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MBA-II Semester

Financial Management
MB0045 (Set-1)

Q1. Show the relationship between required rate of return and coupon rate on the value of a bond?
Answer: The relation between the required rate of interest (K d ) and coupon rate on the value of a bond are displayed below. When required rate of interest (K d ) is equal to the coupon rate, the intrinsic value of the bond is equal to its face value.

When required rate of interest (K d ) is greater than the coupon rate, the intrinsic value of the bond is less than its face value.

When required rate of interest (K d ) is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value.

Number of years of maturity:When required rate of interest (K d ) is greater than the coupon rate, the discount on the bond declines as maturity approaches.

When required rate of interest (K d ) is less than the coupon rate, the premium on the bond declines as the maturity increases.

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 (K d , n) + F*PVIF (K d , n) = 11*PVIFA (13%, 7) + 100*PVIF (13%, 7) = 11*4.423 + 100*0.425 = 48.65 + 42.50 = Rs.91.15

Financial Management 521143716

SMU Roll No.

MBA-II Semester

After 1 year, the maturity period is 6 years, the value of the bond is V0 = I*PVIFA (K d , n) + F*PVIF (K d , 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 K d is 8%, V0 = I*PVIFA (K d , n) + F*PVIF (K d , 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 K d at 8%, V0 = I*PVIFA (K d , n) + F*PVIF (K d , 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

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Q2. What do you understand by operating cycle?


Answer: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 synchronization 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. Operating cycle IC period RC period = IC period + RC period = Inventory conversion period = Receivables conversion period

Inventory conversion period is the average length of time required to produce and sell the product. Inventory Conversion period = (Average Inventory * 365) / Annual Cost of goods sold Receivables conversion period is the average length of time required to convert the firms receivables into cash. Receivables conversion period = Average Accounts Receivables *365 / Annual Sales Accounts payables period is also known as payables deferral period.
Financial Management 521143716 SMU Roll No.

MBA-II Semester

Accounts payables period = Average Creditors / Purchases per day (Payables deferral period) Purchases per day = Total Purchases for year / 365 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

Q3. What is the implication of operating leverage for a firm?


Answer: Operating leverage is associated with the asset purchase activities, while financial leverage is associated with the financial activities. However, combined leverage is the combination of operating leverage and the financial leverage. Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorized into three main sections as shown in figure fixed costs, variable costs and semi-variable costs.

Classification of operating 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 enterprise is planning to start a new business. The

Financial Management 521143716

SMU Roll No.

MBA-II Semester

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. As operating leverage can be favorable or unfavorable, 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. The applications of operating leverage are as follows: Business Rick 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
Financial Management 521143716 SMU Roll No.

MBA-II Semester

planning A change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing 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.

Q4. Explain the factors affecting Financial Plan?


Answer: Factors affecting Financial 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
Financial Management 521143716 SMU Roll No.

MBA-II Semester

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 utilisation 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 globalization 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.

Q5. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%?
Answer: Amount deposit/invested at the end of every year for n years= A = Rs 30000 Time horizon or no. of years= n = 20 years Rate of interest = i = 9% p.a

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Value of PF amount at end of 20 years= = A * FVIFA(i,n) where FVIFA(i,n) = {(1+i)n -1}/i} = 30000 * FVIFA (9%, 20Y) = 30000 * 51.160 = Rs. 1534800

Q6. Mr. Anant purchases a bond whose face value is Rs.1000, and which has a nominal interest rate of 8%. The maturity period is 5 years. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond?

Answer:

Interest payable= 100*8% = Rs. 8 Principal repayment = Rs. 1000 Required rate of return = 10% Therefore, Value of the bond = 8*PVIFA(10%,5y)+1000*PVIF(10%,5y) = 924.28

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Financial Management
MB0045 (Set-2)
Q1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40%?
Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

Answer: Equity = Rs.10lakhs, Cost of capital = 18% Debt = Rs.5lakhs, Cost of debt = 13% Total = Rs 15 lakh Tax rate as 10 / 15 = 0.67 Ke = 18% = 0.18 Wd = 5/15 = 0.33 Kd = I (1-T) WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = 0.67*.18 + 0 + 0 +0.33*13(1-.40) + 0 = 0.146 or 14.6% = 40% We =

Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL?

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Details of ABC Ltd.


Output Fixed costs Variable cost Interest on borrowed funds Selling price per unit 20,000 units Rs.3,500 Rs.0.05 per unit Nil 0.20

Answer:

DFL = Q(S-V) / [Q(S-V) F I {Dp/(1-T)}] = 20000(0.20 0.05) / [20000(0.20 0.05) 0 0 0] = 3000 / 3000 =1

Two companies are identical in all respects except in the debt equity profile.
Q3.

Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach?
Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Answer: S= 1000,000/.22 =4545454.5 B=25, 00,000 =K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15%

Financial Management 521143716

SMU Roll No.

MBA-II Semester

V = 5000000/0.1915 = 26,109,660.57

Q4. Examine the importance of capital budgeting?


Answer: -

Importance of Capital Budgeting:Capital budgeting decisions are the most important decisions in corporate financial management. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area

Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act. Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in

Financial Management 521143716

SMU Roll No.

MBA-II Semester

packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions.

Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders.The best example is the Reliance Group.

Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.

Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors.

Long time investments of the funds sometimes may change the risk profile of the firm.

Capital budgeting is significant for the following reasons:The decision-maker loses some of his flexibility, for the results continue over an extended period of time. He has to make a commitment for the future.
1. 2. 3. 4. 5. 6.

Asset expansion is related to future sales The availability of capital assets has to be phased properly Asset expansion typically involves the allocation of substantial amounts of funds Many firms fail, because they have too much or too little capital equipment

Decision relating to capital investment is among the difficult and, at the same time, a most critical a management has to make. These decisions require an assessment of the future events which are uncertain. The most important reason for capital budgeting decision is that they have long-term implications for a firm. The effects of a capital budgeting decision extend into the future and have to be put up with for a longer period than the consequences of current operating expenditures.
7.

Capital budgeting is an important function of management because it is one of the critical determinants of success or failure of the company. Ill-advised or excessive capital spending may create excessive capacity and increase operating costs, limit the viability of company funds and reduce its profit earning capacity.
8.

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Q5. Briefly explain the process of capital rationing?


Answer: The following are the steps involved in capital rationing. Ranking of different investment proposals Selection of the most profitable investment proposal

Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Net present value method recognizes the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present values of all the cash flows. Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value 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. IRR can be determined by solving the following equation for

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Selection of the most profitable investment proposal After ranking the different investment proposals based on their net present value, profitability index and the internal rate of return, the selection of the most profitable investment proposal is to be done. The selection is done mainly in a view to select the investment proposal which earns more profits than compared to the other proposals. The basic features to be taken under consideration during the selection of the most profitable investment proposal are: The proposal should have the potentiality of making large anticipated profits The proposal should involve high degree of risk

The proposal should involve a relatively long time-period between the initial outlay and the anticipated return Evaluation of the selection procedure PI rule of selecting projects under capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of a single large project Capital rationing also suffers from the multiperiod capital constraints

Q6. Explain the concepts of working capital?


Answer:

Concepts of Working Capital


The four most important concepts of working capital are Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Financial Management 521143716

SMU Roll No.

MBA-II Semester

Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance. Management of current assets is the crucial aspect of working capital management Gross working capital helps in the fixation of various areas of financial responsibility

Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms short term solvency is measured through the net working capital position it commands Permanent Working Capital Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.

Financial Management 521143716

SMU Roll No.

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