ASSIGNMENT -01

NAME REGISTRATION NO LEARNING CENTER LEARNING CENTER CODE COURSE SUBJECT SEMESTER DATE OF SUBMISSION

: SAHITHI GOWDA S : 571124176 :

SYSTEM DOMAIN

: 03337 : MBA : FINANCIAL MANAGEMENT : 2nd SEM : 30/03/2012

DIRECTORATE of DISTANCE EDUCATION SIKKIM MANIPAL UNIVERSITY 2ND FLOOR, SYNDICATE HOUSE MANIPAL -576104

SIGNATURE OF CO-ORDINATOR

SIGNATURE OF CENTER

SIGNATURE OF EVALUATOR

MB0045 Financial Management (Book ID: B1134) Set- 1

Q1. Explain the steps involved in Financial Planning. Answer: Financial Planning The Finance Manager has to estimate the financial requirements of the company. He should determine the sources from which capital can be raised and determine how effectively and judiciously these funds are put into use so that repayments can be done in time. Financial planning is deciding in advance the course of action for future. Financial planning includes: Estimation of the amount of funds to be raised, finding out the various sources of capital and the securities offered against the money so received and laying down policies to administer the usage of funds in the most appropriate way. Estimate capital requirements: This is the first step in financial planning. The following factors may be used to determine the capital: Requirement of fixed assets. Investment intangible assets like patents, copyrights, etc. Amount required for current assets like stocks, cash, bank balances, etc. Cost of set-up and likely expenses to be incurred on the new issue of shares and debentures. Determine the type of sources to be acquired and their proportion: The Finance Manager has to decide on the form in which the money is to be sourced, that is, debt, equity, preference shares, loans from banks and the proportion in which these are to be procured. Steps in Financial Planning: The financial planning process involves the following steps: Projection of financial statements: Financial statements are the company's profit and loss account and the balance sheet. These two statements can be prepared for a certain period of future time and they help the manager to determine the amount of fund requirements. Determination of funds needed: Once the projections are drawn in terms of sales of products, the cost of production, marketing 1

activities, etc., the Finance Manager can draw up a plan as to the fund requirement based on the time factor. He can know whether the funds are to be procured on a short term basis or on a long term basis. Forecast the availability of funds: A company will have a steady flow of funds. If the manager is able to forecast these amounts properly, then the moneys to be borrowed can be reduced, thus saving on the interest payments. Establish and maintain control system: Control system is ineffective without adequate planning and the adequacy of planning can be gauged only through proper control measures. Both these activities are essential for effective utilization of funds. Develop procedures: Procedures should be developed for basic plans how they should be achieved.

Q2. A company is considering a capital project with the following information: The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant a machinery and Rs.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million ad the net working capital will be liquidated at par. The project will increase revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project. Solution: Cost of Project 200 Million 150Million 50 Million Pv factor .909 .826 .751 Pv of Cash inflow 181.8 123.9 37.55

Q3. Discuss the relevance and factors that influence the determination of stock level. Answer: 2

Most of the industries are subject to seasonal fluctuations and sales during different months of the year are usually different. If, however, production during every month is geared to sales demand of the month, facilities have to installed to cater to for the production required to meet the maximum demand. During the slack season, a large portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to be made to obtain a stabilized production programme throughout the year. During the slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively increase. Depending upon various factors of production, storing and cost, a normal capacity will be determined. To meet the pressure of sales during the peak season, however, higher capacity may have to be sued for temporary periods. Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, only consumption of raw material will accordingly vary depending upon the capacity usage. Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period. Maximum Level: Maximum level is that level above which stock of inventory should never rise. Maximum level is fixed after taking in to account the following factors: 1. Requirement and availability of capital 2. Availability of storage space and cost of storing. 3. Keeping the quality of inventory intact 4. Price fluctuations 5. Risk of obsolescence, and 6. Restrictions, if any, imposed by the government. Maximum Level = Ordering level (MRC x MDP) + standard ordering quantity. Where, MRC = minimum rate of consumption MDP= minimum lead time. Minimum Level: Minimum level is that level below which stock of inventory should not normally fall. Minimum level = OL (NRC x NLT) Where, OL = ordering level NRC = Normal rate of consumption NLT = Normal Lead Time. Ordering Level: Ordering level is that level at which action for replenishment of inventory is initiated. OL = MRC X MLT 3

Where, MRC = Maximum rate of consumption MLT = Maximum lead time. 3. Average stock level Average stock level can be computed in two ways 1. Minimum level + maximum level / 2 2. Minimum level + 1 /2 of reorder quantity. Average stock level indicates the average investment in that item of inventory. It in of quite relevant from the point of view of working capital management. Managerial significance of fixation of Inventory level : 1. It ensure the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time. 2. It optimizes the investment in inventories. In this process, management can avoid both overstocking and shortage of each and every essential and vital item of inventory. 3. It can help the management in identifying the dormant and slow moving items of inventory. This brings about better coordination between materials management and production management on the one hand and between stores manager and marketing manager on the other. Re order Point: When to order is another aspect of inventory management. This is answered by re order point. The re order point is that inventory level at which an order should be placed to replenish the inventory. To arrive at the re order point under certainty the two key required details are: 1. Lead time 2. Average usage lead time refers to the average time required to replenish the inventory after placing orders for inventory Re order point = lead time x Average usage Under certainty, re order point refers to that inventory level which will meet the consumption needs during the lead time. Safety Stock: Since it is difficult to predict in advance usage and lead time accurately, provision is made for handling the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to manage the stock out arising out of this uncertainty. When safety stock is maintained, (When Variation is only in usage rate) Re order point = lead time x Average usage + Safety stock 4

Safety stock = [(maximum usage rate) (Average usage rate)] x lead time. Or Safety stock when the variation in both lead time and usage rate are to be incorporated. Safety stock = (Maximum possible usage) (Normal usage) Maximum possible usage = Maximum daily usage x Maximum lead time Normal usage = Average daily usage x Average lead time Example: A manufacturing company has an expected usage of 50,000 units of certain product during the next year. Re cost of processing an order is Rs 20 and the carrying cost per unit per annum is Rs 0.50. Lead time for an order is five days and the company will keep a reserve of two days usage. Calculate 1. EOQ 2. Re order point. Assume 250 days in a year Solution: EOQ = 2DK / Kc = 2 x 50000 x 20 / 0.50 = 2000 units Re order point Daily usage = 50000 / 250 = 200 units Safety stock = 2 x 200 400 units. Re order point (lead time x Average usage) + safety stock (5 x 200) + 400 = 1,400 units

Q4. There was a replacement of its existing machine by a new machine. The new machine will cost Rs 2, 00,000 and have a life of five years. The new machine will yield annual cash revenue of Rs 2, 50,000 and incur annual cash expenses of Rs 1, 30,000. The estimated salvage of the new machine at the end of its economic life is Rs 8,000. The existing machine has a book value of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years is expected to generate annual cash revenue of Rs 2, 00,000 and to involve annual cash expenses of Rs 1, 40,000. If sold after five years, the salvage value of the existing machine will be negligible. The company pays tax at 40%. It writes off depreciation at 30% on the written down value. The companys cost of capital is 20% Compute the incremental cash flows of replacement decisions. Solution: 5

Initial investment and annual cash flow Initial investment Gross investment for new machine Less: Cash received from the sale of existing machine Net cash outlay Annual cash flow from operations Incremental cash flow from revenue Incremental decrease in expenditure Incremental depreciation schedule Year 1 2 3 4 5 Depreciation (new machine) 66,000 46,200 32,340 22,638 15,847 Depreciation (old machine) 10,000 7,500 5,625 4,219 3,164 Incremental Depreciation (Rs) (35,000) (26,250) (19,687) (14,765) (11,074) (2,00,000) 20,000 (1,80,000) 50,000 10,000

Calculation of depreciation Book value Add: cost of new machine Less: sale proceeds of old machine Depreciation for 1 year 30% Depreciation for 2 year 30% Depreciation for 3 year 30% Depreciation for 4 year 30% Depreciation for 5 year 30% Book value after 5 years 40,000 2,00,000 2,40,000 20,000 2,20,000 66,000 1,54,000 46,200 1,07,800 32,340 75,460 22,638 52,822 15,847 36,975

Statement of incremental cash flow Particulars 0 1.Investment in new machine 2.After tax salvage value of old machine 3.Net Cash Out lay 4.Increase in revenue 5.Decrease in expenses 6.Increase in depreciation 7.Increase in EBIT (4+5-6) 8.EBIT (1-T) (1-.30) 9.Incremental Cash flow from operation (8+6) EAT+ Depreciation 10.Salvage value of new machine 11.Incremental Cash flows (2,00,000) 20,000 (1,80,000) 50,000 10,000 (35,000) 25,000 17,500 50,000 10,000 (26,250) 33,750 23,625 50,000 10,000 (19,687) 40,313 28,219 50,000 10,000 (14,765) 45,235 31,665 50,000 10,000 (11,074) 48,926 34,248 1 2 Years 3 4 5

52,500

49,875

47,906

46,430

45,322

8,000 (1,40,000) negative 52,500 49,875 47,906 46,430 53,322

Q5. Explicit cost and implicit cost are the two dimensions of cost. What role does cost play in financial decisions. Answer: The cost of debt has two parts explicit cost and implicit cost. Explicit cost is the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can mean that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralized by the implicit cos t resulting in Ke and Kd being the same. Graphically this is represented as: Percentage cost

Q6. The following details have been extracted from the books of Ashraya Ltd Income Statement (Rs. In millions)

Sales less returns Gross Profit Selling Expenses Administration Deprecation Operating Profit Non operating income EBIT (Earnings before interest & Tax) Interest Profit before tax Tax Profit after tax Dividend Retained earnings

2009 1200 300 100 40 60 100 20 120 15 105 30 75 38 37

2010 1000 520 120 45 75 280 40 320 18 302 100 202 100 102

Solution:

Balance Sheet Liabilities Shareholders fund Share capital Equity Preference Reserves and surplus
Secured loans Unsecured loans Current liabilities Trade creditors Provision Tax Proposed dividend

2009

2010

Assets Fixed assets Less depreciation Investment Current assets, Loans and Advances Cash at bank Receivables Inventories Loans and Advances Miscellaneous expenditure

120 50 122
100 50

120 50 224 120 60

2009 400 100 300 50

2010 510 120 390 50

210 10 38 700

250 60 100 984

10 80 200 50 10

12 128 300 80 24

700

984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions: Sales for the year 2008 will increase by 30% over the sales value for 2007. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007. Depreciation is charged at 25% of fixed assets. Fixed assets will increase by Rs.100 million Investments will increase by Rs.100 million Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007 Miscellaneous expenditure will increase by Rs.19 million Secured loans in 2008 will be based on its relationship with the sales in the year2007 Additional funds required, if any, will be met by bank borrowings Tax rates will be 30 % Dividends will be 50 % of the profit after tax Non- operating income will increase by 10% There will be no change in the total amount of administration expenses to be spent in the year 2008 There is no change in equity and preference capital in 2008 Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007

ASSIGNMENT -02

NAME REGISTRATION NO LEARNING CENTER LEARNING CENTER CODE COURSE SUBJECT SEMESTER DATE OF SUBMISSION

: SAHITHI GOWDA S : 571124176 :

SYSTEM DOMAIN

: 03337 : MBA : FINANCIAL MANAGEMENT : 2nd SEM : 30/03/2012

DIRECTORATE of DISTANCE EDUCATION SIKKIM MANIPAL UNIVERSITY 2ND FLOOR, SYNDICATE HOUSE MANIPAL -576104

SIGNATURE OF CO-ORDINATOR

SIGNATURE OF CENTER

SIGNATURE OF EVALUATOR

MB0045 Financial Management (Book ID: B1134) Set- 2

Q1. Examine the importance of capital budgeting. Answer: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organization. These decisions commit a firm to invest its current funds in the operating assets (i,e long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into 1. Replacement decisions: These decisions may be decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions. 2. Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution. 3. Decisions for products of new goods or rendering of new services. 4. Decisions on penetrating into new geographical area. 5. Decisions to comply with the regulatory structure affecting the operations of the company. Investments in assets to comply with the conditions imposed by Environmental Protection Act come under this category. 6. Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant. There are many reasons that make the Capital budgeting decisions the most crucial for finance Managers 1. These decisions involve large outlay of funds now in anticipation of cash flows in future. For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. a. For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an 1

important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes had declined drastically. The end result is that Metal Box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of lining and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. b. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology creating wealth for shareholders. The best example is the Reliance group. c. Any serious error in forecasting Sales and hence the amount of capital expenditure can significantly affect the firm. An upward bias may lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its competitors. Both are risky fraught with grave consequences. 2. A long term investment of funds sometimes may change the risk profile of the firm. A FMCG company with its core competencies in the business decided to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investors perception of risk of the new business to be taken up by the company will change his required rate of return to invest in the company. In this connection it is to be noted that the power pricing is a politically sensitive area affecting the profitability of the organization. Therefore, Capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want. 3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements during the phase of execution must be synchronized with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operations unproductive. But the major challenge that the management of a firm faces in managing the uncertain future cash inflows and out flows associated with the plan and execution of Capital budgeting decisions. 4. Capital budgeting decisions involve assessment of market for companys products and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realize after committing itself considerable sums of money in the process of implementing the Capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the 2

equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialized costly equipments. Therefore, Capital budgeting decisions are irreversible. 5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs Capital expenditure to build up capacity in anticipation of the expected boom in the demand for its products. The timing of the Capital expenditure decision must match with the expected boom in demand for companys products. If it plans in advance it may effectively manage the timing and the quality of asset acquisition. But many firms suffer from its inability to forecast the future operations and formulate strategic decision to acquire the required assets in advance at the competitive rates. 6. All Capital budgeting decisions have three strategic elements. These three elements are cost, quality and timing. Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing the products of required quality for customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of Capital expenditure decision taken will strategically affect the firms profitability. 7. Liberalization and globalization gave birth to economic institutions like World Trade organization. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell its products in India at a rate less than the rate at which Indian Companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be proactive. Proactive firms cannot avoid the risk of taking challenging Capital budgeting decisions for growth. Therefore, Capital budgeting decisions for growth have become an essential characteristics of successful firms today. 8. The social, political, economic and technological forces generate high level of uncertainty in future cash flows streams associated with Capital budgeting decisions. These factors make these decisions highly complex. 9. Capital expenditure decisions are very expensive. To implement these decisions firms will have to tap the Capital market for funds. The composition of debt and equity must be optimal keeping in view the expectation of investors and risk profile of the selected project.

Q2. Considering the following information, what is the price of the share as per Gordons Model? Net sales Net profit margin Outstanding preference shares No. of equity shares Rs. 120 lakhs 12.5% Rs. 50 lakhs @ 12% dividend 250000 3

Cost of equity shares Retention ratio ROI Solution: P= E (1-b) / Ke-br

12% 40% 16%

Where P is the price of the share, E is Earnings Per Share, b is Retention ratio, (1 b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment. P= E (1-b) / Ke-br P= 3.6(1-0.40) / 0.12-(0.4x0.16) P= 3.6(0.6) / 0.12-0.064 P= 2.16 / 0.056 P= 38.57

Q3. Internal capital rationing is uses by firms for exercising financial control How does a firm achieve this? Answer: Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. Internal capital rationing Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be 4

imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control. The various factors relating to the internal constraints imposed by the management are (see figure 10.2) Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints.

Figure 10.2: Internal constraints Private owned company Under internal constraint, the management of the firms might decide that expansion of the company might be a problem and not worth taking. This kind of condition arises only when the management of a firm fears losing the control in the company. Divisional constraints Another constraint might lead to the allocation of fixed amount for each division in a firm by the upper management. This procedure can also be considered as an overall corporate strategy. These situations arise mainly from the point of view of a department. The cost of capital or the cost structure of the management, the budget constraints imposed by the senior officials or decisions coming from the head-office and wholly owned subsidiary decisions relate to the internal constraints. Human Resource limitations The management of the firm or the company should see that excessive labour is being used for the project. Lack of proper man-power can become an internal constraint. 5

Dilution Dilution refers to the dilution of the company. This constraint occurs mainly when a reluctance in the issuing of further equity takes place, due to the fear of management losing the control over the company. Debt constraints Debt constraints also constitute to the internal constraints in capital rationing. This constraint occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to a certain level. These are the methods by which various factors are effecting the capital rationing of a particular firm or a management. Let us now look at the different types of capital rationing in the following topic.

Q4. A company has two mutually exclusive projects under consideration viz project A & project B Each project requires an initial cash outlay of Rs. 3, 00,000 and has an effective life of 10 years. The companys cost of capital is 12%. The following fore cast of cash flows are made by the management.

Economic Environment
Pessimistic Expected Optimistic

Project A Annual cash inflows

65, 000 75, 000 90, 000

Project B Annual cash inflows

25, 000 75, 000 1, 00, 000

What is the NPV of the project? Which project should the management consider? Given PVIFA = 5.650 Unit 9 worked example Solution:

NPV of project A Economic Environment Pessimistic Expected Optimistic Project Cash inflow 65000 75000 90000 PVIFA
At 12% for 10 years 5.65 5.65 5.65 367250 423750 508500 67250 123750 208500 PV of cash flow NPV

NPV of project B Economic Environment Pessimistic Expected Optimistic Project Cash inflow 25000 75000 100000 PVIFA
At 12% for 10 years 5.65 5.65 5.65 141250 423750 565000 -158750 123750 265000 PV of cash flow NPV

PROJECT A
NPV ACCEPT / REJECT

PROJECT B
NPV (-) Rs.158750 (+) Rs.1,23,750 (+) Rs.2,65,000 ACCEPT / REJECT REJECT ACCEPT (A) OR (B) ACCEPT (HIGHER NPV)

Pessimistic Expected Optimistic

(+) ACCEPT Rs.67,250 (+) ACCEPT (A) OR (B) Rs.1,23,750 (+) Rs.2,08,500
REJECT

Project B is risky compared to Project A because the NPV range is large. Difference between Optimistic and Pessimistic NPV Project A = 1, 14,250 Project B = 4, 23,750

Q5. Explain various types of bonds. Answer: Types of Bonds Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b) Redeemable Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon Bonds. (a)Irredeemable Bonds or Perpetual Bonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Acts restricts the issue of such bonds and therefore these are very rarely issued by corporates these days. In case of these bonds the terminal value or maturity value does not exist because they are not redeemable. The face value is known the interest received on such bonds is constant and received at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the intrinsic value) is calculated as: V0=I/id If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 par value, and the current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875 (b)Redeemable Bonds: There are two types viz., bonds with annual interest payments and bonds with semiannual interest payments. Bonds with annual interest payments Basic Bond Valuation Model: The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principal repayment at the time of maturity. The intrinsic value or the present value of bond can be expressed as: V0 or P0=n t=1 I/ (I+kd) n +F/ (I+kd) n Which can also be stated as follows V0=I*PVIFA (kd, n) + F*PVIF (kd, n) Where V0= Intrinsic value of the bond P0= Present Value of the bond I= Annual Interest payable on the bond F= Principal amount (par value) repayable at the maturity time n= Maturity period of the bond Kd= Required rate of return Example: A bond whose face value is Rs. 100 has a coupon rate of 12% and a maturity of 5 years. The required rate of interest is 10%. What is the value of the bond? 8

Solution: Interest payable=100*12%=Rs. 12 Principal repayment is Rs. 100 Required rate of return is 10% V0=I*PVIFA (kd, n) + F*PVIF (kd, n) Value of the bond=12*PVIFA (10%, 5y) + 100*PVIF (10%, 5y) = 12*3.791 + 100*0.621 = 45.49+62.1 = Rs. 107.59 Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years coupled with a nominal interest rate of 8%. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond? Solution: Interest payable=1000*8%=Rs. 80 Principal repayment is Rs. 1000 Required rate of return is 10% V0=I*PVIFA (kd, n) + F*PVIF (kd, n) Value of the bond=80*PVIFA (10%, 5y) + 1000*PVIF (10%, 5y) = 80*3.791 + 1000*0.621 = 303.28 + 621 =Rs. 924.28

This implies that the company is offering the bond at Rs. 1000 but is worth Rs. 924.28 at the required rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today. Bond Values with Semi-Annual Interest payment: In reality, it is quite common to pay interest on bonds semiannually. With the effect of compounding, the value of bonds with semiannual interest is much more than the ones with annual interest payments. Hence, the bond valuation equation can be modified as: V0 or P0= n t=1 I/2/ (I+id/2) n +F/ (I+id/2) 2n Where V0=Intrinsic value of the bond P0=Present Value of the bond I/2=Semiannual 9

Interest payable on the bond F=Principal amount (par value) repayable at the maturity time 2n=Maturity period of the bond expressed in half-yearly periods Kd/2=required rate of return semi-annually. Example: A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period of 6 years. Interest is payable semiannually. If the required rate of return is 12%, calculate the value of the bond. Solution: V0 or P0= n t=1 (I/2)/ (I+kd/2) n +F/ (I+kd/2) 2n = (100/2)/ (1+0.12/2) 6 + 1000/ (1+0.12/2) 6 =50*PVIFA (6%, 12y) + 1000*PVIF (6%, 12y) =50*8.384 + 1000*0.497 =419.2 + 497 =Rs. 916.20 It is to be kept in mind that the required rate of return is halved (12%/2) and the period doubled (6y*2) as the interest is paid semiannually.

(c)Zero Coupon Bonds: In India Zero coupon bonds are alternatively known as Deep Discount Bonds. For close to a decade, these bonds became very popular in India because of issuance of such bonds at regular intervals by IDBI and ICICI. Zero-coupon bonds have no coupon rate, i.e. there is no interest to be paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the amount payable to the holder of the instrument on maturity. The difference between the discounted issue price and face value is effective interest earned by the investor. They are called deep discount bonds because these bonds are long term bonds whose maturity some time extends up to 25 to 30 years. Example: River Valley Authority issued Deep Discount Bond of the face value of Rs.1, 00,000 payable 25 years later, at an issue price of Rs.14, 600. What is the effective interest rate earned by an investor from this bond? Solution: The bond in question is a zero coupon or deep discount bond. It does not carry any coupon rate. Therefore, the implied interest rate could be computed as follows: Step 1. Principal invested today is Rs.14600 at a rate of interest of r% over 25 years to amount toRs.1, 00,000. Step 2. It can be stated as A = P0 (1+r) n 10

Solving for r, we get

1, 00,000 = 14,600 (1+r) 25 1, 00,000/14600 = (1+r) 25 6.849 = (1+r) 25

Reading the compound value (FVIF) table, horizontally along the 25 year line, we find r equals 8%. Therefore, bond gives an effective return of 8% per annum.

Q6. Given the following information, what will be the price per share using the Walter model. Earnings per share Rs. 40 Rate of return on investments 18% Rate of return required by shareholders 12% Payout ratio being 40%, 50%, or 60%. Solution: Walter Mode Formula P=D/Ke + [r (E-D)/Ke] / Ke P is the market price per share, D is the dividend per Share, Ke is the cost of capital g is the growth rate of earnings, E is earning of share = 40, r is IRR = 18 % Dp ratio = 40 %, 50%, 60% P=D/Ke + [r (E-D) / Ke]/Ke 40% =0.4 / Ke + [0.18(40-0.4) / 0.12]/0.12 =0.4 + [0.18(40-0.4) / 0.12]/0.12 P =Rs.498.33

50%=0.5/0.12 + [0.18(40-0.5) / 0.12] / 0.12 =0.5 + [0.18(40-0.5) / 0.12] / 0.12 P =Rs.497.91 11

60%=0.6 / 0.12 + [0.18(40-0.6) / 0.12] / 0.12 =0.6 + [0.18(40-0.6) / 0.12] /0.12 P =Rs.497.91

12