MBA II SEM

Financial Management - MB0029

Set 1

Q1. Why wealth maximization is superior to profit maximization in todays context?

Justify you answer?

Answer: Maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive
a goal as that of maximizing stockholder wealth. For one thing, total profits are not as important as
earnings per stock. Therefore, wealth maximization is superior in a way that it is based on cash flow,
not on the accounting profit.

Wealth maximization is superior because it values the duration of expected returns. Since
distant flows are uncertain, converting them into comparable values at base period facilitated
better comparison of financial projects. This can be achieved by for example; by discounting
all future earnings to establish their net present value.

When a firm follows wealth maximization goal, it achieves maximization of market value of
share. When a firm practices wealth maximization goal, it is possible only when it produces
quality goods at low cost. On this account therefore, society gains because of the societal
welfare.

Q2. Re: 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 now in such a way that his
account balance becomes zero at the end of 10 years. How much will
be his annual withdrawal?

Present Value(PV) =80000/-

Amount (A) =?
Interest Rat e(I) =10%
No. of Year(N) =10

PVAn = A {1+i)n-1} /{ i(1+i)n}

80000=A{1+.10)10 }/{.10(1+.10)10}
80000=A{ 1.593742/0.259374}
A =80000/ 6.144567
A = 13019.63 Yrly

Q3. What factors affect financial Plan?

Ans. We live in a society and interact with people and environment. What happens to us is not always
accordance to our wishes. Many things turn out in our live are uncontrollable by us. Many decisions
we take are the result of external influences. So do our financial matters. There are many factors
affect our personal financial planning. Range from economic factors to global influences. Aware of
factors affecting your money matters below will certainly benefit your planning.
Life situation and personal value

Your life situation, namely age, marital status, employment status (income), number and age of
household and life cycle will have an effect on how you handle your money. When you are young, you
might not have much money. However, you have longer time to accumulate wealth. Therefore,
younger person usually will cope better with higher risk. If you married and have children, you have to
consider other family member need beside you. You may need to set up more emergency fund,
college fund and buy more protection. Every one of us will go through different stage of life: infant,
youth, and adult then elderly. Every stage has different need. When you reach young adult, you may
not make too much. However, you have many expenses waiting in line. You might need to pay your
education loan. You probably need to buy first car or take a home mortgage. You have to prepare for
wedding or expecting children. The size of your household and their age will also significantly
influence the way you handle your finance. Your personal value, what is important to you, your
principle desire and believed will shape the way you manage your money. Your preference to certain
thing will also make you choose certain financial strategies over the others. For instance, if you like to
move around, it is wiser to rent than buy a house. That is what the first step in the process of financial
planning is to understand yourself. (Read the process of financial planning).

Economic factors

Many economic factors will significantly affect your financial plan, i.e. supply and demand, various
institutions, business, labor force, and government. Supply and demand will form price. Price level will
change your consumption pattern, so do your investment and others. Labor force will determine your
income. When unemployment rate is high, it will be more difficult to find job. When job is rare, people
are willing to work for less money, and vice versa. Financial institutions and others business are the
user of labors. Their activities will shape the economic and eventually affect your financial.
Government will influence economic by monetary and fiscal policy. The steps government take will
affect you financially. When government raise the interest rate, economic will cool down. When
economic slow down, government will lower the interest rate. When interest rate is low, invest your
money in bank will not give you decent return. It means take longer time for your investment to reach
your financial goals. Therefore, in order to get higher return people invest in stock market or business.

Global influence

Since the advance of technology causes this globe to become smaller, especially in the era of
globalization. Now people do business cross the country boundary, therefore what happen in other
country will have an effect on people in another country Rain at Wall Street, drizzle around the
world. The economic of particular country depend on foreign investment. When many foreign
investors come, they will create new businesses. New business will absorb many labors, therefore
lowering unemployment rate and increasing wages. However higher wage does not always guarantee
the prosperity of workers in certain country. When you earn high income but everything is so
expensive there. It is identical with make little, since your much money actually cannot buy many
things. For instance, average worker in Indonesia make approximately 1 million Rupiah monthly. Can
you imagine make 1 million dollars monthly here? Unfortunately, that 1 million Rupiah is only around $
108, since the currency exchange of Rupiah is around Rp. 9,200 to $ 1 USD. Currency exchange
surely will impact your purchasing power and your financial situation. Currency of a country is usually
base on its economic condition i.e. governments budget, balance trade, inflation level and growth.
Foreign exchange is the biggest financial market in the world, we definitely will learn about it in later
articles.

Economic condition

Consumer price, consumer spending, interest rate, money supply, unemployment, house started,
gross domestic product, trade balance and market indication are among economic condition that
affect your decision in handling your money matters.

Consumer price
 measure the value of your money through inflation rate. It influences your personal financial planning
because consumer price alter your money purchasing power. When consumer price increase beyond
your income, you will unable to buy as much thing as you used to. Consumer spending measures
the demand of good and service by individuals and household. When consumer spending is up, more
jobs will be available and wage will be higher. Increase in consumer spending will drive consumer
price to increase and inflation level as well.

Interest rate

measure cost of money or credit and return of investment. Increase in interest rate will make credit
more expensive and discourage borrowing. With high interest, people are more likely to invest their
money to earn interest than take higher risk to do business. Excessive investment from investor with
inability of bank lending to third party will create over supply of fund. In which will drive down the
interest rate eventually.

Money supply

measures money available for spending in an economic. More money make people have more to
save. Therefore, increases in money supply tend to decrease interest rate as more people save.
Moreover, higher saving and lower spending will reduce job opportunity.
Unemployment measures number of people, who willing and able to work, out of work. High
unemployment rate reduce consumer spending and job opportunity. It is wiser to setup higher
emergency fund and reduce debt to cope with high unemployment rate, since it is harder to get new
job when unemployment rate are high. House started measures the number of new house built. New
house build is sign of economic expansion. When new house build increase, it creates more jobs,
higher wage and higher consumer spending.
Gross domestic product measures the total value produce within a countrys border. GDP indicate
country prosperity. High GDP will increase employment opportunity and opportunity for personal
financial wealth.

Trade balance

measures different between export and import. Deficit happen, when import exceed export. Large
deficit over long run will hurt employment and GDP. Surplus happen, when export exceed import.
Large surplus will raise the value of the currency, reducing the future opportunity of export, since
commodity become more expensive to foreigner.
Market indication (stock market index)
measures the relative value of stocks. These indexes provide indication of the price movement of
stocks. Since you will invest your money in the market to help you reach your financial goals,
understand how the market work will benefit you.
 SET-2

Q1. A. What is the cost of retained earnings?

Cost of Retained Earnings

Cost of retained earnings (ks) is the return stockholders require on the companys common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the
U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the companys beta (bi), which is an estimate of the stocks risk. Inputting these assumptions into
the CAPM equation, you can then calculate the cost of retained earnings.

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firms long-
term debt and add a risk premium (typically three to five percentage points):

ks = long-term bond yield + risk premium

c) Discounted Cash Flow ApproachAlso known as the dividend yield plus growth approach. Using the dividend-growth
model, you can rearrange the terms as follows to determine ks.

ks = D1 + g;
P0

where:
D1 = next years dividend
g = firms constant growth rate
P0 = price

Q3. Explain Miler and

Q1. B. 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
companys 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?

(F+P)/2

Where kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate,

F is the redemption price per debenture,

P is the net amount realized per debenture,

N is maturity period

13.5(0.52) + (1.8)/ 13.5*.48+2/7

6.51

(2+1.8)/2 1.9

=3.43

(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4

(2+2.2)/2 2.1

=6.43/.21=3.06

Q3. Explain Miler and Modigiliani Approach to capital structure theory?

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern
thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs,
and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that
firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does
not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often
called the capital structure irrelevance

Principle
Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller
was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for
their "work in the theory of financial economics," with Miller specifically cited for "fundamental
contributions to the theory of corporate finance."

Historical background
Miller and Modigliani derived the theorem and wrote their path breaking article when they were both
professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University.
In contrast to most other business schools, GSIA put an emphasis on an academic approach to
business questions. The story goes that Miller and Modigliani were set to teach corporate finance for
business students despite the fact that they had no prior experience in corpora the finance. When
they read the material that existed they found it inconsistent so they sat down together to try to figure
it out. The result of this was the article in the American Economic Review and what has later been
known as the MM theorem.

Propositions
The theorem was originally proved under the assumption of no taxes. It is made up of two
propositions which can also b e extended to a situation with taxes. Consider two firms which are
identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by
equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The
Modigliani-Miller theorem states that the value of the two firms is the same.

Without taxes
Proposition I: where VU is the value of an unlevered firm = price of buying a firm composed only of
equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of
debt and equity.
To see why this should be true, suppose an investor is considering buying one of the two firms U or L.
Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and
borrow the same amount of money B that firm L does. The eventual returns to either of these i
investments would be the same. Therefore the price of L must be the same as the price of U minus
the money borrowed B, which is the value of L's debt. This discussion also clarifies the role of some of
the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is
the same as that of the firm, which need not be true in the presence of asymmetric information or in
the absence of efficient markets.

Q4. How to estimate cash flows? What are the components of incremental cash flows?

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of any kind. To evaluate
these investment decisions there are some principles of cash flow estimation. In any kind of project,
planning the outputs properly is an important task. At the same time, the profits from the project
should also be very clear to arrange finances in a proper way. These forecasting are some of the
most difficult steps involved in the capital budgeting. These are very important in the major projects
because any kind of fault in the calculations would result in huge problems. The project cash flows
consider almost every kind of inflows of cash. The capital budgeting is done through the coordination
of a wide range of professionals who are going to be involved in the project. The engineering
departments are responsible for the forecasting of the capital outlays. On the other hand, there are
the people from the production team who are responsible for calculating the operational cost. The
marketing team is also involved in the process and they are responsible for forecasting the revenue.
Next comes the financial manager who is responsible to collect all the data from the related
departments. On the other hand, the finance manager has the responsibility of using the set of norms
for better estimation. One of these norms uses the principles of cash flow estimation for the process.
There are a number of principles of cash flow estimation. These are the consistency principle,
separation principle, post-tax principle and incremental principle. The separation principle holds that
the project cash flows can be divided in two types named as financing side and investment side. On
the other hand, there is the consistency principle. According to this principle, some kind consistency is
necessary to be maintained between the flow of cash in a project and the rates of discount that are
applicable on the cash flows. At the same time, there is the post-tax principle that holds that the
forecast of cash flows for any project should be done through the after-tax method.

Incremental Principle

The incremental principle is used to measure the profit potential of a project. According to this theory,
a project is sound if it increases total profit more than total cost. To have a proper estimation of profit
potential by application of the incremental principle, several guidelines should be maintained:
Incidental Effects: Any kind of project taken by a company remains related to the other activities of the
firm. Because of this, the particular project influences all the other activities carried out, either
negatively or positively. It can increase the profits for the firm or it may cause losses. These incidental
effects must be considered.
Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure done by
the firm in the past. These expenditures are not related with any particular project. These costs
denote all those expenditures that are done for the preliminary work related to the project,
unrecoverable in any case.
Overhead Cost: All the costs that are not related directly with a service but have indirect influences
are considered as overhead charges. There are the legal and administrative expenses, rentals and
many more. Whenever a company takes a new project, these costs are assigned.
Working Capital: Proper estimation is essential and should be considered at the time when the
budget for the project's profit potential is prepared.