Master of Business Administration - MBA Semester 2 MB0045 Financial Management - 4 Credits Assignment Set- 1 (60 Marks)

Q.1

What are the 4 finance decisions taken by a finance manager.

Ans:- Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions: Finance decisions Investment decisions Liquidity decisions Dividend decisions Organisation of a finance function

Finance decisions : Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions: Explicit Cost Implicit cost

Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security.

Implicit cost is not a visible cost but it may seriously affect the companys operations especially when it is exposed to business and financial risk In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. An investor in a companys shares has two objectives for investing: Income from capital appreciation (capital gains on sale of shares at market price) Income from dividends

It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements. Investment decisions : To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be: expansion through entering into new markets adding new products to its product mix performing value added activities to enhance customer satisfaction adopting new technology that would drastically reduce the cost of production

rendering services or mass production at low cost or restructuring the organisation to improve productivity

These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation. There are two critical issues to be considered in these decisions. Evaluation of expected profitability of the new investments. Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate or the opportunity cost of capital. Investment decisions are also known as Capital Budgeting Decisions and hence lead to investments in real assets. Dividend decisions : Dividends are pay-outs to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by a finance manager. It is based on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, the management of a company will have to consider the relevance of its policy on bonus shares. The following issues need adequate consideration in deciding on dividend policy: Preferences of share holders Do they want cash dividend or capital gains? Current financial requirements of the company Legal constraints on paying dividends Striking an optimum balance between desires of share holders and the companys funds requirements

Liquidity decision : Liquidity decisions deals with Working Capital Management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities. The important elements of liquidity decisions are: Formulation of inventory policy Policies on receivable management Formulation of cash management strategies Policies on utilisation of spontaneous finance effectively

Q.2

What are the factors that affect the financial plan of a company?

Ans;- Factors affecting Finanical Plan Nature of the industry : The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns. 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 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 Status of the company in the industry : A well established company enjoys 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 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 firms capability to manage the risk exposure.

The capital structure of a company : 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 obtain extra funds for growth by issuing preference shares and debentures to outsiders. 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 the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset investments are to be financed by long term sources, which is a cardinal principle of financial planning. Flexibility : The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market. 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. Q.3 Show the relationship between required rate of return and coupon rate on the value of a bond. Ans:- Bonds are long term debt instruments issued by government agencies or big corporate houses to raise large sums of money. Bonds issued by government agencies are secured and those issued by private sector companies may be secured or unsecured. The rate of interest on bonds is fixed and they are redeemable after a specific period. Let us look at some important terms in bond valuation. Coupon rate is the specified rate of interest in the bond. The interest payable at regular intervals is the product of the par value and the coupon rate broken down to the relevant time horizon. Maturity period refers to the number of years after which the par value becomes payable to the bond-holder. Generally, corporate bonds have a maturity period of 7-10 years and government bonds 20-25 years.

Face value, also known as par value, is the value stated on the face of the bond. It represents the amount that the unit borrows which is to be repaid at the time of maturity, after a certain period of time. A bond is generally issued at values such as Rs. 100 or Rs. 1000. Market value is the price at which the bond is traded in the stock exchange. Market price is the price at which the bonds can be bought and sold and this price may be different from par value and redemption value. Redemption value is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a premium (bond-holder gets more than the par value of the bond) or at a discount (bond-holder gets less than the par value of the bond.

The relation between the required rate of interest (Kd) and the discount rate are displayed below. When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value. When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value. When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value.

Example To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years. If Kd is 13%, then, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 7) + 100*PVIF (13%, 7) = 11*4.423 + 100*0.425 = 48.65 + 42.50 = Rs.91.15 After 1 year, the maturity period is 6 years, the value of the bond is V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 6) + 100*PVIF (13%, 6) = 11* 3.998 + 100*0.480 = 43.98 + 48 = Rs. 91.98.

We see that the discount on the bond gradually decreases and value of the bond increases with the passage of time as required rate of interest (Kd) is higher than the coupon rate. Continuing with the same problem above, let us see the effect on the bond value if the required rate is 8%. If Kd is 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 7) + 100*PVIF (8%, 7) = 11*5.206 + 100*0.583 = 57.27 + 58.3 = Rs. 115.57 One year later, with Kd at 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 6) + 100*PVIF (8%, 6) = 11*4.623 + 100* 0.630 = 50.85 + 63 = Rs. 113.85 For a required rate of return of 8%, the bond value decreases with passage of time and premium on bond declines as maturity approaches.

Q.4

Discuss the implication of financial leverage for a firm.

Ans:- Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories Those which carry a fixed financial charges like debentures, bonds and preference shares and Those which do not carry any fixed charges like equity shares

Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares

is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met. 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 earnings before income and tax (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 favourable or positive leverage. Unfavourable 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. Use of Financial Leverage Studying the degree of financial leverage (DFL) at various levels makes financial decisionmaking, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS). Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.

The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.

Q.5 The cash flows associated with a project are given below: Year Cash flow 0 (100,000) 1 25000 2 40000 3 50000 4 40000 5 30000 Calculate the a) payback period. b) Benefit cost ratio for 10% cost of capital Ans;A ) payback period: The cash flows and the cumulative cash flows of the projects is shown under in table Table cash slows and cumulative cash flows year 1 2 3 4 5 Cash flows (Rs.) 25,000 40,000 50,000 40,000 30,000 Cumulative cash flows 25,000 65,000 115,000 155,000 185,000

From the cumulative cash flows column. A recover the initial cash out tag of Rs. 100000 at the end of the third year. Therefore payback period of project is 2 years. Therefore, payback period 2+ 100,000 - 65,000

50000

2+ 35000 50000 =2.7 years

pay-back period for project is 2.7 years. b) Benefit cost ratio for 10% cost of capital Table: present value (PV) of cash inflows PV of Cash in PV factor at Year Cash in Cumulative flows 10% flows 1 25000 0.909 22725 22725 2 40000 0.826 33040 55765 3 50000 0.751 37550 93315 4 40000 0.683 27320 120635 5 30000 0.621 18630 139265

3 +

100000 - 93315 27320 6685 27320 0.244

3 +

3 +

3.244

Discounted Pay-back period for project is 3.244 years

Q6. A companys earnings and dividends are growing at the rate of 18% pa. The growth rate is expected to continue for 4 years. After 4 years, from year5 onwards, the growth rate will be 6% forever. If the dividend per share last year was Rs.2 and the investors required rate of return is 10% pa, what is the intrinsic price per share or the worth of one share. Ans:n = 4 Years growth = 6 % Ke = 10% required rate of return, D0 = 18 The Present value of this flow of dividends will be pn p4 = = = = = = = (Dn+1)/(ke-g) D5/ ke-g D5(1+gn)ke-g 5(1.25)4+(1+0.05)/0.15-0.08) 15.26 / 0.07 16.48/ 0.07 235.42

The intrinsic price is 235.42

Master of Business Administration - MBA Semester 2 MB0045 Financial Management - 4 Credits Assignment Set- 2 (60 Marks) Q.1 Discuss the objective of profit maximization vs wealth maximization.

Ans:- Wealth maximisation vs. Profit maximisation Let us now see how wealth maximisation is superior to profit maximisation. Wealth maximisation is based on cash flow. It is not based on the accounting profit. Through the process of discounting, wealth maximisation 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. Corporates play a key role in todays competitive business scenario. In an organisation, shareholders typically own the company but the management of the company rests with the board of directors. Directors are elected by shareholders. Company management procures funds for expansion and diversification of capital markets. In the liberalised set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore, to keep the investors happy throughout the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion. When a firm follows wealth maximisation goal, it achieves maximisation 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 corporates 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 consumer needs. Another notable feature 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 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 maximisation could be considered 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 the appropriate goal of financial management in todays context.

Q.2

Explain the Net operating approach to capital structure.

Ans:- As we are aware, equity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and equity in a firms capital structure has to be independently decided case to case. A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value. Assumptions The following are some common assumptions made: The firm has only two sources of funds debt and ordinary shares. There are no taxes both corporate and personal The firms dividend pay-out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero The investment decisions of a company are constant, that is, the firm does not invest any further in its assets The operating profits EBIT are not expected to increase or decrease All investors shall have identical subjective probability distribution of the future expected EBIT A firm can change its capital structure at a short notice without the occurrence of transaction costs The life of the firm is indefinite

Based on the assumptions regarding the capital structure, we derive the following formulae. Debt capital being constant, Kd is the cost of debt which is the discount rate at which the discounted future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I refers to total interest payments and B is the total market value of debt. Therefore value of the debt B = I/Kd Cost of equity capital Ke = (D1/P0) + g one year, P0 is the current market price and

where D1 is dividend after g is the expected growth rate.

Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares. The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 + W2 K2. That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S is the market value of equity and V is the total market value of the firm and can be given as (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt component and Ke being the equity component) which can be expressed as

K0 = I + NI/V or EBIT/V or in other words, net operating income/market value of firm. Net operating income approach (NOI) Net operating income approach is propounded by Durand and is totally opposite of the Net Income Approach. Durand says that any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalisation rate is the same for all degrees of leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke As per the NOI approach the overall capitalisation rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalisation rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is Ke = K0 +[ (K0 Kd)(B/S)]

Q.3

What do you understand by operating cycle.

Ans:- The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold

The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements.

Inventory conversion period is the average length of time required to produce and sell the product.

Receivables conversion period is the average length of time required to convert the firms receivables into cash.

Accounts payables period is also known as payables deferral period.

Accounts payables period = (Payables deferral period)

Purchases per day = Cash conversion cycle is the length of time between the firms actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets. Cash Conversion Cycle is CCC = ICP + RCP PDP CCC = Cash Conversion Cycle ICP = Inventory Conversion Period RCP = Receivables Conversion Period PDP = Payables deferral period

Q.4

What is the implication of operating leverage for a firm.

Ans:- Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorised into three main sections: fixed costs, variable costs and semi-variable costs.

Fixed costs: Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced. For example, consider that a firm named XYZ enterprises is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as fixed costs. Variable costs : Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred. For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as Variable costs, as these costs are not fixed and keep changing depending upon the conditions. Semi-variable costs: Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as Semi-variable costs. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any

time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume. Another way of explaining this phenomenon is examining the effect of the degree of operating leverage (DOL). The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT). DOL = % change in EBIT / % change in output To put in a different way, (EBIT/EBIT) / (Q/Q) EBIT is Q(SV)F Where Q is quantity S is sales V is variable cost F is fixed cost Substituting this we get, {Q(SV)} / {Q(SV)F} As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards. Application of Operating Leverage The applications of operating leverage are as follows: Business risk measurement Production planning

Measurement of business risk : Risk refers to the uncertain conditions in which a company performs. A business risk is measured using the degree of operating leverage (DOL) and the formula of DOL is: DOL = {Q(SV)} / {Q(SV)F} Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa. Production planning : A change in production method increases or decreases DOL. A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

Q.5 A company is considering a capital project with the following information: The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant a machinery and Rs.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million ad the net working capital will be liquidated at par. The project will increase revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project. Ans:Cost of Project 200 Million 150 Million 50 Million Pv factor(10%) 0.909 0.826 0.751 Pv of Cash inflow 181.8 123.9 37.55

Q.6

Given the following information, what will be the price per share using the Walter

model. Earnings per share Rs. 40 Rate of return on investments 18% Rate of return required by shareholders 12% Payout ratio being 40%, 50%, or 60%.

Ans:Walter Mode Formula

D Ke

[r (E-D)/ ke] Ke

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 earning of share = 40, r is IRR = 18 % Dp ratio = 40 %, 50%, 60%

D Ke

[r (E-D)/ ke] Ke

40%

0.4

[0.18 (40-0.4)/0.12)

Ke

0.12

0.4 +[0.18 (40-0.4)/0.12) 0.12

= Rs.498.33

50%

0.5 Ke

[0.18 (40-0.5)/0.12) 0.12

0.5 +[0.18 (40-0.4)/0.12) 0.12

= Rs.497.91

60%

0.6 Ke

[0.18 (40-0.6)/0.12) 0.12

0.6 +[0.18 (40-0.6)/0.12)

0.12 = Rs.497.91