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MBA – II SEM
MB0029
Set – 1
QN.1a. Explain why wealth maximization is superior over profit maximization.
Answer:
Maximization of profits is regarded as the proper objective of the firm, but it is not as
inclusive a goal as that of maximizing stockholder wealth. For one thing, total profits are not
as important as earnings per stock. Therefore, wealth maximization is superior in a way that
it is based on cash flow, not on the accounting profit.
Wealth maximization is superior because it values the duration of expected returns. Since
distant flows are uncertain, converting them into comparable values at base period facilitated
better comparison of financial projects. This can be achieved by for example; by discounting
all future earnings to establish their net present value.
When a firm follows wealth maximization goal, it achieves maximization of market value of
share. When a firm practices wealth maximization goal, it is possible only when it produces
quality goods at low cost. On this account therefore, society gains because of the societal
welfare.
Answer:
The financial planning process turns your own personal objectives into specific plans and
outlines methods and strategies to implement these plans.
Establish Financial Goals and Objectives: Your Financial Consultant will assist you in
identifying your objectives. For example, you may be asked the following questions: At what
age and income level would you like to retire? What level of income would you like to provide
to your surviving spouse? How would you like your estate to be distributed?
Gather Data: Information reviewed may include, for example, tax returns, brokerage
statements, insurance policies, wills, trusts, estate planning documents, or business
agreements. The more information that is available, the more accurate your financial plan
will be.
Process and Analyze Information: Appropriate advisors will consider various alternatives to
meet your objectives.
Adopt a Comprehensive Financial Plan: Illustrations and analyses showing you strategies to
consider meeting your goals.
Implement the Plan: You choose to implement the strategies with which you feel
comfortable.
Monitor the Plan: Periodically, you and your Financial Consultant will review your financial
plan. Circumstances change and you may need to make revisions to your plan.
Answer:
2. Earnings Theory: The earnings theory of Capitalization recognizes the fact that the true
value (capitalization) of an enterprise depends upon its earnings and earning capacity.
According to it, therefore, the value or Capitalization of a company is equal to the capitalized
value of its estimated earnings. For this purpose a new company has to prepare an
estimated profit and loss account. For the first few year of its life, the sales are forecast ad
the manager has to depend upon his experience for determining the probable cost. The
earnings so estimated may be compared with the actual earnings of similar companies in the
industry and the necessary adjustments should be made. Then the promoters will study the
rate at which other companies in the same industry similarly situated are earnings. The rate
is then applied to the estimated earnings of the company for finding out the capitalization. To
take an example a company estimates its average profit in the first few years at Rs. 50,000.
Other companies of the same type are, let us assume, earnings a return of 10 per cent on
their capital. The Capitalization of the company will then be 50,000x100=Rs.500,000.
QN. 2b. A customer wants to deposit Rs.10,000 in ICICI bank for 5 years. The
prevailing interest rate is 9.50% what will be the value of the deposit on maturity.
Answer:
FV = PV (1+i) ^n
FV = 10000(1+0.095) ^5
QN.3a. Reliant Ltd has to redeem 12% Rs. 30 million debenture 5 years hence. How
much should it deposit annually in sinking fund account so that it can accumulate Rs.
30 million at the end of 5 years.
Answer:
QN.3b. Road Transport Corporation issued deep discount bonds in 1996 which has a
face value of Rs. 2, 00, 000 maturing after 25 years. The bond was issued at Rs. 5300.
What is the effective interest rate earned by the investor from this bond?
Answer:
A = Po (1+i) n
200,000 = 5300(1+i) 25
37.7358 = (1+i) 25
37.73581/25 = (1+i)
QN.4. A bond has a par value of Rs. 1000 bearing a coupon rate of 10% maturing after
10 years. If the YTM is 12% what is the market value of the bond? If the YTM is
increase to 14%, what is the market value of the bond? Compare and give the
inference.
Answer:
Vo = Rs 887
Vo = Rs 791.6
The inference is that, the bond’s value moves inversely proportional to its YTM.
As the YTM increases by from 12% to 14% the value of the bond falls from Rs 887 to Rs
791.6.
QN.5. ABC Ltd, produced and sold Rs 100,000 of a product at the rate of Rs 100.for
production of Rs.1,00,000 units, it has spent a variable cost of Rs.6,00,000 at the rate
of Rs.6 per unit and the fixed cost if Rs. 2,50,000. The firm has paid interest Rs. 50,000
at the rate of 5 percent and Rs.1,00,000 debts. Calculate operating leverage.
Answer:
Answer:
Capital budgeting (or investment appraisal) is the planning process used to determine
a firm’s expenditures on assets whose cash flows are expected to extend beyond one year
such as new machinery, equipments, etc. It is also the process of identifying, analyzing and
selecting investment projects whose cash flows are expected to extend beyond one year
such as research and development project.
Capital expenditures can be very large and have a significant impact on the firm’s
financial performance. Besides, the investments take time to mature and capital assets are
long-term, therefore, if a mistake were done in the capital budgeting process, it will affect the
firm for a long period of time. Basically, the importance of capital budgeting are as follow:
Capital budgeting helps a firm to plan its financing. Proper capital budgeting analysis is
critical to a firm’s successful performance because capital investment decisions can improve
cash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distress
and even to bankruptcy.
While working with capital budgeting, a firm is involved in valuation of its business. By
valuation, cash flow is identified and discounted at the present market value. In capital
The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is
the varying key involved in forecasting cash flow. The importance of capital budgeting is not
only its mechanics, but also the parameters of forecasting the incurrence of cash in the
business.
QN.6. Financial planning: Assume you are working for an investment banker. A client
aged 30 has approached you on investment planning. His present salary is
Rs.6,00,000 per year and his current savings is Rs.1,50,000.
(a) How much does this current saving grow to in 3 years if the interest rate is12%
compounded annually.
Answer:
(a) FVAn = A [(1+i) ^n – 1/i]
FVAn = 150000[(1+0.12) ^3 – 1/ 0.12]
FVAn = Rs 506,160
(b) Assume he plans to save Rs.60000 at the end of every year for 5 years, what would
be the amount at the end of 5 years if the interest being 10% compounded annually.
Answer:
ANS 1.
The present value of cash outflows = initial cost of investment and the comment
of project at various points of time ^
Merits
1. The most significant advantage is that it explicitly recognizes the time value of
money, e.g., total cash flows pertaining to two machines are equal but the net
present value are different because of differences of pattern of cash streams.
The need for recognizing the total value of money is thus satisfied.
Demerits
2. The second and more serious problem associated with present value method
is that it involves calculations of the required rate of return to discount the cash
flows. The discount rate is the most important element used in the calculation of
the present value because different discount rates will give different present
values. The relative desirability of a proposal will change with the change of
discount rate. The importance of the discount rate is thus obvious. But the
calculation of required rate of return pursuits serious problem. The cost of capital
is generally the basis of the firm's discount rate. The calculation of cost of capital
is very complicated. In fact there is a difference of opinion even regarding the
exact method of calculating it.
4. The present value method may also give satisfactory results in case of two
projects having different effective lives. The project with a shorter economic life
is preferable, other things being equal. It may be that, a project which has a
higher present value may also have a larger economic life, so that the funds will
remain invested for longer period while the alternative proposal may have
shorter life but smaller present value. In such situations the present value
method may not reflect the true worth of alternative proposals. This method is
suitable for evaluating projects whose capital outlays or costs differ significantly.
Evaluation of IRR
2. It produces multiple rates which can be confusing. This situation arises in the
case of non-conventional projects.
3. In evaluating mutually exclusive proposals, the project with highest IRR would
be picked up in exclusion of all others. However in practice it may not turn out to
be the most profitable and consistent with the objective of the firm i.e.,
maximization of shareholders wealth.
4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the
IRR. It is rather ridiculous to think that the same firm has the ability to reinvest
the cash flows at different rates. The reinvestment rate assumption under the
IRR is therefore very unrealistic. Moreover it is not safe to assume always that
intermediate cash flows from the project may be reinvested at all. A portion of
cash inflows may be paid out as dividends, a portion may be tied up with current
assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the
project if it assumes that it invests the entire intermediate cash proceeds.
Further it is not safe to assume that they will be reinvested at the same rate of
return as the company is currently earning on its capital (IRR) or at the current
cost of capital (k).
NPV versus IRR NPV indicates the excess of the total present value of future
returns over the present value of investments. IRR (or DFC rate) indicates on the
other hand the rate at which the cash flows (at present values) are generated in
the business by a particular project.
Both NPV and IRR iron out the difference due to interest factor or say higher
returns in earlier years and higher returns in later years (though the total returns
in absolute terms may be around the same for several projects).
Between the two, IRR or DFC rate is the more sophisticated method ¬a popular
as well, since:
(b) Whilst under NPV the main basis of comparison is between different NPV's of
different projects, under IRR or DFC rate approach a number of basis is available.
For example ¬
(c) The results under DFC rate approach are simpler for the management to
understand and appreciate. We should however be very careful in applying the
decision rules properly when NPV and IRR calculation shows divergent results.
The rules are ¬
(i) the projects be the basis of decision when mutually exclusive in character;
(d) IRR should be a better guide when there are plenty of project situations (as it
is there in a long enterprise) and no major constraints (for example, in respect of
macro projects).
Machines B C
A
Estimated life 3 Years 3 Years 3years
Cash inflows(in lakhs)
1 Year 27 06 12
2 Year 18 21 80
3 Year 55 33 30
Ans 2
A) Payback period
Machine A. Rs.27 lakhs will be recovered in 1st year & the balance 13 lakhs (40 –
27) will be recovered in 2nd year of 18 lakhs
machine B. Rs.06 lakhs will be recovered in 1st year & the balance 34 lakhs
(40 – 6) will be recovered in 2nd year of 21 lakhs
payback period = 1year +(35/21*12month) or =1year + 35/21
= 1year 20 month = 1year +1.66
2.66year
machine c. Rs.12 lakhs will be recovered in 1st year & the balance 28 lakhs
(40 – 12) will be recovered in 2nd year of 80 lakhs
payback period = 1year + (28/80*12month) or =1year + 28/80
= 1year + 4.2 month = 1year + 0.35
= 1.35year
machine A. Rs. 35.4546 will be recovered in 2nd year & balance 4.5454(40-
35.4546) will be recovered in 3rd year out of 39.149
=2year + (4.5454/39.149)
=2year + 0.1161
=2.11year
machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(40-
22.0968) will be recovered in 3rd year out of 23.489
=2year + (17.9032/23.489)
=2year +0.7621
=2.76year
machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936
(40- 74.4936) will be recovered in 3rd year out of 95.8436
=2year + (-34.4936/95.8436)
=2year + -0.3598
= 1.64year
years 0 1 2 3 4 5 6
Cash flows -120 -100 40 60 80 100 130
(in millions)
The cost of capital is 13% find MIRR.
Ans 3:
1. project – specific risk: the source of this risk could be traced to something
quite specific to the project. Managerial deficiencies or error in estimation of
cash flow or discount rate may lead to a situation of actual cash flow relised
being less than that projected.
2. competitive risk or competition risk: unanticipated of a firm’s competitors will
materially affect the cash flows expected from a project. Because of this the
actual cash flow from a project will be less than that of the forecast.
3. industry- specific : industry – specific risks are those that affect all the firms in
the industry. It could be again grouped in to technological risk, commodity risk
and legal risk. All these risks will affect the earnings and cash flows of the
project. The changes in technology affect all the firms not capable of adapting
themselves to emerging new technology. The best example is the case of firm
manufacturing motors cycles with two stroke engines. When technological
innovation replaced the two stroke engines by the four stroke engines those
firms which could not adapt to new technology had to shut down their
operations. Commodity risk is the arising from the affect
of price – changes on goods produced and marketed. Legal risk arise from
changes in laws and regulations application to the industry to which the firm
belongs. The best example is the imposition of service tax on apartments by the
government of India when the total number
of apartments built by a firm engaged in that industry exceeds a prescribed limit.
Similarly changes in import – export policy of the government of India have led
to the closure of some firms or sickness of some firms.
4. international risk : these types of risk 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 reduce their profitability. Another best example is
that of the textile units in Tirupur in Tamilnadu, exporting their major part of the
garments produces. Rupee gaining and dollar weakening reduced their
competitiveness in the global markets.
The certainty equivalent factor balance as per the following equation α t=1-05.05t. Calculate the
NPV of the project if the risk free rate of return is 9%.
Ans 4:
Ans 5:
For JAN:
Bank over Draft 21,000 for maintain minimum cash balance for
month of
February 21000+4000=25000.
For FEB:
No need to take bank over Draft because closing balance 25,000.
For MARCH:
Bank over Draft 10,000 for maintain minimum cash balance for
month of
April 15,000+10,000=25000.
ANS:-
Credit policy Variables
1. Credit standards.
2. Credit period.
3. Credit discount and
4. Collection programme.
1. Credit standards : The term credit standards refer to the criteria for
extending credit to customers. The bases for setting credit standards are.
a. Credit rating
b. References
c. Average payment period
d. Ratio analysis
There is always a benefit to the company with the extension of credit to its
customers but with the associated risks of delayed payment or non payment,
funds blocked in receivables etc. The firm may have light credit standards. It
may sell on cash basis and extend credit only to financially strong customers.
Such strict credit standards will bring down bad – debt losses and
reduce the cost of credit administration. But the firm may not be able to increase
its sales. The profit on lost sales may be more the costs saved by the firm. The
firm should evaluate the trade – off between cost and benefit ofany credit
standards.
2. Credit period: Credit period refer to the length of time allowed to its
customers by a firm to make payment for the purchase made by customers of
the firm. It is generally expressed in days like 15 days or 20 days. Generally,
firms give cash discount if payment are made within the specified period. If a
firm follows a credit period of ‘net 20’ it means that it allows to its
customers 20 days of credit with no inducement for early payments. Increasing
the credit period will bring in additional sales from existing customers and new
sales from new customers. Reducing the credit period will lower sales, decrease
investments in receivables and reduce the bad debt loss. Increasing the credit
period increases the incidence of bad debt loss. The effect of increasing the
credit period on profits of the firm are similar to that of relaxing the credit
standards.
3. Cash discount: Firms offer cash discount to induce their customer to make
prompt payments. Cash discount have implications on sales volume, average
collection period, investment in receivables, incidence of bad debt and profits. A
cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the