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Master of Business Administration- MBA Semester 2 MB 0045/MBF 201 -FINANCIAL MANAGEMENT - 4 Credits (Book ID:B1628) Assignment Set -1 (60

marks)

Q1. What are the goals of financial management? The financial management has to take three important decision viz. (i) Investment decision i.e., where to invest fund and in what amount, (ii) Financing Decision i.e., from where to raise funds and in what amount, and (iii) Dividend i.e., how much to pay dividend and how much to retain for future expansion. In order to make these decisions the management must have a clear understanding of the objective sought to be achieved. It is generally agreed that the financial objective of the firm should be maximization of owners economic welfare. There are two widely discussed approaches or criterion of maximizing owners welfare -(i) Profit maximization, and (ii) Wealth maximization. It should be noted here that objective is used in the sense of goal or goals or decision criterion for the three decisions involved Profit Maximization: Maximization of profits is very often considered as the main objective of a business enterprise. The shareholders, the owners of the business, invest their funds in the business with the hope of getting higher dividend on their investment. Moreover, the profitability of the business is an indicator of the sound health of the organization , because, it safeguards the economic interests of various social groups which are directly or indirectly connected with the company e.g. shareholders, creditors and employees. All these parties must get reasonable return for their contributions and it is possible only when company earns higher profits or sufficient profits to discharge the obligations to them.

Wealth Maximization: The wealth maximization (also known as value maximization or Net Present Worth Maximization) is also universally accepted criterion for financial decision making. The value of an asset should be viewed in terms of benefits it can produce over the cost of capital investment.

Prof. Era Solomon has defined the concept of wealth maximization as follows- The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or as capitalized) at a rate which reflects their certainty or uncertainty. Wealth or net amount of capital investment required to achieve

the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken) then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximize wealth or net present worth. Thus, the concept of wealth maximization is based on cash flows (inflows and outflows) generated by the decision. If inflows are greater than outflows, the decision is good because it maximizes the wealth of the owners.

We have discussed above the two goals of financial management. Now the question is which one is the best or which goal should be followed in decision making. Certain objections have been raised against the profit maximization goal which strengthens the case for wealth maximization as the goal of financial decisions. Q2. Explain the factors affecting Financial Plan. Answer:-We live in a society and interact with people and environment. What happens tous 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. Factors Affecting Financial Plan 1. Nature of the industry: - Here, we must consider whether it is a capital intensive of labour intensive industry. This will have a major impact on the total assets that thefirm owns. 2. Size of the company: The size of the company greatly influences the availability of funds from different sources.

Asmall company normally finals it difficult to raisefunds from long term sources at competitive terms. On the other hand, largecompanies like Reliance enjoy the privilege of obtaining funds both short term andlong terms at attractive rates. 3 Status of the company in the industry:Awell established company enjoying a good market share, for its products normally commands investors confidence. Such acompany can tap the capital market for raising funds in competitive term for implementation new projects to exploit the new opportunity emerging from changing business environment. 4. Sources of finance available:-Sources of finance could be group into debt and equity. Debt is cheap but risky whereas equity is costly.Afirm should aim at optimum capital structure that would achieve the least cost capital structure.A Large firm with a diversified product mix may manage higher quantum of debt because thefirm may manage higher financial risk with a lower business risk. Selection of sources of finances us closely linked to the firms capacity to manage the risk exposure. 5 The capital structure of a company:-Capital structure of a company is influenced by the desire of the existing management of the company to remain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. 6. Matching the sources with utilization:The product policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed assets-investment are to be finance by long term sources. It is a cardinal principal of financial planning.

7 Flexibility:-The financial plan of company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds.

This factor has become a significant one today because of the globalization of capital market. 8 Government Policy:-

SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of Corporate Affairs (Govt. of India) influence the financial plans of corporate today. Management of public issues of shares demands the companies with much status in India. They are to be compiled with a time constraint.

Q3. Explain the time value of money.

The time value of money is the value of money figuring in a given amount of earned or accrued over a given amount of time. The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the "value" of the money. The time value of money is the central concept in finance theory. For example, $100 of today's money invested for one year and earning 5% interest will be worth $105 after one year. Therefore, $100 paid now or $105 paid exactly one year from now both have the same value to the recipient who assumes 5% interest; using time value of money terminology, $100 invested for one year at 5% interest has a future value of $105. This notion dates at least to (14911586) The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream. All of the standard calculations for time value of money derive from the most basic algebraic expression for the of a future sum, "to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV r PV = FV/(1+r). Some standard calculations based on the time value of money are: The current worth of a future sum of money or stream of given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the

appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations. Present value of an An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due. Present value of a is an infinite and constant stream of identical cash flows is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Q4. XYZ India Ltds share is expected to touch Rs. 450 one year from now. The company is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be willing to buy if his or her required rate of return is 15%?

Solution An equity share can be held at an indefinite period as it has no maturity date, in which case the value of a price at time zero is: P0= D1 /(1+Ke)1+ D2 /(1+Ke)2+ D3 /(1+Ke)3+..+ D /(1+Ke) OrP0= t=1Dn{(1+K e)n}Where P0= Current market price of the shareD1= expected dividend after one yearP1= expected price of the share after one year D = expected dividend at infinite duration Ke = required rate of return on the equity share. The above equation can also be modified to find the value of an equity share for a finite period. P0= D1 /(1+Ke)1+ D2 /(1+Ke)2+ D3 /(1+Ke)3 +..+ D /(1+Ke)+ P n/(1+Ke)n P0= D1 /(1+Ke) + P1 /(1+Ke)= {25/(1+0.15)} + {450/(1+0.15)}=

21.74 + 391.30= Rs. 413.04 An investor would be willing to buy the share at Rs/ 413.04

Q5. Below Table depicts the statistics of a firm and its sales requirements. Compute the DOL according to the values given in the table.

Table: Statistics of a Firm Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT 20000 10000 6000 0 6000

2000

Solution: DOL= {Q(SV)} / {Q(SV)F} {2000(10000)} / {2000(10000) 0} =2000000/2000000 =DOL=1

The DOL according to the values given in the table is 1.

Q6. What are the assumptions of MM approach? Ans: The proposition that the weighted average cost of capital is constant irrespective of the type of capital structure is based on the following assumptions:

(a) Perfect capital markets: The implication of a perfect capital market is that (i) securities are infinitely divisible; (ii) investors are free to buy/sell securities; (iii) investors can borrow without restrictions on the same terms and conditions as firms can; (iv) there are no transaction costs; (v) information is perfect, that is, each investor has the same information which is readily available to him without cost; and (vi) investors are rational and behave accordingly. (b) Given the assumption of perfect information and rationality, all investors have the same expectation5 of firm's net operating income (EBIT) with which to evaluate the value of a firm. (c) Business risk is equal among all firms within similar operating environment that means, all firms can be divided into 'equivalent risk class' or 'homogeneous risk class'. The term equivalent/homogeneous^ risk class means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to have the same risk characteristics. The categorization of firms into equivalent risk class is on the basis of the industry group to which the firm belongs. (d) e) The dividend payout ratio is 100 per cent. There are no taxes. This assumption is removed later.