Master of Business adMinistration SemeSter-II

ASSIGNMENT

Mb0045-Financial ManageMent Set-1

SUBMITTED BY:
NAME ROLL NO COURSE CENTRE CODE CENTRE CITY : : : : : VIJAY KUMAR SHARMA 520933061 mba 3293 NEW DELHI

Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

Note: Note: Each question carries 10 Marks. Answer all the questions.

Q.1 a company has issued a bond with face value of Rs.1000, with 10% pa coupon rate payable annually and tenure of 10 years to maturity. At the end of 10 years, the bond will be redeemed at a premium of 10% to face value. a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk? b) What is the YTM of the bond if the prevailing price is same as calculated in a) above. c) What is the current yield of the bond at the given price? d) If the coupon rate is paid semi-annually, at what price would you buy the bond at the 12% pa prevailing interest rate?
Answer. a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk? Solution: Interest payable = 1000*10% = Rs. 100 Principal repayment is Rs. 1000 Required rate of return is 12% V0=I*PVIFA (Kd, n) + F*PVIF (Kd, n) Therefore, Value of bond = 100*PVIFA (12%, 10yrs) + 1000*PVIF (12%, 10yrs) = 100*5.6502 + 1000*0.3220 = 565.02 + 322 = Rs. 887.02 b) What is the YTM of the bond if the prevailing price is same as calculated in a) above. Solution: YTM = {I + (F P) / n} / { (F P) / 2 } = 100 + {(1000 887.02) / 10 / {(1000 + 887.02) / 2} = {100 + 11.298} / 943.51 = 0.1179 or 11.79%

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

c) What is the current yield of the bond at the given price? Solution: Current Yield (CY) = Coupon Interest / Current Market Price CY = Coupon Interest / Current Market Price = 100 / 887.02 = 0.112 or 11.2% d) If the coupon rate is paid semi-annually, at what price would you buy the bond at the 12% pa prevailing interest rate? Solution: V0 or P 0 = nt=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n 10 = (100/2) / (1 +0.12/2) + 1000 / (1 + 0.12/2)10 = 50*PVIF (6%, 20yrs) + 1000*PVIF (6%, 20yrs) = 50*11.470 + 1000*0.312 = 573.5 + 312 = Rs. 885.50

Q.2 Given the following details for a company: Net operating income Overall cost of capital Value of the firm Cost of debt Interest Market value of debt Market value of equity 200,000 20% 1000,000 15% 75,000 500,000 500,000

a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000. b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000.
Answer: a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000. Solution: The equity capitalization rates are Ke = K0+[ (K0 Kd)(B/S)] = 0.20 + [ (0.20 0.15) (2.5) ]

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I = 0.325 = 32.5% b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000. Solution: Cost of capital K0 = [B/ (B+S)]Kd + [S/(B+S)]Ke = [500,000 / (500,000 + 200,000)] 15% + 200,000 / (500,000 + 200, 000)] 32.5% = 0.107 + 0.092 = 0.199 = 19.9% Q.3 Given the following projects , rank them on the basis of NPV, MIRR

and Payback period if the cost of capital is 10% pa.

Project A Project B Project C

Year Cash flow 0 -10000 1 5000 2 7000 3 8000 4 15000 Solution: Computation of NPV Year 1 2 3 4

Year Cash flow Year Cash flow 0 -10000 0 1 5000 1 2 8000 2 3 6500 3 4 11000 4

-10000 5000 8500 9000 12000

Cash in flows 5000 7000 8000 15000

Project A PV factor at 10% 0.909 1.736 2.487 3.17 PV of Cash inflow Initial cash outlay NPV Project B PV factor at 10% 0.909 1.736 2.487 3.17

PV of Cash in flows 4545 12152 19896 47550 84143 10000 74143

Year 1 2 3 4

Cash in flows 5000 8000 6500 11000

PV of Cash inflow Initial cash outlay

PV of Cash in flows 4545 13888 16165.5 34870 69468.5 10000

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

NPV

59468.5

Year 1 2 3 4

Cash in flows 5000 8500 9000 12000

Project C PV factor at 10% 0.909 1.736 2.487 3.17 PV of Cash inflow Initial cash outlay NPV

PV of Cash in flows 4545 14756 22383 38040 79724 10000 69724

Computation of Payback Period Project A Cash Cumulative Flow Cash Flows 5000 5000 7000 12000 8000 20000 15000 35000 Project B Cash Cumulative Flow Cash Flows 5000 5000 8000 13000 6500 19500 11000 30500 Project C Cash Cumulative Flow Cash Flows 5000 5000 8500 13500 9000 22500 12000 34500

Year 1 2 3 4

From the cumulative cash flow the initial cash outlay of Rs. 10000 lies between 1st year and 2nd year in respect of project a, project B and project C. Therefore, payback period for project A is 1+ 10000 5000 = 1.4years 12152 Therefore, payback period for project B is 1+ 10000 5000 = 1.36years 13188 Therefore, payback period for project C is 1+ 10000 5000 = 1.3years 14756 Ranking of Projects NPV Project Absolute A B C 74143.00 59468.50 79724.00 Rank 2 3 1 Absolute 1.4 1.36 1.3 Rank 1 2 3 Payback Period

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

Q.4 Given the following information, calculate Degree of operating leverage, Degree of Financial leverage, Degree of total leverage. Quantity sold Variable cost per unit Selling price Fixed cost Number of equity shares Debt Preference shares Tax rate 100,000 units 200 800 10,000 50,000 1000,000 @ 15%pa 10,000 of Rs.100 each @ 10% 30%

Solution: To Find out Degree of Operating Leverage DOL = {Q(SV)} / {Q(SV)F} = {100,000 (800 200)} / 100,000 (800 200) 10,000 = 60,000,000 / 59,990,000 = 1.00016 To Find out Degree of Financial Leverage DFL = EBIT {EBITI{Dp/(1-T)}} = 59,990,000 {59,990,000 150,000 {100,000/10.30} = 59,990,000 59,697,142.86 = 1.0049 To Find out Degree of Total Leverage DTL = DOL*DFL = 1.00016*1.0049 = 1.0050 DTL = Q(S V) / Q(S V) F I {DP / (1 T)} = 60,000,000 / 60,000,000 10,000 150,000 {100,000/0.7} = 1.0050

Q.5 Explain the following concepts : a) Operating cycle b) Total inventory cost c) Price earnings ratio d) Financial risk
Answer. Operating Cycle The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Page 6 of 9

Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. Total Inventory Cost Total Inventory cost is the total cost associated with ordering and carrying inventory, not including the actual cost of the inventory itself. It is important for companies to understand what factors influence the total cost they pay, so as to be able to minimize it. Use the total inventory cost calculator below to solve the formula.

Total Inventory Cost Definition

Total Inventory Cost is the sum of the carrying cost and the ordering cost of inventory.

Variables
C=Carrying cost per unit per year Q=Quantity of each order F=Fixed cost per order D=Demand in units per year Total Inventory Cost Formula : Price Earnings Ratio The price earnings ratio reflects the amount investors are willing to pay for each rupee of earnings. Expected earnings per share = (Expected PAT) (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit margin, depreciation and interest and tax rate. The price earnings ratio has to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay-out ratio. Where, 1-b is dividend pay-out ratio R is required rate of return ROE*b is expected growth rate

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

Financial Risk The risk that a company will not have adequate cash flow to meet financial obligations. Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Financial risk is an umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return. Risk related to an investment is often called investment risk. Risk related to a companys cash flow is called business risk.

Q. 6 Explain the Net operating income approach to capital structure theories? Answer: The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mix any mix is as good as any other. Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach: At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate. The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm Value of debt Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remain constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

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Master of Business Administration Semester-II

MB0045 Financial Management
Assignment Set- I

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