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MBA202 – FINANCIAL MANAGEMENT

ASSIGNMENT SET – 1

Q.1 Capitalization of a firm refers to the composition of its long-term

funds and its capital structure. Explain.

ANS: Capitalization of a firm refers to the composition of its long-term funds and
its capital structure. It has two components – debt and equity.
After estimating the financial requirements of a firm, the next decision that the
management has to take is to arrive at the value at which the company has to be
capitalized.

There are two theories of capitalization for the new companies:

i) COST THEORY: Under this theory, the total amount of capitalization for
a new company is the sum of: cost of fixed assets, cost of establishing
the business, amount of working capital required.

MERITS OF COST APPROACH:

- It helps promoters to estimate the amount of capital required for
incorporation of company, conducting market surveys, preparing
detailed project report, procuring funds, procuring assets both fixed
and current, running a trial production, positioning, and marketing its
products or rendering of services.
- If done systematically, it will lay the foundation for successful
initiation of the working of the firm.

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DEMERITS OF COST APPROACH:

- If the firm establishes its production facilities at inflated prices, the
productivity of the firm will become less than that of the industry.
- Net worth of the company is decided by the investors and the
earnings of a company. Earning capacity based on net worth helps a
firm to arrive at the total capital in terms of industry-specified
yardstick. Cost theory falls in this respect.

ii) EARNINGS THEORY: Earnings are forecasted and capitalized at a rate of

return, which actually is the representative of the industry. Earnings
theory involves two steps. They are:
 Estimation of the average annual future earnings.
 Estimation of the normal earning rate of the industry to which the
company belongs.

MERITS OF EARNINGS THEORY:

- Earnings theory is superior to cost theory because of its lesser
chances of being either under or over capitalization.
- Comparison of earnings approach to that of cost approach will make
the management to be cautious in negotiating the technology and
the cost of procuring and establishing the new business.

DEMERITS OF EARNINGS THEORY:

- The major challenge that the new firm faces is deciding on
capitalization and its division thereof into various procurement
sources.
- Arriving at the capitalization rate is equally a formidable task because
the investor’s perception of established company cannot be really
unique of what the investors perceive from the earning power of the
new company.

Due to this problem most of the new companies are forced to adopt the cost
theory of capitalization. Changing business environment, role of international
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forces, and dynamics of capital market conditions force us to think in terms of

‘what is optional today need not to be so tomorrow’.
Even with these constraints, management of every firm should continuously
monitor its capital structure to ensure and avoid the bad consequences of over
and under capitalization.

Q.2 a) Explain Zero Coupon Bond

b) Explain the concept of Yield to Maturity
ANS:
a) ZERO COUPON BOND:

In India, zero coupon bonds are alternatively known as Deep Discount

Bonds. These bonds became very popular in India for over a decade
because of issuance of such bonds at regular intervals by IDBI and ICICI.

Zero Coupon bonds have no coupon rate, that is, there is no interest to be
paid out. Instead, these bonds are issued at a discount to their face value,
and the face value is the amount payable to the holder of the instrument
on maturity. Thus, no interest or any other type of payment is available to
the holder before maturity. Since there is no intermediate payment the
date of issue and the maturity date, these DDB’s are also called zero
coupon bonds. The valuation of DDB’s is similar to the ordinary bonds
valuation. Since DDB at the time of maturity generates only one future cash
flow, the value of this may be taken as equal to the present value of this
future cash flow discounted as the required rate of return of the investor
for the number of years of the life of DDBs. The value of DDB is calculated
as:

B0 (DDB) = FV/ (1+ r) n

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B0 (DDB) = Value of the DDB

FV = Face value of DDB payable at maturity

r =The required rate of return
n = Life of the DDB

Effectiveness interest earned = discounted issue price- face value

They are called deep discounts bonds because these bonds are long term
bonds whose maturity sometimes extends up to 25 to 30 years. Reading
the compound value (FVIF) table, horizontally along the 25-year line, we
find ‘r’ equals 8%. Therefore, the bond gives an effective return of 8% per
annum.

b) YIELD TO MATURITY:

Yield to Maturity is the rate of return earned by an investor who purchases

a bond and holds it till its maturity.
The Yield to Maturity (YTM) is the discount rate equaling the present values
of cash flow to the current market price/purchase price.
The rate of return (Kd), which makes the discounted values of these cash
flow equal to the bond’s market value, is known as the Yield to Maturity of
the bond. So, a bond’s YTM may be defined as the Internal Rate of Return
(IRR) for a given level of risk.
In other words, YTM is the IRR for the investor who buys the bond.
Calculation of YTM assumes that the bond is held till maturity. It may be
noted that like in the case of coupon yield, the YTM will equal the coupon
rate only if the bond is trading at par. The YTM of a bond is not constant
over its lifetime, and it changes as the bond price changes.
While finding out the YTM, an implied assumption is that all interest
received are reinvested at a rate of return equal t the bond’s YTM.

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Discounting is the process used in bond markets to find the price of a bond.
We add the Present Values (PV) of all future cash flow to arrive at the price
of the bond. This ‘i’ is substituted by the YTM while calculating the PV of
bond’s future cash flow.

Yield to Maturity is an important factor in bond pricing. This is the rate

applied to the future cash flow S(coupon payment) to arrive at its present
value. If the YTM increases, the present value of the cash flow will go down.
This is obvious as the YTM appears in the denominator of the formula, and
we know as the denominator increases, the value of the ratio goes down.
So here as well, as the Yield to Maturity increases, the present value falls.

Q.3 Determine the value of assets of the two projects, A and B,

with a discount rate of 12%.

Year Cash Flows of A Cash flows of B

1 20,000 15,000
2 50,000 25,000
3 30,000 45,000

ANS:

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COMPUTATION OF VALUE OF ASSET A:

Year Cash flows F.V factor @12% P. Value

1 20,000 0.895 17,860
2 50,000 0.797 39,850

VALUE OF ASSETS A = 79,070

COMPUTATION OF VAUE OF ASSETS B:

Year Cash flows F.V Factor at 12% P value

1 15,000 0.893 13,395
2 25,000 0.797 19,925
3 45,000 0.712 32,040

VALUE OF ASSET B = 65,360

CONCLUSION:
Project A IS MORE BENEFICIAL IN COMPARISON TO PROJECT B.

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ASSIGNMENT SET – 2

Q.1Briefly explain types and sources of Risk in Capital budgeting.

ANS: Capital budgeting: it is a process of evaluating the profitability of the

projects under consideration and deciding on the proposal to be included in
the capital budget for implementation.

Capital budgeting involves four types of risks in a project: stand-alone

risk, portfolio risk, market risk and corporate risk.

i) Stand-alone risk:
Standalone risk of a project is considered when the project is in
isolation. Stand-alone risk is measured by the variability of expected
returns of the project.

ii) Portfolio risk:

A firm can be viewed as portfolio of projects having a certain degree
of risk. When new project is added to the existing portfolio of
project, the risk profile of the firm will alter. The degree of the
change in the risk depends on the following:

- The co-variance of return from the new project

- The return from the existing portfolio of the projects

iii) Market risk:

Market risk is defined as the measure of the unpredictability of a
given stock value. However, market risk is also referred to as
systematic risk. The market risk has a direct influence on stock

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prices. Market risk is measured by the effect of the project on the

beta of the firm. The market risk for a project is difficult to estimate,
as it includes a wide range of external factors like recessions, wars,
political issues, etc.

iv) Corporate risk:

Corporate risk focuses on the analysis of the risk that might
influence the project in terms of entire cash flow of the firms.
Corporate risk is the projects’ risks of the firm.

 SOURCES OF RISK:

The five different sources of risk are:

i) Project-specific risk: Project-specific risk could be traced to

something quite specific to the project. Managerial deficiencies or
error in estimation of cash flows or discount rate may lead to
situation of actual cash flows realized being less than the projected
cash flow.

ii) Competitive or competition risk: Unanticipated actions of a firm’s

competitors will materially affect the cash flows expected from a
project. As a result of this, the actual cash flows from a project will be
less than that of the forecast.

iii) Industry-specific risk: Industry specific risks are those that affect all
the firms in the particular industry. Industry- specific risk could be
again grouped into technological risk, commodity risk and legal risk.
Let us discuss the groups in industry-specific risks as follows:

- Technological risk: The changes in technology affect all the firms not
capable of adapting themselves in emerging into a new technology.

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- Commodity risk: It is the risk arising from the effect of price-changes

on goods produced and marketed.

- Legal risk: It arises from changes in laws and regulations applicable to

the industry to which the firm belongs.

iv) International risk: These types of risks are faced by firms whose
business consists mainly of exports or those who procure their main
raw material from international markets. The firms facing such kind
of risks are :
- The rupee-dollar crisis affected the software and BPO’s, because it
drastically reduced their profitability.
- The surging crude oil prices coupled with the governments delay in
taking decision on pricing of petro products eroded the profitability
of oil marketing companies in public sector like Hindustan Petroleum
Corporation Limited.
- Another example is the impact of US sub-prime crisis on certain
segments of Indian economy.

v) Market risk: Factors like inflation, changes in interest rated, and

changing general economic conditions affect all firms and all
industries. Firms cannot diversify the risk in the normal course of
business.
There are many techniques of incorporation of risk perceived in the
evaluation of capital budgeting proposals. They differ in their
approach and methodology as far as incorporation of risk in the
evaluation process is concerned.

Q.2 ABC Ltd current dividend is Rs 6. It expect to have a

supernormal growth period running to 4 Years during which
the growth rate would be 25%. The company expects
normal growth rate of 8% after the period of supernormal
growth period. The Investor is required rate of return is 15%.

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Calculate what the value of one share of this company is

worth?

ANS:

Present value Interest Factor (PVIF) @ 15%

For:
Year 1 = 0.870
Year 2 = 0.756
Year 3 = 0.658
Year 4 = 0.572

SOLUTION:
D0 = Rs.6
D1 = Rs.6(1.25)1 = Rs. 7.5
D2 = Rs.6(1.25)2 = Rs. 9.38
D3 = Rs.6(1.25)3 = Rs. 11.72
D4 = Rs.6(1.25)4 = Rs.14.68
D5 = Rs.6(1.25)4 (1.08)1 = Rs.15.82

P0 = D1/(1+Ke) + D2/(1+Ke)2 + D3/(1+Ke)3 + D4/(1+Ke)4 + P4/(1+Ke)4

P4 = D5/(Ke – g ) = Rs.15.82/(0.15-0.08) = Rs. 226

P0 = (7.5X0.870) + (9.38X0.756) + (11.72X0.658) + (14.65X0.572) + (226X0.572)

P0 = 6.53 + 7.09+ 7.71 + 8.38 + 129.27

P0 = 158.98 or 159

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Therefore, the value of one share of this company is worth Rs.158.90 or Rs.159.

Q.3 An Investment will have an initial outlay of Rs.150,000. It is

expected to generate cash inflows.

Year Cash Inflow

1 50,000
2 50,000
3 20,000
4 30,000

If the Risk Free rate and the Risk Premium is 15%. Then Compute:
a. Compute the NPV using the risk free rate
b. Compute NPV using Risk-Adjusted discount rate.
ANS:

a) NPV using risk free rate:

Year Cash flow PV@15% P.V

1 50,000 0.870 43,500
2 50,000 0.756 37,800
3 20,000 0.658 13,160
4 30,000 0.572 17,160
= 1,11,620

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NPV = 1,11,620 –1,50,000

= (38,380)

Hence, this project should not be accepted.

b) NPV using Risk-Adjusted Discount rate:

PV = 50,000/(1+15)1 + 50,000/(1+ 15%)2 + 20,000/(1+15%)3 +

30,000/(1+15%)4
PV = 1,11,588
NPV = 1,11,588 – 1,50,000
= (38,412)
Since, the present value of the expected cash flow is lower than the
invested capital. Hence, we should calculate the expected cash flow using
risk adjusted discount rate i.e .01%.
Present value of the project using risk adjustment discount rate i.e ,

Rs. 50,000 x 0.999 = 49,950

Rs. 50,000 x 0.998 = 49,900

Rs. 20,000 x 0.997 = 19,940

Rs. 30,000 x 0.996 = Rs. 29,880

= Rs.1,49,670

By using the risk adjustment discount rate, the present value of expected cash
flow is almost equal to the invested capital of Rs.1,50,000. However, with the
adjustment of the discount rate to reflect all the risk of the project, the present

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value of cash flows is still lower than the invested capital. Therefore, the project
should not be undertaken.

X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X-X

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