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Fall 2011

(Book ID: B1134)

Q.1 What are the 4 finance decisions taken by a finance manager.

Ans. A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firms activities. Let us note at the outset hat shareholders are made better off by a financial decision that increases the value of their shares, Thus while performing the finance function, the financial manager should strive to maximize the market value of shares. Whatever decision does a manger takes need to result in wealth maximization of a shareholder. Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are: (a) the evaluation of the prospective profitability of new investments, and (b) the measurement of a cut-off rate against that the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems.

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Financing Decision Financing decision is the second important function to be performed by the financial manager. Broadly, her or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firms capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and the firms capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility loan convenience, legal aspects etc. in deciding its capital structure. Dividend Decision Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability, bonus shares and cash dividends in practice. Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonus share (or stock dividend), are also issued to the existing shareholders in addition to the cash dividend. Liquidity Decision Current assets management that affects a firms liquidity is yet another important finances function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firms profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of

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managing current assets. He or she should estimate firms needs for current assets and make sure that funds would be made available when needed. It would thus be clear that financial decisions directly concern the firms decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. It is in this context that finance functions are said to influence production, marketing and other functions of the firm. This, in consequence, finance functions may affect the size, growth, profitability and risk of the firm, and ultimately, the value of the firm. To quote Ezra Solomon The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management is directly concerned with production, marketing and other functions, within an enterprise whenever decisions are about the acquisition or distribution of assets. Various financial functions are intimately connected with each other. For instance, decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. Likewise, dividend decisions influence financing decisions and are themselves influenced by investment decisions. In view of this, finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit should be made after consulting production and marketing executives. However, in the management of income finance manager has to act on his own. The determination of dividend policies is almost exclusively a finance function. A finance manager has a final say in decisions on dividends than in asset management decisions. Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finance manager works as a part of total management. In principle, a finance manager is held responsible to handle all such problem: that involve money matters. But in actual practice, as noted above, he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively.

Q.2 What are the factors that affect the financial plan of a company?

Ans. To help your organization succeed, you should develop a plan that needs to be followed. This applies to starting the company, developing new product, creating a

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new department or any undertaking that affects the companys future. There are several factors that affect planning in an organization. To create an efficient plan, you need to understand the factors involved in the planning process. Priorities In most companies, the priority is generating revenue, and this priority can sometimes interfere with the planning process of any project. For example, 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, then you might have to shelve the expansion planning until the customer issue is resolved. When you start the planning process for any project, you need to assign each of the issues facing the company a priority rating. That priority rating will determine what issues will sidetrack you from the planning of your project, and which issues can wait until the process is complete. Company Resources Having an idea and developing a plan for your company can help your company to grow and succeed, but if the company does not have the resources to make the plan come together, it can stall progress. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project, compared to the resources the company has available. Some of the resources to consider are finances, personnel, space requirements, access to materials and vendor relationships. Forecasting A company constantly should be forecasting to help prepare for changes in the marketplace. Forecasting sales revenues, materials costs, personnel costs and overhead costs can help a company plan for upcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance of success, if the company has the capabilities to pull off the plan and if the plan will help to strengthen the companys standing within the industry. For example, if your forecasting for the cost of goods has changed due to a sudden increase in material costs, 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. Contingency Planning To successfully plan, an organization needs to have a contingency plan in place. If the company has decided to pursue a new product line, there needs to be a part of the plan that addresses the possibility that the product line will fail. The reallocation of company resources, 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

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Q.3

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 bonds 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 bonds 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 bonds 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 receivedwe 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 bonds price, which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present.

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You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, 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. The following diagram illustrates how present value is calculated for an ordinary annuity: Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. 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. The farther into the future a payment is to be received, the less it is worth today is the fundamental concept for which the PV-ofordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesnt require that we add the value of each coupon payment. (For more on calculating the time value of annuities, see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. ) By incorporating the annuity model into the bond pricing formula, which requires us to also include the present value of the par value received at maturity, we arrive at the following formula: Lets go through a basic example to find the price of a plain vanilla bond. Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example well assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bonds par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula:

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From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds. Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above, which are required if the coupon payments occur more than once a year. A simple modification of the above 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, which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Ans. The financial leverage implies the employment of source of funds, involving fixed return so as to cause more than a proportionate change in earnings per share (EPS) due to change in operating profits. Like the operating leverage, financial leverage can be positive when operating profits are increasing and can be negative in the situation of decrease in such profits. In view of these, financial leverage will affect the financial risk of the firm. An important analytical tool for financial leverage is the indifference point at which the EPS/market price is the same for different financial plans under consideration. The objective of this study was to provide additional evidence on the relationship between financial leverage and the market value of common stock. Numerous empirical studies have been done in this area, and, concurrently, many theories have been developed to explain the relationship between financial leverage and the market value of common stock. Because of the methodological weaknesses of past studies, however, no conclusions can be drawn as to the validity of the theories. Theories on financial leverage may be classified into three categories: irrelevance theorem, rising from value indefinitely with increase in financial leverage, and optimal financial leverage. Empirical implications of these categories along with the consequences of serious confounding effects are analyzed. The implications are then compared with evidence from actual events involving financial leverage changes, and distinguished from each other as finely as possible, using simple and multiple regression analyses,

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normal Z-test, and a simulation technique. The evidence shows that changes in the market value of common stock are positively related to changes in financial leverage for some firms and negatively related for other firms. This evidence is consistent with the existence of an optimal financial leverage for each firm, assuming that financial leverages of firms with a positive relationship are below the optimum and those of firms with a negative relationship are above the optimum. The results of the study do not depend upon the definition of the market portfolio, the definition of the event period, or the choice of financial leverage measure. Betas estimated from equally weighted market portfolios were generally higher than those estimated from value weighted market portfolios during 1981-1982. However, the results of the study were the same for both portfolios. Abnormal returns were computed for seven and two day event periods, and the results were the same for both periods. Seven different definitions of financial leverage were tested, and the results were the same for all measures.

Q.5 The cash flows associated with a project are given below:

Year 0 1 2 3 4 5 Cash flow (100,000) 25000 40000 50000 40000 30000

Calculate the a) payback period. sb) Benefit cost ratio for 10% cost of capital Q6. A companys earnings and dividends are growing at the rate of 18% pa. The growth rate is expected to continue for 4 years. After 4 years, from year5 onwards, the growth rate will be 6% forever. If the dividend per share last year was Rs.2 and the investors required rate of return is 10% pa, what is the intrinsic price per share or the worth of one share.

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