Q1. Why wealth maximization is superior to profit maximization in today’s context?

Justify you answer?

Superiority of Wealth Maximization over Profit Maximization:

1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it takes care of the quality of cash flows. Distant uncertain
cash flows into comparable values at base period facilitates better comparison of projects. There
are various ways of dealing with risk associate with cash flows. These risk are adequately
considered when present values of cash of any project.

3. In today's competitive business scenario corporate plays a key role. In company form of
organization, shareholders own the company but the management of the company rests with the
board of directors. Directors are elected by shareholders and hence agents of the shareholders.
Company management procures funds for expansion and diversification from Capital Markets.
In the liberalized set up-, the society expects corporate to tap the capital market effectively for
their capital requirements. Therefore to keep the investors happy through the performance of
value of shares in the market, management of the company must meet the wealth maximization
criterion.

4. When a firm follows wealth maximization goal, it achieve maximization of market value of
share. When a firm pact wealth maximization goal, it is possible only when procedures quality
goods at low cost. On this account society gains became of the society welfare.

5. Maximization of wealth demands on the part of corporate to develop new products or render
new services in the most effective and efficient manner. This helps the consumers all it will bring
to the market the products and services that consumer’s need.

6. Another notable features of the firms committed to the maximization of wealth is that to
achieve this goal they are forced to render efficient service to their customer s with courtesy.
This enhance consumer and hence the benefit to the society.

7. From the point of evaluation of performance of listed firms, the most remarkable measure is
that of performance of the company in the share market. Every corporate action finds its
reflection on the market value of shares of the company. Therefore, shareholders wealth
maximization could be considered a superior goal compared to profit maximization.

8. Since listing ensures liquidity to the shares held by the investor’s shareholders can reap the
benefits arising from the performance of company only when they sell their shares. Therefore, it
is clear that maximization of the net wealth of shareholders.
Therefore we can conclude that maximization of wealth is the appropriate of goal of financial
management in today's context.

Q2. Your grandfather is 75 years old. He has total savings of Rs.80, 000. He expects that he
live for another 10 years and will like to spend his savings by then. He places his savings
into a bank account earning 10 per cent annually. He will draw equal amount each year-
the first withdrawal occurring one year from now in such a way that his account balance
becomes zero at the end of 10 years. How much will be his annual withdrawal?

Answer: -

Present Value (PV) =80000/-

Amount (A) =?

Interest Rate (I) =10%

No. of Year (N) =10

PVAn = A {1+i) n-1} / {i (1+i) n}

80000=A {1+.10)10}/ {.10(1+.10)10}

80000=A {1.593742/0.259374}

Annual withdrawal =80000/ 6.144567

Annual withdrawal = 13019.63 Yearly

Q3. What factors affect financial Plan?

Answer: - We live in a society and interact with people and environment. What happens to us is
not always accordance to our wishes. Many things turn out in our live are uncontrollable by us.
Many decisions we take are the result of external influences. So do our financial matters. There
are many factors affect our personal financial planning. Range from economic factors to global
influences. Aware of factors affecting your money matters below will certainly benefit your
planning.

Factors Affecting Financial Plan

1. Nature of the industry: - Here, we must consider whether it is a capital intensive of labour
intensive industry. This will have a major impact on the total assets that the firm owns.

2. Size of the company: - The size of the company greatly influences the availability of funds
from different sources. A small company normally finals it difficult to raise funds from long term
sources at competitive terms. On the other hand, large companies like Reliance enjoy the
privilege of obtaining funds both short term and long term at attractive rates.

3. Status of the company in the industry: - A well established company enjoying a good
market share, for its products normally commands investor’s confidence. Such a company can
tap the capital market for raising funds in competitive term for implementation new projects to
exploit the new opportunity emerging from changing business environment.

4. Sources of finance available: - Sources of finance could be group into debt and equity. Debt
is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that
would achieve the least cost capital structure. A large firm with a diversified product mix may
manage higher quantum of debt because the firm may manage higher financial risk with a lower
business risk. Selection of sources of finances us closely linked to the firm’s capacity to manage
the risk exposure.

5. The capital structure of a company: - Capital structure of a company is influenced by the

desire of the existing management of the company to remain control over the affairs of the
company. The promoters who do not like to lose their grip over the affairs of the company
normally obtain extra funds for growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization: - The product policy of any good financial plan is to
match the term of the source with the term of investment. To finance fluctuating working capital
needs, the firm resorts to short term finance. All fixed assets-investment are to be finance by long
term sources. It is a cardinal principal of financial planning.
7. Flexibility: - The financial plan of company should possess flexibility so as to effect changes
in the composition of capital structure when ever need arises. If the capital structure of a
company is flexible, it will not face any difficulty in changing the sources of funds. This factor
has become a significant one today because of the globalization of capital market.

8. Government Policy:- SEBI guidelines, finance ministry circulars, various clauses of Standard
Listing Agreement and regulatory mechanism imposed by FEMA and Department of Corporate
Affairs (Govt. of India) influence the financial plans of corporate today. Management of public
issues of shares demands the companies with much status in India. They are to be compiled with
a time constraint.
Q4. Suppose you buy a one -year government bond that has a maturity value of Rs. 1000.
The market interest rate is 8 per cent. (a) How much will you pay for the bond? (b) If you
purchase the bond for Rs.904.98, what interest rates will you earn from this investment?

Answer: - A.

Bond value maturity = 1000

Market interest rate = 8%

Period of maturity = 1Yrs

Valu of bond = Maturity value

1 + rate of return

= 1000
1 + 0.08

= 926

Pay for the bond = 926

Answer: - B.

Purchase price of bond = 904.98

Maturity value = 1000

Interest earning = Maturity value - Purchase price of bon

= 1000-904.98

= 95.02

Rate of Interest = Interest X100

Current price of bond

= 95.02 X100
904.98
 = 10.50%

Interest rate earned form this

Investment = 10.50%

Case Study
Deepak Hand tools Private Limited

DHPL is a small sized firm manufacturing hand tools. It manufacturing plan is situated in
Haryana. The company’s sales in the year ending on 31st March 2007 were Rs.1000 million
(Rs.100 crore) on an asset base of Rs.650 million. The net profit of the company was Rs.76
million. The management of the company wants to improve profitability further. The required
rate of return of the company is 14 percent. The company is currently considering an investment
proposal. One is to expand its manufacturing capacity. The estimated cost of the new equipment
is Rs.250 million. It is expected to have an economic life of 10 years. The accountant forecasts
that net cash inflows would be Rs.45 million per annum for the first three years, Rs.68 million
per annum from year four to year eight and for the remaining two years Rs.30million per annum.
The plant can be sold for Rs.55 million at the end of its economic life. The company would need
to raise debt to the extent of Rs.200 million. The company has the following options of
borrowing Rs.200 million: a. The Company can borrow funds from a nationalized bank at the
interest rate of 14 percent for 10 years. It will be required to pay equal annual installment of
interest and repayment of principal. b. A financial institution has offered to lend money to DHPL
at 13.5 per annum but it needs to pay equated quarterly installment of interest and
repayment of principal.

Questions:

1. Should the company expand its capacity? Show the computation of NPV

2. What is the annual installment of bank loan?

3. Calculate the quarterly installments of the Financial Institution loan

4. Should the company borrow from the bank or from the financial institution?

Answer 1.

Investment in New Equipment : 250000000

Life of machine : 10 Years

Salvage : 55000000
Years Cash inflows PV factors at 14 % PV of cash inflows

1 45,000,000 0.877 39,473,684

2 45,000,000 0.769 34,626,039

3 45,000,000 0.675 30,373,718

4 68,000,000 0.592 40,261,459

5 68,000,000 0.519 35,317,069

6 68,000,000 0.456 30,979,885

7 68,000,000 0.400 27,175,338

8 68,000,000 0.351 23,838,016

9 30,000,000 0.308 9,225,238

10 30,000,000 0.270 8,092,314

Salvage 55,000,000 0.270 14,835,910

PV of cash inflows 294,198,670

Initial cash out flow 250,000,000

NPV 44,198,670

Here NPV is positive it is advisable to the company to expand its capacity

Answer 2.

Loan Amount : 200000000

Interest rate : 14 %

No of Year(N) : 10 Years
 Installment X PVIFA (14%,10) =20,00,00,000

Installment = 20,00,00,000 / 5.216

= 3,83,43,558
Answer 3.

Loan Amount : 20,00,00,000

Interest rate : 13.5 %

No of Year (N) Quarterly : 10 Years

Installment X PVIFA (13.5% / 4, 40) =20,00,00,000

Installment = 20,00,00,000 / 5.176

= 3,86,39,876

Answer 4. Should the company borrow from the bank because payback by the company less
then financial institution