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MBA – II SEM

Financial Management- MB0029

MB0029

Registration No:520922527
MBA – II SEM
Financial Management - MB0029
Set – 1

Q1. Why wealth maximization is superior to profit maximization in today’s context? Justify you
answer?

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.

Q2. Re: 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?

Present Value(PV) =80000/-


Amount (A) =?
Interest Rat e(I) =10%
No. of Year(N) =10

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

Q3. What factors affect financial Plan?


Ans. We live in a society and interact with people and environment. What happens to us is not always
accordance to our wishes. Many things turn out in our live are uncontrollable by us. Many decisions we take are
the result of external influences. So do our financial matters. There are many factors affect our personal
financial planning. Range from economic factors to global influences. Aware of factors affecting your money
matters below will certainly benefit your planning.

Life situation and personal value

Your life situation, namely age, marital status, employment status (income), number and age of household
and life cycle will have an effect on how you handle your money. When you are young, you might not have
much money. However, you have longer time to accumulate wealth. Therefore, younger person usually will
cope better with higher risk. If you married and have children, you have to consider other family member need
beside you. You may need to set up more emergency fund, college fund and buy more protection. Every one of
us will go through different stage of life: infant, youth, and adult then elderly. Every stage has different need.
When you reach young adult, you may not make too much. However, you have many expenses waiting in line.
You might need to pay your education loan. You probably need to buy first car or take a home mortgage. You
have to prepare for wedding or expecting children. The size of your household and their age will also
significantly influence the way you handle your finance. Your personal value, what is important to you, your
principle desire and believed will shape the way you manage your money. Your preference to certain thing will
also make you choose certain financial strategies over the others. For instance, if you like to move around, it is
wiser to rent than buy a house. That is what the first step in the process of financial planning is to understand
yourself. (Read the process of financial planning).

Economic factors

Many economic factors will significantly affect your financial plan, i.e. supply and demand, various institutions,
business, labor force, and government. Supply and demand will form price. Price level will change your
consumption pattern, so do your investment and others. Labor force will determine your income. When
unemployment rate is high, it will be more difficult to find job. When job is rare, people are willing to work for
less money, and vice versa. Financial institutions and others business are the user of labors. Their activities will
shape the economic and eventually affect your financial. Government will influence economic by monetary
and fiscal policy. The steps government take will affect you financially. When government raise the interest
rate, economic will cool down. When economic slow down, government will lower the interest rate. When
interest rate is low, invest your money in bank will not give you decent return. It means take longer time for
your investment to reach your financial goals. Therefore, in order to get higher return people invest in stock
market or business.

Global influence

Since the advance of technology causes this globe to become “smaller”, especially in the era of globalization.
Now people do business cross the country boundary, therefore what happen in other country will have an effect
on people in another country “Rain at Wall Street, drizzle around the world”. The economic of particular
country depend on foreign investment. When many foreign investors come, they will create new businesses.
New business will absorb many labors, therefore lowering unemployment rate and increasing wages. However
higher wage does not always guarantee the prosperity of workers in certain country. When you earn high
income but everything is so expensive there. It is identical with make little, since your much money actually
cannot buy many things. For instance, average worker in Indonesia make approximately 1 million Rupiah
monthly. Can you imagine make 1 million dollars monthly here? Unfortunately, that 1 million Rupiah is only
around $ 108, since the currency exchange of Rupiah is around Rp. 9,200 to $ 1 USD. Currency exchange
surely will impact your purchasing power and your financial situation. Currency of a country is usually base on
its economic condition i.e. government’s budget, balance trade, inflation level and growth. Foreign exchange is
the biggest financial market in the world, we definitely will learn about it in later articles.

Economic condition

Consumer price, consumer spending, interest rate, money supply, unemployment, house started, gross domestic
product, trade balance and market indication are among economic condition that affect your decision in
handling your money matters.

Consumer price

measure the value of your money through inflation rate. It influences your personal financial planning because
consumer price alter your money purchasing power. When consumer price increase beyond your income, you
will unable to buy as much thing as you used to. Consumer spending measures the demand of good and service
by individuals and household. When consumer spending is up, more jobs will be available and wage will be
higher. Increase in consumer spending will drive consumer price to increase and inflation level as well.

Interest rate

measure cost of money or credit and return of investment. Increase in interest rate will make credit more
expensive and discourage borrowing. With high interest, people are more likely to invest their money to earn
interest than take higher risk to do business. Excessive investment from investor with inability of bank lending
to third party will create over supply of fund. In which will drive down the interest rate eventually.
Money supply

measures money available for spending in an economic. More money make people have more to save.
Therefore, increases in money supply tend to decrease interest rate as more people save. Moreover, higher
saving and lower spending will reduce job opportunity.
Unemployment measures number of people, who willing and able to work, out of work. High unemployment
rate reduce consumer spending and job opportunity. It is wiser to setup higher emergency fund and reduce debt
to cope with high unemployment rate, since it is harder to get new job when unemployment rate are high.
House started measures the number of new house built. New house build is sign of economic expansion. When
new house build increase, it creates more jobs, higher wage and higher consumer spending.
Gross domestic product measures the total value produce within a country’s border. GDP indicate country
prosperity. High GDP will increase employment opportunity and opportunity for personal financial wealth.

Trade balance

measures different between export and import. Deficit happen, when import exceed export. Large deficit over
long run will hurt employment and GDP. Surplus happen, when export exceed import. Large surplus will raise
the value of the currency, reducing the future opportunity of export, since commodity become more expensive
to foreigner.
Market indication (stock market index)
measures the relative value of stocks. These indexes provide indication of the price movement of stocks. Since
you will invest your money in the market to help you reach your financial goals, understand how the market
work will benefit you.
SET-2

Q1. A. What is the cost of retained earnings?

Cost of Retained Earnings


Cost of retained earnings (ks) is the return stockholders require on the company’s common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using
the CAPM approach, you must first
estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the
expected rate of return on the market (rm).

The next step is to estimate the company’s beta (bi), which is an estimate of the stock’s risk. Inputting these assumptions into
the CAPM equation, you can then calculate the cost of retained earnings.

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm’s long-
term debt and add a risk premium (typically three to five percentage points):

ks = D1 + g;
P0
ks = long-term bond where:
yield + risk premium D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price

Q3. Explain Miler and


c) Discounted Cash
Flow ApproachAlso known as the “dividend yield plus growth approach”. Using the dividend-growth model, you can
rearrange the terms as follows to determine ks.
Q1. 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 company’s 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?

(F+P)/2

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

Q3. Explain Miler and Modigiliani Approach to capital structure theory?

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on
capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric
information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not
matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend
policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance

Principle
Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller was
awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work
in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory
of corporate finance."

Historical background
Miller and Modigliani derived the theorem and wrote their path breaking article when they were both professors
at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. In contrast to most
other business schools, GSIA put an emphasis on an academic approach to business questions. The story goes
that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had
no prior experience in corpora the finance. When they read the material that existed they found it inconsistent so
they sat down together to try to figure it out. The result of this was the article in the American Economic Review
and what has later been known as the MM theorem.

Propositions
The theorem was originally proved under the assumption of no taxes. It is made up of two propositions which
can also b e extended to a situation with taxes. Consider two firms which are identical except for their financial
structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it
is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two
firms is the same.

Without taxes
Proposition I: where VU is the value of an unlevered firm = price of buying a firm composed only of equity,
and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.
To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead
of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same
amount of money B that firm L does. The eventual returns to either of these i investments would be the same.
Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of
L's debt. This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly
assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in
the presence of asymmetric information or in the absence of efficient markets.

Q4. How to estimate cash flows? What are the components of incremental cash flows?

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of any kind. To
evaluate these investment decisions there are some principles of cash flow estimation. In
any kind of project, planning the outputs properly is an important task. At the same time,
the profits from the project should also be very clear to arrange finances in a proper way.
These forecasting are some of the most difficult steps involved in the capital budgeting.
These are very important in the major projects because any kind of fault in the
calculations would result in huge problems. The project cash flows consider almost every
kind of inflows of cash. The capital budgeting is done through the coordination of a wide
range of professionals who are going to be involved in the project. The engineering
departments are responsible for the forecasting of the capital outlays. On the other hand,
there are the people from the production team who are responsible for calculating the
operational cost. The marketing team is also involved in the process and they are
responsible for forecasting the revenue.
Next comes the financial manager who is responsible to collect all the data from the
related departments. On the other hand, the finance manager has the responsibility of
using the set of norms for better estimation. One of these norms uses the principles of
cash flow estimation for the process.
There are a number of principles of cash flow estimation. These are the consistency
principle, separation principle, post-tax principle and incremental principle. The
separation principle holds that the project cash flows can be divided in two types named
as financing side and investment side. On the other hand, there is the consistency
principle. According to this principle, some kind consistency is necessary to be
maintained between the flow of cash in a project and the rates of discount that are
applicable on the cash flows. At the same time, there is the post-tax principle that holds
that the forecast of cash flows for any project should be done through the after-tax
method.
Incremental Principle

The incremental principle is used to measure the profit potential of a project. According
to this theory, a project is sound if it increases total profit more than total cost. To have a
proper estimation of profit potential by application of the incremental principle, several
guidelines should be maintained:

Incidental Effects: Any kind of project taken by a company remains related to the other
activities of the firm. Because of this, the particular project influences all the other
activities carried out, either negatively or positively. It can increase the profits for the
firm or it may cause losses. These incidental effects must be considered.
Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure
done by the firm in the past. These expenditures are not related with any particular
project. These costs denote all those expenditures that are done for the preliminary work
related to the project, unrecoverable in any case.
Overhead Cost: All the costs that are not related directly with a service but have
indirect influences are considered as overhead charges. There are the legal and
administrative expenses, rentals and many more. Whenever a company takes a new
project, these costs are assigned.
Working Capital: Proper estimation is essential and should be considered at the time
when the budget for the project's profit potential is prepared.