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# Spring / February 2012 Master of Business Administration

## Master of Business Administration-MBA Semester II

MB0045 Financial Management

Assignment

## MB0045 Financial Management - 4 Credits (Book ID: B1134)

Set - 1
Q1. Show the relationship between required rate of return and coupon rate on the value of a bond. Answer: It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bonds price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bonds price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bonds coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) which is based on the assumption that each payment is reinvested at some interest rate once it is receivedwe have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with the calculations, refer to Understanding the Time Value of Money.) Here is the formula for calculating a bonds price, which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present. You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, we can use the shorter PV-ofordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon

Q6. Mr. Anant purchases a bond whose face value is Rs.1000, and which has a nominal interest rate of 8%. The maturity period is 5 years. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond? Solution: Interest payable=1000*8%=Rs. 80, Principal repayment is Rs. 1000 Required rate of return is 10% V0=I*PVIFA(kd, n) + F*PVIF(kd, n) Value of the bond=80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y) = 80*3.791 + 1000*0.621 = 303.28 + 621 =Rs. 924.28 This implies that the company is offering the bond at Rs. 1000 but is worth Rs.924.28 at the required rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today.

## MB0045 Financial Management - 4 Credits (Book ID: B1134)

Set - 2
Q1. Show The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% Solution: Step I is to determine the cost of each component. Ke = ( D1/P0) + g= (2/32) + 0.1 = 0.1625 or 16.25% Kp = [D + {(FP)/n}] / {F+P)/2} = [14 + (10584)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or 17.59% Kr = Ke which is 16.25% Kd = [I(1T) + {(FP)/n}] / {F+P)/2} = [12(1 0.4) + (10590)/7] / (105+90)/2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6% Kt = I(1T)= 0.11(10.4) = 0.066 or 6.6% Step II is to calculate the weights of each source. We = 200/750 = 0.267 Wp = 100/750 = 0.133 Wr = 100/750 = 0.133 Wd = 300/750 = 0.4 Wt = 50/750 = 0.06

Step III Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066) = 0.043 + 0.023 + 0.022 + 0.0384 + 0.004 = 0.1457 or 14.57% The value of WACC is 14.57% Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL. Details of ABC Ltd. Output 20,000 units Fixed costs Rs.3,500 Variable cost Rs.0.05 per unit Interest on borrowed Nil funds Selling price per unit 0.20 Solution: EBIT - 200000 Less: interest on borrowed funds - NIL EBT - 150000 DFL= EBIT {EBITI{Dp/(1-T)}} = 200000/(20000050000{25000/(10.50)} DFL=2.0 The degree of financial leverage of ABC ltd is found to be 2.0. Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Solution: S = 1000,000/.22 = 4545454.5 B = 25,00,000 K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 =0.0496+.142 =.1915 or 19.15% V = 5000000/0.1915 = 26,109,660.57 Q4. Examine the importance of capital budgeting. Answer: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or

decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders. The best example is the Reliance Group. Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm. Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.

If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly

equipments.Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are:
Cost Quality Timing

Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability. Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project. Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today. Q5. Briefly explain the process of Capital Rationing. Answer: The following are the steps involved in capital rationing (see figure 10 .4). Ranking of different investment proposals Selection of the most profitable investment proposal

Figure 10.4: Steps involved in capital rationing Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Net present value method recognises the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present values of all the cash flows. NPV can be represented with the following formula.

Net Present Value = present value of cash inflows present value of cash outflows

Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.

## P1 = present value of cash inflows/initial cash outlay

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value of cash outflows. IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. IRR can be determined by solving the following equation for

Selection of the most profitable investment proposal After ranking the different investment proposals based on their net present value, profitability index and the internal rate of return, the selection of the most profitable investment proposal is to be done. The selection is done mainly in a view to select the investment proposal which earns more profits than compared to the other proposals. The basic features to be taken under consideration during the selection of the most profitable investment proposal are: The proposal should have the potentiality of making large anticipated profits The proposal should involve high degree of risk The proposal should involve a relatively long time-period between the initial outlay and the anticipated return Evaluation of the selection procedure PI rule of selecting projects under capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of a single large project Capital rationing also suffers from the multi-period capital constraints Q6.Explain the concepts of working capital Answer: The four most important concepts of working capital are (see figure 11.1) Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Figure 11.1: Concepts of working capital Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance. Management of current assets is the crucial aspect of working capital management Gross working capital helps in the fixation of various areas of financial responsibility

Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms short term solvency is measured through the net working capital position it commands Permanent Working Capital Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.