(Spring 2013)

Master of Business Administration MBA Semester 2

MB0045 Financial Management (4 credits)
(Book ID: B1628)
ASSIGNMENT- Set 1
Marks 60

Roll No. 1208000294
Student Name: patil rasika somnath
Email Id:rasikapatil111.rp@gmail.com
Phone no: 9833172911
Note: Assignment Set -1 must be written within 6-8 pages. Answer all questions

Q1. What are the goals of financial management? (10 Marks) (350-400 words)

Answer:

All businesses aim to maximize their profits, minimize their expenses and maximize their
market share. Here is a look at each of these goals.

Maximize Profits A company's most important goal is to make money and keep it. Profit-
margin ratios are one way to measure how much money a company squeezes from its total
revenue or total sales.

There are three key profit-margin ratios: gross profit margin, operating profit margin and net
profit margin.

1. Gross Profit Margin

The gross profit margin tells us the profit a company makes on its cost of sales or cost of
goods sold. In other words, it indicates how efficiently management uses labor and supplies
in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales

2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins
show how successful a company's management has been at generating income from the
operation of the business:

Operating Profit Margin = EBIT/Sales

3. Net Profit Margin: Net profit margins are those generated from all phases of a business,
including taxes. In other words, this ratio compares net income with sales. It comes as close
as possible to summing up in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes/Sales

Minimize Costs
Companies use cost controls to manage and/or reduce their business expenses. By identifying
and evaluating all of the business's expenses, management can determine whether those costs
are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs
through methods such as cutting back, moving to a less expensive plan or changing service
providers. The cost-control process seeks to manage expenses ranging from phone, internet
and utility bills to employee payroll and outside professional services.
Maximize Market Share
Market share is calculated by taking a company's sales over a given period and dividing it by
the total sales of its industry over the same period. This metric provides a general idea of a
company's size relative to its market and its competitors. Companies are always looking to
expand their share of the market, in addition to trying to grow the size of the total market by
appealing to larger demographics, lowering prices or through advertising. Market share
increases can allow a company to achieve greater scale in its operations and improve
profitability.





Q2. Calculate the PV of an annuity of Rs. 500 received annually for four years when
discounting factor is 10%. (10 Marks) (350-400 words)

Answer:

The present value of annuity can be calculated from the table 3.6 as shown under:

Table 3.6: Computation 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
3.17 1585

Present value of an annuity is Rs.1585.




Q3.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? (10 Marks)
(350-400 words)

Answer:

Ke = (D1/Pe) + g
= (5/110) + 0.10
= 0.1454 or 14.54 %
Cost of equity capital is 14.54%




































Q4. What are the assumptions of MM approach? (10 Marks) (350-400 words)

Answer:

Modigliani Millar approach, popularly known as the MM approach is similar to the Net
operating income approach. The MM approach favours 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 behavioural 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.








Q5. An investment will have an initial outlay of Rs 100,000. It is expected to generate
cash inflows. Table 1.2 highlights the cash inflow for four years.

Table 1.2: 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
(10 Marks) (350-400 words)

Answer:

(a) Using risk free rate
Year
Cash
flows (inflows) Rs
PV
Factor at 10%
PV of Cash flows (in
flows)
1 40,000 0.909 36,360
2 50,000 0.826 41,300
3 15,000 0.751 11,265
4 30,000 0.683 20,490
PV of cash in flows 1,09,415
PV of Cash outflows 1,00,000
NPV 9,415

(b) Using risk adjusted discount rate

Year
Cash
flows (inflows) Rs PV factor at 20%
PV of Cash flows (in
flows)
1 40,000 0.833 33,320
2 50,000 0.694 34,700
3 15,000 0.579 8,685
4 30,000 0.482 14,460
PV of cash in flows 91,165
PV of Cash outflows 100,000
NPV -8,835

The project would be acceptable when no allowance is made for risk. But it will
not be acceptable if risk premium is added to the risk free rate. It moves from positive NPV
to negative NPV.
If the firm were to use the internal rate of return, then the project would be accepted when
IRR is greater than the risk adjusted discount rate.






































Q6. What are the features of optimum credit policy? (10 marks) (350-400 words)

Answer:

The term credit policy refers to those decision variables that influence the amount of trade
credit; i.e. the investment in receivables. Main factors that affect the credit policy are general
economic conditions, industry norms, pace of technological change, competition, etc.
Lenient or stringent credit policy: Firms following lenient credit policy tend to sell on
credit very liberally, even to those customers whose creditworthiness is doubtful, where as,
the firm following stringent credit policy; will give credit only to those customers who have
proven their creditworthiness.
Firms having liberal credit policy, attract more sales, and also enjoy more profits. However at
the same time, they suffer from high bad debt losses and from problem of liquidity.
The concept of probability can be used to make the sales forecast. Different economic
conditions; good bad and average, can be anticipated and accordingly sales forecast under
different credit policies can be made.
We also need to consider the cost of credit extension, which mainly involves increased bad
debts, production cost, selling cost, administration cost, cash discount and opportunity cost.
Credit policy should be relaxed if the increase in profits from additional sales is greater than
the corresponding cost. The optimum credit policy should occur at a point where there is a
trade off between liquidity and profitability.
The important variables you need to consider before deciding the credit policy are:
Credit terms: Two important components of credit terms are credit period and cash
discounts. Credit period is generally stated in terms of net period, for e.g., net 30.it
means that the payment has to be made within 30 days from day of credit sale.
Cash discount is normally given to get faster payments from the debtors. The complete credit
terms indicate the rate of cash discount, the period of credit and the discount period. For ex:
3/10, net 30 this implies that 3 % discount will be granted if the payment is made by the
tenth day, if the offer is not availed the payment has to be made by the thirtieth day.
The firm also needs to consider the competitors action, if the competitors also relax their
policy, when you relax your policy, the sales may not go up as expected.
Credit standards: Liberal credit standard tend to put up sales and vice-versa. The
firms credit standards are influenced by the five Cs:
i. Character- the willingness of the customer to pay
ii. Capacity- the ability of the customer to pay
iii. Conditions- the prevailing economic conditions
iv. Capital- the financial reserves of a customer. If the customer has difficulty
in paying from operating cash flow, the focus shifts to its capital.
v. Collateral- The security offered by the customers.
The effect of liberalizing credit standards on profit may be estimated by:

P = change in profit
S = change in sales
V = ratio of variable cost to sales
K = cost of capital
I = increase in receivables investment
b = bad debts loss ratio on new sales
Collection policy: A collection policy is needed s as to induce the customer to pay his
bills on time and to remind him of payment if the credit period is over and he has still
not paid the bill.




P = S (1-V)-kI-bS