MASTER OF BUSINESS ADMINISTRATION MBA SEMESTER 2

MB0045 FINANCIAL MANAGEMENT

Assignment Set 1

Name: Mahavadi Dhanshyam Venkatram Suryanarayan Roll No: 511110147 Centre Code: 846 City: Angul

Q1] What are the 4 finance decisions taken by a finance manager. Ans] A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firms activities. The shareholders are made better off by a financial decision that increases the value of their shares. Thus while performing the finance function, the financial manager should strive to maximize the market value of shares. Whatever decision does a manager takes need to result in wealth maximization of a shareholder. Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are: (a) the evaluation of the prospective profitability of new investments, and (b) the measurement of a cut-off rate against that the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems. Financing Decision Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firms capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and the firms capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility loan convenience, legal aspects etc. in deciding its capital structure.

Dividend Decision Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability, bonus shares and cash dividends in practice. Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonus share (or stock dividend), are also issued to the existing shareholders in addition to the cash dividend. Liquidity Decision Current assets management that affects a firms liquidity is yet another important finance function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firms profitability, liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets. He or she should estimate firms needs for current assets and make sure that funds would be made available when needed. It would thus be clear that financial decisions directly concern the firms decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. It is in this context that finance functions are said to influence production, marketing and other functions of the firm. This, in consequence, finance functions may affect the size, growth, profitability and risk of the firm, and ultimately, the value of the firm. To quote Ezra Solomon The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management is directly concerned with production, marketing and other functions, within an enterprise whenever decisions are about the acquisition or distribution of assets. Various financial functions are intimately connected with each other. For instance, decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. Likewise, dividend decisions influence financing decisions and are themselves influenced by investment decisions.

In view of this, finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit should be made after consulting production and marketing executives. However, in the management of income finance manager has to act on his own. The determination of dividend policies is almost exclusively a finance function. A finance manager has a final say in decisions on dividends than in asset management decisions. Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finance manager works as a part of total management. In principle, a finance manager is held responsible to handle all such problem: that involve money matters. But in actual practice, as noted above, he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively.

Q2] What are the factors that affect the financial plan of a company? Ans] The various factors affecting the financial plan are as follows: 1. Nature of the industry: The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or a labour intensive industry. This will have a major impact on the total assets that a firm owns. 2. Size of the company: The size of the company greatly influences the availability of funds from different sources. A small company finds 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 from both short term and long term sources at attractive terms. 3. Status of the company in the industry: A well established company enjoys a good market share, for its products normally command investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment 4. Sources of finance available: Sources of finance could be grouped 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 finance is closely linked to the firms capability to manage the risk exposure. 5. Capital Structure of the Company: The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain 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 the growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization: The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset investments are to be financed by long term sources, which is a cardinal principle of financial planning. 7. Flexibility: The financial plan of a company should possess flexibility so as to affect changes in the composition of capital structure whenever the need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of 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 decisions and plans of the corporate today. Management of public issues of shares demands the compliance of many statutes in India. They are to be complied with a time constraint.

Q3] Show the relationship between required rate of return and coupon rate on the value of a bond. Ans] It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. Some bond price calculations for various types of bond instruments are as shown: Bonds can be priced at a premium, discount, or at par. If the bonds 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 bonds 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 we calculate the price of a bond, we are calculating the maximum price we would want to pay for the bond, given the bonds 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: all we are doing is discounting the known future cash flows. All one needs to remember is that to calculate present value (Vo) which is based on the assumption that each payment is re-invested at some interest rate once it is receivedwe 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 bonds price, which uses the basic present value (Vo) formula: Vo = I * PVIFA(Kd,n) + F * PVIF(Kd,n) Where, Vo = Present Value of the bond I = Annual Interest payable on the bond F = Principal Amount (par value) repayable at maturity time N = Maturity period of the bond Kd= required rate of return.

To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years. If Kd is 13%, then, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 7) + 100*PVIF (13%, 7) = 11*4.423 + 100*0.425 = 48.65 + 42.50 = Rs.91.15 After 1 year, the maturity period is 6 years, the value of the bond is V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 6) + 100*PVIF (13%, 6) = 11* 3.998 + 100*0.480 = 43.98 + 48 = Rs. 91.98. We see that the discount on the bond gradually decreases and value of the bond increases with the passage of time as required rate of interest (Kd) is higher than the coupon rate. Continuing with the same problem above, let us see the effect on the bond value if the required rate is 8%. If Kd is 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 7) + 100*PVIF (8%, 7) = 11*5.206 + 100*0.583 = 57.27 + 58.3 = Rs. 115.57 One year later, with Kd at 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 6) + 100*PVIF (8%, 6) = 11*4.623 + 100* 0.630 = 50.85 + 63 = Rs. 113.85 For a required rate of return of 8%, the bond value decreases with passage of time and premium on bond declines as maturity approaches.

Q4] Discuss the implication of financial leverage for a firm. Ans] Financial leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories Those which carry a fixed financial charges like debentures, bonds and preference shares and Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

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 companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT). It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity. Implication of Financial Leverage: Studying the degree of financial leverage (DFL) at various levels makes financial decisionmaking, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS). The risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage: Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used. The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.

Q5] 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

Soln] a.) The cash flows and the cumulative cash flows of the project are as shown in the table below: Year Cash Flow (Rs.) Cumulative Cash flow (Rs.) 0 (100000) (100000) 1 25000 25000 2 40000 65000 3 50000 115000 4 40000 155000 5 30000 185000 From the cumulative cash flow column, the project recovers the initial cash outlay of Rs. 100000 between the 2nd and 3rd year. Therefore the payback period of the project is given as: Pay-back period = 2 + (100000-65000)/50000 = 2 + 0.7 = 2.7 years (approx.) b.) For 10 % cost of capital, the cash flow column is as shown in the table below: Year Cash Flow (Rs.) PV factor at 10 % PV of Cash Flows Cumulative positive cash flows (Rs.) 0 (100000) 1 (100000) 1 25000 0.909 22725 22725 2 40000 0.826 33040 55765 3 50000 0.751 37550 93315 4 40000 0.683 27320 120635 5 30000 0.621 18630 139265 From the cumulative cash flow column, we can see that the initial cash outlay of Rs. 100000 lies between the 3rd and the 4th year. Thus, the discounted payback period is given by: Discounted pay-back period = 3 + (100000 93315) / 27320 = 3 + 0.244 = 3.244 years The Benefit cost ratio is given by: BCR = (Cumulative Positive Cash flow) / (Initial Cash Outlay) = 139265 / 100000 BCR = 1.393

Q6] 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. Ans] Given data: P = Intrinsic price per share E = Earnings per share = 18%,

D = Dividend per share = 2 r = Rate of return = 10%

Since the dividends and earnings of the company are growing by 18 % every year and by 6 % after that, the intrinsic price per share after 6 years is given by: P = [2(1.18)/(1.10)1] + [2(1.18)2/(1.10)2] + [2(1.18)3/(1.10)3]+ [2(1.18)4/(1.10)4] + [2(1.18)4(1.06)/(1.10)5] + [2(1.18)4(1.06)2/(1.10)6] = 2.15 + 2.30 + 2.47 + 2.65 + 2.55 + 2.46

Intrinsic price per share = Rs. 14.58