2. Through the process of discounting it takes care of the quality of cash flows. Distant
uncertain cash flows into comparable values at base period facilitates better
comparison of projects. There are various ways of dealing with risk associate with
cash flows. These risk are adequately considered when present values of cash of any
project.
3. In today’s competitive business scenario corporate play a key role. In company from
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 market 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.
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 enhance consumer 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 help 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 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.
Q2. 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?
Answer:-
Present Value(PV) =80000/-
Amount (A) =?
Interest Rat e(I) =10%
No. of Year(N) =10
80000=A{1+.10)10 }/{.10(1+.10)10}
80000=A{ 1.593742/0.259374}
Answer:- We live in a society and interact with people and environment. What happens to
us is not always accordance to our wishes. Many things turn out in our live are uncontrollable
by us. Many decisions we take are the result of external influences. So do our financial
matters. There are many factors affect our personal financial planning. Range from economic
factors to global influences. Aware of factors affecting your money matters below will
certainly benefit your planning.
2. Size of the company: - The size of the company greatly influences the availability of
funds from different sources. A small company normally finals it difficult to raise
funds from long 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.
4. Sources of finance available:- Sources of finance could be group 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 finances us closely linked to the firms capacity to manage the risk exposure.
6. Matching the sources with utilization:- The product 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 term finance. All fixed
assets-investment are to be finance by long term sources. It is a cardinal principal of
financial planning.
Answer:- A.
Maturity value
Valu of bond =
1 + rate of return
1000
=
1 + 0.08
= 926
Answer:- B.
= 1000 - 904.98
= 95.02
Interest
Rate of interest = Current Price of X 100
bond
95.02
= X 100
904.98
= 10.50%
Questions:
1. Should the company expand its capacity? Show the computation of NPV
2. What is the annual installment of bank loan?
3. Calculate the quarterly installments of the Financial Institution loan
4. Should the company borrow from the bank or from the financial institution?
Salvage : 55000000
Interest rate : 14 %
No of Year(N) : 10 Years
= 3,83,43,558
Answer 3.
= 3,86,39,876
Answer 4. Should the company borrow from the bank because payback by the company less then
financial institution .
_________________________________________________________________________________
Q1. A. What is the 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.
where:
D1 = next year’s dividend
c) Discounted Cash Flow g = firm’s constant growth rate ApproachAlso known as
the “dividend yield plus P0 = price growth approach”. Using the
dividend-growth model, you can rearrange the terms
as follows to determine ks.
Q3. Explain Miler and
Q1. 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?
Answer:-
Where Kd is post tax cost of debenture capital,
N is maturity period
A.
I(1-T)+{(F-P)/N}
Kd =
(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
B.
I(1-T)+{(F-P)/N}
Kd =
(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
Q2. Volga is a large manufacturing company in the private sector. In 2007 the company
had a gross sale of Rs.980.2 crore. The other financial data for the company are given
below:
Items Rs. In crore
Net worht 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding interest) 118.23
B. Operating leverage
C. Financial leverage
Answer:
Sale 980.20
Less Variable cost ?
Contribution 161.40
Less Fixed Cost 118.23
EBIT 43.17
Less interest 34.39
PBT 8.78
= 43.17 + 118.23
= 161.40
Debt
Debt equity ratio =
Equity
165.47
=
152.31
= 1.09
B. Operating leverage
Operating leverage = Contribution
EBIT (Operating Earning)
161.40
=
43.17
= 3.74
C. Financial leverage
EBIT
Financial leverage =
PBT (Profit before tax)
43.17
=
8.78
= 4.92
D. Combined leverage
Contribution EBIT
= 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 1.09 it means that on every Rupees (Net worth) there is Rs.1.09
external liability. Hence the company has over burden of external liability is his capital.
Hence the risk is excess and shareholders require return is also higher.
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.
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
V + (S + D) = O/Ko = NOI/Ko
Cost of
Ko Ke
Capital
Leverage ►
D/S
The basic argument for proposition I is that equilibrium is restored in the market by
the arbitrage mechanism. Arbitrage is the process of buying security at lower price in
one market and selling it in another market at higher price bringing about equilibrium.
This is a balancing act. Miller and Modigliani perceive that the investors of firm
whose value is higher will sell their share and in return 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 shares price of those share which are being sold.
This switching operation will continue till the market price of identical firms becomes
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 decision are independent.
Q4. How to estimate cash flows? What are the components of incremental cash flows?
Estimating the cash flows associated with the project under consideration is the most difficult
and crucial step in the evaluation of an investment proposal. It is the result of the team work
of many professionals in an organization.
1. Capital outlays are estimated by engineering department after examining all aspects
of production process.
2. Marketing department on the basis of market survey forecasts the expected sales
revenue during the period of accrual of benefits from project executions.
4. Incremental cash flows and out flows statement is prepared by the cost accountant on
the basis of details generated in the above steps. The ability of the firm to forecast
the cash flows with reasonable accuracy lies at the root of the implementation of any
capital expenditure decision.
Investment (Capital budgeting) decision required the estimation of incremental cash flow
stream the life of the investment. Incremental cash flow are estimated on after tax basis.
2. Operating Cash inflows: Operating cash inflows are estimated for the entire
economic life of investment. Operating cash inflows constitute a stream of inflows
and outflows over the life of the project. Here also incremental inflows and outflows
attributable to operating activities are considered. Any saving in cost on installation
of new machinery in the place of the old machinery will have to be accounted to on
post tax basis. In this connection incremental cash flows refer to the change in cash
flows on implementation of a new project over the existing position.
3. Terminal Cash inflows: At the end of the economic life of the project, the operating
assets installed now will be disposed off. It is normally known as salvage value of
equipments. These terminal cash inflows are computed on post tax basis.
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.
Cash Inflows
Projec
t Initial Cash outlay Year 1 Year 2 Year 3
Computation of NPV
Project A
NPV 16,320
PV of Cash inflows
Profitability index =
PV of Cash outflows
1,16,000
=
1,00,000
= 1.1632
Project B
Cash
Year Inflows PV factors at 15% PV of Cash inflows
20,0 17,4
1 00 0.870 00
40,0 30,3
2 00 0.758 20
20,0 13,1
3 00 0.658 60
60,8
PV of cash inflows 80
50,0
Initial cash outlay 00
10,8
NPV 80
PV of Cash inflows
Profitability index =
PV of Cash outflows
60880
=
50000
= 1.2176
Project C
Cash
Year Inflows PV factors at 15% PV of Cash inflows
20,0 17,4
1 00 0.870 00
30,0 22,7
2 00 0.758 40
30,0 19,7
3 00 0.658 40
59,8
PV of cash inflows 80
50,0
Initial cash outlay 00
9,8
NPV 80
PV of Cash inflows
Profitability index =
PV of Cash outflows
59880
=
50000
= 1.1976
Ranking of Project
A 16320 1 1.1632 3
B 10880 2 1.2176 1
C 9880 3 1.1976 2
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 the incur individually an initial outlay of Rs. 50,000. Therefore,
with the execution of projects 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 ranked on the
basis of the profitability index. Funds should be allocated on the basis 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 equipments is 11% . Calculate the
IRR and NPV for the equipments. Which equipment should be accepted and why?
Answer:
NPV of Project A
9611
= 11 + X (16-11)
9611 - (1305)
= 11 + 4.4
IRR = 15.40%
NPV of Project B
9228
= 11 + X (18-11)
9228 - (1034)
= 11 + 6.29
IRR = 17.29%
Equipment A has positive NPV where as equipment B negative NPV hence equipment A
should be accepted.
___________________________________________________________________________