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Summer 2011- May drive

Masters of Business Administration- MBA Semester 2 MB0045 Financial Management - 4 Credits (Book ID: B1134) Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks.Answer all the questions.
1. A company has issued a bond with face value of Rs.1000 , with 10% pa coupon rate payable annually and a tenure of 10 years to maturity. At the end of 10 years, the bond will be redeemed at a premium of 10% to face value . a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk? b) What is the YTM of the bond if the prevailing price is same as calculated in a) above. c) What is the current yield of the bond at the given price? d) If the coupon rate is paid semi-annually, at what price would you buy the bond at the 12% pa prevailing interest rate? At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk?

a)

Solution: Interest payable = 1000*10% = Rs. 100 Principal repayment is Rs. 1000 Required rate of return is 12% V0=I*PVIFA(Kd, n) + F*PVIF(Kd, n) Therefore, Value of bond = 100*PVIFA (12%, 10yrs) + 1000*PVIF (12%, 10yrs) = 100*5.6502 + 1000*0.3220 = 565.02 + 322 = Rs. 887.02
b)

What is the YTM of the bond if the prevailing price is same as calculated in a) above.

Solution: YTM = {I + (F P) / n} / { (F P) / 2 } = 100 + {(1000 887.02) / 10 / {(1000 + 887.02) / 2} = {100 + 11.298} / 943.51 = 0.1179 or 11.79%

c)

What is the current yield of the bond at the given price?

Solution: Current Yield (CY) = Coupon Interest / Current Market Price CY = Coupon Interest / Current Market Price = 100 / 887.02 = 0.112 or 11.2%

e) If the coupon rate is paid semi-annually, at what price would

you buy the bond at the 12% pa prevailing interest rate? Solution: V0 or P0 = nt=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n 10 = (100/2) / (1 +0.12/2) + 1000 / (1 + 0.12/2)10 = 50*PVIF (6%, 20yrs) + 1000*PVIF (6%, 20yrs) = 50*11.470 + 1000*0.312 = 573.5 + 312 = Rs. 885.50

2. Given the following details for a company:

Net operating income Overall cost of capital Value of the firm Cost of debt Interest Market value of debt Market value of equity

200,000 20% 1000,000 15% 75,000 500,000 500,000

a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000. b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000. a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000. Solution: The equity capitalization rates are

Summer 2011- May drive Ke = K0+[ (K0 Kd)(B/S)]

= 0.20 + [ (0.20 0.15) (2.5) ] = 0.325 = 32.5% b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000. Solution: Cost of capital K0 = [B/ (B+S)]Kd + [S/(B+S)]Ke = [500,000 / (500,000 + 200,000)] 15% + 200,000 / (500,000 + 200, 000)] 32.5% = 0.107 + 0.092 = 0.199 = 19.9%

3. Given the following projects , rank them on the basis of NPV, MIRR and Payback period if the cost of capital is 10% pa. Project Year 0 1 2 3 4 A Year Project B Cash flow 0 1 2 3 4 5000 8000 6500 11000 Year Project C Cash flow 0 5000 8500 9000 12000 -10000

Cash flow -10000 5000 7000 8000 15000

-10000 1 2 3 4

Solution: Computation of NPV Year 1 2 3 4 Cash in flows 5000 7000 8000 15000 Project A PV factor at 10% 0.909 1.736 2.487 3.17 PV of Cash inflow Initial cash outlay NPV PV of Cash in flows 4545 12152 19896 47550 84143 10000 74143

Year 1

PV of Cash in flows 4545

Summer 2011- May drive 2 3 4 8000 6500 11000 1.736 2.487 3.17 PV of Cash inflow Initial cash outlay NPV 13888 16165.5 34870 69468.5 10000 59468.5

Project C PV factor at 10% PV of Cash in flows 0.909 4545 1.736 14756 2.487 22383 3.17 38040 PV of Cash inflow 79724 Initial cash outlay 10000 NPV 69724 Computation of Payback Period Project A Project B Project C Year Cash Cumulative Cash Cumulative Cash Cumulative Flow Cash Flows Flow Cash Flows Flow Cash Flows 1 5000 5000 5000 5000 5000 5000 2 7000 12000 8000 13000 8500 13500 3 8000 20000 6500 19500 9000 22500 4 15000 35000 11000 30500 12000 34500 From the cumulative cash flow the initial cash outlay of Rs. 10000 lies between 1st year and 2nd year in respect of project A, project B and project C. Therefore, payback period for project A is 1+ 10000 5000 = 1.4years 12152 Therefore, payback period for project B is 1+ 10000 5000 = 1.36years 13188 Therefore, payback period for project C is 1+ 10000 5000 = 1.3years 14756 Ranking of Projects NPV Payback Period Project Absolute Rank Absolute Rank A 74143.00 2 1.4 1 B 59468.50 3 1.36 2 C 79724.00 1 1.3 3 Year 1 2 3 4 Cash in flows 5000 8500 9000 12000

Summer 2011- May drive 4. Given the following information, calculate Degree of operating leverage, Degree of Financial leverage, Degree of total leverage.

Quantity sold Variable cost per unit Selling price Fixed cost

1000,000 @ 15%pa

Preference shares 10,000 of Rs.100 each @ 10% Tax rate 30%

Quantity sold 100,000 units Variable cost per unit 200 Selling price 800 Fixed cost 10,000 Number of equity shares 50,000 Debt 1000,000 @ 15%pa Preference shares 10,000 of Rs.100 each @ 10% Tax rate 30% Solution: To Find out Degree of Operating Leverage DOL = {Q(SV)} / {Q(SV)F} = {100,000 (800 200)} / 100,000 (800 200) 10,000 = 60,000,000 / 59,990,000 = 1.00016 To Find out Degree of Financial Leverage DFL = EBIT {EBITI{Dp/(1-T)}} = 59,990,000 {59,990,000 150,000 {100,000/1-0.30} = 59,990,000 59,697,142.86 = 1.0049 To Find out Degree of Total Leverage DTL = DOL*DFL = 1.00016*1.0049 = 1.0050 DTL = Q(S V) / Q(S V) F I {DP / (1 T)} = 60,000,000 / 60,000,000 10,000 150,000 {100,000/0.7} = 1.0050

Summer 2011- May drive 5. Explain the following concepts : a) Operating cycle b) Total inventory cost c) Price earnings ratio d) Financial risk

Operating Cycle The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. Total Inventory Cost Total Inventory cost is the total cost associated with ordering and carrying inventory, not including the actual cost of the inventory itself. It is important for companies to understand what factors influence the total cost they pay, so as to be able to minimize it. Use the total inventory cost calculator below to solve the formula. Total Inventory Cost Definition Total Inventory Cost is the sum of the carrying cost and the ordering cost of inventory. Variables C=Carrying cost per unit per year Q=Quantity of each order F=Fixed cost per order D=Demand in units per year Total Inventory Cost Formula : Price Earnings Ratio The price earnings ratio reflects the amount investors are willing to pay for each rupee of earnings. Expected earnings per share = (Expected PAT) (Preference dividend) / Number of outstanding shares.

Summer 2011- May drive Expected PAT is dependent on a number of factors like sales, gross profit margin, depreciation and interest and tax rate. The price earnings ratio has to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay-out ratio. Where, 1-b is dividend pay-out ratio r is required rate of return ROE*b is expected growth rate Financial Risk The risk that a company will not have adequate cash flow to meet financial obligations. Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Financial risk is an umbrella term for any risk associated with any form offinancing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return. Risk related to an investment is often called investment risk. Risk related to a companys cash flow is called business risk.

6. Explain the Net operating income approach to capital structure theories.

Answer : The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mixany mix is as good as any other. Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach: At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate. The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm Value of debt Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the

Summer 2011- May drive capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

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

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

1. Given the following information, prepare a cash budget: Month Jan Feb March April May June Sales 100000 120000 150000 160000 175000 200000 Purchases 40000 45000 35000 30000 25000 20000 Wages 10000 15000 18000 20000 22000 24000 Production overheads 6000 6500 7000 7700 8000 8500 Selling overheads 6000 6500 6600 6800 6200 6300

The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000. The company has a opening balance of cash of Rs. 40,000 on 1 st Jan 2010. Prepare a cash budget for Jan to June.

Solution: Cash Budget Opening Cash Balance Cash Receipts: Cash Sales Credit Sales Jan 40000 50000 Feb 90000 60000 25000 March 113000 April 170000 May 225900 June 326400 100000 43750 40000 510150 25000 22000 8000 6200 61200

Total Cash available Cash Payments: Materials 40000 45000 35000 30000 Wages 10000 15000 18000 20000 Production overheads 6000 6500 7000 7700 Selling overheads 6000 6500 6600 6800 Capital Expenditure 25000 Total cash payments 0 62000 73000 91600 64500 Closing cash 90000 113000 170000 225900 326400 balances

75000 80000 87500 30000 37500 40000 25000 30000 37500 90000 175000 243000 317500 390900

Summer 2011- May drive 2. Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement. Raw material Direct labour Overheads Total cost Profit Selling price 22 44 126 18 140 60

The following additional information is available: Average raw material in stock Average materials in process Credit allowed by suppliers one month 15 days one month

Credit allowed to debtors two months Time lag in payment of wages 15 days

Time lag in payment of overheads one month Sales on cash basis 20%

Cash balance to be maintained 80,000 You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.

Solution: Estimation of Working Capital a) Investment in inventory 1. Raw material = 360 = 100,000 x 60 x 30 360 = 500,000 2. Work in process inventory = 360 = 100,000 x 126 x 15

RMC x RMCP

COP x WIPCP

Summer 2011- May drive 360 = 525,000 3. Finished goods inventory = COS x FGCP 360 = 100000 x 126 x 60 360 = 2,100,000 b) Investment in debtors = Cost of credit sales x DCP 360 = 80,000 x 126 x 60 360 = 1,680,000 c) Cash Balance = 80,000 d) Total Current Asset (A+B+C) = 4,885,000 e) Current Liabilities 1. Creditors = Purchase of raw materials x PDP 360 = 100,000 x 60 x 30 / 360 = 500,000 Wages = 100,000 x 22 x 15 / 360 =91,667 3. Overheads = 100000 x 44 x 30/360 =366,667 f) Total Current Liabilities = 958334 Net Working Capital (D F) = 3,926,666

3. Given the following information, calculate the weighted average cost of capital. Capital structure in millions Equity capital ( Rs.10 par value) 14% preference share capital Rs.100 each Retained earnings 12% Debentures Rs.100 each 8% term loan Total 10 2 4 0.5 2 1.5

The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital.

Summer 2011- May drive

Solution: Step I is to determine the cost of each component. Ke = (D1/P0) + g = (5/45) + 0.15 = 0.2611 or 26.11% Kp = [D + {(F-P/n}] / [{F+P/2] = [14+ (215-90)/5] / (215-90)/2 = 14+25/62.5 = 0.624 or 62.4% Kr = Ke which is 26.11% Kd = [1(1-T) + (F-P) /n}] / {F+P)/2] = [12(1-0.3) + (210-90)/5] / (210-90)/2 = 8.4+24/60 = 0.54 or 54% Kt = 1(1-T) = 0.8(1-0.3) = 0.56 or 56% Step II is to calculate the weight of each source. We = 2/10 = 0.2 Wp = 15/10 = 0.15 Wr = 2/10 = 0.2 Wd = 4/10 = 0.4 Wt = 0.510 = 0.05 Step III WACC = Weke + Wpkp + Wrk r+ WdKd + WtKt = (0.2*0.2611) + (0.15*0.624) + (0.2*0.2611) + (0.4*0.54) + (0.05*0.56) = 0.052 + 0.0936 + 0.052 + 0.216 + 0.028 = 0.4416 or 44.16%

4. Calculate the present value of the following options: a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years Solution: a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present valve 5y) = = 10, 000*PVIF (10%,

10,000*0.621

Summer 2011- May drive = 6210

The PV of Rs. 10,000 after 5years is Rs. 6210. b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually Present valve 10y) = = 6140 = 10, 000*PVIF (5%,

10,000*0.614

The PV of Rs. 10,000 after 5years is Rs. 6140. c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa Present valve = = 3105 = 5, 000*PVIF (10%, 5y) 5,000*0.621

The PV of Rs. 5,000 after 5years is Rs. 3105. d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years Present valve of annuity = 5,000*0.621 = 3105 Present valve of annuity 10y) = 5, 000*PVIF (10%, 5y)

10, 000*PVIF (10%,

= 10,000*0.386 = 3860 The PV of Rs. 5,000 after 5years is Rs. 3105 and PV of Rs. 10,000 after 10years is Rs.3860. 5. Explain each of the following:

a) Operating cycle b) Shareholders wealth maximisation c) Capital rationing d) Economic order quantity

Answer : Operating Cycle The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers

Summer 2011- May drive

Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. Shareholders wealth maximisation Wealth maximisation means maximising the net wealth of a companys shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements. Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented. Capital Rationing 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. Capital rationing may be needed due to: External factors Internal constraints imposed by management External capital rationing External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to: Deficiencies in market information Rigidities that hamper the force flow of capital between firms When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing:-

Summer 2011- May drive

The inability of the firm to procure required funds from capital market because the firm does not command the required investors confidence National and international economic factors may make the market highly volatile and unstable Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for funds 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 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. Economic order quantity (EOQ) Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. EOQ model answers the following key quantum of inventory management. What should be the quantity ordered for each replenishment of stock? How many orders are to be placed in a year to ensure effective inventory management? EOQ is defined as the order quantity that minimises the total cost associated with inventory management. EOQ is based on the following assumptions: Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of the order size Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory Constant ordering cost: Cost per order is constant whatever be the size of the order Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

6. a) Discuss the advantages of ordering Economic order quantity of inventory. c) Discuss the Dividend discount model of measuring cost of equity.

Summer 2011- May drive Answer : Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. Advantages of ordering Economic order quantity of inventory. Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of the order size Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory Constant ordering cost: Cost per order is constant whatever be the size of the order Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory. Dividend discount model of measuring cost of equity The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends. Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as whereP0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity. This equation is also used to estimate cost of capital by solving for r From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; r g cannot be negative, i.e., r>g. In the short run if g>r, then usually a two stage DDM is used: Therefore, whereg denotes the short-run expected growth rate, denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.