Q.1:- Why wealth maximization is superior to profit maximization in today’s context? Justify your answer Ans:- Profit maximization has been considered as the legitimate objective of a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect competition allocation of resources shall be based on the goal of profit maximization. A firm’s performance is evaluated in terms of profitability. Investor’s perception of company’s performance can be traced to the goal of profit maximization. But, the goal of pro fit maximization has been criticized on many accounts. Wealth Maximization has, been accepted by the finance managers, because it overcomes the limitations of profit maximisation. Wealth maximisation means maximizing the net wealth of the Company’s share holders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. Superiority of Wealth Maximisation over Profit Maximisation 1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. 3. In today’s competitive business scenario corporates play a key role. In company form of organization, shareholders own the company but the management of the company rests with the board of directors. Directors are elected by shareholders and hence agents of the shareholders. Company management procures funds for expansion and diversification from Capital Markets. In the liberalized set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore to keep the investors happy through the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion.


4. When a firm follows wealth maximisation goal, it achieves maximization of market value of share. When a firm practices wealth maximisation goal, it is possible only when it produces quality goods at low cost. On this account society gains because of the societal welfare. 5. Maximization of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers as it will bring to the market the products and services that consumers need. 6. Another notable features of the firms committed to the maximisation of wealth is that to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and hence the benefit to the society. 7. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximization could be considered a superior goal compared to profit maximisation. 8. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximization of market value of shares will lead to maximisation of the net wealth of shareholders Q.2:- Your grandfather is 75 years old. He has total savings of Rs.80,000. He expects that he live for another 10 years and will like to spend his savings by then. He places his savings into a bank account earning 10 per cent annually. He will draw equal amount each year- the first withdrawal occurring one year from now in such a way that his account balance becomes zero at the end of 10 years. How much will be his annual withdrawal? Ans:Present Value(PV) =80000/Amount (A) =? Interest Rat e(I) =10% No. of Year(N) =10 PVAn = A {1+i)n-1} /{ i(1+i)n} 80000=A{1+.10)10 }/{.10(1+.10)10} 80000=A{ 1.593742/0.259374} A =80000/ 6.144567 A = 13019.63 Yrly

Q.3:- What factors affect financial plan? -2-

Ans:- Factors Affecting Financial Plan 1. Nature of the industry Here, we must consider whether it is a capital intensive or labour intensive industry. This will have a major impact on the total assets that the firm owns. 2. Size of the Company The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long X Ds X 1000 , term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates. 3. Status of the company in the industry A well established company enjoying a good market share, for its products normally commands investors’ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment. 4. Sources of finance available Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firm’s capacity to manage the risk exposure. 5. The Capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obt ain extra funds for growth by issuing preference shares and debentures to outsiders. 6. Matching the sources with utilization The prudent policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs the firm resorts to short terms finance. All fixed assets financed investments are to be financial by long term sources. It is a cardinal principle of financial planning. 7. Flexibility The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market.


8. Government Policy SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint. 9. Economic factors Many economic factors will significantly affect your financial plan, i.e. supply and demand, various institutions, business, labor force, and government. Supply and demand will form price. Price level will change your consumption pattern, so do your investment and others. Labor force will determine your income. When unemployment rate is high, it will be more difficult to find job. When job is rare, people are willing to work for less money, and vice versa. Financial institutions and others business are the user of labors. Their activities will shape the economic and eventually affect your financial. Government will influence economic by monetary and fiscal policy. The steps government take will affect you financially. When government raise the interest rate, economic will cool down. When economic slow down, government will lower the interest rate. When interest rate is low, invest your money in bank will not give you decent return. It means take longer time for your investment to reach your financial goals. Therefore, in order to get higher return people invest in stock market or business. 10. Global influence Since the advance of technology causes this globe to become “smaller”, especially in the era of globalization. Now people do business cross the country boundary, therefore what happen in other country will have an effect on people in another country “Rain at Wall Street, drizzle around the world”. The economic of particular country depend on foreign investment. When many foreign investors come, they will create new businesses. New business will absorb many labors, therefore lowering unemployment rate and increasing wages. However higher wage does not always guarantee the prosperity of workers in certain country. When you earn high income but everything is so expensive there. It is identical with make little, since your much money actually cannot buy many things. For instance, average worker in Indonesia make approximately 1 million Rupiah monthly. Can you imagine make 1 million dollars monthly here? Unfortunately, that 1 million Rupiah is only around $ 108, since the currency exchange of Rupiah is around Rp. 9,200 to $ 1 USD. Currency exchange surely will impact your purchasing power and your financial situation. Currency of a country is usually base on its economic condition i.e. government’s budget, balance trade, inflation level and growth. Foreign exchange is the biggest financial market in the world, we definitely will learn about it in later articles. 11. Economic condition Consumer price, consumer spending, interest rate, money supply, unemployment, house started, gross domestic product, trade balance and market indication are among economic condition that affect your decision in handling your money matters. 12. Consumer price measure the value of your money through inflation rate. It influences your personal financial planning because consumer price alter your money purchasing power. When consumer price increase beyond your income, you will unable to -4-

buy as much thing as you used to. Consumer spending measures the demand of good and service by individuals and household. When consumer spending is up, more jobs will be available and wage will be higher. Increase in consumer spending will drive consumer price to increase and inflation level as well. 13. Interest rate measure cost of money or credit and return of investment. Increase in interest rate will make credit more expensive and discourage borrowing. With high interest, people are more likely to invest their money to earn interest than take higher risk to do business. Excessive investment from investor with inability of bank lending to third party will create over supply of fund. In which will drive down the interest rate eventually. 14. Money supply measures money available for spending in an economic. More money make people have more to save. Therefore, increases in money supply tend to decrease interest rate as more people save. Moreover, higher saving and lower spending will reduce job opportunity. Unemployment measures number of people, who willing and able to work, out of work. High unemployment rate reduce consumer spending and job opportunity. It is wiser to setup higher emergency fund and reduce debt to cope with high unemployment rate, since it is harder to get new job when unemployment rate are high. House started measures the number of new house built. New house build is sign of economic expansion. When new house build increase, it creates more jobs, higher wage and higher consumer spending. Gross domestic product measures the total value produce within a country’s border. GDP indicate country prosperity. High GDP will increase employment opportunity and opportunity for personal financial wealth. 15. Trade balance measures different between export and import. Deficit happen, when import exceed export. Large deficit over long run will hurt employment and GDP. Surplus happen, when export exceed import. Large surplus will raise the value of the currency, reducing the future opportunity of export, since commodity become more expensive to foreigner. Market indication (stock market index) measures the relative value of stocks. These indexes provide indication of the price movement of stocks. Since you will invest your money in the market to help you reach your financial goals, understand how the market work will benefit you. Q.4:- Suppose you buy a one-year government bond that has a maturity value of Rs.1000. The market interest rate is 8 per cent. (a) How much will you pay for the bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you earn from this investment? Case Study: Deepak Hand tools Private Limited DHPL is a small sized firm manufacturing hand tools. It manufacturing plan is situated in Haryana. The company’s sales in the year ending on 31st March 2007 were Rs.1000 million (Rs.100 crore) on an asset base of Rs.650 million. The net profit of the company was Rs.76


million. The management of the company wants to improve profitability further. The required rate of return of the company is 14 percent. The company is currently considering an investment proposal. One is to expand its manufacturing capacity. The estimated cost of the new equipment is Rs.250 million. It is expected to have an economic life of 10 years. The accountant forecasts that net cash inflows would be Rs.45 million per annum for the first three years, Rs.68 million per annum from year four to year eight and for the remaining two years Rs.30million per annum. The plant can be sold for Rs.55 million at the end of its economic life. The company would need to raise debt to the extent of Rs.200 million. The company has the following options of borrowing Rs.200 million: a. The company can borrow funds from a nationalized bank at the interest rate of 14 percent for 10 years. It will be required to pay equal annual installment of interest and repayment of principal. b. A financial institution has offered to lend money to DHPL at 13.5 per annum but it needs to pay equated quarterly installment of interest and repayment of principal. Questions: 1. Should the company expand its capacity? Show the computation of NPV 2. What is the annual installment of bank loan? 3. Calculate the quarterly installments of the Financial Institution loan 4. Should the company borrow from the bank or from the financial institution?


ASSIGNMENTS - MBA – II SEMESTER MB0029 (4 CREDITS) SET 2 FINANCIAL MANAGEMENT Q.1:- A. What is the cost of retained earnings? B. A company issues new debentures of Rs.2 million, at par; the net proceeds being Rs.1.8 million. It has a 13.5 per cent rate of interest and 7 years maturity. The


company’s tax rate is 52 per cent. What is the cost of debenture issue? What will be the cost in 4 years if the market value of debentures at that time is Rs.2.2 million? Ans:A. Cost of Retained Earnings A company’s earnings can be reinvested in full to fuel the ever-increasing demand of company’s fund requirements or they may be paid off to equity holders in full or they may be partly held back and invested and partly paid off. These decisions are taken keeping in mind the company’s growth stages. High growth companies may reinvest the entire earnings to grow more, companies with no growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilizing funds for reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of retained earnings is the same as the cost of shareholder’s expected return from the firm’s ordinary shares. That is, Kr=Ke There are three methods one can use to derive the cost of retained earnings: (a) Capital-asset-pricing-model (CAPM) approach To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm). The next step is to estimate the company’s beta (bi), which is an estimate of the stock’s risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

(b) Bond-yield-plus-premium approach This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm’s long-term debt and add a risk premium (typically three to five percentage points): ks = long-term bond yield + risk premium


(c) Discounted cash flow approach Also known as the “dividend yield plus growth approach”. Using the dividend-growth model, you can rearrange the terms as follows to determine ks. ks= D1 + g; P0 where: D1 = next year’s dividend g = firm’s constant growth rate P0 = price

Q3. Explain Miler and (F+P)/2 Where kd is post tax cost of debenture capital, I is the annual interest payment per unit of debenture, T is the corporate tax rate, F is the redemption price per debenture, P is the net amount realized per debenture, N is maturity period 13.5(0.52) + (1.8)/ 13.5*.48+2/7 6.51 (2+1.8)/2 1.9 =3.43 (b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4 (2+2.2)/2 2.1 =6.43/.21=3.06


Q.2:- Volga is a large manufacturing company in the private sector. In 2007 the company had a gross sale of Rs.980.2 crore. The other financial data for the company are given below: Items Net worth Borrowing EBIT Interest Fixed cost (excluding interest) You are required to calculate: a. Debt equity ratio b. Operating leverage c. Financial leverage d. Combined leverage. Interpret your results and comment on the Volga’s debt policy Ans:Q.3:- Explain Miller and Modigliani Approach to capital structure theory. Ans:- The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance Principle Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance." Historical background Miller and Modigliani derived the theorem and wrote their path breaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. In contrast to most other business schools, GSIA put an emphasis on an academic approach to business questions. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corpora the finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the MM theorem. Rs. In crore 152.31 165.47 43.17 34.39 118.23


Propositions The theorem was originally proved under the assumption of no taxes. It is made up of two propositions which can also b e extended to a situation with taxes. Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same. Without taxes Proposition I: where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these i investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt. This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information or in the absence of efficient markets. Q.4:- How to estimate cash flows? What are the components of incremental cash flows? Ans:- Cash flow estimation is a must for assessing the investment decisions of any kind. To evaluate these investment decisions there are some principles of cash flow estimation. In any kind of project, planning the outputs properly is an important task. At the same time, the profits from the project should also be very clear to arrange finances in a proper way. These forecasting are some of the most difficult steps involved in the capital budgeting. These are very important in the major projects because any kind of fault in the calculations would result in huge problems. The project cash flows consider almost every kind of inflows of cash. The capital budgeting is done through the coordination of a wide range of professionals who are going to be involved in the project. The engineering departments are responsible for the forecasting of the capital outlays. On the other hand, there are the people from the production team who are responsible for calculating the operational cost. The marketing team is also involved in the process and they are responsible for forecasting the revenue. Next comes the financial manager who is responsible to collect all the data from the related departments. On the other hand, the finance manager has the responsibility of using the set of norms for better estimation. One of these norms uses the principles of cash flow estimation for the process.


There are a number of principles of cash flow estimation. These are the consistency principle, separation principle, post-tax principle and incremental principle. The separation principle holds that the project cash flows can be divided in two types named as financing side and investment side. On the other hand, there is the consistency principle. According to this principle, some kind consistency is necessary to be maintained between the flow of cash in a project and the rates of discount that are applicable on the cash flows. At the same time, there is the post-tax principle that holds that the forecast of cash flows for any project should be done through the after-tax method. Incremental Principle The incremental principle is used to measure the profit potential of a project. According to this theory, a project is sound if it increases total profit more than total cost. To have a proper estimation of profit potential by application of the incremental principle, several guidelines should be maintained: Incidental Effects: Any kind of project taken by a company remains related to the other activities of the firm. Because of this, the particular project influences all the other activities carried out, either negatively or positively. It can increase the profits for the firm or it may cause losses. These incidental effects must be considered. Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure done by the firm in the past. These expenditures are not related with any particular project. These costs denote all those expenditures that are done for the preliminary work related to the project, unrecoverable in any case. Overhead Cost: All the costs that are not related directly with a service but have indirect influences are considered as overhead charges. There are the legal and administrative expenses, rentals and many more. Whenever a company takes a new project, these costs are assigned. Working Capital: Proper estimation is essential and should be considered at the time when the budget for the project's profit potential is prepared. Q.5:- What are the steps involved in capital rationing? Ans:- 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 and viable proposals but cannot execute because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all the projects. When a


firm imposes constraints Rationing.



total size of firm’s capital budget, it is requires Capital

Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. Capital Rationing may be due to:1. External Capital Rationing External Capital Rationing is due to the imperfections of capital markets Imperfection may be caused by: (a) (b) Deficiencies in market information Rigidities that hamper the force flow of Capital between firms.

When capital markets are not favourable to the company the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing: 1. Inability of the firm to procure required funds from Capital market because the firm does not command the required investor’s confidence. 2. National and international economic factors may make the market highly volatile and instable.

3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds. 4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital markets for funds. 2. Internal Capital Rationing Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for Capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control.


Q.6:- Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per year for six years. A substitute equipment B would cost Rs.50,000 and generate net cash flow of Rs.14,000 per year for six years. The required rate of return of both equipments is 11 per cent. Calculate the IRR and NPV for the equipments. Which equipment should be accepted and why? Ans:-