Q1.

Why wealth maximization is superior to profit maximization in today¶s contex t

? Justify you answer? Answer: Superiority of Wealth Maximization over Profit Ma
ximization: 1. It is based on cash flow, not based on accounting profit. 2. Thro
ugh the proc ess of discounting it takes care of the quality of cash flows. Dist
ant uncertain cash flows into comparable values at base period facilitates bette
r comparison of projects. There are various ways of dealing with risk associate
with cash flo ws. These risk are adequately considered when present values of ca
sh of any proj ect. 3. In today¶s competitive business scenario corporate play a k
ey role. In c ompany from of organization, shareholders own the company but the
management of the company rests with the board of directors. Directors are elect
ed by sharehol ders and hence agents of the shareholders. Company management pro
cures funds for expansion and diversification from Capital Markets. In the liber
alized set up-, the society expects corporate to tap the capital market effectiv
ely for their c apital requirements. Therefore to keep the investors happy throu
gh the performan ce of value of shares in the market, management of the company
must meet the wea lth maximization criterion. 4. When a firm follows wealth maxi
mization goal, it achieve maximization of market value of share. When a firm pac
t wealth maximizat ion goal, it is possible only when procedures quality goods a
t low cost. On this account society gains became of the society welfare. 5. Maxi
mization of wealth demands on the part of corporate to develop new products or r
ender new services in the most effective and efficient manner. This helps the co
nsumers all 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 customer s with courtesy. This enhance consumer and hence the benefit t
o the society. 7. From the point of evaluation of performance of listed firms, t
he most remarkable measure is that of performance of the company in the share ma
rket. Every corpor ate action finds its reflection on the market value of shares
of the company. Th erefore, shareholders wealth maximization could be considere
d a superior goal co mpared to profit maximization. 8. Since listing ensures liq
uidity to the shares help by the investors shareholders can reap the benefits ar
ising from the perfor mance of company only when they sell their shares. Therefo
re, it is clear that m aximization of the net wealth of shareholders. Therefore
we can conclude that maximization of wealth is the appropriate of goal of financ
ial management in today¶s context.
Q2. Your grandfather is 75 years old. He has total savings of Rs.80,000. He expe
cts that he live for another 10 years and will like to spend his savings by the
n . He places his savings into a bank account earning 10 per cent annually. He w
il l draw equal amount each year- the first withdrawal occurring one year from n
ow in such a way that his account balance becomes zero at the end of 10 years. H
ow much will be his annual withdrawal? Answer:Present Value(PV) Amount (A) Inter
est Rat e(I) No. of Year(N) =80000/ =? =10% =10 PVAn = A {1+i)n -1} /{ i(1+i)n}
80000=A{1+.10)10 }/{.10(1+.10)10} 80000=A{ 1.593 742/0.259374} Annual withdrawal
=80000/ 6.144567 Annual withdrawal = 13019.63 Yr ly
Q3. What factors affect financial Plan? Answer:- We live in a society and intera
ct with people and environment. What happens to us is not always accordance to
o ur wishes. Many things turn out in our live are uncontrollable by us. Many dec
is ions we take are the result of external influences. So do our financial matte
rs. There are many factors affect our personal financial planning. Range from ec
ono mic factors to global influences. Aware of factors affecting your money matt
ers below will certainly benefit your planning. Factors Affecting Financial Plan
1. Nature of the industry:- Here, we must consider whether it is a capital inte
n sive of labour intensive industry. This will have a major impact on the total
as sets that the firm owns. 2. Size of the company: - The size of the company gr
eat ly influences the availability of funds from different sources. A small comp
any normally finals it difficult to raise funds from long term sources at compet
itiv e terms. On the other hand, large companies like Reliance enjoy the privile
ge of obtaining funds both short term and long term at attractive rates. 3. Stat
us of the company in the industry:- A well established company enjoying a good m
arket share, for its products normally commands investor¶s confidence. Such a comp
any can tap the capital market for raising funds in competitive term for impleme
nta tion new projects to exploit the new opportunity emerging from changing busi
ness environment. 4. Sources of finance available:- Sources of finance could be
grou p 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
capit al structure. A large firm with a diversified product mix may manage highe
r quan tum of debt because the firm may manage higher financial risk with a lowe
r busin ess risk. Selection of sources of finances us closely linked to the firm
s capaci ty 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 mana
gement of the company to remain control over the affairs of the company. The pro
moters wh o do not like to lose their grip over the affairs of the company norma
lly obtain extra funds for growth by issuing preference shares and debentures to
outsiders . 6. Matching the sources with utilization:- The product policy of an
y good fina ncial plan is to match the term of the source with the term of inves
tment. To fi nance 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 car dinal principal of financial planning. 7. Flexibility:- The financ
ial plan of co mpany should possess flexibility so as to effect changes in the c
omposition of c apital structure when ever need arises. If the capital structure
of a company is flexible, it will not face any difficulty in changing the sourc
es of funds. Thi s factor has become a significant one today because of the glob
alization of capi tal market.
8. Government Policy:- SEBI guidelines, finance ministry circulars, various clau
ses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and
D epartment of Corporate Affairs (Govt of India) influence the financial plans o
f corporate today. Management of public issues of shares demands the companies w
it h many status in India. They are to be compiled with a time constraint.
Q4. Suppose you buy a one -year government bond that has a maturity value of Rs.
1000. The market interest rate is 8 per cent. (a) How much will you pay for the
bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you e
a rn from this investment? Answer:- A. Bond value maturity Market interest rate
Period of maturity Valu of bond = = = = 1000 8% 1Yrs Maturity value 1 + rate of
return 1000 1 + 0.08 926 92 6 = = Pay for the bond = Answer:- B. Purchase price
of bond Maturity value Interest earning = = = = = 904 .98 1000 Maturity value -
Purchase price of bond 1000 - 904.98 95.02 Interest Cu rrent Price of bond 95.02
904.98 10.50% Rate of interest = X 100 = X 100 = Interest rate earn from this i
nvestment = 10.50%
Case Study Deepak Hand tools Private Limited DHPL is a small sized firm manufact
uring hand tools. It manufacturing plan is situated in Haryana. The company¶s sa
les in the year ending on 31 st March 2007 were Rs.1000 million (Rs.100 crore) o
n an asset base of Rs.650 million. The net profit of the company was Rs.76 mill
i on. The management of the company wants to improve profitability further. The
re quired rate of return of the company is 14 percent. The company is currently
con sidering an investment proposal. One is to expand its manufacturing capacity
. Th e estimated cost of the new equipment is Rs.250 million. It is expected to
have an economic life of 10 years. The accountant forecasts that net cash inflow
s wou ld be Rs.45 million per annum for the first three years, Rs.68 million per
annum from year four to year eight and for the remaining two years Rs.30million
per a nnum. The plant can be sold for Rs.55 million at the end of its economic
life. T he company would need to raise debt to the extent of Rs.200 million. The
company has the following options of borrowing Rs.200 million: a . The company
can borr ow funds from a nationalized bank at the interest rate of 14 percent fo
r 10 year s. It will be required to pay equal annual installment of interest and
repayment of principal. b. A financial institution has offered to lend money to
DHP L at 13.5 per annum but it needs to pay equated quarterly installment of in
terest and repayment of principal. Questions: 1. Should the company expand its c
apacity? Show the computation of NP V 2. What is the annual installment of bank
loan? 3. Calculate the quarterly ins tallments of the Financial Institution loan
4. Should the company borrow from th e bank or from the financial institution?
Answer 1. Investment in New Equipment : Life of machine Salvage : : 250000000 10
Years 55000000 Years 1 2 3 4 5 6 7 8 9 10 Salvage Cash inflows 45,000,000 45,00
0,000 45,000,000 68,000,000 68,000,000 68,000,000 6 8,000,000 68,000,000 30,000,
000 30,000,000 55,000,000 PV factors at 14 % 0.877 0.769 0.675 0.592 0.519 0.456
0.400 0.351 0.308 0.270 0 .270 PV of cash inflows Initial cash out flow NPV PV
of cash inflows 39,473,684 34,626,039 30,373,718 40,261,459 35,317,069 30,979 ,8
85 27,175,338 23,838,016 9,225,238 8,092,314 14,835,910 294,198,670 250,000,00 0
44,198,670 Here NPV is positive it is advisable to the company to expand its ca
pacity.
Answer 2. Loan Amount Interest rate No of Year(N) : : : 200000000 14 % 10 Years
Installment X PVIFA (14%,10) =20,00,00,000 Installment = 20,00,00,000 / 5.216 =
3,83,43,558 Answer 3. Loan Amount Interest rate No of Year(N) Quarterly : : : 20
,00,00,000 13.5 % 10 Years Installment X PVIFA (13.5% / 4, 40) =20,00,00,000 Ins
tallment = 20,00,00,000 / 5 .176 = 3,86,39,876 Answer 4. Should the company borr
ow from the bank because payback by the company less then financial institution
. ______________________________________________________________________________
__ _
Q1. A. What is the cost of retained earnings? Answer:- Cost of Retained Earnings
Cost of retained earnings (ks) is the return stockholders require on the compan
y ¶s common stock. There are three methods one can use to derive the cost of retai
ned 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 riskfre
e rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treas
u ry-bill rate as well as the expected rate of return on the market (rm). The ne
xt 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 calcula
te the cost of retained earnings. b) Bond-Yield-Plus-Premium Approach This is a
simple, ad hoc approach to estimat ing the cost of retained earnings. Simply tak
e the interest rate of the firm¶s l ong-term debt and add a risk premium (typicall
y three to five percentage points) : ks = long-term bond yield + risk premium ks
= D1 + g; P0 where: D1 = next year¶s dividend g = firm¶s constant growth rate P0 =
price iler and
c) Discounted Cash Flow ApproachAlso known as the ³dividend yield plus growth appr
o ach´. Using the dividend-growth model, you can rearrange the terms as follows to
determine ks.
Q1. B. A company issues new debentures of Rs. 2 million, at par; the net proceed
s being Rs. 1.8 million. It has a 13.5 per cent rate of interest and 7 years ma
t urity. The company¶s tax rate is 52 per cent. What is the cost of debenture issu
e? What will be the cost in 4 years if the market value of debentures at that t
i me is Rs. 2.2 million? Answer:Where Kd is post tax cost of debenture capital,
I is the annual interest payment per unit of debenture, T is the corporate tax r
ate, F is the redemption price per debenture, P is the net amount realized per d
ebenture, N is maturity p eriod A. Kd = I(1-T)+{(F-P)/N} (F+P)/2 = 13.5(1-.52)+(
2-1.8)/7 (2+1.8)/2 = 6.48+0.03 1.9 = 6.51 1.9 = 3.43% or 343 Cost of debenture 3
.43
B. Kd = I(1-T)+{(F-P)/N} (F+P)/2 = 13.5(1-.52)+(2.2-1.8)/4 (2.2+1.8)/2 = 6.48+0.
1 2 = 6.58 2 = 3.29% or 329 Cost of debenture 3.29
Q2. Volga is a large manufacturing company in the private sector. In 2007 the co
mpany had a gross sale of Rs.980.2 crore. The other financial data for the comp
a ny are given below: Items Net worht Borrowing EBIT Interest Fixed cost (exclud
ing interest) Rs. In crore 152.31 165.47 43.17 34.39 118.23 You are required to
calculate: A. Debt equity ratio B. Operating leverage C. Fin ancial leverage D.
Combined leverage. Interpret your results and components of i ncremental cash fl
ows? Answer: Sale Less Variable cost Contribution Less Fixed Cost EBIT Less inte
rest PBT 980.20 ? 161.40 118.23 43.17 34.39 8.78 Contribution = Sale ± Variable co
st Variable cost not given so Contribution = EB IT + Interest = 43.17 + 118.23 =
161.40 A. Debt equity ratio Debt equity ratio = Debt Equity
= 165.47 152.31 = B. Operating leverage 1.09 Operating leverage = Contribution E
BIT (Operating Earning) = 161.40 43.17 = 3.74 C. Financial leverage Financial le
verage = EBIT PBT (Profit before tax) = 43.17 8.78 = 4.92 D. Combined leverage C
obined leverage = Operating leverage = Contribution EBIT X Financial leverage X
EBIT PBT
= 161.40 43.17 X 43.17 8.78 = 3.74 X 4.92 = 18.38 Ratio of debt to equity is 1.0
9 it means that on every Rupees (Net worth) there is Rs.1.09 external liability.
Hence the company has over burden of external lia bility is his capital. Hence
the risk is excess and shareholders require return is also higher.
Q3. Explain Miler and Modigliani Approach to capital structure theory? Answer: M
iller and Modigliani Approach Miller and Modigliani criticize that the cost of
e quity remains unaffected by leverage up to a reasonable limit and Ko being con
st ant at all degrees of leverage. They state that the relationship between leve
rag e and cost of capital is elucidated as in NOI approach. The assumptions for
thei r analysis are: y Perfect capital markets: Securities can be freely traded,
that is, investors are free to buy and sell securities( both shares and debt in
struments), there are n o hindrances on the borrowings, no presence of transacti
on costs, securities inf initely divisible, availability of all required informa
tion at all times. Invest ors behave rationally, that is, they choose that combi
nation of risk and return that is most advantageous to them. Homogeneity of inve
stors 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 activitie
s. y y y y Basic propositions: The following three propositions can be derived b
ased on the above assumptions: Proposition I: The market value of the firm is eq
ual to the total market value of equity and total market value of debt and is in
dependent o f the degree of leverage. It can be expressed as : Expected NOI Expe
cted overall capitalization rate V + (S + D) = which is equal to O/Ko which is e
qual to NOI/ Ko V + (S + D) = O/Ko = NOI/Ko Where V is the market value of the f
irm, S is the market value of the firm¶s equ ity, D is the market value of the deb
t, O is the net operating income, K/o is th e capitalization rate of the risk cl
ass of the firm.
Cost of Capital Ko Ke Leverage D/S The basic argument for proposition I is that
equilibrium is restored in the mark et by the arbitrage mechanism. Arbitrage is
the process of buying security at lo wer price in one market and selling it in a
nother market at higher price bringin g about equilibrium. This is a balancing a
ct. Miller and Modigliani perceive tha t the investors of firm whose value is hi
gher will sell their share and in retur n buy shares of the firm whose value is
lower. They will earn the same return at lower outlay and lower the share prices
risk.. Such behaviours are expected to increase the share price of whose shares
are being purchased and lowering the sh ares price of those share which are bei
ng sold. This switching operation will co ntinue till the market price of identi
cal firms becomes identical. Proposition II: The expected yield on equity is equ
al to discount rate (capitali zation rate) applicable plus a premium. Ke = Ko +
[ ( Ko ± Kd ) D/S ] Proposition III: The average cost of capital is not affected b
y the financing de cisions as investment and financing decision are independent.
Q4. How to estimate cash flows? What are the components of incremental cash flow
s? Answer: Estimation of cash flows Estimating the cash flows associated with t
h e project under consideration is the most difficult and crucial step in the ev
al uation of an investment proposal. It is the result of the team work of many p
rof essionals in an organization. 1. Capital outlays are estimated by engineerin
g de partment after examining all aspects of production process. 2. Marketing de
partm ent on the basis of market survey forecasts the expected sales revenue dur
ing th e period of accrual of benefits from project executions. 3. Operating cos
t is es timated by cost accountants and production engineers. 4. Incremental cas
h flows and out flows statement is prepared by the cost accountant on the basis
of detai ls generated in the above steps. The ability of the firm to forecast th
e cash fl ows with reasonable accuracy lies at the root of the implementation of
any capit al expenditure decision. Investment (Capital budgeting) decision requ
ired the es timation of incremental cash flow stream the life of the investment.
Incremental cash flow are estimated on after tax basis. 1. Initial Cash outlay
(Initial inv estment): Initial cash outlay to be incurred is determined after co
nsidering any post tax cash inflows if any. In replacement decision existing old
machinery is disposed of and new machinery incorporating the latest technology
is installed in its place. On disposed of existing old machinery the firm has a
cash inflow. This cash inflow has to be computed on post tax basis. The net cash
out flow (to tal cash required for investment in capital assets minus post tax
cash inflow on disposal on the old machinery being replaced by a new one) theref
ore is the inc remental cash outflow. Additional net working capital required on
implementation of new project is to be added to initial investment. 2. Operatin
g Cash inflows: Operating cash inflows are estimated for the entire economic lif
e of investment . Operating cash inflows constitute a stream of inflows and outf
lows over the li fe of the project. Here also incremental inflows and outflows a
ttributable to op erating activities are considered. Any saving in cost on insta
llation of new mac hinery in the place of the old machinery will have to be acco
unted to on post ta x basis. In this connection incremental cash flows refer to
the change in cash f lows on implementation of a new project over the existing p
osition. 3. Terminal Cash inflows: At the end of the economic life of the projec
t, the operating asse ts installed now will be disposed off. It is normally know
n as salvage value of equipments. These terminal cash inflows are computed on po
st tax basis.
Q5. What are the steps involved in capital rationing? Answer: Steps involved in
Capital Rationing are: 1. Ranking of different investm ent proposals 2. Selectio
n of the most profitable investment proposals Ranking of different investment pr
oposal The various investment proposals should be ranked on the basis of their p
rofitability. Ranking is done on the basis of NPV. Profitability index or IRR in
the descending order. Profitability index as the basis of Capital Rationing The
following details are Cash Inflows Project A B C Initial Cash outlay 100,000 50
,000 50,000 Year 1 60,0 00 20,000 20,000 Year 2 50,000 40,000 30,000 Year 3 40,0
00 20,000 30,000 Cost of Capital is 15% Computation of NPV Project A Year 1 2 3
Cash Inflows 60,000 50,000 40,000 PV factors at 15% 0.870 0 .758 0.658 PV of cas
h inflows Initial cash outlay NPV PV of Cash inflows 52,200 37,800 26,320 116,32
0 100,000 16,320
PV of Cash inflows Profitability index = PV of Cash outflows 1,16,000 = 1,00,000
= 1.1632 Project B Cash Inflows Year PV factors at 15% PV of Cash inflows 1 20,
000 0.870 17,400 2 40,000 0.758 30,320 3 20,000 0.658 13,160 PV of cash inflows
60,880 Initial cash outlay 50,000 NPV 10,880 PV of Cash inflows Profitability in
dex = PV of Cash outflows 60880 = 50000 = 1.2176
Project C Cash Inflows Year PV factors at 15% PV of Cash inflows 1 20,000 0.870
17,400 2 30,000 0.758 22,740 3 30,000 0.658 19,740 PV of cash inflows 59,880 Ini
tial cash outlay 50,000 NPV 9,880 PV of Cash inflows Profitability index = PV of
Cash outflows 59880 = 50000 = 1.1976 Ranking of Project Project NPV Absolute Ra
nk 1 2 3 Profitability Index Absolute 1.1632 1.2176 1.1976 Rank 3 1 2
A B C 16320 10880 9880
If the firm has sufficient funds and no capital rationing restriction, then all
the projects can be accepted because all of them have positive NPVs. Let us assu
me that the firm is forced to resort to capital rationing because the total fun
d s available for execution of project is only Rs. 1, 00,000. In this case on th
e basis of NPV Criterion, Project A will be cleared. It incurs an initial cash o
ut lay of Rs. 1,00,000. After allocating Rs.1, 00,000 to project A, left over fu
nds is nil. Therefore, on the basis of NPV criterion other projects i,e B & C ca
nno t be taken up for execution by the firm. It will increase the net wealth of
the firm by Rs, 16,320. On the other hand on the basis of profitability index, p
roje ct B and C can be executed with Rs. 1,00,000 because both of the incur indi
vidua lly an initial outlay of Rs. 50,000. Therefore, with the execution of proj
ects B and C, increase in net wealth of the firm will be Rs. 10880 + 9880 = Rs.
20760. The objective is to maximize NPV per rupees of capital and project should
be ra nked on the basis of the profitability index. Funds should be allocated o
n the b asis ranks assigned by profitability.
Q6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20,000 per year
for six years. A substitute B would cost Rs.50,000 and generate net cash flow of
Rs.14,000 per year for six years. The required rate of return of both equipment
s is 11% . Calculate the IRR and NPV for the equipments. Which equipment should
be accepted and why? Answer: NPV of Project A Cash inflows 20000 20000 20000 20
000 20000 20000 PV factors at 11 % 0.901 0.812 0.731 0.659 0.593 0.535 PV of cas
h inflows Initial cash out flow NPV PV of cash inflows 18018 16232 14624 13175 1
1869 10693 84611 75000 9611 PV factors at 16 % 0.862 0.743 0.641 0.552 0.476 0.4
10 PV of cash inflows Initial cash out flow NPV PV of cash inflows 17241 14863 1
2813 11046 9522 8209 73695 75000 -1305 Years 1 2 3 4 5 6 IRR = Lower rate + NPV
at lower rate NPV at lower rate - NPV at higher rate X (different in rate) = 11
+ 9611 9611 - (1305) X (16-11) = IRR = 11 15.40% + 4.4 NPV of Project B Cash inf
lows 14000 14000 14000 14000 14000 14000 PV factors at 11 % 0.901 0.812 0.731 0.
659 0.593 0.535 PV of cash inflows Initial cash out flow NPV PV of cash inflows
12613 11363 10237 9222 8308 7485 59228 50000 9228 PV factors at 18 % 0.8 47 0.71
8 0.609 0.516 0.437 0.370 PV of cash inflows Initial cash out flow NPV PV of cas
h inflows 11864 10055 8521 7221 6120 5186 48966 50000 -1034 Years 1 2 3 4 5 6
IRR = Lower rate + NPV at lower rate NPV at lower rate - NPV at higher rate X (d
ifferent in rate) = 11 + 9228 9228 - (1034) X (18-11) = IRR = 11 17.29% + 6.29 E
quipment A has positive NPV where as equipment B negative NPV hence equipment A
should be accepted. ____________________________________________________________
_______________