MB0045 FINANCE MANAGEMENT

Question1. When a firm follows wealth maximization goal, it achieves

maximization of market value of a share. Do you agree? Substantiate your
arguments.
Wealth Maximization:

The term wealth means shareholders wealth or the wealth of the persons those who are
involved in the business concern. Wealth maximization is also known as value maximization or
net present worth maximization. This objective is a universally accepted concept in the field of
business.
Wealth maximization is possible only when the company pursues policies that would increase the
market value of shares of the company. It has been accepted by the finance managers as it
overcomes the limitations of profit maximization.

When a firm follows wealth maximization goal, it achieves

maximization of market value of a share:

A firm can practice wealth maximization goal only when it produces quality goods at
low cost. On this account, society gains because of the societal welfare.
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,
as it brings to the market the products and services that a consumer needs.
Another notable feature of the firms that are 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 enhances consumer welfare and benefit to the society.
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 as a superior goal compared to profit
maximization.
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
maximization of the net wealth of shareholders.

Therefore, we can conclude that maximization of wealth is probably the more appropriate goal of
financial management in todays context. Though this cannot be a goal in isolation, it is
important to understand that profit maximization as a goal, in a way, leads to wealth
maximization.

Question 2: A) If you deposit Rs 10000 today in a bank that offers 8% interest,

how many years will the amount take to double?
B) What is the future value of a regular annuity of Re 1.00 earning a rate of
12% interest p.a. for 5 years?
A)Doubling Period :
Given:
Interest Rate: 8%
Number of years it takes to double the deposited amount is given by,

Doubling Period = 0.35+69/Interest Rate

=0.35+69/8
=0.35+8.625
=8.975 years
It takes 8.975 years to double the deposited amount.

B)Future value of regular annuity:

Given:
Number of Years: 5
Rate of interest: 12%
Amount invested: 1 Rupee
The future value of a regular annuity for a period of n years at i rate of interest is given
by,
FVAn= FVIFA (Future Value Interest Factor for Annuity)

(1+i) 1
}
FVAn =A {
i

End of Year

Amount
Invested(Rs.)

1
2
3
4
5

1
1
1
1
1

Number of Years
compounded

4
3
2
1
0
Amount at the end of the fifth year

Compounded
interest factors
from tables
1.5735
1.4049
1.2544
1.1200
1.0000

FV in RS.
1.5735
1.4049
1.4049
1.1200
1.0000
6.3528

The future value of regular annuity is 6.3528 Rupees.

Question 3. The concept of financial leverage is a significant, as it has

direct relation with capital structure. Do you agree? If so, substantiate
your arguments.
Relation between financial leverage and capital
structure:

Financial leverage is the degree to which a company uses fixed-income securities such as
debt and preferred equity.

The more debt financing a company uses, the higher its financial leverage.

A high degree of financial leverage means high interest payments, which negatively affect
the company's bottom-line earnings per share.

Financial leverage relates to the financing activities of a firm and measures the effect of EBIT on
Earnings Per Share (EPS) of the company. A companys sources of funds fall under two
categories:

Those which carry fixed financial charges like debentures, bonds, and preference shares

Those which do not carry any fixed charges like equity shares Debentures and bonds carry
a fixed rate of interest and are to be paid off irrespective of the firms revenues.

The dividends are not contractual obligations, but the dividend on preference shares is a fixed
charge and should be paid off before equity shareholders. The equity holders are entitled to only

the residual income of the firm after all prior obligations are met.
Financial leverage refers to a firms use of fixed-charge securities like debentures and preference
shares (though the latter is not always included in debt) in its plan of financing the assets.

The concept of financial leverage is a significant one because it has direct relation with
capital structure management.

It determines the relationship that could exist between the debt and equity securities.

A firm which does not issue fixed-charge securities has an equity capital structure and does
not have any financial leverage.

However, it is common for firms to issue some debt securities, in which case, the leverage
is either favorable or unfavorable.
Financial leverage is a process of using debt capital to increase the rate of return on equity.
For this reason, it is also referred to as trading on equity.

Borrowing is done by a company because of the financial advantage that is expected from
it.

The use of borrowings for the purpose of such advantage for residual shareholders is also
called trading on equity or leverage.

4. A Project requires an initial outlay of Rs.1,00,000.It is expected to generate

the cash inflows shown in table
Cash Inflows
Year
Cash inflows
1
50,000
2
50,000
3
30,000
4
40,000
Calculate the IIR of the project.

Solution:
Step 1: The average of annual cash inflows is computed as shown below

Average of Cash inflows

Year
Cash inflows
1
50,000
2
50,000
3
30,000
4
40,000
Total
1,70,000

Average

1,70,000
4

=42,500

Step 2: Divide the initial investment by the average of annual cash inflows

1,00,000
42,500

=2.35

Step 3: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%.
Therefore, the first initial rate is 25% as shown below
Trial Rate at 25%
Year
1
2
3
4

Cash flows
50,000
50,000
30,000
40,000

PV factor at 25%
0.800
0.640
0.512
0.410
Total

PV of Cash flows
40,000
32,000
15,360
16,400
1,03,760

As the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760,
the next trial rate is 26%
Trial Rate at 26%
Year
1
2
3
4

Cash flows
50,000
50,000
30,000
40,000

PV factor at 25%
0.7937
0.6299
0.4999
0.3968
Total

The next trial rate is 27%, the changes are as shown below
Trial Rate at 27%

PV of Cash flows
39,685
31,495
14,997
15,872
1,02,049

Year
1
2
3
4

Cash flows
50,000
50,000
30,000
40,000

PV factor at 25%
0.7874
0.6200
0.4882
0.3844
Total

PV of Cash flows
39,370
31,000
14,646
15,376
1,00,392

The next trial rate is 28%, the changes are as shown below

Trial Rate at 28%

Year
1
2
3
4

Cash flows
50,000
50,000
30,000
40,000

PV factor at 25%
0.7813
0.6104
0.4768
0.3725
Total

PV of Cash flows
39,065
30,520
14,3047
14,900
98,789

Because the initial investment of Rs.1,00,000 lies between 98789(28%) and 1,00,392(27%),the
IRR by interpolation is equal to:
1,00,3921,00,000

=27+ 1,00,39298,799

392

=27+ 1603 *1
=27+0.2445
=27.2445
=27.24%

5. Below Table gives the complete details of sales and costs of the goods
produced by XYZ ltd for the year 31.03.08
Sales and cost produced by XYZ Ltd.

Sales
Cost of goods

80,000
56,000

Inventory
31.03.07
31.03.08
Accounts
Receivables
31.0.07
31.03.08
Accounts Payable
31.03.07
31.03.08

9,000
12,000

12,000
16,000
7,000
10,000

What is the length of the operating cycle? What is the cash cycle?
Assume 365 days in the year

Solution:
Operating Cycle=Inventory conversion period + Accounts Receivables Conversion period
From the above formula we need to first calculate the individual conversion periods,

Inventory Conversion Period :

=

Average Inventory
Annual Cost of goods sold *365

(9000+12000)
*365
56000

10500365
56000

= 68.4 days

Receivables Conversion Period :

=

Average Accounts Receivables

*365
Annual Sales

12000+16000
365
2
=
56000

8500365
56000

= 55.4 days

Operating Cycle = ICP+RCP

= 68.4+63.9
=132.3 days

Cash Conversion Cycle =OC-PDP

=132.3-55.4
=76.9 days
The length of operating cycle is 132.3 days
The length of cash cycle is 76.9 days

6. Facebook bought WhatsApp on Feb, 19, 2014 for $19 billion. This was
split between $4 billion in cash, $12 billion worth of Facebook shares, and $3
billion in restricted stock units to be paid in four years. Do you think the
market capitalization has played a significant role in pricing the valuation.
Discuss the Walters model assumptions in this context.
Walter Model:
Walter model clearly establishes a relationship between the firms rate of return r and
its cost of capital k to give a dividend policy that maximizes shareholders wealth. The firm
would have the optimum dividend policy that enhances the value of the firm.

Walter Model Assumptions:

Financing
Constant rate of return and cost of capital
100% pay out or retention
Constant EPS and DPS
Life

The following are the assumptions on which the Walters model is based:

1. All financing is done through retained earnings: external sources of funds like debt or new
equity capital are not used. Similarly Face book did not go for external funds instead it splited
the money as shares and stock.
2. With additional investments undertaken, the firm's business risk does not change. It implies
that r and k are constant.
3. There is no change in the key variables, namely, beginning earnings per share, E, and
dividends per share, D. The values of D and E may be changed in the model to determine results,
but, any given value of E and D are assumed to remain constant in determining a given value.
4. The firm has perpetual (or very long) life.
According to this approach, the market price of the share is taken as the sum of the present value
of the future cash dividends and capital gains. Walters formula to determine the market price is
as follows:
Market price per share of the firm is given as:

Implies,

P = D / (Ke g)
Ke = D/P + g,
where g = P / P

Thus,
Ke = D/P + P / P
But since,
P = [r /Ke (E -D)],
We get
P =D/Ke+[r /Ke (E D)]/Ke
Where,
P is the market price per share
D is the dividend per share
Ke is the cost of capital
g is the growth rate of earnings
E is Earnings per share
r is IRR
P is change in price.