Amity Campus

Uttar Pradesh
India 201303
ASSIGNMENTS
PROGRAM: MFC
SEMESTER-II

Subject Name: FINANCIAL MANAGEMENT

Study COUNTRY: SOMALIA
Roll Number (Reg. No.): MFC001512014-2016091
Student Name: MOHAMED ABDULLAHI KHALAF

INSTRUCTIONS

a) Students are required to submit all three assignment sets.

ASSIGNMENT DETAILS MARKS

Assignment A Five Subjective Questions 10
Assignment B Three Subjective Questions + Case Study 10
Assignment C Objective or one line Questions 10

b) Total weight-age given to these assignments is 30%. OR 30 Marks

c) All assignments are to be completed as typed in word/pdf.
d) All questions are required to be attempted.
e) All the three assignments are to be completed by due dates and need to be
submitted for evaluation by Amity University.
f) The students have to attach a scanned signature in the form.

Signature : _________________________

Date: 06, June, 2015

( ) Tick mark in front of the assignments submitted

Assignment A Assignment B Assignment C

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 FINANCIAL MANAGEMENT

Assignment A

Q: 1). What is stock split? What are its advantages?

Answer:

All publicly-traded companies have a set number of shares that are outstanding on the stock
market. A stock split is an action taken by companys board of directors to increase the
number of shares that are outstanding by issuing more shares to current shareholders and
giving each stockholder two new shares for each one formerly held.

A stock split is a proportionate increase in the number of outstanding shares that does not
affect the issuing companys assets, liabilities, or earnings. A stock split resembles a stock
dividend in that an increase occurs in the number of shares issued on a proportionate base,
whereas the assets, liabilities, equity and earnings remain the same.

A Company may split its stock because the price is too high for investors to buy it, and with
a lower price the companys stock becomes more marketable.

A stock split is a method to increase the number of outstanding shares by proportionately

reducing the face value of a share. A stock split affects only the par value and does not have
any effect on the total amount outstanding in share capital.

Although there is little empirical evidence to support the contention, there is nevertheless a
widespread belief in financial circles that an optimal price range exists for stocks. Optimal
means that if the price is within this range, the price/earnings ratio, hence the firms value
will be maximized. Many observers believe that the best range for most stocks is from $20 to
$80 per share. Accordingly, if the price of stock rose to $80, management would probably
declare a two-for-one stock split, thus doubling the number of shares outstanding, halving
the earnings and dividends per share, and thereby lowering the stock price. Each stockholder
would have more shares, but each share would be worth less.

Stock splits can be of any size, for example, the stock could be split two-for-one, three-for-
one, one-and-a-half-for-one, or in any other way.

Reverse splits is a stock split that reduces the number of outstanding shares, by giving each
stockholder less than the number of shares held. Reverse splits can be of any size, for

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example, the stock could be reversely split one-for-two, one-for-three, one-for-four, or in
any other way. For example, a company whose stock sells for $5 might employ a one-for-
five reverse split, exchanging one new share for five old ones and raising the value of the
shares to about $25, which is within the optimal price range.

Advantages of Stock Split:

The following are advantages and reasons for splitting shares are:

To make shares attractive: The prime reason for affecting a stock split is to reduce
the market price of a share to make it more attractive to investors. Shares of some
companies enter into higher trading zone making it out of reach to small investors.
Splitting the shares will place them in more popular trading range thus providing
marketability and motivating small investors to buy them.
Indication of higher future profits: Share split is generally considered a method of
management communication to investors that the company is expecting high profits
in future.
Higher dividend to shareholders: When shares are split, the company does not
resort to reducing the cash dividends. If the company follows a system of stable
dividend per share, the investors would surely get higher dividends with stock split.
Liquidity: Another reason, and arguably a more logical one, for splitting a stock is to
increase a stock's liquidity, which increases with the stock's number of outstanding
shares. When stocks get into the hundreds of dollars per share, very large bid or ask
spreads can result. A perfect example is Warren Buffetts Berkshire Hathaway, which
has never had a stock split. At times, Berkshire stock has traded at nearly $100,000
and its bid or ask spread can often be over $1,000. By splitting shares a lower bid or
ask spread is often achieved, thereby increasing liquidity.

Q: 2). Discuss the techniques of inventory control.

Answer:

Inventories are the most significant part of current assets of most of the firms in India. Since
they constitute an important element of total current assets held by a firm, the need to
manage inventories efficiently and effectively for ensuring optimal investment in inventory
cannot be ignored. Any lapse on the part of management of a firm in managing inventories
may cause the failure of the firm. The major objectives of inventory management are:

a) Maximum satisfaction to customer.

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 b) Minimum investment in inventory.
c) Achieving low cost plant operation.

These objectives conflict each other. Therefore, a scientific approach is required to arrive at
an optimal solution for earning maximum profit on investment in inventories.

Decisions on inventories involve many departments:

a) Raw material policies are decided by purchasing and production departments;

b) Production department plays an important role in work-in-process inventory policy.
c) Finished goods inventory policy is shaped by production and marketing departments.

But the decisions of these departments have financial implications. Therefore, as an

executive entrusted with the responsibility of managing finance of the company, the financial
manager of the firm has to ensure that monitoring and controlling inventories of the firm are
executed in a scientific manner for attaining the goal of wealth maximization of the firm.

Techniques of inventory control:

The various techniques or methods applied for inventory management and control are:
Economic Order Quantity (EOQ), ABC Analysis, Determination of stock levels, Re-Order
Point & Safety Stock, Just-in-time (JIT) and Material Requirement Plan (MRP).

1) ECONOMIC ORDER QUANTITY (EOQ)

The firm has to decide the inventory order quantity. If the order quantity is large, the firm
economizes on the ordering cost, as the number of the orders will be less during the year.
The ordering cost is the administrative cost associated with the placing of an order.

Economic Order Quantity (EOQ) refers to the optimal order size that will result in the
lowest ordering and carrying costs for an item of inventory based on its expected usage.

Economic Order Quantity (EOQ) is defined as the order quantity that minimizes the total
cost associated with inventory management.

EOQ model answers the following key quantum of inventory management:

a) What should be the quantity ordered for each replenishment of stock?

b) How many orders are to be placed in a year to ensure effective inventory
Management?

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For example, if the annual production level of a motorbike manufacturer is 100,000 units,
the tyres and tubes required will be 200,000. If the firm places an order for 50000 tyres and
tubes at one time, it has to place just four orders during the year. However, the inventory
carrying cost of 50,000 tyres and tubes will be very high. The inventory carrying cost
includes the insurance, rental of stores, spoilage, obsolescence, and interest on investment in
the inventories. Thus, the trade-off is between the ordering cost and the carrying cost.

It is based on the following assumptions:

Constant or uniform demand: The demand or usage is even throughout the period.
Known demand or usage: Demand or usage for a given period is known Le
deterministic.
Constant Unit price: Per unit price of material does not change and is constant
irrespective of the order size.
Constant Carrying Costs: The cost of carrying is a fixed percentage of the average
value of inventory.
Constant ordering cost: Cost per order is constant whatever the size of the order is.
Inventories can be replenished immediately as the stock level reaches exactly equal to
zero. Consequently there is no shortage of inventory.

Where,

A = annual demand
O = ordering cost per order
C = carrying cost per unit

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 2) ABC ANALYSIS:

The inventory of an industrial firm generally comprises of thousands of items of raw

materials, parts, supplies, work-in-process and finished goods, all of which are with diverse
prices, large lead time and procurement problems. It is not possible to exercise the same
degree of control over all these items. Items of high value require maximum attention while
items of low value do not require same degree of control. For purpose of inventory control,
the firm has to be selective in its approach to control its investment in various items of
inventory. Such an approach is known as selective inventory control, and ABC system (ABC
Analysis) belongs to selective inventory control.

Firms pay maximum attention to those inventory items whose value is the highest. They
classify inventories to identify which items should receive the most effort in controlling.
The ABC approach analysis and measures the significance of each item of inventories in
terms of its value and classifies it into three categories; namely: A, B and C.

A Items: are those of high value but small in number. These items require strict
control.
B Items: are those of moderate value and size which require reasonable attention of
the management.
C Items: are those of relatively small value items and require simple control.

Since this method concentrates attention on the basis of the relative importance of various
items of inventory it is also known as control by importance and exception (CIE) and
proportional value analysis (PVA). As the items are classified in order of their relative
importance in terms of value, it is also known as proportional value Analysis.

The following steps are involved in implementing the ABC analysis:

1) Classify the items of inventories, determining the expected use in units and the price
per unit for each item.
2) Determine the total value of each item by multiplying the expected units by its units
price
3) Rank the items in accordance with the total value, giving first rank to the item with
highest total value and so on.
4) Compute the ratios (percentage) of number of units of each item to total units of all
items and the ratio of total value of each item to total value of all items.
5) Combine items on the basis of their relative value to form three categories: A, B & C.

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Advantages of ABC analysis:

a) It ensures closer controls on costly elements in which firm's greater part of resources
are invested.
b) By maintaining stocks at optimum level it reduces the clerical costs of inventory
control.
c) Facilitates inventory control and control over usage of materials, leading to effective
cost control.

Limitations:

a) A never ending problem in inventory management is adequately handling thousands

of low value of c items. ABC analysis fails to answer this problem.
b) If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose
of ABC approach.

3) DETERMINATION OF STOCK LEVELS

Most of the industries are subject to seasonal fluctuations and sales during different months
of the year are usually different. If, however, production during every month is geared to
sales demand of the month, facilities have to be installed to cater to for the production
required to meet the maximum demand. During the slack season, a large portion of the
installed facilities will remain idle with consequent uneconomic production cost. To remove
this disadvantage, attempt has to be made to obtain a stabilized production programme
throughout the year. During the slack season, there will be accumulation of finished
products which will be gradually cleared as sales progressively increase. Depending upon
various factors of production, storing and cost, a normal capacity will be determined. To
meet the pressure of sales during the peak season, however, higher capacity may have to be
sued for temporary periods. Similarly, during the slack season, to avoid loss due to excessive
accumulation, capacity usage may have to be scaled down. Accordingly, there will be a
maximum capacity and minimum capacity, only consumption of raw material will
accordingly vary depending upon the capacity usage.

Again, the delivery period or lead time for procuring the materials may fluctuate.
Accordingly, there will be maximum and minimum delivery period and the average of these
two is taken as the normal delivery period.

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 a) Maximum Level:

Maximum level is that level above which stock of inventory should never rise. Maximum
level is fixed after taking in to account the following factors:

1) Requirement and availability of capital

2) Availability of storage space and cost of storing.
3) Keeping the quality of inventory intact
4) Price fluctuations
5) Risk of obsolescence, and
6) Restrictions, if any, imposed by the government.

Maximum Level = Ordering level - (MRC x MDP) + standard ordering quantity.

Where,

MRC = minimum rate of consumption

MDP = minimum lead time.

b) Minimum level:

Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL - (NRC x NL T)

Where,

OL = ordering level
NRC = Normal rate of consumption
NL T = Normal Lead Time.

c) Ordering level:

The Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X ML T

Where,
MRC = Maximum rate of consumption
ML T = Maximum lead time.

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 d) Average stock level

Average stock level can be computed in two ways

Average stock level indicates the average investment in that item of inventory. It is quite
relevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level:

1) It ensures the smooth productions of the finished goods by making available the raw
material of right quality in right quantity at the right time.
2) It optimizes the investment in inventories. In this process, management can avoid
both overstocking and shortage of each and every essential and vital item of
inventory.
3) It can help the management in identifying the dormant and slow moving items of
inventory. This brings about better co-ordination between materials management and
production management on the one hand and between stores manager and marketing
manager on the other.

4) RE-ORDER POINT & SAFETY STOCK:

"When to order" is another aspect of inventory management. This is answered by re - order

point. The re - order point is that inventory level at which an order should be placed to
replenish the inventory.

To arrive at the re - order point under certainty the two key required details are:

1) Lead time
2) Average usage

Lead time refers to the average time required to replenish the inventory after placing orders
for inventory

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Under certainty, Re-Order Point refers to that inventory level which will meet the
consumption needs during the lead time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately,
provision is made for handling the uncertainty in consumption due to changes in usage rate
and lead time. The firm maintains a safety stock to manage the stock - out arising out of this
uncertainty.

When safety stock is maintained, (When Variation is only in usage rate)

Or

Safety stock when the variation in both lead time and usage rate are to be incorporated.

5) JUST-IN-TIME (JIT) SYSTEM

As you must have guessed from the name, under this system materials arrive exactly at the
time they are needed for production.

The just-in-time (JIT) system is used to minimize inventory investment. The philosophy is
that materials should arrive at exactly the time they are needed for production. Ideally, the
firm would have only work-in-process inventory. Because its objective is to minimize
inventory investment, a JIT system uses no, or very little, safety stocks. Extensive
coordination must exist between the firm, its suppliers, and shipping companies to ensure
that material inputs arrive on time. Failure of materials to arrive on time results in a
shutdown of the production line until the materials arrive. Likewise, a JIT system requires
high-quality parts from suppliers. When quality problems arise, production must be stopped
until the problems are resolved.

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The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for
attaining efficiency by emphasizing quality in terms of both the materials used and their
timely delivery. When JIT is working properly, it forces process inefficiencies to surface and
be resolved. A JIT system requires cooperation among all parties involved in the process-
suppliers, shipping companies, and the firm's employees.

6) MATERIAL REQUIREMENTS PLANNING (MRP)

Material Requirements Planning (MRP) is a computer-based production planning and

inventory control system. MRP is concerned with both production scheduling and inventory
control. It is a material control system that attempts to keep adequate inventory levels to
assure that required materials are available when needed. MRP is applicable in situations of
multiple items with complex bills of materials. MRP is not useful for job shops or for
continuous processes that are tightly linked.

MRP is designed to answer three questions: what is needed? How much is needed?
And when is it needed?"

MRP was developed by engineer Joseph Orlicky as a response to the Toyota Production
System. The first MRP systems of inventory management evolved in the 1940s and 1950s.

The major objectives of an MRP system are simultaneously:

1) Ensure the availability of materials, components, and products for planned

production and for customer delivery,
2) Maintain the lowest possible level of inventory,
3) Plan manufacturing activities, delivery schedules, and purchasing activities.

MRP is especially suited to manufacturing settings where the demand of many of the
components and subassemblies depend on the demands of items that face external demands.
Demands for end items are independent. In contrast, demand for components used to
manufacture end items depend on the demands for the end items. The distinctions between
independent and dependent demands are important in classifying inventory items and in
developing systems to manage items within each demand classification. MRP systems were
developed to cope better with dependent demand items.

The three major inputs of an MRP system are the master production schedule, the product
structure records, and the inventory status records. Without these basic inputs the MRP
system cannot function.

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The demand for end items is scheduled over a number of time periods and recorded on a
master production schedule (MPS). The master production schedule expresses how much of
each item is wanted and when it is wanted. The MPS is developed from forecasts and firm
customer orders for end items, safety stock requirements, and internal orders. MRP takes the
master schedule for end items and translates it into individual time-phased component
requirements.

The product structure records, also known as bill of material records (BOM), contain
information on every item or assembly required to produce end items. Information on each
item, such as part number, description, quantity per assembly, next higher assembly, lead
times, and quantity per end item, must be available.

The inventory status records contain the status of all items in inventory, including on hand
inventory and scheduled receipts. These records must be kept up to date, with each receipt,
disbursement, or withdrawal documented to maintain record integrity.

MRP will determine from the master production schedule and the product structure records
the gross component requirements; the gross component requirements will be reduced by
the available inventory as indicated in the inventory status records.

Q: 3). Examine risk adjusted discount rate as a technique of incorporating

risk factor in capital budgeting.

Answer:

The Risk-Adjusted Discount Rate, or project cost of capital, is the rate used to evaluate a
particular project. It is based on the corporate Weighted Average Cost of Capital (WACC),
which is increased for projects that are riskier than the firms average project but decreased
for less risky projects.

The discount rate that applies to a particular risky stream of income; the riskier the projects
income stream, the higher the discount rate.

Risk-adjusted discount rate approach under which differential project risk is dealt with by
changing the discount rate; Average-risk projects are discounted at the firms average cost of
capital, higher-risk projects are discounted at a higher cost of capital, and lower-risk projects
are discounted at a rate below the firms average cost of capital. Unfortunately, there is no
good way of specifying exactly how much higher or lower these discount rates should be.

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Given the present state of the art, risk adjustments are necessarily judgmental and somewhat
arbitrary.

The basis of this approach is that there should be adequate reward in the form of return to
firms which decide to execute risky business projects. Man by nature is risk averse and tries
to avoid risk. To motivate firms to take up risky projects returns expected from the project
shall have to be adequate, keeping in view the expectations of the investors. Therefore risk
premium need to be incorporated in discount rate in the evaluation of risky project
proposals. Therefore the discount rate for appraisal of projects has two components. The
more uncertain the returns of the project the higher the risk greater the premium; Therefore,
risk adjusted Discount rate is a composite rate of risk free rate and risk premium of the
project.

Advantages:

1) It is simple and easy to understand.

2) Risk premium takes care of the risk element in future cash flows.
3) It satisfies the businessmen who are risk averse.

Limitations:

1) There are no objective bases of arriving at the risk premium. In this process the
premium rates computed become arbitrary.
2) The assumption that investors are risk averse may not be true in respect of certain
investors who are willing to take risks. To such investors, as the level of risk
increases, the discount rate would be reduced.
3) Cash flows are not adapted to incorporate the risk adjustment for net cash inflows.

Risk premium need to be incorporated in discount rate in the evaluation of risky project
proposals. Therefore the discount rate for appraisal of projects has two components.

Those components are: Risk-free rate and risk premium

Risk free rate is computed based on the return on government securities.

Risk premium is the additional return that investors require as compensation for assuming
the additional risk associated with the project.

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 Q: 4). Critically examine the payback period as a technique of approval of
projects.

Answer:

Payback Period Method: Payback period method is defined as the length of time required
to recover the initial cash out lay. It is also called a Pay-Out Period and Pay-Off Period.

It refers to the period with in which the entire cost of project is expected to be completely
recovered by way of cash inflows. Cash Inflow means earning after tax but before
depreciation.

Calculation of Payback Period:

Payback period can be calculated in the following two different situations:
a) In case of equal Annual Cash Inflows
b) In case of Unequal Annual Cash Inflows
In case of equal Annual Cash Inflows: if the project generates constant cash flow the
payback period can be computed by dividing cash outlays by annual cash inflows. The
following formula can be used to ascertain payback period:

In case of Unequal Annual Cash Inflows, in case of unequal annual cash inflows the
payback period is determined with the help of cumulative cash inflows. The cash flow for
each year may be different. In such case, it can be calculated by adding up the cash flows
until the total is equal to the initial investment.
Example:
The following details are available in respect of the cash flows of two projects A & B.
Year Project A Cash flows (Rs.) Project B Cash flows (Rs.)
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,000
5 1,50,000 2,00,000
Compute payback period for A and B.
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Solution:

Project A Project B
Year Cash Flows Cumulative Cash Cash Cumulative Cash
Rs flows Flows Rs flows
1 2,00,000 2,00,000 1,00,000 1,00,000
2 1,75,000 3,75,000 2,00,000 3,00,000
3 25,000 4,00,000 3,00,000 6,00,000
4 2,00,000 6,00,000 4,00,000 10,00,000
5 1,50,000 7,50,000 2,00,000 12,00,000

From the cumulative cash flows column project A recovers the initial cash outlay of
Rs.4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years.

From the cumulative cash flow column the initial cash outlay of Rs.5,00,000 lies between
2nd year and 3rd year in respect of project B. Therefore, payback period for project B is:

Accept/Reject Rule:
Accept the project if: Payback Period < Maximum Acceptable Payback Period.
Reject the project if: Payback Period > Maximum Acceptable Payback Period.
Consider the project if: Payback Period = Maximum Acceptable Payback Period.

Merits of Pay Back method

Simple to understand, Easy to calculate
Saves in Cost as lesser time and labor
Short term approach so Suitable for firms which has shortage of cash or liquidity
position is not good.
Suitable for developing countries.

Demerits of Pay Back Method

Ignores the Time Value of Money
Ignores the cash flows occurring after the payback period.
No objective way to determine the minimum or maximum acceptable payback
period.

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 No consideration to cost of capital
It treats each asset individually in isolation.
Does not necessarily maximize the wealth of the shareholders.

Q: 5). Examine the relationship of financial management with other

functional areas of finance

Answer:

Financial Management of a firm is concerned with procurement and effective utilization of

fund for the benefit of its stakeholders. All corporate decisions have financial implication.
Therefore, financial management embraces all those managerial activities that are required to
procure funds at the least cost and their effective deployment. Finance is the life blood of all
organizations. It occupies a pivotal role in corporate management. Any business which
ignores the role of finance in its functioning cannot grow competitively in today's complex
business world. Value maximization is the cardinal rule of efficient financial managers today.
Meaning and Definitions
The branch of knowledge that deals with the art and science of managing money is called
financial management. With liberalization and globalization, regulatory and economic
environments have undergone drastic changes. This has changed the profile of financial
managers.
Traditionally, financial management was considered a branch of knowledge with focus on
the procurement of funds. Instruments of financing, formation, merger & restructuring of
firms, legal and institutional frame work involved therein occupied the prime place in this
traditional approach.
The modern approach transformed the field of study from the traditional narrow approach
to the most analytical nature. The core of modern approach evolved around, is procurement
of the least cost funds and its effective utilization for maximization of share holders' wealth.
Globalization of business and impact of information technology on financial management
have added new dimensions to the scope of financial management.
Finance functions are closely related to financial decisions. The functions performed by a
finance manager are known as finance functions. In this course of performing these
functions finance manager takes the following decisions: Financing decision, Investment
decision, Dividend decision and Liquidity decision.
Financial decisions are strategic in character and therefore, an efficient organization structure
is required to administer the same. Finance is like blood that flows throughout the

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organization. In all organization CFOs play an important role in ensuring proper reporting
based on substance to the stake holders of the company. Because of the crucial role these
functions play, finance functions are organized directly under the control of Board of
Directors. For the survival of the firm, there is a need to ensure both long term and short
term financial solvency. Failure to achieve this will have its impact on all other activities of
the firm.
Week function performance by financial department will weaken production, marketing and
HR activities of the company. The result would be the organization becoming anemic. Once
anemic, unless crucial and effective remedial measures are taken up, it will pave way for
corporate bankruptcy.

Relationship of Financial Management with Other Functional Areas

The relationship between financial management and other functional areas can be defined as
follows:
Finance and Accounting
Looking at the hierarchy of the finance function of an organization; the controller reports to
CFO. Accounting is one of the functions that a controller discharges. Accounting and
finance are closely related. For computation of Return on Investment, earnings per share
and of various ratios for financial analysis the data base will be accounting information.
Finance and Marketing
Many marketing decisions have financial implication. Selections of channels of distribution,
deciding on advertisement policy, remunerating the salesmen etc have financial implications.
Finance and Production (Operations)
Finance and operation are closely related. Decisions on plant layout, technology selection,
productions / operations, process plant size, removing imbalance in the flow of input
material in the production / operation process and batch size are all operations management
decisions but their formulation and execution cannot be done unless evaluated from the
finance angle.
Finance and Human Resource
Attracting and retaining the best man power in the industry cannot be done unless they are
paid salary at competitive rates. If an organization formulates & implements a policy for
attracting the competent man power it has to pay the most competitive salary packages to
them. But it improves organizational capital and productivity.

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 Assignment B

Q: 1). What are the assumptions of MM (Modigliani Miller) approach?

Answer:

Modern capital structure theory also known as; Modigliani-Miller (MM) approach began
in 1958, when Professors Franco Modigliani and Merton Miller (hereafter MM) published
what has been called the most influential finance article ever written. MM proved, under a
very restrictive set of assumptions, that a firms value is unaffected by its capital structure.

Professors Franco Modigliani and Merton Miller (MM) stunned the finance community by
proofing that, under certain circumstances, the conclusion of the net operating income
approach was in fact correct: there is no optimal financing mix. Although MMs conclusions
were the same as those of the net operating income approach, the way they reached their
conclusions was very different.

Perfect market assumptions MM began their analysis by making some simplifying

assumptions, in particular, that the financial markets were uncomplicated and without any
imperfections. Specifically, MM assumed:

a) Unlimited borrowing and lending is available to both companies and investors at one
common interest rate. Individual borrowing to purchase stock is secured by the
shares purchased, and the borrowers liability is limited to the value of the shares.
Should a company default on its debt, its creditors would seize the remaining assets
and the company would suffer no further loss of value (there are no bankruptcy
costs).
b) Firms can be grouped into equivalent risk classes, groups of companies with the
same business risk.
c) Securities trade in perfect capital markets in which every participant is a price taker
too small to influence prices directly; no transactions costs (brokerage, flotation,
transfer taxes, etc.) exist; complete and free information is available to all traders; and
securities are infinitely divisible.
d) No taxes are paid on corporate income.
e) Shareholders are indifferent to receiving their returns in the form of dividends or
capital gains, and ordinary income and capital gains are taxed at the same rate.

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Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a
reasonable limit and Ko being constant at all degrees of leverage. They state that the
relationship between leverage and cost of capital is elucidated as in NOI approach.

The assumptions for their analysis are:

Perfect capital markets: Securities can be freely traded, that is, investors are free to
buy and sell securities (both shares and debt instruments), there are no hindrances on
the borrowings, no presence of transaction costs, securities infinitely divisible,
availability of all required information at all times.
Investors behave rationa1ly, that is, they choose that combination of risk and
return that is most advantageous to them.
Homogeneity of investors risk perception, that is, all investors have the same
perception of business risk and returns.
Taxes: There is no corporate or personal income tax.
Dividend pay-out is 100%, that is, the firms do not retain earnings for future
activities.

Basic propositions: The following three propositions can be derived based on the above
assumptions:
Proposition I: The market value of the firm is equal to the total market value of equity and
total market value of debt and is independent of the degree of leverage. It can be expressed
as:
Expected NOI
Expected overall capitalization rate
V + (S+D) which is equal to O/Ko which is equal to NOI/Ko
V + (S+D) = O/Ko = NOI/Ko

Where

V is the market value of the firm,

S is the market value of the firm's equity,
D is the market value of the debt,
O is the net operating income,
Ko is the capitalization rate of the risk class of the firm.
The basic argument for proposition I is that equilibrium is restored in the market by the
arbitrage mechanism. Arbitrage is the process of buying a security at lower price in one

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market and selling it in another market at a higher price bringing about equilibrium. This is a
balancing act. Miller and Modigliani perceive that the investors of a firm whose value is
higher will sell their shares and in return buy shares of the firm whose value is lower. They
will earn the same return at lower outlay and lower perceived risk. Such behaviours are
expected to increase the share prices whose shares are being purchased and lowering the
share prices of those share which are being sold. This switching operation will continue till
the market prices of identical firms become identical.
Proposition II: The expected yield on equity is equal to discount rate (capitalization rate)
applicable plus a premium.
Ke = Ko +[(Ko-Kd)D/S]
Proposition III: The average cost of capital is not affected by the financing decisions as
investment and financing decisions are independent.
Criticisms of MM Proposition
Risk perception: The assumption that risks are similar is wrong and the risk perceptions of
investors are personal and corporate leverage is different. The presence of limited liability of
firms in contrast to unlimited liability of individuals puts firms and investors on a different
footing. All investors lose if a levered firm becomes bankrupt but an investor loses not only
his shares in a company but would also be liable to repay the money he borrowed. Arbitrage
process is one way of reducing risks. It is more risky to create personal leverage and invest in
unlevered firm than investing in levered firms.
Convenience: Investors find personal leverage inconvenient. This is so because it is the
firm's responsibility to observe corporate formalities and procedures whereas it is the
investor's responsibility to take care of personal leverage. Investors prefer the former rather
than taking on the responsibility and thus the perfect substitutability is subject to question.
Transaction costs: Another cost that interferes in the system of balancing with arbitrage
process is the presence of transaction costs. Due to the presence of such costs in buying and
selling securities, it is necessary to invest a higher amount to earn the same amount of return.
Taxes: When personal taxes are considered along with corporate taxes, the Miller and
Modigliani approach fails to explain the financing decision and firm's value.
Agency costs: A firm requiring loan approach creditors and creditors may sometimes
impose protective covenants to protect their positions. Such restriction may be in the nature
of obtaining prior approval of creditors for further loans, appointment of key persons,
restriction on dividend pay-outs, limiting further issue of capital, limiting new investments or
expansion schemes etc.

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 Q: 2). Summaries the features of DCF (Discounted cash flow) technique.

Answer:

Discounted cash flow method (DCF) or time adjusted technique is an improvement over
the traditional techniques. In evaluation of the projects the need to give weightage to the
timing of return is effectively considered in all DCF methods. DCF methods are cash flow
based and take the cognizance of both the interest factors and cash flow after the payback
period.

DCF technique involves the following:

1) Estimation of cash flows, both inflows and outflows of a project over the entire life
of the project.
2) Discounting the cash flows by an appropriate interest factor (discount factor).
3) Sum of the present value of cash outflow is deducted from the sum of present value
of cash inflows to arrive at net present value of cash flows.

The most popular techniques of DCF methods are: The net present value, the internal rate
of return, Modified internal rate of return and Profitability index.

THE NET PRESENT VALUE:

NPV method recognizes the time value of money. It correctly admits that cash flows
occurring at different time periods differ in value. Therefore, there is the need to find out the
present values of all cash flows.

NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method:

a) Forecast the cash flows, both inflows and outflows of the projects to be taken up for
execution.
b) Decisions on discount factor or interest factor. The appropriate discount rate is the
firm's cost of capital or required rate of return expected by the investors.
c) Compute the present value of cash inflows and outflows using the discount factor
selected.
d) NPV is calculated by subtracting the PV of cash outflows from the present value of
cash inflows.

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Accept or reject criterion:

If NPV is positive, the project should be accepted. If NPV is negative the project should be
rejected. Accept or reject criterion can be summarized as given below:

a) NPV > Zero = accept

b) NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining
whether incremental investment generates a positive net present value.

Merits of NPV method:

a) It takes into account the time value of money.

b) It considers cash flows occurring over the entire life of the project.
c) NPV method is consistent with the goal of maximizing the net wealth of the
company.
d) It analyses the merits of relative capital investments.
e) Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project
generates profits from the investment made for it.

Demerits of NPV method:

a) Forecasting of cash flows is difficult as it involves dealing with effect of elements of

uncertainties on operating activities of firm.
b) To decide on the discounting factor, there is the need to assess the investor's required
rate of return. But it is not possible to compute the discount rate precisely.
c) There are partial problems associated with the evaluation of projects with unequal
lives or under funds' constraints.

For ranking of projects under NPV approach the project with the highest positive NPV is
preferred to that with lower NPV.

Properties of the NPV

a) NPV are additive. If two projects A and B have NPV (A) and NPV(B) then by
additive rule the net present value of the combined investment is NPV(A + B).
b) Intermediate cash inflows are reinvested at a rate of return equal to the cost of
capital.

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Demerits of NPV:

a) NPV expresses the absolute positive or negative present value of net cash flows.
Therefore, it fails to capture the scale of investment.
b) In the application of NPV rule in the evaluation of mutually exclusive projects with
different lives, bias occurs in favour of the long term projects.

INTERNAL RATE OF RETURN

Internal Rate of Return: It is the rate of return (i.e. discount rate) which makes the NPV of
any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows
with the PV of cash flows.

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity
of capital, rate of return, time adjusted rate of return, IRR is the rate of return that project
earns.
Evaluation of IRR:
a) IRR takes into account the time value of money
b) IRR calculates the rate of return of the project, taking into account the cash flows
over the entire life of the project.
c) It gives a rate of return that reflects the profitability of the project.
d) It is consistent with the goal of financial management i.e. maximization of net wealth
of share holders.
e) IRR can be compared with the firm's cost of capital.
f) To calculate the NPV the discount rate normally used is cost of capital. But to
calculate IRR, there is no need to calculate and employ the cost of capital for
discounting because the project is evaluated at the rate of return generated by the
project. The rate of return is internal to the project.
Demerits:
a) IRR does not satisfy the additive principle.
b) Multiple rates of return or absence of a unique rate of return in certain projects will
affect the utility of these techniques as a tool of decision making in project evaluation.
c) In project evaluation, the projects with the highest IRR are given preference to the
ones with low internal rates. Application of this criterion to mutually exclusive
projects may lead under certain situations to acceptance of projects of low
profitability at the cost of high profitability projects.
d) IRR computation is quite tedious.

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Accept or Reject Criterion:

If the project's internal rate of return is greater than the firm's cost of capital, accept the
proposal. Otherwise reject the proposal.

IRR can be determined by solving the following equation for r =

Where, t = 1 to n

MODIFIED INTERNAL RATE OF RETURN:

MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more appealing
than the rupees of NPV because IRR is expressed on a percentage rate of return. MIRR
modifies IRR. MIRR is a better indicator or relative profitability of the projects.

MIRR is defined as: PV of Costs = PV of terminal value

PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital.

To calculate the terminal value, the future value factor is based on the cost of capital.

Then obtain MIRR on solving the following equation.

Superiority of MIRR over IRR

a) MIRR assumes that cash flows from the project are reinvested at the cost of capital.
The IRR assumes that the cash flows from the project are reinvested at the projects
own IRR. Since reinvestment at the cost of capital is considered realistic and correct,
the MIRR measures the projects true profitability.
b) MIRR does not have the problem of multiple rates which we come across in IRR.
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PROFITABILITY INDEX

Profitability Index also known as Benefit cost ratio is the ratio of the present value of cash
inflows to initial cash outlay. The discount factor based on the required rate of return in used
to discount the cash inflows.

Accept or Reject Criterion:

a) Accept the project if PI is greater than 1
b) Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of
the present value of cash inflows is equal to the sum of present value of cash outflows. It
neither adds nor reduces the existing wealth of the company.

Merits of Profitability Index:

a) It takes into account the time value of money
b) It is consistent with the principle of maximization of shareholders wealth.
c) It measures the relative profitability.

Demerits of Profitability Index:

a) Estimation of cash flows and discount rate cannot be done accurately with certainty.
b) A conflict may arise between NPV and profitability index if a choice between
mutually exclusive projects has to be made.

Q: 3). Examine the type and sources of risk in capital budgeting.

Answer:

Risk is the possibility that the result of some activity will not be exactly as (and particularly,
will be worse than) forecast. It is the chance that something will come out worse than
planned. If we cross the street, our plan is to get to the other side safely. The risk is the
chance that we might be injured in the process. The same concept is true in finance. For
example, if we invest in the common stock of a company, we anticipate a fair rate of return
on our investment. The risk is that we may earn less than anticipated.

Risks in a project are many. Although it is intuitively clear that riskier projects should be
assigned a higher cost of capital, it is often difficult to estimate project risk. First, note that
three separate and distinct types of risk can be identified:

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 a) Standalone risk:

Standalone risk is the risk an asset would have if it were a firms only asset and if investors
owned only one stock. It is measured by the variability of expected returns of the project.

Stand-alone risk, which is the projects risk disregarding the facts (a) that it is but one asset
within the firms portfolio of assets and (b) that the firm is but one stock in a typical
investors portfolio of stocks.

b) Portfolio risk:

Portfolio Risk is also called Corporate Risk and Within-Firm Risk. It is the risk of not
considering the effects of stockholders diversification.

A firm can be viewed as portfolio of project having a certain degree of risk. When new
project is added to the existing portfolio of project, the risk profile of firm will alter. The
degree of the change in the risk depends on the covariance of return from the new project
and the return from the existing portfolio of the projects. If the return from the new project
is negatively correlated with the return from portfolio, the risk of the firm will be further
diversified away.

Corporate, or within-firm risk which is the projects risk to the corporation, giving
consideration to the fact that the project represents only one of the firms portfolio of assets,
hence that some of its risk effects on the firms profits will be diversified away. Corporate
risk is measured by the projects impact on uncertainty about the firms future earnings.

c) Market or Beta Risk:

Market or Beta Risk is that part of a projects risk that cannot be eliminated by
diversification. This is the riskiness of the project as seen by a well-diversified stockholder
who recognizes that the project is only one of the firms assets and that the firms stock is
but one small part of the investors total portfolio. It is measured by the effect of the project
on the beta of the firm. The market risk for a project is difficult to estimate.

Stand alone risk is the risk of project when the project is considered in isolation. Corporate
risk is the projects risks of the firm. Market risk is systematic risk. The market risk is the
most important risk because of the direct influence it has on stock prices.

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Sources of risk:

The sources of risks are:

1) ProjectSpecific Risk: The source of this risk could be traced to something quite
specific to the project. Managerial deficiencies or error in estimation of cash flows or
discount rate may lead to a situation of actual cash flows realized being less than that
projected.

2) Competitive Risk or Competition Risk: unanticipated actions of a firms

competitors will materially affect the cash flows expected from a project. Because of
this the actual cash flows a project will be less than that of the forecast.

3) IndustrySpecific Risks: are those that affect all the firms in industry. It could be
again grouped into technological risk, commodity risk and legal risk.

4) International Risk: These types of risks are faced by firms whose business consists
mainly of exports or those who procure their main raw material from international
markets. For example, rupee dollar crisis affected the software and BPOs because it
drastically reduced their profitability. The changes in international political scenario
also affect the operations of certain firms.

5) Market Risk: Factors like inflation, changes in interest rates, and changing general
economic conditions affect all firms and all industries. Firms cannot diversify this risk
in the normal course of business.

6) Environmental Risks: Are the unexpected changes outside the firm that impact its
operations. The source of environmental risk, which comes from events outside the
firm. This includes changes in the business and economic climate, actions of
competitors, technological advances, revaluation of currency prices, political
limitations such as restrictions on transferring currency or other resources from one
country to another, etc. While the firm typically cannot influence these forces, it can
prepare for them so that if they occur, plans are in place to minimize their negative
impact. In addition, good strategic planning often finds ways to position the firm to
take advantage of these events.

7) Process Risk: is the unnecessary variability caused by systems within the firm that
are out of control. The source of process risk includes problems due to out-of-
control production operations as well as complications caused by dissatisfied
customers, employees, and suppliers. If the firms internal processes are functioning

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 well, the only variability is the small amount of natural variation found in all
processes. By contrast, poorly functioning processes vary greatly in their output and
tend to magnify any problems due to changes in the environment.

8) Business Risk: is the total variability of a firms operating results. Taken together,
the combination of environmental risk and process risk is known as business risk in
that it describes the variability of the operating results of the business. In financial
terms, business risk is variability in the firms operating profit stream.

9) Financial Risk: is the increased variability in a firms financial results caused by its
financing mix. The source of financial risk comes from the financing mix the firm
chooses. A firm that finances with debt adds the magnification of leverage to its
profit and cash flow. For creditors, financial risk is the risk of default on the debt. For
stockholders, leverage magnifies any variability in the firms operating profit and cash
flow.

Q: 4).

a) Deepak steel has issued non convertible debentures for Rs.5 Cr. Each
debenture is of par value of Rs.100, carrying a coupon rate of 14%, interest is
payable annually and they are redeemable after 7yrs at a premium of 5 %. The
company issued the Non convertible debentures at a discount of 3 %.

What is the cost of debenture to the company? Tax rate is 40%.

Answer:

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 b) Supersonic Industries Ltd. has entered into an agreement with Indian
Overseas bank for a loan of Rs.10Cr. with an interest rate of 10%.

What is the cost of loan if the tax rate is 45%?

Answer:

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 Assignment 3 (40 MCQs)

Q: 1). We all live under conditions of ____________ and _______________.

a) Risk, return
b) Risk, uncertainty ()
c) Return, premium
d) Uncertainty, premium

Q: 2). Find the present value of Rs.1,00,000 receivable after 10 yrs. if 10% is
time preference for money.

a) 38400
b) 38500
c) 38600 ()
d) 38700

Q: 3). What is the future value of a regular annuity of Re.1 earning a rate of
12% interest p.a. for 5 Years?

a) 5.353
b) 6.353 ()
c) 7.353
d) 7.153

Q: 4). If a borrower promises to pay Rs.20000 eight years from now in return
for a loan of Rs.12550 today, what is the annual interest being offered?

a) 6% approx ()
b) 7% approx
c) 8% approx
d) 9% approx

Q: 5). A loan of Rs.5,00,000 is to be repaid in 10 equal installments. If the loan

carries 12% interest p.a.. What is the value of one installment?
a) 68492
b) 78492
c) 88492 ()
d) 98492

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Q: 6). If you deposit Rs.10,000 today in a bank that offers 8% interest, in how
many years will this amount double by 72 rule?

a) 9 ()
b) 8
c) 7
d) 6

Q: 7). An employee of a bank deposits Rs.30,000 into his FD A/c at the end of
each year for 20 yrs. What is the amount he will accumulate in his FD at the
end of 20 years, if the rate of interest is 9%.

a) 1534800 ()
b) 1535000
c) 1535200
d) 1535400

Q: 8). ____________ decisions could be grouped into two categories.

a) Make or buy
b) Capital budgeting ()
c) Fixed capital
d) Working capital

Q: 9). _____________ and revenue generation are the two important

categories of capital budgeting.

a) Cost reduction ()
b) Production
c) Investment
d) dividend

Q: 10). _________ appraisal examines the project from the social point of view.

a) Financial
b) Cost
c) Economic ()
d) Technical

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Q: 11). All technical aspects of the implementation of the project are
considered in _____________ appraisal.
a) Financial
b) Cost
c) Economic
d) Technical ()

Q: 12). __________ of a project is examined by financial appraisal.

a) Financial viability ()
b) Cost viability
c) Economic viability
d) Technical viability

Q: 13). Among the elements that are to be examined under commercial

appraisal, the most crucial one is the __________.
a) Supply of the product
b) Demand for the product ()
c) Cost of the product
d) Elements of cost

Q: 14). Formulating is the third step in the evaluation of investment proposal.

a) No
b) Yes ()

Q: 15). A __________ is not a relevant cost for the project decision.

a) Sunk cost ()
b) Direct cost
c) Indirect cost
d) Works cost

Q: 16). Effect of a project on the working of other parts of a firm is known as

__________.

a) Separation principal
b) Formulation
c) Externalities ()
d) After effects

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Q: 17). The essence of separation principal is the necessity to treat __________
elements of a project separately from that of ___________ elements.

a) Production, operations
b) Financing, production
c) Investment, financing ()
d) Investment, production

Q: 18). Payback period ______________ time value of money.

a) Ignores ()
b) Considers
c) None of the above

Q: 19). IRR gives a rate of return that reflects the _____________ of the project.

a) Cost
b) Profitability ()
c) Cash inflows
d) Cash outflows

Q: 20). The methods of appraising an investment proposal can be grouped into

__________ methods and ___________ methods.

a) Traditional, modern ()
b) Primary, secondary
c) First, second
d) old, new

Q: 21). The time gap between acquisition of resources from suppliers and
collection of cash from customers is known as ________.

a) Financial year
b) Calendar year
c) Operating cycle ()
d) Current cycle

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Q: 22). __________ is the average length of time required to produce and sell
the product.

a) Inventory period
b) Stock cycle
c) Inventory conversion period ()
d) None of the above

Q: 23). __________ is the average length of time required to convert the firms
receivables into cash.

a) Receivables period
b) Receivables cycle
c) Receivables conversion period ()
d) None of the above

Q: 24). ______________ is length of time between firms actual cash

expenditure and its own receipt.

a) Cash conversion period

b) Cash cycle ()
c) Cash period
d) Cash and bank cycle

Q: 25). Capital intensive industries require _______ amount of working capital.

a) Lower
b) Medium
c) Higher
d) None of the above ()

Q: 26). There is a ______________ between volume of sales and the size of

working capital of a firm.

a) Positive direct correlation ()

b) Negative direct correlation
c) Negative indirect correlation
d) Positive indirect correlation

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Q: 27). Under inflating conditions same level of inventory will require
____________ investment in working capital.

a) Decreased
b) Increased ()
c) Same
d) zero

Q: 28). Longer the manufacturing cycle ____ the investment in working capital.
a) Larger ()
b) smaller

Q: 29). ____________ is used to estimate working capital requirement of a firm.

a) Trend analysis
b) Risk analysis
c) Capital rationing
d) Operating cycle ()

Q: 30). Operating cycle approach is based on the assumption that production

and sales occur on ____________.
a) Continuous basis ()
b) Alternate basis
c) Alternate & Continuous basis
d) None of the above

Q: 31). ____________ is considered to be superior to RADR.

a) IRR
b) NPV
c) CE ()
d) PI

Q: 32). ____________ analyse the changes in the project NPV on account of a

given change in one of the input variables of the project.
a) Sensitivity analysis ()
b) Profitability Index
c) Project evaluation
d) Risk analysis

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Q: 33). Examining and defining the mathematical relation between the variable
of the NPV is one of the steps of _____________.

a) Sensitivity analysis ()
b) Profitability Index
c) Project evaluation
d) Risk analysis

Q: 34). Forecasts under Sensitivity analysis are made under different ________.

a) Political conditions
b) Economic conditions ()
c) Industry conditions
d) Regional conditions

Q: 35). Receiving a required inventory item at the exact time needed.

a) ABC
b) JIT ()
c) FOB
d) PERT

Q: 36). Post completion audit is ____________ in the phases of capital

budgeting decisions.

a) First Step
b) Last step ()
c) Middle step
d) None of the above

Q: 37). Why is a discount rate used to calculate net present value?

a) Money has value

b) Money has enhancing value
c) Money has diminishing value ()
d) Money has constant value

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Q: 38). What does net present value give?

a) future values of present cash flows

b) present value of present cash flow
c) present value of future cash flows ()
d) future values of future cash flows

Q: 39). Of what is sinking fund an example of?

a) Perpetuity
b) Annuity ()
c) Gratuity
d) None of the above

Q: 40). What stream of cash flows continues indefinitely?

a) Perpetuity ()
b) Annuity
c) Futurity
d) None of the above

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