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Explain why wealth maximization is superior over profit maximization. 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. 1b. Briefly explain the steps involved in financial plan. Answer: The financial planning process turns your own personal objectives into specific plans and outlines methods and strategies to implement these plans. Establish Financial Goals and Objectives: Your Financial Consultant will assist you in identifying your objectives. For example, you may be asked the following questions: At what age and income level would you like to retire? What level of income would you like to provide to your surviving spouse? How would you like your estate to be distributed? Gather Data: Information reviewed may include, for example, tax returns, brokerage statements, insurance policies, wills, trusts, estate planning documents, or business agreements. The more information that is available, the more accurate your financial plan will be. Process and Analyze Information: Appropriate advisors will consider various alternatives to meet your objectives. Adopt a Comprehensive Financial Plan: Illustrations and analyses showing you strategies to consider meeting your goals. Implement the Plan: You choose to implement the strategies with which you feel comfortable. Monitor the Plan: Periodically, you and your Financial Consultant will review your financial plan. Circumstances change and you may need to make revisions to your plan.
QN.2a. Explain the two theories of capitalization. Answer: 1. Cost Theory: According to the cost theory of capitalization, the value of a company is arrived at by adding up the cost of fixed assets like plants, machinery patents, etc., the capital regularly required for the continuous operation of the company (working capital), the cost of establishing business and expenses of promotion. The original outlays on all these items become the basis for calculating the capitalization of company. Such calculation of capitalization is useful in so far as it enables the promoters to know the amount of capital to be raised. But it is not wholly satisfactory. On import objection to it is that it is based o a figure (i.e., cost of establishing and starting business) which will not change with variation in the earning capacity of the company. The true value of an enterprise is judged from its earning capacity rather than from the capital invested in it. If, for example, some assets become obsolete and some others remain idle, the earnings and the earning capacity of the concern will naturally fall. But such a fall will not reduce the value of the investment made in the company's business. 2. Earnings Theory: The earnings theory of Capitalization recognizes the fact that the true value (capitalization) of an enterprise depends upon its earnings and earning capacity. According to it, therefore, the value or Capitalization of a company is equal to the capitalized value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few year of its life, the sales are forecast ad the manager has to depend upon his experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same industry similarly situated are earnings. The rate is then applied to the estimated earnings of the company for finding out the capitalization. To take an example a company estimates its average profit in the first few years at Rs. 50,000. Other companies of the same type are, let us assume, earnings a return of 10 per cent on their capital. The Capitalization of the company will then be 50,000x100=Rs.500,000. QN. 2b. A customer wants to deposit Rs.10,000 in ICICI bank for 5 years. The prevailing interest rate is 9.50% what will be the value of the deposit on maturity. Answer: FV = PV (1+i) ^n FV = 10000(1+0.095) ^5 FV= Rs.15, 742.39
QN.3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5 years hence. How much should it deposit annually in sinking fund account so that it can accumulate Rs. 30 million at the end of 5 years. Answer: FV = installment * PVIFA (i, y) 30,000,000 = installment * PVIFA (12%, 5) 30,000,000 = installment *3.605 30,000,000 ÷ 3.605 = installment. Installment = 8,321,775.31 QN.3b. Road Transport Corporation issued deep discount bonds in 1996 which has a face value of Rs. 2, 00, 000 maturing after 25 years. The bond was issued at Rs. 5300. What is the effective interest rate earned by the investor from this bond? Answer: A = Po (1+i) n 200,000 = 5300(1+i) 25 Solving for r, 200,000/5300 = (1+i) 25 37.7358 = (1+i) 25 37.73581/25 = (1+i) i = 15.63% is the effective interest rate per annum. QN.4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10% maturing after 10 years. If the YTM is 12% what is the market value of the bond? If the YTM is increase to 14%, what is the market value of the bond? Compare and give the inference. Answer: Interest payable = 1000*10% = Rs 100 Principal payment = 1000 YTM = 12%
Vo = I*PVIFA (kd, n) + F*PVIF (kd, n) Vo =100*5.650 (12%, 10y) + 1000*0.322 (12%, 10y) Vo = Rs 887
Using YTM as 14% Vo =100*5.216 (14%, 10y) + 1000*0.270 (14%, 10y) Vo = Rs 791.6 Compare and give inference. When the YTM is low the market value of the bond is high and when the YTM is high the market value of the bond is low. The inference is that, the bond’s value moves inversely proportional to its YTM. As the YTM increases by from 12% to 14% the value of the bond falls from Rs 887 to Rs 791.6. QN.5. ABC Ltd, produced and sold Rs 100,000 of a product at the rate of Rs 100.for production of Rs.1,00,000 units, it has spent a variable cost of Rs.6,00,000 at the rate of Rs.6 per unit and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs. 50,000 at the rate of 5 percent and Rs.1,00,000 debts. Calculate operating leverage. Answer: Operating Leverage = % Change in EBIT / % Change in Sales Operating Leverage = (100 – 6)100000 / [(100 – 6)100000]-250000 Operating Leverage = 1.03
b) Explain the importance of capital budgeting. Answer: Capital budgeting (or investment appraisal) is the planning process used to determine a firm’s expenditures on assets whose cash flows are expected to extend beyond one year such as new machinery, equipments, etc. It is also the process of identifying, analyzing and selecting investment projects whose cash flows are expected to extend beyond one year such as research and development project. Capital expenditures can be very large and have a significant impact on the firm’s financial performance. Besides, the investments take time to mature and capital assets are long-term, therefore, if a mistake were done in the capital budgeting process, it will affect the firm for a long period of time. Basically, the importance of capital budgeting are as follow: Capital budgeting helps to avoid forecast error. The future success of a business largely depends on the investment decisions that corporate managers make today. Investment decisions may result in a major departure from what the company has been doing in the past. Through making capital investments, firm acquires the long-lived fixed assets that generate the firm’s future cash flows and determine its level of profitability. Thus, this decision greatly influences a firm’s ability to achieve its financial objectives. For example, if the firm invests too much it will cause higher depreciation and expenses. On the other hand, if the firm does not invest enough, the firm will face a problem of inadequate capacity and thus, lose its market share to its competitors. Capital budgeting helps a firm to plan its financing. Proper capital budgeting analysis is critical to a firm’s successful performance because capital investment decisions can improve cash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distress and even to bankruptcy. While working with capital budgeting, a firm is involved in valuation of its business. By valuation, cash flow is identified and discounted at the present market value. In capital budgeting, valuation techniques are undertaken to analyze the impact of assets instead of financial assets. The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is the varying key involved in forecasting cash flow. The importance of capital budgeting is not only its mechanics, but also the parameters of forecasting the incurrence of cash in the business.
6. Financial planning: Assume you are working for an investment banker. A client aged 30 has approached you on investment planning. His present salary is Rs.6,00,000 per year and his current savings is Rs.1,50,000. (a) How much does this current saving grow to in 3 years if the interest rate is12% compounded annually. Answer: (a) FVAn = A [(1+i) ^n – 1/i] FVAn = 150000[(1+0.12) ^3 – 1/ 0.12] FVAn = Rs 506,160 (b) Assume he plans to save Rs.60000 at the end of every year for 5 years, what would be the amount at the end of 5 years if the interest being 10% compounded annually. Answer: FVAn = A [(1+i) ^n – 1/i] FVAn = 60000[(1+0.10) ^5 – 1/ 0.10] FVAn = Rs 366,306
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