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MBA- II

Q.No.1: Why wealth maximization is superior to profit maximization in today’s


context? Justify your answer.

Answer: Wealth maximisation is superior to profit maximisation, below are the reasons
and justification.
· Wealth maximisation is based on cash flow. It is not based on the accounting profit.
· Through the process of discounting, wealth maximisation takes care of the quality of
cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into
comparable values at base period facilitates better comparison of projects. There are
various ways of dealing with risk associated with cash flows. These risks are adequately
considered when present values of cash flows are taken to arrive at the net present
value of any project.
· Corporates play a key role in today’s competitive business scenario. In an organisation,
shareholders typically own the company but the management of the company rests
with the board of directors. Directors are elected by shareholders. Company
management procures funds for expansion and diversification of capital markets.
In the liberalised set up, the society expects corporates to tap the capital markets
effectively for their capital requirements. Therefore, to keep the investors happy
throughout the performance of value of shares in the market, management of the
company must meet the wealth maximisation criterion.
· When a firm follows wealth maximisation goal, it achieves maximisation of market value
of share. A firm can practice wealth maximisation goal only when it produces quality
goods at low cost. On this account, society gains because of the societal welfare.
Maximisation of wealth demands on the part of corporates to develop new products or
render new services in the most effective and efficient manner. This helps the consumers
as it brings to the market the products and services that consumer needs.
· Another notable feature of the firms committed to the maximisation of wealth is that to
achieve this goal, they are forced to render efficient service to their customers with
courtesy. This enhances consumer welfare and benefit to the society.
· 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 maximisation could be considered a superior goal compared to
profit maximisation.
· Since listing ensures liquidity to the shares held 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 maximisation of market value of shares will lead to maximisation
of the net wealth of shareholders
Therefore, we can conclude that maximisation of wealth is the appropriate goal of
financial management in today’s context.

Q.No.2: 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

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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: Installment* PVIFA (10%, 10) = 80,000


Installment*6.145 =80,000

Installment = 80000/6.145 = 13018.71

He will draw an amount of Rs 13018.71 annually.

Q.No.3: What factors affect financial plan?

Answer: Factors affecting Financial Plan

The various other factors affecting financial plan are listed down

· Nature of the industry


The very first factor affecting the financial plan is the nature of the industry. Here, we must
check whether the industry is a capital intensive or labour intensive industry. This will have
a major impact on the total assets that a firm owns.
· Size of the company
The size of the company greatly influences the availability of funds from different sources.
A small company normally finds 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
· Status of the company in the industry
A well established company enjoys a good market share, for its products normally
commands investors’ confidence. Such a company can tap the capital market for
raising funds in competitive terms for implementing new projects to exploit the new
opportunities emerging from changing business environment
· Sources of finance available

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Sources of finance could be grouped 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 finance is closely linked to the firm’s
capability to manage the risk exposure.
· The capital structure of a company
The capital structure of a company is influenced by the desire of the existing
management (promoters) of the company to retain control over the affairs of the
company. The promoters who do not like to lose their grip over the affairs of the
company normally obtain extra funds for growth by issuing preference shares and
debentures to outsiders.
· Matching the sources with utilisation
The prudent policy of any good financial plan is to match the term of the source with the
term of the investment. To finance fluctuating working capital needs, the firm resorts to
short term finance. All fixed asset – investments are to be financed by long term sources,
which is a cardinal principle of financial planning.
· Flexibility
The financial plan of a company should possess flexibility so as to effect changes in the
composition of capital structure whenever need arises. If the capital structure of a
company is flexible, there will not be any difficulty in changing the sources of funds. This
factor has become a significant one today because of the globalisation of capital
market.
· Government policy
SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement
and regulatory mechanism imposed by FEMA and Department of corporate affairs
(Govt. of India) influence the financial plans of corporates today. Management of public
issues of shares demands the compliances with many statues in India. They are to be
complied with a time constraint.

Q.No.4: Suppose you buy a one-year government bond that has a maturity
value of Rs.1000. The market interest rate is 8 per cent. (a) How much will you
pay for the bond? (b) If you purchase the bond for Rs.904.98, what interest rate
will you earn from this investment?

Answer: a) since bond does not have any coupon rate, so it’s a Zero coupon
bond

Present Value of Zero coupon bond = I*PVIFA (Kd, time)+ F*PVIF (Kd, time)

= 0 + 1000*(8%, 1)

= 1000*. 9259

= 925.9, so Rs 926 will have to pay to purchase the bond.

b) The rate will be earned by the investor can be calculated as

1000 = 904.98 (1+r)

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1000/904.98 = (1+r)

1.1050 = (1+r)

From FVIF table it will be 10.5%

Q. No.5: Case Study:


Deepak Hand tools Private Limited
DHPL is a small sized firm manufacturing hand tools. It manufacturing plan is
situated in Haryana. The company’s sales in the year ending on 31st March 2007
were Rs.1000 million (Rs.100 crore) on an asset base of Rs.650 million. The net
profit of the company was Rs.76 million. The management of the company
wants to improve profitability further. The required rate of return of the company
is 14 percent.
The company is currently considering an investment proposal. One is to expand
its manufacturing capacity. The estimated cost of the new equipment is Rs.250
million. It is expected to have an economic life of 10 years. The accountant
forecasts that net cash inflows would be Rs.45 million per annum for the first three
years, Rs.68 million per annum from year four to year eight and for the remaining
two years Rs.30million per annum. The plant can be sold for Rs.55 million at the
end of its economic life.
The company would need to raise debt to the extent of Rs.200 million. The
company has the following options of borrowing Rs.200 million:

a. The company can borrow funds from a nationalized bank at the interest rate
of 14 percent for 10 years. It will be required to pay equal annual installment
of interest and repayment of principal.

b. A financial institution has offered to lend money to DHPL at 13.5 per annum
but it needs to pay equated quarterly installment of interest and repayment of
principal.

Questions: Answer
1. Should the company expand its capacity? Show the computation of NPV.

Ye Cash PV PV of
ar flow factor cash
at 14% flows
1 450000 0.877 3946500
0
2 450000 0.769 3460500
0
3 450000 0.675 3037500
0
4 680000 0.592 4025600
0

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5 680000 0.519 3529200
0
6 680000 0.456 3100800
0
7 680000 0.4 2720000
0
8 680000 0.351 2386800
0
9 300000 0.308 924000
0
10 300000 0.27 810000
0
Total 2794090
0

Scrap 5500000
Value

Total cash inflow = 27940900 + 550000 = 33440900

NPV = Cash inflows-Initial Investment

=33440900-25000000 =8440900

Company should expand, as NPV is positive.

2. What is the annual installment of bank loan?

Annual Installment * PVIFA (14%, 10) = 2,00,000,000

Installment* 5.2161 = 2,00,000,000

Installment = 2,00,000,000/ 5.2161

Installment = Rs 38342823.18

3. Calculate the quarterly installments of the Financial Institution loan.

Quarterly Installment * PVIFA (13.5/4, 40) = 2,00,000,000

Installment * PVIFA (3.38%, 40) = 2,00,000,000

Installment * 23.027 = 2,00,000,000

Installment = 2,00,000,000/23.027

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Installment = Rs 8685456.20

4. Should the company borrow from the bank or from the financial institution?

Amount will be paid to bank in 10 years = Yearly Installment * 10 = Rs 383428231.8

Amount will be paid to FI in 10 years = Qty Installment*40 = Rs 347418248

Clearly the amount will be paid to FI is lower, so company should borrow from
Financial Institution.

MB 0045 Set- 2

Q.No.1A). What is the cost of retained earnings?

Answer: Cost of Retained Earnings


A company’s earnings can be reinvested in full to fuel the ever-increasing demand of
company’s fund requirements or they may be paid off to equity holders in full or they
may be partly held back and invested and partly paid off. These decisions are taken
keeping in mind the company’s growth stages.
High growth companies may reinvest the entire earnings to grow more, companies with
no growth opportunities return the funds earned to their owners and companies with
constant growth invest a little and return the rest. Shareholders of companies with high
growth prospects utilising funds for reinvestment activities have to be compensated for
parting with their earnings.
Therefore the cost of retained earnings is the same as the cost of shareholders’ expected
return from the firm’s ordinary shares. So,
Kr = Ke

Q.No. 1B). 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: Value of Debenture = 2,00,000 at par

Net amount realized = 1,80,000


Time 07 years @ rate 13.5%
Tax Rate = 52%
Cost of Debenture = I(1-T) + { (F-P)/n}/(F+P)/2
= 13.5(1-. 52) + {(2,00,000-1,80,000)/7}/ (2,00,000 + 1,80,000)/2
=13.5* .48 + {20000/7} / 3,80,000/2
=6.48+ (2857/1,90,000)

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=6.48+ .0150 = 6.459 = 645.9%

If time is 04 years and market value is Rs 2,20,000

Cost of Debenture = 13.5(1- .52) +{(2,20,000-1,80,000)/4} / (2,20,000+1,80,000)/2


=13.5* .48 + {40,000/4} / 4,00,000/2
=6.48 + {10,000/2,00,000}
=6.48 + .050
=6.530 = 653%

Q. No.2: 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: (10 Marks)
Items Rs. In crore
Net worth 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding 118.23
interest)

You are required to calculate:


a. Debt equity ratio
b. Operating leverage
c. Financial leverage
d. Combined leverage. Interpret your results and comment on the Volga’s
debt policy

Answer:

A. Clearly debt = 165.47 crore, Equity = Rs 152.31 crore

Debt Equity ratio = Debt/Equity = 165.47/152.31 =1.09

B. DOL = Total sale/Total sale- Fixed cost

=980.2/980.2-118.23

=980.2/861.97

= 1.14

C. DFL = EBIT/EBIT-I –{D/(1-T)}

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= 43.17/43.17-34.39-0

=43.17/8.78 = 4.92

D. DTL = DOL * DFL

=1.14 * 4.92

= 5.61

Q.No.3: Explain Miller and Modigliani Approach to capital structure theory.

Answer: Miller and Modigliani Theory

Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up
to a reasonable limit and K0 remains constant at all degrees of leverage. They state that
the relationship between leverage and cost of capital is elucidated as in net operating
income(NOI) approach.
The assumptions regarding Miller and Modigliani (“MM”) approach are (see figure 7.6):
Perfect capital markets, Rational behaviour, Homogeneity, Taxes and Dividend Pay-out.

· 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 are infinitely divisible, availability
of all required information at all times.
· Investors behave rationally: They choose the combination of risk and return which is
most advantageous to them.
· Homogeneity of investors’ risk perception: All investors have the same perception of
business risk and returns.

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· Taxes: There is no corporate or personal income tax.
· Dividend pay-out is 100%: The firms do not retain earnings for future activities.

Three propositions can be derived based on the assumptions made on Miller and
Modigliani approach:
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. Therefore, the
market value of the firm can be expressed as:

Expected overall capitalisation rate

Which is equal to O/K0


Which is equal to NOI/K0

Where V is the market value of the firm,


S is the market value of the firm’s equity,
D is the market value of the debt,
O is the net operating income,
K0 is the capitalisation rate of the risk class of the firm

Q.No.4: How to estimate cash flows? What are the components of incremental
cash flows?

Answer: Estimation of 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. Estimation is the
result of the teamwork of many professionals in an organisation.
· Capital outlays are estimated by engineering departments after examining all aspects
of production process
· Marketing department on the basis of market survey forecasts the expected sales
revenue during the period of accrual of benefits from project executions
· Operating costs are estimated by cost accountants and production engineers

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· Incremental cash flows and cash out flow statement is prepared by the cost
accountant on the basis of the 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 success of the implementation of any capital expenditure decision.

Estimation of incremental cash flows

Investment (capital budgeting) decision requires the estimation of incremental cash flow
stream over the life of the investment. Incremental cash flows are estimated on tax basis.
Incremental cash flows stream of a capital expenditure decision has three components.

· Initial cash outlay (Initial investment)


Initial cash outlay to be incurred is determined after considering any post tax cash
inflows. In replacement decisions existing old machinery is disposed of and a new
machinery incorporating the latest technology is installed in its place.
On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be
computed on post tax basis. The net cash out flow (total cash required for investment in
capital assets minus post tax cash inflow on disposal of the old machinery being
replaced by a new one) therefore is the incremental cash outflow. Additional net
working capital required on implementation of new project is to be added to initial
investment.

· Operating cash inflows


Operating cash inflows are estimated for the entire economic life of investment (project).
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 savings in cost on installation of a new machinery in the place of the
old machinery will have to be accounted on post tax basis. In this connection
incremental cash flows refer to the change in cash flows on implementation of a new
proposal over the existing positions.

· Terminal cash inflows


At the end of the economic life of the project, the operating assets installed will be
disposed off. It is normally known as salvage value of equipments. This terminal cash
inflows are computed on post tax basis.

The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are – Separation
principle, Increment principle, Post-tax principle and Consistency principle.

Separation principle

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The essence of this principle is the necessity to treat investment element of the project
separately (i.e. independently) from that of financing element. The financing cost is
computed by the cost of capital. Cost of capital is the cut off rate and rate of return
expected on implementation of the project. Therefore, we compute separately cost of
funds for execution of project through the financing mode. The rate of return expected
on implementation if the project is arrived at by the investment profile of the projects.
Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formula is used to calculate profit after tax

EBIT = earnings (profit) before interest and taxes


t = tax rate

Incremental principle
Incremental principle says that the cash flows of a project are to be considered in
incremental terms. Incremental cash flows are the changes in the firms total cash flows
arising directly from the implementation of the project. Keep the following in mind while
determining incremental cash flows.
· Ignore sunk costs
Sunk costs are costs that cannot be recovered once they have been incurred. Therefore,
sunk costs are ignored when the decisions on project under consideration is to be taken.
· Opportunity costs
If the firm already owns an asset or a resource which could be used in the execution of
the project under consideration, the asset or resource has an opportunity cost. The
opportunity cost of such resources will have to be taken into account in the evaluation of
the project for acceptance or rejection.

Post tax principle


All cash flows should be computed on post tax basis
Consistency principle
Cash flows and discount rates used in project evaluation need to be consistent with the
investor group and inflation.

Q.No.5: What are the steps involved in capital rationing?

Answer: Steps involved in Capital Rationing

In the above topic we have discussed about the different types of capital rationing. Now
let us look at the different steps involved in capital rationing. The following are the steps
involved in capital rationing.

· Ranking of different investment proposals


· Selection of the most profitable investment proposal.

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Ranking of different investment proposals means 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.

Net present value method recognises the time value of money. Net present value
correctly admits that cash flows occurring at different time periods differ in value.
Therefore, there is a need to find out the present values of all the cash flows. NPV can be
represented with the following formula.

Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the
present value of cash inflows to initial cash outlay. The discount factor based on the
required rate of return is used to discount the cash inflows.

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present
value of any project equal to zero. Internal rate of return is the rate of interest which
equates the present value (PV) of cash inflows with the present value of cash outflows.
IRR is also called as yield on investment, managerial efficiency of capital, marginal
productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of
return that a project earns. IRR can be determined by solving the following equation for

Selection of the most profitable investment proposal

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After ranking the different investment proposals based on their net present value,
profitability index and the internal rate of return, the selection of the most profitable
investment proposal is to be done. The selection is done mainly in a view to select the
investment proposal which earns more profits than compared to the other proposals.
The basic features to be taken under consideration during the selection of the most
profitable investment proposal are:
· The proposal should have the potentiality of making large anticipated profits
· The proposal should involve high degree of risk
· The proposal should involve a relatively long time-period between the initial outlay and
the anticipated return

Evaluation of the selection procedure

· 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 a single large project
· Capital rationing also suffers from the multi-period capital constraints

Q. No.6: Equipment A has a cost of Rs.75, 000 and net cash flow of Rs.20000 per
year for six years. A substitute equipment 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 per cent. Calculate the IRR and NPV for the equipments.
Which equipment should be accepted and why?

Answer: For Equipment A:


Initial investment of Rs 75000 for 06 year @ 11%.
Total cash Inflows in 06 years = Rs 120000
Average cash inflow = 120000/6 = Rs 20000
When divide Initial investment by average cabs inflow = 75000/20000 = 3.75

From FVIFA for 06 years, the annuity factor, which is very near to 3.75, is 15%.

Computed value at 15 % in 06 years = 20000 * PVIFA (15%, 6)

= 20000* 3.7845 = 75690

Since the initial investment is less than the computed value, we will try next rate as 16 %

Computed value at 16 % in 06 years = 20000 * PVIFA (16%, 6)


== 20000* 3.6847 = 73694

Since the initial investment lies between 73694 (16%) and 75690 (15%)

IRR = 15 + (75690-75000/75690-73694) *1
= 15.35 %

NPV = PV of cash flows – Initial Investment


PV of cash flow = 20000*PVIFA (11%, 6)

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=20000*4.2305 = 84610
NPV for equipment A = 84610-75000=9610

For Equipment B:
Initial investment of Rs 50000 for 06 year @ 11%.
Total cash Inflows in 06 years = Rs 84000
Average cash inflow = 84000/6 = Rs 14000
When divide Initial investment by average cabs inflow = 50000/14000 = 3.571

From FVIFA for 06 years, the annuity factor, which is very near to 3.571, is 16%.

Computed value at 16 % in 06 years = 14000 * PVIFA (16%, 6)

= 14000* 3.6847 = 51586

Since the initial investment is less than the computed value, we will try next rate as 17 %

Computed value at 17 % in 06 years = 14000 * PVIFA (17%, 6)


= 20000* 3.3255 = 46557

Since the initial investment lies between 51586 (16%) and 46557 (17%)

IRR = 16 + (51586-50000/51586-46557) *1
= 16.32 %

NPV = PV of cash flows – Initial Investment


PV of cash flow = 14000*PVIFA (11%, 6)
=14000*4.2305 = 59227
NPV for equipment B =59227-50000 =9227

Equipment B will be accepted, since the IRR is higher for equipment

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