ASSIGNMENT-02

Name: Registration No: Learning Centre: Learning Centre Code: Course: Subject: Semester: Module No: Date of Submission: Marks Awarded: MBA
Financial Management

2ND Semester
MB0045

Director of Distance Education Sikkim Manipal University II Floor, Syndicate House Manipal-576 104

Signature of Coordinator Signature of Center Signature of Evaluator

Q1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt Solution: Equity Debt Total Tax rate as = Rs.10lakhs, Cost of capital = 18% = Rs.5lakhs, Cost of debt = 13% = Rs 15 lakh = 40%

We = 10 / 15 = 0.67 Ke = 18% = 0.18 Wd = 5/15 = 0.33 Kd = I (1-T) WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = 0.67*.18 + 0 + 0 +0.33*13(1-.40) + 0 = 0.146 or 14.6%

Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL. Details of ABC Ltd. Output 20,000 units Fixed costs Rs.3,500 Variable cost Rs.0.05 per unit Interest on borrowed funds Nil Selling price per unit 0.20

Solution : DFL = Q(S-V) / [Q(S-V) F I {Dp/(1-T)}] = 20000(0.20 0.05) / [20000(0.20 0.05) 0 0 0] = 3000 / 3000 =1

Q3. Two companies are identical in all respects except in the debt equity profile.

Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Solution: S= 1000,000/.22 =4545454.5 B=25,00,000 =K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15% V = 5000000/0.1915 = 26,109,660.57

Q4. Examine the importance of capital budgeting. Answer: -

Importance of Capital Budgeting: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area

Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act. Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

 For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders.The best example is the Reliance Group. Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm. Capital budgeting is significant for the following reasons: 1. The decision-maker loses some of his flexibility, for the results continue over an extended period of time. He has to make a commitment for the future. 2. Asset expansion is related to future sales 3. The availability of capital assets has to be phased properly 4. Asset expansion typically involves the allocation of substantial amounts of funds 5. Many firms fail, because they have too much or too little capital equipment 6. Decision relating to capital investment are among the difficult and, at the same time, a most critical a management has to make. These decisions require an assessment of the future events which are uncertain. 7. The most important reason for capital budgeting decision is that they have long-term implications for a firm. The effects of a capital budgeting decision extend into the future and have to be put up with for a longer period than the consequences of current operating expenditures.

8. Capital budgeting is an important function of management because it is one of the critical determinants of success or failure of the company. Ill-advised or excessive capital spending may create excessive capacity and increase operating costs, limit the viability of company

funds and reduce its profit earning capacity.

Q5. Briefly explain the process of capital rationing Answer: The following are the steps involved in capital rationing. Ranking of different investment proposals Selection of the most profitable investment proposal

Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Net present value method recognises the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present values of all the cash flows. Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value of cash outflows. IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. IRR can be determined by solving the following equation for

Selection of the most profitable investment proposal After ranking the different investment proposals based on their net present value, profitability index and the internal rate of return, the selection of the most profitable investment proposal is to be done. The selection is done mainly in a view to select the investment proposal which earns more profits than compared to the other proposals. The basic features to be taken under consideration during the selection of the most profitable investment proposal are: The proposal should have the potentiality of making large anticipated profits The proposal should involve high degree of risk

The proposal should involve a relatively long time-period between the initial outlay and the anticipated return Evaluation of the selection procedure PI rule of selecting projects under capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of a single large project Capital rationing also suffers from the multi-period capital constraints

Q6. Explain the concepts of working capital. Answer: Concepts of Working Capital The four most important concepts of working capital are Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance. Management of current assets is the crucial aspect of working capital management Gross working capital helps in the fixation of various areas of financial responsibility

Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets

Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms short term solvency is measured through the net working capital position it commands Permanent Working Capital Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital. The need for working capital arises on account of two reasons: To finance operations during the time gap between sale of goods on credit and realisation of money from customers of the firm To finance investments in current assets for achieving the growth target in sales Therefore to finance the operations in operating cycle of a firm, working capital is required.