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Published by: Dipesh Jalui on Apr 20, 2013
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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.

This applies to starting the company. it can be difficult to tell if the plan has any chance of success. Similarly if the firm borrows funds from a bank or from any other source.Having an idea and developing a plan for your company can help your company to grow and succeed. it will require an immediate cash outlay and will generate cash flows during many future periods. the firm may make decisions which may allow it to miss its objective of maximizing the owner’s welfare. Sound decisionmaking requires that the cash flows which a firm is expected to give up over period should be logically comparable. The firm may also raise funds by issuing equity shares. personnel. you need to assign each of the issues facing the company a priority rating. It recognizes that the value of money is different .There are several factors that affect planning in an organization.creating a new department or any undertaking that affects the company’s future. but as the firm pays dividends in future. The welfare of owners would be maximized when Net Present Value is created from making a financial decision. Forecasting. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project. If the company has decided to pursue a new product line. then that can affect elements of your product roll-out plan. developing new product. access to materials and vendor relationships. you need to understand the factors involved in the planning process. That priority rating will determine what issues will side track you from the planning of your project. Organizational planning is affected by many factors: Priorities. and this priority can sometimes interfere with the planning process of any project. To create an efficient plan. compared to the resources the company has available. Some of the resources to consider are finances.A company constantly should be forecasting to help prepare for changes in the marketplace. Thus. it receives cash and commits an obligation to pay interest and repay principal in future periods. and which issues can wait until the process is complete. Without accurate forecasting. the outflow of cash will occur. the priority is generating revenue. To help your organization succeed. For example.To successfully plan. affect the firm’s cash flows in different time periods. but if the company does not have the resources to make the plan come together. time value concept which is important for financial decisions. it can stall progress. you should develop a plan that needs tobe followed. The recognition of the time value of money and risk is extremely vital in financial decision making. In fact. if your forecasting for the cost of goods has changed due to a sudden increase in material costs. Ans. Company Resources. Money has time value. It is on this concept “the time value of money” is based. When you start the planning process for any project. It is thus. The firm’s cash balance will increase at the time shares are issued. an organization needs to have a contingency plan in place. we conclude that time value of money is central to the concept of finance. Contingency Planning. Forecasting sales revenues. there needs to be a part of the plan that addresses the possibility that the product line will fail. For example.In most companies. including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. the absolute cash flows which differ in timing and risk are not directly comparable. if a fixed asset is purchased. Most financial decisions such as the purchase of assets or procurement of funds. space requirements. The recognition of the time value of money and risk is extremely vital in financial decision-making. Q3. if the company has the capabilities to pull off the plan and if the plan will help to strengthen the company’s standing within the industry. Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk. materials costs. personnel costs and overhead costs can help a company plan for upcoming projects. A rupee today is more valuable than a year hence. If the timing and risk of cash flows is not considered. Explain the time value of money.Ans.

67 Q6. It is not because of the uncertainty involved with time but purely on account of timing. 25 per share. its value is different depending upon when it is received or paid.74 + 391. XYZ India Ltd‟s share is expected to touch Rs. popularly known as the MM approach is similar to the Net operating income approach.450 one year from now. The difference in the value of money today and tomorrow is referred as time value of money. What are the assumptions of MM approach? Ans. 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 value of a certain amount of money today are more valuable than its value tomorrow.30 = Rs. Whereas. 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+0.04 An investor would be willing to buy the share at Rs 413. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage.15)} = 21. Q4. Since money can be put to productive use.20000 Variable cost 10000 Contribution 6000 Fixed cost 0 EBIT 6000 DOL = (Sales-Variable Costs) /EBIT = (20000-10000)/6000 = 1. Modigliani Millar approach. The company is expected to declare a dividend of Rs. 413.at different points a of time. Insimpler terms.15)} + {450/(1+0. Table: Statistics of a Firm Sales in units 2000 Sales revenue Rs. Compute the DOL according to the values given in the table. the net operating . Below Table depicts the statistics of a firm and its sales requirements.04 Q5.

Limitations of MM hypothesis: 1. All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm. The total value can be obtained by capitalizing the operating earnings stream that is expected in future. The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed. However. discounted at an appropriate discount rate suitable for the risk undertaken. 2. 2. 2. Investors would find the personal leverage inconvenient. 3. Basic Propositions of MM approach: 1. the business risk is equal among all firms. The corporate leverage and personal leverage are not perfect substitutes. At any degree of leverage. which has been removed. 100% dividend payout ratio. Arbitrage process would also be affected by the transaction costs. 4. 6. Within similar operating environments. . An assumption of "no taxes" was there earlier. Corporate taxes do exist. This means that it is independent of the capital structure. Arbitrage process cannot be smooth due the institutional restrictions. the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. Assumptions of MM approach: 1. 5. 3. 5. 3.income approach does not provide operational justification for independence of the company's cost of capital. The risk perception of corporate and personal leverage may be different. 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. Capital markets are perfect. 4. the assumption of "no taxes" has been removed later.

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