TUSHAR JAIN

ROLL NO. 1411006595

DRIVESUMMER 2015
PROGRAMMBA
SEMESTERII
SUBJECT CODE & NAME - MB0045FINANCIAL MANAGEMENT

Qus:1 Critically analyze the four broad areas of strategic financing decision.

Four broad areas of strategic financing decision

Answer:
Strategic financing decision:
An important decision which finance manager has to take is deciding source of finance. A company can
raise finance from various sources such as by issue of shares, debentures or by taking loan and advances.
Deciding how much to raise from which source is concern of financing decision. Mainly sources of finance
can be divided into two categories:
1. Owners fund.
2. Borrowed fund.
Share capital and retained earnings constitute owners fund and debentures, loans, bonds, etc. constitute
borrowed fund.

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The main concern of finance manager is to decide how much to raise from owners fund and how much to
raise from borrowed fund.
While taking this decision the finance manager compares the advantages and disadvantages of different
sources of finance. The borrowed funds have to be paid back and involve some degree of risk whereas in
owners fund there is no fix commitment of repayment and there is no risk involved. But finance manager
prefers a mix of both types. Under financing decision finance manager fixes a ratio of owner fund and
borrowed fund in the capital structure of the company.
Factors Affecting Financing Decisions:
While taking financing decisions the finance manager keeps in mind the following factors:
1. Cost:
The cost of raising finance from various sources is different and finance managers always prefer the source
with minimum cost.
2. Risk:
More risk is associated with borrowed fund as compared to owners fund securities. Finance manager
compares the risk with the cost involved and prefers securities with moderate risk factor.
3. Cash Flow Position:
The cash flow position of the company also helps in selecting the securities. With smooth and steady cash
flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow,
then they must go for owners fund securities only.
4. Control Considerations:
If existing shareholders want to retain the complete control of business then they prefer borrowed fund
securities to raise further fund. On the other hand if they do not mind to lose the control then they may go
for owners fund securities.
5. Floatation Cost:
It refers to cost involved in issue of securities such as brokers commission, underwriters fees, expenses on
prospectus, etc. Firm prefers securities which involve least floatation cost.

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6. Fixed Operating Cost:
If a company is having high fixed operating cost then they must prefer owners fund because due to high
fixed operational cost, the company may not be able to pay interest on debt securities which can cause
serious troubles for company.
7. State of Capital Market:
The conditions in capital market also help in deciding the type of securities to be raised. During boom
period it is easy to sell equity shares as people are ready to take risk whereas during depression period there
is more demand for debt securities in capital market.

Qus:2 What is FVIFA ? Is it different from Sinking fund factor ?

A finance company offers to pay Rs. 44,650 after five years to investors who deposit annually Rs.
6,000 for five years. Calculate the rate of interest implicit in this offer.

What is FVIFA ? Differentiate FVIFA and Sinking Fund factor

Solve the case

Answer:
FVIFA:
The expression

is called the Future Value Interest Factorfor Annuity (FVIFA). This

represents the accumulation of Re.1 invested atthe end of every year for n number of years at i rate of
interest.
Differentiate FVIFA and Sinking Fund factor:
FVIFA:
The future value of a regular annuity for a period of n years at i rate ofinterest can be summed up as
follows:

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Where,
FVAn = Accumulation at the end of n years
i = Rate of interest
n = Time horizon or number of years
A = Amount invested at the end of every year for n years

The expression

is called the Future Value Interest Factorfor Annuity (FVIFA). This

represents the accumulation of Re.1 invested atthe end of every year for n number of years at i rate of
interest.As in the case of FVIFA, this expression has also been evaluated fordifferent combinations of i and
n.
Sinking fund:
Sinking fund is a fund which is created out of fixed payments each period toaccumulate for a future sum
after a specified period.
It can be said that it is a fund created for a specified purpose by way ofsequence of periodic payments over a
time period at a specified interestrate.The sinking fund factor is useful in determining the annual amount to
be putin a fund, to repay bonds or debentures, or to purchase a fixed asset or aproperty at the end of a
specified period.

is called the sinking fund factor.

A finance company offers to pay Rs. 44,650 after five years to investors who deposit annually Rs.
6,000 for five years. Calculate the rate of interest implicit in this offer.
Solution:
1. Divide the total payback amount by the deposited amount.

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Deposited amount for 5 years=5x6000
=30000
Pay back amount=44650
=44650/30000=1.4
2. Raise the result of the first step to the power of 1/n, where n is the number of periods interest is
paid.
we can use n=5 for 5 years to calculate the implied annual interest rate. Thus, 1.4^(1/5) =1.4^0.2=1.0696
3. Subtract 1 from the above result.
Thus 1.0696-1 = 0.0696
4. Multiply the above result by 100%, to arrive at 6.96%, which is the implicit interest rate per
year..
Hence Implicitinterest is 6.96%

Qus:3 A firm owns a machine furnishes the following information :

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The firm follows straight line method of depreciation (permitted by the Income-tax authorities).
The management of the company is now considering selling of the machine. If it does so, the total
operating costs to perform the work, now done by the machine, will increase by Rs. 40,000 p.a.
Advise the management.
Solve the case.
Solution:
Cash Inflows(if machine is sold)
Selling price of the old machine

Rs. 80,000

Add Tax service (0.35xRs 30,000, short-term capital loss) 10500

------------------90,500
Present value of cash outflows saved if machine is not sold(PV of keeping machine)
Particulars
Amount before tax
Annual cash operating costs Rs. 40,000

Amount after tax

Rs. 26,000

saved (Rs. 78,00-36,000

Plus:

Tax

service

on 22,000

depreciation(Rs. 1,10,000+5)

14,300

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Net annual cash flows

40,300

(X) PVIFA

(X) 3,352
------------------

PV of keeping machine

1,35,086

PV of selling machine

90,500
------------------

Difference

favoring

the

44,586

keeping machine
Recommendation: The machine should not be sold

Qus:4How will you compute the cost of equity capital using CAPM ?
The Xavier Corporation, a dynamic growth firm which pays no dividends, anticipates a long-run level
of future earnings of Rs. 7 per share. The current market price of Xaviers share is Rs. 55.45.
Floatation costs for the sale of new equity shares would average about 10 % of the price of the shares.
What is the cost of new equity capital to Xavier Corporation ?

How will you compute the cost of equity capital using CAPM ?

Solve the case

Answer:
The cost of equity capital using CAPM:
This model establishes a relationship between the required rate of return ofa security and its systematic risks
expressed as . According to this model,

Where,

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Ke is the rate of return on share
Rf is the risk free rate of return
is the beta of security
Rm is rate of return on market portfolio
Beta is a key component for the Capital Asset Pricing Model (CAPM), which is used to calculate cost of
equity. the cost of capital represents the discount rate used to arrive at the present value of a company's
future cash flows. All things being equal, the higher a company's beta, the higher its cost of capital discount
rate. The higher the discount rate, the lower the present value placed on the company's future cash flows. In
short, beta can impact a company's share valuation. The CAPM model is based on some assumptions, some
of which are:

Investors are risk-averse.

Investors make their investment decisions on a single-period horizon.
Transaction costs are low and therefore can be ignored. This translatesto assets being bought and
sold in any quantity desired. The onlyconsiderations that matter are the price and amount of money

at theinvestors disposal.
All investors agree on the nature of return and risk associated with eachinvestment.

Solution:
Xavier Corporation
Before Floatation Cost
Ke=(EPS1/P0)x100
=(7/55.45)x100
=12.62%
After Floatation Cost
Ke=12.62/(1- Floatation Cost)

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=12.62(1-0.10)
=14.02%

Qus:5Jharkhand Mining ltd. has to select one of the two alternative projects whose particulars are
furnished below :

The company can arrange necessary funds @ 8 %. Compute the NPV and IRR of each project and
comment on the results.
Is there any contradiction in the results ? If so, state the reason for such contradictions. How would
you propose to resolve the contradictions ?
Solve the case

Solution:
The PV of Re. 1, to be received at the end of each year, at different cost of capital, is the following:
YEAR
1
2
3
4

8%
0.926
0.857
0.794
0.735

10%
0.909
0.826
0.751
0.683

12%
0.893
0.797
0.712
0.636

14%
0.877
0.770
0.675
0.592

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According to the NPV method Project F is more profitable than Project E.

According to the IRR method, project E is more profitable than F.

Thus, there is a contradiction in the results arrived at under the NPV and IRR methods. The main reason for
the contradiction with regard to the assumption regarding the reinvestment rate. The NPV method assumes

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that funds released from a project can be reinvested at a rate equivalent to the firms cost of capital (8% in
this case.). The IRR method assumes that funds released from a project can be reinvested at a rate equivalent
to the IRR i.e. for project E at 12% whereas for project F, at 10%. Thus the NPV is based on more logical
assumption than that of the IRR, and it maximize net present value which is in line with the corporate
objectives of the value maximization.
Thus, in the case of a contradiction in the results, one may give preference to the NPV over the IRR method
for the reason already stated. Accordingly, project F has to be selected (in spite of its lower IRR) as its NPV
is higher than that of project E.
Note: It is true that the amount by which the NPV of F exceeds that of project E is very small. But the nature
of the problem demonstrates the approach to be followed.

Qus:6Premier Steel Ltd. has a present annual sales turnover of Rs. 40,00,000. The unit sale price is
Rs. 20. The variable costs are Rs. 12 per unit and fixed costs amount to Rs. 5,00,000 per annum. The
present credit period of 1 month is proposed to be extended to either 2 or 3 months whichever is
profitable. The following additional information is available :

Fixed costs will increase by Rs. 75,000 when sales increase by 30 %. The company requires a pre-tax
return on investment of 20 %.
Evaluate the profitability of the proposals and recommend the best credit period for the company.
Solve the case 10
Solution:

Sales

1 month
4000000

2 month
4400000

3 month
5200000

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40000

88000

260000

Bad debt to sales

Net sales
3960000
Net incremental sales -

4312000
352000

4940000
980000

(A)
Cost of sales
Variable cost @rs.12
Fixed cost
Cost of sales
Net incremental cost

2640000
500000
3140000
240000

3120000
575000
3695000
795000

523333

923750

cost
Increase in average -

281667

682083

debtors
Cost of incremental -

56333

136417

debtors @20% (C)

Total incremental cost -

269333

931417

(B+C)
Net increase in profit -

55667

48593

(B)
Average

debtors

240000
500000
2900000
-

at 241667

{A-(B+C)}

The change of credit period from 1 month to 2 months is expected to increase the profit by rs 55667, which
is more than rs 48583. Hence, the firm may changes its credit policy from the present credit period of 1
month to 2 months.
Conclusion:
Alternative 1 should be considered.