ADL 13 Financial Management V2.pdf

28
Financial Management Assignment - A Question 1a: Should the titles of controller and treasurer be adopted under Indian context? Would you like to modify their functions in view of the company practice in India? Justify your opinion? Answer to 1a: Controller & Treasurer are independent & they have their own Perspectives & Drivers as detailed below: Controller Treasurer Responsibilities include, Double entry accounting, financial reporting, Fraud measure, detective controls, Financial restatement, Compliance with statutory requirements like Rules, Accounting standards, GAAP, IFRS etc., Responsible for Liquidity management (very important function), Risk Management, More focus on financial statements, follows leading practices & responsible for the future performance of company (projects cash flows) Controller works & forecasts the events for a long term. Main focus – income statement Treasurer works/ forecasts the events regularly (daily / weekly) – focus – Balance sheet & future capital structure, capital expenditure etc., Ex: Cash involved event Controller looks from compliance angle (how to record, what GAAP provides etc.,) Treasurer concentrates more on cash availability focus – i.e. how to bring in the required cash etc, Therefore, from the above it is clear that, controller & treasurer have different roles to play. However, majority of the Indian companies works with Financial Controller who himself takes care of the treasury department / Portfolio. Therefore, as far as from Indian context, it can be concluded that, controller is also responsible for treasury jobs & there is no separate treasurer / treasury department exists Question 1b: firm purchases a machinery for Rs. 8, 00,000 by making a down payment of Rs.1,50,000 and remainder in equal installments of Rs. 1,50,000 for six years. What is the rate of interest to the firm? Answer to Q1b: Particulars Ref Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Rs. Cost of Machinery (a) 800,000 Down Payment made by firm (b) 150,000 Financed through borrowings c = (a- b) 650,000 Repayment in equal instalments every year d=6*15 0,000 900,000 150,000 150,000 150,000 150,000 150,000 150,000 (maximum of six years) Total interest paid over 6 year period e = d - c 250,000 Rate of Interest = total interest / total borrowings f = e / c 38.46%

Transcript of ADL 13 Financial Management V2.pdf

Page 1: ADL 13 Financial Management V2.pdf

Financial Management

Assignment - A

Question 1a: Should the titles of controller and treasurer be adopted underIndian context? Would you like to modify their functions in view of thecompany practice in India? Justify your opinion?

Answer to 1a:

Controller & Treasurer are independent & they have their own Perspectives & Drivers as detailed below:

Controller TreasurerResponsibilities include, Double entryaccounting, financial reporting, Fraud measure,detective controls, Financial restatement,Compliance with statutory requirements likeRules, Accounting standards, GAAP, IFRS etc.,

Responsible for Liquidity management (veryimportant function), Risk Management, Morefocus on financial statements, follows leadingpractices & responsible for the futureperformance of company (projects cash flows)

Controller works & forecasts the events for along term. Main focus – income statement

Treasurer works/ forecasts the events regularly(daily / weekly) – focus – Balance sheet & futurecapital structure, capital expenditure etc.,

Ex: Cash involved eventController looks from compliance angle (how torecord, what GAAP provides etc.,)

Treasurer concentrates more on cash availabilityfocus – i.e. how to bring in the required cash etc,

Therefore, from the above it is clear that, controller & treasurer have different roles to play. However,majority of the Indian companies works with Financial Controller who himself takes care of the treasurydepartment / Portfolio.

Therefore, as far as from Indian context, it can be concluded that, controller is also responsible for treasuryjobs & there is no separate treasurer / treasury department exists

Question 1b: firm purchases a machinery for Rs. 8, 00,000 by making a down payment of Rs.1,50,000and remainder in equal installments of Rs. 1,50,000 for six years. What is the rate of interest to the firm?

Answer to Q1b:

Particulars Ref Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Rs.

Cost of Machinery (a) 800,000Down Paymentmade by firm (b) 150,000Financed throughborrowings

c = (a-b) 650,000

Repayment in equalinstalments everyyear

d=6*150,000 900,000 150,000 150,000 150,000 150,000 150,000 150,000

(maximum of sixyears)

Total interest paidover 6 year period

e = d -c 250,000

Rate of Interest= total interest/ totalborrowings f = e / c 38.46%

Page 2: ADL 13 Financial Management V2.pdf

Rate of interetper annum

g = f / 6yrs 6.41%

Break of interestcost / principalrepayment:

1) interest cost (canbe apportioned inthe ratio of

6:5:4:3:2:1 21 6 5 4 3 2 1

no of yearsrepayment - i.e.earlier the yearsmore (ratio)

(6+5+4+3+2+1)

the interest cost &vice versa) h 250000 71429 59524 47619 35714 23810 11905

(250,000*6/21)

(250,000*5/21)

(250,000*4/21)

(250,000*3/21)

(250,000*2/21)

(250,000*1/21)

2) PrincipalOutstandingadjustment i = d - h 650000 78571 90476 102381 114286 126190 138095

Yearwise Interestrates: - PrincipalOutstanding at yearend j 650000 571429 480952 378571 264286 138095 0 (prinicpal o/s atyear beginning -Principalrepayment)

(650000-i)

(571429-i)

(480952- i)

(378571- i)

(264286-i)

(138095- i)

RATE OFINTERESTEVERY YEAR

h /principal o/s

at yearbeginni

ng) 11.0% 10.4% 9.9% 9.4% 9.0% 8.6%(h /650000)

(h /571429)

(h /480952)

(h /378571)

(h /264286)

(h /138095)

Question 2a: Explain the mechanism of calculating the present value ofcash flows. What is annuity due? How can you calculate the present andfuture values of an annuity due? Illustrate

Answer 2a:

Calculating Present Value of Cash flows:

Money has time value. For ex: Rs.1000 received today is not the same worth after a year (actually it isless)

Present value of cash flows: It indicates the value of expected worth at current value. (Discounts theexpected cash flows at appropriate discount rate (may be 10%, 20% etc.,)Discount rate will generally be equal to = Inflation rate + Reqd. rate of return + risk free premium rateDetails required for calculating Present Value of cash flows: Cash flows year wise, discount rate. Thistechnique is very useful for decision-making.

Page 3: ADL 13 Financial Management V2.pdf

Annuity due: Uniform/ Constant/ Equal cash flows every year

Present value of annuity Future value of annuityWorth of Lump sum consideration today whichis going to be received tomorrow

Value of fixed investment every year – worthtomorrow. (i.e. corpus it grows)

Computation:Annuity * Present value annuity factor (PVAF)

PVAF is calculated as = 1-[1/(1+r) to the powern].

Annuity * Future value annuity factor (FVAF)

FVAF is calculated as = [(1+r) to the power n] - 1

Illustration:

Mr. A would like to receive Rs.1000/- everyyear for 10 years from now.

It is assumed discount rate 10%, the presentvalue annuity factor for 10 years 10% is 6.144.

Present value of annuity = 1000 * 6.144 =Rs.6145/-

Mr.X would like to grow a corpus by investmentof Rs.10, 000 – 10 years from now.

Rate of interest @10%, the future value annuityfactor for 10 years 10% is 1.594

Future value of annuity = 10000 * 1.594=Rs.15937/-

Question 2b: "The increase in the risk-premium of all stocks, irrespective oftheir beta is the same when risk aversion increases" Comment withpractical examples

Answer 2b:

The security's beta is a function of the correlation of the security's returns with the market index returnsand the variability of the security's returns relative to the variability of the index returns.

In simple, beta measures the sensitivity of the stock with reference to broad based market index.

For instance: a beta of 1.2 for a stock would indicate that this stock is 20% riskier than the index &similarly beta of 0.9 for a stock indicates 10% less riskier than the index.Finally, a beta of 1.0 means, stock is as risky as the stock market index.

Therefore, the given statement is false. Expected risk-premium for stock is beta times the market riskpremium. For ex: let us assume beta = 1.2 times, market risk premium = 10%, then expected risk premium= 10% * 1.2 times = 12%.

Question 3a: How leverage is linked with capital structure? Take example ofa MNC and analyze.

Answer to 3a:Leverage: It is an advantage gained (it may be anything)

Leverage is linked with Capital Structure, since an organization having a optimum capital structure (whereWACC (weighted average cost of capital) is minimum) is a great leverage/ advantage both to the companyas well for the investors.

Organizations, generally have two types of risks; operating risks – impact of fixed costs & variability ofEBIT & Financial risks – impact of interest cost/financial charges & variability of EBT.

Example:

XYZ ltd has the following nos:

Contribution – Rs.100 lacs, fixed cost – Rs.25 lacs, Financial Charges/debt cost – Rs.40 lacs.

Page 4: ADL 13 Financial Management V2.pdf

Particulars Value (Rs. In lacs)Contribution 100Fixed cost 25EBIT 75Interest cost 35EBT 40

XYZ Ltd. has following:

Operating leverage Financial leverageContribution / EBIT = 100 / 75 = 1.33 EBIT / EBT = 75 / 40 = 1.87

It is always preferable to have low operating risk & high financial risk (subject to Return on capitalemployed (ROCE) > Interest cost on debt funds)

We can conclude that, XYZ ltd (MNC) is having a optimum capital structure & manageable risk.

Question 3b: The following figures relate to two companies (10)

P LTD. Q LTD.(In Rs. Lakhs)

Sales 500 1,000Variable costs 200 300

----- --------Contribution Fixed costs 300 700Fixed Cost 150 400

----- --------150 400

Interest 50 100----- --------

Profit before tax 100 200

You are required to:(i) Calculate the operating, financial and combined leverages for the two companies; and

Comment on the relative risk position of them

Answer 3b:

P ltd Q ltdParticulars (in Rs. Lacs)

Sales 500 1000Variable costs 200 300Contibution 300 700Fixed cost 150 400PBIT / EBIT 150 300Interest 50 100Profit before Tax / EBT 100 200

Computation:

a) Opearting leverage: = Contribution / EBIT 2.0 2.3

b) Financial leverage: = EBIT / EBT 1.5 1.5

Page 5: ADL 13 Financial Management V2.pdf

c) Combined leverage: = Contirbution / EBT 3.0 3.5

Comments: Operating risk is higher Operating risk is higher than 'P' ltd(i.e. fixed costs are high) (i.e. fixed costs are high)

Financial risk looks low Financial risk looks low

Overall risk is low as compared Overall risk is high as comparedto 'Q' ltd. to 'P' ltd.

It is always preferable to have low Operating leverage & high Financialleverage (provided, Return on capital employed > Interest on debt funds)

Question 4a: Define various concepts of cost of capital. Explain theprocedure of calculating weighted average cost of capital.

Answer 4a:

Concepts of Cost of Capital:

a) All source of finance have its own cost. Out of long source finance, equity mode of sourcing is costlierthan debt financing because of expectation of shareholders.

b) RISK VS. COST: Equity mode of finance will have low risk but costlier as against debt funds which willhave high risk but relatively cheaper & have tax advantage thus reducing the net cost of debt.Organizations have to effectively trade off between risk, cost & control.

c) Optimum Capital Structure: When the firm / organization has a combination of debt and equity, suchthat the wealth of the firm is maximum. At this point, cost of capital is minimum & market price of ashare is maximum.

Procedure of calculating Weighted Average Cost of Capital (WACC):

It is computed by reference to proportion of each component of capital (book value or market value asspecified) as weights.

WACC = Sum [proportion of each component of capital (weights) * individual cost of capital]Note: Tax rates needs to be adjusted in respect of debt funds.

Question 4b: The following items have been extracted from the liabilitiesside of the balance sheet of XYZ Company as on 31st December 2005.

Paid up capital:4, 00,000 equity shares of Rs each 40,00,000

Loans:16% non-convertible debentures 20,00,00012% institutional loans 60,00,000

Other information about the company as relevant is given below:

31st dec Dividend Earning average market price2005 Per share per share per share

7.2 10.50 65You are required to calculate the weighted average cost of capital, using book values as weights andearnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate

Page 6: ADL 13 Financial Management V2.pdf

Answer 4b:

Computation of Weighted Average Cost of Capital (WACC):

Nature of Capital Value Weights Cost of capitalWeights * Cost of

Capital(basis of

bookvaluesO/S.)

a) Equity Capital 4,000,000 33% 16.15 5.38(refer W.No.1)

b) 16% non-convertible debentures 2,000,000 17% 14.53 2.42Interest (1-taxrate) =16% (100%-9.2%)

c) 12% institutional loans 6,000,000 50% 10.90 5.45Interest (1-taxrate) =12% (100%-9.2%)

Total 12,000,000 100% 13.25

Working Note: 1

Cost of equity:

Price earnings approach =Earnings pershare /Market price pershare

10.50 / 65 =16.15%

Question 5a: A company has issued debentures of Rs. 50 Lakhs to berepaid after 7 years. How much should the company invest in a sinking fundearning 12% in order to be able to repay debentures? Show the procedure ofloan amortization and capital recovery through an example.

Answer 5a:

Debentures to be redeemed after 7 years 5,000,000

Expected rate of return - on sinking fund investment to be created 12%

Discount rate@12%, 7 yrs 0.452

Present value of expected repayment of debentures @12% 7 yrs 2,261,746

therefore, company has to invest Rs.22,61,746 @ 12% earning in Sinking fund to coverthe repayment expected 7 years from now.

Page 7: ADL 13 Financial Management V2.pdf

Loan Amortization Capital RecoveryA loan amortization schedule is a repayment plan thatis calculated before repayment of a loan begins.

Amortization schedules are used for fixed interest long– term loans such as mortgages, expenses like R& Dexpenses, Purchase of Goodwill, Voluntary Retirementpayment expenses, Amalgamation expenses etc.

The reciprocal of Present value annuity factor(PVAF) is the capital recovery.

Below example will clarify better the meaning:

Procedure with Ex:

M/s.XYZ ltd has incurred a Rs.50, 00,000 as lump sumpayment towards voluntary retirement separationcharges during the accounting year 2009-2010.

XYZ ltd have planned to amortize the above expensesfor a period of 10 years commencing from FY.09-10

Therefore, the schedule of amortization for 10 yearperiod as follows:

Rs. 500,000/- per years for 10 years

Procedure with Ex: Mr.X plan to lend Rs.1 lactoday for a period of 5 years @ int.rate of 12%,how much income Mr.X should receive each yearto recover investment & principal back.

The result is known as capital recovery & whichcan be arrived by capital recovery factor.

Calculation:

Present value = Annuity * PVAF @12%,5years

Capital Recovery = Annuity * 1 /PVAF@12%,5years

Therefore, capital recovery = 100,000 * 0.27739= Rs.27,740 each year for 5 years.

Question 5b: A bank has offered to you an annuity of Rs. 1,800 for 10 yearsif you invest Rs. 12,000 today. What is the rate of return you would earn? .

Answer 5b:

Particulars Rs.Return expected per annum 1800Fixed return/annuity for no of years 10Total return expected 18000

Investment required today 12000

Nett return expected from investment 6000

Percentage of return for 10 years 50%Percentage of return per annum 5%

Page 8: ADL 13 Financial Management V2.pdf

Assignment - C

Question 1: The proforma of cost-sheet of HLL provides the following data:

Cost (perunit): Rs.

Raw materials 52.0

Direct labour 19.5

Overheads 39.0

Total cost (per unit): 110.5

Profit 19.5

Selling price 130.0

The following is the additional information available:

Average raw material in stock: one month; Average materials in process: half month; Credit allowed bysuppliers: one month; Credit allowed to debtors: two months; Time lag in payment of wages: one and halfweeks; Overheads: one month. One-fourth of sales are on cash basis. Cash balance expected to be Rs.12,000.

You are required to prepare a statement showing the working capital needed o finance a level of activity of70,000 units of output. You may assume that production is carried on evenly throughout the year andwages and overheads accrue similarly.

Answer 1:Particulars Cost/unit Production = 70,000 units

cost (Rs.) for 70000 units

Raw Material 52 3640000Direct Labour 19.5 1365000Prime cost 5005000Overheads 39 2730000Total cost 110.5 7735000Profit 19.5 1365000Sales 130 9100000

Statement of Working Capital for HLL - 70,000 units production per year:

ParticularsNo of

months Computation Rs.

Current Assets: (A)

Raw material stock 1 36,40,000/12*1month 303333Process stock - Work in progress (WIP) 0.5 50,05,000/12*0.5 months 208542Debtors - customers 2 91,00,000*3/4 (credit sales)/12*2 1137500Cash balance expected to maintain 12000

Total of CURRENT ASSETS - (A) 1661375

Current Liabilities: (B)

Page 9: ADL 13 Financial Management V2.pdf

Creditors - suppliers 1 36,40,000/12*1month 303333

Wages Outstanding1.5 weeks

or 13,65,000/12*0.34 386750.34

monthOverheads outstanding 1 27,30,000/12*1 227500

Total of CURRENT LIABILITIES - (B) 569508

NETT WORKING CAPITALREQUIRED 1091867

Question 2a: Through quantitative analysis prove that PI is a bettertechnique than NPV in Capital Budgeting.

Answer 2a:

PI – Profitability Index & NPV – Net Present Value both are capital budgeting techniques.

Profitability Index (PI) Net Present Value (NPV)PI = Present value of inflows / Present value ofoutflows

NPV = Present value of inflows – Presentvalue of outflows

Ideal = should be > 1 Ideal = NPV should be positive, it showsabsolute present value of tomorrow’s wealth

Quantitative analysis:

Present value of inflows = Rs. 200,000Present value of outflows = Rs. 100,000

PI = 2

Present value of inflows = Rs. 200,000Present value of outflows = Rs. 100,000

NPV = Rs.100,000

NPV technique is better than PI technique for capital budgeting decisions. NPV shows wealth at the end inabsolute amount, which will be helpful to make decisions clearly, whereas the same advantage is notavailable with PI technique.

However, PI shows – return over investment in times, which will be very useful for immediate decisionmaking.

Generally, over the years, organizations prefer NPV technique for capital budgeting decisions than PItechnique.

Question 2b: A company is considering the following investment projects:

Cash Flows (Rs.)Projects

Co C1 C2 C3

A - 10,000 + 10,000 ----- -----B -10,000 + 7,500 + 7,500 -----C - 10,000 + 2,000 + 4,000 + 12,000

D -10,000 + 10,000 + 3,000 + 3,000

I. according to each of the following methods: (1.) Payback, (2.) ARR, (3.) IRR, (4.) NPV assumingdiscount rates of 10 and 30 percent.

II. Assuming the project is independent, which one should be accepted? If the projects are mutuallyexclusive, which project is the best?

Page 10: ADL 13 Financial Management V2.pdf

Answer 2b:

I)

Project A Project B Project C Project DMethods(1) Payback @10% discount rate @30% discount rate

1 + years1 + years

1.13 years1.25 years

2.14 years3 + years

1.7 years2.8 years

(2) Accounting rate ofreturn (ARR)

100% 150% 180% 160%

(3) NPV @10% discount rate @30% discount rate

(909)(2308)

3017207

4140(633)

3824833

(4) IRR 0% 32% 26% 38%

Independent project: Project with higher NPV needs to be selected, which shows wealth in absolutevalue at the end of the project

Therefore, Project C needs to be accepted.

II) In case projects are mutually exclusive:

First disparity between projects needs to be resolved. NPV selects Project C whereas IRR selects ProjectD, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for both the projects, thedisparity arisen is called as Cash flow disparity.

It can be resolved by using Incremental cash flow technique. After resolving, the right project can beaccepted.

Workings are as follows:

PROJECT A:

The following has been calculated assuming discount rates of 10%& 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discountrate *

Discountedcash flows

Unrecovered

discounted cashflows

Years Cashflows

Discount rate

*

Discountedcashflows

Unrecovered

discounted cashflows

@ 10% @30%

(1) (2) (3) (4) =(2) * (3) (5) (1) (2) (3)

(4) = (2)* (3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 10,000 0.909 9,091 (909) 1 10,000 0.769 7,692 (2,308)* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /

Page 11: ADL 13 Financial Management V2.pdf

disocunted cash flows of next year) *12]

Payback period exceed 1 year, since unrecovered cash flows turnspositive only from IInd yr onwards

where base year = year in which unrecovered cashflows turns 0 or +ve

Payback period @ 10% & 30% discountrate = 1 + years

=1+years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depreciation & Tax / Initialinvestment

Since no information on profits, depreciation & taxes, it is treated cash inflowsconsidered as profits after depreciation & taxes

therefore=

(10,000 (inflow) / 10,000(investment)) * 100

accounting rate of return = 100%; effectively 0% return(whatever invested taken back)

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discounted

cashflowsYears Cash

flowsDiscount rate *

Discounted

cashflows @ 10% @ 30%

(1) (2) (3) (4) =(2) * (3) (1) (2) (3)

(4) =(2) * (3)

0(10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 10,000 0.909 9,091 1 10,000 0.769 7,692

NPV (909) NPV (2,308)

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

3) IRR (Internal rate of return): which is the rate ofreturn at which NPV = 0

In project A , IRR is '0'% at which NPV =0

(i.e. there is no return fromthe project)

Page 12: ADL 13 Financial Management V2.pdf

PROJECT B:

The following has been calculated assuming discount rates of 10% &30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discounted

cashflows

Unrecovered

discounted cashflows

Years Cashflows

Discount rate

*

Discountedcashflows

Unrecovered

discounted cashflows

@ 10% @30%

(1) (2) (3) (4) =(2) * (3) (5) (1) (2) (3)

(4) =(2) * (3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 7,500 0.909 6,818 (3,182) 1 7,500 0.769 5,769 (4,231)

2 7,500 0.826 6,198 3,017 2 7,500 0.592 4,438 207

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /disocunted cash flows of next year) *12]

where base year = year in which unrecovered cashflows turns 0 or +ve

Payback period @ 10% discount rate= 1 +[(3182/3017)*12]

Payback period @ 30% discount rate=1 + [(4231/207)*12]

=1.13years

=1.25years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initialinvestment

Since no information on profits, depreciation & taxes, it is treated cash inflowsconsidered as profits after depreciation & taxes

therefore =

(15,000 (inflow) / 10,000(investment)) * 100

accounting rate of return = 150%;effectively 50% return

Page 13: ADL 13 Financial Management V2.pdf

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discounted

cashflowsYears Cash

flowsDiscount rate *

Discountedcashflows

@ 10% @ 30%

(1) (2) (3) (4) =(2) * (3) (1) (2) (3)

(4) = (2)* (3)

0 (10,000) 1.000 (10,000) 0(10,000) 1.000 (10,000)

1 7,500 0.909 6,818 1 7,500 0.769 5,769

2 7,500 0.826 6,198 2 7,500 0.592 4,438

NPV 3,017 NPV 207

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

3) IRR (Internal rate of return): which is the rate ofreturn at which NPV = 0

For project B , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted atgiven required rate of return) L2 = one more guessrate

Relationship between discount rate and NPV:inverse relationship:

Discount rategoes up NPV falls

Discount rate comes downNPV goesup

Let us assume L1 = 30% (why, because as could be seen at 30%@ discount rate NPV is +ve

by applying the relationship,increased disocunt rate)

Let us calculate L2 = 32%

Discounted @32%(assumed rate)

Years Cashflows

Discount rate *

Discounted

Page 14: ADL 13 Financial Management V2.pdf

cashflows

@ 32%

(1) (2) (3) (4) =(2) * (3)

0 (10,000) 1.000 (10,000)

1 7,500 0.758 5,682

2 7,500 0.574 4,304

NPV (14)

therefore, IRR for Project B = 30% + [207 /(207+14)]*32% - 30%

IRR30% +1.873 31.87%

PROJECT C:

The following has been calculated assuming discount rates of 10%& 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted@10%

b) Discounted@30%

Years Cashflows

Discount rate *

Discounted

cashflows

Unrecovered

discounted cashflows

Years Cashflows

Discountrate *

Discountedcashflows

Unrecovered

discounted cashflows

@ 10% @ 30%

(1) (2) (3) (4) =(2) * (3) (5) (1) (2) (3)

(4) =(2) *(3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000(10,000) (10,000)

1 2,000 0.909 1,818 (8,182) 1 2,000 0.769 1,538 (8,462)

2 4,000 0.826 3,306 (4,876) 2 4,000 0.592 2,367 (6,095)

3 12,000 0.751 9,016 4,140 3 12,000 0.455 5,462 (633)

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted

Page 15: ADL 13 Financial Management V2.pdf

cash flows of next year) *12]

where base year = year in which unrecovered cashflows turns 0 or +ve

Payback period @ 10% discount rate= 2 +[(4876/4140)*12]

Payback period @ 30% discount rate=exceeds 3 years

=2.14years

= 3 +years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initialinvestment

Since no information on profits, depreciation & taxes, it is treated cash inflows consideredas profits after depreciation & taxes

therefore =

(18,000 (inflow) / 10,000(investment)) * 100

accounting rate of return = 180%;effectively 80% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discountedcash flows Years Cash

flows

Discount

rate *

Discounted

cashflows

@ 10% @30%

(1) (2) (3) (4) =(2) * (3) (1) (2) (3)

(4) =(2) * (3)

0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 2,000 0.909 1,818 1 2,000 0.769 1,538

2 4,000 0.826 3,306 2 4,000 0.592 2,367

3 12,000 0.751 9,016 3 12,000 0.455 5,462

NPV 4,140 NPV (633)

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Page 16: ADL 13 Financial Management V2.pdf

3) IRR (Internal rate of return): which is the rate ofreturn at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted atgiven required rate of return) L2 = one more guessrate

Relationship between discount rate and NPV:inverse relationship:

Discount rategoes up NPV falls

Discount rate comes downNPV goesup

Let us assume L1 = 30% (why, because as could be seen at 30% @discount rate NPV is -ve

by applying the relationship, reduceddisocunt rate)

Let us calculate L2 = 26%

Discounted @26%(assumed rate)

Years Cashflows

Discount rate *

Discounted

cashflows @ 26%

(1) (2) (3) (4) =(2) * (3)

0 (10,000) 1.000 (10,000)

1 2,000 0.794 1,587

2 4,000 0.630 2,520

3 12,000 0.500 5,999

NPV 106

therefore, IRR for Project B = 30% + [-633 /( -633-106)]*26% - 30%

IRR30% -3.43 26.57

PROJECT D:

The following has been calculated assuming discount rates of 10% &30% separately:

Page 17: ADL 13 Financial Management V2.pdf

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discounted

cashflows

Unrecovered

discounted cashflows

Years Cashflows

Discount rate *

Discounted

cashflows

Unrecovered

discounted cashflows

@ 10% @ 30%

(1) (2) (3) (4) =(2) * (3) (5) (1) (2) (3)

(4)= (2) *

(3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 10,000 0.909 9,091 (909) 1 10,000 0.769 7,692 (2,308)

2 3,000 0.826 2,479 1,570 2 3,000 0.592 1,775 (533)

3 3,000 0.751 2,254 3,824 3 3,000 0.455 1,365 833

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /disocunted cash flows of next year) *12]

where base year = year in which unrecovered cashflows turns 0 or +ve

Payback period @ 10% discount rate= 1 +[(909/1570)*12]

Payback period @ 30% discount rate=2 + [(533/833)*12]

=1.7years

= 2.8years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initialinvestment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered asprofits after depreciation & taxes

therefore =

(16,000 (inflow) / 10,000(investment)) * 100

Page 18: ADL 13 Financial Management V2.pdf

accounting rate of return = 160%;effectively 60% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Years Cashflows

Discount rate *

Discounted cashflows

Years Cashflows

Discount

rate *

Discountedcashflows

@ 10% @30%

(1) (2) (3) (4) =(2) * (3) (1) (2) (3)

(4) = (2)* (3)

0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 10,000 0.909 9,091 1 10,000 0.769 7,692

2 3,000 0.826 2,479 2 3,000 0.592 1,775

3 3,000 0.751 2,254 3 3,000 0.455 1,365

NPV 3,824 NPV 833

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

3) IRR (Internal rate of return): which is the rate ofreturn at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted atgiven required rate of return) L2 = one more guessrate

Relationship between discount rate and NPV:inverse relationship:

Discount rategoes up NPV falls

Discount rate comes downNPV goesup

Let us assume L1 = 30% (why, because as could be seen at 30% @discount rate NPV is+ve

by applying the relationship,increased disocunt rate)

Let us calculate L2 = 38%

Page 19: ADL 13 Financial Management V2.pdf

Discounted @38%(assumed rate)

Years Cashflows

Discount rate *

Discounted

cashflows @ 38%

(1) (2) (3) (4) =(2) * (3)

0(10,000) 1.000 (10,000)

1 10,000 0.725 7,246

2 3,000 0.525 1,575

3 3,000 0.381 1,142

NPV (37)

therefore, IRR for Project B = 30% + [833 /(833+37)]*38% - 30%

IRR30% +7.66 37.66%

1) NPV (net present value): for increments cash flows

a) Discounted @10% b) Discounted @30%

Years

Incremental

Cashflows

(projectC –

projectD)

Discount rate

*

Discountedcashflows Years Cash

flows

Discount rate

*

Discounted

cashflows

@10%

@30%

(1) (2) (3) (4) =(2) * (3) (1) (2) (3)

(4) =(2) * (3)

0 0 1.000 - 0 0 1.000 -

1 (8,000) 0.909 (7,273) 1 (8,000) 0.769 (6,154)

2 1,000 0.826 826 2 1,000 0.592 592

3 9,000 0.751 6,762 3 9,000 0.455 4,096

NPV 316 NPV (1,466)

* disocunt rate computed using formule = 1 / (1+r) to the power n;where r = disocunt rate & n = year

Page 20: ADL 13 Financial Management V2.pdf

3) IRR (Internal rate of return): which is the rate ofreturn at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted atgiven required rate of return) L2 = one more guessrate

Relationship between discount rate and NPV:inverse relationship:

Discount rategoes up NPV falls

Discount rate comes downNPV goesup

Let us assume L1 = 10% (why, because as could be seen at 30% @discount rate NPV is+ve

by applying the relationship,increased disocunt rate)

Let us calculate L2 = 13%

Discounted @13%(assumed rate)

Years Cashflows

Discount rate *

Discounted

cashflows @ 13%

(1) (2) (3) (4) =(2) * (3)

0 0 1.000 -

1 (8,000) 0.885 (7,080)

2 1,000 0.783 783

3 9,000 0.693 6,237

NPV (59)

therefore, IRR for Project B = 10% + [316 /(316+59)]*13% - 10%

IRR10% +2.5 12.50%

Target return =10%IRR for incremental cashflows = 12.5%

Page 21: ADL 13 Financial Management V2.pdf

since IRR for incremental cash flows > Target return,select / accept Project C

Question 3a: "Firm should follow a policy of very high dividend pay-out”Taking example of two organization comment on this statement"

Answer 3a:The statement not necessarily be true. Let us take 2 companies;

High dividend pay out company – 100% payout Low dividend payout company – 20% payouta) Less retained earningsb) Slower / lower growth ratec) Lower market priced) Cost of equity (Ke) > IRR (r = rate of return

earned by company on its investment.e) Indicates that company is declining.

a) More retained earningsb) Accelerated/higher growth ratec) Higher market priced) Cost of equity (Ke) < IRR (r = rate of return

earned by company on its investment.e) Indicates that company is growing.

It must be noted that, dividend is a trade off between retaining money for capital expenditure and issuingnew shares.

Question 3b: An investor gains nothing from bonus share "Critically analysethe statement through some real life situation of recent past.

Answer 3b:

The statement is false. An investor gains bonus shares at zero cost, However, the market price of thestock will come down & over the long period, the investor definitely maximizes his wealth due to bonusshares.

From company angle, bonus issue is only an accounting entry & it doesn’t change the wealth/value of thefirm.

Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained Bonus sharesat zero cost & the market have come down to the extent of bonus issue & immediately went up & investorshave cashed the bonus shares thus maximized their wealth. However, currently it is trading down due tovaried reasons.

Page 22: ADL 13 Financial Management V2.pdf

CASE STUDY

Ques 1: You are required to make these calculations and in the light thereof,advise the finance manager about the suitability, or otherwise, of machine Aor machine B.

Solution:

Advise to finance manager of Brown metals ltd, to select the appropriate machine:

Particulars Machine A (Rs. In lacs) Machine B (Rs. In lacs)1) NPV 12 142) Profitability index 1.48 1.353) Pay Back period 2 years 3 years4) Discounted pay back period 3.18 years 3.21 years

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm.NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higherNPV needs to be invested.

Workings are as follows:

(a) to buy machine A which is similar to the existing machine:

Years

Cashflows

(Rs. Inlacs)

Unrecoveredcash flows

Discount rate*

Discountedcashflows

Unrecovereddiscountedcash flows

@10%

(1) (2) (3) (4) = (2) *

(3) (5)

0 (25) (25) 1.000 (25) (25)1 - (25) 0.909 - (25)

2 5 (20) 0.826 4 (21)

3 20 - 0.751 15 (6)

4 14 14 0.683 10 4

5 14 28 0.621 9 12NPV 12

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate & n = year

1) Net Present value = Present value of inflows - Present value of outflows = 12 (as computed above)

2) Profitability Index = Present value of inflows / present value of outflows which should be >1 37 / 25 1.48

3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 2 + [(20/0)*12] = 2 years

Page 23: ADL 13 Financial Management V2.pdf

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cashflows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(6/4)*12] =3.18 years

(b) to go in for machine B which is more expensive & has much greater capacity:

Years

Cashflows

(Rs. Inlacs)

Unrecoveredcash flows

Discount rate*

Discountedcashflows

Unrecovereddiscountedcash flows

@10%

(1) (2) (3) (4) = (2) *

(3) (5)

0 (40) (40) 1.000 (40) (40)

1 10 (30) 0.909 9 (31)

2 14 (16) 0.826 12 (19)

3 16 - 0.751 12 (7)

4 17 17 0.683 12 4

5 15 32 0.621 9 14NPV 14

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate & n = year

1) Net Present value = Present value of inflows - Present value of outflows = 14 (as computed above)

2) Profitability Index = Present value of inflows / present value of outflows which should be>1

54 / 40 1.35

3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(16/0)*12] = 3 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cashflows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(7/4)*12] =3.21 years

Page 24: ADL 13 Financial Management V2.pdf

Assignment - C1. The main function of a finance manager is(a) capital budgeting(b) capital structuring(c) management of working capital(d) (a),(b)and(c)Answer – (d)

2. Earning per share(a) refers to earning of equity and preference shareholders.(b) refers to market value per share of the company.(c) reflects the value of the firm.(d) refers to earnings of equity shareholders after all other obligations of the company have been met.Answer – (d)

3. If the cut off rate of a project is greater than IRR, we may(a) accept the proposal.(b) reject the proposal.(c) be neutral about it.(d) wait for the IRR to increase and match the cut off rate.Answer – (b)

4. Cost of equity share capital is(a) equal to last dividend paid to equity shareholders.(b) equal to rate of discount at which expected dividends are discounted to determine their PV.(c) less than the cost of debt capital.(d) equal to dividend expectations of equity shareholders for coming year.Answer – (b)

5. Degree of the total leverage (DTL) can be calculated by the following formula[Given degree of operating leverage (DOL) and degree of financial leverage (DFL)](a) DOL + DFL(b) DOL /DFL(c) DFL-DOL(d) DOL x DFLAnswer – (d)

6. Risk- Return trade off implies(a) increasing the profits of the firm through increased production(b) not taking any loans which increase the risk of the firm(c) taking decisions in a way which optimizes the balance between risk and return(d) not granting credit to risky customersAnswer – (c)

7. The goal of a firm should be(a) maximization of profit(b) maximization of earning per share(c) maximization of value of the firm(d) maximization of return on equityAnswer – (c)

8. Current Assets minus current liabilities is equal to(a) Gross working capital(b) Capital employed(c) Net worth(d) Net working capital.Answer – (d)

9. The indifference level of EBIT is one at which(a) EPS increases(b) EPS remains the same(c) EPS decreases

Page 25: ADL 13 Financial Management V2.pdf

(d) EBIT=EPS.Answer – (d)

10. Money has time value since(a) The value of money gets compounded as time goes by(b) The value of money gets discounted as time goes by(c) Money in hand today is more certain than money in future(d) (b) and (c)Answer – (b)

11. Net working capital is(a) excess of gross current assets over current liabilities(b) same as net worth(c) same as capital employed(d) same as total assets employedAnswer – (a)

12. The internal rate of return of a project is the discount rate at which NPV is(a) positive(b) negative(c) zero(d) negative minus positiveAnswer – (c)

13. Compounding technique is(a) same as discounting technique(b) slightly different from discounting technique(c) exactly opposite of discounting technique(d) one where interest is compounded more than once in a year.Answer – (c)

14. For determining the value of a share on the basis of P/E ratio, information is requiredregarding:(a) earning per share(b) normal rate of return(c) capital employed in the business(d) contingent liabilitiesAnswer – (a)

15. Tandon committee suggested inventory and receivable norms for(a) 15 major industries(b) 20 minor industries(c) 25 major and minor industries(d) 30 major and minor industriesAnswer – (c)

16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000 share ofRs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax is Rs. 20,000. Thedegree of financial leverage is(a) 1.00(b) 1.25(c) 2.50(d) 2.00Answer – (b)

17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70, Total fixedcost- Rs. 1,00,000 Interest Charges Rs. 3,668, Output-1,00,000 units. The degree of operating leverage is(a) 4.00(b) 4.33(c) 4.75(d) 5.33Answer – (b)

18. Market price of equity share of a company is Rs. 25 and the dividend expected a year hence is Rs. 10.

Page 26: ADL 13 Financial Management V2.pdf

The expected rate of dividend growth is 5%. The cost of equal capital to company will be(a) 40%(b) 45%(c) 35%(d) 50%Answer – (b)

19. The dilemma of "liquidity Vs profitability" arise in case of(a) Potentially sick unit(b) Any business organization(c) Only public sector unites(d) Purely trading companiesAnswer – (b)

20. The present value of Rs. 15000 receivable in 7 years at a discount rate of 15% is(a) 5640(b) 5500(c) 5900(d) 5940Answer – (a)

21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the requiredrate of return is 10% the value of bond is(a) 1000(b) 1123(c) 1140(d) 1150Answer – (a)

22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at return rateof 15% and dividend pay out ratio of 40% is(a) 100(b) 120(c) 130(d) 150Answer – (a)

23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of not availingthe cash discount is(a) 22.58%(b) 27.45%(c) 37.75%(d) 38.50%Answer – (a)

24. The costliest of long term sources of finance is(a) Preference share capital(b) Retained earnings(c) Equity share capital(d) DebenturesAnswer – (c)

25. Which of the following approaches advocates that the cost of equity capital & debit capitalremains the degree of leverages varies(a) Net income approach(b) Net operating income approach(c) Traditional approach(d) Modigliani-Miller approachAnswer – (b) & (d)

26. Which of the following is not a feature of an optimal capital structure.(a) Profitability(b) Safety(c) Flexibility

Page 27: ADL 13 Financial Management V2.pdf

(d) ControlAnswer – (b)

27. While calculating weighted average cost of capital(a) Retained earnings are excluded(b) Bank borrowings for working capital are included(c) Cost of issues are included(d) Weights are based on market value or on book valueAnswer – (a)

28. Which of the following factors influence the capital structure of a business entity?(a) Bargaining power with suppliers(b) Demand for product of company(c) Expected income(d) Technology adoptedAnswer – (c)

29. According to the Walters model, a firm should have 100% dividend pay-out ratio when.(a) r = ke(b) r < ke(c) r > ke(d) g > keAnswer – (a)

30. Operating cycle can be delayed by(a) Increase in WIP period(b) Decrease in raw material storage period(c) Decrease in credit payment period(d) Both a & c aboveAnswer – (d)

31. If net working capital is negative, it signifies that(a) The liquidity position is not comfortable(b) The current ratio is less then 1(c) Long term uses are met out of short- term sources(d) All of a, b and c aboveAnswer – (d)

32. Which of the following models on dividend policy stresses on investors preference for thecurrent dividend(a) Traditional model(b) Walters model(c) Gordon model(d) MM modelAnswer – (d)

33. Which of the following is a technique for monitoring the status of receivables(a) ageing schedule(b) outstanding creditors(c) selection matrix(d) credit evaluationAnswer – (a)

34. Average collection period is equal to(a) 360/ Receivables Turnover Ratio(b) Average Creditors / Sales per day(c) Sales / Debtors(d) Purchases / DebtorsAnswer – (a)

35. In IRR, the cash flows are assumed to be reinvested in the project at(a) Internal rate of return(b) cost of capital(c) Marginal cost of capital(d) risk free rate

Page 28: ADL 13 Financial Management V2.pdf

Answer – (d)

36. In a capital budgeting decision, incremental cash flow mean(a) cash flows which are increasing.(b) cash flows occurring over a period of time(c) cash flows directly related to the project(d) difference between cash inflows and outflows for each and every expenditure.Answer – (d)

37. The simple EOQ model will not hold good under which of the following conditions(a) Stochastic demand(b) constant unit price(c) Zero lead time(d) Fixed ordering costsAnswer – (a)

38. The opportunity cost of capital refers to the(a) net present value of the investment.(b) return that is foregone by investing in a project.(c) required investment in a project.(d) future value of the investments cash flows.Answer – (b)

39. Which of the following factors does not influence the composition of Working Capitalrequirements(a) Nature of the business(b) seasonality of operations(c) availability of raw materials(d) amount of fixed assetsAnswer – (d)

40. The capital structure ratio measure the(a) Financial Risk(b) Business Risk(c) Market Risk(d) operating risksAnswer – (a)