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Sikkim Manipal University

Directorate of Distance Education






Drive: SPRING 2014
Assignment Marks 60
FINANCIAL MANAGEMENT 4 credits
Subject Code MB 0045



Name MAYANK JAIN
Registration Number 1305002748
Learning Centre Media Features (India) Pvt. Ltd., NEW DELHI
Learning Centre Code 2017
Program MBA
Semester II
Subject FINANCIAL MANAGEMENT
Subject Code MB 0045


Question1. When a firm follows wealth maximization goal, it achieves maximization of
market value of a share. Do you agree? Substantiate your arguments.
A. Wealth maximization
The term wealth means shareholders wealth or the wealth of the persons those who are involved
in the business concern. Wealth maximization is also known as value maximisation or net
present worth maximisation. This objective is an universally accepted concept in the field of
business.
Wealth maximization 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 profit maximisation. The following arguments are in support of the
superiority of wealth maximisation over profit maximisation:

1. 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 maximization is based
on accounting profit and it also contains many subjective elements.

2. Wealth maximization considers time value of money. Time value of money translates cash
flow occurring at different periods into a comparable value at zero periods. 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.

Question 2. A) If you deposit Rs 10000 today in a bank that offers 8% interest, how many
years will the amount take to double?
A: Solution: By Rule of 72 =
Doubling Period = 72/Rate of interest
= 72/8 yrs = 9yrs.

And By Rule of 69
Doubling Period = 0.35+69/8
= 0.35+8.625 = 8.975 yrs.

B) What is the future value of a regular annuity of Re 1.00 earning a rate of 12% interest p.a.
for 5 years?
A: Solution:
FVAn = A * FVIFA (12%, 5yrs)

= 1*FVIFA (12%, 5y) = 1*6.353 = Rs. 6.353

Question3. The concept of financial leverage is a significant, as it has direct relation
with capital structure. Do you agree? If so, substantiate your arguments.
A: Financial leverage relates to the financing activities of a firm and measures the effect of EBIT
on Earnings per Share (EPS) of the company. A companys sources of funds fall under two
categories:
1. Those which carry fixed financial charges like debentures, bonds, and preference shares.
2. Those which do not carry any fixed charges like equity shares.

The concept of financial leverage is a significant one because it has direct relation with capital
structure management. It determines the relationship that could exist between the debt and equity
securities. A firm which does not issue fixed-charge securities has an equity capital structure and
does not have any financial leverage. However, it is common for firms to issue some debt
securities, in which case, the leverage is either favorable or unfavorable. Financial leverage is a
process of using debt capital to increase the rate of return on equity. For this reason, it is also
referred to as trading on equity. Borrowing is done by a company because of the financial
advantage that is expected from it. The use of borrowings for the purpose of such advantage for
residual shareholders is also called trading on equity or leverage. It refers to the mix of debt
and equity in the capital structure of the firm. This results from the presence of fixed financial
charges in the companys income stream. Such expenses have nothing to do with the firms
performance and earnings and should be paid off regardless of the amount of EBIT. It is the
firms ability to use fixed financial charges to increase the effects of changes in EBIT on the
EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A
company earning more by the use of assets funded by fixed sources is said to be having a
favorable or positive leverage. Unfavourable leverage occurs when the firm is not earning
sufficiently to cover the cost of funds.

Question 4. A project requires an initial outlay of Rs. 1, 00,000. It is expected to
generate the cash inflows shown in table
Table: Cash Inflows

Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000
What is the IRR of the project?
A: Solution:
Step 1: Average of Annual Cash = 50,000+50,000+30,000+40000/4
= 1, 70,000/4 = Rs. 42,500

Step 2: Divide the initial investment by the average of annual cash inflows
= 1, 00,000/42,500= 2.35

Step 3: From the PVIFA table for 4 years, the annuity factor very near 2.35 is
25%. Therefore, the first initial rate is 25% as shown in table



Trial Rate at 25%
Year
Cash
inflows PV factor at 25% PV of Cash flows
1 50,000 0.800 40,000
2 50,000 0.640 32,000
3 30,000 0.512 15,360
4 40,000 0.410 16,400
Total 1,03,760

As the initial investment of Rs.1, 00,000 is less than the computed value at 25% of Rs.1,
03,760; the next trial rate is 26%. Hence the changes in the calculations are as shown in table
Trial Rate at 26%
Year
Cash
inflows PV factor at 26% PV of Cash flows
1 50,000 0.7937 39,685
2 50,000 0.6299 31,495
3 30,000 0.4999 14,997
4 40,000 0.3968 15,872

Total 1,02,049

The next trial rate is 27%, the changes are as shown in table
Trial Rate at 27%
Year
Cash
inflows PV factor at 27% PV of Cash flows
1 50,000 0.7874 39,370
2 50,000 0.6200 31,000
3 30,000 0.4882 14,646
4 40,000 0.3844 15,376
Total 1,00,392

The next trial rate is 28%, the changes are as shown in table

Trial Rate at 28%
Year
Cash
inflows PV factor at 26% PV of Cash flows
1 50,000 0.7813 39,065
2 50,000 0.6104 30,520
3 30,000 0.4768 14,3047
4 40,000 0.3725 14,900
Total 98,789

Because, initial investment of Rs.1, 00,000 lies between 98789 (28 %) and 1, 00,392 (27%), the
IRR by interpolation is equal to:
= 27 + 1, 00,392 - 1, 00,000 / 1, 00,392 98,789 X 1
= 27 + 392 / 1603 X 1
= 27 + 0.2445 = 27.2445 = 27.24 %
Hence IRR is 27.24 %

Question 5. Below Table gives the complete details of sales and costs of the goods produced
by XYZ ltd for the year 31.03.12.
Table -Sales and Costs Produced by XYZ Ltd.
Sales 80,000 Inventory
Cost of
Goods 56,000 31.03.07 9,000
31.03.08 12,000
Accounts Receivables
31.03.07 12,000
31.03.08 16,000
Accounts Payable
31.03.07 7,000
31.03.08 10,000

What is the length of the operating cycle? What is the cash cycle? Assume 365 days in a year.

A: Operating Cycle = Inventory Conversion Period + Accounts Receivables
Conversion Period

From the above formula we need to first calculate the individual conversion periods.
Inventory conversion period: =


x 365

=


x 365

=


= 68.4 days

Receivables Conversion Period =


x 365

=


x 365

=


= 63.9 days

Receivables Conversion Period =


x 365

=


x 365

=


= 55.4 days

Operating Cycle = ICP + RCP
= 68.4 + 63.9 = 132.3 days


Cash Conversion Cycle = OC PDP
= 132.3 55.4 = 76.9 days

Question 6. Face book bought WhatsApp on Feb, 19, 2014 for $19 billion. This was split
between $4 billion in cash, $12 billion worth of Face book shares, and $3 billion in
restricted stock units to be paid in four years. Do you think the market capitalization has
played a significant role in pricing the valuation? Discuss the Walters model assumptions
in this context.
A: The following are the assumptions on which the Walters model is based:

Financing All financing is done through retained earnings. Retained earning is the only source
of finance, available and the firm does not use any external source of funds like debt or equity.

Constant rate of return and cost of capital The firms r and k remain constant and any
additional investment made by the firm will not change the risk and return profile.

100% pay-out or retention All earnings are either completely distributed or immediately re-
invested.

Constant EPS and DPS The earnings and dividends do not change and are assumed to be
constant forever.

Life The firm has a perpetual life.

According to this approach, the market price of the share is taken as the sum of the present value
of the future cash dividends and capital gains. Walters formula to determine the market price is
as follows:

Market price per share of the firm is given as:

P = D / (Ke g)

Implies, Ke = D/P + g, where g = P / P

Thus, Ke = D/P + P / P

But since, P = [r /Ke(E - D)], we get

P = D/Ke+[r /Ke (E - D)]/Ke

Where P is the market price per share
D is the dividend per share
Ke is the cost of capital
g is the growth rate of earnings
E is Earnings per share
r is IRR
P is change in price

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