FINANCIAL MANAGEMENT

NAZIA PARVEEN
Roll No - 112162599 MBA IGNOU SEM-II

FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT

MODULE TITLE: FINANCIAL MANAGEMENT

INSTRUCTIONS Students would carry a Plagiarism Check of the submitted document on VIPER and submit the report alongwith the assignment. He/she would also sign the Plagiarism check statement on the cover page. Weightage will be given to critical evaluation or reflection on the problem/issue being analyzed.

Q1. A project requires an initial outlay of Rs.20, 000. It generates year ending cash flows of Rs. 12,000, Rs.6, 000, Rs.4, 000, Rs.10, 000 and Rs. 10,000. The required rate of return is 10 percent and pays tax at 50 percent. The project has a life of 5 years and depreciated on straight-line basis. Assume that the above year ending cash flows are after depreciation and tax. You are required to compute:(50) 1. 2. 3. 4. 5. Pay back period. Average rate of return. NPV @ 10%. Profitability index. Internal rate of return.

Q2. Godrej, a leader in FMCG markets needed a financial advice to further expand its operations across India. The management of Godrej has identified a niche market in rural parts that needed a particular product development, not currently manufactured by the company. The company is there fore thinking of producing a new type of product i.e. Dry less Soap. The survey of the companys marketing department reveals that the company could sell 1, 20,000 dry less soaps each year for ten years at a price of Rs. 1,200 each. The Companys current facilities cannot be used to manufacture the new dry less soaps. A S.M.E. has offered two options to the company. The first option is that the company could buy four small machines with the capacity of manufacturing 30,000 soaps each at Rs.115 million each. The machine operation & manufacturing cost of each tank will be Rs.535.Alternatively; Godrej can buy a larger machine with a capacity of 1, 20,000 units per annum for Rs. 500 million. The machine operation & manufacturing costs of each tank will be rs.450. The company has a required rate of return of 12 percent. Assume that the company does not pay any taxes. Comment which option should the company accept? And also state why do you think the method chosen by you is the most suitable method of evaluation? (50)

FINANCIAL MANAGEMENT

CALCULATION OF CASH FLOWS AFTER TAX ( C.F.A.T)

Working note
Particulars CFAT and depreciation Add: Depreciation (20000/5) C.F.AT 1 12000 4000 2 6000 4000 3 4000 4000 4 10000 4000 5 10000 4000

16000

10000

8000

14000

14000

PAY BACK PERIOD:Payback period means The length of time it takes to recover the cost of an investment. It is calculated as:-

Year 1 2 3 4 5

cash inflows 16000 10000 8000 14000 14000

cumulative cash inflows 16000 26000 34000 48000 62000

PBP =

1 + 20000-16000 26000-16000

1.4 Years

FINANCIAL MANAGEMENT
AVERAGE RATE OF RETURN (ARR):The rate of return on an investment that is calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. The average rate of return does not guarantee that the cash inflows are the same in a given year; it simply guarantees that the return averages out to the average rate of return.

AVERAGE RATE OF RETURN = Average Profit after tax (PAT) Average Investment

* 100

Average Profit after tax (PAT) = 12000+ 6000+ 4000+ 10000+ 10000 5 = 8400

Average Rate of Return = 8400 * 100 10000

84%

NPV (Net Present value):The NPV of an investment proposal may be defines as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with a proposal. It is a discounted cash flow technique.

NPV= Present value of cash inflows Present value of cash outflows

NPV

= [(16000*0.909)+ (10000*0.826)+ (8000*0.751)+ (14000*0.683)+ (14000*0.621)] - 20000

= =

47068 20000 27068

FINANCIAL MANAGEMENT
Profitability Index:The profitability index is an alternative way of stating the net present value (NPV), also known as benefit/cost ratio. The Profitability Index is a great indicator of how good of an investment we are making. It's especially useful if we can only invest a limited amount on a real estate investment property. We can calculate the Profitability Index for multiple real estate investment possibilities, and the one that has the highest profitability index value is the one where we should focus our resources.

Profitability Index = Present value of cash inflows Present value of cash outflows
= 47068 20000 = 2.3534

IRR (INTERNAL RATE OF RETURN):The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)". Present value of cash inflows: At 60% = (0.625*16000+ 0.391*10000+ 0.244*8000+ 0.153*14000+ 0.095*14000) =19334 At 50% = (0.667*16000+ 0.444*10000+ 0.296*8000+ 0.198*14000+ 0.132*14000) =22100
IRR 50% 60% 10% PVCI 22100 19334 2766

At At Difference

IRR = 50% + 22100-20000 * 10% 22100-19334 = 57.59% (approx.)

FINANCIAL MANAGEMENT
Part-II

EVALUATION OF PROPOSAL

Computation of Present value of cash outflow (PVCOF) 1st Option

Particulars Time Present value factor 1 5.65 Amount 460 64.2

(Figures in millions)
Present Value 460 362.73

Cost of machine 0 (4 machines *115) Operation and 0-10 manufacturing cost (30000*4machines*535) PVCOF

822.73

1st Option
Particulars Time Present value factor 1 5.65 Amount 500 54

(Figures in millions)
Present Value 500 305.10

Cost of machine 0 Operation and 0-10 manufacturing cost (120000*450) PVCOF

805.10

Computation of Present value of cash inflow (PVCIF)

Cash inflows Particulars Revenue from sales (1200*120000) PVCIF Time 1-10 Present value factor 5.65 Amount 144 Present Value 813.6

813.6

FINANCIAL MANAGEMENT
1st OPTION Net Present Value (NPV) = PVCIF PVCOF = 813.6 822.73 = (9.13) million (in millions)

2nd

OPTION Net Present Value (NPV) = PVCIF PVCOF =813.60- 805.10 = 8.5 million

(in millions)

Thus 2nd Option is a better proposal REASON:

Option 2 should be chosen as it leads to positive cash flow unlike 1st option. It is a profitable to invest in proposal 2nd hence it is a better deal.

NPV A suitable method of evaluation: NPV technique recognises the time value of money. Thus it is suitable because it helps evaluation of proposals involving cash flows over a period of several years. The cash flows occurring at different point of time are not directly comparable but they can be compared by application of discounting technique. As it is based on cash flows rather than on accounting profit, it helps in analysing the effect of the proposal on the wealth of shareholders in a better way. The discount rate incorporates both the pure return as well as premium required to set off risk. When the cash outlay of the two projects is different i.e size disparity problem, then NPV method is better than IRR because it is compatible with the goal of wealth maximization.

FINANCIAL MANAGEMENT

BIBLOGRAPHY: Rustagi, R P, Fundamentals of Financial Management, Galgotia Publishing Company,

2006 edition.
Khan, M Y. et al., PK Jain, Financial Management, Tata Mc-Graw Hill Publications,

Sixth Edition.
Quirin, G D, The Capital Expenditure Decision, Richard D. Irwin, Homewood Ill.,

1967.
http://www.realbench.net/profitability_index.php http://www.investopedia.com/terms http://www.investopedia.com/terms http://www.investopedia.com/terms/p/paybackperiod.asp#axzz1c3lsi4My http://www.investopedia.com/terms/i/irr.asp#axzz1cOX6Syfb