33590551 32935489 file mb0045 financial management solved

8/8/2019 33590551 32935489 File MB0045 Financial Management Solved

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Q1. Why wealth maximization is superior to profit maximization in todays contex t? Justify you answer? Answer: Superiority of Wealth Maximization over Profit Maximization: 1. It is based on cash flow, not based on accounting profit. 2. Through the proc ess of discounting it takes care of the quality of cash flows. Distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associatewith cash flo ws. These risk are adequately considered when present values of ca

sh of any proj ect. 3. In todays competitive business scenario corporate play a key role. In c ompany from of organization, shareholders own the company but themanagement of the company rests with the board of directors. Directors are elected by sharehol ders 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 corporate to tap the capital market effectively for their c apital requirements. Therefore to keep the investors happy through the performan ce of value of shares in the market, management of the companymust meet the wea lth maximization criterion. 4. When a firm follows wealth maximization goal, it achieve maximization of market value of share. When a firm pact wealth maximizat ion goal, it is possible only when procedures quality goods at low cost. On this account society gains became of the society welfare. 5. Maxi

mization 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 all it will bring to the market the products and services that consumersneed. 6. Another notable features of the firms committed to the maximization ofwealth is that to achieve this goal they are forced to render efficient serviceto their customer s with courtesy. This enhance consumer 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 corpor ate action finds its reflection on the market value of sharesof the company. Th erefore, shareholders wealth maximization could be considered a superior goal co mpared to profit maximization. 8. Since listing ensures liquidity to the shares help by the investors shareholders can reap the benefits arising from the perfor mance of company only when they sell their shares. Therefo

re, it is clear that m aximization of the net wealth of shareholders. Thereforewe can conclude that maximization of wealth is the appropriate of goal of financial management in todays context.


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Q2. 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 wil l 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? Answer:Present Value(PV) Amount (A) Interest Rat e(I) No. of Year(N) =80000/ =? =10% =10 PVAn = A {1+i)n -1} /{ i(1+i)n}

80000=A{1+.10)10 }/{.10(1+.10)10} 80000=A{ 1.593 742/0.259374} Annual withdrawal=80000/ 6.144567 Annual withdrawal = 13019.63 Yr ly


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Q3. What factors affect financial Plan? Answer:- We live in a society and interact with people and environment. What happens to us is not always accordance too ur wishes. Many things turn out in our live are uncontrollable by us. Many decis ions we take are the result of external influences. So do our financial matters. There are many factors affect our personal financial planning. Range from econo mic factors to global influences. Aware of factors affecting your money matters below will certainly benefit your planning. Factors Affecting Financial Plan

1. Nature of the industry:- Here, we must consider whether it is a capital inten sive of labour intensive industry. This will have a major impact on the totalas sets that the firm owns. 2. Size of the company: - The size of the company great ly influences the availability of funds from different sources. A small company normally finals it difficult to raise funds from long term sources at competitiv e 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 term for implementa tion new projects to exploit the new opportunity emerging from changing business environment. 4. Sources of finance available:- Sources of finance could be

grou p into debt and equity. Debt is cheap but risky whereas equity is costly. Afirm should aim at optimum capital structure that would achieve the least costcapit al structure. A large firm with a diversified product mix may manage higher quan tum of debt because the firm may manage higher financial risk with a lower busin ess risk. Selection of sources of finances us closely linked to the firms capaci ty to manage the risk exposure. 5. The capital structure of a company:-Capital structure of a company is influenced by the desire of the existing management of the company to remain control over the affairs of the company. The promoters wh o 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 tooutsiders . 6. Matching the sources with utilization:- The product policy of any good fina ncial plan is to match the term of the source with the term of investment. To fi nance fluctuating working capital needs, the firm resorts to short

term finance. All fixed assets-investment are to be finance by long term sources. It is a car dinal principal of financial planning. 7. Flexibility:- The financial plan of co mpany should possess flexibility so as to effect changes in the composition of c apital structure when ever need arises. If the capital structureof a company is flexible, it will not face any difficulty in changing the sources of funds. Thi s factor has become a significant one today because of the globalization of capi tal 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 andD epartment of Corporate Affairs (Govt of India) influence the financial plans of corporate today. Management of public issues of shares demands the companies wit h many status in India. They are to be compiled with a time constraint.


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Q4. 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 thebond? (b) If you purchase the bond for Rs.904.98, what interest rate will you ea rn from this investment? Answer:- A. Bond value maturity Market interest ratePeriod of maturity Valu of bond = = = = 1000 8% 1Yrs Maturity value 1 + rate ofreturn 1000 1 + 0.08 926 92 6 = = Pay for the bond = Answer:- B. Purchase priceof bond Maturity value Interest earning = = = = = 904 .98 1000 Maturity value -

Purchase price of bond 1000 - 904.98 95.02 Interest Cu rrent Price of bond 95.02904.98 10.50% Rate of interest = X 100 = X 100 = Interest rate earn from this investment = 10.50%


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Case Study Deepak Hand tools Private Limited DHPL is a small sized firm manufacturing hand tools. It manufacturing plan is situated in Haryana. The companys sales in the year ending on 31 st 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 milli on. The management of the company wants to improve profitability further. There quired rate of return of the company is 14 percent. The company is currentlycon sidering an investment proposal. One is to expand its manufacturing capacity

. Th e estimated cost of the new equipment is Rs.250 million. It is expected tohave an economic life of 10 years. The accountant forecasts that net cash inflows wou ld be Rs.45 million per annum for the first three years, Rs.68 million perannum from year four to year eight and for the remaining two years Rs.30millionper a nnum. The plant can be sold for Rs.55 million at the end of its economiclife. T he company would need to raise debt to the extent of Rs.200 million. Thecompany has the following options of borrowing Rs.200 million: a . The companycan borr ow funds from a nationalized bank at the interest rate of 14 percent for 10 year s. It will be required to pay equal annual installment of interest andrepayment of principal. b. A financial institution has offered to lend money toDHP L 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 c

apacity? Show the computation of NP V 2. What is the annual installment of bankloan? 3. Calculate the quarterly ins tallments of the Financial Institution loan4. Should the company borrow from th e bank or from the financial institution?Answer 1. Investment in New Equipment : Life of machine Salvage : : 250000000 10Years 55000000 Years 1 2 3 4 5 6 7 8 9 10 Salvage Cash inflows 45,000,000 45,000,000 45,000,000 68,000,000 68,000,000 68,000,000 6 8,000,000 68,000,000 30,000,000 30,000,000 55,000,000 PV factors at 14 % 0.877 0.769 0.675 0.592 0.519 0.4560.400 0.351 0.308 0.270 0 .270 PV of cash inflows Initial cash out flow NPV PVof cash inflows 39,473,684 34,626,039 30,373,718 40,261,459 35,317,069 30,979 ,885 27,175,338 23,838,016 9,225,238 8,092,314 14,835,910 294,198,670 250,000,00 044,198,670 Here NPV is positive it is advisable to the company to expand its capacity.


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Answer 2. Loan Amount Interest rate No of Year(N) : : : 200000000 14 % 10 YearsInstallment X PVIFA (14%,10) =20,00,00,000 Installment = 20,00,00,000 / 5.216 =3,83,43,558 Answer 3. Loan Amount Interest rate No of Year(N) Quarterly : : : 20,00,00,000 13.5 % 10 Years Installment X PVIFA (13.5% / 4, 40) =20,00,00,000 Installment = 20,00,00,000 / 5 .176 = 3,86,39,876 Answer 4. Should the company borrow from the bank because payback by the company less then financial institution. ______________________________________________________________________________

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Q1. A. What is the cost of retained earnings? Answer:- Cost of Retained EarningsCost of retained earnings (ks) is the return stockholders require on the company s common stock. There are three methods one can use to derive the cost of retained earnings: a) Capital-asset-pricing-model (CAPM) approach b) Bond-yield-pluspremium approach c) Discounted cash flow approach a) CAPM Approach To calculatethe cost of capital using the CAPM approach, you must first estimate the riskfree rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treas

u ry-bill rate as well as the expected rate of return on the market (rm). The next step is to estimate the companys beta (bi), which is an estimate of the stock srisk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings. b) Bond-Yield-Plus-Premium Approach This is asimple, ad hoc approach to estimat ing the cost of retained earnings. Simply take the interest rate of the firms l ong-term debt and add a risk premium (typically three to five percentage points) : ks = long-term bond yield + risk premium ks= D1 + g; P0 where: D1 = next years dividend g = firms constant growth rate P0 =price iler and


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c) Discounted Cash Flow ApproachAlso known as the dividend yield plus growth appro ach. Using the dividend-growth model, you can rearrange the terms as follows todetermine ks.


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Q1. 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 mat urity. The companys 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 ti me is Rs. 2.2 million? Answer: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 d

ebenture, N is maturity p eriod A. Kd = I(1-T)+{(F-P)/N} (F+P)/2 = 13.5(1-.52)+(2-1.8)/7 (2+1.8)/2 = 6.48+0.03 1.9 = 6.51 1.9 = 3.43% or 343 Cost of debenture 3.43


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B. Kd = I(1-T)+{(F-P)/N} (F+P)/2 = 13.5(1-.52)+(2.2-1.8)/4 (2.2+1.8)/2 = 6.48+0.1 2 = 6.58 2 = 3.29% or 329 Cost of debenture 3.29


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Q2. 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 compa ny are given below: Items Net worht Borrowing EBIT Interest Fixed cost (excluding interest) Rs. In crore 152.31 165.47 43.17 34.39 118.23 You are required tocalculate: A. Debt equity ratio B. Operating leverage C. Fin ancial leverage D.Combined leverage. Interpret your results and components of i ncremental cash flows? Answer: Sale Less Variable cost Contribution Less Fixed Cost EBIT Less inte

rest PBT 980.20 ? 161.40 118.23 43.17 34.39 8.78 Contribution = Sale Variable cost Variable cost not given so Contribution = EB IT + Interest = 43.17 + 118.23 =161.40 A. Debt equity ratio Debt equity ratio = Debt Equity


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= 165.47 152.31 = B. Operating leverage 1.09 Operating leverage = Contribution EBIT (Operating Earning) = 161.40 43.17 = 3.74 C. Financial leverage Financial leverage = EBIT PBT (Profit before tax) = 43.17 8.78 = 4.92 D. Combined leverage Cobined leverage = Operating leverage = Contribution EBIT X Financial leverage XEBIT PBT


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= 161.40 43.17 X 43.17 8.78 = 3.74 X 4.92 = 18.38 Ratio of debt to equity is 1.09 it means that on every Rupees (Net worth) there is Rs.1.09 external liability.Hence the company has over burden of external lia bility is his capital. Hencethe risk is excess and shareholders require return is also higher.


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Q3. Explain Miler and Modigliani Approach to capital structure theory? Answer: Miller and Modigliani Approach Miller and Modigliani criticize that the cost ofe quity remains unaffected by leverage up to a reasonable limit and Ko being const ant at all degrees of leverage. They state that the relationship between leverag e and cost of capital is elucidated as in NOI approach. The assumptions forthei r analysis are: y Perfect capital markets: Securities can be freely traded,that is, investors are free to buy and sell securities( both shares and debt in

struments), there are n o hindrances on the borrowings, no presence of transaction costs, securities inf initely divisible, availability of all required information at all times. Invest ors behave rationally, that is, they choose that combination of risk and return that is most advantageous to them. Homogeneity of investors risk perception that is all investors have the same perception of businessrisk and returns. Taxes: There is no corporate or personal income tax. Dividendpay-out is 100%, that is, the firms do not retain earnings for future activities. y y y y Basic propositions: The following three propositions can be derived based on the above assumptions: Proposition I: The market value of the firm is equal to the total market value of equity and total market value of debt and is independent o f the degree of leverage. It can be expressed as : Expected NOI Expected overall capitalization rate V + (S + D) = which is equal to O/Ko which is e

qual to NOI/ Ko V + (S + D) = O/Ko = NOI/Ko Where V is the market value of the firm, S is the market value of the firms equ ity, D is the market value of the debt, O is the net operating income, K/o is th e capitalization rate of the risk class of the firm.


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Cost of Capital Ko Ke Leverage D/S The basic argument for proposition I is thatequilibrium is restored in the mark et by the arbitrage mechanism. Arbitrage isthe process of buying security at lo wer price in one market and selling it in another market at higher price bringin g about equilibrium. This is a balancing act. Miller and Modigliani perceive tha t the investors of firm whose value is higher will sell their share and in retur n buy shares of the firm whose value islower. They will earn the same return at lower outlay and lower the share prices

risk.. Such behaviours are expected to increase the share price of whose sharesare being purchased and lowering the sh ares price of those share which are being sold. This switching operation will co ntinue till the market price of identical firms becomes identical. Proposition II: The expected yield on equity is equal to discount rate (capitali zation rate) applicable plus a premium. Ke = Ko +[ ( Ko Kd ) D/S ] Proposition III: The average cost of capital is not affected by the financing de cisions as investment and financing decision are independent.


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Q4. How to estimate cash flows? What are the components of incremental cash flows? Answer: Estimation of cash flows Estimating the cash flows associated with th e project under consideration is the most difficult and crucial step in the eval uation of an investment proposal. It is the result of the team work of many prof essionals in an organization. 1. Capital outlays are estimated by engineering de partment after examining all aspects of production process. 2. Marketing departm ent on the basis of market survey forecasts the expected sales revenue dur

ing th e period of accrual of benefits from project executions. 3. Operating cost is es timated by cost accountants and production engineers. 4. Incremental cash flows and out flows statement is prepared by the cost accountant on the basisof detai ls generated in the above steps. The ability of the firm to forecast the cash fl ows with reasonable accuracy lies at the root of the implementation ofany capit al expenditure decision. Investment (Capital budgeting) decision required the es timation of incremental cash flow stream the life of the investment.Incremental cash flow are estimated on after tax basis. 1. Initial Cash outlay(Initial inv estment): Initial cash outlay to be incurred is determined after considering any post tax cash inflows if any. In replacement decision existing oldmachinery is disposed of and new machinery incorporating the latest technologyis installed in its place. On disposed of existing old machinery the firm has a

cash inflow. This cash inflow has to be computed on post tax basis. The net cashout flow (to tal cash required for investment in capital assets minus post taxcash inflow on disposal on the old machinery being replaced by a new one) therefore is the inc remental cash outflow. Additional net working capital required onimplementation of new project is to be added to initial investment. 2. Operating Cash inflows: Operating cash inflows are estimated for the entire economic life of investment . Operating cash inflows constitute a stream of inflows and outflows over the li fe of the project. Here also incremental inflows and outflows attributable to op erating activities are considered. Any saving in cost on installation of new mac hinery in the place of the old machinery will have to be accounted to on post ta x basis. In this connection incremental cash flows refer tothe change in cash f lows on implementation of a new project over the existing position. 3. Terminal Cash inflows: At the end of the economic life of the projec

t, the operating asse ts installed now will be disposed off. It is normally known as salvage value of equipments. These terminal cash inflows are computed on post tax basis.


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Q5. What are the steps involved in capital rationing? Answer: Steps involved inCapital Rationing are: 1. Ranking of different investm ent proposals 2. Selection of the most profitable investment proposals Ranking of different investment proposal The various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV. Profitability index or IRR inthe descending order. Profitability index as the basis of Capital Rationing Thefollowing details are Cash Inflows Project A B C Initial Cash outlay 100,000 50

,000 50,000 Year 1 60,0 00 20,000 20,000 Year 2 50,000 40,000 30,000 Year 3 40,000 20,000 30,000 Cost of Capital is 15% Computation of NPV Project A Year 1 2 3Cash Inflows 60,000 50,000 40,000 PV factors at 15% 0.870 0 .758 0.658 PV of cash inflows Initial cash outlay NPV PV of Cash inflows 52,200 37,800 26,320 116,320 100,000 16,320


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PV of Cash inflows Profitability index = PV of Cash outflows 1,16,000 = 1,00,000= 1.1632 Project B Cash Inflows Year PV factors at 15% PV of Cash inflows 1 20,000 0.870 17,400 2 40,000 0.758 30,320 3 20,000 0.658 13,160 PV of cash inflows60,880 Initial cash outlay 50,000 NPV 10,880 PV of Cash inflows Profitability index = PV of Cash outflows 60880 = 50000 = 1.2176


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Project C Cash Inflows Year PV factors at 15% PV of Cash inflows 1 20,000 0.87017,400 2 30,000 0.758 22,740 3 30,000 0.658 19,740 PV of cash inflows 59,880 Initial cash outlay 50,000 NPV 9,880 PV of Cash inflows Profitability index = PV ofCash outflows 59880 = 50000 = 1.1976 Ranking of Project Project NPV Absolute Rank 1 2 3 Profitability Index Absolute 1.1632 1.2176 1.1976 Rank 3 1 2


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A B C 16320 10880 9880


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If the firm has sufficient funds and no capital rationing restriction, then allthe projects can be accepted because all of them have positive NPVs. Let us assume that the firm is forced to resort to capital rationing because the total fund s available for execution of project is only Rs. 1, 00,000. In this case on the basis of NPV Criterion, Project A will be cleared. It incurs an initial cash out lay of Rs. 1,00,000. After allocating Rs.1, 00,000 to project A, left over funds is nil. Therefore, on the basis of NPV criterion other projects i,e B & C ca

nno t be taken up for execution by the firm. It will increase the net wealth ofthe firm by Rs, 16,320. On the other hand on the basis of profitability index, proje ct B and C can be executed with Rs. 1,00,000 because both of the incur individua lly an initial outlay of Rs. 50,000. Therefore, with the execution of projects B and C, increase in net wealth of the firm will be Rs. 10880 + 9880 = Rs.20760. The objective is to maximize NPV per rupees of capital and project shouldbe ra nked on the basis of the profitability index. Funds should be allocated on the b asis ranks assigned by profitability.


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Q6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20,000 per yearfor six years. A substitute B would cost Rs.50,000 and generate net cash flow ofRs.14,000 per year for six years. The required rate of return of both equipments is 11% . Calculate the IRR and NPV for the equipments. Which equipment shouldbe accepted and why? Answer: NPV of Project A Cash inflows 20000 20000 20000 20000 20000 20000 PV factors at 11 % 0.901 0.812 0.731 0.659 0.593 0.535 PV of cash inflows Initial cash out flow NPV PV of cash inflows 18018 16232 14624 13175 1

1869 10693 84611 75000 9611 PV factors at 16 % 0.862 0.743 0.641 0.552 0.476 0.410 PV of cash inflows Initial cash out flow NPV PV of cash inflows 17241 14863 12813 11046 9522 8209 73695 75000 -1305 Years 1 2 3 4 5 6 IRR = Lower rate + NPVat lower rate NPV at lower rate - NPV at higher rate X (different in rate) = 11+ 9611 9611 - (1305) X (16-11) = IRR = 11 15.40% + 4.4 NPV of Project B Cash inflows 14000 14000 14000 14000 14000 14000 PV factors at 11 % 0.901 0.812 0.731 0.659 0.593 0.535 PV of cash inflows Initial cash out flow NPV PV of cash inflows12613 11363 10237 9222 8308 7485 59228 50000 9228 PV factors at 18 % 0.8 47 0.718 0.609 0.516 0.437 0.370 PV of cash inflows Initial cash out flow NPV PV of cash inflows 11864 10055 8521 7221 6120 5186 48966 50000 -1034 Years 1 2 3 4 5 6


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IRR = Lower rate + NPV at lower rate NPV at lower rate - NPV at higher rate X (different in rate) = 11 + 9228 9228 - (1034) X (18-11) = IRR = 11 17.29% + 6.29 Equipment A has positive NPV where as equipment B negative NPV hence equipment Ashould be accepted. ___________________________________________________________________________


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33590551 32935489 file mb0045 financial management solved

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