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(3 credits)

Set 1

Management

NAME : PRANAY SRIVASTAV

ROLL NO :

L C CODE: 02782

DDE

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.

Ans.

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.

Percentage cost

2. Assume you are newly appointed as Finance Executive in a

Manufacturing firm. What guidelines you need to follow in financial

planning?

Ans.

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

g term sources.

productivity of resources.

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.

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.

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

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.

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

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

Ans.

FVn=PV (1+i/m)m*n

Where

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) =?

= PV (1.1)5

= PV * 1.61051

PV = 50,000/1.61051

PV = 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?

Ans.

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

For 10% and 3 years we get 3.310

= 1,000 * 3.310

= Rs. 3,310

Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b)

Redeemable

Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon 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:

V0=I/id

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;

The holder of a bond receives a fixed annual interest for a specified number of years and a

fixed

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)

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

P0=Present Value of the bond

I/2=Semiannual

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.

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?

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

Ans.

F = Rs. 100

n = 5 years

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

=40.6549+59.3

=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

=41.6988+62.1

=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

=40.6549+54.3

=Rs. 94.95

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