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Subject code: MB0029

(3 credits)

Set 1





L C CODE: 02782


MBA – II Semester

MB0029 - Set 1

Financial Management

1. Explicit cost and implicit cost are the two dimensions of cost. What role
does cost play in financial decisions.
The cost of debt has two parts – explicit cost and implicit cost. Explicit cost is the given rate
of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can
mean that the increasing proportion of debt does not affect the financial risk of lenders and
they do not charge higher interest. Implicit cost is increase in Ke attributable to Kd. Thus
the advantage of use of debt is completely neutralized by the implicit cost resulting in Ke
and Kd being the same.

Graphically this is represented as:

Percentage cost
2. Assume you are newly appointed as Finance Executive in a
Manufacturing firm. What guidelines you need to follow in financial

Guidelines for financial planning that I would follow:

1. Never ignore the coordinal principle that fixed asset requirements be met from thelon
g term sources.

2. Make maximum use of spontaneous source of finance to achieve highest

productivity of resources.

3. Maintain the operating capital intact by providing adequately out of the

current periods earnings. Due attention to be given to physical capital maintenance
or operating capability.

4. Never ignore the need for financial capital maintenance in units of constant
purchasing power.

5. Employ current cost principle wherever required.

6. Give due weightage to cost and risk in using debt and equity.

7. Keeping the need for finance for expansion of business, formulate plough
back policy of earnings.

8. Exercise thorough control over overheads.

9. Seasonal peak requirements to be met from short term borrowings from banks.

3. Due to over capitalization the company may collapse which would

certainly affect its employees, society, consumers and its shareholders.
What remedies you would suggest? Give suitable example.
Ans. I would suggest following Remedies for Overcapitalization
1. Reduction of debt burden.

2. Negotiation with term lending institutions for reduction in interest obligation.

3. Redemption of preference shares through a scheme of capital reduction.

4. Reducing the face value and paidup value of equity shares.

5. Initiating merger with well managed profit making companies interested in taking over
ailing company.
A company is said to be overcapitalized, when its total capital (both equity and debt)
true value of its assets. It is wrong to identify overcapitalization with excess of capital
because most of the overcapitalized firms suffer from the problems of liquidity. The correct
indicator of overcapitalization is the earnings capacity of the firm. If the earnings of the
firm are less then that of the market expectation, it will not be in a position to pay dividends
to its shareholders as per their expectations. It is a sign of overcapitalization. It is also
possible that a company has more funds than its requirements based on current operation
levels, and yet have low earnings.

4a. Mr. Avinash aged 40 years, needs 50000 after 5 years. If the interest
rate is 10% how much should he save now to get Rs.50000 at the end
of 5 years

FVn=PV (1+i/m)m*n
i = annual nominal interest rate (as a decimal)=0.1
m = number of times the interest is compounded per year=1
n = number of years = 5
FVn = amount after time t ie 5 yrs = 50,000
PV = principal amount (initial investment=Present Value) =?

50,000 = PV (1+ 0.1/1)1*5

= PV (1.1)5

= PV * 1.61051

PV = 50,000/1.61051

PV = Rs. 31,046.07

The ampount to be saved now is Rs. 31,046.07

4b. A Senior citizen intents to deposit Rs.1000 annually in ICICI bank for 3 years. The
prevailing interest rate is 10%. What is the maturity value of the deposit?

Amount at the end of 3 years with 10% rate of interest = Deposit * FVIFA(10%, 3y)
Where, FVIFA = Future Value of Interest Factor for Annuity

From Compound Value of Annuity table we have

For 10% and 3 years we get 3.310

= 1,000 * 3.310
= Rs. 3,310

5. Explain various types of bonds.

Ans. Types of Bonds

Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b)
Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon Bonds.

1) Irredeemable Bonds or Perpetual Bonds

Bonds which will never mature are known as irredeemable or perpetual bonds. Indian
Companies Acts restricts the issue of such bonds and therefore these are very rarely issued
by corporates these days. In case of these bonds the terminal value or maturity value does
not exist because they are not redeemable. The face value is known; the interest received
on such bonds is constant and received at regular intervals and hence the interest receipts
resemble a perpetuity. The present value (the intrinsic value) is calculated as:

If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 par value, and the
current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875

2) Redeemable Bonds :

There are two types viz.,bonds with annual interest payments and bonds with semiannual
Interest payments.
Bonds with annual interest payments;

Basic Bond Valuation Model:

The holder of a bond receives a fixed annual interest for a specified number of years and a
principal repayment at the time of maturity. The intrinsic value or the present value of bond
can be expressed as:

V0 or P0=Σ n
t=1 I/(I+kd) n +F/(I+kd) n
Which can also be stated as folloows
V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Where V0= Intrinsic value of the bond

P0= Present Value of the bond
I= Annual Interest payable on the bond
F= Principal amount (par value) repayable at the maturity time
n= Maturity period of the bond
Kd= Required rate of return
Bond Values with Semi-Annual Interest payment:

In reality, it is quite common to pay interest on bonds semiannually. the value of bonds with
semiannual interest is much more than the ones with annual interest payments. Hence, the
bond valuation equation can be modified as:

V0 or P0=Σ n
t=1 I/2/(I+id/2) n +F/(I+id/2) 2n

Where V0=Intrinsic value of the bond

P0=Present Value of the bond

Interest payable on the bond

F=Principal amount (par value) repayable at the maturity time
2n=Maturity period of the bond expressed in half yearly periods
kd/2=Required rate of return semiannually.

Zero Coupon Bonds

In India Zero coupon bonds are alternatively known as Deep Discount Bonds. For close to a
decade, these bonds became very popular in India because of issuance of such bonds at
regular intervals by IDBI and ICICI. Zero coupon bonds have no coupon rate, i.e. there is no
interest to be paid out. Instead, these bonds are issued at a discount to their face value,
and the face value is the amount payable to the holder of the instrument on maturity. The
difference between the discounted issue price and face value is effective interest earned by
the investor. They are called deep discount bonds because these bonds are long term bonds
whose maturity
some time extends up to 25 to 30 years.

6. Sushma Industries wishes to issue bonds with Rs.100 as par value, 5 years
to maturity, coupon rate 11% and YTM of 11%.
a. What is the value of the bond?

b. If the YTM is 10% what would be the value of the bond?

c. If the YTM is 13% what is the value of the bond


Note: In the above problem YTM is misprint. It should be Kd.

F = Rs. 100
n = 5 years

Coupon rate = 11%

I = F * Coupon rate = 100 * 11% = Rs. 11

V0 = Value of Bond = ?

(a) If kd is 11%,
V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
=11*PVIFA(11%, 5) + 100*PVIF(11%, 5)
=11*3.6959 + 100*0.593
=Rs. 99.95

(b) If kd is 10%,

V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
=11*PVIFA(10%, 5) + 100*PVIF(10%, 5)
=11*3.7908 + 100*0.621
=Rs. 103.79

(c) If kd is 13%,

V0=I*PVIFA(Kd, n) + F*PVIF(kd, n)
=11*PVIFA(13%, 5) + 100*PVIF(13%, 5)
=11*3.5172 + 100*0.543
=Rs. 94.95