MASTER OF BUSINESS ADMINISTRATION- MBA SEMESTER 2 MB 0045/MBF 201 -FINANCIAL MANAGEMENT - 4 CREDITS (BOOK ID:B1628) ASSIGNMENT SET -1 (60

MARKS)

Note: Assignment Set -1 must be written within 6-8 pages. Answer all questions.

Q1.

What are the goals of financial management?

Ans. There are two versions of the goals of financial management of the firm Profit Maximisation and Wealth Maximisation. (a) Profit maximisation. Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns with the best output and price levels. A firms performance is evaluated in terms of profitability. Profit maximisation is the traditional and narrow approach, which aims at maximising the profit of the concern. Allocation of resources and investors perception of the companys performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts: The concept of profit lacks clarity. What does profit mean? In this sense, profit is neither defined precisely nor correctly. Profit maximisation neither considers the time value of money nor the net present value of the cash inflow. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Profit maximisation as a concept, even though has the above-mentioned drawbacks, is still given importance as profits do matter for any kind of business.

Goals

Profit Maximisation
Financial Management

Wealth Maximisation
Goals of

(b) Wealth maximisation. The term wealth means shareholders wealth or the wealth of the persons those who are involved in the business concern. Wealth maximisation is also known as value maximisation or net present worth maximisation. This objective is an universally accepted concept in the field of business. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. 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. 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. Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flow. Time value factor is known as the time preference rate; that is, the sum of risk free rate and risk premium. Risk free rate is the rate that an investor can earn on any government security for the duration under consideration. Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security. Required rate of return is the return that the investors want for making investment in that sector.

Q2.

Explain the factors affecting Financial Plan.

Ans. The following factors affecting financial plan:(a) Nature of the industry. The first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capitalintensive or labour-intensive industry. This will have a major impact on the total assets that a firm owns. (b) 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. (c) Status of the company in the industry. A well-established company enjoys a good market share, because its products normally command 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. (d) 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. (e) 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. (f) 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. (g) Flexibility. The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever the 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. (h) Government policy. SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA, and Department of Corporate Affairs (government of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statutes in India. They are to be complied with a time constraint.
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Q3.

Explain the time value of money.

Ans.1. Time value of money is the value of a unit of money at different time intervals. The value of the money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has always more value, rational investors would prefer current receipts over future receipts. That is why this phenomenon is referred to as time preference of money. Some important factors contributing to this nature are: (a) (b) (c) Investment opportunities Preference for consumption & Risk

2. These factors remind us of the famous English saying, A bird in hand is worth two in the bush. The question now is: why should money have time value? Some of the reasons are as below:(a) Productivity. Money can be employed productively to generate real returns. For example, if we spend `. 500 on materials, `. 300 on labour, and Rs. 200 on other expenses and the finished product is sold for `. 1100, we can say that the investment of `. 1000 has fetched us a return of 10%. (b) Inflation. During periods of inflation, a rupee has higher purchasing power than a rupee in the future. (c) Risk and uncertainty. We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty, individuals prefer current consumption over future consumption. Most people have subjective preference for present consumption either because of their current preferences or because of inflationary pressures. 3. Time preference rate and required rate of return. The time preference for money is generally expressed by an interest rate which remains positive even in the absence of any risk. It is called the risk- free rate. For example, if an individuals time preference is 8%, it implies that he or she is willing to forego `. 100 today to receive `. 108 after a period of one year. Thus he or she considers `. 100 and `. 108 as equivalent in value. In reality though, this is not the only factor he or she considers. He or she requires another rate for compensating him or her for the amount of risk involved in such an investment. This risk is called the risk premium.

Q4. XYZ India Ltds share is expected to touch Rs. 450 one year from now. The company is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be willing to buy if his or her required rate of return is 15%? Solution: This model holds well when an investor holds an equity share for one year. The price of such a share will be: P0= Where:P0 = Current market price of the share D1 = Expected dividend after one year P1 = Expected price of the share after one year Ke = Required rate of return on the equity share P0 = D1/(1+Ke) + P1/(1+Ke) = {25/(1+0.15)} + {450/(1+0.15)} = 21.74 + 391.30 = Rs. 413.04 An investor would be willing to buy the share at ` 413.04 Q5. Below Table depicts the statistics of a firm and its sales requirements. Compute the DOL according to the values given in the table. Table Statistics of a Firm Sales in unit Sales revenue Rs Variable Costs Contribution Fixed Cost IBIT Solution:Where: Q is quantity S is sales V is variable cost F is fixed cost Substituting this we get, {Q(SV)} / {Q(SV)F} DOL= {Q(SV)} / {Q(SV)F} {2000(10000)} / {2000(10000) 0}
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D1 (1+Ke)

P1 (1+Ke)

2000 20000 10000 6000 0 6000

= 20000000/20000000 = DOL=1

Q6. What are the assumptions of MM approach? Ans. Miller and Modigliani criticise traditional approach that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in NOI approach. Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return, buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk. The MM hypothesis thus states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation. The assumptions regarding Miller and Modigliani (MM) approach: perfect capital markets, rational behaviour, homogeneity, taxes, and dividend payout.

Perfect capital Market

Dividend Payout
M and M Approach

Rational Approach

Taxes

Homog -eneity

The following are the assumptions in detail:(a) Perfect capital markets. Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, and availability of all required information at all times. (b) Investors behave rationally. They choose the combination of risk and return which is most advantageous to them. (c) Homogeneity of investors risk perception. All investors have the same perception of business risk and returns. (d) Taxes. There is no corporate or personal income tax.

(e) Dividend payout is 100%. The firms do not retain earnings for future activities.