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SHIVENDRA SINGH 1208005653

(Spring/Feb 2013)

Master of Business Administration - MBA Semester 2 MB0045 Financial Management ASSIGNMENT- Set 1

Q1. What are the goals of financial management? Financial Management means maximization of economic welfare of its shareholders. Maximization of economic welfare means maximization of wealth of its shareholders. Shareholders wealth maximization is reflected in the market value of the firms shares. Experts believe that, the goal of the financial management is attained when it maximizes its value. There are two versions of the goals of financial management of the firm Profit Maximization and Wealth Maximization. Profit Maximization: Profit maximization is based on the cardinal rule of efficiency. Its goal is to maximize the returns, with the best output and price levels. A firms performance is evaluated in terms of profitability. Allocation of resources and investors perception of the companys performance can be traced to the goal of profit maximization. Profit maximization has been criticized on many accounts: 1. The concept of profit lacks clarity. What does profit mean? Is it profit after tax or before tax? Is it operating profit or net profit available to share holders? Differences in interpretation on the concept of profit expose the weakness of profit maximization. 2. Profit maximization ignores time value of money. It does not differentiate between profits of current year with the profit to be earned in later years. 3. The concept of profit maximization fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk of the firm. 4. The concept of profit maximization apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximization fails to meet the standards stipulated in an operational and a feasible criterion for maximizing shareholders wealth, because of the deficiencies explained above. Wealth Maximization Wealth maximization means maximizing the net wealth of a companys shareholders. Wealth maximization 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 maximization. The following arguments are in support of the superiority of wealth maximization over profit maximization Wealth maximization 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 maximization is based on accounting profit and it also contains many subjective elements.

Wealth maximization 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 crystallizes into the rate of return that will motivate investors to part with their hard earned savings. Maximizing the wealth of the shareholders means positive net present value of the decisions implemented.

Q2. Calculate the PV of an annuity of Rs. 500 received annually for four years when discounting factor is 10%. Solution: Computation of PV of Annuity End of year Cash inflows PV factor PV in Rs. 1 Rs.500 0.909 454.5 2 3 4 Rs.500 Rs.500 Rs.500 0.827 0.751 0.683 3.170 413.5 375.5 341.5 1585.0

Present value of an annuity is Rs. 1585. Or By directly looking at the table we can calculate: = 500*PVIFA (10%, 4y) = 500*3.170 = Rs. 1585 The present value of annuity is Rs. 1585.

Q3. Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10% p.a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company? Solution:Ke = (D1/Pe) + g = (5/110) + 0.10 = 0.1454 or 14.54% Cost of equity capital is 14.54%

Q4. What are the assumptions of MM approach? 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. Certain assumptions regarding Miller and Modigliani model are as follows: 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 investors large enough to influence the share value. 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

The dividends and the profits of the firm have 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 programmers, simultaneously. The two transactions which the arbitrate process refers to are: paying out dividends and raising external funds to finance additional investment programmers

If the firm pays out dividend, it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralize 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. Q5. An investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows. Table 1.2 highlights the cash inflow for four years. Year 1 2 3 4 Table 1.2: Cash inflow Cash inflow 40000 50000 15000 30000

If the risk free rate and the risk premium is 10%, a) Compute the NPV using the risk free rate b) Compute NPV using risk-adjusted discount rate

Solution: a) NPV can be computed using risk free rate.NPV calculation using the risk free rate. PV Using Risk Free Rate

Year 1 2 3 4

Cash flows (inflows) Rs. 40000 50000 15000 30000 PV of cash inflows PV of cash outflows NPV

PV factor at 10% 0.909 0.826 0.751 0.683 (1,00,000)

PV of cash flows (inflows ) 36,360 41,300 11,265 20,490 1,09,415 9,415

b) NPV can be computed using risk-adjusted discount. NPV calculation using the risk-adjusted discount. NPV Using Risk-adjusted Discount Rate Year 1 2 3 4 Cash inflows Rs. 40000 50000 15000 30000 PV of Cash in flows PV of cash outflows NPV PV factor at 20% PV of cash inflows 0.833 0.694 0.579 0.482 33,320 34,700 8,685 14,460 91,165 (100, 000) (8, 835)

The project would be acceptable when no allowance is made for risk. However, it will not be acceptable if risk premium is added to the risk free rate. By doing so, it moves from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be accepted, when IRR is greater than the risk-adjusted discount rate. Q6. What are the features of optimum credit policy? Optimum credit policy is one which would maximize the value of the firm. Value of a firm is maximized when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the Investment. Therefore, credit policy of a firm can be regarded as: Trade-off between higher profits from increased sales and The incremental cost of having large investment in receivables

The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for companys products. To summaries, in order to achieve the goal of maximizing the value of the firm the evaluation of investment in receivables accounts should involve the following four steps: 1. Estimation of incremental operating profit. 2. Estimation of incremental investment in accounts receivables. 3. Estimation of the incremental rate of return of investment. 4. Comparison of incremental rate of return with the required rate of return It is rather a different task to establish an optimum credit policy as the best combination of variables of credit policy is quite difficult to obtain. The important variables of credit policy should be identified before establishing an optimum credit policy and then they should be evaluated.

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