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Master of Business Administration- MBA Semester 2 MB0045 –Financial Management (B 1134) Assignment Set- 1 Q.1 . Show the relationship between required rate of return and coupon rate on the value of a bond. Ans: It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bond’s price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond’s price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond’s coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) – which is based on the assumption that each payment is re-invested at some interest rate once it is received–we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with the calculations, refer to Understanding the Time Value of Money.) Here is the formula for calculating a bond’s price, which uses the basic present value (PV) formula: C = coupon payment
T. Antony Joseph Prabakar Page1
Because these payments are paid at an ordinary annuity. which is a series of fixed payments at set intervals over a fixed period of time. or required yield M = value at maturity. Antony Joseph Prabakar Page2 . You may be now wondering whether there is a formula that does not require steps two and three outlined above. two and three. which are required if the coupon payments occur more than once a year. The farther into the future a payment is to be received. (Coupons on a straight bond are paid at ordinary annuity.MBA – R. it doesn’t require that we add the value of each coupon payment. however.511222964 n = number of payments i = interest rate. You may have guessed that the bond pricing formula shown above may be tedious to calculate. No . A simple modification of the above T.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. The calculation assumes this time is the present. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one. the less it is worth today – is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. It calculates the sum of the present values of all future cash flows. as it requires adding the present value of each future coupon payment. so we divided the interest rate and coupon payments in half to represent the two payments per year. (For more on calculating the time value of annuities. but unlike the bondpricing formula we saw earlier. or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity.) Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually.
Keeping inventory during a long operating cycle does not just tie up funds. for example. but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high.MBA – R. inventory can depreciate if it is kept in a store too long. 2. Should a bond pay quarterly payments. companies want to keep their operating cycles short for a number of reasons. This money may be borrowed or paid up front. Operating cycles are not tied to accounting periods. An operating cycle is the length of time between the acquisition of inventory and the sale of that inventory and subsequent generation of a profit. Therefore. such as humidity controls or security. because of the nature of the business. F would be two. Antony Joseph Prabakar Page3 . but in either case. especially with items that require special handling. Inventory must be stored and this can become costly. but in certain industries. those funds are not available for other uses. As a general rule. it ties up money in the inventory until it can be sold. and this adds to overall operating expenses. the return on T. No . When a business buys inventory.511222964 formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency: Notice that the only modification to the original formula is the addition of “F”. In these industries. In the case of perishable goods. Wineries and distilleries. for bonds paying annual coupons. but are rather calculated in terms of how long goods sit in inventory before sale. Q. F would have a value of one. There are cases where a long operating cycle in unavoidable. which represents the frequency of coupon payments. keep inventory on hand for years before it is sold. Inventory must also be insured and managed by staff members who need to be paid. a long operating cycle is actually the norm. once the business has purchased inventory. or the number of times a year the coupon is paid. The shorter the operating cycle. the faster a business gets a return on investment (ROI) for the inventory it stocks. F would equal four. it can even be rendered unsalable. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns. Furthermore. What do you understand by operating cycle? Ans. and if the bond paid semi-annual coupons.
while periods of growth may be marked by more rapid turnover. but firm A also has a higher breakeven point—the point at which total costs equal total sales. whereas labor-intensive firm B has fixed costs of only $15. it has a high degree of operating leverage. No . All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.000 per year and variable costs of only $1. and taxes. utility companies.000 widgets per year at a price of $5. equipment and technology.3 What is the implication of operating leverage for a firm? Ans: Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. but not interest on debt.MBA – R. Operating cycles can fluctuate. Certain products can be consistent sellers that move in and out of inventory quickly. Antony Joseph Prabakar Page4 . As an illustration of operating leverage. Automated and high-tech companies.00 per unit. The “degree of operating leverage” measures this effect. Q. and airlines generally have high degrees of operating leverage. produce and sell widgets. During periods of economic stagnation. but not for firm B. a change of I percent in sales causes more than a I percent change in operating profits for firm A. By using fixed production costs. inventory tends to sit around longer. Highly automated firm A has fixed costs of $35. The following simplified equation demonstrates the type of equation used to compute the T. A and B.00 per widget. rather than the short term. may be purchased less frequently.511222964 investment happens in the long term. Firm A has a higher amount of operating leverage because of its higher fixed costs. If a company has a large percentage of fixed costs. like big ticket items. a company can increase its profits.000 per year. but its variable cost per unit is much higher at $3. depreciation. Such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations. whereas firm B assembles the widgets using primarily semiskilled labor. Nevertheless. Table 1 shows both firm’s operating cost structures. Firm A uses a highly automated production process with robotic machines. which is part of financial leverage. Both firms produce and sell 10. administrative costs.00 per unit. Fixed costs include advertising expenses. assume two firms. Others.
companies with high degrees of business risk tend to be financed with relatively low amounts of debt. The opposite also holds: companies with low amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levels. Q. and this priority can sometimes interfere with the planning process of any project. you should develop a plan that needs to be followed. although to calculate this figure the equation would require several additional factors such as the quantity produced. If firm A’s sales decrease by I percent. To create an efficient plan. Antony Joseph Prabakar Page5 . the unpredictability of consumer demand for products and services. Business risk stems from the unpredictable nature of doing business.In most companies. i. however.MBA – R. the degree of operating leverage shows the responsiveness of profits to a given change in sales. additional risk—financial risk—is placed on the company’s common shareholders. which are used to determine changes in profits and sales: Operating leverage is a double-edged sword. you need to understand the factors involved in the planning process. Consequently. however. Business risk refers to the stability of a company’s assets if it uses no debt or preferred stock financing. Hence. No . developing new product. it also involves the uncertainty of long-term profitability. which in turn. too.e. There are several factors that affect planning in an organization. to provide leverage during periods of deflation. creating a new department or any undertaking that affects the company’s future. raises a company’s costs. Organizational planning is affected by many factors: Priorities . For T. such as the period during the late 1990s brought on by the Asian financial crisis.511222964 degree of operating leverage. using debt as leverage is a successful tool during periods of inflation. Debt fails. variable cost per unit. Moreover. They demand a higher expected return for assuming this additional risk.4 Explain the factors affecting Financial Plan Ans: To help your organization succeed.. This applies to starting the company. and the price per unit. the priority is generating revenue. When a company uses debt or preferred stock financing. As a result. Implications: Total risk can be divided into two parts: business risk and financial risk. its profits will decrease by more than I percent.
A company constantly should be forecasting to help prepare for changes in the marketplace. Contingency Planning . One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project. it can be difficult to tell if the plan has any chance of success. T. then you might have to shelve the expansion planning until the customer issue is resolved. Forecasting sales revenues. there needs to be a part of the plan that addresses the possibility that the product line will fail. the acceptable financial losses and the potential public relations problems that a failed product can cause all need to be part of the organizational planning process from the beginning. and which issues can wait until the process is complete. Without accurate forecasting. If the company has decided to pursue a new product line.Having an idea and developing a plan for your company can help your company to grow and succeed. access to materials and vendor relationships. Some of the resources to consider are finances. Antony Joseph Prabakar Page6 . Forecasting . you need to assign each of the issues facing the company a priority rating. if you are in the process of planning a large expansion project and your largest customer suddenly threatens to take their business to your competitor.511222964 example. personnel costs and overhead costs can help a company plan for upcoming projects. Company Resources .To successfully plan. No . That priority rating will determine what issues will sidetrack you from the planning of your project. materials costs. personnel. it can stall progress. For example. space requirements.MBA – R. compared to the resources the company has available. then that can affect elements of your product roll-out plan. including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. but if the company does not have the resources to make the plan come together. if your forecasting for the cost of goods has changed due to a sudden increase in material costs. an organization needs to have a contingency plan in place. When you start the planning process for any project. The reallocation of company resources. if the company has the capabilities to pull off the plan and if the plan will help to strengthen the company’s standing within the industry.
The maturity period is 5 years. if the rate of interest given by PF authorities is 9%? Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Amount 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 Interest 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% Total 30000 32700 35643 38851 42347 46159 50313 54841 59777 65157 71021 77413 84380 91974 100252 109274 119109 129829 141514 154250 Q.28 T. 5y) = 80*3. The required rate of return is 10%. 30000 into his PF A/c at the end of each year for 20 years. 5y) + 1000*PVIF(10%.6 Mr. What is the price he should be willing to pay now to purchase the bond? Ans: Solution: Interest payable=1000*8%=Rs.28 + 621 =Rs.621 = 303. 924. Principal repayment is Rs. n) Value of the bond=80*PVIFA(10%. Anant purchases a bond whose face value is Rs.791 + 1000*0.1000. What is the amount he will accumulate in his PF at the end of 20 years.MBA – R. 80. No . Antony Joseph Prabakar Page7 . 1000 Required rate of return is 10% V0=I*PVIFA(kd.511222964 Q.5 An employee of a bank deposits Rs. n) + F*PVIF(kd. and which has a nominal interest rate of 8%.
924.511222964 This implies that the company is offering the bond at Rs. No . T. The investor may not be willing to pay more than Rs.28 for the bond today.MBA – R. 1000 but is worth Rs. Antony Joseph Prabakar Page8 . 924.28 at the required rate of return of 10%.