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Sikkim Manipal University

Eduway Academy (CBD Belapur Navi Mumbai)

Center code : 01736

Course : MBA Semester II

Subject : Financial Management

Subject code : MB0029

Assignment : Set 1

Name : Ms. Snehita Chatterjee

Roll no. : 520962550


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ASSIGNMENTS- MBA Semester II

Subject code: MB0029

(4 credits)

Set 1

Marks 60

Subject Name: Financial Management

Q.1. Why wealth maximization is superior to profit maximization in todays context? Justify your

answer. [Marks 10]

Ans. Following are the reasons why wealth maximization is superior to profit maximization in todays

context:

1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it 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. Theserisks are adequately considered when present values of cash flows are taken to arrive at the net present

value of any project.

3. In todays competitive business scenario corporate play a key role. In company form of organization,

shareholders own the company but the management of the company rests with the board of directors.

Directors are elected by shareholders 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 markets effectively for their capital requirements. Therefore to

keep the investors happy through the performance of value of shares in the market, management of the

company must meet the wealth maximization criterion.

4. When a firm follows wealth maximization goal, it achieves maximization of market value of share.

When a firm practices wealth maximization goal, it is possible only when it produces quality goods at low

cost. On this account society gains because of the societal welfare.


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5. Maximization 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 will bring to the market

the products and services that consumers need.

6. Another notable features of the firms committed to the maximization of wealth is that to achieve thisgoal they are forced to render efficient service to their customers with courtesy. This enhances consumer

welfare 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 corporate action finds its reflection on the market

value of shares of the company. Therefore, shareholders wealth maximization could be considered a

superior goal compared to profit maximization.

8. 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

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

Therefore, we can conclude that maximization of wealth is the appropriate of goal of financial

management in todays context.

Q.2. 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 will 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? [Marks 10]

Ans.

Present Value(PV) =80000/-

Amount (A) =?

Interest Rat e(I) =10%

No. of Year(N) =10


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PVAn = A {1+i)n-1} /{ i(1+i)n}

80000=A{1+.10)10 }/{.10(1+.10)10}

80000=A{ 1.593742/0.259374}

A =80000/ 6.144567

A = 13019.63 Yrly

Therefore, 13019.63 Yrly will be his annual withdrawal.

Q.3. What factors affect financial plan? [Marks 10]

Ans.Factors Affecting Financial Plan

1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour intensive

industry. This will have a major impact on the total assets that the firm owns.

2. 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.

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 terms for implementing new projects to exploit the new opportunities

emerging from changing business environment.

4. 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


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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 capacity to manage the risk exposure.

5. 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 notlike to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing

preference shares and debentures to outsiders.

6. 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 investment. To finance fluctuating working capital needs, the firm

resorts to short terms finance. All fixed asset investments are to be financed by long term sources. It is a

cardinal principle of financial planning.

7. Flexibility: The financial plan of a company should possess flexibility so as to effect changes in the

composition of capital structure when ever need arises. If the capital structure of a company is flexible, it

will not face any difficulty in changing the sources of funds. This factor has become a significant one

today because of the globalization of capital market.

8. 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.4. 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 the bond? (b) If you purchase the

bond for Rs.904.98, what interest rate will you earn from this investment? [Marks 10]

Ans. a. Bond value maturity = 1000

Market interest rate = 8%

Period of maturity = 1 Yrs.

Value of bond = Maturity values

1 + rate of return

= 1000 d

1 + 0.08


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= 926

Pay for the bond = 926

b. Purchase price of bond = 904.98

Maturity value = 1000

Interest earning = Maturity value - Purchase price of bond

= 1000 - 904.98

= 95.02

Rate of interest = Interestmm d x 100

Current prise of bond

= 95.02m x 100

904.98= 10.50%

Interest rate earn from this investment = 10.50%

Q.5. 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 31st 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 million. The

management of the company wants to improve profitability further. The required rate of return of

the company is 14 percent.

The company is currently considering an investment proposal. One is to expand its manufacturing

capacity. The estimated cost of the new equipment is Rs.250 million. It is expected to have an

economic life of 10 years. The accountant forecasts that net cash inflows would be Rs.45 million per

annum for the first three years, Rs.68 million per annum from year four to year eight and for the

remaining two years Rs.30million per annum. The plant can be sold for Rs.55 million at the end of

its economic life.


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The company would need to raise debt to the extent of Rs.200 million. The company has the

following options of borrowing Rs.200 million:

a. The company can borrow funds from a nationalized bank at the interest rate of 14

percent for 10 years. It will be required to pay equal annual installment of interest and repaymentof principal.

b. A financial institution has offered to lend money to DHPL 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 capacity? Show the computation of NPV

2. What is the annual installment of bank loan?

3. Calculate the quarterly installments of the Financial Institution loan

4. Should the company borrow from the bank or from the financial institution?

[Marks 20]

Ans. 1. Investment in New Equipment : 250000000

Life of machine : 10 Years

Salvage : 55000000

Years Cash inflows PV factors at 14 % PV of cash inflows

1 45,000,000 0.877 39,473,684

2 45,000,000 0.769 34,626,039

3 45,000,000 0.675 30,373,718

4 68,000,000 0.592 40,261,459

5 68,000,000 0.519 35,317,069

6 68,000,000 0.456 30,979,885

7 68,000,000 0.400 27,175,338

8 68,000,000 0.351 23,838,016

9 30,000,000 0.308 9,225,238

10 30,000,000 0.270 8,092,314

Salvage 55,000,000 0.270 14,835,910

PV of cash inflows 294,198,670

Initial cash out flow 250,000,000

NPV 44,198,670


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Here NPV is positive it is advisable to the company to expand its capacity.

2. Loan Amount : 200000000

Interest rate : 14 %

No of Year(N) : 10 Years

Installment X PVIFA (14%,10) = 20,00,00,000

Installment = 20,00,00,000 / 5.216

= 3,83,43,558

3. Loan Amount : 20,00,00,000

Interest rate : 13.5 %

No of Year(N) Quarterly : 10 Years

Installment X PVIFA (13.5% / 4, 40) = 20,00,00,000

Installment = 20,00,00,000 / 5.176

= 3,86,39,876

4. Should the company borrow from the bank because payback by the company less then financial

institution.


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Sikkim Manipal University

Eduway Academy (CBD Belapur Navi Mumbai)

Center code : 01736

Course : MBA Semester II

Subject : Financial Management

Subject code : MB0029

Assignment : Set 2

Name : Ms. Snehita Chatterjee

Roll no. : 520962550


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ASSIGNMENTS- MBA Semester II

Subject code: MB0029

(3 credits)

Set 2

Marks 60

Subject Name: Financial Management

Q.1. a. What is the cost of retained earnings? [Marks 3]

Ans.Cost of Retained Earnings

A companys earnings can be reinvested in full to fuel the ever-increasing demand of companys fund

requirements or they may be paid off to equity holders in full or they may be partly held back and

invested and partly paid off. These decisions are taken keeping in mind the companys growth stages.

High growth companies may reinvest the entire earnings to grow more, companies with no growth

opportunities return the funds earned to their owners and companies with constant growth invest a little

and return the rest. Shareholders of companies with high growth prospects utilizing funds for

reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of

retained earnings is the same as the cost of shareholders expected return from the firms ordinary shares.

That is, Kr = Ke.

Q.1. 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 maturity. 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 time is Rs.2.2 million? [Marks 7]

Ans.

(F+P)/2


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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 debenture,

N is maturity period

13.5(0.52) + (1.8)/ 13.5*.48+2/7

6.51

(2+1.8)/2 1.9

=3.43

(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4

(2+2.2)/2 2.1

=6.43/.21=3.06

Q.2. 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 company are given below: [Marks 10]

Items Rs. In crore

Net worth 152.31

Borrowing 165.47

EBIT 43.17

Interest 34.39

Fixed cost (excluding interest) 118.23


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You are required to calculate:

a. Debt equity ratio

b. Operating leverage

c. Financial leverage

d. Combined leverage. Interpret your results and comment on the Volgas debt policy.

Ans.

a. Debt equity ratio=Borrowing/Interest

=165.47/34.39

=4.81

b. Operating leverage DOL=Q(S-V)/Q(S-V)-F where F= fixed cost

Now EBIT=Q(S-V)-F

So Q(S-V) =EBIT+F

= 43.17+118.23

=161.47

So DOL=161.47/43.17=3.74

c. Financial leverage DFL=EBIT/{EBIT-I-{Dp/(1-T)}}

Where I is interest, Dp is dividend on preference shares; T is tax rate

= 4.92


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d. Combined leverage= DOL*DFL= 3.74*4.92

=18.4

As combined leverage is high so it is risky.

Q.3. Explain Miller and Modigliani Approach to capital structure theory. [Marks 10]

Ans.Miller and Modigliani Model

The MM hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the

share prices of the firm. This model advocates that it is the investment policy through which the firm can

increase its share value and hence this should be given more importance.

Assumptions

Existence of perfect capital markets: All investors are rational and have access to all information free

of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single

investor is large enough to influence the share value.

No taxes: There are no taxes, implying there is no difference between capital gains and dividends.

Constant investment policy: The investment policy of the company does not change. The implication

is that there is no change in the business risk position and the rate of return.

No Risk Certainty about future investments, dividends and profits of the firm. This assumption

was, however, dropped at a later stage.

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the

crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions

which are entered into simultaneously. The two transactions are paying out dividends and raising external

funds to finance additional investment programs. If the firm pays out dividend, it will have to raise capital

by selling new shares for financing activities. The arbitrage process will neutralize the increase in share


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value (due to dividends) with the issue of new shares. This makes the investor indifferent to dividend

earnings and capital gains as the share value is more dependent on the future earnings of the firm than on

its current dividend policy.

Symbolically, the model is given as:

Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price

at the end of the period.

P0 = 1 x (D1 + P1)

(1+Ke)

Where P0 is the current market price,

P1 is market price at the end of period 1,

D1 is dividends to be paid at the end of period 1,

Ke is the cost of equity capital.

Step II: Assuming there is no external financing, the value of the firm is:

nP0 = 1 x(nD1 + nP1)

(1+Ke)

Where n is number of shares outstanding.

Step III: If the firms internal sources of financing its investment opportunities fall short of funds

required, new shares are issued at the end of year 1 at price P1. The capitalized value of the dividends to

be received during the period plus the value of the number of shares outstanding is less than the value of

new shares.

nP0 = 1 x(nD1 +(n + n1)P1 n1p1)

(1+Ke)

Firms will have to raise additional capital to fund their investment requirements after utilizing their

retained earnings, that is,

n1P1 = I (E nD1) which can be written as n1P1 = I E + nD1


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Where I is total investment required,

nD1 is total dividends paid,

E is earnings during the period,

(E nD1) is retained earnings.

Step IV: The value of share is thus:

nP0 = 1 x(nD1 + (n + n1) P1 I + E nD1)

(1+Ke)

Example:

A company has a capitalization rate of 10%. It currently has outstanding shares worth 25000 shares

selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current

financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs.

600000 to fund its investment requirement. Show that under MM model, the dividend payment does not

affect the value of the firm.

Solution:

Case I: When dividends are paid:

Step I:P0 = 1 x (D1 + P1)(1+Ke)

100 = 1/(1+0.1) x (4 + P1)

P1 = Rs. 106

Step II: n1P1 = I (E nD1), nD1 is 25000*4

n1P1 = 600000 (400000 100000) = Rs. 300000

Step III: Number of additional shares to be issued

300000/106 = 2831 shares


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Step IV: The firm value

nP0 = (n+n1) P1-I+E

(1+Ke)

= (25000+2831) x 106600000+400000(1+Ke)

equals Rs. 2500000

Case II: When dividends are not paid:

Step I:P0 = 1 x (D1 + P1)(1+Ke)

100 = 1/(1+0.1) * (0 + P1)

P1 = Rs. 110

Step II: n1P1 = I (E nD1), nD1 is 25000*4

n1P1 = 600000 (400000 0) = Rs. 200000

Step III: Number of additional shares to be issued

200000/110 = 1819 shares

Step IV: The firm value

nP0 = (n+n1) P1-I+E

(1+Ke)

= (25000+2831) x 106600000+400000

(1+0.1)

equals Rs. 2500000

Thus, the value of the firm remains the same in both the cases whether or not dividends are declared.


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Critical Analysis of MM Hypothesis:

Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation costs

refer to the cost involved in raising capital from the market, that is, the costs incurred towards

underwriting commission, brokerage and other costs. These costs ordinarily account to around 10%-15%of the total issue and they cannot be ignored given the enormity of these costs. The presence of these costs

affects the balancing nature of retained earnings and external financing. External financing is definitely

costlier than retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are

12%, the net proceeds are only Rs. 88.

Transaction costs: This is another assumption made by MM that there are no transaction costs like

brokerage involved in capital market. These are the costs associated with sale of securities by investors.

This theory implies that if the company does not pay dividends, the investors desirous of current income

sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities

involves cost, investors wishing to get current income should sell higher number of shares to get the

income they are to receive.

Under-pricing of shares: If the company has to raise funds from the market, it should sell shares at a

price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices,

the firm should sell more shares to replace the dividend amount.

Market conditions: If the market conditions are bad and the firm has some lucrative opportunities, it is

not worth-approaching new investors at this juncture, given the presence of floatation costs. In such cases,

the firms should depend on retained earnings and low pay-out ratio to fuel such opportunities.

Q.4. How to estimate cash flows? What are the components of incremental cash flows?

Ans. Estimation of Cash flows: Estimating the cash flows associated with the project under

consideration is the most difficult and crucial step in the evaluation of an investment proposal. It is the

result of the team work of many professionals in an organization.

1. Capital outlays are estimated by engineering departments after examining all aspects of production

process.


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2. Marketing department on the basis of market survey forecasts the expected sales revenue during the

period of accrual of benefits from project executions.

3. Operating costs are estimated by cost accountants and production engineers

4. Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of

the details generated in the above steps. The ability of the firm to forecast the cash flows with reasonable

accuracy lies at the root of the success of the implementation of any capital expenditure decision.

Investment (Capital budgeting) decision required the estimation of incremental cash flow stream over the

life of the investment. Incremental cash flows are estimated on after tax basis.

Incremental cash flows stream of a capital expenditure decision has three components.

1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is determined after

considering any post tax cash inflows if any, In replacement decisions existing old machinery is disposed

of and a new machinery incorporating the latest technology is installed in its place. On disposal of

existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis.

The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on

disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow.

Additional net working capital required on implementation 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 (project). Operating cash inflows constitute a stream of inflows and outflows over the life of

the project. Here also incremental inflows and outflows attributable to operating activities are considered.

Any savings in cost on installation of a new machinery in the place of the old machinery will have to be

accounted to on post tax basis. In this connection incremental cash flows refer to the change in cash flows

on implementation of a new proposal over the existing positions.

3. Terminal Cash inflows: At the end of the economic life of the project, the operating assets installed

now will be disposed off. It is normally known as salvage value of equipments. This terminal cash

inflows are computed on post tax basis.


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Profitability index = PV of Cash inflowsm

PV of Cash outflow

= 116320 = 1.1632

100000

Project B

Year Cash in flows PV factor at 15% PV ofCash in flows

1 20,000 0.870 17,400

2 40,000 0.756 30,240

3 20,000 0.658 13,160

PV of Cash inflow 60,800

Initial Cash out lay 50,000

NPV 10,800

Profitability index = 60800 = 1.216

50000

Project C

Year Cash in flows PV factor at 15% PV of Cash in flows

1 20,000 0.870 17,400

2 30,000 0.756 22,680

3 30,000 0.658 19,740

PV of Cash inflow 59,820

Initial Cash out lay 50,000

NPV 9,820

Profitability index = 59820 = 1.1964

50000


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Q.6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per year for six years. A

substitute equipment B would cost Rs.50,000 and generate net cash flow of Rs.14,000 per year for

six years. The required rate of return of both equipments is 11 per cent. Calculate the IRR and

NPV for the equipments. Which equipment should be accepted and why? [Marks 10]

Ans. For equipment A average cash flow Rs. 20000/- per year

And the initial investment Rs. 75000/-

So the ratio of initial cash flow & initial investment =75000/20000

=3.75

From the PVIFA table for 6 years annuity factor vary near 3.75

is 16%

So PV of cash flow at 16% is 73600/-

For next trial rate 15% so PV of cash flow is 75706

So IRR of the for the equipment A is 16+ (75706-75000)/ (75706-73600)

=16.34%

For equipment B average cash flow Rs. 14000/- per year

And the initial investment Rs. 50000/-

So the ratio of initial cash flow & initial investment=50000/14000

=3.57

From the PVIFA table for 6 years annuity factor vary near 3.75 is 18%

So PV of cash flow at 18% is 49000/-

For next trial rate 17% so PV of cash flow is 50257/-


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So IRR of the for the equipment A is 18+ (50257-50000)/ (50257-49000)

=18.2%

Now NPV of equipment A = PV of net cash flow initial cost

= (20000/- of PVIF 11% for 6 y)-75000/-

=9610/-

& NPV for the equipment B= PV of net cash flow-initial cost

= (14000/- of PVIF 11% for 6 y)-50000/-

=9227/-

So B is preferable because of highest rate of Profitability index.

finan mgt done

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