NAME: MEENAKSHI

MBA-II semester

MB0029

Financial Management

SET 1
Q1. Why wealth maximization is superior to profit maximization in today’s context? Justify
your answer.

Ans.: Superiority of Wealth Maximization over Profit maximization:-

1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it takes care of the quality of cash flows.
Distant cash flows are uncertain. Converting distant uncertain cash flows into
comparable values at base period facilitates better comparison of projects.
There are various ways of dealing with risk associated with cash flows. These
risks are adequately considered when present values of cash flows are taken
to arrive at the net present value of any project.

3. In today’s competitive business scenario corporate play a key role. In

company form of organization, shareholders own the company but the
management of the company rests with the board of directors. Directors are
elected by shareholders and hence agents of the shareholders. Company
management procures funds for expansion and diversification from Capital
Markets. In the liberalized set up, the society expects corporate to tap the
capital markets effectively for their capital requirements. Therefore to keep
the investors happy through the performance of value of shares in the market,
management of the company must meet the wealth maximization criterion.

4. When a firm follows wealth maximization goal, it achieves maximization of

market value of share. When a firm practices wealth maximization goal, it is
possible only when it produces quality goods at low cost. On this account
society gains because of the societal welfare.

5. Maximization of wealth demands on the part of corporate to develop new

products or render new services in the most effective and efficient manner.
This helps the consumers as it will bring to the market the products and
services that consumer’s need.

6. Another notable features of the firms committed to the maximization of

wealth is that to achieve this goal they are forced to render efficient service to
their customers with courtesy. This enhances consumer welfare and hence the
benefit to the society.

7. From the point of evaluation of performance of listed firms, the most

remarkable measure is that of performance of the company in the share
market. Every corporate action finds its reflection on the market value of
shares of the company. Therefore, shareholders wealth maximization could be
considered a superior goal compared to profit maximization.

8. Since listing ensures liquidity to the shares held by the investors, shareholders
can reap the benefits arising from the performance of company only when
they sell their shares.

Therefore, it is clear that maximization of market value of shares will lead to

maximization of the net wealth of shareholders.

Therefore, we can conclude that maximization of wealth is the appropriate of goal of

financial management in today’s context.
Q 2. Your grandfather is 75 years old. He has total savings of Rs.80, 000. He expects that
he live for another 10 years and will like to spend his savings by then. He places his
savings into a bank account earning 10 per cent annually. He will draw equal amount each
year- the first withdrawal occurring one year from now in such a way that his account
balance becomes zero at the end of 10 years. How much will be his annual withdrawal?

Ans.:

Present Value (PV) =80000/-

Amount (A) =?

Interest Rat e (I) =10%

No. of Year (N) =10

PVAn = A {1+i) n-1} / {i (1+i) n}

80000=A {1+.10)10}/ {.10(1+.10)10}

80000=A {1.593742/0.259374}

A =80000/ 6.144567
A = 13019.63 yearly

Q 3. What factors affect financial plan?

Ans.: Factors Affecting Financial Plan

1. Nature of the industry: Here, we must consider whether it is a capital intensive

or labor intensive industry. This will have a major impact on the total assets that the
firm owns.
2. Size of the Company: The size of the company greatly influences the availability
of funds from different sources. A small company normally finds it difficult to raise
funds from long
X Ds X 1000
X Ds X 1000 term sources at competitive terms. On the other hand, large companies
like Reliance enjoy the privilege of obtaining funds both short term and long term at
attractive rates.

3. Status of the company in the industry: A well established company enjoying a

good market share, for its products normally commands investors’ confidence. Such
a company can tap the capital market for raising funds in competitive terms for
implementing new projects to exploit the new opportunities emerging from changing
business environment.

4. Sources of finance available: Sources of finance could be grouped into debt and
equity.
Debt is cheap but risky whereas equity is costly. A firm 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 the firm may
manage higher financial risk with a lower business risk. Selection of sources of
finance is closely linked to the firm’s capacity to manage the risk exposure.

5. The Capital structure of a company is influenced by the desire of the existing

management (promoters) of the company to retain 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 prudent 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 terms finance. All fixed
assets financed investments are to be financial by long term sources. It is a cardinal
principle of financial planning.

7. Flexibility: The financial plan of a 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 compliances with many statues
in India.
They are to be complied with a time constraint.
 SET 2

Q 1. A. What is the cost of retained earnings?

B. a company issues new debentures of Rs.2 million, at par; the net proceeds
being Rs.1.8 million. It has a 13.5 per cent rate of interest and 7 years maturity.
The company’s tax rate is 52 per cent. What is the cost of debenture issue? What
will be the cost in 4 years if the market value of debentures at that time is Rs.2.2
million?

Ans.:
Cost of Retained Earnings
Cost of retained earnings (ks) is the return stockholders require on the company’s
common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the
risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-
bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the company’s beta (bi), which is an estimate of the stock’s
risk. Inputting these assumptions into the CAPM equation, you can then calculate the
cost of retained earnings.

B) Bond-Yield-Plus-Premium Approach
this is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take
the interest rate of the firm’s long-term debt and add a risk premium (typically three to
five percentage points):

Ks = long-term bond yield + risk premium

 c) Discounted Cash Flow Approach Also known as the “dividend yield plus growth
approach”. Using the dividend-growth model, you can rearrange the terms as
follows to determine ks.

ks = D1 + g;
P0

where:
D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price

Q3. Explain Miler

B Ans.:

(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,
F is the redemption price per debenture,
P is the net amount realized per debenture,
N is maturity period
13.5(0.52) + (1.8)/ 13.5*.48+2/7
6.51
(2+1.8)/2 1.9
=3.43
(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4
(2+2.2)/2 2.1
=6.43/.21=3.06

Q 3. Explain Miller and Modigliani Approach to capital structure theory.

Ans.: Miller and Modigliani Approach Miller and Modigliani criticize that the cost of equity
remains unaffected by leverage up to a reasonable limit and KO being constant at all degrees of
leverage. They state that the relationship between leverage and cost of capital is elucidated as in
NOI approach. The assumptions for their analysis are:
 • Perfect capital markets: Securities can be freely traded, that is, investors are free to
buy and sell securities (both shares and debt instruments), there are no hindrances on
the borrowings, no presence of transaction costs, securities infinitely divisible, availability
of all required information at all times.
• Investors behave rationally, that is, they choose that combination of risk and return
that is most advantageous to them.
• Homogeneity of investors risk perception, that is, all investors have the same
perception of business risk and returns.
• Taxes: There is no corporate or personal income tax.
• Dividend pay-out is 100%, that is, the firms do not retain earnings for future activities.
Basic propositions: The following three propositions can be derived based on the above
assumptions: Proposition I: The market value of the firm is equal to the total market value of
equity and total market value of debt and is independent of the degree of leverage. It can be
expressed as: Expected NOI Expected overall capitalization rate V + (S+D) which is equal to
O/Ko which is equal to NOI/Ko V + (S+D) = O/Ko = NOI/Ko Where V is the market value of the
firm, S is the market value of the firm’s equity, D is the market value of the debt, O is the net
operating income, Ko is the capitalization rate of the risk class of the firm.

Error!

The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage
mechanism. Arbitrage is the process of buying a security at lower price in one market and selling
it in another market at a higher price bringing about equilibrium. This is a balancing act. Miller and

Modigliani perceives that the investors of a firm whose value is higher will sell their shares and in
return buy shares of the firm whose value is lower. They will earn the same return at lower outlay
and lower perceived risk. Such behaviors are expected to increase the share prices whose
shares are being purchased and lowering the share prices of those share which are being sold.
This switching operation will continue till the market prices of identical firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization rate)
applicable plus a premium.
Ke = KO + [(KO—KD) D/S]

Proposition III: The average cost of capital is not affected by the financing decisions as
investment and financing decisions are independent.

Q4. How to estimate cash flows? What are the components of incremental cash flows?

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of

any kind. To evaluate these investment decisions there are some principles of
cash flow estimation. In any kind of project, planning the outputs properly is
an important task. At the same time, the profits from the project should also
be very clear to arrange finances in a proper way. These forecasting are
some of the most difficult steps involved in the capital budgeting. These are
very important in the major projects because any kind of fault in the
calculations would result in huge problems. The project cash flows consider
almost every kind of inflows of cash. The capital budgeting is done through
the coordination of a wide range of professionals who are going to be
involved in the project. The engineering departments are responsible for the
forecasting of the capital outlays. On the other hand, there are the people
from the production team who are responsible for calculating the operational
cost. The marketing team is also involved in the process and they are
responsible for forecasting the revenue.
Next comes the financial manager who is responsible to collect all the data
from the related departments. On the other hand, the finance manager has
the responsibility of using the set of norms for better estimation. One of these
norms uses the principles of cash flow estimation for the process.
There are a number of principles of cash flow estimation. These are the
consistency principle, separation principle, post-tax principle and incremental
principle. The separation principle holds that the project cash flows can be
divided in two types named as financing side and investment side. On the
other hand, there is the consistency principle. According to this principle,
some kind consistency is necessary to be maintained between the flow of
cash in a project and the rates of discount that are applicable on the cash
flows. At the same time, there is the post-tax principle that holds that the
forecast of cash flows for any project should be done through the after-tax
method.

Incremental Principle

The incremental principle is used to measure the profit potential of a project.

According to this theory, a project is sound if it increases total profit more
than total cost. To have a proper estimation of profit potential by application
of the incremental principle, several guidelines should be maintained:

Incidental Effects: Any kind of project taken by a company remains related to

the other activities of the firm. Because of this, the particular project
influences all the other activities carried out, either negatively or positively. It
can increase the profits for the firm or it may cause losses. These incidental
effects must be considered.
Sunk Costs: These costs should not be considered. Sunk costs represent an
expenditure done by the firm in the past. These expenditures are not related
with any particular project. These costs denote all those expenditures that
are done for the preliminary work related to the project, unrecoverable in any
case.
Overhead Cost: All the costs that are not related directly with a service but
have indirect influences are considered as overhead charges. There are the
legal and administrative expenses, rentals and many more. Whenever a
company takes a new project, these costs are assigned.
Working Capital: Proper estimation is essential and should be considered at
the time when the budget for the project's profit potential is prepared.