DRIVE- SPRING 2014

PROGRAM- MBA
SEMESTER- II
MB0045 - FINANCIAL MANAGEMENT

Q1. When a firm follows wealth maximization goal, it achieves maximization of market value of a
share. Do you agree? Substantiate your arguments.
(Explain Wealth maximization) 10 marks
Answer.
Wealth maximization
Maximization of economic welfare means maximisation of wealth of its shareholders. Shareholders
wealth maximisation is reflected in the market value of the firms shares. Experts believe that, the goal of
financial management is attained when it maximises the market value of shares.

Wealth maximisation is also known as value maximisation or net present worth maximisation. This
objective is an universally accepted concept in the field of business. Wealth maximisation 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 maximisation. to keep the
investors happy throughout the performance of value of shares in the market, management of the
company must meet the wealth maximization criterion.

When a firm follows wealth maximisation goal, it achieves maximization of market value of
share. A firm can practice wealth maximisation goal only when it produces quality goods at low
cost. On this account, society gains because of the societal welfare. Maximisation 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 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 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 maximisation.

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

Therefore, we can conclude that maximisation 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 maximisation as a goal, in a way, leads to wealth maximisation.

Q2. A) If you deposit Rs 10000 today in a bank that offers 8% interest, how many years will the
amount take to double?
(Problem) 5 marks
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?
(Problem) 5 marks

Solution.
A)

Given,

Principal amount=10000
Interest Rate= 8%
Accumulated amount=2*(Principal amount)
Time=?

We know that

Accumulated amount=principal amount[1+Rate/100]n

20000=10000[1+8/100]n
20000/10000= [1+8/100]n

2=[1+8/100]n

2=[1.08]n

Take the log of both sides:

log[2] = n*log[1.08]
Divide by log[1.08]:
log[2]/log[1.08] = n
30103/.033424 = n = 9.01 years
So it will take only 9.01 years to double the principal amount.

B) If we deposit Rs 10000 today in a bank that offers 8% interest, then years will the amount take to
double are:

FVAn = A * FVIFA (12%,5yrs)

= 1*FVIFA (12%, 5y)
= 1*6.353
= Rs. 6.353

Q3. 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 the capital structure) 10 marks
Answer.
Relation between Financial leverage and the capital structure

Financial leverage refers to a firm's 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.

Thus, financial leverage refers to the mix of debt and equity in the capital structure of the firm. This
results from the presence of fixed financial charges in the companys income stream. Such expenses have
nothing to do with the firms performance and earnings and should be paid off regardless of the amount of
EBIT.

It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS.
It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company
earning more by the use of assets funded by fixed sources is said to be having a favorable or positive
leverage. Unfavorable leverage occurs when the firm is not earning sufficiently to cover the cost of funds.
Financial leverage is also referred to as trading on equity. Thus, the effect of financial leverage is also
measured through another variable, viz, EPS. This is done in the case of joint stock companies which
have raised their proprietary capital by selling units of such capital known as equity shares. EPS is
obtained by dividing earnings (after interest and taxes) by total equity. If a company has preference shares
also on its capital structure, net equity earnings will be arrived at after deducting interest, taxes, and
preference dividends.

Capital structure refers to the permanent long-term financing of a company represented by a mix of
long-term debt, preference shares, and net worth (which included paid-up capital, reserves, and surplus).
Financial leverage and its effects are a crucial consideration in planning and designing capital structures.

Q4. A project requires an initial outlay of Rs. 1, 00,000. It is expected to generate the cash inflows
shown in table

What is the IRR of the project?

(Compute IRR) 10 marks
Answer.

Internal rate of return (IRR)

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any project equal to
zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows. IRR
is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital,
rate of return and time adjusted rate of return. IRR is the rate of return that a project earns.

Solution:
Step 1

The average of annual cash inflows is computed as shown in table:

Year

Cash inflows

50000

50000

30000

40000

Total

170000

Average=170000/4
Rs. 42500/-

Q5. Below Table gives the complete details of sales and costs of the goods produced by XYZ ltd for
the year 31.03.12.

What is the length of the operating cycle? What is the cash cycle?
Assume 365 days in a year.
a) length of the operating cycle
b) cash cycle
(length of the operating cycle, cash cycle) 5,5 marks
Answer.

length of the operating cycle and cash cycle

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=

( 9000+ 12000) /2
Average inventory
x 365
x 365
Annual cost of goods sold
56000

10500 x 365
=68.4 days
56000

Receivable conversion period=

Average account receivables

x 365
Annual sales

(12000+16000)/2 x 365
=63.9 days
8000

Payablesconversion period=

(7000+10000)/2 x 365
56000

8500 x 365
=55.4 days
56000

Average account paybles

x 365
Annual cost of goods sold

Operating Cycle = ICP + RCP

= 68.4 + 63.9 = 132.3 days
Cash Conversion Cycle= OC PDP
= 132.3 55.4 = 76.9 days

Q6. 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.
(Walters model assumptions) 10 marks
Answer.

Walters model assumptions

Prof. James E. Walter considers that dividend pay-outs are relevant and have a bearing on the share prices
of the firm. He further states that investment policies of a firm cannot be separated from its dividend
policy and both are inter-linked. The choice of an appropriate dividend policy affects the value of the
firm. 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 can be studied with the relationship between r and k.

If r>k, the firms earnings can be retained, as the firm has better and profitable investment
opportunities and the firm can earn more than what the shareholders could earn by re-investing, if
earnings are distributed. Firms which have r>k are called growth firms and such firms should

have a zero pay-out ratio.

If r<k, the firm should have a 100% pay-out ratio as the investors have better investment

opportunities than the firm. Such a policy will maximize the firm value.
If r = k, the firms dividend policy will have no impact on the firms value. The dividend pay-outs
can range between zero and 100% and the firm value will remain constant in all cases. Such firms

are called normal

firms. Figure depicts the assumptions on which the Walters model is based.

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

Financing All financing is done through retained earnings. Retained earnings is the only source

of finance, available and the firm does not use any external source of funds like debt or equity.
Constant rate of return and cost of capital The firms r and k remain constant and any

additional investment made by the firm will not change the risk and return profile.
100% pay-out or retention All earnings are either completely distributed or immediately re-

invested.
Constant EPS and DPS The earnings and dividends do not change and are assumed to be

constant forever.
Life The firm has a perpetual 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.