INDIAN INSTITUTE OF MANAGEMENT KOZHIKODE

EXECUTIVE POST GRADUATE PROGRAMME

FINANCIAL MANAGEMENT - I
Assignment 1

Batch 15
Term II
Section A
Instructor Prof. Jijo Lukose
Group Number NA
Group Members (Name with Reg no) EPGP-15A-100 VIKIN JAIN
Question 1

For what three main reasons is profit maximization inconsistent with wealth maximization?

Answer.

Profit maximization is inconsistent with wealth maximization because profit maximization focuses on
increasing the profit of the company in the short term, while wealth maximization focuses on increasing the
market value of the company’s shares in the long term.

Thus, profit maximization ignores the timings of returns, cash flow available to shareholders and risk. It
does not consider the risks and uncertainty as inherent to business operations. It focuses on achieving
efficiency in the company’s day-to-day operations to make the business profitable either by increasing their
revenue or minimizing their cost structure. While in wealth management, as the market value depends on
several tangible and intangible factors, it is achieved by attaining a leadership position, which translates to a
larger market share and higher share price with consideration of inherent risks and uncertainties of the
business.

Question 2

Liability Comparisons

John Bailey invested $50,000 in The Entertainment Company seven years ago.

He is concerned about the future of the firm as the profits have plummeted over the last four years.

The firm has $120,000 in outstanding debt and is considering declaring bankruptcy.

a. If John is the sole proprietor, describe the financial implication of the firm going bankrupt.

b. If John and his brother, Peter, are partners with an equal partnership distribution, describe the
financial implication of the firm going bankrupt.

c. If the firm is a corporation, describe the financial implication of the firm going bankrupt.

Answers.
(a) John being the sole proprietor, he will be held personally liable for the complete outstanding debt, i.e.,
$120,000.
(b) In case of equal partnership, liability for outstanding debt will be divided equally between John and
Peter, thus, they will be held personally liable for the $120,000 in outstanding debt with the distribution
being equal, each one is liable for $60,000.
(c) In case of corporation, there is no personal liability. John being an investor will only be held liable for
invested amount, i.e., $50,000 against the outstanding debt, i.e., John will lose his complete
investment.

Question 3
Worldwide Rugs is a rug importer located in the United States that resells its import products to local
retailers. Last year, Worldwide Rugs imported $2.5 million worth of rugs from around the world, all of
which were paid for prior to shipping.

On receipt of the rugs, the importer immediately resold them to local retailers for $3 million.

To allow its retail clients time to resell the rugs, Worldwide Rugs sells to retailers on credit.

Prior to the end of its business year, Worldwide Rugs collected 85 percent of its outstanding accounts
receivable.

a. What is the accounting profit that Worldwide Rugs generated for the year?

b. Did Worldwide Rugs have a successful year from an accounting perspective?

c. What is the financial cash flow that Worldwide Rugs generated for the year?

d. Did Worldwide Rugs have a successful year from a financial perspective?

e. If the current pattern persists, what is your expectation for the future success of Worldwide Rugs?

Answers.
(a) As far as accounting profit is concerned, expense and revenue on accrual accounting basis will be
$2,500,000 and $3,000,000, thus, accounting profit will be $500,000.
(b) Yes, it seems so as they have made a profit of $500,000.
(c) As the firm has collected 85% of the outstanding accounts receivables, i.e., 0.85*3,000,000 =
$2,550,000 (cash inflow), while expenses are $2,500,000 (cash outflow). Thus, net cash inflow is
$50,000.
(d) Yes, it seems so as they have made a cash profit of $50,000.
(e) As the company was only able to collect 85% of accounts receivable in the complete financial year
and 15% is still on credit which is declining the value of the anticipated profits with the time, thus, the
company needs to improve its collection efficiency in order to improve financial health of the
company.

Question 4

You are the CEO of Nelson Corporation, and the current stock price is $27.80.

Pollack Enterprises announced today that it intends to buy Nelson Corporation.

To obtain all the stock of Nelson Corporation, Pollack Enterprises is willing to pay $38.60 per share.

At a meeting with your BoD, you realize that the management is not happy with the offer, and is against
the takeover.

Therefore, with the full support of your management team, you are fighting to prevent the takeover
from Pollack Enterprises.
Is the management of Nelson Corporation acting in the best interest of the Nelson Corporation
stockholders? Explain your reasoning

Answer.

Though, the offer extended by M/s Pollack Enterprises seems irresistible as they are offering more than the
market price, i.e., $38.60 per share against the market value of $27.80, i.e., almost 39% increase from the
current market price. With this purchase, shareholders will of course get benefitted. However, this offer is not
normal stock purchase, but an acquisition of the company, i.e., the company will no longer be in the hands of
present major shareholders and present management. Thus, there can be a bias in making the right decision.

Though by not accepting this offer, the shareholders will be at loss, only when we ignore the future anticipated
wealth, this company is able to generate. Thus, if the management thinks that it can improve profitability to
the extent that share price will go beyond the offered price, then, the offer should not be accepted. Moreover,
the company should also analyse whether at the current market, company is undervalued or overvalued and
with the anticipated upcoming projects, what the situation will be. The company can fight by putting up
counter offer above $38.60, if most of the major investors are seeking exit.

However, if firm can add value or and not able to correct the market if undervalued, then the company accept
the offer in the interest of the shareholders.