MB 0045-FINANCIAL MANAGEMENT Q1. What are the goals of financial management?

Profit maximisation Profit maximisation is based on the cardinal rule of efficiency. its goal is to maximise the returns with the best output and price levels. A firms performance is evaluated in terms of profitability. Prot maximisation is the traditional and narrow approach, which aims at maximising the prot of the concern. Allocation of resources and investors perception of the company's performance can be traced to the goal of prot maximisation. Prot maximisation has been criticized on many accounts: The concept of profit lacks clarity. What does prot mean? o ls it profit after tax or before tax? o ls it operating profit or net profit available to shareholders? ln this sense, profit is neither defined precisely nor correctly. It creates unnecessary conflicts regarding the earning habits of the business concern. Differences in interpretation of the concept of prot thus expose the weakness of prot maximisation. Prot maximisation neither considers the time value of money nor the net present value of the cash inflow. lt does not differentiate between prots of current year with the profits to be earned in later years. The concept of prot maximisation fails to consider the uctuations in prots earned from year to year. Fluctuations may be attributed to the business risk of the rm. Risks may be internal or external which will affect the overall operation of the business concern. The concept of profit maximization apprehends to be either accounting profit or economic normal prot or economic supemormal prot .Profit maximisation as a concept, even though has the above-mentioned drawbacks, and is still given importance as prots do matter for any kind of business. Ensuring continued prots ensure of shareholders wealth. Wealth maximisation The term wealth means shareholder's wealth or the wealth of the persons those who are involved in the business concern. Wealth maximisation is also known as value maximisation or net present worth maximisation. This objective is an universally accepted concept in the field of business. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of prot maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation: Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting prot and it also contains many subjective elements. Wealth maximisation considers time value of money. Time value of money translates cash flow occurring at different periods into a comparable value at zero period. In this process, the quality of cash flow is considered critical in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallizes into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented. Q2. Explain the factors affecting Financial Plan. Nature of the industry - The rst factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital-intensive or labour-intensive industry. This will have a major impact on the total assets that a firm owns.

 Size of the company - The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long-term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short-term and long-term at attractive rates. Status of the company in the industry A well-established company enjoys a good market share, because its products normally command investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment. Sources of finance available - Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. Matching the sources with utilization - The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short-term finance. All fixed-asset investments are to be financed by long-term sources which is a cardinal principle of financial planning. Flexibility The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever the need arises. lf the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market. Government policy SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA, and Department of Corporate Affairs (government of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statutes in India. They are to be complied with a time constraint. Q3. Explain the time value of money. Time value of money is the value of a unit of money at different time intervals. The value of the money received today is more than its value received at a later date. ln other words, the value of money changes over a period of time. Since a rupee received today has always more value, rational investors would prefer current receipts over future receipts. That is why this phenomenon is referred to as "time preference of money". Consider this we intuitively know that Rs.100 in hand now is more valuable than Rs. 100 receivable after a year. In other words, we will not part with Rs. 100 now in return for a rm assurance that the same sum will be repaid after a year. But we might part with the same Rs. 100 now if we are assured

that something more than Rs. 100 will be paid at the end of first year. This additional compensation required for parting with Rs. 100 now is called the interest or the time value of money. Some important factors contributing to this nature are: Investment opportunities Preference for consumption Risk These factors remind us of the famous English saying, A bird in hand is worth two in the bush. The question now is: why should money have time value? Some of the reasons are: Productivity Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials, Rs. 300 on labour. and Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%. Inflation - During periods of inflation, a rupee has higher purchasing power than a rupee in the future. Risk and uncertainty We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty, individuals prefer current consumption over future consumption. Most people have subjective preference for present consumption either because of their current preferences or because of inationary pressures. Q4. XYZ India Ltds share is expected to touch Rs. 450 one year from now. The company is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be willing to buy if his or her required rate of return is 15%? Solution: P0 = D1/(1+Ke) + P1/(1+Ke) = {25/(1+0.15)} + {45O/(1+0.15)} = 21.74 + 391.30 = Rs. 413.04 An investor would be willing to buy the share at Rs. 413.04 Q5. Below Table depicts the statistics of a firm and its sales requirements. Compute the DOL according to the values given in the table. Table: Statistics of a Firm Sales in units 2000 Sales revenue Rs. 20000 Variable cost 10000 Contribution 6000 Fixed cost 0 EBIT 6000 Solution: DOL= {Q(SV)} / {Q(SV)F} {2000(10000)} / {2000(10000) - 0} = 2000000/2000000 = DOL=1 The DOL according to the values given in the table is 1

Q6. What are the assumptions of MM approach? Miller and Modigliani approach Miller and Modigliani criticise traditional approach that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in NOl approach. The assumptions regarding Miller and Modigliani (MM) approach: perfect capital markets, rational behaviour, homogeneity, taxes, and dividend payout. Let us now discuss these assumptions in detail. Perfect capital markets - Securities can be freely traded, that is. Investors are free to buy and sell securities (both shares and debt instruments), no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, and availability of all required information at all times. Investors behave rationally They choose the combination of risk and return which is most advantageous to them. Homogeneity of investors risk perception - All investors have the same perception of business risk and returns. Taxes - There is no corporate or personal income tax. Dividend payout is 100% The firms do not retain earnings for future activities.