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) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Considering the following information, what is the price of the share as per Gordon’s Model? Details of the Company
Net sales Net profit margin Outstanding preference shares No. of equity shares Cost of equity shares Retention ratio Rate of interest (ROI) Rs.120 lakhs 12.5% Rs.50 lakhs@ 12% dividend 25, 000 12% 40% 16%
Answer : GORDON’S MODEL:
: Gordon’s model assumes investors are rational and risk averse. They prefer certainreturns touncertain returns and therefore give a premium to the constant returns and discountuncertainreturns. The shareholders therefore prefer current dividends to avoid risk. In otherwords, theydiscount future dividends. Retained earnings are evaluated by the shareholders asrisky andtherefore the market price of the shares would be adversely affected. Gordon explainshis theorywith preference for current income. Investors prefer to pay higher price for stockswhich fetchthem current dividend income.Gordon’s model can be symbolically expressed as:
P = E (1 - b) / Ke – br Where, P is the price of the share, E is Earnings Per Share, b is Retention ratio, (1 – b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment.According to question,E = (12000000*12.5%)= 1500000b = 40%(1 - b) = (1 - 40%) = 0.60Ke = (250000*12%)= 30000br = 16% = 0.16 Therefore,P = (1500000 x 0.60) / (30000 – 0.16)
= 29.84= 30.00 (rounded-off)Hence, The price of the share is Rs. 29.84 or Rs. 30.00 (rounded-off) Q.2 Examine the components of working capital & also explain the concepts of working capital
Answer : There are two important concepts of Working Capital – gross and net Gross Working Capital: 11.2 Components of working capital Working capital management is concerned with managing the different componentsof current assets and current liabilities. The following are the components of current assets:· Inventories· Sundry debtors· Bills receivables· Cash and bank balances· Short-term investments· A d v a n c e s s u c h a s a d v a n c e s f o r p u r c h a s e o f r a w m a t e r i a l s , c o m p o n e n t s a n d co nsumable stores and pre-paid expenses The components of current liabilities are:· Sundry creditors· Bills payable· Creditors for out-standing expenses· Provision for tax· Other provisions against the liabilities payable within a period of 12 monthsA f i r m m u s t h a v e a d e q u a t e w o r k i n g c a p i t a l , n e i t h e r e x c e s s n o r i n a d e q u a t e . Ma intaining adequate working capital is crucial for maintaining the competitiveness of a firm.Any lapse of a firm on this account may lead a firm to the state of insolvency. 11.3 Concepts of Working Capital The four most important concepts of working capital are (s ee figure 11.1) – Grosswork i ng c apital , Net worki ng c api tal, Temp orary work ing c apital and Permanent working capital. Figure 11.1: Concepts of working capital
Gross working capital Gross W orki ng Capi tal refers to the amounts inv ested i n vari ous 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, forimproving the profitability on its investment a finance manager of a company mustgive top priority to efficient management of current assets· The need to plan and monit or the util isati on of funds of a fi rm demands work ing capital management, as applied to current assets Net working capital Net working capital is the excess of current assets over current liabilities andprovisions. Net working capital is positive when current a s s e t s e x c e e d c u r r e n t liabilities and negative when current liabilities exceed current assets. This concept hasthe following practical relevance.· Net working capital indicates the ability of the firm to effectively use the spontaneousfinance in managing the firm’s working capital requirements· A firm’s short term solvency is measured through the net working capital position itcommands Permanent Working Capital Permanent working capital is the minimum amount of investment required to be madein current assets at all times to carry on the day to day operation of firm’s business. This minimum level of current assets has been given the name of core current assetsby the Tandon Committee.Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable worki ng capital or fluctuatingworking capital. The firm’s work ing capital requirements vary depending upon thes easonal and c yc lical c hanges i n demand for a fi rm’ s produc ts. The extra worki ng capital
required as per the changing production and sales levels of a firm is known astemporary working capital
Q.3 Internal capital rationing is used by firms for exercising financial control. How does a firm achieve this? Answer : Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and economic compulsion of the firm. It is not possible for a company to take up all the projects at a time. There is the need to rank them on the basis of strategic compulsion and funds availability. Since companies will have to choose one from among many competing investment proposal the need to develop criteria for Capital rationing cannot be ignored. The companies may have many profitable
Imposition s of restriction s by a firm on the fun ds allocated for fresh in vestment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restrictionmay be imposed on divisional heads on the total amount that they can commit on newprojects.Another internal restriction for capital budgeting decision may be imposed by a firmbased on the need to generate a minimum rate of return. Under this criterion onlyprojects capable of generating the management’s expectation on the rate of returnwill be cleared.Generally internal capital rationing is used by a firm as a means of financial control. The various factors relating to the internal constrai nts imposed by the managementare (see figure) – Private owned company, Divisional constraints, Human resourcelimitations, Dilution and Debt constraints.Figure: Internal constraints· Private owned company Under internal constraint, the management of the firms might decide that expansionof the company might be a problem and not worth taking. This kind of condition
arisesonly when the management of a firm fears losing the control in the company.· Divisional constraints Another constraint might lead to the allocation of fixed amount for each division in afirm by the upper management. This procedure can also be considered as an overallc o r p o r a t e s t r a t e g y . T h e s e s i t u a t i o n s arise mainly from the point of view of ad epartment. The cost of capital or the cost structure of the management, the budgetconstraints imposed by the senior officials or decisions coming from the headofficeand wholly owned subsidiary decisions relate to the internal constraints.
· Human Resource limitations The management of the firm or the company should see that excessive labour is beingused for the project. Lack of proper man-power can become an internal constraint.· Dilution Dilution refers to the dilution of the company. This constraint occurs mainly when areluctance in the issuing of further equity takes place, due to the fear of managementlosing the control over the company.· Debt constraints Debt constraints also constitute to the internal constraints in capital rationing. Thisconstraint occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to a certain level. These are the methods by which various factors are effecting the capital rationing of apartic ul ar fi rm or a
management. Let us now look at the di fferent types of capi tal rationing in the following topic.
Q.4 What are the objectives of working capital management? Briefly explain the various elements of operating cycle. Answer : Aim of Working Capital Management Working Capital Management: Working Capital Management refers to the planning, execution and control of investment in and financing of
11.4 Objective of Working Capital Management The objective of financial management is maximising the n et wealth of theshareholders. A firm must earn sufficient returns from its operations to ensure thereal isati on of this obj ec tiv e. There exists a p osi tive c o-rel ation between s al es andfirm’s return on its investment. The amount of earnings that a firm earns dependsupon the volume of sales achieved. There is the need to ensure adequate investmentin current assets, keeping pace with accelerating sales volume.Fi rms mak e sales on c redi t. There is al ways a ti me gap between s al e of goods onc redit and the reali sati on of earnings of sales from the fi rm’s c ustomers . Fi nanc e manger of a firm is required to finance the operation during this time gap. Therefore, objective of working capital management i s to ensure smooth functioningof the normal business operations of a firm. The firm has to decide on the amount of working capital to be employed. The firm may have a conservative policy of holding large quantum of current assets toensure larger market share and to prevent the competitors from snatching any marketf o r t h e i r p r o d u c t s . H o w e v e r s u c h a p o l i c y w i l l a f f e c t t h e f i r m ’ s r e t u r n s o n i t s in vestment. The firm will have returns higher than the required amount of investmenti n c urrent ass ets. This
exc ess funds lock ed i n c urrent assets will reduc e the fi rm’s profitability on operating capital. On the other hand a firm may have an aggressive policy of depending on spontaneousfinance to the maximum extent. Credit obtained by a firm from its suppliers is knownas spontaneous finance. Here a firm will try to reduce its investments in current assetsas much as possible but checks that they are not affecting the firm’s ability to meetworking capital needs for sales growth targets. Such a policy will ensure higher returnon its investment as the firm will not be locking in any excess funds in current assets.However, any error in forecasting can affect the operations of the firm unfavourably if the error is fraught with the down side risk. There is also another risk of firm losing onmaintaining its liquidity position.Objective of working capital management is achieving a trade–off between liquidityand profitability of operations for the smooth conduct of normal business operations of the firm. 11.6 Operating Cycle The time gap between acquisition of resources and collection of cash from customersis known as the operating cycle Operating cycle of a firm involves the following elements.· Acquisition of resources from suppliers· Making payments to suppliers· Conversion of raw materials into finished products· Sale of finished products to customers· Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a con tinuous basis. There is nosynchronisation between the activities in the operating cycle. Cash outflows occurbefore the occurrences of cash inflows in operating cycle.C a s h o u t f l o w s a r e c e r t a i n . H o w e v e r , c a s h i n f l o w s a r e u n c e r t a i n b e c a u s e o f unc ertainties associated with effecting sales as per the
sales forecast and ultimateti mel y col lec ti on of amount due from the c us tomers to whom the fi rm has s old its goods.Sinc e c as h i nflows do not matc h wi th c as h out fl ows , fi rm has to i nvest i n v ari ous current assets to ensure smooth conduct of day to day business operations. Therefore,t h e f i r m h a s t o a s s e s s t h e o p e r a t i ng cycle time of its operation for providi n g adequately for its working capital requirements. Inventory conversion period is the average length of time required to produce and sellthe product.
Receivables conversion period is the average length of time required to convert thefirm’s receivables into cash. Accounts payables period is also known as payables deferral period.Accounts payables period =(Payables deferral period)Purchases per day =Cash conversion cycle is the length of time between the firms actual cash expenditureand its own cash receipt. The cash conversion cycle is the average length of time arupee is tied up in current assets.Cash Conversion Cycle isCCC = ICP + RCP – PDPCCC = Cash Conversion CycleICP = Inventory Conversion PeriodRCP = Receivables Conversion PeriodPDP = Payables deferral period
Q.5 Define risk. Examine the need for assessing the risks in a project. Answer : Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any human endeavour carries some risk, but some are much more risky than others.
9.1.2 Definition of Risk
Before we start to discuss about risk analysi s i n c a p i t a l b u d g e t i n g , l e t u s f i r s t understand what risk in capital budgeting means. Risk in capital budgeting may be defined as the variation of actual cash flows from theexpected cash flows .Every business decision involves risk. Risk exists on account of the inability of a firm tomake perfect forecasts of cash flows. The inability can be attributed to factors thataffect forecasts of investment, cost and revenue. Some of these are as follows:· T h e b u s i n e s s i s a f f e c t e d b y c h a n g e s i n p o l i t i c a l s i t u a t i o n s , m o n e t a r y p o l i c i e s , taxa tion, interest rates and policies of the central bank of the country on lending bybank · Industry specific factors influence the demand for the products of the industry towhich the firm belongs· Company specific factors like change in management, wage negotiations with theworkers, strikes or lockouts affect company’s cost and revenue positionsLet us see a case explaining why making a perfect forecast of cash flows is difficult. 9.2 Types and Sources of Risk in Capital Budgeting Having understood what risk in capital budgeting means, let us now understand thetypes of risk and their sources. Capital budgeting involves four types of risks in a project – stand-alone risk, portfoliorisk, market risk and corporate risk (see figure 9.1 Stand-alone risk Stand alone risk of a project is considered when the project is in isolation. Stand-alonerisk is measured by the variability of expected returns of the project. Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree of risk. When newproject is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on:· The co-variance of return from the new project· The return from the existing portfolio of the projectsI f t h e r e t u r n f r o m t h e n e w p r o j e c t i s n e g a t i v e l y c o r r e l a t e d w i t h t h e r e t u r n f r o m portfo lio, the risk of the firm will be further diversified. Market risk Market risk is defined as the measure of the unpredictability of a given stock value.Howev er, mark et risk is als o referred to as s ys tematic risk . The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project onthe beta of the firm. The market risk for a project is difficult to estimate.
Corporate risk Corporate risk focuses on the analysis of the risk that might influence the project interms of entire cash flow of the firms. Corporate risk is the projects risks of the firm. 9.2.1 Sources of risk The five different sources of risk are:· Project – specific risk· Competitive or Competition risk· Industry – specific risk· International risk· Market risk Project-specific risk Projectspecific risk could be traced to something q
u i t e s p e c i f i c t o t h e p r o j e c t . Managerial deficiencies or error in estimation of cash flows or discount rate may leadto a situation of actual cash flows realised being less than the projected. Competitive or Competition risk Unanti cipated ac ti ons of a firm’s competitors wil l materi all y affect the cas h flows expected from a project. As a result of this, the actual cash flows from a project will beless than that of the forecast. Industry-specific risk Industry-specific risks are those that affect all the industrial firms. Industry-specific riskcould be again grouped into technological risk, commodity risk and legal risk. All theserisks will affect the earnings and cash flows of the project.· Technological risk The changes in technology affect all the firms not capable of adapting themselves inemerging into a new technology.· Commodity risk Commodity risk is the risk arising from the effect of pricechanges on goods producedand marketed.· Legal risk Legal risk arises from changes in laws and regulations applicable to the industry towhich the firm belongs. International risk These types of risks are faced by firms whose business co nsists mainly of exports orthose who procure their main raw material from international markets.Let us now look at the firms facing such kind of risk:· The rupee-dollar crisis affected the software and BPOs because it drastically reducedtheir profitability.· Another example is that of the textile units in Tirupur in Tamil Nadu, which exportst h e m a j o r p a r t o f t h e g a r m e n t s p r o d u c e d . R u p e e g a i n i n g a n d d o l l a r w e a k e n i n g reduc
ed their competitiveness in the global markets.· The surging Crude oil prices coupled with the governments delay in taking decisionon pricing of petro products, eroded the profitability of oil marketing companies inpublic sector like Hindustan Petroleum Corporation Limited.· Another example is the impact of US sub-prime crisis on certain segments of Indianeconomy. The changes in international political s cenario also affected the operations of certainfirms. Market risk Factors lik e i nflati on, changes in i nteres t rates, and changi ng general economicc ondi tions affect all fi rms and all i ndus tries . Fi rms cannot div ersify thi s risk i n the normal course of business. There are many techniques of incorporation of ri sk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far asincorporation of risk in the evaluation process is concerned
Q.6 Briefly examine the significance of identification of investment opportunities in capital budgeting process Answer : The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm's existing assets and management's desire to change that composition, timing of expenditures associated with the that are finally accepted. 1. Planning
2. 8.5 Identification of Investment Opportunities 3. A firm is in a position to identify investment proposal only when it is responsive to thei d e a s o f c a p i t a l p r o j e c t s e m e r g i n g f r o m various levels of the organisation. Th e proposal may be to:· Add new products to the
company’s product line,· Expand capacity to meet the emerging market at demand for company’s products· Add new tec hnol ogy bas ed proc ess of manufactu re that will reduc e the c os t of production. 4. 5. Therefore, generation of ideas with the feasibility to convert the same into investmentproposals occ upies a c ruci al pl ac e i n the c api tal budgeti ng decisi ons. Proactiv e organisations encourage a continuous flow of investment proposals from all levels inthe organisation.In this connection following points deserve to be considered:· A n a l y s i n g t h e d e m a n d a n d s u pply conditions of the market for the co m p a n y ’ s product could be a fertile source of potential investment proposals.· Market surveys on customer’s perception of company’s product could be a potentiali nv estment proposal to redefi ne the c ompany’ s produc ts i n terms of c us tomer’s ex pectations.· Companies which invest in Research and Development constantly get exposure tothe benefit of adapting the new technology quite relevant to keep the firm competitivei n the mos t dynamic bus iness environment. Reports emergi ng from R & D s ec ti on could be a potential source of investment proposal.· E c o n o m i c g r o w t h o f t h e c o u n t r y and the emerging middle class endowed w i t h purchasing power could generate new business opportunities in existing firms. Thesenew business opportunities could be potential investment ideas.· P u b l i c a w a r e n e s s o f t h e i r r i g h t s c ompels many firms to initiate projects fr o m environmental protection angle. If ignored, the
firm may have to face the public wraththrough PILs entertained at the Supreme Court and High courts. Therefore project ideas that would improve th e competitiveness of the firm byconstantly improving the production process with the sole objective of cost reductionand customer welfare, are accepted by well managed firms. 6. 8.7 Capital Budgeting Process 7. Once the screening of proposals for potential involvement is over, the company shouldtake up the following aspects of capital budgeting process:· A proposal should be commercially viable. The following aspects are examined toascertain the commercial viability of any investment proposalMarket for the product- Availability of raw materialsSources of raw materials- The elements that influence the location of a plant i.e. the factors to be considered inthe site selection· Infrastructural facilities such as roads, communication facilities, financial servicessuch as banking and public transport services 8. 9. Ascertaining the demand for the product or services is crucial. It is done by marketa p p r a i s a l . I n a p p r a i s a l o f m a r k e t f or the new product, the following details a r e compiled and analysed.· Consumption trends· Competition and players in the market· Availability of substitutes· Purchasing power of consumers· Regulations stipulated by Government on pricing the proposed products or services· Production constraintsRel ev ant forecas ting tec hnol ogies are employed to get a realistic pic ture of th epotential demand for the proposed product or service. Many projects fail to achievethe planned targets on profitability and cash flows if the firm could not succeed inforecasting the
demand for the product on a realistic basis. Capital budgeting processinvolves three steps (see figure 8.1) – Financial appraisal, Technical appraisal andEconomic appraisa Figure 8.1: Capital budgeting process
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