Master of Business Administration - MBA Semester 2 MB0045 Financial Management ASSIGNMENT- Set I

Question1. What are the goals of financial management? Answer- Financial management means maximization of economic welfare of its shareholders. Shareholder`s wealth maximization is reflected in the market value of the firm`s shares. The goal of financial management is attained when it maximizes the market value of shares. There are two versions of the goals of financial management of the firm: 1. Profit maximization 2. Wealth maximization Profit maximization- profit maximization is based on the cardinal rule of efficiency. Its goal is to maximize the return with the best output and price levels. Profit maximization is the traditional and narrow approach, which aims at maximizing the profit of the concern. Allocation of resources and investor`s perception of the company`s performance can be traced to the goal of profit maximization. The concept of profit lacks clarity. What does profit mean? Is it profit after tax or before tax? Is it operating profit or net profit available to shareholders? In this sense, profit is neither defined precisely nor correctly. It creates unnecessary conflicts regarding the earning habits of the business concern. Differences in interpretation of the concept of profits thus expose the weakness of profit maximization. Profit maximization neither considers the time value of money nor the net present value of the cash inflow. It does not differentiate between profits of current year with the profits to be earned in later years.The concept of profit maximization apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Wealth maximization-The term wealth means shareholder`s wealth of the persons those who are involved in the business concern, also known as value maximization or net present worth maximization. Wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the company. Argument is in support of the superiority of wealth maximization over profit maximization; wealth maximization is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. Time value factor is known as the time preference maximization rate; that is, the sum of risk free rate and risk premium.We can conclude that maximization of wealth is probably the more appropriate goal of

financial management in today`s context. It is important to understand that profit maximization as a goal, in a way, leads to wealth maximization.

Question 2. Calculate the PV of an annuity of Rs. 500 received annually for four years when discounting factor is 10%. AnswerComputation of PV of Annuity End of year cash inflows PV factor PV in Rs. 1 Rs.500 0.909 454.5 2 RS.500 0.827 413.5 3 Rs.500 0.751 375.5 4 Rs.500 0.683 341.5 3.170 1585.0 Present value of an annuity is Rs. 1585. Calculation: PV= 500*PVIFA(10%,4y) =500*3.170 =RS.1585 The present value of annuity is Rs. 1585.

Question 3. Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10% P.a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company? Answer- Calculation of cost of equity capital : Ke = (D1/Pe) +g = (5/110) +0.10 = 0.1454 or 14.54% Cost of equity capital is 14.54% Question4. What are the assumptions of MM approach? Answer- Following the basic assumptions of the MM approach: Perfect capital markets Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, and 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. Taxes There is no corporate or personal income tax.

 Dividend payout is 100% The firms do not retain earnings for future activities. Question5. An investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows. Table highlights the cash inflow for four years. Table : cash inflow Year Cash inflow 1 40000 2 50000 3 15000 4 30000 If the risk free rate and the risk premium is 10%, a) compute the NPV using the risk free rate b) Compute NPV using risk-adjusted discount rate. Answer- a) NPV can be computed using risk free rate. Calculation of NPV risk free rate Table: PV Using Risk Free Rate Year 1 2 3 4 Cash flows(inflows) PV factor at 40000 50000 15000 30000 PV of cash inflows PV of cash outflows NPV 0.909 0.826 0.751 0.683 1, 09,415 (1, 00,000) 9,415 PV of cash flows (inflows) 36,360 41,300 11,265 20,490

B) NPV can be computed using risk-adjusted discount. Table: NPV Using Risk-adjusted Discount Rate Year 1 2 3 4 cash inflows Rs. sPV factor at 20% 40000 50000 15000 30000 0.833 0.694 0.579 0.482 PV of cash inflows 33,320 34,700 8,685 14,460

PV of cash inflows PV of cash outflows NPV

91,165 (100,000) (8,835)

The project would be accepted when no allowance is made for risk. However, it will not be acceptable if risk premium is added to the risk free rate. By doing so, it moves from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be accepted, when IRR is greater than the risk-adjusted discount rate. Question6. What are the features of optimum credit policy? Answer- Optimum credit policy is one which would maximise the value of the firm. Value of a firm is maximised when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the investment. Therefore, credit policy of a firm can be regarded as: Trade-off between higher profits from increased sales and The incremental cost of having large investment in receivables The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for companys products. To summarise, in order to achieve the goal of maximising the value of the firm the evaluation of investment in receivables accounts should involve the following four steps: 1. Estimation of incremental operating profit. 2. Estimation of incremental investment in accounts receivables. 3. Estimation of the incremental rate of return of investment. 4. Comparison of incremental rate of return with the required rate of return In reality, it is rather a different task to establish an optimum credit policy as the best combination of variables of credit policy is quite difficult to obtain. The important variables of credit policy should be identified before establishing an optimum credit policy and then they should be evaluated.