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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 profit maximization has been criticized on many accounts.

Wealth Maximization has, been accepted by the finance managers, because it

overcomes the limitations of profit maximization. Wealth maximization means
maximizing the net wealth of the Company’s share holders. Wealth maximization is
possible only when the company pursues policies that would increase the market
value of shares of the company.

Superiority of Wealth Maximization over Profit Maximization

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 pro

3. In today’s competitive business scenario corporate 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 corporate 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 maximization criterion.

4. When a firm follows wealth maximization goal, it achieves maximization of


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 society gains because of the
societal welfare.

Maximization of wealth demands on the part of corporates to develop new produc
ts or
render new services in the most effective and efficient manner. This helps the consume
rs as it will bring to the market the products and services that consumers need.

6. Another notable features of the firms committed to the maximization 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 maximization.

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
maximization 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?

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 b
oth 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
obtain 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 corporate 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 slowdown, 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

10. Global influence Since the advance of technology causes this globe to
become “smaller”, especially in the era of globalization. Now people do business across
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 economy
of particular country depends 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 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.


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?

Answer 1. Investment in New Equipment : 250000000
Life of machine : 10 Years
Salvage : 55000000
Years Cash inflows PV factors at 14 % PV of cash inflows
1 0 0.877 39,473,684
2 0 0.769 34,626,039
3 0 0.675 30,373,718
4 0 0.592 40,261,459
5 0 0.519 35,317,069
6 0 0.456 30,979,885
7 0 0.400 27,175,338
8 0 0.351 23,838,016
9 0 0.308 9,225,238
10 0 0.270 8,092,314
Salvage 0 0.270 14,835,910
PV of cash inflows 294,198,670
Initial cash out flow 250,000,000

NPV 44,198,670

Here NPV is positive it is advisable to the company to expand its capacity.

Answer 2.

Loan Amount : 200000000

Interest rate : 14 %
No of Year(N) : 10 Years

Installment X PVIFA (14%,10) =20,00,00,000

Installment = 20,00,00,000 / 5.216
= 3,83,43,558

Answer 3.

Loan Amount : 20,00,00,000

Interest rate : 13.5 %
No of Year(N) Quarterly : 10 Years

Installment X PVIFA (13.5% / 4, 40) =20,00,00,000

Installment = 20,00,00,000 / 5.176
= 3,86,39,876

Answer 4. The company should borrow from bank because payback installment is lesser
than the financial institution.





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?

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

(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

(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;

D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price

Q3. Explain Miler and

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
(2+1.8)/2 1.9
(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4
(2+2.2)/2 2.1

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 Rs. In crore

Net worth 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding interest) 118.23

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


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.

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

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 on the
total size of firm’s capital budget, it is requires Capital Rationing.

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) Deficiencies in market information

(b) Rigidities that hamper the force flow of Capital between firms.

When capital markets are not favorable 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 restri
ction 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?


For equipment A
Average cash flow Rs. 20000/- per year
And the initial investment Rs. 75000/-
So the ratio of initial cash flow & initial investment=75000/20000
From the PVIFA table for 6 years annuity factor vary near 3.75 is 16%
So PV of cash flow at 16% is 73600/-
For next trial rate 15% so PV of cash flow is 75706
So IRR of the for the equipment A is 16+ (75706-75000)/ (75706-73600)

For equipment B average cash flow Rs. 14000/- per year
And the initial investment Rs. 50000/-
So the ratio of initial cash flow & initial investment=50000/14000
From the PVIFA table for 6 years annuity factor vary near 3.75 is 18%
So PV of cash flow at 18% is 49000/-

For next trial rate 17% so PV of cash flow is 50257/-

So IRR of the for the equipment A is 18+ (50257-50000)/ (50257-49000)
Now NPV of equipment A = PV of net cash flow – initial cost
= (20000/- of PVIF 11% for 6 y)-75000/-
& NPV for the equipment B= PV of net cash flow-initial cost
= (14000/- of PVIF 11% for 6 y)-50000/-

So B is preferable because of highest rate of Profitability index