Master of Business Administration Semester II MB0045 Financial Management - 4 Credits Assignment Set- 1 (60 Marks) Q1.

. Explain the steps involved in Financial Planning Ans:- There are six steps involved in financial planning 1. Establish corporate objectives : The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into qualitative and quantitative. For example, a companys mission statement may specify create economic value added. However this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives. 2. Formulate strategies : The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans helps achieve the purpose. Operating plans are framed with a time horizon. It can be a five year plan or a ten year plan. 3. Delegate responsibilities : Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench-marks, profit targets is to be fixed on respective executives. 4. Forecast financial variables : The next step is to forecast the various financial variables such as sales, assets required, flow of funds and costs to be incurred. These variables are to be translated into financial statements. Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost. 5 . Develop plans ; This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constrains in obtaining funds on the basis of covenants of borrowings is given due weight-age. There is also a need to collaborate the firms business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage. 6 . Create flexible economic environment : While formulating the plans, certain assumptions are made about the economic environment. The environment, however, keeps changing with the implementation of plans. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.

Q2. A company is considering a capital project with the following information: The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant a machinery and Rs.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million and the net working capital will be liquidated at par. The project will increase revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project. Ans:Project cash flow
Rs.in million 4 5

1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 5 1 6

Fixed Assets Net working capital Revenues Cost (other than depreciaton and interest) Depreciation Profit before tax Tax Profit after tax Net salvage value of fixed assets Recovery of net working capital Initial outlay Operating cash inflow ( 8+5) Terminal cash inflow (9 +10) Net cash flow PVF at 10 % PV ( 14 X 15) NPV (11 +12 +13)

0 150.00 50.00

250.00 100.00 37.50 112.50 33.75 78.75

250.00 100.00 28.12 121.88 36.56 85.32

250.00 100.00 21.10 128.90 38.67 90.23

250.00 100.00 15.82 134.18 40.25 93.93

250.00 100.00 11.86 138.14 41.44 96.70 48.00 50.00

200.00 116.25 113.44 111.33 109.75 108.56 98.00 116.25 0.909 200.00 286.29 105.68 113.44 0.826 93.75 111.33 0.751 83.64 109.75 0.683 74.96 206.56 0.621 128.26

Q3. Discuss the relevance and factors that influence the determination of stock level. Ans:- Most of the industries which are subjected to seasonal fluctuations and sales during different months of the year are usually different. If, however, production during every month is geared to

sales demand of the month, facilities have to be installed to cater for the production required to meet the maximum demand. During the slack season, a large portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to be made to obtain a stabilized production program throughout the year. During the slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively increase. Depending upon various factors of production, storing and cost, a normal capacity will be determined. To meet the pressure of sales during the peak season, however, higher capacity may have to be used for temporary periods. Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, consumption of raw material will accordingly vary depending upon the capacity usage. Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period. Maximum level : Maximum level is that level above which stock of inventory should never rise. Maximum level is fixed after taking in to account the following factors. Requirement and availability of capital Availability of storage space and cost of storing Keeping the quality of inventory intact Price fluctuations Risk of obsolescence Restrictions, if any, imposed by the government

Maximum Level = Ordering level (MRC x MDP) + standard ordering quantity Where, MRC = minimum rate of consumption MDP = minimum lead time Minimum Level : Minimum level is that level below which stock of inventory should not normally fall. Minimum level = OL (NRC x NLT) Where, OL = ordering level NRC = Normal rate of consumption NLT = Normal lead time

Ordering Level : Ordering level is that level at which action for replenishment of inventory is initiated. OL = MRC X MLT Where, MRC = Maximum rate of consumption MLT = Maximum lead time Average stock level Average stock level can be computed in two ways

1. 2. Minimum level + 1 /2 of re-order quantity Average stock level indicates the average investment in that item of inventory. It is quite relevant from the point of view of working capital management. Managerial significance of fixation of Inventory level Inventory level ensures the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time. Inventory level optimises the investment in inventories. In this process, management can avoid both overstocking and shortage of each and every essential and vital item of inventory. Inventory level can help the management in identifying the dormant and slow moving items of inventory. This brings about better co-ordination between materials management and production management on one hand and between stores manager and marketing manager on the other.

Re-order Point : When to order is another aspect of inventory management. This is answered by re-order point. The re-order point is that inventory level at which an order should be placed to replenish the inventory. To arrive at the re-order point under certainty, the two key required details are: Lead time Average usage

Lead time refers to the average time required to replenish the inventory after placing orders for inventory.

Under certainty, re-order point refers to that inventory level which will meet the consumption needs during the lead time. Safety Stock : Since it is difficult to predict in advance usage and lead time accurately, provision is made for handling the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to manage the stock out arising out of this uncertainty. When safety stock is maintained, (When variation is only in usage rate) Q4. There was a replacement of its existing machine by a new machine. The new machine will cost Rs 2,00,000 and have a life of five years. The new machine will yield annual cash revenue of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the new machine at the end of its economic life is Rs 8,000. The existing machine has a book value of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash expenses of Rs 1,40,000. If sold after five years, the salvage value of the existing machine will be negligible. The company pays tax at 40%. It writes off depreciation at 30% on the written down value. The companys cost of capital is 20% Compute the incremental cash flows of replacement decisions. Ans:Initial investments and annual cash flows
Initial Investment Gross investment for new machine Less cash received from the sale of existing machine Net cash outlay Aannual cash flows from operations Incrementa cash flows from revenue Incremental decrease in expenditure

200000 20000 180000 50000 10000

Incremental depreciation schedule

Depreciation (New machine) 66000 46200 32340 22638 15847 Depreciation (Old machine) 12000 8400 5880 4116 2881 Incremental depreciation 54000 37800 26460 18522 12966

Year 1 2 3 4 5

Calculation of depreciaton
Book value Add cost of new machine 40000 200000

Less sale proceeds old machine Depreciation 1 year 25 % Depreciation 2 year 25 % Depreciation 3 year 25 % Depreciation 4 year 25 % Depreciation 5year 25 % Book value after 5 years

240000 20000 220000 66000 154000 46200 107800 32340 75460 22638 52822 15847 36975

Statement of incremental cash flows S.No 1 2 3 4 5 6 7 8 9 10 11 Paticulars Investment new machine After tax salvage value of old machine Net cash outlay Increase in revenue Decrease in expenses Increase in operation Increase in EBIT EBIT (1-T) Incremental cash flows from operation ( 8+6) Salvage value of new machine Incremental cash flows 180000 Negative 0 200000 20000 180000 1 2 Year 3 4 5

5000 5000 0 0 1000 1000 0 0 2646 0 18522 3354 4147 6000 22200 0 8 2488 4200 13320 20124 7 4658 4340 58200 51120 4 9 5820 0 5112 0 4658 4 4340 9

5000 0 1000 0 5400 0

5000 0 1000 0 3780 0

50000 10000 12966 47034 28220 41186 8000 49186

Q5. Explicit cost and Implicit cost are the two dimensions of cost. What role does cost play in financial decisions Ans:- Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions: Explicit Cost Implicit cost

Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security.

Implicit cost is not a visible cost but it may seriously affect the companys operations especially when it is exposed to business and financial risk In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. An investor in a companys shares has two objectives for investing: Income from capital appreciation (capital gains on sale of shares at market price) Income from dividends

It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements. Q6. The following details have been extracted from the books of Ashraya Ltd Income Statement (Rs. In millions) 2009 1200 300 100 40 60 100 20 120 15 105 30 75 2010 1000 520 120 45 75 280 40 320 18 302 100 202

Sales less returns Gross Profit Selling Expenses Administration Deprecation Operating Profit Non operating income EBIT (Earnings before interest & Tax Interest Profit before tax Tax Profit after tax

Dividend Retained earnings

38 37

100 102

Ans:Income Statement for the Year 2011 (Rs. In million)

Particulars a. Sales b. Cost of Sales c. Gross profit d. Selling Expenses e. Adminstration f. Depreciaton g . Operating Profit h. Non Operating income i. EBIT J. Interest k. PBT l. Tax m. Profit after tax n. Dividends o. Retained earnings

Basis Increase by 30 % Increase by 30 % Sale - Cost of sales 30 % increase No change % given

Working 1000 X 1.3 480 X 1.3 1300 -624 120 X 1.3 390 + 100 4

Amount 1300 624 676 156 45 123 352 44 396 23.4 372.6 112 261 130 131

C - ( D+E+F) Increase by 10 % 1.1 X 40 18 of 1000 sale 18 X 1300 1000

Master of Business Administration Semester II MB0045 Financial Management - 4 Credits Assignment Set- 2 (60 Marks) Q1. Examine the importance of capital budgeting Ans:- Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant

The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds 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. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realise after committing itself to 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 specialised costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: Cost quality

timing

Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the 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 firms profitability. Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE 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 todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.

Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

Q2 Considering the following information, what is the price of the share as per Gordons Model? Net sales Net profit margin Outstanding preference shares No. of equity shares Cost of equity shares Retention ratio ROI Ans:Gordon formula of Rs. 120 lakhs 12.5% Rs. 50 lakhs @ 12% dividend 250000 12% 40% 16%

= 12.5(1- 0.40)/12

Where P is the price of the share, E is Earnings per share, b is Retention ratio, (1 b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment = 12.5 ( 1-0.40) 0.12 - (0.40 X 0.16 7.5 0.056

= 134 Q3. Internal capital rationing is uses by firms for exercising financial control How does a firm achieve this ? Ans:- Because of the limited financial resources, firms may have to make a choice from among profitable investment opportunities. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for Capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control. Steps involved in Capital Rationing Steps involved in Capital Rationing are: 1. Ranking of different investment proposals 2. Selection of the most profitable investment proposal Ranking of different investment proposals

The various investment proposals should be ranked on the basis of their profitability. 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 available:

Cost of Capital is 15 % Computation of NPV

Year 1 2 3 Cash in flows 60,000 50,000 40,000 PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV PV of Cash in flows 52,200 37,800 26,320 1,16,320 1,00,000 16,320

Profitability index =

Project B
Year 1 2 3 Cash in flows 20,000 40,000 20,000 PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV PV of Cash in flows 17,400 30,240 13,160 60,800 50,000 10,800

Profitability index = Project C

Year 1 Cash in flows 20,000 PV factor at 15% 0.870 PV of Cash in flows 17,400

2 3

30,000 30,000

0.756 0.658 PV of Cash inflow Initial Cash out lay NPV

22,680 19,740 59,820 50,000 9,820

Profitability index = Ranking of Projects

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 assume that the firm is forced to resort to capital rationing because the total funds available for execution of project is only Rs.1,00,000. In this case on the basis of NPV Criterion, project A will be cleared. It incurs an initial cash outlay of Rs.1,00,000. After allocating Rs.1,00,000 to project A, left over funds is nil. Therefore, on the basis of NPV criterion other projects i,e B & C cannot 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, project B and C can be executed with Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000. Therefore, with the execution of projects B and C, increase in net wealth of the firm will be 10800 + 9820 = Rs20620 The objective is to maximize NPV per rupee of Capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis ranks assigned by profitability index. Evaluation: 1. PI rule of selecting projects under Capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of single large project. 2. It also suffers from the multi-period Capital constraints. Programming approach: There are many programming techniques to Capital rationing. Among them are:-

1. Linear Programming: LP approach to Capital rationing tries to achieve maximum NPV subject to many constraints. Here the objective function is maximisation of sum of the NPVs of the projects. Here the constraints matrix incorporates all the restrictions associated with Capital rationing imposed by the firm. 2. Integer Programming: LP may give an optimal mix of projects in which there may be need to accept fraction of a project. Accepting fraction of a project is not feasible. Therefore, optimum may not be attainable. The actual implementation of projects may be suboptimal. When projects are not divisible, integer programming can be employed to avoid the chances of accepting fraction of projects. The advantage of programming approach is that it provides information on dual variables. It also gives information on shadow prices of budget constraints. Dual variables provide information for decision on transfer of funds from one year to another year The demerits of programming approach is that Costly to use when large, indivisible projects are being examined. They are deterministic models. But variables of Capital budgeting are subject to change making the assumption of deterministic highly invalid.

Q4. A company has two mutually exclusive projects under consideration viz project A & project B. Each project requires an initial cash outlay of Rs 3,00,000 and has an effective life of 10 years. The companys cost of capital is 12%. The following fore cast of cash flows are made by the management. Economic Environment Pessimistic Expected Optimistic Project A Annual cash inflows 65,000 75,000 90,000 Project B Annual cash in flows 25,000 75,000 1,00,000

What is the NPV of the project? Which project should the management consider? Given PVIFA = 5.650 Ans:NPV of project A Economic Project PVIFA PV of cash in flows NPV

Environment Pessimistic Expected Optimistic

cash inflows 65,000 75,000 90,000

at 12% 10 years 5.650 5.650 5.650

3,67,250 4,23,750 5,08,500

67,250 1,23,750 2,08,500

NPV of Project B Pessimistic 25,000 5.650 1,41,250 (1,58,750) Expected 75,000 5.650 4,23,750 1,23,750 Optimistic 1,00,000 5.650 5,65,000 2,65,000

Decision 1. Under pessimistic conditions project A gives a positive NPV of Rs 67,250 and Project B has a negative NPV of Rs 1,58,750 Project A is accepted. 2. Under expected conditions, both gave some positive NPV of Rs 1,23,000. Any one of two may be accepted. 3. Under optimistic conditions Project B has a higher NPV of Rs 2,65,000 compared to that of As NPV of Rs 2,08,500. 4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for Project B the difference is Rs 4,23,750. 5. Project B is risky compared to Project A because the NPV range is of large differences.

Q5. Explain various types of bonds. Ans;- Bonds are of three types: 1. Irredeemable Bonds (also called perpetual bonds) 2. Redeemable Bonds (i.e., Bonds with finite maturity period) and 3. 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 semi-annual 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:

Bond Values with Semi-Annual Interest payment In reality, it is quite common to pay interest on bonds semi-annually. With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with annual interest payments. 3 Valuation of 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. Q6. Given the following information, what will be the price per share using the Walter model. Earnings per share Rs. 40 Rate of return on investments 18% Rate of return required by shareholders 12% Payout ratio being 40%, 50%, or 60%. Ans;Walter Mode Formula P = D Ke + [r (E-D)/ ke] Ke

P is the market price per share, D is the dividend per Share,

Ke is the cost of capital g is the growth rate of earnings, E is earning of share = 40, r is IRR = 18 % Dp ratio = 40 %, 50%, 60%

D Ke

[r (E-D)/ ke] Ke

40%

0.4 Ke

[0.18 (40-0.4)/0.12) 0.12

0.4 +[0.18 (40-0.4)/0.12) 0.12

= Rs.498.33

50%

0.5 Ke

[0.18 (40-0.5)/0.12) 0.12

0.5 +[0.18 (40-0.4)/0.12) 0.12

= Rs.499.16

60%

0.6 Ke

[0.18 (40-0.6)/0.12) 0.12

= = Rs.497.50

0.6 +[0.18 (40-0.6)/0.12) 0.12