MB0045 Q1. What are the goals of financial management? Ans.

The financial management has to take three important decision viz. i) Investment decision i.e., where to invest fund and in what amount, ii) Financing decision i.e., from where to raise funds and in what amount, and iii) Dividend i.e., how much to pay dividend and how much to retain for future expansion. In order to make these decisions the management must have a clear understanding of the objective sought to be achieved. It is generally agreed that the financial objective of the firm should be maximization of owner's economic welfare. There are two widely discussed approaches or criterion of maximizing owners' welfare i) Profit maximization, and ii) Wealth maximization. It should be noted here that objective is used in the sense of goal or goals or decision criterion for the three decisions involved. Profit Maximization: Maximization of profits is very often considered as the main objective of a business enterprise. The shareholders, the owners of the business, invest their funds in the business with the hope of getting higher dividend on their investment. Moreover, the profitability of the business is an indicator of the sound health of the organisation, because, it safeguards the economic interests of various social groups which are directly or indirectly connected with the company e.g. shareholders, creditors and employees. All these parties must get reasonable return for their contributions and it is possible only when company earns higher profits or sufficient profits to discharge the obligations to them. Wealth Maximization: The wealth maximization (also known as value maximization or Net Present Worth Maximization) is also universally accepted criterion for financial decision making. The value of an asset should be viewed in terms of benefits it can produce over the cost of capital investment. Prof. Era Solomon has defined the concept of wealth maximization as follows- "The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or as capitalized) at a rate which reflects their certainty or uncertainty. Wealth or net amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken) then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximize wealth or net present worth. Thus, the concept of wealth maximization is based on cash flows (inflows and outflows) generated by the decision. If inflows are greater than outflows, the decision is good because it maximizes the wealth of the owners. We have discussed above the two goals of financial management. Now the question is which one is the best or which goal should be followed in decision making. Certain objections have been raised against the profit maximization goal which strengthen the case for wealth maximization as the goal of financial decisions.

Q2. Explain the factors affecting Financial Plan.

Ans. To help your organization succeed, you should develop a plan that needs tobe followed. This applies to starting the company, developing new product,creating a new department or any undertaking that affects the companys future.There are several factors that affect planning in an organization. To create an efficient plan, you need to understand the factors involved in the planning process. Organizational planning is affected by many factors: Priorities- In most companies, the priority is generating revenue, and this priority can sometimes interfere with the planning process of any project. When you start the planning process for any project, you need to assign each of the issues facing the company a priority rating. That priority rating will determine what issues will side track you from the planning of your project, and which issues can wait until the process is complete. Company Resources- Having an idea and developing a plan for your company can help your company to grow and succeed, but if the company does not have the resources to make the plan come together, it can stall progress. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project, compared to the resources the company has available. Some of the resources to consider are finances, personnel, space requirements, access to materials and vendor relationships. Forecasting- A company constantly should be forecasting to help prepare for changes in the marketplace. Forecasting sales revenues, materials costs, personnel costs and overhead costs can help a company plan for upcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance of success, if the company has the capabilities to pull off the plan and if the plan will help to strengthen the companys standing within the industry. For example, if your forecasting for the cost of goods has changed due to a sudden increase in material costs, then that can affect elements of your product roll-out plan, including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. Contingency Planning- To successfully plan, an organization needs to have a contingency plan in place. If the company has decided to pursue a new product line, there needs to be a part of the plan that addresses the possibility that the product line will fail.

Q3. Explain the time value of money. Ans. Money has time value. A rupee today is more valuable than a year hence. It is on this concept the time value of money is based. The recognition of the time value of money and risk is extremely vital in financial decision making. Most financial decisions such as the purchase of assets or procurement of funds, affect the firms cash flows in different time periods. For example, if a fixed asset is purchased, it will require an immediate cash outlay and will generate cash flows during many future periods. Similarly if the firm borrows funds from a bank or from any other source, it receives cash and commits an obligation to pay interest and repay principal in future periods. The firm may also raise funds by issuing equity shares. The firms cash balance will increase at the time shares are issued, but as the firm pays dividends in future, the outflow of cash will occur. Sound decisionmaking requires that the cash flows which a firm is expected to give up over period should be logically comparable. In fact, the absolute cash flows which differ in timing and risk are not directly comparable. Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk. The recognition of the time value of money and risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not considered, the firm may make decisions which may allow it to miss its objective of maximizing the owners welfare. The welfare of owners would be maximized when Net Present Value is created from making a financial decision. It is thus, time value concept which is important for financial decisions. Thus, we conclude that time value of money is central to the concept of finance. It recognizes that the value of money is different

at different points a of time. Since money can be put to productive use, its value is different depending upon when it is received or paid. Insimpler terms, the value of a certain amount of money today are more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The difference in the value of money today and tomorrow is referred as time value of money.

Q4. XYZ India Ltds share is expected to touch Rs.450 one year from now. The company is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be willing to buy if his required rate of return is 15%? Ans P0 = D1 /(1+Ke) + P1 /(1+Ke) = {25/(1+0.15)} + {450/(1+0.15)} = 21.74 + 391.30 = Rs. 413.04 An investor would be willing to buy the share at Rs 413.04

Q5. Below Table depicts the statistics of a firm and its sales requirements. Compute the DOL according to the values given in the table. Table: Statistics of a Firm Sales in units 2000 Sales revenue Rs.20000 Variable cost 10000 Contribution 6000 Fixed cost 0 EBIT 6000 DOL = (Sales-Variable Costs) /EBIT = (20000-10000)/6000 = 1.67

Q6. What are the assumptions of MM approach? Ans. Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating

income approach does not provide operational justification for independence of the company's cost of capital.

Basic Propositions of MM approach: 1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken. 2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio. 3. The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed. Assumptions of MM approach: 1. Capital markets are perfect. 2. All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm. 3. Within similar operating environments, the business risk is equal among all firms. 4. 100% dividend payout ratio. 5. An assumption of "no taxes" was there earlier, which has been removed.

Limitations of MM hypothesis: 1. Investors would find the personal leverage inconvenient. 2. The risk perception of corporate and personal leverage may be different. 3. Arbitrage process cannot be smooth due the institutional restrictions. 4. Arbitrage process would also be affected by the transaction costs. 5. The corporate leverage and personal leverage are not perfect substitutes. 6. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.