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Prema N 511124286 MBA Financial Management 1. Sampoorna Academy of Management & Science 07-Jan-2012 9
Assignment SET-2
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and not the profit Maximization. Prof. Soloman of Stanford University has handled the issued very logically. Heargues that it is useful to make a distinction between profit and 'profitability'. Maximization of profits with a via to maximising the wealth of shareholders is clearly an unreal motive. On the other hand, profitability Maximization with a view to using resources to yield economic values higher than the joint values of inputs required is a useful goal. Thus the proper goal of financial management is wealth maximization.
As a general rule, companies want to keep their operating cycles short for a number of reasons, but in certain industries, a long operating cycle is actually the norm. Operating cycles are not tied to accounting periods, but are rather calculated in terms of how long goods sit in inventory before sale. When a business buys inventory, it ties up money in the inventory until it can be sold. This money may be borrowed or paid up front, but in either case, once the business has purchased inventory, those funds are not available for other uses. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns, but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be stored and this can become costly, especially with items that require special handling, such as humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishable goods, it can even be rendered unsalable. Inventory must also be insured and managed by staff members who need to be paid, and this adds to overall operating expenses. There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for example, keep inventory on hand for years before it is sold, because of the nature of the business. In these industries, the return on investment happens in the long term, rather than the short term. Such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations. Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit around longer, while periods of growth may be marked by more rapid turnover. Certain products can be consistent sellers that move in and out of inventory quickly. Others, like big ticket items, may be purchased less frequently. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.
Assignment SET-2
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Operating leverage is a double-edged sword, however. If firm As sales decrease by I percent, its profits will decrease by more than I percent, too. Hence, the degree of operating leverage shows the responsiveness of profits to a given change in sales. Implications: Total risk can be divided into two parts: business risk and financial risk. Business risk refers to the stability of a companys assets if it uses no debt or preferred stock financing. Business risk stems from the unpredictable nature of doing business, i.e., the unpredictability of consumer demand for products and services. As a result, it also involves the uncertainty of long-term profitability. When a company uses debt or preferred stock financing, additional riskfinancial riskis placed on the companys common shareholders. They demand a higher expected return for assuming this additional risk, which in turn, raises a companys costs. Consequently, companies with high degrees of business risk tend to be financed with relatively low amounts of debt. The opposite also holds: companies with low amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levels. Moreover, using debt as leverage is a successful tool during periods of inflation. Debt fails, however, to provide leverage during periods of deflation, such as the period during the late 1990s brought on by the Asian financial crisis.
Q.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 a 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 ad 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 Incremental approach Revenue Cost Rs. 250 Million Rs. 100 Million = 150 Million Pr factor @10% for 5 years = 3.790 @ 150 X 3.790 = Rs. 568.62 Calculation of depreciation:
150 25%
Year 1
Depreciation 37.5
PV@10% 0.909
Assignment SET-2
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2 3 4 5
Total inflow: 568.62 + 27.398 = 596.018 + Inflow in 5th year 50+48 = 98 X 0.621 60.858 656.876
Q.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%.
1. D=40 % EPS = 40 Kc = 12% ROI =18% E = dividend/payout ratio (40/0.4 = 16%) According to Walter Model, P = [D + (E - D) x ROI / Kc] / Kc P = [40 + (16-40) x 0.18/0.12] / 0.12 = 200
Assignment SET-2
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2. D=50 % EPS = 40 Kc = 12% ROI =18% E = dividend/payout ratio (50/0.4 = 20%) According to Walter Model, P = [D + (E - D) x ROI / Kc] / Kc P = [50 + (20-50) x 0.18/0.12] / 0.12 = 250 3. D=60 % EPS = 40 Kc = 12% ROI =18% E = dividend/payout ratio (60/0.4 = 24%) According to Walter Model, P = [D + (E - D) x ROI / Kc] / Kc P = [60 + (24-60) x 0.18/0.12] / 0.12 = 300
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Assignment SET-2
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