FINANCIAL MANAGEMENT ANSWERS:

Q1. What is the difference between NPV and IRR?

Ans: The basic differences between NPV and IRR are presented below:

1. The aggregate of all present value of the cash flows of an asset, immaterial of
positive or negative is known as Net Present Value. Internal Rate of Return is
the discount rate at which NPV = 0.
2. The calculation of NPV is made in absolute terms as compared to IRR which is
computed in percentage terms.
3. The purpose of calculation of NPV is to determine the surplus from the project,
whereas IRR represents the state of no profit no loss.
4. Decision making is easy in NPV but not in the IRR. An example can explain this,
In the case of positive NPV, the project is recommended. However, IRR = 15%,
Cost of Capital < 15%, the project can be accepted, but if the Cost of Capital is
equal to 19%, which is higher than 15%, the project will be subject to rejection.
5. Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR
such an investment is made at the rate of IRR.
6. When the timing of cash flows differs, the IRR will be negative, or it will show
multiple IRR which will cause confusion. This is not in the case of NPV.
7. When the amount of initial investment is high, the NPV will always show large
cash inflows while IRR will represent the profitability of the project irrespective
of the initial invest. So, the IRR will show better results.
Q2. How do we compare the cash flow streams?

Ans:

Q3. What is annuity and growing annuity?

Ans: It is a fixed amount (payment or receipt) each year for a specified number of years. The equal –
installment loans from the house financing companies or employers are common examples of
annuities.

A growing annuity refers to a series of regular payments that increase in amount with each payment.
For example, you may start a business that you expect to generate incomes that grow until you sell it.
You may also buy an investment vehicle that pays you regularly after you make an initial investment.

Q4. What is the difference between present value and future value?
Ans: • Present value is the current value of future cash flow. Future value is the value of
future cash flow after a specific future period.

• Present value is the value of an asset (investment) at the beginning of the period. Future
value is the value of an asset (investment) at the end of the period that is being considered.

• Present value is the discounted value of future sums of money (Inflation is taken into
consideration). Future value is the nominal value of future sums of money (Inflation is not
taken into account).

• Present value involves both discount rate and interest rate. Future value involves interest
rate only.

• Present value is more important for investors to decide upon whether to accept or reject a
proposal. Future value shows only the future gains of an investment, so the importance for
investment decision making is less.

Q5. Why we use NPV in terms of investment valuation?

Ans: NPV of a financial decision is the difference between the PV of cash inflows and the PV of cash
outflows.

Net present value analysis eliminates the time element in comparing

alternative investments. The NPV method usually provides better
decisions than other methods when making capital investments.
Consequently, it is the more popular evaluation method of capital
budgeting projects.There are two reasons for that. One, NPV considers the time value of
money, translating future cash flows into today’s worth. Two, it provides a concrete number that
managers can use to easily compare an initial outlay of cash against the present value of the return.

When choosing between competing investments using the net present

value calculation you should select the one with the highest present value.

If:

NPV > 0, accept the investment.

NPV < 0, reject the investment.
NPV = 0, the investment is marginal
Q6. What are the problems with the payback period?

Ans: Problems are as follows:

 It does not take into account, the cash flows that occur after the payback period.
 Payback period does not take into account the time value of money .
 It does not consider all cash inflows yielded by the project.
 It fails to consider the pattern of cash inflows, i.e., magnitude and timinf of cash inflows.
 It is not consistent with the objective of maximizing the market value of the firms shares.

Q7. What are the problems with IRR approach?

Ans: The first disadvantage of IRR method is that IRR, as an investment decision tool, should
not be used to rate mutually exclusive projects, but only to decide whether a single project is
worth investing in.
 IRR overstates the annual equivalent rate of return for a project whose interim cash
flows are reinvested at a rate lower than the calculated IRR.
 IRR does not consider cost of capital; it should not be used to compare projects of
different duration.
 In the case of positive cash flows followed by negative ones and then by positive ones,
the IRR may have multiple values.
Q8. What is profitability index? Define with the help of formula and what are the applications of PI?

Ans: Defined as a tool for measuring profitability of a proposed corporate

project by comparing the cash flows created by the project to the capital
investments required for the project. Profitability index is also called cost-
benefit ratio, benefit-cost ratio, or capital rationing.

Acceptance:
PI> 1 ACCEPT
PI<1 REJECT
PI=1 MAY ACCEPT
Q9. What is the difference between CML and SML?

Ans: 1. The CML is a line that is used to show the rates of return, which
depends on risk-free rates of return and levels of risk for a specific portfolio.
SML, which is also called a Characteristic Line, is a graphical representation
of the market’s risk and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient

determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient portfolios, the
Security Market Line graphs define both efficient and non-efficient
portfolios.

4. The Capital Market Line is considered to be superior when measuring the

risk factors.

5. Where the market portfolio and risk free assets are determined by the
CML, all security factors are determined by the SML.
Q10. What is systematic and non-systematic risk?

Ans:
  SYSTEMATIC RISK ALSO KNOWN AS UNDIVERSIFIABLE RISK AND MARKET RISK.
 UNSYSTEMATIC RISK ALSO KNOWN AS DIVERSIFIABLE RISK AND RESIDUAL RISK.
Q11. What is an optimum portfolio?

Ans: An efficient
portfolio most preferred by an investor because its risk/reward characteristics approximate theinvestor's utility
function. A portfolio that maximizes an investor's preferences with respect to return and risk.

Q12. How would you define risk, when investors hold market portfolio?

Q13. What is the relation between risk and expected returns?

Ans: The risk-return tradeoff is the principle that potential return rises with an increase in risk. Low
levels of uncertainty or risk are associated with low potential returns, whereas high levels of
uncertainty or risk are associated with high potential returns. According to the risk-return tradeoff,
invested money can render higher profits only if the investor is willing to accept the possibility of
losses.

Q14. How do you define working capital and what are its major determinants?

Ans:

The capital of a business which is used in its day-to-day trading operations, calculated as the current
assets minus the current liabilities.

Q15. What is the cost of capital? Cost of capital is divided into how many financial assets?

Ans: The project cost of capital is the minimum required rate of return on funds committed to the
project, which depends on the riskiness of its cash flows.

The firms cost of capital will be the overall, or average, required rate of return on the aggregate of
investment projects.

Various types of cost of capital are described below:

i. Explicit Cost of Capital:
Explicit cost of any source may be defined as the discount rate that
equates the present value of the funds received by a firm with the present
value of expected cash outflows.
ii. Implicit Cost of Capital:
The implicit cost may be defined as the rate of return associated with the
best investment opportunity for the firm and its shareholders that will be
foregone if the project under consideration by the firm is accepted.

iii. Specific Cost of Capital:

The cost of each component of capital is known as specific cost of capital.

iv. Weighted Average Cost of Capital:

The weighted average cost of capital is the combined cost of each
component of funds employed by the firm. The weights are the proportion
of the value of each component of capital in the total capital.

v. Marginal Cost of Capital:

Marginal cost is defined as the cost of raising one extra rupee of capital. It
is also called the incremental or differential cost of capital. It refers to the
change in overall cost of capital resulting from the raising of one more
rupee of fund.

Q16. How do you estimate the cost of equity capital?

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with
equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to
make a given investment

Ans: The cost of equity is the return a company requires to decide if an investment meets
capital return requirements; it is often used as a capital budgeting threshold for required rate
of return. A firm's cost of equity represents the compensation the market demands in
exchange for owning the asset and bearing the risk of ownership. The traditional formulas for
cost of equity (COE) are the dividend capitalization model and the capital asset pricing model.

CAPM Formula
The CAPM formula is: Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of
Return - Risk-Free Rate of Return).

Q17. How do you estimate the cost of debt?

Ans: Cost of debt refers to the effective rate a company pays on its current debt. In most
cases, this phrase refers to after-tax cost of debt, but it also refers to a company's cost of debt
before taking taxes into account. The difference in cost of debt before and after taxes lies in
the fact that interest expenses are deductible.

To calculate its cost of debt, a company needs to figure out the total amount of interest it is
paying on each of its debts for the year. Then, it divides this number by the total of all of its
debt. The quotient is its cost of debt.

For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan
with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first
two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to
$140,000. The total interest for the year is $202,000. As the total debt is $3.2 million, the
company's cost of debt is 6.31%.

To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and
multiply the difference by its cost of debt. Do not use the company's marginal tax rate;
rather, add together the company's state and federal tax rate to ascertain its effective tax
rate.
For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of
debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5%
is 3%. The after-tax cost of debt is 3%.

The rationale behind this calculation is based on the tax savings the company receives from
claiming its interest as a business expense. To continue with the above example, imagine the
company has issued $100,000 in bonds at a 5% rate. Its annual interest payments are $5,000.
It claims this amount as an expense, and this lowers the company's income on paper by
$5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes by writing off its interest.
As a result, the company only pays $3,000 on its debt. This equates to a 3% interest rate on its
debt.

Q18. How do we evaluate cost of capital of firm employing weighted average cost of capital method?
REFER PAGE – 198-199 FROM IM PANDEY.(THE ABOVE PICTURES ARE OF THE CLASS NOTES.)

Q19. What do you mean by asset pricing?

Ans:
The amount one pays for an asset when buying it. The price represents the amount of value the market has assig
ned,fairly or unfairly, to an asset.

Q20. Explain capital asset pricing model(in detail)?

Ans: The Capital Asset Pricing Model (CAPM) is a model that describes the
relationship between expected return and risk of a security. It shows that the
return on a security is equal to the risk-free return plus a risk premium, which is
based on the beta of that security.
Expected return
The expected return is a long-term assumption about how an
investment will play out over its entire life.
Risk-free rate
The “Rff” notation is for the risk-free rate, which represents the time value
of money is typically equal to the yield on a 10-year government bond.
Beta
The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk
(volatility of returns), which is the fluctuation of its price changes relative to the
market.
Market risk premium
The market risk premium is the excess return expected to compensate an investor
for the additional volatility of returns they will experience over and above the risk-
free rate.

Q21. What is the difference average stock return and risk-free return?

Ans: Average returns are the simple mathematical average of a series of returns generated over a
period of time. An average return is calculated the same way a simple average is calculated for any set
of numbers; the numbers are added together into a single sum, and then the sum is divided by the
count of the numbers in the set.

Risk-free return is the theoretical rate of return attributed to an investment with zero risk. The risk-
free rate represents the interest on an investor's money that he or she would expect from an
absolutely risk-free investment over a specified period of time.

Q22. What do you mean by diversification principle?

Ans:
A principle of investing stating that a portfolio containing many different assets and kinds of assets carries lower
risk than a portfolio with only a few. The principle of diversification states that unsystemic
risk may be alleviatedthrough diversification, but systemic risk is more difficult to reduce.

Q23. What does beta indicate?

Ans: Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a
beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.

Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate the cost
of equity.

Q24. What types of different estimation methods do we have to measure beta of firm?

Ans: Direct method – Refer page – 117 IM PANDEY

The Market Model – Refer page – 117 IM PANDEY

Q25. What is the agency problem?

Ans: The agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, the agency problem usually refers to
a conflict of interest between a company's management and the company's stockholders.

Q26. How do you define shareholders wealth maximization?

Ans: It simply means maximization of shareholder’s wealth. It is a combination of two words viz. wealth
and maximization. A wealth of a shareholder maximizes when the net worth of a company maximizes.
Q27. What is the importance of cash flows for firm?

Ans:
1) preventing and monitoring company debt
2) preventing unnecessary expenditures from interest, late
payment penalties and debt costs
3) ensuring timely investment and cash available for
investment opportunities
4) ensuring timely payment of expenses and debts
5) and most importantly – ensuring a level of regular
business income without relying on outside investment or
cash borrowing.
Q28. What is the difference between nominal and real returns?
Ans: nominal returns are not adjusted for inflation.

Real returns are adjusted for inflation.

A real rate of return is the annual percentage return realized on an investment, which is adjusted for
changes in prices due to inflation or other external effects.

A nominal rate of return is the amount of money generated by an investment before factoring in
expenses such as taxes, investment fees and inflation.