ASSIGNMENTMB0029

(3 Credits)
SET 1
MARKS 60
Financial Management

QN.1a. Explain why wealth maximization is superior over profit maximization.

Answer: Maximization of profits is regarded as the proper objective of the firm, but it is
not as inclusive a goal as that of maximizing stockholder wealth. For one thing, total
profits are not as important as earnings per stock. Therefore, wealth maximization is
superior in a way that it is based on cash flow, not on the accounting profit.
Wealth maximization is superior because it values the duration of expected returns. Since
distant flows are uncertain, converting them into comparable values at base period
facilitated better comparison of financial projects. This can be achieved by for example;
by discounting all future earnings to establish their net present value.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 therefore, society gains because of the societal
welfare.

1b. Briefly explain the steps involved in financial plan.

Answer: The financial planning process turns your own personal objectives into specific
plans and outlines methods and strategies to implement these plans. Establish Financial
Goals and Objectives: Your Financial Consultant will assist you in identifying your
objectives. For example, you may be asked the following questions: At what age and
income level would you like to retire? What level of income would you like to provide to
your surviving spouse? How would you like your estate to be distributed? Gather Data:
Information reviewed may include, for example, tax returns, brokerage statements,
insurance policies, wills, trusts, estate planning documents, or business agreements. The
more information that is available, the more accurate your financial plan will be. Process
and Analyze Information: Appropriate advisors will consider various alternatives to meet
your objectives. Adopt a Comprehensive Financial Plan: Illustrations and analyses
showing you strategies to consider meeting your goals. Implement the Plan: You choose
to implement the strategies with which you feel comfortable. Monitor the Plan:
Periodically, you and your Financial Consultant will review your financial plan.
Circumstances change and you may need to make revisions to your plan.

QN.2a. Explain the two theories of capitalization.

Answer:

1. Cost Theory: According to the cost theory of capitalization, the value of a

company is arrived at by adding up the cost of fixed assets like plants, machinery
patents, etc., the capital regularly required for the continuous operation of the
company (working capital), the cost of establishing business and expenses of
 promotion. The original outlays on all these items become the basis for
calculating the capitalization of company. Such calculation of capitalization is
useful in so far as it enables the promoters to know the amount of capital to be
raised. But it is not wholly satisfactory. On import objection to it is that it is based
o a figure (i.e., cost of establishing and starting business) which will not change
with variation in the earning capacity of the company. The true value of an
enterprise is judged from its earning capacity rather than from the capital invested
in it. If, for example, some assets become obsolete and some others remain idle,
the earnings and the earning capacity of the concern will naturally fall. But such a
fall will not reduce the value of the investment made in the company's business.2.
Earnings Theory: The earnings theory of Capitalization recognizes the fact that
the true value (capitalization) of an enterprise depends upon its earnings and
earning capacity. According to it, therefore, the value or Capitalization of a
company is equal to the capitalized value of its estimated earnings. For this
purpose a new company has to prepare an estimated profit and loss account. For
the first few year of its life, the sales are forecast ad the manager has to depend
upon his experience for determining the probable cost. The earnings so estimated
may be compared with the actual earnings of similar companies in the industry
and the necessary adjustments should be made. Then the promoters will study the
rate at which other companies in the same industry similarly situated are earnings.
The rate is then applied to the estimated earnings of the company for finding out
the capitalization. To take an example a company estimates its average profit in
the first few years at Rs. 50,000. Other companies of the same type are, let us
assume, earnings a return of 10 per cent on their capital. The Capitalization of the
company will then be 50,000x100=Rs.500,000.

QN. 2b. A customer wants to deposit Rs.10,000 in ICICI bank for 5 years. The
prevailing interest rate is 9.50% what will be the value of the deposit on maturity

Answer:
FV = PV (1+i) ^n
FV = 10000(1+0.095) ^5
FV= Rs.15, 742.39

QN.3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5 years hence. How
much should it deposit annually in sinking fund account so that it can accumulate Rs. 30
million at the end of 5 years.

Answer:
FV = installment * PVIFA (i, y)
30,000,000 = installment * PVIFA (12%, 5)
30,000,000 = installment *3.605
30,000,000 ÷ 3.605 = installment.
Installment = 8,321,775.31
QN.3b. Road Transport Corporation issued deep discount bonds in 1996 which has a face
value of Rs. 2, 00, 000 maturing after 25 years. The bond was issued at Rs. 5300. What is
the effective interest rate earned by the investor from this bond?

Answer:
A = Po (1+i) n

200,000 = 5300(1+i) 25

Solving for r, 200,000/5300 = (1+i) 25

37.7358 = (1+i) 25

37.73581/25 = (1+i)

i = 15.63% is the effective interest rate per annum.

QN.4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10% maturing after
10 years. If the YTM is 12% what is the market value of the bond? If the YTM is
increase to 14%, what is the market value of the bond? Compare and give the inference.

Answer:

Interest payable = 1000*10% = Rs 100

Principal payment = 1000
YTM = 12%
Vo = I*PVIFA (kd, n) + F*PVIF (kd, n)

Vo =100*5.650 (12%, 10y) + 1000*0.322 (12%, 10y)

Vo = Rs 887

Using YTM as 14%

Vo =100*5.216 (14%, 10y) + 1000*0.270 (14%, 10y)

Vo = Rs 791.6

Compare and give inference.

When the YTM is low the market value of the bond is high and when the YTM is high
the market value of the bond is low.

The inference is that, the bond’s value moves inversely proportional to its YTM.
As the YTM increases by from 12% to 14% the value of the bond falls from Rs 887 to Rs
791.6.
QN5. ABC Ltd, produced and sold Rs 100,000 of a product at the rate of Rs 100.for
production of Rs.1,00,000 units, it has spent a variable cost of Rs.6,00,000 at the rate of
Rs.6 per unit and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs. 50,000 at
the rate of 5 percent and Rs.1,00,000 debts. Calculate operating leverage.

Answer:

Operating Leverage = % Change in EBIT / % Change in Sales

Operating Leverage = (100 – 6)100000 / [(100 – 6)100000]-250000
Operating Leverage = 1.03

b) Explain the importance of capital budgeting.

Answer:

Capital budgeting (or investment appraisal) is the planning process used to

determine a firm’s expenditures on assets whose cash flows are expected to extend
beyond one year such as new machinery, equipments, etc. It is also the process of
identifying, analyzing and selecting investment projects whose cash flows are expected to
extend beyond one year such as research and development project.
Capital expenditures can be very large and have a significant impact on the firm’s
financial performance. Besides, the investments take time to mature and capital assets are
long-term, therefore, if a mistake were done in the capital budgeting process, it will affect
the firm for a long period of time. Basically, the importance of capital budgeting are as
follow:
Capital budgeting helps to avoid forecast error.
The future success of a business largely depends on the investment decisions that
corporate managers make today. Investment decisions may result in a major departure
from what the company has been doing in the past. Through making capital investments,
firm acquires the long-lived fixed assets that generate the firm’s future cash flows and
determine its level of profitability. Thus, this decision greatly influences a firm’s ability
to achieve its financial objectives. For example, if the firm invests too much it will cause
higher depreciation and expenses. On the other hand, if the firm does not invest enough,
the firm will face a problem of inadequate capacity and thus, lose its market share to its
competitors.
Capital budgeting helps a firm to plan its financing. Proper capital budgeting analysis is
critical to a firm’s successful performance because capital investment decisions can
improve cash flows and lead to higher stock prices. Yet, poor decisions can lead to
financial distress and even to bankruptcy.

While working with capital budgeting, a firm is involved in valuation of its business. By
valuation, cash flow is identified and discounted at the present market value. In capital
budgeting, valuation techniques are undertaken to analyze the impact of assets instead of
financial assets.
The importance of capital budgeting is not the mechanics used, such as NPV and IRR,
but is the varying key involved in forecasting cash flow. The importance of capital
budgeting is not only its mechanics, but also the parameters of forecasting the incurrence
of cash in the business.

6. Financial planning: Assume you are working for an investment banker. A client aged
30 has approached you on investment planning. His present salary is Rs.6,00,000 per year
and his current savings is Rs.1,50,000. (a) How much does this current saving grow to in
3 years if the interest rate is12% compounded annually.

Answer:
(a) FVAn = A [(1+i) ^n – 1/i]
FVAn = 150000[(1+0.12) ^3 – 1/ 0.12]
FVAn = Rs 506,160

(b) Assume he plans to save Rs.60000 at the end of every year for 5 years, what would be
the amount at the end of 5 years if the interest being 10% compounded annually.

Answer:

FVAn = A [(1+i) ^n – 1/i]

FVAn = 60000[(1+0.10) ^5 – 1/ 0.10]
FVAn = Rs 366,30

ASSIGNMENTMB0029
(3 Credits)
SET 2
MARKS 60
Financial Management

1. Compare and contrast NPV with IRR .ANS.

Net present value method

The cash inflow in different years are discounted (reduced) to their present value by
applying the appropriate discount factor or rate and the gross or total present value of
cash flows of different years are ascertained. The total present value of cash inflows are
compared with present value of cash outflows (cost of project) and the net present value
or the excess present value of the project and the difference between total present value
of cash inflow and present value of cash outflow is ascertained and on this basis, the
various investments proposals are ranked.Cash inflow = earnings / profits of an
investment after taxes but before depreciationThe present value of cash outflows = initial
cost of investment and the comment of project at various points of time ^
Decision rule
After ranking various investments proposals on basis on net present value, projects with
negative net present value (net present value of cash inflows less than their original costs)
are rejected and projects with positive NPV are considered acceptable. In case of
mutually exclusive alternative projects, projects with higher net present value are
selected. Net present value method is suitable for evaluating projects where cash flows
are uneven.

Merits
1. The most significant advantage is that it explicitly recognizes the time value of
money, e.g., total cash flows pertaining to two machines are equal but the net
present value are different because of differences of pattern of cash streams. The
need for recognizing the total value of money is thus satisfied.
2. It also fulfills the second attribute of a sound method of appraisal. In that it
considers the total benefits arising out of proposal over its life time.
3. It is particularly useful for selection of mutually exclusive projects.
4. This method of asset selection is instrumental for achieving the objective of
financial management, which is the maximization of the shareholder's wealth. In
brief the present value method is a theoretically correct technique in the selection
of investment proposals.

Demerits
1. It is difficult to calculate as well as to understand and use, in comparison with
payback method or average return method.
2. The second and more serious problem associated with present value method is that
it involves calculations of the required rate of return to discount the cash flows. The
discount rate is the most important element used in the calculation of the present value
because different discount rates will give different present values. The relative
desirability of a proposal will change with the change of discount rate. The importance of
the discount rate is thus obvious. But the calculation of required rate of return pursuits
serious problem. The cost of capital is generally the basis of the firm's discount rate. The
calculation of cost of capital is very complicated. In fact there is a difference of opinion
even regarding the exact method of calculating it.
3. Another shortcoming is that it is an absolute measure. This method will accept the
project which has higher present value. But it is likely that this project may also involve a
larger initial outlay. Thus, in case of projects involving different outlays, the present
value may not give dependable results.
4. The present value method may also give satisfactory results in case of two projects
having different effective lives. The project with a shorter economic life is preferable,
other things being equal. It may be that, a project which has a higher present value may
also have a larger economic life, so that the funds will remain invested for longer period
while the alternative proposal may have shorter life but smaller present value. In such
situations the present value method may not reflect the true worth of alternative
proposals. This method is suitable for evaluating projects whose capital outlays or costs
differ significantly.
Internal rate of return method
The technique is also known as yield on investment, marginal efficiency value of capital,
marginal productivity of capital, rate of return, time adjusted rate of return and so on.
Like net present value, internal rate of return method also considers the timevalue of
money for discounting the cash streams. The basis of the discount factor however, is
difficult in both cases. In the net present value method, the discount rate is the required
rate of return and being a predetermined rate, usually cost of capital and its determinants
are external to the proposal under consideration. The internal rate of return on the other
hand is based on facts which are internal to the proposal. In other words, while arriving at
the required rate of return for finding out the present value of cash flows, inflows and
outflows are not considered. But the IRR depends entirely on the initial outlay and cash
proceeds of project which is being evaluated for acceptance or rejection. It is therefore
appropriately referred to as internal rate of return. The IRR is usually, the rate of return
that a project earns. It is defined as the discount rate which equates the aggregate present
value of net cash inflows (CFAT) with the aggregate present value of cash outflows of a
project. In other words it is that rate which gives the net present value zero. IRR is the
rate at which the total of discounted cash inflows equals the total of discounted cash
outflows (the initial cost of investment). It is used where the cost of investment and its
annual cash inflows are known but the rate of return or discounted rate is not known and
is required to be calculated.

Accept / Reject decision

The use of IRR as a criterion to accept capital investment decision involves a comparison
of actual IRR with requiredrate of return, also known as cut off rate or hurdle rate. The
project should qualify to be accepted if the internal rate of return exceeds the cut off rate.
If the internal rate of return and the required rate of return be equal, the firm is indifferent
as to accept or reject the project. In case of mutually exclusive or alternative projects, the
project which has the highest IRR will be selected provided its IRR is more than the cut
off rate. In case there are budget constraints, the projects are ranked in descending order
of their IRR and are selected subject to provisions.

Evaluation of IRR
1. Is a theoretically correct technique to evaluate capital expenditure decision.
It possesses the advantages which are offered by the NPV criterion such as, it considers
the time value of money and takes into account the total cash inflows and outflows.
2. In addition, the IRR is easier to understand. Business executives and non-technical
people understand the concept of IRR much more readily than they understand the
concept of NPV. For instance, Business X will understand the investment proposal in a
better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10%
instead of saying that NPV of Machine B is Rs. 15,396.
3. It itself provides a rate of return which is indicative of profitability of proposal. The
cost of capital enters the calculation later on.
4. It is consistent with overall objective of maximizing shareholders wealth. According to
IRR, the acceptance / rejection of a project is based on a comparison of IRR with
required rate of return. The required rate of return is the minimum rate which investors
expect on their investment. In other words, if the actual IRR of an investment proposal is
equal to the rate expected by the investors, the share prices will remain unchanged. Since,
with IRR, only such projects are accepted which have IRR of the required rate, therefore,
the share prices will tend to rise. This will naturally lead of maximization of shareholders
wealth. ^

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicated computation problems.
2. It produces multiple rates which can be confusing. This situation arises in the case of
non-conventional projects.
3.In evaluating mutually exclusive proposals, the project with highest IRR would be
picked up in exclusion of all others. However in practice it may not turn out to be the
most profitable and consistent with the objective of the firm i.e., maximization of
shareholders wealth.
4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It
is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at
different rates. The reinvestment rate assumption under the IRR is therefore very
unrealistic. Moreover it is not safe to assume always that intermediate cash flows from
the project may be reinvested at all. A portion of cash inflows may be paid out as
dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly,
the firm will get a wrong picture of the project if it assumes that it invests the entire
intermediate cash proceeds.

Further it is not safe to assume that they will be reinvested at the same rate of return as
the company is currently earning on its capital (IRR) or at the current cost of capital (k).
NPV versus IRR
NPV indicates the excess of the total present value of future returns over the present
value of investments. IRR (or DFC rate) indicates on the other hand the rate at which the
cash flows (at present values) are generated in the business by a particular project.
Both NPV and IRR iron out the difference due to interest factor or say higher returns in
earlier years and higher returns in later years (though the total returns in absolute terms
may be around the same for several projects).Between the two, IRR or DFC rate is the
more sophisticated method -a popular as well, since:
(a)IRR method -mostly subjective decision regarding discounting rate. ^
(b)Whilst under NPV the main basis of comparison is between different NPV's of
different projects, under IRR or DFC rate approach a number of basis is available. For
example –
DFC rate Vs Discount rate of return (on normal operations) ^
DFC rate Vs Cut off rate of thecompany
DFC rate Vs Borrowing rate (on cost of capital)
DFC rates between different projects