maintained between the flow of cash
in a project and the rates of discount that are applicable on the cash flows. At the same time,
there is the post-tax principle that holds that the forecast of cash flows for any project should
be done through the after-tax method.

Incremental Principle The incremental principle is used to measure the profit

potential of a project. According to this theory, a project is sound if it increases total profit
more than total cost. To have a proper estimation of profit potential by application of the
incremental principle, several guidelines should be maintained:

Incidental Effects: Any kind of project taken by a company remains related to the other
activities of the firm. Because of this, the particular project influences all the other activities
carried out, either negatively or positively. It can increase the profits for the firm or it may
cause losses. These incidental effects must be considered.

Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure done
by the firm in the past. These expenditures are not related with any particular project. These
costs denote all those expenditures that are done for the preliminary work related to the
project, unrecoverable in any case.

Overhead Cost: All the costs that are not related directly with a service but have indirect
influences are considered as overhead charges. There are the legal and administrative
expenses, rentals and many more. Whenever a company takes a new project, these costs are
assigned.

Working Capital: Proper estimation is essential and should be considered at the time when
the budget for the project's profit potential is prepared.

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Q.5:- What are the steps involved in capital rationing?

Ans:- Capital budgeting decisions involve huge outlay of funds. Funds available for
projects may be limited. Therefore, a firm has to prioritize the projects on the basis of
availability of funds and economic compulsion of the firm. It is not possible for a company
to take up all the projects at a time. There is the need to rank them on the basis of strategic
compulsion and funds availability. Since companies will have to choose one from among
many competing investment proposal the need to develop criteria for Capital rationing
cannot be ignored. The companies may have many profitable and viable proposals but
cannot execute because of shortage of funds. Another constraint is that the firms may
not be able to generate additional funds for the execution of all the projects. When a
firm imposes constraints on the total size of firm’s capital budget, it is requires Capital
Rationing.

Capital rationing refers to a situation in which the firm is under a constraint of funds,
limiting its capacity to take up and execute all the profitable projects. Such a situation may be
due to external factors or due to the need to impose internal constraints, keeping in view of
the need to exercise better financial control.

Capital Rationing may be due to:-

1. External Capital Rationing External Capital Rationing is due to the

imperfections of capital markets Imperfection may be caused by:

(a) Deficiencies in market information

(b) Rigidities that hamper the force flow of Capital between firms.

When capital markets are not favourable to the company the firm cannot tap the
capital market for executing new projects even though the projects have positive net present
values. The following reasons attribute to the external capital rationing:

1. Inability of the firm to procure required funds from Capital market because the
firm does not command the required investor’s confidence.

2. National and international economic factors may make the market highly
volatile and instable.

3. Inability of the firm to satisfy the regularity norms for issue of

instruments for tapping the market for funds.

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4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller
firms may have to incur high costs of issue of securities. This discourages small firms
from tapping the capital markets for funds.

2. Internal Capital Rationing Impositions of restrictions by a firm on the

funds allocated for fresh investment is called internal capital rationing. This decision may
be the result of a conservative policy pursued by a firm. Restriction may be imposed on
divisional
heads on the total amount that they can commit on new projects. Another internal restriction
for Capital budgeting decision may be imposed by a firm based on the need to generate a
minimum rate of return. Under this criterion only projects capable of generating the
management’s expectation on the rate of return will be cleared. Generally internal capital
rationing is used by a firm as a means of financial control.

Q.6:- Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per year for six
years. A substitute equipment 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
per cent. Calculate the IRR and NPV for the equipments. Which equipment should be
accepted and why?

Ans:-

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