MBA – II Semester

MB0028 - Set 1

Financial Management

1. 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 cost resulting in Ke and Kd being the same.

Graphically this is represented as:

Percentage cost
 2. Assume you are newly appointed as Finance Executive in a Manufacturing
firm. What guidelines you need to follow in financial planning?

Answer : Guidelines for financial planning that I would follow:

1. Never ignore the coordinal principle that fixed asset requirements be met from
thelong term sources.

2. Make maximum use of spontaneous source of finance to achieve

highest productivity of resources.

3. Maintain the operating capital intact by providing adequately out of

the current periods earnings. Due attention to be given to physical capital
maintenance or operating capability.

4. Never ignore the need for financial capital maintenance in units of constant
purchasing power.

5. Employ current cost principle wherever required.

6. Give due weightage to cost and risk in using debt and equity.

7. Keeping the need for finance for expansion of business, formulate

plough back policy of earnings.

8. Exercise thorough control over overheads.

9. Seasonal peak requirements to be met from short term borrowings from

banks.

3. Due to over capitalization the company may collapse which would certainly
affect its employees, society, consumers and its shareholders. What remedies
you would suggest? Give suitable example.

Answer : I would suggest following Remedies for Overcapitalization

1. Reduction of debt burden.
2. Negotiation with term lending institutions for reduction in interest obligation.
3. Redemption of preference shares through a scheme of capital reduction.
4. Reducing the face value and paidup value of equity shares.
5. Initiating merger with well managed profit making companies interested in taking
over ailing company.
A company is said to be overcapitalized, when its total capital (both equity and debt)
true value of its assets. It is wrong to identify overcapitalization with excess of
capital because most of the overcapitalized firms suffer from the problems of
liquidity. The correct indicator of overcapitalization is the earnings capacity of the
firm. If the earnings of the firm are less then that of the market expectation, it will
not be in a position to pay dividends to its shareholders as per their expectations. It
is a sign of overcapitalization. It is also possible that a company has more funds
than its requirements based on current operation levels, and yet have low earnings.

4a. Mr. Avinash aged 40 years, needs 50000 after 5 years. If the interest rate is
10% how much should he save now to get Rs.50000 at the end of 5 years

Answer :
FVn=PV (1+i/m)m*n
Where
i = annual nominal interest rate (as a decimal)=0.1
m = number of times the interest is compounded per year=1
n = number of years = 5
FVn = amount after time i.e. 5 yrs = 50,000
PV = principal amount (initial investment=Present Value) =?

50,000 = PV (1+ 0.1/1)1*5

= PV (1.1)5

= PV * 1.61051

PV = 50,000/1.61051

PV = Rs. 31,046.07

The amount to be saved now is Rs. 31,046.07

4b. A Senior citizen intents to deposit Rs.1000 annually in ICICI bank for 3
years. The prevailing interest rate is 10%. What is the maturity value of
the deposit?
Answer : Amount at the end of 3 years with 10% rate of interest = Deposit *
FVIFA(10%, 3y)
Where, FVIFA = Future Value of Interest Factor for Annuity

From Compound Value of Annuity table we have

For 10% and 3 years we get 3.310
= 1,000 * 3.310
= Rs. 3,310

5. 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.

1) 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

2) 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=Σ 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

Bond Values with Semi-Annual Interest payment:

In reality, it is quite common to pay interest on bonds semiannually. 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=Σ 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
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 semiannually.

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.

6. Sushma Industries wishes to issue bonds with Rs.100 as par value, 5

years to maturity, coupon rate 11% and YTM of 11%.

a. What is the value of the bond?

b. If the YTM is 10% what would be the value of the bond?

c. If the YTM is 13% what is the value of the bond

Answer : Note: In the above problem YTM is misprint. It should be Kd.

F = Rs. 100

n = 5 years
Coupon rate = 11%

I = F * Coupon rate = 100 * 11% = Rs. 11

V0 = Value of Bond = ?

(a) If kd is 11%,

V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
=11*PVIFA(11%, 5) + 100*PVIF(11%, 5)
=11*3.6959 + 100*0.593
=40.6549+59.3
=Rs. 99.95

(b) If kd is 10%,

V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
=11*PVIFA(10%, 5) + 100*PVIF(10%, 5)
=11*3.7908 + 100*0.621
=41.6988+62.1
=Rs. 103.79

(c) If kd is 13%,
V0=I*PVIFA(Kd, n) + F*PVIF(kd, n)
=11*PVIFA(13%, 5) + 100*PVIF(13%, 5)
=11*3.5172 + 100*0.543
=40.6549+54.3
=Rs. 94.95

MBA – II Semester

MB0028 - Set 2

Financial Management

1. Is Equity Capital Free of cost? Substantiate your statement.

Ans. No. Equity Capital is not free of cost. Some people are of the opinion that
equity capital is free of cost for the reason that a company is not legally bound to
pay dividends and also the rate of equity dividend is not fixed like preference
dividends. This is not a correct view as equity shareholders buy shares with the
expectation of dividends and capital appreciation. Dividends enhance the market
value of shares and therefore equity capital is not free of cost.

Equity shareholders do not have a fixed rate of return on their investment. There is
no legal requirement (unlike in the case of loans or debentures where the rates are
governed by the deed) to pay regular dividends to them. Measuring the rate of
return to equity holders is a difficult and complex exercise. There are many
approaches for estimating return - the dividend forecast approach, capital asset
pricing approach, realized yield approach, etc. According to dividend forecast
approach, the intrinsic value of an equity share is the sum of present values of
dividends associated with it.

2 (a) What is the rate of return for a company if the β is 1.25,

risk free rate of return is 8% and the market rate of return is 14%. Use
CAPM model.

Ans.
Ke = Rf + β (Rm—Rf)
 = 0.08 + 1.25(0.14 - 0.08)
= 0.08 + 0.075

= 0.155 or 15.5%

(b) Sundaram Transports has the following capital structure.

Equity capital Rs.10 par value 250 lakhs

12% preference share capital Rs.100 each 100 lakhs

Retained earnings 150 lakhs

12% Debentures (Rs.100 each) 350 lakhs

14% Term loan from SBI 150 lakhs

Total 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare a
dividend per share of Rs.2 per share and there will be a growth of 10% in
the dividends for the next 5 years. The preference shares are redeemable
at a premium of Rs.5 per share after 8 years. The current market price of
preference share is Rs.92. Debenture redemption will take place after 7
years at a discount of 2% and the current market price is Rs.91 per
debenture. The corporate tax rate is 40%. Calculate WACC.

Ans.

Ke is the cost of external equity,

D1 is the dividend expected at the end of year 1 = 2

P0 is the current market price per share = Rs. 92

g is the constant growth rate of dividends = 10%

f is the floatation costs as % of current market price.

Step I is to determine the cost of each component.

Cost of external equity:

Ke =( D1/P0) + g

= (2/54) + 0.1
= 0.137 or 13.7%
Cost of preference capital:
Kp = D + {(F—P)/n} / (F+P)/2
D is the preference dividend per share payable=11
F is the redemption price=105
P is the net proceeds per share = 92
n is the maturity period =8

Kp = D + {(F—P)/n} / (F+P)/2
= 11 + (105—92)/8] / (105+92)/2

=12.625/98.5
= 0.1281 or 12.81%

Cost of Retained Earnings:

Kr=Ke which is 13.7%

Cost of debentures:

Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate = 40%

F is the redemption price per debenture = Rs. 98

P is the net amount realized per debenture = Rs. 91

n is maturity period = 7 years

Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}

= [12(1—0.4) + (98—91)/7] / (98+91)/2

= [7.2 + 1] / 94.5
= 0.0867 or 8.67%

Cost of Term Loans:

Kt = I(1—T)
=0.14(1—0.4)

= 0.084 or 8.4%

Step II is to calculate the weights of each source.

We = 250/1000 = 0.25
Wp = 100/1000 = 0.1

Wr = 150/1000 = 0.15
Wd = 350/1000 = 0.35

Wt = 150/1000 = 0.15

Step III Multiply the costs of various sources of finance with corresponding weights
and WACC calculated by adding all these components.

Weighted Average of Cost of Capital:

WACC = WeKe + WpKp +WrKr + WdKd + WtKt

= (0.25*0.137) + (0.1*0.1281) + (0.15*0.137) + (0.35*0.0867) + (0.15*0.084)

= 0.03425+ 0.01281+ 0.02055+ 0.030345+ 0.0126

= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004

= 0.1105 or 11.05%
3. The effective cost of debt is less than the actual interest payment made
by the firm. Do you agree with this statement? If yes/no substantiate your
views.

Ans. Yes. The debentures carry a fixed rate of interest. Interest qualifies for tax
deduction in determining tax liability. Therefore the effective cost of debt is less than
the actual interest payment made by the firm.
The Net Cash Outflows in terms of Amount of Periodic interest Payment and
Repayment of Principal in Installments or in lump-sum on Maturity.

The Interest Payment made by the firm on Debt Issues qualifies for tax deduction in
determining the net taxable income. Therefore, the effective cash outflow is less than
the actual payment of Interest made by the firm to the debt holders by the amount
of tax shield on Interest Payment. The debt can either be Perpetual/Irredeemable or
Redeemable.

4. Why capital budgeting decision very crucial for finance managers?

Ans. 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 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 some times 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. Investor’s 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 over run 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 over run and time over run can make a company’s
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 company’s 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 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 company’s 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 firm’s 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
today’s 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

firm’s 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.

5. A road project require an initial investment of Rs.10,00,000. It is expected

to generate the following cash flow in the form of toll tax recovery.
Year Cash Inflows

1 4,50,000
2 4,25,000

3 3,00,000
4 3,50,000

What is the IRR of the project?

Ans.

To calculate Internal Rate of Return (IRR):

Step I: Compute the average of annual cash inflows

Year Cash Inflow in Rs.

1 4,50,000

2 4,25,000

3 3,00,000

4 3,50,000

Total 15,25,000

Average = 15,00,000 / 4 = Rs. 3,81,250

Step II: Divide the initial investment by the average of annual cash inflows:
=10,00,000 / 3,81,250
=2.622

Step III: From the PVIFA table for 4 years, the annuity factor very near to 2.622 is
20%. Therefore
the first initial rate is 20%

Year Cash flows PV factor at 20% PV of Cash

1 4,50,000 0.833 3,74,850

2 4,25,000 0.694 2,94,950

3 3,00,000 0.579 1,73,700

4 3,50,000 0.482 1,68,700

Total 10,12,200

Since the initial investment of Rs.10,00,000 is less than the computed value at 20%
of
Rs. 10,12,200 then next trial rate is 22%.
 Year Cash flows PV factor at 22% PV of Cash

1 4,50,000 0.82 3,69,000

2 4,25,000 0.672 2,85,600

3 3,00,000 0.551 1,65,300

4 3,50,000 0.451 1,57,850

Total 9,77,750

Since initial investment of Rs.10,00,000 lies between 9,77,750 (22%) and 10,12,200
(20%), the IRR by interpolation is,

IRR = 20 + ((10,12,200-10,00,000) / (10,12,200-9,77,750))*2

= 20 + 0.3541 *2
= 20.70%

6. What is sensitivity analysis? Mention the steps involved in it.

Ans. Sensitivity Analysis:

There are many variables like sales, cost of sales, investments, tax rates etc which
affect the NPV and IRR of a project. Analysing the change in the project’s NPV or IRR
on account of a given change in one of the variables is called Sensitivity Analysis. It
is a technique that shows the change in NPV given a change in one of the variables
that determine cash flows of a project. It measures the sensitivity of NPV of a project
in respect to a change in one of the input variables of NPV.
The reliability of the NPV depends on the reliability of cash flows. If fore casts go
wrong on account of changes in assumed economic environments, reliability of NPV
& IRR is lost. Therefore, forecasts are made under different economic conditions viz
pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions.

Steps involved in Sensitivity analysis:

1. Identification of variables that influence the NPV & IRR of the project.
2. Examining and defining the mathematical relationship between the variables.
3. Analysis of the effect of the change in each of the variables on the NPV of the
project