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: =
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