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FINANCIAL MANAGEMENT

MB0029
SET – 2

MBA – 2nd SEM

Name Mohammed Roohul Ameen


Roll Number
Learning Center SMU Riyadh (02543)
Subject Financial Management
Date of Submission 28 Feb 2010
Assignment Number MB0029
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Assignment MBA 2nd Semester Subject: MB0029
1. Is Equity Capital Free of cost? Substantiate your statement.

Calculating the cost of equity can be tricky since there are two different types of equity.
Firms have retained earnings (the money left over after dividends are paid) as the first
type of equity. The second form of equity comes from issuing new shares of stock.

Cost of equity capital is acknowledged as the rate of return that is necessary to satisfy
commitments made to the common shareholders of a corporation. Generally, the cost of
equity capital is expected to be equal to the rate of return that is expected on equity-
supplied capital.
In order to determine the cost of equity capital, it is necessary to know three specific
figures. First, the current market value associated with the shares must be determined.
Second, the dividend growth rate as it relates to the period under consideration must be
calculated. Last, the number of dividends per share should be identified. Once these three
pieces of information are in hand, it is possible quickly calculate the current cost of equity
capital.

The cost of equity under dividend valuation model is calculated by the following formula:

The formula above calculates the cost of equity based on a firm's current rate of return. If one
assumes a perfect market, industry-specific costs of equity reflect the riskiness of particular
industries. A high cost of equity would then indicate a higher-risk industry that should command
a higher return to compensate for the higher risk.

And using the CAPM model, the cost of equity is the product of the Market Risk Premium and
the equity's beta plus the risk-free interest rate.

Or

Symbolically written as

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Assignment MBA 2nd Semester Subject: MB0029
Equity Capital is not free of cost:

Some people are of the opinion that equity capital is free of cost for the reason that a company
is not legally bound to pay dividends and also the rate of equity dividend is not fixed like
preference dividends. This is not a correct view as equity shareholders buy shares with the
expectation of dividends and capital appreciation. Dividends enhance the market value of
shares and therefore equity capital is not free of cost.

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Assignment MBA 2nd Semester Subject: MB0029
2.
A) What is the rate of return for a company if the β is 1.25, risk free rate of
return is 8% and the market rate of return is 14%? Use CAPM model.

β = 1.25
Risk free Rate of Return= 8%
Market Rate of return = 14%
Rate of return for a company is given by,
Ke = Rf + β [Rm-Rf]

Ke = 0.08 + 1.25(0.14-0.08)
Ke = 0.08 + 0.275

= 0.155 or 15.5%

Therefore the rate of return for the company is 15.5%


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Assignment MBA 2nd Semester Subject: MB0029
2.
B) Sundaram Transports has the following capital structure.

Equity capital Rs.10 par value 250 lakhs


12% preference share capital Rs.100 each 100 lakhs
Retained earnings 150 lakhs
12% Debentures (Rs.100 each) 350 lakhs
14% Term loan from SBI 150 lakhs
Total 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare a dividend per share
of Rs.2 per share and there will be a growth of 10% in the dividends for the next 5 years. The
preference shares are redeemable at a premium of Rs.5 per share after 8 years. The current
market price of preference share is Rs.92. Debenture redemption will take place after 7 years at
a discount of 2% and the current market price is Rs.91 per debenture. The corporate tax rate is
40%. Calculate WACC.

Solution:

Market price per equity = PO = 54


Expected dividend per share = D1 = Rs.2
Rate of growth of dividend = g =0.1

Step I is to determine the cost of each component.

Cost of equity capital, Ke =( D1/P0) + g

= (2/54) + 0.1

= 0.137 or 13.7%

Preference dividend payable = D = 12


Present value P =92
Future Value F =105
Period n =8
Cost of preference capital, Kp = [D + {(F—P)/n}] / {F+P)/2}

= [12 + (105—92)/8] / (105+92)/2

=13.625/98.5

= 0.1383 or 13.83%
Cost of retained earnings, Kr = Ke this is 13.7%
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Assignment MBA 2nd Semester Subject: MB0029
Annual interest payable per unit debenture = I = 12%
Corporate tax rate = T = 40%
Redemption price per debenture = F = 105
Net amount realized per debenture = P= 92
Maturity period = n = 7

Cost of debentures, Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}

= [12(1—0.4) + (105—92)/7] / (105+92)/2

= [7.2 + 1.857] / 98.5

= 0.09195 or 9.2%

Cost of term loans, Kt = I (1–T)

= 0.14(1–0.4)

= 0.084 or 8.4%

Step II is to calculate the weights of each source.

We = 250/1000 = 0.25

Wp = 100/1000 = 0.1

Wr = 150/1000 = 0.15

Wd = 350/1000 = 0.35

Wt = 150/1000 = 0.15

Step III Multiply the costs of various sources of finance with corresponding weights and WACC
calculated by adding all these components.

WACC = WeKe + WpKp +WrKr + WdKd + WtKt

= (0.25*0.137) + (0.1*0.1383) + (0.15*0.137) + (0.35*0.092) + (0.15*0.084)

= 0.03425 + 0.01383 + 0.021 + 0.0322 + 0.0126

= 0.1139 or 11.39%

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Assignment MBA 2nd Semester Subject: MB0029
3. The effective cost of debt is less than the actual interest payment made by the firm.
Do you agree with this statement? If yes/no substantiate your views.

Yes the effective cost of debt is less than actual interest payment made by the firm.

True cost of debt Most small and emerging businesses use debt as part of their financing
structure. (The exceptions--and they have dwindled--are those high-potential ventures that can
raise money through promises of potentially lucrative slices of equity.)

The financial crisis is proof that too few people either 1) know how to perform these
calculations or 2) bother to live by what the numbers are telling them. The first part is
somewhat easily remedied; the second, sadly, is perhaps something only a painful recession can
drive home.

Lenders like to receive interest each month. (Bonds carry less frequent payments, with
quarterly or semi-annual installments, but smaller businesses usually do not have access to the
bond market.) Here's where things get tricky: Paying interest monthly effectively raises your
interest rate.
Say the lender says it will lend to you at 12% per year, to be paid 1% per month. (On $100, that
means you will pay $1 each month.) But by paying monthly, you have raised your effective rate,
which takes into account the time value of money. Observed through that lens, your annual
interest cost is 12.7%.

The cost of debt is computed by taking the rate on a risk free bond whose duration and
conditions match the term structure of the corporate debt, then adding a default premium due
to the risk factor involved in that investment. This default premium will rise as the amount of
debt increases in the capital structure of the entity. Since in most cases debt expense is a
deductible expense for tax purpose, the cost of debt is computed as an after tax cost to make it
comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms,
debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate) (1-T),
where T is the corporate tax rate and Rf is the risk free rate.
A company will use various bonds, loans and other forms of debt, so this measure is useful for
giving an idea as to the overall rate being paid by the company to use debt financing. The
measure can also give investors an idea as to the riskiness of the company compared to others,
because riskier companies generally have a higher cost of debt.

To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax
rate (before-tax rate x (1-marginal tax)). If a company's only debt were a single bond in which it
paid 5%, the before-tax cost of debt would simply be 5%. If, however, the company's marginal
tax rate were 40%, the company's after-tax cost of debt would be only 3% (5% x (1-40%)).

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Assignment MBA 2nd Semester Subject: MB0029
4. Why capital budgeting decision very crucial for finance managers?

Capital budgeting decision is very crucial as it helps with the “go-no-go” decisions of firm.

Financial management is largely concerned with financing, dividend and investment decisions of
the firm with overall goal in mind. Corporate finance theory has developed around a goal of
maximizing the market value of the firm to its shareholders. This is also known as shareholder
wealth maximization. Although various objectives or goals are possible in the field of finance,
the most widely accepted objective for the firm is to maximize the value of the firm to its
owners.

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager
must be able to decide whether an investment is worth undertaking and be able to choose
intelligently between two or more alternatives. To do this, a sound procedure to evaluate,
compare, and select projects is needed.

The planning process used to determine whether a firm's long term investments such as new
machinery, replacement machinery, new plants, new products, and research development
projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Many formal methods are used in capital budgeting, including the techniques such as

 Accounting rate of return


 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.

Accounting rate of return or ARR

Is a financial ratio used in capital budgeting. The ratio does not take into account the concept of
time value of money. ARR calculates the return, generated from net income of the proposed
capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the
project is expected to earn seven cents out each dollar invested. If the ARR is equal to or greater
than the required rate of return, the project is acceptable. If it is less than the desired rate, it
should be rejected. When comparing investments, the higher the ARR, the more attractive the
investment.

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Assignment MBA 2nd Semester Subject: MB0029
Net present value (NPV) or Net present worth (NPW)

The net present value (NPV) or net present worth (NPW) of a time series of cash flows, both
incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash
flows. In case when all future cash flows are incoming (such as coupons and principal of a bond)
and the only outflow of cash is the purchase price, the NPV is simply the NPV of future cash
flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash
flow (DCF) analysis, and is a standard method for using the time value of money to appraise
long-term projects. Used for capital budgeting, and widely throughout economics, finance, and
accounting, it measures the excess or shortfall of cash flows, in present value terms, once
financing charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or
discount curve and outputting a price; the converse process in DCF analysis, taking as input a
sequence of cash flows and a price and inferring as output a discount rate (the discount rate
which would yield the given price as NPV) is called the yield, and is more widely used in bond
trading.

Profitability index (PI)

Also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of
investment to payoff of a proposed project. It is a useful tool for ranking projects because it
allows you to quantify the amount of value created per unit of investment.

The ratio is calculated as follows:

Another formula to calculate Profitability index (P.I) is[1]

Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than one would indicate that the
project's PV is less than the initial investment. As the value of the profitability index increases,
so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

 If PI > 1 then accept the project


 If PI < 1 then reject the project

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Assignment MBA 2nd Semester Subject: MB0029
Internal rate of return

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and
compare the profitability of investments. It is also called the discounted cash flow rate of return
(DCFROR) or simply the rate of return (ROR). In the context of savings and loans the IRR is also
called the effective interest rate. The term internal refers to the fact that its calculation does
not incorporate environmental factors (e.g., the interest rate or inflation).

Modified internal rate of return

Modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness.


It is used in capital budgeting to rank alternative investments. As the name implies, MIRR is a
modification of the internal rate of return (IRR) and as such aims to resolve some problems with
the IRR.

Equivalent annual cost

In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an
asset over its entire lifespan.

EAC is often used as a decision making tool in capital budgeting when comparing investment
projects of unequal life spans. For example if project A has an expected lifetime of 7 years, and
project B has an expected lifetime of 11 years it would be improper to simply compare the net
present values (NPVs) of the two projects, unless neither project could be repeated.

EAC is calculated by dividing the NPV of a project by the present value of an annuity factor.
Equivalently, the NPV of the project may be multiplied by the loan repayment factor.

EAC=

The use of the EAC method implies that the project will be replaced by an identical project.

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Assignment MBA 2nd Semester Subject: MB0029
5. A road project require an initial investment of Rs.10,00,000. It is expected to
generate the following cash flow in the form of toll tax recovery.
Year Cash Inflows
1 4,50,000
2 4,25,000
3 3,00,000
4 3,50,000

What is the IRR of the project?

Step I:
Compute the average of annual cash inflows

Year Cash inflows


1 450000
2 425000
3 300000
4 350000
Total 1525000

Average = 1525000 /4
= Rs. 381250

Step II:
Divide the initial investment by the average of annul cash inflows:
= 1000000/381250
= 2.62

Step III:
From PVIFA table for 4 years, the annuity factor very near 2.62 is 19%. Therefore the first initial
rate is 19%

Year Cash flows PVIF factor @ 19% PV of cash flows


1 450000 0.84 378000
2 425000 0.706 300050
3 300000 0.593 177900
4 350000 0.499 174650
Total 1030600

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Assignment MBA 2nd Semester Subject: MB0029
Since the initial investment of Rs. 10,00,000 is less than computed value at 19% of Rs. 1030600
the next trail rate is 20%
Year Cash flows PVIF factor @ 20% PV of cash flows
1 450000 0.833 374850
2 425000 0.694 294950
3 300000 0.579 173700
4 350000 0.482 168700
Total 1012200

The next trail is 21%


Year Cash flows PVIF factor @ 21% PV of cash flows
1 450000 0.826 371700
2 425000 0.683 290275
3 300000 0.564 169200
4 350000 0.467 163450
Total 994625

Since the investment of Rs.10,00,000 lies between 21% and 20%, the IRR by interpolation is,
1000000 − 1012200
20 + x1
(1000000 − 994625)
IRR = 20.7%

Mohammed Roohul Ameen 13 Roll Number:


Assignment MBA 2nd Semester Subject: MB0029
6. What is sensitivity analysis? Mention the steps involved in it.

Sensitivity Analysis

A technique used to determine how different values of an independent variable will impact a
particular dependent variable under a given set of assumptions. This technique is used
within specific boundaries that will depend on one or more input variables, such as the
effect that changes in interest rates will have on a bond's price.

Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be
different compared to the key prediction(s).

Sensitivity analysis is very useful when attempting to determine the impact the actual outcome
of a particular variable will have if it differs from what was previously assumed. By creating
a given set of scenarios, the analyst can determine how changes in one variable(s) will impact
the target variable.

For example, an analyst might create a financial model that will value a company's equity
(the dependent variable) given the amount of earnings per share (an independent variable) the
company reports at the end of the year and the company's price-to-earnings multiple (another
independent variable) at that time. The analyst can create a table of predicted price-to-earnings
multiples and a corresponding value of the company's equity based on different values for each
of the independent variables.

In other words before an investment decision is taken, numerous forecasts of many factors
connected with the project are considered. Cash flows are predicted based on sales. Sales are in
turn dependent on the volume and unit selling price. Volume of sales depends on the market
size and the firm’s market share. Costs include variable costs which depend on the sales
volume. The NPV or
IRR of the project is again determined by the by analyzing the after-tax cash flows. We can
understand that it is difficult to arrive at an unbiased and accurate forecast of each variable. If
forecasts go wrong, the reliability of NPV or IRR is lost. Therefore each item of forecast is
changed, one at a time, to at least three values – pessimistic, expected and optimistic. NPV is re-
calculated for all the three assumptions. This method of re-calculating NPV or IRR for each
forecast is called sensitivity analysis.

The steps involved in sensitivity analysis are:


 Identification of variables that will influence on the project’s NPV/IRR.
 Determining the mathematical relationship between the variables.
 Analyzing the impact of the change in each of the variable on the project’s NPV.

Mohammed Roohul Ameen 14 Roll Number:


Assignment MBA 2nd Semester Subject: MB0029