Name: Falguni Pandit Registration No.

: 520966021
MBA – II SEM

Financial Management - MB0029

MB0029

Registration No.: 520966021

Page No: 1 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Set – 1
QN.1a. Explain why wealth maximization is superior over profit maximization.

Answer:

Maximization of profits is regarded as the proper objective of the firm, but it is not as
inclusive a goal as that of maximizing stockholder wealth. For one thing, total profits are not
as important as earnings per stock. Therefore, wealth maximization is superior in a way that
it is based on cash flow, not on the accounting profit.

Wealth maximization is superior because it values the duration of expected returns. Since
distant flows are uncertain, converting them into comparable values at base period facilitated
better comparison of financial projects. This can be achieved by for example; by discounting
all future earnings to establish their net present value.

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 therefore, society gains because of the societal
welfare.

1b. Briefly explain the steps involved in financial plan.

Answer:

The financial planning process turns your own personal objectives into specific plans and
outlines methods and strategies to implement these plans.
Establish Financial Goals and Objectives: Your Financial Consultant will assist you in
identifying your objectives. For example, you may be asked the following questions: At what
age and income level would you like to retire? What level of income would you like to provide
to your surviving spouse? How would you like your estate to be distributed?

Gather Data: Information reviewed may include, for example, tax returns, brokerage
statements, insurance policies, wills, trusts, estate planning documents, or business
agreements. The more information that is available, the more accurate your financial plan
will be.
Process and Analyze Information: Appropriate advisors will consider various alternatives to
meet your objectives.
Adopt a Comprehensive Financial Plan: Illustrations and analyses showing you strategies to
consider meeting your goals.

Implement the Plan: You choose to implement the strategies with which you feel
comfortable.
Monitor the Plan: Periodically, you and your Financial Consultant will review your financial
plan. Circumstances change and you may need to make revisions to your plan.

QN.2a. Explain the two theories of capitalization.

Answer:

Page No: 2 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

1. Cost Theory: According to the cost theory of capitalization, the value of a company is
arrived at by adding up the cost of fixed assets like plants, machinery patents, etc., the
capital regularly required for the continuous operation of the company (working capital), the
cost of establishing business and expenses of promotion. The original outlays on all these
items become the basis for calculating the capitalization of company. Such calculation of
capitalization is useful in so far as it enables the promoters to know the amount of capital to
be raised. But it is not wholly satisfactory. On import objection to it is that it is based o a
figure (i.e., cost of establishing and starting business) which will not change with variation in
the earning capacity of the company. The true value of an enterprise is judged from its
earning capacity rather than from the capital invested in it. If, for example, some assets
become obsolete and some others remain idle, the earnings and the earning capacity of the
concern will naturally fall. But such a fall will not reduce the value of the investment made in
the company's business.

2. Earnings Theory: The earnings theory of Capitalization recognizes the fact that the true
value (capitalization) of an enterprise depends upon its earnings and earning capacity.
According to it, therefore, the value or Capitalization of a company is equal to the capitalized
value of its estimated earnings. For this purpose a new company has to prepare an
estimated profit and loss account. For the first few year of its life, the sales are forecast ad
the manager has to depend upon his experience for determining the probable cost. The
earnings so estimated may be compared with the actual earnings of similar companies in the
industry and the necessary adjustments should be made. Then the promoters will study the
rate at which other companies in the same industry similarly situated are earnings. The rate
is then applied to the estimated earnings of the company for finding out the capitalization. To
take an example a company estimates its average profit in the first few years at Rs. 50,000.
Other companies of the same type are, let us assume, earnings a return of 10 per cent on
their capital. The Capitalization of the company will then be 50,000x100=Rs.500,000.

QN. 2b. A customer wants to deposit Rs.10,000 in ICICI bank for 5 years. The
prevailing interest rate is 9.50% what will be the value of the deposit on maturity.

Answer:

FV = PV (1+i) ^n

FV = 10000(1+0.095) ^5

FV= Rs.15, 742.39

QN.3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5 years hence. How
much should it deposit annually in sinking fund account so that it can accumulate Rs.
30 million at the end of 5 years.

Answer:

Page No: 3 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

FV = installment * PVIFA (i, y)

30,000,000 = installment * PVIFA (12%, 5)

30,000,000 = installment *3.605
30,000,000 ÷ 3.605 = installment.
Installment = 8,321,775.31

QN.3b. Road Transport Corporation issued deep discount bonds in 1996 which has a
face value of Rs. 2, 00, 000 maturing after 25 years. The bond was issued at Rs. 5300.
What is the effective interest rate earned by the investor from this bond?

Answer:

A = Po (1+i) n

200,000 = 5300(1+i) 25

Solving for r, 200,000/5300 = (1+i) 25

37.7358 = (1+i) 25

37.73581/25 = (1+i)

i = 15.63% is the effective interest rate per annum.

QN.4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10% maturing after
10 years. If the YTM is 12% what is the market value of the bond? If the YTM is
increase to 14%, what is the market value of the bond? Compare and give the
inference.

Answer:

Interest payable = 1000*10% = Rs 100

Principal payment = 1000
YTM = 12%

Vo = I*PVIFA (kd, n) + F*PVIF (kd, n)

Vo =100*5.650 (12%, 10y) + 1000*0.322 (12%, 10y)

Vo = Rs 887

Using YTM as 14%

Vo =100*5.216 (14%, 10y) + 1000*0.270 (14%, 10y)

Vo = Rs 791.6

Compare and give inference.

Page No: 4 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

When the YTM is low the market value of the bond is high and when the YTM is high the
market value of the bond is low.

The inference is that, the bond’s value moves inversely proportional to its YTM.
As the YTM increases by from 12% to 14% the value of the bond falls from Rs 887 to Rs
791.6.

QN.5. ABC Ltd, produced and sold Rs 100,000 of a product at the rate of Rs 100.for
production of Rs.1,00,000 units, it has spent a variable cost of Rs.6,00,000 at the rate
of Rs.6 per unit and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs. 50,000
at the rate of 5 percent and Rs.1,00,000 debts. Calculate operating leverage.

Answer:

Operating Leverage = % Change in EBIT / % Change in Sales

Operating Leverage = (100 – 6)100000 / [(100 – 6)100000]-250000

Operating Leverage = 1.03

b) Explain the importance of capital budgeting.

Answer:

Capital budgeting (or investment appraisal) is the planning process used to determine
a firm’s expenditures on assets whose cash flows are expected to extend beyond one year
such as new machinery, equipments, etc. It is also the process of identifying, analyzing and
selecting investment projects whose cash flows are expected to extend beyond one year
such as research and development project.

Capital expenditures can be very large and have a significant impact on the firm’s
financial performance. Besides, the investments take time to mature and capital assets are
long-term, therefore, if a mistake were done in the capital budgeting process, it will affect the
firm for a long period of time. Basically, the importance of capital budgeting are as follow:

Capital budgeting helps to avoid forecast error.

The future success of a business largely depends on the investment decisions that
corporate managers make today. Investment decisions may result in a major departure from
what the company has been doing in the past. Through making capital investments, firm
acquires the long-lived fixed assets that generate the firm’s future cash flows and determine
its level of profitability. Thus, this decision greatly influences a firm’s ability to achieve its
financial objectives. For example, if the firm invests too much it will cause higher
depreciation and expenses. On the other hand, if the firm does not invest enough, the firm
will face a problem of inadequate capacity and thus, lose its market share to its competitors.

Capital budgeting helps a firm to plan its financing. Proper capital budgeting analysis is
critical to a firm’s successful performance because capital investment decisions can improve
cash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distress
and even to bankruptcy.

While working with capital budgeting, a firm is involved in valuation of its business. By
valuation, cash flow is identified and discounted at the present market value. In capital

Page No: 5 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

budgeting, valuation techniques are undertaken to analyze the impact of assets instead of
financial assets.

The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is
the varying key involved in forecasting cash flow. The importance of capital budgeting is not
only its mechanics, but also the parameters of forecasting the incurrence of cash in the
business.

QN.6. Financial planning: Assume you are working for an investment banker. A client
aged 30 has approached you on investment planning. His present salary is
Rs.6,00,000 per year and his current savings is Rs.1,50,000.
(a) How much does this current saving grow to in 3 years if the interest rate is12%
compounded annually.

Answer:
(a) FVAn = A [(1+i) ^n – 1/i]
FVAn = 150000[(1+0.12) ^3 – 1/ 0.12]
FVAn = Rs 506,160

(b) Assume he plans to save Rs.60000 at the end of every year for 5 years, what would
be the amount at the end of 5 years if the interest being 10% compounded annually.

Answer:

FVAn = A [(1+i) ^n – 1/i]

FVAn = 60000[(1+0.10) ^5 – 1/ 0.10]
FVAn = Rs 366,306
Set – 2

Q1: Compare and contrast NPV with IRR.

ANS 1.

Net present value method

The cash inflow in different years are discounted (reduced) to their present value
by applying the appropriate discount factor or rate and the gross or total present
value of cash flows of different years are ascertained. The total present value of
cash inflows are compared with present value of cash outflows (cost of project)
and the net present value or the excess present value of the project and the
difference between total present value of cash inflow and present value of cash
outflow is ascertained and on this basis, the various investments proposals are
ranked.

Cash inflow = earnings / profits of an investment after taxes but before

depreciation

The present value of cash outflows = initial cost of investment and the comment
of project at various points of time ^

Page No: 6 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Decision rule After ranking various investments proposals on basis on net
present value, projects with negative net present value (net present value of
cash inflows less than their original costs) are rejected and projects with positive
NPV are considered acceptable. In case of mutually exclusive alternative
projects, projects with higher net present value are selected. Net present value
method is suitable for evaluating projects where cash flows are uneven.

Merits

1. The most significant advantage is that it explicitly recognizes the time value of
money, e.g., total cash flows pertaining to two machines are equal but the net
present value are different because of differences of pattern of cash streams.
The need for recognizing the total value of money is thus satisfied.

2. It also fulfills the second attribute of a sound method of appraisal. In that it

considers the total benefits arising out of proposal over its life time.

3. It is particularly useful for selection of mutually exclusive projects.

4. This method of asset selection is instrumental for achieving the objective of
financial management, which is the maximization of the shareholder's wealth. In
brief the present value method is a theoretically correct technique in the
selection of investment proposals.

Demerits

1. It is difficult to calculate as well as to understand and use, in comparison with

payback method or average return method.

2. The second and more serious problem associated with present value method
is that it involves calculations of the required rate of return to discount the cash
flows. The discount rate is the most important element used in the calculation of
the present value because different discount rates will give different present
values. The relative desirability of a proposal will change with the change of
discount rate. The importance of the discount rate is thus obvious. But the
calculation of required rate of return pursuits serious problem. The cost of capital
is generally the basis of the firm's discount rate. The calculation of cost of capital
is very complicated. In fact there is a difference of opinion even regarding the
exact method of calculating it.

3. Another shortcoming is that it is an absolute measure. This method will accept

the project which has higher present value. But it is likely that this project may
also involve a larger initial outlay. Thus, in case of projects involving different
outlays, the present value may not give dependable results.

4. The present value method may also give satisfactory results in case of two
projects having different effective lives. The project with a shorter economic life
is preferable, other things being equal. It may be that, a project which has a
higher present value may also have a larger economic life, so that the funds will
remain invested for longer period while the alternative proposal may have
shorter life but smaller present value. In such situations the present value
method may not reflect the true worth of alternative proposals. This method is
suitable for evaluating projects whose capital outlays or costs differ significantly.

Page No: 7 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Internal rate of return method The technique is also known as yield on
investment, marginal efficiency value of capital, marginal productivity of capital,
rate of return, time adjusted rate of return and so on. Like net present value,
internal rate of return method also considers the time value of money for
discounting the cash streams. The basis of the discount factor however, is
difficult in both cases. In the net present value method, the discount rate is the
required rate of return and being a predetermined rate, usually cost of capital
and its determinants are external to the proposal under consideration. The
internal rate of return on the other hand is based on facts which are internal to
the proposal. In other words, while arriving at the required rate of return for
finding out the present value of cash flows, inflows and outflows are not
considered. But the IRR depends entirely on the initial outlay and cash proceeds
of project which is being evaluated for acceptance or rejection. It is therefore
appropriately referred to as internal rate of return. The IRR is usually, the rate of
return that a project earns. It is defined as the discount rate which equates the
aggregate present value of net cash inflows (CFAT) with the aggregate present
value of cash outflows of a project. In other words it is that rate which gives the
net present value zero. IRR is the rate at which the total of discounted cash
inflows equals the total of discounted cash outflows (the initial cost of
investment). It is used where the cost of investment and its annual cash inflows
are known but the rate of return or discounted rate is not known and is required
to be calculated.

Accept / Reject decision

The use of IRR as a criterion to accept capital investment decision involves a
comparison of actual IRR with required rate of return, also known as cut off rate
or hurdle rate. The project should qualify to be accepted if the internal rate of
return exceeds the cut off rate. If the internal rate of return and the required rate
of return be equal, the firm is indifferent as to accept or reject the project. In
case of mutually exclusive or alternative projects, the project which has the
highest IRR will be selected provided its IRR is more than the cut off rate. In case
there are budget constraints, the projects are ranked in descending order of their
IRR and are selected subject to provisions.

Evaluation of IRR

1. Is a theoretically correct technique to evaluate capital expenditure decision. It

possesses the advantages which are offered by the NPV criterion such as, it
considers the time value of money and takes into account the total cash inflows
and outflows.

2. In addition, the IRR is easier to understand. Business executives and non-

technical people understand the concept of IRR much more readily than they
understand the concept of NPV. For instance, Business X will
understand the investment proposal in a better way if it is said that the total IRR
of Machine B is 21% and cost of capital is 10% instead of saying that NPV of
Machine B is Rs. 15,396.
3. It itself provides a rate of return which is indicative of profitability of proposal.
The cost of capital enters the calculation later on.

Page No: 8 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

4. It is consistent with overall objective of maximizing shareholders wealth.
According to IRR, the acceptance / rejection of a project is based on a
comparison of IRR with required rate of return. The required rate of return is the
minimum rate which investors expect on their investment. In other words, if the
actual IRR of an investment proposal is equal to the rate expected by the
investors, the share prices will remain unchanged. Since, with IRR, only such
projects are accepted which have IRR of the required rate, therefore, the share
prices will tend to rise. This will naturally lead of maximization of shareholders
wealth. ^

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicated computation problems.

2. It produces multiple rates which can be confusing. This situation arises in the
case of non-conventional projects.

3. In evaluating mutually exclusive proposals, the project with highest IRR would
be picked up in exclusion of all others. However in practice it may not turn out to
be the most profitable and consistent with the objective of the firm i.e.,
maximization of shareholders wealth.

4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the
IRR. It is rather ridiculous to think that the same firm has the ability to reinvest
the cash flows at different rates. The reinvestment rate assumption under the
IRR is therefore very unrealistic. Moreover it is not safe to assume always that
intermediate cash flows from the project may be reinvested at all. A portion of
cash inflows may be paid out as dividends, a portion may be tied up with current
assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the
project if it assumes that it invests the entire intermediate cash proceeds.

Further it is not safe to assume that they will be reinvested at the same rate of
return as the company is currently earning on its capital (IRR) or at the current
cost of capital (k).

NPV versus IRR NPV indicates the excess of the total present value of future
returns over the present value of investments. IRR (or DFC rate) indicates on the
other hand the rate at which the cash flows (at present values) are generated in
the business by a particular project.
Both NPV and IRR iron out the difference due to interest factor or say higher
returns in earlier years and higher returns in later years (though the total returns
in absolute terms may be around the same for several projects).
Between the two, IRR or DFC rate is the more sophisticated method ¬a popular
as well, since:

(a) IRR method -mostly subjective decision regarding discounting rate. ^

(b) Whilst under NPV the main basis of comparison is between different NPV's of
different projects, under IRR or DFC rate approach a number of basis is available.
For example ¬

Page No: 9 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

DFC rate Vs Discount rate of return (on normal operations) ^ DFC rate Vs Cut
off rate of the company DFC rate Vs Borrowing rate (on cost of capital) DFC
rates between different projects

(c) The results under DFC rate approach are simpler for the management to
understand and appreciate. We should however be very careful in applying the
decision rules properly when NPV and IRR calculation shows divergent results.
The rules are ¬

(i) the projects be the basis of decision when mutually exclusive in character;

(ii) there is capital rationing situation

(d) IRR should be a better guide when there are plenty of project situations (as it
is there in a long enterprise) and no major constraints (for example, in respect of
macro projects).

Page No: 10 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Q2: Zodiac Ltd is considering purchase of investment worth Rs. 40
lakhs. The estimated life and the new cash flow fir 3 years are as under.

Machines B C
A
Estimated life 3 Years 3 Years 3years
Cash inflows(in lakhs)
1 Year 27 06 12
2 Year 18 21 80
3 Year 55 33 30

Ans 2

A) Payback period

Machine A. Rs.27 lakhs will be recovered in 1st year & the balance 13 lakhs (40 –
27) will be recovered in 2nd year of 18 lakhs

Payback period = 1year +(13/18*12month) or =1year +13/18

1 year 8.6 month = 1year + 0.72
1.72year

machine B. Rs.06 lakhs will be recovered in 1st year & the balance 34 lakhs
(40 – 6) will be recovered in 2nd year of 21 lakhs
payback period = 1year +(35/21*12month) or =1year + 35/21
= 1year 20 month = 1year +1.66
2.66year

machine c. Rs.12 lakhs will be recovered in 1st year & the balance 28 lakhs
(40 – 12) will be recovered in 2nd year of 80 lakhs
payback period = 1year + (28/80*12month) or =1year + 28/80
= 1year + 4.2 month = 1year + 0.35
= 1.35year

Page No: 11 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

machine A. Rs. 35.4546 will be recovered in 2nd year & balance 4.5454(40-
35.4546) will be recovered in 3rd year out of 39.149
=2year + (4.5454/39.149)
=2year + 0.1161
=2.11year

machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(40-
22.0968) will be recovered in 3rd year out of 23.489
=2year + (17.9032/23.489)
=2year +0.7621
=2.76year

machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936
(40- 74.4936) will be recovered in 3rd year out of 95.8436
=2year + (-34.4936/95.8436)
=2year + -0.3598
= 1.64year

Page No: 12 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Q3: The cash flow stream of Nanotech Ltd, is as follows:

years 0 1 2 3 4 5 6
Cash flows -120 -100 40 60 80 100 130
(in millions)
The cost of capital is 13% find MIRR.

Ans 3:

Present value of cost = 120 * 100/1.13

= 194.69
Terminal value of cash flow
432
= 40(1.13) + 60(1.13) +80(1.13)+100(1.13)+130
= 40*1.6305 + 60*1.4429 + 80*1.2769 + 113 + 130
=496.95
MIRR is obtain on solving the following equation.
6
194.69 = 496.95/(1+mirr)
6
(1+mirr) = 496.95/194.69
6
(1+mirr) = 2.5525

Q3: Elaborate different sources of risk in a project

ANS. Risk in the project are many. It is possible to identify three separate and
distinct type of risk in any project.
1. Stand – alone risk : it is measured by the variability of expected returns of the
project
2. portfolio risk : a firm can be viewed as portfolio of projects having a certain
degree of risk. When new project is added to the existing portfolio of project, the
risk profile of the firm will alter. The degree of the change in the risk depends on
the existing portfolio of the
projects. If the return from the new project is negatively correlated with the
return from portfolio, the risk of the firm will be further diversified away.
3. market or beta risk: it is measured by the effect of the project on the beta of
the firm. The market risk for a project is difficult to estimate. Stand alone risk of
a project when the project is considered in isolation. Corporate risk is the
projects risks of the firm. Market risk is systematic risk. The market risk is the
most important risk because of the direct influence it has on stock prices.

Source of risk: the source of risk are

1. project – specific risk
2. competitive or competition risk
3. industry - specific risk
4. international risk

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Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

5. market risk

1. project – specific risk: the source of this risk could be traced to something
quite specific to the project. Managerial deficiencies or error in estimation of
cash flow or discount rate may lead to a situation of actual cash flow relised
being less than that projected.
2. competitive risk or competition risk: unanticipated of a firm’s competitors will
materially affect the cash flows expected from a project. Because of this the
actual cash flow from a project will be less than that of the forecast.
3. industry- specific : industry – specific risks are those that affect all the firms in
the industry. It could be again grouped in to technological risk, commodity risk
and legal risk. All these risks will affect the earnings and cash flows of the
project. The changes in technology affect all the firms not capable of adapting
themselves to emerging new technology. The best example is the case of firm
manufacturing motors cycles with two stroke engines. When technological
innovation replaced the two stroke engines by the four stroke engines those
firms which could not adapt to new technology had to shut down their
operations. Commodity risk is the arising from the affect
of price – changes on goods produced and marketed. Legal risk arise from
changes in laws and regulations application to the industry to which the firm
belongs. The best example is the imposition of service tax on apartments by the
government of India when the total number
of apartments built by a firm engaged in that industry exceeds a prescribed limit.
Similarly changes in import – export policy of the government of India have led
to the closure of some firms or sickness of some firms.
4. international risk : these types of risk are faced by firms whose business
consists mainly of exports or those who procure their main raw material from
international markets. For example, rupee –dollar crisis affected the software and
BPOs because it drastically reduce their profitability. Another best example is
that of the textile units in Tirupur in Tamilnadu, exporting their major part of the
garments produces. Rupee gaining and dollar weakening reduced their
competitiveness in the global markets.

Page No: 14 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Q4: The expected cash flow of Tejaswini Ltd, are an follow. (5 Marks)

Year Cash flow

0 (50000)
1 9000
2 8000
3 7000
4 12000
5 21000

The certainty equivalent factor balance as per the following equation α t=1-05.05t. Calculate the
NPV of the project if the risk free rate of return is 9%.

Ans 4:

Page No: 15 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Q5: From the following information prepare cash budgets for VSI Co. Ltd.:

Particulars Jan Feb March April

Opening cash balance 20,000 1,60,000 1,65,000 2,30,000
Collection from customer 1,30,000 45,000 40,000 63200
Payments : 25,000 1,05,000 1,00,000 1,14,200
Raw materials purchase 1,00,000 10,000 15,000 12,000
Salary and Wages 15,000 ---- ---- ---
Other expenses 6,000 ---- 20,000 ---
Income Tax ---
Machinery

The firm wants to maintain a minimum cash balance of Rs.25000 for

each month. Creditors are allowed one-month credit. There is no lag in
payment of salary, other expenses.

Ans 5:

For JAN:
Bank over Draft 21,000 for maintain minimum cash balance for
month of
February 21000+4000=25000.

For FEB:
No need to take bank over Draft because closing balance 25,000.
For MARCH:
Bank over Draft 10,000 for maintain minimum cash balance for
month of
April 15,000+10,000=25000.

At last closing balance month of April 65,600 so return to bank 31,000

form month
of april , 65,600 – 31,000= 34,400

Page No: 16 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

Case Study
Assume you are an external financial consultant. You have been
approached by a client M/s Technotron Ltd to give a presentation on
Credit Policy adopted by Information technology companies. You are
specifically asked to deal with credit standards, credit period, cash
discounts and collection programme. For the sake of simplicity take any
two information technology companies and analyze the credit policy
followed by them.

ANS:-
Credit policy Variables
1. Credit standards.
2. Credit period.
3. Credit discount and
4. Collection programme.

1. Credit standards : The term credit standards refer to the criteria for
extending credit to customers. The bases for setting credit standards are.
a. Credit rating
b. References
c. Average payment period
d. Ratio analysis

There is always a benefit to the company with the extension of credit to its
customers but with the associated risks of delayed payment or non payment,
funds blocked in receivables etc. The firm may have light credit standards. It
may sell on cash basis and extend credit only to financially strong customers.
Such strict credit standards will bring down bad – debt losses and
reduce the cost of credit administration. But the firm may not be able to increase
its sales. The profit on lost sales may be more the costs saved by the firm. The
firm should evaluate the trade – off between cost and benefit ofany credit
standards.

2. Credit period: Credit period refer to the length of time allowed to its
customers by a firm to make payment for the purchase made by customers of
the firm. It is generally expressed in days like 15 days or 20 days. Generally,
firms give cash discount if payment are made within the specified period. If a
firm follows a credit period of ‘net 20’ it means that it allows to its
customers 20 days of credit with no inducement for early payments. Increasing
the credit period will bring in additional sales from existing customers and new
sales from new customers. Reducing the credit period will lower sales, decrease
investments in receivables and reduce the bad debt loss. Increasing the credit
period increases the incidence of bad debt loss. The effect of increasing the
credit period on profits of the firm are similar to that of relaxing the credit
standards.

3. Cash discount: Firms offer cash discount to induce their customer to make
prompt payments. Cash discount have implications on sales volume, average
collection period, investment in receivables, incidence of bad debt and profits. A
cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the

Page No: 17 Name: Falguni Pandit |Registration No.: 520966021

Name: Falguni Pandit Registration No.: 520966021
MBA – II SEM

Financial Management - MB0029

payment is made by the tenth day; other wise full payment will have to be made
by 20th day.
4. Collection programme : The success of a collection programme depends on
the collection policy pursued by the firm. The objective of a collection policy is to
achieve. Timely collection of receivable, there by releasing funds locked in
receivables and minimize the incidence
of bad debts. The collection programmes consists of the following.

1. Monitoring the receivables

2. Reminding customers about due date of payment
3. On line interaction through electronic media to customers about the payments
due around the due date.
4. Initiating legal action to recover the amount from overdue customer as the
last resort the dues from defaulted customers. Collection policy formulated shall
not lead to bad relationship with customers.

Page No: 18 Name: Falguni Pandit |Registration No.: 520966021