MB0045 - Financial Management - Set 2


Course MBA – 2nd Semester

Subject: Financial Management

Assignment MB0045 – Set 2



Q. 1 Discuss the three broad areas of Financial Decision Making
Finance Decisions:
Finance decisions relate to the acquisition of funds at the least cost. Here cost has two
dimensions viz explicit cost and implicit cost. Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the securities etc.

Implicit cost is not a visible cost but it may seriously affect the company’s operations especially when it is exposed to business and financial risk. For example, implicit cost is the failure of the organization to pay to its lenders or debenture holders loan installments on due date on account of fluctuations in cash flow attributable to the firms business risk. In India if the company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high
degree of business risk.

In all financing decisions a firm has to determine the proportion of equity and debt. The
composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India.

An investor in company’s shares has two objectives for investing:

1. Income from Capital appreciation (i.e. Capital gains on sale of shares at market price)
2. Income from dividends.

It is the ability of the company to give both these incomes to its shareholders that determines the market price of the company’s shares.

The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market.
But, dividend is declared out of the profit earned by the company after paying income tax to the Govt of India.

Investment Decisions:
To survive and grow, all organizations must be innovative. Innovation demands managerial proactive actions. Proactive organization’s continuously search for innovative ways of performing the activities of the organization. Innovation is wider in nature. It could be expansion through entering into new markets, adding new products to its product mix, performing value added activities to enhance the customer satisfaction, or adopting new technology that would drastically reduce the cost of production or rendering services or mass production at low cost or restructuring the organization to improve productivity. All these will change the profile of an organization. These decisions are strategic because, they are risky but if executed successfully with a clear plan of action, they generate super normal growth to the organization. If the management errs in any phase of taking these decisions and executing them, the firm may become bankrupt. Therefore, such decisions will have to be taken after taking into account all facts affecting the decisions and their execution.

Two critical issues to be considered in these decisions are:

1. Evaluation of expected profitability of the new investments.
2. Rate of return required on the project.

The rate of return required by investor is normally known by hurdle rate or cutoff rate or opportunity cost of capital. After a firm takes a decision to enter into any business or expand it’s existing business, plans to invest in buildings, machineries etc. are conceived and executed. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organization is directly attributable to the execution of capital budgeting decisions taken. Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting decisions lead to investment in real assets Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend policy formulation requires the decision of the management as to how much of the profits earned will be paid as dividend. A growing firm may retain a large portion of profits as retained earnings to meet its needs of financing capital projects. Here, the finance manager has to strike a balance between the expectation of shareholders on dividend payment and the need to provide for funds out of the profits to meet the organization’s growth.

Dividend Decisions
Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in his portfolio management decisions. But dividend yield is the result of dividend decision. Dividend decision is a major decision made by a finance manager. It is the decision on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend on the market value of the shares. Optimum dividend policy requires decision on dividend payment rates so as to maximize the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, management of a company must consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Since company’s ratings in the Capitalmarket have a major impact on its ability to procure funds by issuing securities in the capital markets, dividend policy, a determinant of dividend yield has to be formulated having regard to all the crucial elements in building up the corporate image. The following need adequate consideration in deciding on dividend policy:

1. Preferences of share holders Do they want cash dividend or Capital gains?
2. Current financial requirements of the company
3. Legal constraints on paying dividends.
4. Striking an optimum balance between desires of share holders and the company’s funds requirements.

Liquidity Decision
Liquidity decisions are concerned with Working Capital Management. It is concerned with the day to–day financial operations that involve current assets and current liabilities.

The important element of liquidity decisions are:

1) Formulation of inventory policy
2) Policies on receivable management.
3) Formulation of cash management strategies
4) Policies on utilization of spontaneous finance effectively.



Q.2 What is the future value of an annuity and state the formulae for future value of an annuity

The value of a group of payments at a specified date in the future. These payments are known as an annuity, or set of cash flows. The future value of an annuity measures how much you would have in the future given a specified rate of return or discount rate. The future cash flows of the annuity grow at the discount rate, and the higher the discount rate, the higher the future value of the annuity.

This calculation is useful for determining the actual cost of an annuity to the issuer:

C = Cash flow per period

i = Interest rate

n = Number of payments


This calculates the future value of an ordinary annuity. To calculate the future value of an annuity due, multiply the result by (1+i). (Payments start immediately instead of one period into the future.)
Example: What amount will accumulate  if we deposit $5,000 at the end of each year for the next 5 years?  Assume an interest of 6% compounded annually.
PV = 5,000
i = .06
n = 5
FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46
Year
1
2
3
4
5
Begin
0
5,000.00
10,300.00
15,918.00
21,873.08
Interest
0
300.00
618.00
955.08
1,312.38
Deposit
5,000.00
5,000.00
5,000.00
5,000.00
5,000.00
End
5,000.00
10,300.00
15,918.00
21,873.08
28,185.46

Q.3 The equity stock of ABC Ltd is currently selling for Rs 30 per share. The dividend expected next year is Rs 2.00. the investors required rate of return on this stock is 15 per cent. If the constant growth model applies to ABC Ltd, What is the expected growth rate?
Formula to be used to resolve this problem
P0=D1/Ke-g
In this case,
P0 = Price of One share = Rs. 30
Ke=Required rate of return on the equity share = 15% = 0.15
D1=Expected dividend after one year = Rs. 2
g = growth rate = ?
Hence,
P0=D1/Ke-g
Ke-g = D1/P0
0.15-g = 2/30
0.15-g = 0.0666
g=0.15-0.0666
g = 0.0834
Hence Growth Rate of ABC Ltd = 8.34%
Q.4 State the assumptions underlying the CAPM model and MM model
Capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (ß) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
Assumptions made are as below -
  1. Aim to maximize economic utilities.
  2. Are rational and risk-averse.
  3. Are broadly diversified across a range of investments.
  4. Are price takers, i.e., they cannot influence prices.
  5. Can lend and borrow unlimited amounts under the risk free rate of interest.
  6. Trade without transaction or taxation costs.
  7. Deal with securities that are all highly divisible into small parcels.
  8. Assume all information is available at the same time to all investors.
The model assumes that either asset returns are (jointly) normally distributed random variables or that investors employ a quadratic form of utility. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect
The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature.
The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).[citation needed]
The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001)
The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).[citation needed]
The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.[citation needed]
The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.[citation needed]
The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.[citation needed]
The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique
The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[citation needed]
CAPM assumes that all investors will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio — see behavioral portfolio theory and Maslowian Portfolio Theory


MM's key assumptions and the role played by each are:
(1) Unlimited borrowing and lending is available to all market participants at one rate of interest. Role: makes the cost of personal and corporate borrowing and lending the same.
(2) Individual margin borrowing is secured by the shares purchased, the borrower's liability is limited to the value of these shares, there are no costs to bankruptcy. Role: makes the risk of personal and corporate borrowing and lending the same.
(3) All companies can be grouped into equivalent risk classes. Role: enables investors to identify companies with identical business risk.
(4) Capital markets are perfect. Role: permits investors to easily and costlessly arbitrage between securities of companies which differ only in their financing mix.
(5) There are no corporate income taxes. Role: prevents the tax code from making debt financing more valuable by allowing interest and not dividends as a tax deduction.
(6) Shareholders are indifferent to the form of their returns, all returns are taxed at the same rate. Role: prevents investors from seeing any difference in value between interest, dividends, and capital gains.






Q.5 Write the cash flow analysis?

  1. Estimate your annual gross income as the first step in preparing a cash flow analysis. Allow for subtractions if your business is not operating at full potential. For instance, if you own an apartment complex, you add the amount of rent for each month, but subtract an estimated amount for unforeseen vacancies. The longer you are in business, the easier it will be to predict operating losses.
  2. Add any other income you receive and you will arrive at your "effective gross income." This is a reliable business accounting figure that represents your entire annual projected gross income. Write this number down for future figuring.
  3. Compile a list of the expenses you incur in order to operate your business. Separate this by category. Think about the purchases of big equipment you make. If you have a painting business, you would write down the expenses you pay annually for paint sprayers, rollers, brushes and drop cloths.
  4. Write down all your office expenses, utility charges, advertising expenses and other fees you pay for equipment repairs and maintenance. Everything you need to purchase in the operation of your business counts.
  5. Remember to include professional fees and taxes in your cash flow analysis. If you have an accountant, his fee goes here--so does insurance policy expense, worker's compensation payments, unemployment insurance fees and taxes charged on your equipment or building.
  6. Add your business accounting expense together and double check your chart of accounts to make sure you got them all. This number represents the total amount of expenses necessary to operate your business. Write it down beneath the effective income figure.
  7. Figure out your debt service. Calculate the amount of payments you will make to the bank for loans, mortgages or other financing. Add these together and write the number down beneath the total expenses figure.
  8. Subtract the total expenses and the total debt service figures from the effective annual income number. This is your cash flow analysis for the year.

Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each. The income returns after tax for these projects are as follows:
Year
Project A
Project B
1
Rs. 80,000
Rs. 20,000
2
Rs. 80,000
Rs. 40,000
3
Rs. 40,000
Rs. 40,000
4
Rs. 20,000
Rs. 40,000
5
Rs. 60,000
6
Rs. 60,000

Ans: Using the following criteria determine which of the projects is preferable.
Project A














year
Income
PVCI
1
80000
0.909
72720
2
80000
0.826
66080
3
40000
0.751
30040
4
20000
0.683
13660
PVCI
182500


PVCI
-
NPV




182500


200000
=
-17500


Project B


















year
Income
PVCI


1
20000
0.909
18180


2
40000
0.826
33040


3
40000
0.751
30040


4
40000
0.683
27320


5
60000
0.621
37260


6
60000
0.564
33840


PVCI
179680



PVCI
-
NPV




179680


200000
=
-20320
As Project A is preferable option as it has minimal losses.