SET 1

1. What are the 4 finance decisions taken by a finance manager?

Financial Decision taken by a Finance Manager : i) ii) iii) iv) i) Finance Decisions Investment Decisions Dividend Decisions Liquidity Decisions Finance Decisions: This decision relates to the acquisition of funds at the least cost. Cost has two dimensions ii) Explicit Cost - It refers to the cost in the form of coupon rate, cost of floating and issuing the security. Implicit Cost - It is not a visible cost but it may seriously affect the company's operations especially when it is exposed to business and financial risk. An investor in a company's shares has two objectives for investing. Income from Dividends.

Investment Decisions : Expansion through entering into new markets. Adding new products to its product mix. Performing value added activities to enhance customer satisfaction. Adopting new technology that would drastically reduce the cost of production. Rendering services or mass production at low cost or restructuring the organization to improve productivity. Dividend Decisions: Dividend Policy influences the dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the security in his portfolio management decisions. Preferences of shareholders - Do they want cash dividend or capital gains? Current financial requirements of the Company. Legal constraints on paying dividends. Striking an optimum balance between desires of shareholders and the Company's funds requirements

iii)

iv)

Liquidity Decisions: Liquidity decisions deal with working capital management. It is concerned with the day today financial operations that involve current assets and current liabilities. Formation of Inventory Policy. Policies on Receivable Management. Formulation of cash management strategies. Policies on utilization of spontaneous financial effectively.

1. What are the factors that affect the financial plan of a company?
Nature of the industry: The very first factor affecting the financial plan is the nature of the industry. Size of the company: The size of the company greatly influences the availability of funds from different sources. iii) Status of the company in the industry: A well established company enjoys a good market share, for its products normally command investors' confidence. iv) Sources of financial available: Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. v) The capital structure of a company: The capital structure of a company is influenced by the desire of the existing management of the company to retain control over the affairs of the company. vi) Matching Sources with utilization: The prudent policy of any good financial plan is to match the term of the sources with the term of the investment. vii) Flexibility: The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. viii) Government policy : SEBI guidelines, Finance Ministry circulars, various clauses of standard listing agreement and regulatory mechanism imposed by FEMA and Department of Corporate Affairs influence the financial plan of corporate today. i) ii)

2. Show the relationship between required rate of return and coupon rate on the value of a bond.
Mainly there are 3 relationships between the coupon rate and the required rate of return i) When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value. ii) When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value iii) When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value. Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When the price of a bond is calculated, the maximum price one would want to pay for the bond is calculated, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: discounting the known future cash flows. To calculate present value (PV) which is based on the assumption that each payment is re-invested at some interest rate once it is received-one have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula:

C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. The first payment of an ordinary annuity occurs in one interval from the time at which the debt security is acquired. The calculation assumes this time is the present.

3. Discuss the implication of financial leverage for a firm.

Financial Leverage as opposed to operating leverage relates to the financing activities of a firm measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. Financial Leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the company's income stream. Such expenses have nothing to do with the firm's performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT). Financial Leverage is considered to be favorable till such time that the rate of return exceeds the rate of return obtained when no debt is used. Sales = (-) V.C = Contribution (-) Fixed Cost = EBIT (-) Interest on Debenture EBT (-) Tax @ 50% / 40%

EAT (-) Profit Dividend Earnings available to Equity Shareholder No Equity Shares DFL EBIT = EBT = DFL = EBIT EBT Earnings Before Interest and Tax Earnings Before Tax Financial Leverage

4. The cash flows associated with a project are given below: Year Cash flow 0 100,000 1 25000 2 40000 3 50000 4 40000 5 30000 Calculate the a) payback period. b) Benefit cost ratio for 10% cost of capital
YEAR 1 2 3 4 5 Pay Back Period: X-2 3-2 Or, X 2 Or, X = = = 2 + 0.70 = 1,00,000 - 65,000 1,15,000 - 65,000 35,000 50,000 2.7 years ANNUAL 25000 40000 50000 40000 30000 CIAT 25000 65000 115000 155000 185000

Benefit cost refers to the NPV value of the cost of capital

1 2 3 4 5

25,000 40,000 50,000 40,000 30,000

0.909 0.826 0.757 0.683 0.621

22,725 33,040 37,550 27,320 18,630 139,265 100,000 39,625

Less : Initial Investment NPV

5. A companys earnings and dividends are growing at the rate of 18% pa. The growth rate is expected to continue for 4 years. After 4 years, from year 5 onwards, the growth rate will be 6% forever. If the dividend per share last year was Rs. 2 and the investors required rate of return is 10% pa, what is the intrinsic price per share or the worth of one share?
D1 D2 D3 D4 = = = = 2 (1.18) 2 (1.18) 2 (1.18) 2 (1.18) = = = = 2.36 2.7848 3.286 3.8775

The present value of this flow of dividends will be:

2x(1.18) 1.10 2.36 1.10 2.36 1.10

2x(1.18) (1.10) 2.7848 (1.10) 2.7848 1.21

2x(1.18) (1.10) 3.2860 (1.10) 3.2860 1.331

2x(1.18) (1.10) 3.8775 (1.10) 3.8775 1.4641

= 2.1454 + 2.3015 + 2.4688 + 2.6484 = 9.5641

= =

D = Ke - g 3.8775 (1+0.06) 0.10 - 0.06 4.11015 0.04 =

D (1 + g) Ke - g

102.75

The discounted value of this price is 102.75 (1.10) = 102.75 1.4641 = 70.18

SET - 2
1. Discuss the objective of profit maximization vs. wealth maximization.
Profit Maximization It is based on the cardinal rule of efficiency. Its goal is to maximize the returns with the best output and price levels. A firm's performance is evaluated in terms of profitability. Wealth Maximization Wealth maximization means maximizing the net wealth of a company's shareholders. It is possible only when the company pursues policies that would increase the market value of shares of the company.

The concept of profit lacks clarify. What does profit mean? Is it profit after tax or before tax? Is it operating profit or net profit available to shareholders? Wealth maximization is based on cash flow. Through the process of discounting, Wealth maximization takes care of the quality of cash flows. Distant cash flows are uncertain. Corporate play a key role in today's competitive business scenario. In an organization, shareholders typically own the company but the management rests with the Board of Directors. When a firm follows wealth maximization goal it achieves maximization of market value of share. A firm can practice wealth maximization goal only when it produces quality goods at low cost. Another notable feature of the firms committed to the maximization of wealth is that to achieve this goal. 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. Since listing ensures liquidity to the shares held by the investors, shareholder can reap the benefits arising from the performance of company only when they sell their shares. Therefore, we can conclude that maximization of wealth is the appropriate goal of financial management in today's context.

2. Explain the Net operating approach to capital structure.

Net Operating Income Approach 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. Example: Let us assume that a firm has an EBIT level of Rs.50,000, cost of debt 10%, the total value of debt Rs. 200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate). Total market value of the firm = EBIT/Ko = Rs.50,000/12.5% = Rs.400,000 Total value of debt =Rs.200,000

Therefore, total value of equity = Total market value - Value of debt =Rs.(400,000 - 200,000) = Rs.200,000 Cost of equity capital = Earnings available to equity holders/Total market value of equity shares Earnings available to equity holders = EBIT - Interest on debt =Rs.(50,000 - (10% on Rs.200,000)) =Rs.30,000 Therefore, cost of equity capital = Rs.(30,000/200,000) x100 =15% Verification of WACC: 10% x Rs.(200,000/400,000) + 15% xRs.(200,000/400,000) = 12.5% Effect of change in Capital structure (to prove irrelevance) Let us now assume that the leverage increases from $200,000 to $300,000 in the firm's capital structure. The firm also uses the proceeds to re-purchase its equity stock so that the market value of the firm remains the same at Rs.400,000. EBIT = Rs.50,000 WACC = 12.5% (overall capitalization rate) Total market value of the firm = Rs.50,000/12.5% =Rs.400,000 Less: Total market value of debt =Rs.300,000 Therefore, market value of equity = Rs.(400,000 - 300,000) =Rs.100,000 Equity-capitalization rate = (50,000 (10% on Rs.300,000))/100,000 =20% Overall cost of capital = 10% xRs.(300,000/400,000) + 20% xRs.(100,000/400,000)=12.5% The above example proves that a change in the leverage does not affect the total value of the firm, the market price of the shares as well as the overall cost of capital.

3. What do you understand by operating cycle?

The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle. Elements: Acquisition of resources from suppliers. Making payment to suppliers Conversion of raw materials to finished products Sale of finished goods to the customers Collection of cash from customers for the goods sold Operating Cycle =IC Period + RC Period IC = Inventory Conversion Period RC = Receivables Conversion period IC is the average length of time required to produce and sell the product IC = Average Inventory x 365 Annual Cost of goods sold RC is the average length of time required to convert the firms receivables into cash. RC = Average Accounts Receivable x 365 Annual Sales Accounts payables period is also known as payables deferred period. Average Creditors Accounts Payables Period = Purchases per day Total Purchases for year Purchases per day = 365 Cash conversion cycle is the length of time between the firms actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets. Cash conversion cycle i.e. CCC=ICP+RCP-PDP

4. What is the implication of operating leverage for a firm?

Implication of operating leverage for a firm: Operating leverage arises due to the presence of fixed operating expenses in the firm's income flows. A company's operating costs can be categorized into three main sections: fixed costs, variable costs and semi variable costs. Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time.

 Variable costs are those which vary in direct proportion to output and sales. Semi variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. Sales Variable Cost Contribution Fixed Cost Earning before Interest and Tax (EBIT) Operating Leverage = Contribution EBIT

(-) (-)

Another way of explaining operating leverage is (% change in EBIT/ % change in output).

5. A company is considering a capital project with the following information: The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant machinery and Rs.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million and the net working capital will be liquidated at par. The project will increase revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project.
Total Outflow = Rs.150 million+ Rs.50 million= Rs.200 million Increment Approach: Revenue-Cost=Rs.250 million-Rs.100 million=Rs.150 million Pr factor @ 10% for 5 Years = 3.790 150 x 3.790 = Rs.568.62 Calculation of depreciation Tax Saving PV @10% 11.25 0.909 8.4375 6.327 4.746 3.561 0.826 0.751 0.683 0.621 Tax Saving 10.226 6.969 4.751 3.241 2.211 27.398 Total inflow: 568.62+27.398 = 596.018 + inflow in 5th year 50+48=98 60.858 x 0.621 = 656.876 Net Present Value = 656.876 200 = 456.876 (Ans.)

150 25%

Year 1 2 3 4 5

Dep 37.5 28.125 21.09 15.82 11.87

6. Given the following information, what will be the price per share using the Walter model? Earnings per share Rs. 40 Rate of return on investments 18% Rate of return required by shareholders 12% Payout ratio being 40%, 50% or 60%.
Walter Model: D + r/Ke (E-D) P = Ke P=Price of equity share D=Initial dividend per share=4, 5 and 6 E=Initial earning per share=Rs. 40 r=Expected rate of return on firms investment=0.18 Ke=Cost of equity capital=0.12 (i) P = P = P = (ii) P = P = (iii) P = P = 4+.18/.12 (40 - 4) 0.12 4+.18 x 36 0.12 0.12 4 + 54 = Rs. 483.33 0.12 5+.18/.12 (40 - 5) 0.12 5 + 52.50 = Rs. 479.17 0.12 6 +.18/.12 (40 - 6) 0.12 57 = Rs.475 0.12