Master of Business Administration - MBA Semester 2

MB0045 Financial Management - 4 Credits

(Book ID: B1134)
Assignment Set- 1


1 What are the 4 f|nance dec|s|ons taken by a f|nance manager

Ans A flrm performs flnance funcLlons slmulLaneously and conLlnuously ln Lhe normal course of Lhe
buslness 1hey do noL necessarlly occur ln a sequence llnance funcLlons call for skllful plannlng conLrol
and execuLlon of a flrm's acLlvlLles LeL us noLe aL Lhe ouLseL haL shareholders are made beLLer off by a
flnanclal declslon LhaL lncreases Lhe value of Lhelr shares 1hus whlle performlng Lhe flnance funcLlon
Lhe flnanclal manager should sLrlve Lo maxlmlze Lhe markeLvalue of shares WhaLever declslon does a
manger Lakes need Lo resulL lnwealLh maxlmlzaLlon of a shareholder
1 nvesLmenL ueclslon
nvesLmenL declslon or caplLal budgeLlng lnvolves Lhe declslon of allocaLlon of caplLal or commlLmenL of
funds Lo longLerm asseLs LhaL would yleld beneflLs ln Lhe fuLure 1wo lmporLanL aspecLs of Lhe
lnvesLmenL declslon are
(a) Lhe evaluaLlon of Lhe prospecLlve proflLablllLy of new lnvesLmenLs and
(b) Lhe measuremenL of a cuLoff raLe agalnsL LhaL Lhe prospecLlve reLurn of new lnvesLmenLs could be
compared luLure beneflLs of lnvesLmenLs are dlfflculL Lomeasure and cannoL be predlcLed wlLh
cerLalnLy 8ecause of Lhe uncerLaln fuLure lnvesLmenL declslons lnvolve rlsk nvesLmenL proposals
should Lherefore be evaluaLed ln Lerms of boLh expecLed reLurn and rlsk 8esldes Lhe declslon for
lnvesLmenL managers do see where Lo commlL funds when an asseL becomes less producLlve or non
proflLable
1here ls a broad agreemenL LhaL Lhe correcL cuLoff raLe ls Lhe requlred raLe of reLurn or Lhe opporLunlLy
cosL of caplLal Powever Lhere are problems lncompuLlng Lhe opporLunlLy cosL of caplLal ln pracLlce
from Lhe avallable daLa and lnformaLlon A declslon maker should be aware of caplLal ln pracLlce from
Lhe avallable daLa and lnformaLlon A declslon maker should be aware of Lhes problems
2 llnanclng ueclslon
llnanclng declslon ls Lhe second lmporLanL funcLlon Lo be performed by Lhe flnanclal manager 8roadly
her or she musL declde when where and how Loacqulre funds Lo meeL Lhe flrm's lnvesLmenL needs 1he
cenLral lssue before hlm or her ls Lo deLermlne Lhe proporLlon of equlLy and debL 1he mlx of debL and
equlLy ls known as Lhe flrm's caplLal sLrucLure 1he flnanclal manager musL sLrlve Lo obLaln Lhe besL
flnanclng mlx or Lhe opLlmum caplLal sLrucLure for hls or herflrm 1he flrm's caplLal sLrucLure ls
consldered Lo be opLlmum when Lhe markeL value of shares ls maxlmlzed 1he use of debL affecLs Lhe
reLurn and rlsk of shareholders lL may lncrease Lhe reLurn on equlLy funds buL lL always lncreasesrlsk A
proper balance wlll have Lo be sLruck beLween reLurn and rlsk When Lheshareholders' reLurn ls
maxlmlzed wlLh mlnlmum rlsk Lhe markeL value per sharewlll be maxlmlzed and Lhe flrm's caplLal
sLrucLure would be consldered opLlmum Cnce Lhe flnanclal manager ls able Lo deLermlne Lhe besL
comblnaLlon of debL and equlLy he or she musL ralse Lhe approprlaLe amounL Lhrough Lhe besL avallable
sources n pracLlce a flrm conslders many oLher facLors such as conLrol flexlblllLy loan convenlence
legal aspecLs eLc ln decldlng lLs caplLal sLrucLure
3 ulvldend ueclslon
ulvldend declslon ls Lhe Lhlrd ma[or flnanclal declslon 1he flnanclal manager musL declde wheLher Lhe
flrm should dlsLrlbuLe all proflLs or reLaln Lhem or dlsLrlbuLe a porLlon and reLaln Lhe balance Llke Lhe
debL pollcy Lhe dlvldend pollcy should be deLermlned ln Lerms of lLs lmpacL on Lhe shareholders' value
1he opLlmum dlvldend pollcy ls one LhaL maxlmlzes Lhe markeL value of Lhe flrm's shares 1hus lf
shareholders are noL lndlfferenL Lo Lhe flrm's dlvldend pollcy Lhe flnanclal manager musL deLermlne Lhe
opLlmum dlvldend payouL raLlo 1he payouL raLlo ls equal Lo Lhe percenLage of dlvldends Lo earnlngs
avallable Lo shareholders 1he flnanclal manager should also conslder Lhe quesLlons of dlvldend sLablllLy
bonus shares and cash dlvldends ln pracLlce MosL proflLable companles pay cash dlvldends regularly
erlodlcally addlLlonal shares called bonus share (or sLock dlvldend) are also lssued Lo Lhe exlsLlng
shareholders ln addlLlon Lo Lhe cashdlvldend
4 LlquldlLy ueclslon
CurrenL asseLs managemenL LhaL affecLs a flrm's llquldlLy ls yeL anoLher lmporLanL flnances funcLlon ln
addlLlon Lo Lhe managemenL of longLerm asseLs CurrenL asseLs should be managed efflclenLly for
safeguardlng Lhe flrm agalnsL Lhe dangers of llllquldlLy and lnsolvency nvesLmenL ln currenL asseLs
affecLs Lhe flrm's proflLablllLy LlquldlLy and rlsk A confllcL exlsLs beLween proflLablllLy and llquldlLy whlle
managlng currenL asseLs f Lhe flrm does noL lnvesL sufflclenL funds ln currenL asseLs lL may become
llllquld 8uL lL would lose proflLablllLy as ldle currenL asseLs would noL earn anyLhlng 1hus a proper
Lradeoff musL be achleved beLween proflLablllLy and llquldlLy n order Lo ensure LhaL nelLher
lnsufflclenL nor unnecessary funds are lnvesLed ln currenL asseLs Lhe flnanclal manager should develop
sound Lechnlques of managlng currenL asseLs Pe or she should esLlmaLe flrm's needs for currenL asseLs
and make sure LhaL funds would be made avallable when needed L would Lhus be clear LhaL flnanclal
declslons dlrecLly concern Lhe flrm's declslon Lo acqulre or dlspose off asseLs and requlre commlLmenL
or recommlLmenL of funds on a conLlnuous basls L ls ln Lhls conLexL LhaL flnance funcLlons are sald Lo
lnfluence producLlon markeLlng and oLher funcLlons of Lhe flrm 1hls ln consequence flnance funcLlons
may affecL Lhe slze growLh proflLablllLy and rlsk of Lhe flrm and ulLlmaLely Lhe value of Lhe flrm 1o
quoLe Lzra Solomon 1he funcLlon of flnanclal managemenL ls Lo revlew and conLrol declslons Lo commlL
or recommlL funds Lo new or ongolng uses 1hus ln addlLlon Lo ralslng funds flnanclal managemenL ls
dlrecLly concerned wlLh producLlon markeLlng and oLher funcLlonswlLhln an enLerprlse whenever
declslons are abouL Lhe acqulslLlon or dlsLrlbuLlon of asseLs varlous flnanclal funcLlons are lnLlmaLely
connecLed wlLh each oLher lor lnsLancedeclslon perLalnlng Lo Lhe proporLlon ln whlch flxed asseLs and
currenL asseLs aremlxed deLermlnes Lhe rlsk complexlon of Lhe flrm CosLs of varlous meLhods
offlnanclng are affecLed by Lhls rlsk
Llkewlse dlvldend declslons lnfluence flnanclng declslons and are Lhemselves lnfluenced by lnvesLmenL
declslons n vlew of Lhls flnance manager ls expecLed Lo call upon Lhe experLlse of oLherfuncLlonal
managers of Lhe flrm parLlcularly ln regard Lo lnvesLmenL of funds
ueclslons perLalnlng Lo klnds of flxed asseLs Lo be acqulred for Lhe flrm level oflnvenLorles Lo be kepL ln
hand Lype of cusLomers Lo be granLed credlL faclllLlesLerms of credlL should be made afLer consulLlng
producLlon and markeLlngexecuLlves
Powever ln Lhe managemenL of lncome flnance manager has Lo acL on hls own 1he deLermlnaLlon of
dlvldend pollcles ls almosL excluslvely a flnance funcLlon A flnance manager has a flnal say ln declslons
on dlvldends Lhan ln asseLmanagemenL declslons
llnanclal managemenL ls looked on as cuLLlng across funcLlonal even dlsclpllnary boundarles L ls ln such
an envlronmenL LhaL flnance manager works as a parL of LoLal managemenL n prlnclple a flnance
manager ls held responslble Lo handle all such problem LhaL lnvolve money maLLers 8uL ln acLual
pracLlce as noLed above he has Lo call on Lhe experLlse of Lhose ln oLher funcLlonal areas Lo dlscharge
hlsresponslblllLles effecLlvely
2 What are the factors that affect the f|nanc|a| p|an of a company?
Ans 1o help your organlzaLlon succeed you should develop a plan LhaL needs Lo be followed 1hls
applles Lo sLarLlng Lhe company developlng new producL creaLlng a new deparLmenL or any
underLaklng LhaL affecLs Lhe company's fuLure 1here are several facLors LhaL affecL plannlng ln an
organlzaLlon 1o creaLe an efflclenL plan you need Lo undersLand Lhe facLors lnvolved ln Lhe plannlng
process
A buslnessman an buslnesswoman havlng a meeLlng
A buslnessman an buslnesswoman havlng a meeLlng
CrganlzaLlonal plannlng ls affecLed by many facLors
rlorlLles
n mosL companles Lhe prlorlLy ls generaLlng revenue and Lhls prlorlLy can someLlmes lnLerfere wlLh Lhe
plannlng process of any pro[ecL lor example lf you are ln Lhe process of plannlng a large expanslon
pro[ecL and your largesL cusLomer suddenly LhreaLens Lo Lake Lhelr buslness Lo your compeLlLor Lhen
you mlghL have Lo shelve Lhe expanslon plannlng unLll Lhe cusLomer lssue ls resolved When you sLarL
Lhe plannlng process for any pro[ecL you need Lo asslgn each of Lhe lssues faclng Lhe company a prlorlLy
raLlng 1haL prlorlLy raLlng wlll deLermlne whaL lssues wlll sldeLrack you from Lhe plannlng of your
pro[ecL and whlch lssues can walL unLll Lhe process ls compleLe
Company 8esources
Pavlng an ldea and developlng a plan for your company can help your company Lo grow and succeed
buL lf Lhe company does noL have Lhe resources Lo make Lhe plan come LogeLher lL can sLall progress
Cne of Lhe flrsL sLeps Lo any plannlng process should be an evaluaLlon of Lhe resources necessary Lo
compleLe Lhe pro[ecL compared Lo Lhe resources Lhe company has avallable Some of Lhe resources Lo
conslder are flnances personnel space requlremenLs access Lo maLerlals and vendor relaLlonshlps
lorecasLlng
A company consLanLly should be forecasLlng Lo help prepare for changes ln Lhe markeLplace lorecasLlng
sales revenues maLerlals cosLs personnel cosLs and overhead cosLs can help a company plan for
upcomlng pro[ecLs WlLhouL accuraLe forecasLlng lL can be dlfflculL Lo Lell lf Lhe plan has any chance of
success lf Lhe company has Lhe capablllLles Lo pull off Lhe plan and lf Lhe plan wlll help Lo sLrengLhen Lhe
company's sLandlng wlLhln Lhe lndusLry lor example lf your forecasLlng for Lhe cosL of goods has
changed due Lo a sudden lncrease ln maLerlal cosLs Lhen LhaL can affecL elemenLs of your producL roll
ouL plan lncludlng pro[ecLed proflL and Lhe longLerm commlLmenL you mlghL need Lo make Lo a
suppller Lo Lry Lo geL Lhe lowesL prlce posslble
ConLlngency lannlng
1o successfully plan an organlzaLlon needs Lo have a conLlngency plan ln place f Lhe company has
declded Lo pursue a new producL llne Lhere needs Lo be a parL of Lhe plan LhaL addresses Lhe posslblllLy
LhaL Lhe producL llne wlll fall 1he reallocaLlon of company resources Lhe accepLable flnanclal losses and
Lhe poLenLlal publlc relaLlons problems LhaL a falled producL can cause all need Lo be parL of Lhe
organlzaLlonal plannlng process from Lhe beglnnlng
3 Show the re|at|onsh|p between requ|red rate of return and coupon rate on the va|ue of a bond
Ans L ls lmporLanL for prospecLlve bond buyers Lo know how Lo deLermlne Lhe prlce of a bond because
lL wlll lndlcaLe Lhe yleld recelved should Lhe bond be purchased n Lhls secLlon we wlll run Lhrough
some bond prlce calculaLlons for varlous Lypes of bond lnsLrumenLs
8onds can be prlced aL a premlum dlscounL or aL par f Lhe bond's prlce ls hlgher Lhan lLs par value lL
wlll sell aL a premlum because lLs lnLeresL raLe ls hlgher Lhan currenL prevalllng raLes f Lhe bond's prlce
ls lower Lhan lLs par value Lhe bond wlll sell aL a dlscounL because lLs lnLeresL raLe ls lower Lhan currenL
prevalllng lnLeresL raLes When you calculaLe Lhe prlce of a bond you are calculaLlng Lhe maxlmum prlce
you would wanL Lo pay for Lhe bond glven Lhe bond's coupon raLe ln comparlson Lo Lhe average raLe
mosL lnvesLors are currenLly recelvlng ln Lhe bond markeL 8equlred yleld or requlred raLe of reLurn ls
Lhe lnLeresL raLe LhaL a securlLy needs Lo offer ln order Lo encourage lnvesLors Lo purchase lL usually Lhe
requlred yleld on a bond ls equal Lo or greaLer Lhan Lhe currenL prevalllng lnLeresL raLes
lundamenLally however Lhe prlce of a bond ls Lhe sum of Lhe presenL values of all expecLed coupon
paymenLs plus Lhe presenL value of Lhe par value aL maLurlLy CalculaLlng bond prlce ls slmple all we are
dolng ls dlscounLlng Lhe known fuLure cash flows 8emember LhaL Lo calculaLe presenL value (v)
whlch ls based on Lhe assumpLlon LhaL each paymenL ls relnvesLed aL some lnLeresL raLe once lL ls
recelvedwe have Lo know Lhe lnLeresL raLe LhaL would earn us a known fuLure value lor bond prlclng
Lhls lnLeresL raLe ls Lhe requlred yleld (f Lhe concepLs of presenL and fuLure value are new Lo you or you
are unfamlllar wlLh Lhe calculaLlons refer Lo undersLandlng Lhe 1lme value of Money)
Pere ls Lhe formula for calculaLlng a bond's prlce whlch uses Lhe baslc presenL value (v) formula
C coupon paymenL
n number of paymenLs
l lnLeresL raLe or requlred yleld
M value aL maLurlLy or par value
1he successlon of coupon paymenLs Lo be recelved ln Lhe fuLure ls referred Lo as an ordlnary annulLy
whlch ls a serles of flxed paymenLs aL seL lnLervals over a flxed perlod of Llme (Coupons on a sLralghL
bond are pald aL ordlnary annulLy) 1he flrsL paymenL of an ordlnary annulLy occurs one lnLerval from
Lhe Llme aL whlch Lhe debL securlLy ls acqulred 1he calculaLlon assumes Lhls Llme ls Lhe presenL
?ou may have guessed LhaL Lhe bond prlclng formula shown above may be Ledlous Lo calculaLe as lL
requlres addlng Lhe presenL value of each fuLure coupon paymenL 8ecause Lhese paymenLs are pald aL
an ordlnary annulLy however we can use Lhe shorLer vofordlnaryannulLy formula LhaL ls
maLhemaLlcally equlvalenL Lo Lhe summaLlon of all Lhe vs of fuLure cash flows 1hls vofordlnary
annulLy formula replaces Lhe need Lo add all Lhe presenL values of Lhe fuLure coupon
Lach full moneybag on Lhe Lop rlghL represenLs Lhe flxed coupon paymenLs (fuLure value) recelved ln
perlods one Lwo and Lhree noLlce how Lhe presenL value decreases for Lhose coupon paymenLs LhaL
are furLher lnLo Lhe fuLure Lhe presenL value of Lhe second coupon paymenL ls worLh less Lhan Lhe flrsL
coupon and Lhe Lhlrd coupon ls worLh Lhe lowesL amounL Loday 1he farLher lnLo Lhe fuLure a paymenL ls
Lo be recelved Lhe less lL ls worLh Loday ls Lhe fundamenLal concepL for whlch Lhe vofordlnary
annulLy formula accounLs L calculaLes Lhe sum of Lhe presenL values of all fuLure cash flows buL unllke
Lhe bondprlclng formula we saw earller lL doesn'L requlre LhaL we add Lhe value of each coupon
paymenL (lor more on calculaLlng Lhe Llme value of annulLles see AnyLhlng buL Crdlnary CalculaLlng
Lhe resenL and luLure value of AnnulLles and undersLandlng Lhe 1lme value of Money )
Lxample 1 CalculaLe Lhe prlce of a bond wlLh a par value of $1000 Lo be pald ln Len years a coupon raLe
of 10 and a requlred yleld of 12 n our example we'll assume LhaL coupon paymenLs are made seml
annually Lo bond holders and LhaL Lhe nexL coupon paymenL ls expecLed ln slx monLhs Pere are Lhe
sLeps we have Lo Lake Lo calculaLe Lhe prlce
1 ueLermlne Lhe number of Coupon aymenLs 8ecause Lwo coupon paymenLs wlll be made each year
for Len years we wlll have a LoLal of 20 coupon paymenLs
2 ueLermlne Lhe value of Lach Coupon aymenL 8ecause Lhe coupon paymenLs are semlannual dlvlde
Lhe coupon raLe ln half 1he coupon raLe ls Lhe percenLage off Lhe bond's par value As a resulL each
semlannual coupon paymenL wlll be $30 ($1000 x 003)
3 ueLermlne Lhe SemlAnnual ?leld Llke Lhe coupon raLe Lhe requlred yleld of 12 musL be dlvlded by
Lwo because Lhe number of perlods used ln Lhe calculaLlon has doubled f we lefL Lhe requlred yleld aL
12 our bond prlce would be very low and lnaccuraLe 1herefore Lhe requlred semlannual yleld ls 6
(012/2)
4 lug Lhe AmounLs nLo Lhe lormula lrom Lhe above calculaLlon we have deLermlned LhaL Lhe bond ls
selllng aL a dlscounL Lhe bond prlce ls less Lhan lLs par value because Lhe requlred yleld of Lhe bond ls
greaLer Lhan Lhe coupon raLe 1he bond musL sell aL a dlscounL Lo aLLracL lnvesLors who could flnd
hlgher lnLeresL elsewhere ln Lhe prevalllng raLes n oLher words because lnvesLors can make a larger
reLurn ln Lhe markeL Lhey need an exLra lncenLlve Lo lnvesL ln Lhe bonds
AccounLlng for ulfferenL aymenL lrequencles
n Lhe example above coupons were pald semlannually so we dlvlded Lhe lnLeresL raLe and coupon
paymenLs ln half Lo represenL Lhe Lwo paymenLs per year ?ou may be now wonderlng wheLher Lhere ls
a formula LhaL does noL requlre sLeps Lwo and Lhree ouLllned above whlch are requlred lf Lhe coupon
paymenLs occur more Lhan once a year A slmple modlflcaLlon of Lhe above formula wlll allow you Lo
ad[usL lnLeresL raLes and coupon paymenLs Lo calculaLe a bond prlce for any paymenL frequency
noLlce LhaL Lhe only modlflcaLlon Lo Lhe orlglnal formula ls Lhe addlLlon of l" whlch represenLs Lhe
frequency of coupon paymenLs or Lhe number of Llmes a year Lhe coupon ls pald 1herefore for bonds
paylng annual coupons l would have a value of one Should a bond pay quarLerly paymenLs l would
equal four and lf Lhe bond pald semlannual coupons l would be Lwo
4 D|scuss the |mp||cat|on of f|nanc|a| |everage for a f|rm
Ans 1he flnanclal leverage lmplles Lhe employmenL of source of funds lnvolvlng flxed reLurn so as Lo
cause more Lhan a proporLlonaLe change ln earnlngs per share (LS) due Lo change ln operaLlng proflLs
Llke Lhe operaLlng leverage flnanclal leverage can be poslLlve when operaLlng proflLs are lncreaslng and
can be negaLlve ln Lhe slLuaLlon of decrease ln such proflLs n vlew of Lhese flnanclal leverage wlll affecL
Lhe flnanclal rlsk of Lhe flrm An lmporLanL analyLlcal Lool for flnanclal leverage ls Lhe lndlfference polnL
aL whlch Lhe LS/markeL prlce ls Lhe same for dlfferenL flnanclal plans under conslderaLlon
1he ob[ecLlve of Lhls sLudy was Lo provlde addlLlonal evldence on Lhe relaLlonshlp beLween flnanclal
leverage and Lhe markeL value of common sLock numerous emplrlcal sLudles have been done ln Lhls
area and concurrenLly many Lheorles have been developed Lo explaln Lhe relaLlonshlp beLween
flnanclal leverage and Lhe markeL value of common sLock 8ecause of Lhe meLhodologlcal weaknesses of
pasL sLudles however no concluslons can be drawn as Lo Lhe valldlLy of Lhe Lheorles 1heorles on
lnanclal leverage may be classlfled lnLo Lhree caLegorles lrrelevance Lheorem rlslng from value
lndeflnlLely wlLh lncrease ln flnanclal leverage and opLlmal flnanclal leverage Lmplrlcal lmpllcaLlons of
Lhese caLegorles along wlLh Lhe consequences of serlous confoundlng effecLs are analyzed 1he
lmpllcaLlons are Lhen compared wlLh evldence from acLual evenLs lnvolvlng flnanclal leverage changes
and dlsLlngulshed from each oLher as flnely as posslble uslng slmple and mulLlple regresslon analyses
normal ZLesL and a slmulaLlon Lechnlque 1he evldence shows LhaL changes ln Lhe markeL value of
common sLock are poslLlvely relaLed Lo changes ln flnanclal leverage for some flrms and negaLlvely
relaLed for oLher flrms 1hls evldence ls conslsLenL wlLh Lhe exlsLence of an opLlmal flnanclal leverage for
each flrm assumlng LhaL flnanclal leverages of flrms wlLh a poslLlve relaLlonshlp are below Lhe opLlmum
and Lhose of flrms wlLh a negaLlve relaLlonshlp are above Lhe opLlmum 1he resulLs of Lhe sLudy do noL
depend upon Lhe deflnlLlon of Lhe markeL porLfollo Lhe deflnlLlon of Lhe evenL perlod or Lhe cholce of
flnanclal leverage measure 8eLas esLlmaLed from equally welghLed markeL porLfollos were generally
hlgher Lhan Lhose esLlmaLed from value welghLed markeL porLfollos durlng 19811982 Powever Lhe
resulLs of Lhe sLudy were Lhe same for boLh porLfollos Abnormal reLurns were compuLed for seven and
Lwo day evenL perlods and Lhe resulLs were Lhe same for boLh perlods Seven dlfferenL deflnlLlons of
flnanclal leverage were LesLed and Lhe resulLs were Lhe same for all measures