Master of Business Administration- MBA Semester 2 MB0045 Financial Management - 4 Credits (Book ID: B1134) Assignment Set- 2 (60

0 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q. 1 Discuss the three broad areas of Financial Decision Making Marks)

(10

Q.2 What is the future value of an annuity and state the formulae for future value of an annuity Q.3 The equity stock of ABC Ltd is currently selling for Rs 30 per share. The dividend expected next year is Rs 2.00. the investors required rate of return on this stock is 15 per cent. If the constant growth model applies to ABC Ltd, What is the expected growth rate? Marks) Q.5 Write the cash flow analysis? Marks) Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each. The Year 1 2 3 4 5 6 income returns after tax for these projects are as follows: (10 Marks) Project A Rs. 80,000 Rs. 80,000 Rs. 40,000 Rs. 20,000 Project B Rs. 20,000 Rs. 40,000 Rs. 40,000 Rs. 40,000 Rs. 60,000 Rs. 60,000 Using the following criteria determine which of the projects is preferable. (10 (10 Marks) (10 Q.4 State the assumptions underlying the CAPM model and MM model

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Q.1. Discuss the three broad areas of Financial Decision Making

Ans:-

Financial Decisions Decision needs to be taken on the sources from which the funds required for the capital investments could be obtained. There are two sources of funds - debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan. Finance decisions Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions:

Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security. Implicit cost is not a visible cost but it may seriously affect the companys operations especially when it is exposed to business and financial risk In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. Another thing notable in connection to this is that the firm cannot avoid its obligation to pay interests and loan instalments to its lenders and debentures.

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An investor in a companys shares has two objectives for investing:

It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements

Q.2. What is the future value of an annuity and state the formulae for future value of an annuity?
Ans: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 is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 as equivalent in value. In reality though this is not the only factor he considers. He requires another rate for compensating him for the amount of risk involved in such an investment. This risk is called the risk premium.

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There are two methods by which the time value of money can be calculated:

Compounding technique In the compounding technique, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are calculated. The amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. Future value of an annuity Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts or payments. Example If you have subscribed to the Recurring Deposit Scheme of a bank requiring you to pay Rs. 5000 annually for 10 years, this stream of pay-outs can be called Annuities. Annuities require calculations based on regular periodic contribution of a fixed sum of money The future value of a regular annuity for a period of n years at i rate of interest can be summed up as under: FV An = A Where, FVAn = Accumulation at the end of n years i = Rate of interest n = Time horizon or no. of years A = Amount invested at the end of every year for n years The expression (1+i)n 1 is called the Future Value Interest Factor for Annuity (FVIFA). This represents the accumulation of Re.1 invested at the end of every year for n number of years at i rate of interest. different combinations of i and n can (1+i)n 1 /i

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be calculated. We just have to multiply the relevant value with A and get the accumulation in the formula given above. We notice that we can get the accumulations at the end of n period using the tables. Calculations for a long time horizon are easily done with the help of reference tables. Annuity tables are widely used in the field of investment banking as ready beckoners. Money has time preference. A rupee in hand today is more valuable than a rupee a year later. Individuals prefer possession of cash now rather than at a future point of time. Therefore cash flows occurring at different points in time cannot be compared. Interest rate gives money its value and facilitates comparison of cash flows occurring at different periods of time. Compounding and discounting are two methods used to calculate the time value of money.

Q.3. Calculate the WACC.

Ans:Solution Step I is to determine the cost of each component. Ke = ( D1/P0) + g = (2/32) + 0.1 = 0.1625 or 16.25% Kp = [D + {(FP)/n}] / {F+P)/2} = [14 + (10584)/8] / (105+84)/2

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=16.625/94.5 = 0.1759 or 17.59% Kr = Ke which is 16.25% Kd = [I(1T) + {(FP)/n}] / {F+P)/2} = [12(10.4) + (10590)/7] / (105+90)/2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6% Kt = I(1T) = 0.11(10.4) = 0.066 or 6.6% Step II is to calculate the weights of each source. We = 200/750 = 0.267 Wp = 100/750 = 0.133 Wr = 100/750 = 0.133 Wd = 300/750 = 0.4 Wt = 50/750 = 0.06 Step III Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066) = 0.043 + 0.023 + 0.022 + 0.0384 + 0.004 = 0.1304 or 13.04% The value of WACC is 13.04%

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Q.4. State the assumptions underlying the CAPM model and MM model
Ans:Capital Asset Pricing Model Approach This model establishes a relationship between the required rate of return of a security and its systematic risks expressed as . According to this model, Ke = Rf + (Rm Rf) Where Ke is the rate of return on share, Rf is the risk free rate of return, is the beta of security, Rm is return on market portfolio 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 translates to assets being bought and sold in any quantity desired. The only considerations that matter are the price and amount of money at the investors disposal. All investors agree on the nature of return and risk associated with each investment. Miller and Modigliani Model The Miller and Modigliani (MM) hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. This model advocates that it is the investment policy through which the firm can increase its share value and hence this should be given more importance. The following are certain assumptions regarding Miller and Modigliani model:

Existence of perfect capital markets: All investors are rational and have access to all information, free of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to influence the share value

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No taxes: There are no taxes, implying there is no difference between capital gains and dividends Constant investment policy: The investment policy of the company does not change. The implication is that there is no change in the business risk position and the rate of return Certainty about future investments, dividends and profits of the firm had no risk. This assumption was, however, dropped at a later stage Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions which are entered into investment programmes simultaneously. The two transactions which the arbitrate process refers to are:

If the firm pays out dividend, it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralise the increase in share value (due to dividends) with the issue of new shares. This makes the investor indifferent to dividend earnings and capital gains as the share value is more dependent on the future earnings of the firm than on its current dividend policy. Symbolically, the model is given as Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price at the end of the period. Step II: Assuming there is no external financing Step III: If the firms internal sources of financing its investment opportunities fall short of funds required, new shares are issued at the end of year 1 at price P1. The capitalised value of the dividends to be received during the period plus the value of the number of shares outstanding is less than the value of new shares.

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Firms will have to raise additional capital to fund their investment requirements after utilising their retained earnings, Step IV: The value of share is thus Critical Analysis of MM Hypothesis The analysis of MM hypothesis considers the following costs (see figure 15.2) transaction cost, floatation cost, under-pricing of shares,

Floatation cost Miller and Modigliani have assumed the absence of floatation costs. Floatation costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards underwriting commission, brokerage and other costs. Floatation costs ordinarily account for around 10%-15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of these costs affects the balancing nature of retained earnings and external financing. External financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are 12%, then the net proceeds are only Rs. 88.

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Transaction cost This is another assumption made by MM which implies that there are no transaction costs like brokerage involved in capital market. These are the costs associated with sale of securities by investors. This theory implies that if the company does not pay dividends, the investors desirous of current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities involves cost; investors wishing to get current income should sell higher number of shares to get the income they are to receive. Under-pricing of shares If the company has to raise funds from the market, it should sell shares at a price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell more shares to replace the dividend amount. Market conditions If the market conditions are bad and the firm has some lucrative opportunities, it is not worth-approaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low pay-out ratio to fuel such opportunities.

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Q.5. Write the cash flow analysis?

Ans:Estimation of cash flows Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation. Capital outlays are estimated by engineering departments after examining all aspects of production process Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions Operating costs are estimated by cost accountants and production engineers Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision. Estimation of incremental cash flows Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis. Incremental cash flows stream of a capital expenditure decision has three components . Initial cash outlay (Initial investment) Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow.

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Additional net working capital required on implementation of new project is to be added to initial investment. Operating cash inflows Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions. Terminal cash inflows At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis. Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows. Separation principle The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. Incremental principle Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash

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flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows. Ignore sunk costs Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken. Opportunity costs If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has an opportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection Need to take into account all incident effect Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. Cannibalisation Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored Post tax principle All cash flows should be computed on post tax basis Consistency principle Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation.

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