Name Anil Kumar Joshi

Roll No. 520949950

Course & Semester MBA Semester – II

Subject Name & Code FINANCIAL MANAGEMENT - MB0029

Assignment No. Set-2

LC name & Code NIPSTec LTD. 1640

Date of Submission

Session FEB – 2010 (Spring 2010)

Q1. A. What is the cost of retained earnings?
Cost of Retained Earnings

Cost of retained earnings (ks) is the return stockholders require on the company’s
common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate
the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company’s beta (b i), which is an estimate of the
stock’s risk. Inputting these assumptions into the CAPM equation, you can then
calculate the cost of retained earnings.

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings.
Simply take the interest rate of the firm’s long-term debt and add a risk premium
(typically three to five percentage points):

ks = long-term bond yield + risk premium

c) Discounted Cash Flow Approach: Also known as the “dividend yield plus
growth approach”. Using the dividend-growth model, you can rearrange the
terms as follows to determine ks.

ks = D1 + g;
P0

where:

D1 = next year’s dividend

g = firm’s constant growth rate
P0 = price
Q1. B. A company issues new debentures of Rs. 2 million, at par; the net
proceeds being Rs. 1.8 million. It has a 13.5 per cent rate of interest and 7
years maturity. The company’s tax rate is 52 per cent. What is the cost of
debenture issue? What will be the cost in 4 years if the market value of
debentures at that time is Rs. 2.2 million?

(F+P)/2
Where kd is post tax cost of debenture capital,
I is the annual interest payment per unit of debenture,
T is the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realized per debenture,
N is maturity period
13.5(0.52) + (1.8)/ 13.5*.48+2/7
6.51
(2+1.8)/2 1.9
=3.43
(b) 13.5(1-.52) + (2-2.2)/4 13.5*.48-.2/4
(2+2.2)/2 2.1
=6.43/.21=3.06
2. Volga is a large manufacturing company in the private sector. In 2007 the
company had a gross sale of Rs.980.2 crore. The other financial data for
the company are given below: (10 Marks)

Items Rs. In crore

Net worth 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding 118.23
interest)

You are required to calculate:

a. Debt equity ratio

b. Operating leverage
c. Financial leverage
d. Combined leverage. Interpret your results and comment on the Volga’s
debt policy

Answer:

a. Debt equity ratio=Borrowing/Interest

=165.47/34.39
=4.81

b. Operating leverage DOL=Q(S-V)/Q(S-V)-F where F= fixed cost

Now EBIT=Q(S-V)-F
So Q(S-V) =EBIT+F
= 43.17+118.23
=161.47
So DOL=161.47/43.17=3.74

c. Financial leverage DFL=EBIT/{EBIT-I-{Dp/(1-T)}}

Where I is interest, Dp is dividend on preference shares; T is tax rate

= 4.92

d. Combined leverage= DOL*DFL

= 3.74*4.92
=18.4

As combined leverage is high so it is risky.

Q3. Explain Miler and Modigiliani Approach to capital structure theory?

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the
basis for modern thinking on capital structure. The basic theorem states that, in
the absence of taxes, bankruptcy costs, and asymmetric information, and in an
efficient market, the value of a firm is unaffected by how that firm is financed. It
does not matter if the firm's capital is raised by issuing stock or selling debt. It
does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller
theorem is also often called the capital structure irrelevance

Principle
Modigliani was awarded the 1985 Nobel Prize in Economics for this and other
contributions. Miller was awarded the 1990 Nobel Prize in Economics, along with
Harry Markowitz and William Sharpe, for their "work in the theory of financial
economics," with Miller specifically cited for "fundamental contributions to the
theory of corporate finance."

Historical background
Miller and Modigliani derived the theorem and wrote their path breaking article
when they were both professors at the Graduate School of Industrial
Administration (GSIA) of Carnegie Mellon University. In contrast to most other
business schools, GSIA put an emphasis on an academic approach to business
questions. The story goes that Miller and Modigliani were set to teach corporate
finance for business students despite the fact that they had no prior experience in
corpora the finance. When they read the material that existed they found it
inconsistent so they sat down together to try to figure it out. The result of this was
the article in the American Economic Review and what has later been known as
the MM theorem.

Propositions
The theorem was originally proved under the assumption of no taxes. It is made
up of two propositions which can also b e extended to a situation with taxes.
Consider two firms which are identical except for their financial structures. The
first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm
L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-
Miller theorem states that the value of the two firms is the same.

Without taxes
Proposition I: where VU is the value of an unlevered firm = price of buying a firm
composed only of equity, and VL is the value of a levered firm = price of buying a
firm that is composed of some mix of debt and equity.
To see why this should be true, suppose an investor is considering buying one of
the two firms U or L. Instead of purchasing the shares of the levered firm L, he
could purchase the shares of firm U and borrow the same amount of money B
that firm L does. The eventual returns to either of these i investments would be
the same. Therefore the price of L must be the same as the price of U minus the
money borrowed B, which is the value of L's debt. This discussion also clarifies
the role of some of the theorem's assumptions. We have implicitly assumed that
the investor's cost of borrowing money is the same as that of the firm, which
need not be true in the presence of asymmetric information or in the absence of
efficient markets.
Q4. How to estimate cash flows? What are the components of incremental
cash flows?

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of any
kind. To evaluate these investment decisions there are some principles of cash
flow estimation. In any kind of project, planning the outputs properly is an
important task. At the same time, the profits from the project should also be very
clear to arrange finances in a proper way. These forecasting are some of the
most difficult steps involved in the capital budgeting. These are very important in
the major projects because any kind of fault in the calculations would result in
huge problems. The project cash flows consider almost every kind of inflows of
cash. The capital budgeting is done through the coordination of a wide range of
professionals who are going to be involved in the project. The engineering
departments are responsible for the forecasting of the capital outlays. On the
other hand, there are the people from the production team who are responsible
for calculating the operational cost. The marketing team is also involved in the
process and they are responsible for forecasting the revenue.
Next comes the financial manager who is responsible to collect all the data from
the related departments. On the other hand, the finance manager has the
responsibility of using the set of norms for better estimation. One of these norms
uses the principles of cash flow estimation for the process.
There are a number of principles of cash flow estimation. These are the
consistency principle, separation principle, post-tax principle and incremental
principle. The separation principle holds that the project cash flows can be
divided in two types named as financing side and investment side. On the other
hand, there is the consistency principle. According to this principle, some kind
consistency is necessary to be maintained between the flow of cash in a project
and the rates of discount that are applicable on the cash flows. At the same time,
there is the post-tax principle that holds that the forecast of cash flows for any
project should be done through the after-tax method.

Incremental Principle

The incremental principle is used to measure the profit potential of a project.

According to this theory, a project is sound if it increases total profit more than
total cost. To have a proper estimation of profit potential by application of the
incremental principle, several guidelines should be maintained:

Incidental Effects: Any kind of project taken by a company remains related to the
other activities of the firm. Because of this, the particular project influences all the
other activities carried out, either negatively or positively. It can increase the
profits for the firm or it may cause losses. These incidental effects must be
considered.
Sunk Costs: These costs should not be considered. Sunk costs represent an
expenditure done by the firm in the past. These expenditures are not related with
any particular project. These costs denote all those expenditures that are done
for the preliminary work related to the project, unrecoverable in any case.
Overhead Cost: All the costs that are not related directly with a service but have
indirect influences are considered as overhead charges. There are the legal and
administrative expenses, rentals and many more. Whenever a company takes a
new project, these costs are assigned.
Working Capital: Proper estimation is essential and should be considered at the
time when the budget for the project's profit potential is prepared.
5. What are the steps involved in capital rationing?

Answer: Generally, firms fix maximum amount that can be invested in capital
projects, during a given period of time, say a year. The firm then attempts to
select a combination of investment proposals, that will be within the specific limits
providing maximum profitability, and rank them in descending order according to
their rate of return, such a situation is of capital rationing.

A firm should accept all investment project with positive NPV, with an objective to
maximize the wealth of shareholders. However, there may be resource
constraints due to which a firm may have to select from among various projects.
Thus there may arise a situation of capital rationing where there may be internal
or external constraints on procurement of necessary funds to invest in all
investment proposals with positive NPVs.

Capital rationing can be experienced due to external factors, mainly

imperfections in capital markets which can be attributed to non-availability of
market information, investor attitude etc. Internal capital rationing is due to the
self-imposed restrictions imposed by management like not to raise additional
debt or laying down a specified minimum rate of return on each project.

There are various ways of resorting to capital rationing. For instance, a firm may
effect capital rationing through budgets. It may also put up a ceiling when it has
been financing investment proposals only by way of retained earnings (ploughing
back of profits). Since the amount of capital expenditure in that situation cannot
exceed the amount of retained earnings, it is said to be an example of capital
rationing.

Capital rationing may also be introduced by following the concept of

‘Responsibility Accounting’, whereby management may introduce capital
rationing by authorizing a particular department to make investment only upto a
specified limit, beyond which the investment decisions are to be taken by higher-
ups.

The selection of project under capital rationing involves two steps:

(i) To identify the projects which can be accepted by using the technique of
evaluation discussed above.

(ii) To select the combination of projects.

In capital rationing it may also be more desirable to accept several small

investment proposals than a few large investment proposals so that there may be
full utilization of budgeting amount. This may result in accepting relatively less
profitable investment proposals if full utilization of budget is a primary
consideration. Similarly, capital rationing may also mean that the firm foregoes
the next most profitable investment following after the budget ceiling even
through it is estimated to yield a rate much higher than the required rate of return.
Thus capital rationing does not always lead to optimum results.

In other words:

1. Ranking of different investment proposals

2. Selection of the most profitable investment proposal

Ranking of different investment proposals:-

The various investment proposals should be ranked on the basis of their

profitability. Ranking is done on the basis of NPV, profitability index or IRR in the
descending order.

Example:

Profitability index as the basis of capital rationing:-

The following details are available:

Cash inflows

Project Initial cash outlay Year1 Year2 Year3

A 1,00,000 60,000 50,000 40,000

B 50,000 20,000 40,000 20,000

C 50,000 20,000 30,000 30,000

Cost of capital is 15%

PV cash flow for Project A with PV factor at 15% for 3 years is 1, 16,320/-

Initial cash out lay 100000/-

So, for project A; NPV is 16,320/- & Profitability index=PV of cash flow/PV of
cash outflows =1.1632

For Project B; NPV is 10,800/- & Profitability index =1.216

For Project C; NPV is 9820/- & profitability index=1.1964

So if the firm has sufficient funds & no capital rationing restriction, then all the
projects can be accepted for the + NPV

On the other hand on the basis of profitability index, project B & C can be
executed than project A.

The objective is to maximize the NPV per rupee of capital & projects should be
ranked on the basis of the profitability index. Funds should be allocated on the
basis ranks assigned by profitability index.
6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per
year for six years. A substitute equipment B would cost Rs.50,000 and
generate net cash flow of Rs.14,000 per year for six years. The required rate
of return of both equipments is 11 per cent. Calculate the IRR and NPV for
the equipments. Which equipment should be accepted and why?

Answer:

For equipment A average cash flow Rs. 20000/- per year

And the initial investment Rs. 75000/-

So the ratio of initial cash flow & initial investment=75000/20000

=3.75

From the PVIFA table for 6 years annuity factor vary near 3.75 is 16%

So PV of cash flow at 16% is 73600/-

For next trial rate 15% so PV of cash flow is 75706

So IRR of the for the equipment A is 16+ (75706-75000)/ (75706-73600)

=16.34%

For equipment B average cash flow Rs. 14000/- per year

And the initial investment Rs. 50000/-

So the ratio of initial cash flow & initial investment=50000/14000

=3.57

From the PVIFA table for 6 years annuity factor vary near 3.75 is 18%

So PV of cash flow at 18% is 49000/-

For next trial rate 17% so PV of cash flow is 50257/-

So IRR of the for the equipment A is 18+ (50257-50000)/ (50257-49000)

=18.2%
Now NPV of equipment A = PV of net cash flow – initial cost

= (20000/- of PVIF 11% for 6 y)-75000/-

=9610/-

& NPV for the equipment B= PV of net cash flow-initial cost

= (14000/- of PVIF 11% for 6 y)-50000/-

=9227/-

So B is preferable because of highest rate of Profitability index