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DINA BUSINESS SCHOOL

DINA INSTITUTE OF HOTEL AND BUSINESS MANAGEMENT

PUNE 411 028

CENTRE CODE 02758

ASSIGNMENT SET 1 / SET 2

NAME : TAHA MOHAMMED DHILAWALA

ROLL.NO. : 520850852

PAPER / SUBJECT : Financial Management

CODE : MB0029

SEMESTER : I / II / III / IV

SIKKIM MANIPAL UNIVERSITY

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1. a. Explain why wealth maximization is superior over

profit maximization.

ANS. Its is based on cash flow, not based on accounting profit.

Through the process of discounting it takes care of the qualityof cash flows. Distant cash flows are uncertain. Converting distant uncertaincash flows into comparable values at base period facilitates better

comparison of projects. There are various ways of dealing with riskassociated with cash flows. These risks are adequately to arrive at the net

present value of any project.

In todays competitive business scenario corporate play a key

role. In company form of organization, shareholders own the company butthe management of the company rests with the board of directors. Directors

are elected by shareholders and hence agents of the shareholder . companymanagement procures funds for expansion and diversification from capital

markets. In the liberalized setup, the society expects corporate to tap thecapital market. There fore to keep the investors happy through the

performance of value of shares in the market, management of the companymust meet the wealth maximization criterion.

When a firm follows wealth maximization goal, it achievesmaximization of market values of share. When a firm partices wealth

maximization goal, it is possible only when it produces quality goods at lowcost. On this account society gains because of the societal walfare.

Maximization of wealth demands on the part of corporate toDevelop new products or render new services in the most effective and

efficient manner. This helps the consumer as it will bring to the market theproduct and services that consumer need.

Another notable features of the firms committed to the

maximization of wealth is that to achieve this goal they are forced to renderefficient service to their customers with courtesy. This enchances consumer

welfare and hence the benefits to the society.

From the point of evaluation of performance of listed firms, the

most remarkable measures is that of performance of the company in theshare market. Every corporate action finds its reflection on the market values

of share of the company. Therefore, shareholder wealth maximization could

be considered a superior goal compared to profit maximization.

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Since listing ensures liquidity to the share held by the investors,

Shareholder can reap the benefits arising from the performance company

only when they sell their shares. Therefore it is clear that maximization ofmarket will lead to maximization of the net wealth of shareholders.

Therefore , we can conclude that maximization of wealth is the appropriate

of goal of financial management in todays context.

1. b. Briefly explain the steps involved in financial plan

Ans. Establish corporate objective:- corporate objective could be

grouped Into qualitative and quantitative. For example, acompanys mission statement may specify create economic

value added. But this qualitative statement has to be stated in

quantitative teams such as a 25% ROE or a 12% earnings growth

rates. There is a need to formulate both short run and long runobjectives.

Next stage is formulation of strategies for attaining the objectives set.In this connection corporate develop operating plans. Operating plans

are framed with a time horizon. It could be a five year plan or ten year

plan.

Once the plans are formulated, responsibility for achieving salestarget, operating targets, cost management bench marks, profits

targets etc is fixed on respective executives. Forecast the various financial variables such as assets required, flow

of funds, cost to be incurred and then translate the same into financialstatements. Such forecasts help the finance manager to monitor the

deviations of actual from the forecasts and take effective remedialmeasures to ensure that targets set are achieved without any time

overrun and cost overrun.

Develop a detailed plan for funds required for the plan period undervarious heads of expenditure.

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From the funds required plan, develop a forecast of funds that can beobtained from internal as well as external sources during the time

horizon for which plans are developed. In this correction legalconstrains in obtaining funds on the basis of covenants of borrowings

should be given due weight age. There is also a need to collaboratethe firms business risk with implications of a particular sources of

funds. Develop a control mechanism for allocation of funds and their

effective use. At the time of formulating the plans certain assumptions need to be

made about the economics environment. But when plans areimplemented economic environment may change. To manage such

situations, there is a need to incorporate an inbuilt mechanism whichwould scale up or scale down the operations acoordingly.

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2a. Explain the two theories of capitalization.ANS. Capitalizations :-

Meaning : capitalization of a firm refers the composition of its long term

funds. It refers to the capital structure of the firm. It has two components viz

debt and equity.After estimating the financial requirements of a firm, then the next decision

that the management has to take is to arrive at the value at which thecompany has to be capitalized.

There are two theories of capitalization for new companies.

1. cost theory and 2. earnings theory

Cost Theory

Under this approach, the total amount of capitalization for a new company is

the sum of the following :1. cost fixed assets.

2. cost of establishing the business.3. amount of working capital required

Merits of cost approach1. its helps promoters to estimate the amount of capital required for

incorporation of company, conducting market surveys, preparingdetailed project report, procuring funds, procuring assets both fixed

and current, trial production run and successfully producing,

positioning and marketing of its products or rendering of services.

2. if done firm systematically it will founding for successful initiation ofthe working of the firm

Demerits

1. if the firm establishes its production facilities at inflated prices,

productivity of the firm will be less than that of the industry.

2. net worth of a company is decided by the investors by the earnings ofa company. Earning capacity based net worth helps a firm to arrive at

the total capital in terms of industry specified yardstick (i,e, operatingcapital based on bench markes in that industry) cost theory fails in this

respect.

Earnings Theory

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Earnings are forecast and capitalized at a rate of return which isrepresentative of the industry. It involves two steps.

1. Estimation of the average annual future earnings.2. Normal earning rate of the industry to which the company belongs.

Merits

1. It is superior to cost theory because there are the least changes ofneither under nor over capitalization.

2. Comparison of earnings approach with that of cost approach willmake the management to be cautions in negotiating the technology

and cost of procuring and establishing the new business.

Demerits1. The major challenge that a new firm faces is in deciding on

capitalization and its division thereof into various procurementsources.

2. arriving at capitalization rate is equally a formidable task because the

investors perception of established companies cannot be really

representative of what investors perceive of the earning power of newcompany.

Because of the problem, most of the new companies are forced to adopt thecost theory of capitalization.

Ideally every company should have normal capitalization. But it is an

utopian way of thinking.

Changing business environment, role of international forces and dynamics ofcapital market condition forces us to think in terms of what is optimal today

need not be so tomorrow. Even with these constraints, management of everyfirm should continuously monitors the firm capital structure to ensure to

avoid the bad consequences of over and under capitalization.

Over capitalization

A company is said to be overcapitalized, when its total capital (both equityand debt) exceeds the true value of its assets. It is wrong to identify

overcapitalization with excess of capital because most of the overcapitalizedfirm suffer from the problems of liquidity. The correct indicator of

overcapitalization is the earning capacity of the firm. If the earnings of the

firm are less then that of the market expectation. It is a sign of

overcapitalization. It is also possible that a company has more funds than itsrequirements based on current operation levels, and yet have low earnings.

Under capitalization

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Under capitalization is just the reverse of over capitalization. A company isconsidered to be under capitalized when its actual capitalization is lower

than its proper capitalization as warranted by its earning capacity.

Symptoms of under capitalization1. Actual capitalization is less than that warranted by its earning

capacity.2. Its rate of earnings is exceptionally high in relation to the return

enjoyed by similar situated companies in the same industry.

Causes of under capitalization

1. Under estimation of future earnings at the time of promotion of thecompany.

2. Abnormal increase in earnings from new economic and businessenvironment.

3. Under estimation of total funds requirements.

4. Maintaining very high efficiency through improved means of

production of goods or renderings of services.5. Companies which are set up during recession start making higher

earnings capacity as soon as the recession is over.6. Use of lower capitalization rates.

7. Companies which follow conservative dividend policy will achieve a

process of gradually rising profits.

8. Purchase o assets at exceptionally low prices during recession.

B .A customer wants to deposit Rs.10,000 in ICICI bank for 5 years.

The prevailing interest rate is 9.50% what will be the value of the

deposit on maturity

ANS.B) AA= P (1+i) 5

= 10000(1+0.095)5

= 10000(1.095)= 10000 (1.5742)

Rs = 15,742.39

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3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5

years hence. How much should it deposit annually in sinking

fund account so that it can accumulate Rs. 30 million at the

end of 5 years.

ANS A)A= FVA * i

{1+i)n-1}

= 3,00,00,000 *0.12

{1+0.12)5-1}

= 36,00,000

1.7623-1

= 36,00,000

0.7623

= Rs. 47,22,291.92

B. Road Transport Corporation issued deep discount bands in

1996 which has a face value of Rs. 2,00,000 maturing after 25

years. The bond was issued at Rs. 5300. What is the effective

interest rate earned by the investor from this bond?

ANS.B) nA = Po (1+r)

25

2,00,00 = 5300 (1+r)25

2,00,000 = (1+r)5300

2537.7358 = (1+r)

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4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10%

maturing in 10 years. If the YTM is 12% what is the market value of the

bond? If the YTM is increase to 14%, what is the market value of the

bond? Compare and give the inference.

ANS .

@ 12%

Vo = I * PVIFA (KD,N) + F* PVIF (KD,N)

= 12 * PVIFA(12 % ,10) + 1000 * PVIF (12 %, 10)

= ( 12 * 5.65) + 1000 * 0.322= 67.8 + 322

= Rs. 389.8

@ 14 %

= 14* PVIFA(14%10) + 1000*PVIF(14%,10)

= (14 * 5.2161 ) + 1000 *0.2697

= 73.0254 + 269.7

= Rs. 342.73

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5a. ABC Ltd, produced and sold Rs.1,00,000 of a product at

the rate of Rs.100. For production of Rs.1,00,000 units, it hasspent a variable cost of Rs.6,00,000 at the rate of Rs.6 per unit

and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs.

50,000 at the rate of 5 percent and Rs.1,00,000 debts. Calculate

operating leverage.

ANS.A)

PART Rs.

Sales 10,00,000

(-)variable 6,00,000

contribution 4,00,000

(-)Fixed cost 2,50,000

EBIT 1,50,000

DOL = contribution

EBIT= 4,00,000

1,50,000

= 2.67 time

5.b. Explain the importance of capital budgeting

ANS. Capital budgetingThe term 'Capital Budgeting' is used interchangeably with capital

expenditure management, capital expenditure decision, long term investmentdecision, management of fixed assets, etc. It may be defined as "planning,

evaluation and selection of capital expenditure proposals." Capital budgeting

involves a current outlay or serves as outlays of cash resources in return foran anticipated flow of future benefits.According to G. C. Philippalys, "Capital budgeting is concerned with the

allocation of firm's scarce financial resources among the available marketopportunities. The consideration of investment opportunities involves

comparison of expected future streams of earnings from a project withimmediate and subsequent streams of expenditure for it."

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Lynch - "Cash budgeting consists in planning, development of available

capital for the purpose of maximizing the long term profitability in the

concern."

In other words, the system of capital budgeting is employed to evaluate

expenditure decisions which involve current outlays, but likely to producebenefits over a period of time longer than one year. These benefits may be

either in the form of increased revenue or reduction in costs. Capitalexpenditure management therefore includes addition, disposition,

modification and replacement of fixed assets. The basic features of capitalbudgeting are:

1.potentially large anticipated benefits;2. a relatively high degree of risk;3. a relatively long time period between initial outlay and anticipated returns.Fixed assets are frequently termed as earning assets of the firm in the sense

that they usually generate large return. Future sales growth is correlated withexpansion of capital expenditure. It is a specialized process requiring highly

sophisticated techniques and intricate forecasting for future years. Closely

scrutinized capital expenditure selections result in increased sales, profits,

dividends and ultimately share price value of the firm.

Importance

Capital budgeting is of paramount importance in financial decision making.

Special care should be taken in making these decisions on account of the

following reasons:

1. Such decisions affect the profitability of the firm. They also have bearing

on the competitive position of the enterprise. This is mainly because of thefact that they relate to fixed assets. The fixed assets represent in a sense, the

true earning assets of the firm. They enable the firm to generate finishedgoods that can ultimately be sold for a profit. However, current assets are not

generally earning assets. They provide a buffer that allows the firm to makesales and extend credit. Capital budgeting decision determine the future

destiny of the company. An opportune investment decision can yieldspectacular returns. On the other hand an ill advised and incorrect

investment decision can endanger the very survival even of large sized

firms. A few wrong decisions and a firm can be forced into bankruptcy.

Capital budgeting is of utmost importance to avoid over-investment andunder-investment in fixed assets.

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2. A capital expenditure decision has its effect over a long time span andinevitably affects the company's future cost structure. To illustrate, if a

particular plan has been purchased by a company to start a new product, thecompany commits itself to a sizable amount of fixed assets in terms of

supervisors, salary, insurance, rent of buildings and so on. If the investmentin future turns out to be unsuccessful or yields less profit than anticipated,

the firm will have to bear the burden of fixed costs unless it writes off theinvestment completely. In short, a firm's future costs, break-even point, sales

and profits will all be determined by the firm's selection of assets i.e., capitalbudgeting. Long term investment decision are more difficult to take because

(i) decision extends to a series of years and beyond the current accounting

period;(ii) uncertainties of future; and

(iii) higher degree of risk.

3. Capital investment decision once made are not easily reversible without

much financial loss to the firm. It is because there may be no market for

second hand plant and equipment and their conversion to other uses may notbe financially feasible.4. Capital investment involves cost and the majority of the firms have scarcecapital resource. This underlines the need for thoughtful, wise and correct

investment decisions as an incorrect decision would not only result in losses

but also prevent the firm from earning profits from other investments whichcould not be undertaken for want of funds.

5. Over / Under capacity - To improve timing and quality of asset

acquisition, the capital expenditure decision must be carefully drawn. If thefirm has invested too much in assets, it will incur unnecessary heavy

expenditure. If it has not spent enough on fixed assets, two serious problemsmay arise

(i) The firms equipment may not be sufficiently modern to enable it toproduce competitively.

(ii) If it has inadequate capacity it may lose a portion of its share ofmarket to its rival firm. To regain lost customers it would require heavy

selling expenses, price reduction, product improvement, etc.

6. Investment decision though taken by individual concerns is one ofnational importance because it determines employment, economic activities

and economic growth.

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Capital Budget Decision

Capital budgeting refers to the total process of generating, evaluating,

selecting and following up on capital expenditure alternatives. The firmallocates or budgets financial resources to new investment proposals.

Basically the firm may be confronted with three types of capital budgetingdecisions1. Accept / Reject decision - This is the fundamental decision in capitalbudgeting. If the project is accepted, the firm invests in it. If the proposal is

rejected the firm does not invest. In general all those proposals which yield arate of return greater than a certain required rate of return or cost of capital

are accepted and the rest are rejected. By applying this criteria, allindependent projects are accepted. Independent projects are projects that do

not compete with one another in such a way that acceptance of one precludesthe possibility of acceptance of another. Under the acceptance decision, all

the independent projects that satisfy the minimum investment criteria are

implemented.

2. Mutually exclusive project decision - Mutually exclusive projects are

projects which compete with other projects in such a way that the acceptanceof one will exclude the acceptance of other projects. The alternatives are

mutually exclusive and only one may be chosen. It may be noted that the

mutually exclusive project decisions are not independent of accept / rejectdecision. Mutually exclusive investment decisions acquire significance when

more than one proposal is acceptable under the accept / reject decision. Thensome techniques have to be used to determine the best one. The acceptance

of 'best' alternative automatically eliminates the other alternatives.

3. Capital rationing decision - In a situation where the firm has unlimitedfunds, capital budgeting becomes a very simple process. In that, independent

investment proposals yielding a return greater than some predeterminedlevel are accepted. However, this is not the situation prevailing in most of

the business firm's of real world. They have fixed capital budget. A largenumber of investment proposals compete in these limited funds. The firm

allocates funds to projects in a manner that it maximizes long run returns.

Thus capital rationing refers to the situation where the firm has more

acceptable investments requiring a greater amount of finance than isavailable with the firm. It is concerned with the selection of a group of

investment proposals acceptable under the accept / reject decision. Ranking

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(b) Profitability index / Benefit cost ratio(c) Internal rate of return

Payback Method

It is a traditional method of capital budgeting. It is the simplest and most

widely employed quantitative method for appraising capital expendituredecisions. This method answers the question - how many years will it take

for cash benefits to pay the original cost of an investment normallydisregarding salvage value. Cash benefits here represent cash flow after tax

(CFAT) technique to pay back the original outlay required in an investmentproposal.

There are two ways of calculating the payback period. The first method canbe applied when the cash flow stream is in the nature of annuity for each

year of project's life, where cash flow adjusted techniques are uniform. Insuch a situation the initial cost of investment is divided by the constant

annual cash flow. The second method is used when a project's cash flows are

not equal, but vary from year to year. In such a situation payback is

calculated by the process of accumulating cash flows till the time whencumulative cash flows are equal to original investment outlay.

Accept / Reject criterion

The payback period can be used as a decision criterion to accept or reject aninvestment proposal. One application of this technique is to compare the

actual payback period with a predetermined payback i.e., the payback set up by the management. If the actual payback period is less than the

predetermined payback, the project will be accepted. If not, it will berejected. Alternatively the payback can be used as a rationing method. When

mutually exclusive projects are under one consideration, they may be rankedaccording to the length of payback period. Thus the project having the

shortest payback may be assigned rank one followed in the order so that the project with longest payback might be ranked last. The term mutually

exclusive refers to the proposals out of which only one can be accepted.Obviously project with shorter payback period will be selected.

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6. Financial Planning: Assume you are working for an investment

banker. A client aged 30 has approached you on investment planning.

His present salary is Rs.6,00,000 per year and his current savings is

Rs.1,50,000. (a) How much does this current saving grow to in 3 years if

the interest rate is12% compounded annually. (b) Assume he plans to

save Rs.60000 at the end of every year for 5 years, what would be the

amount at the end of 5 years if the interest being 10% compounded

annually.

ANS. A)

=1,50,000 FUIFA (12 % , 3year)

= 1,50,000 * 4.408

= Rs. 6,61, 200

B)= 60,000 FVIFA (10% , 5 year)

= 60,000 * 7.165

= Rs. 4,29,900

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