assignment - mb0045 - financial management-ans

Summer 2011- May drive

Masters of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks.Answer all the questions.

1. A company has issued a bond with face value of Rs.1000 , with 10% pa coupon rate payable annually and a tenure of 10 years to maturity. At the end of 10 years, the bond will be redeemed at a premium of 10% to face value .

a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk?

b) What is the YTM of the bond if the prevailing price is same as calculated in a) above.c) What is the current yield of the bond at the given price?d) If the coupon rate is paid semi-annually, at what price would you buy the bond at the

12% pa prevailing interest rate?

a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk?

Solution: Interest payable = 1000*10% = Rs. 100

Principal repayment is Rs. 1000Required rate of return is 12%V0=I*PVIFA(Kd, n) + F*PVIF(Kd, n)Therefore,Value of bond= 100*PVIFA (12%, 10yrs) + 1000*PVIF (12%, 10yrs)= 100*5.6502 + 1000*0.3220= 565.02 + 322= Rs. 887.02

b) What is the YTM of the bond if the prevailing price is same as calculated in a) above.

Solution:YTM = {I + (F – P) / n} / { (F – P) / 2 }= 100 + {(1000 – 887.02) / 10 / {(1000 + 887.02) / 2}= {100 + 11.298} / 943.51= 0.1179 or 11.79%

c) What is the current yield of the bond at the given price?

Solution:Current Yield (“CY”) = Coupon Interest / Current Market Price


CY = Coupon Interest / Current Market Price= 100 / 887.02 = 0.112 or 11.2%

e) If the coupon rate is paid semi-annually, at what price would you buy the bond at the 12% pa prevailing interest rate?

Solution: V0 or P0 = ∑n

t=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n

= (100/2) / (1 +0.12/2)10 + 1000 / (1 + 0.12/2)10

= 50*PVIF (6%, 20yrs) + 1000*PVIF (6%, 20yrs)= 50*11.470 + 1000*0.312= 573.5 + 312= Rs. 885.50

2. Given the following details for a company:

Net operating income 200,000Overall cost of capital 20%Value of the firm 1000,000Cost of debt 15%Interest 75,000Market value of debt 500,000Market value of equity 500,000

a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000.

b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000.

a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000.

Solution:The equity capitalization rates areKe = K0+[ (K0 – Kd)(B/S)] = 0.20 + [ (0.20 – 0.15) (2.5) ] = 0.325 = 32.5%b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000.Solution:Cost of capitalK0 = [B/ (B+S)]Kd + [S/(B+S)]Ke

= [500,000 / (500,000 + 200,000)] 15% + 200,000 / (500,000 + 200, 000)] 32.5% = 0.107 + 0.092 = 0.199= 19.9%


3. Given the following projects , rank them on the basis of NPV, MIRR and Payback period if the cost of capital is 10% pa.

Project A Project B Project C

Year Cash flow Year Cash flow Year Cash flow0 -10000 0 -10000 0 -100001 5000 1 5000 1 50002 7000 2 8000 2 85003 8000 3 6500 3 90004 15000 4 11000 4 12000

Solution:Computation of NPV

Project AYear Cash in flows PV factor at 10% PV of Cash in flows

1 5000 0.909 45452 7000 1.736 121523 8000 2.487 198964 15000 3.17 47550

PV of Cash inflow 84143Initial cash outlay 10000

NPV 74143

Project BYear Cash in flows PV factor at 10% PV of Cash in flows

1 5000 0.909 45452 8000 1.736 138883 6500 2.487 16165.54 11000 3.17 34870

PV of Cash inflow 69468.5Initial cash outlay 10000NPV 59468.5

Project CYear Cash in flows PV factor at 10% PV of Cash in flows

1 5000 0.909 45452 8500 1.736 147563 9000 2.487 223834 12000 3.17 38040

PV of Cash inflow 79724Initial cash outlay 10000

NPV 69724Computation of Payback Period

Year Project A Project B Project C


Cash Flow Cumulative Cash Flows



1 5000 5000 5000 5000 5000 50002 7000 12000 8000 13000 8500 135003 8000 20000 6500 19500 9000 225004 15000 35000 11000 30500 12000 34500

From the cumulative cash flow the initial cash outlay of Rs. 10000 lies between 1st year and 2nd year in respect of project A, project B and project C.Therefore, payback period for project A is1+ 10000 – 5000 = 1.4years12152Therefore, payback period for project B is1+ 10000 – 5000 = 1.36years13188Therefore, payback period for project C is1+ 10000 – 5000 = 1.3years14756

Ranking of Projects

Project NPV Payback PeriodAbsolute Rank Absolute Rank

A 74143.00 2 1.4 1B 59468.50 3 1.36 2C 79724.00 1 1.3 3

4. Given the following information, calculate Degree of operating leverage, Degree of Financial leverage, Degree of total leverage.

Quantity sold 100,000 unitsVariable cost per unit 200Selling price 800Fixed cost 10,000Number of equity shares 50,000Debt 1000,000 @ 15%paPreference shares 10,000 of Rs.100 each @ 10%Tax rate 30%

Quantity sold 100,000 unitsVariable cost per unit 200Selling price 800Fixed cost 10,000Number of equity shares 50,000Debt 1000,000 @ 15%pa


Preference shares 10,000 of Rs.100 each @ 10%Tax rate 30%Solution:To Find out Degree of Operating LeverageDOL = {Q(S–V)} / {Q(S–V)–F} = {100,000 (800 – 200)} / 100,000 (800 – 200) – 10,000 = 60,000,000 / 59,990,000 = 1.00016To Find out Degree of Financial LeverageDFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}} = 59,990,000 ÷ {59,990,000 – 150,000 – {100,000/1-0.30} = 59,990,000 ÷59,697,142.86 = 1.0049To Find out Degree of Total Leverage DTL = DOL*DFL = 1.00016*1.0049 = 1.0050DTL = Q(S – V) / Q(S – V) – F – I – {DP / (1 – T)}= 60,000,000 / 60,000,000 – 10,000 – 150,000 – {100,000/0.7}= 1.0050

5. Explain the following concepts :a) Operating cycleb) Total inventory costc) Price earnings ratiod) Financial risk

Operating CycleThe time gap between acquisition of resources and collection of cash from customers is known as the operating cycleOperating 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.Total Inventory CostTotal Inventory cost is the total cost associated with ordering and carrying inventory, not including the actual cost of the inventory itself. It is important for companies to understand what factors


influence the total cost they pay, so as to be able to minimize it. Use the total inventory cost calculator below to solve the formula.Total Inventory Cost DefinitionTotal Inventory Cost is the sum of the carrying cost and the ordering cost of inventory.VariablesC=Carrying cost per unit per yearQ=Quantity of each orderF=Fixed cost per orderD=Demand in units per yearTotal Inventory Cost Formula : Price Earnings RatioThe price earnings ratio reflects the amount investors are willing to pay for each rupee of earnings.Expected earnings per share = (Expected PAT) – (Preference dividend) / Number of outstanding shares.Expected PAT is dependent on a number of factors like sales, gross profit margin, depreciation and interest and tax rate. The price earnings ratio has to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay-out ratio.Where, 1-b is dividend pay-out ratior is required rate of returnROE*b is expected growth rate Financial RiskThe risk that a company will not have adequate cash flow to meet financial obligations. Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity.Financial risk is an umbrella term for any risk associated with any form offinancing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return.Risk related to an investment is often called investment risk. Risk related to a company’s cash flow is called business risk.

6. Explain the Net operating income approach to capital structure theories.

Answer : The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mixany mix is as good as any other.Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

http://en.wikipedia.org/wiki/Finance

http://en.wikipedia.org/wiki/Risk


Features of NOI approach: At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a

given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm – Value of debt

Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.


Masters of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 2 (60 Marks)

Note: Each question carries 10 Marks.Answer all the questions.

1. Given the following information, prepare a cash budget:

Month Sales Purchases Wages Production overheads

Selling overheads

Jan 100000 40000 10000 6000 6000Feb 120000 45000 15000 6500 6500March 150000 35000 18000 7000 6600April 160000 30000 20000 7700 6800May 175000 25000 22000 8000 6200June 200000 20000 24000 8500 6300

The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000.

The company has a opening balance of cash of Rs. 40,000 on 1st Jan 2010. Prepare a cash budget for Jan to June.

Solution: Cash Budget

Jan Feb March April May June

Opening Cash Balance 40000 90000 113000 170000 225900 326400Cash Receipts:Cash Sales 50000 60000 75000 80000 87500 100000Credit Sales 25000 30000 37500 40000 43750

25000 30000 37500 40000Total Cash available 90000 175000 243000 317500 390900 510150Cash Payments:


Materials 40000 45000 35000 30000 25000Wages 10000 15000 18000 20000 22000Production overheads 6000 6500 7000 7700 8000Selling overheads 6000 6500 6600 6800 6200Capital Expenditure 25000Total cash payments 0 62000 73000 91600 64500 61200Closing cash balances 90000 113000 170000 225900 326400

2. Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement.Raw material 60Direct labour 22Overheads 44Total cost 126Profit 18Selling price 140The following additional information is available:Average raw material in stock one monthAverage materials in process 15 daysCredit allowed by suppliers one monthCredit allowed to debtors two monthsTime lag in payment of wages 15 daysTime lag in payment of overheads one monthSales on cash basis 20%Cash balance to be maintained 80,000You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.

Solution:Estimation of Working Capital a) Investment in inventory 1. Raw material = RMC x RMCP 360= 100,000 x 60 x 30360= 500,0002. Work in process inventory = COP x WIPCP 360 = 100,000 x 126 x 15360= 525,000


3. Finished goods inventory = COS x FGCP 360 = 100000 x 126 x 60360= 2,100,000b) Investment in debtors = Cost of credit sales x DCP360= 80,000 x 126 x 60360= 1,680,000c) Cash Balance = 80,000d) Total Current Asset (A+B+C) = 4,885,000e) Current Liabilities 1. Creditors = Purchase of raw materials x PDP360= 100,000 x 60 x 30 / 360 = 500,000Wages = 100,000 x 22 x 15 / 360 =91,6673. Overheads = 100000 x 44 x 30/360 =366,667f) Total Current Liabilities = 958334 Net Working Capital (D – F) = 3,926,666

3. Given the following information, calculate the weighted average cost of capital. Capital structure in millionsEquity capital ( Rs.10 par value) 2 14% preference share capital Rs.100 each 1.5Retained earnings 212% Debentures Rs.100 each 48% term loan 0.5Total 10The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital.

Solution:Step I is to determine the cost of each component.Ke = (D1/P0) + g= (5/45) + 0.15= 0.2611 or 26.11%Kp = [D + {(F-P/n}] / [{F+P/2]= [14+ (215-90)/5] / (215-90)/2= 14+25/62.5 = 0.624 or 62.4%Kr = Ke which is 26.11%Kd = [1(1-T) + (F-P) /n}] / {F+P)/2]


= [12(1-0.3) + (210-90)/5] / (210-90)/2= 8.4+24/60 = 0.54 or 54%Kt = 1(1-T)= 0.8(1-0.3) = 0.56 or 56%Step II is to calculate the weight of each source.We = 2/10 = 0.2Wp = 15/10 = 0.15Wr = 2/10 = 0.2Wd = 4/10 = 0.4Wt = 0.510 = 0.05Step IIIWACC = Weke + Wpkp + Wrk r+ WdKd + WtKt

= (0.2*0.2611) + (0.15*0.624) + (0.2*0.2611) + (0.4*0.54) + (0.05*0.56)= 0.052 + 0.0936 + 0.052 + 0.216 + 0.028= 0.4416 or 44.16%

4. Calculate the present value of the following options:a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pab) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable

semi annuallyc) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pad) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years

Solution:a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present valve = 10, 000*PVIF (10%, 5y) = 10,000*0.621= 6210 The PV of Rs. 10,000 after 5years is Rs. 6210.b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually Present valve = 10, 000*PVIF (5%, 10y) = 10,000*0.614= 6140 The PV of Rs. 10,000 after 5years is Rs. 6140.c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa Present valve = 5, 000*PVIF (10%, 5y) = 5,000*0.621= 3105 The PV of Rs. 5,000 after 5years is Rs. 3105.


d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years Present valve of annuity = 5, 000*PVIF (10%, 5y)= 5,000*0.621= 3105 Present valve of annuity = 10, 000*PVIF (10%, 10y) = 10,000*0.386= 3860The PV of Rs. 5,000 after 5years is Rs. 3105 and PV of Rs. 10,000 after 10years is Rs.3860.

5. Explain each of the following:

a) Operating cycleb) Shareholders wealth maximisationc) Capital rationingd) Economic order quantity

Answer : Operating CycleThe time gap between acquisition of resources and collection of cash from customers is known as the operating cycleOperating 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.Shareholders wealth maximisationWealth maximisation means maximising the net wealth of a company’s shareholders. 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.The following arguments are in support of the superiority of wealth maximisation over profit maximisation

Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.

Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with


the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.Capital RationingFirms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control.Capital rationing may be needed due to:

External factors Internal constraints imposed by management

External capital rationingExternal capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to:

Deficiencies in market information Rigidities that hamper the force flow of capital between firms

When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing:-

The inability of the firm to procure required funds from capital market because the firm does not command the required investor’s confidence

National and international economic factors may make the market highly volatile and unstable

Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds

High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for fundsInternal capital rationingImpositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects.Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared.Generally internal capital rationing is used by a firm as a means of financial control.Economic order quantity (EOQ)Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.EOQ model answers the following key quantum of inventory management.

What should be the quantity ordered for each replenishment of stock? How many orders are to be placed in a year to ensure effective inventory management?

EOQ is defined as the order quantity that minimises the total cost associated with inventory management.EOQ is based on the following assumptions:

Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of

the order size


Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory

Constant ordering cost: Cost per order is constant whatever be the size of the orderInventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

6. a) Discuss the advantages of ordering Economic order quantity of inventory. c) Discuss the Dividend discount model of measuring cost of equity.

Answer : Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.Advantages of ordering Economic order quantity of inventory.

Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of

the order size Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of

inventory Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.Dividend discount model of measuring cost of equityThe Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends.Dividend discount model is a tool that produces a number based on the data provided. The equation can be written aswhereP0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.This equation is also used to estimate cost of capital by solving for rFrom the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; r − g cannot be negative, i.e., r>g. In the short run if g>r, then usually a two stage DDM is used:Therefore,whereg denotes the short-run expected growth rate, denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.

http://en.wikipedia.org/wiki/Cost_of_equity

http://en.wikipedia.org/wiki/Cost_of_capital

http://en.wikipedia.org/wiki/Dividends

http://en.wikipedia.org/wiki/Net_present_value

http://en.wikipedia.org/wiki/Stock

assignment - mb0045 - financial management-ans

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