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Adl 13-financial-management

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Assignment Financial Management ADL 13
Amity University M.B.A 2nd Sem.

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Adl 13-financial-management

  1. 1. 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%
  2. 2. Rate of interet per annum g = f / 6 yrs 6.41% Break of interest cost / principal repayment: 1) interest cost (can be apportioned in the ratio of 6:5:4:3: 2:1 21 6 5 4 3 2 1 no of years repayment - i.e. earlier the years more (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) (250,00 0*4/21) (250,00 0*3/21) (250,000* 2/21) (250,00 0*1/21) 2) Principal Outstanding adjustment i = d - h 650000 78571 90476 102381 114286 126190 138095 Yearwise Interest rates: - Principal Outstanding at year end j 650000 571429 480952 378571 264286 138095 0 (prinicpal o/s at year beginning - Principal repayment) (650000- i) (571429- i) (480952 - i) (378571 - i) (264286- i) (138095 - i) RATE OF INTEREST EVERY YEAR h / princip al o/s at year beginni 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 of cash flows. What is annuity due? How can you calculate the present and future 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 is less) Present value of cash flows: It indicates the value of expected worth at current value. (Discounts the expected 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 rate Details required for calculating Present Value of cash flows: Cash flows year wise, discount rate. This technique is very useful for decision-making.
  3. 3. Annuity due: Uniform/ Constant/ Equal cash flows every year Present value of annuity Future value of annuity Worth of Lump sum consideration today which is going to be received tomorrow Value of fixed investment every year – worth tomorrow. (i.e. corpus it grows) Computation: Annuity * Present value annuity factor (PVAF) PVAF is calculated as = 1-[1/(1+r) to the power n]. 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/- every year for 10 years from now. It is assumed discount rate 10%, the present value 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 investment of Rs.10, 000 – 10 years from now. Rate of interest @10%, the future value annuity factor 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 of their beta is the same when risk aversion increases" Comment with practical examples Answer 2b: The security's beta is a function of the correlation of the security's returns with the market index returns and 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 risk premium. 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 of a 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 (where WACC (weighted average cost of capital) is minimum) is a great leverage/ advantage both to the company as well for the investors. Organizations, generally have two types of risks; operating risks – impact of fixed costs & variability of EBIT & 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.
  4. 4. Particulars Value (Rs. In lacs) Contribution 100 Fixed cost 25 EBIT 75 Interest cost 35 EBT 40 XYZ Ltd. has following: Operating leverage Financial leverage Contribution / 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 capital employed (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 1,000 Variable costs 200 300 ----- -------- Contribution Fixed costs 300 700 Fixed 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 ltd Particulars (in Rs. Lacs) Sales 500 1000 Variable costs 200 300 Contibution 300 700 Fixed cost 150 400 PBIT / EBIT 150 300 Interest 50 100 Profit before Tax / EBT 100 200 Computation: a) Opearting leverage: = Contribution / EBIT 2.0 2.3 b) Financial leverage: = EBIT / EBT 1.5 1.5
  5. 5. 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 compared to 'Q' ltd. to 'P' ltd. It is always preferable to have low Operating leverage & high Financial leverage (provided, Return on capital employed > Interest on debt funds) Question 4a: Define various concepts of cost of capital. Explain the procedure 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 costlier than 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 will have 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, such that the wealth of the firm is maximum. At this point, cost of capital is minimum & market price of a share 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 as specified) 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 liabilities side 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 20,00,000 12% institutional loans 60,00,000 Other information about the company as relevant is given below: 31st dec Dividend Earning average market price 2005 Per share per share per share 7.2 10.50 65 You are required to calculate the weighted average cost of capital, using book values as weights and earnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate
  6. 6. Answer 4b: Computation of Weighted Average Cost of Capital (WACC): Nature of Capital Value Weights Cost of capital Weights * Cost of Capital (basis of bookvalues O/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 2.42 Interest (1-taxrate) = 16% (100%-9.2%) c) 12% institutional loans 6,000,000 50% 10.90 5.45 Interest (1-taxrate) = 12% (100%-9.2%) Total 12,000,000 100% 13.25 Working Note: 1 Cost of equity: Price earnings approach = Earnings per share / Market price per share 10.50 / 65 = 16.15% Question 5a: A company has issued debentures of Rs. 50 Lakhs to be repaid after 7 years. How much should the company invest in a sinking fund earning 12% in order to be able to repay debentures? Show the procedure of loan 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 cover the repayment expected 7 years from now.
  7. 7. Loan Amortization Capital Recovery A loan amortization schedule is a repayment plan that is calculated before repayment of a loan begins. Amortization schedules are used for fixed interest long – term loans such as mortgages, expenses like R& D expenses, Purchase of Goodwill, Voluntary Retirement payment 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 sum payment towards voluntary retirement separation charges during the accounting year 2009-2010. XYZ ltd have planned to amortize the above expenses for a period of 10 years commencing from FY.09-10 Therefore, the schedule of amortization for 10 year period as follows: Rs. 500,000/- per years for 10 years Procedure with Ex: Mr.X plan to lend Rs.1 lac today for a period of 5 years @ int.rate of 12%, how much income Mr.X should receive each year to recover investment & principal back. The result is known as capital recovery & which can 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 years if you invest Rs. 12,000 today. What is the rate of return you would earn? . Answer 5b: Particulars Rs. Return expected per annum 1800 Fixed return/annuity for no of years 10 Total 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%
  8. 8. 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 by suppliers: one month; Credit allowed to debtors: two months; Time lag in payment of wages: one and half weeks; 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 of 70,000 units of output. You may assume that production is carried on evenly throughout the year and wages and overheads accrue similarly. Answer 1: Particulars Cost/unit Production = 70,000 units cost (Rs.) for 70000 units Raw Material 52 3640000 Direct Labour 19.5 1365000 Prime cost 5005000 Overheads 39 2730000 Total cost 110.5 7735000 Profit 19.5 1365000 Sales 130 9100000 Statement of Working Capital for HLL - 70,000 units production per year: Particulars No of months Computation Rs. Current Assets: (A) Raw material stock 1 36,40,000/12*1month 303333 Process stock - Work in progress (WIP) 0.5 50,05,000/12*0.5 months 208542 Debtors - customers 2 91,00,000*3/4 (credit sales)/12*2 1137500 Cash balance expected to maintain 12000 Total of CURRENT ASSETS - (A) 1661375 Current Liabilities: (B)
  9. 9. Creditors - suppliers 1 36,40,000/12*1month 303333 Wages Outstanding 1.5 weeks or 13,65,000/12*0.34 38675 0.34 month Overheads outstanding 1 27,30,000/12*1 227500 Total of CURRENT LIABILITIES - (B) 569508 NETT WORKING CAPITAL REQUIRED 1091867 Question 2a: Through quantitative analysis prove that PI is a better technique 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 of outflows NPV = Present value of inflows – Present value of outflows Ideal = should be > 1 Ideal = NPV should be positive, it shows absolute present value of tomorrow’s wealth Quantitative analysis: Present value of inflows = Rs. 200,000 Present value of outflows = Rs. 100,000 PI = 2 Present value of inflows = Rs. 200,000 Present 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 in absolute amount, which will be helpful to make decisions clearly, whereas the same advantage is not available with PI technique. However, PI shows – return over investment in times, which will be very useful for immediate decision making. Generally, over the years, organizations prefer NPV technique for capital budgeting decisions than PI technique. 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 assuming discount rates of 10 and 30 percent. II. Assuming the project is independent, which one should be accepted? If the projects are mutually exclusive, which project is the best?
  10. 10. Answer 2b: I) Project A Project B Project C Project D Methods (1) Payback @10% discount rate @30% discount rate 1 + years 1 + years 1.13 years 1.25 years 2.14 years 3 + years 1.7 years 2.8 years (2) Accounting rate of return (ARR) 100% 150% 180% 160% (3) NPV @10% discount rate @30% discount rate (909) (2308) 3017 207 4140 (633) 3824 833 (4) IRR 0% 32% 26% 38% Independent project: Project with higher NPV needs to be selected, which shows wealth in absolute value 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 Project D, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for both the projects, the disparity arisen is called as Cash flow disparity. It can be resolved by using Incremental cash flow technique. After resolving, the right project can be accepted. 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 Cash flows Discount rate * Discounted cash flows Unrecover ed discounte d cash flows Years Cash flows Discou nt rate * Discounted cashflows Unrecove red discounte d cash flows @ 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 /
  11. 11. disocunted cash flows of next year) *12] Payback period exceed 1 year, since unrecovered cash flows turns positive only from IInd yr onwards where base year = year in which unrecovered cash flows turns 0 or +ve Payback period @ 10% & 30% discount rate = 1 + years =1+ years 2) Accounting rate of return: rate of return on initial investment made: given as: Average profit after depreciation & Tax / Initial investment Since no information on profits, depreciation & taxes, it is treated cash inflows considered 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 Cash flows Discoun t rate * Discounte d cashflows Years Cash flows Discoun t rate * Discounte d 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 of return at which NPV = 0 In project A , IRR is '0'% at which NPV =0 (i.e. there is no return from the project)
  12. 12. 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 Cash flows Discoun t rate * Discounte d cashflows Unrecover ed discounte d cash flows Years Cash flows Discou nt rate * Discounted cashflows Unrecove red discounte d cash flows @ 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 cash flows turns 0 or +ve Payback period @ 10% discount rate= 1 + [(3182/3017)*12] Payback period @ 30% discount rate= 1 + [(4231/207)*12] =1.13 years =1.25 years 2) Accounting rate of return: rate of return on initial investment made: given as: Average profit after depriciation & Tax / Initial investment Since no information on profits, depreciation & taxes, it is treated cash inflows considered as profits after depreciation & taxes therefor e = (15,000 (inflow) / 10,000 (investment)) * 100 accounting rate of return = 150%; effectively 50% return
  13. 13. 4) NPV (net present value): a) Discounted @10% b) Discounted @30% Years Cash flows Discoun t rate * Discounte d cashflows Years Cash flows Discoun t 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 (10,0 00) 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 of return 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 at given required rate of return) L2 = one more guess rate Relationship between discount rate and NPV: inverse relationship: Discount rate goes up NPV falls Discount rate comes down NPV goes up 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 Cash flows Discoun t rate * Discounte d
  14. 14. 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% IRR 30% + 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 Cash flows Discoun t rate * Discounte d cashflows Unrecover ed discounte d cash flows Years Cash flows Discount rate * Disco unted cashf lows Unrecove red discounte d cash flows @ 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 (10,0 00) (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
  15. 15. cash flows of next year) *12] where base year = year in which unrecovered cash flows turns 0 or +ve Payback period @ 10% discount rate= 2 + [(4876/4140)*12] Payback period @ 30% discount rate= exceeds 3 years =2.14 years = 3 + years 2) Accounting rate of return: rate of return on initial investment made: given as: Average profit after depriciation & Tax / Initial investment Since no information on profits, depreciation & taxes, it is treated cash inflows considered as profits after depreciation & taxes therefor e = (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 Cash flows Discoun t rate * Discounted cash flows Years Cash flows Disco unt rate * Discoun ted cashflo ws @ 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
  16. 16. 3) IRR (Internal rate of return): which is the rate of return 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 at given required rate of return) L2 = one more guess rate Relationship between discount rate and NPV: inverse relationship: Discount rate goes up NPV falls Discount rate comes down NPV goes up Let us assume L1 = 30% (why, because as could be seen at 30% @ discount rate NPV is -ve by applying the relationship, reduced disocunt rate) Let us calculate L2 = 26% Discounted @26% (assumed rate) Years Cash flows Discoun t rate * Discounte d 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% IRR 30% - 3.43 26.57 PROJECT D: The following has been calculated assuming discount rates of 10% & 30% separately:
  17. 17. 1) Payback period: time period to recover initial investment a) Discounted @10% b) Discounted @30% Years Cash flows Discoun t rate * Discounte d cashflows Unrecover ed discounte d cash flows Years Cash flows Discoun t rate * Discou nted cashflo ws Unrecove red discounte d cash flows @ 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 cash flows turns 0 or +ve Payback period @ 10% discount rate= 1 + [(909/1570)*12] Payback period @ 30% discount rate= 2 + [(533/833)*12] =1.7 years = 2.8 years 2) Accounting rate of return: rate of return on initial investment made: given as: Average profit after depriciation & Tax / Initial investment Since no information on profits, depreciation & taxes, it is treated cash inflows considered as profits after depreciation & taxes therefor e = (16,000 (inflow) / 10,000 (investment)) * 100
  18. 18. accounting rate of return = 160%; effectively 60% return 4) NPV (net present value): a) Discounted @10% b) Discounted @30% Years Cash flows Discoun t rate * Discounte d cash flows Years Cash flows Disco unt 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 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 of return 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 at given required rate of return) L2 = one more guess rate Relationship between discount rate and NPV: inverse relationship: Discount rate goes up NPV falls Discount rate comes down NPV goes up 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%
  19. 19. Discounted @38% (assumed rate) Years Cash flows Discoun t rate * Discounte d 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% IRR 30% + 7.66 37.66% 1) NPV (net present value): for increments cash flows a) Discounted @10% b) Discounted @30% Years Increme ntal Cash flows (project C – project D) Discou nt rate * Discounted cashflows Years Cash flows Discou nt rate * Discounte d 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
  20. 20. 3) IRR (Internal rate of return): which is the rate of return 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 at given required rate of return) L2 = one more guess rate Relationship between discount rate and NPV: inverse relationship: Discount rate goes up NPV falls Discount rate comes down NPV goes up 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 Cash flows Discoun t rate * Discounte d 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% IRR 10% + 2.5 12.50% Target return = 10% IRR for incremental cash flows = 12.5%
  21. 21. 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% payout a) Less retained earnings b) Slower / lower growth rate c) Lower market price d) Cost of equity (Ke) > IRR (r = rate of return earned by company on its investment. e) Indicates that company is declining. a) More retained earnings b) Accelerated/higher growth rate c) Higher market price d) 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 issuing new shares. Question 3b: An investor gains nothing from bonus share "Critically analyse the 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 the stock will come down & over the long period, the investor definitely maximizes his wealth due to bonus shares. From company angle, bonus issue is only an accounting entry & it doesn’t change the wealth/value of the firm. Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained Bonus shares at zero cost & the market have come down to the extent of bonus issue & immediately went up & investors have cashed the bonus shares thus maximized their wealth. However, currently it is trading down due to varied reasons.
  22. 22. 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 A or 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 14 2) Profitability index 1.48 1.35 3) Pay Back period 2 years 3 years 4) 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 higher NPV needs to be invested. Workings are as follows: (a) to buy machine A which is similar to the existing machine: Years Cash flows (Rs. In lacs) Unrecovered cash flows Discount rate * Discounted cashflows Unrecovered discounted cash 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 12 NPV 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
  23. 23. 4) Discounted 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 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 Cash flows (Rs. In lacs) Unrecovered cash flows Discount rate * Discounted cashflows Unrecovered discounted cash 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 14 NPV 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 cash flows 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
  24. 24. Assignment - C 1. 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 DFL Answer – (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 customers Answer – (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 equity Answer – (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
  25. 25. (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 employed Answer – (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 positive Answer – (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 required regarding: (a) earning per share (b) normal rate of return (c) capital employed in the business (d) contingent liabilities Answer – (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 industries Answer – (c) 16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000 share of Rs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax is Rs. 20,000. The degree of financial leverage is (a) 1.00 (b) 1.25 (c) 2.50 (d) 2.00 Answer – (b) 17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70, Total fixed cost- 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) 5.33 Answer – (b) 18. Market price of equity share of a company is Rs. 25 and the dividend expected a year hence is Rs. 10.
  26. 26. 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 companies Answer – (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) 5940 Answer – (a) 21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the required rate of return is 10% the value of bond is (a) 1000 (b) 1123 (c) 1140 (d) 1150 Answer – (a) 22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at return rate of 15% and dividend pay out ratio of 40% is (a) 100 (b) 120 (c) 130 (d) 150 Answer – (a) 23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of not availing the 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) Debentures Answer – (c) 25. Which of the following approaches advocates that the cost of equity capital & debit capital remains the degree of leverages varies (a) Net income approach (b) Net operating income approach (c) Traditional approach (d) Modigliani-Miller approach Answer – (b) & (d) 26. Which of the following is not a feature of an optimal capital structure. (a) Profitability (b) Safety (c) Flexibility
  27. 27. (d) Control Answer – (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 value Answer – (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 adopted Answer – (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 > ke Answer – (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 above Answer – (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 above Answer – (d) 32. Which of the following models on dividend policy stresses on investors preference for the current dividend (a) Traditional model (b) Walters model (c) Gordon model (d) MM model Answer – (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 evaluation Answer – (a) 34. Average collection period is equal to (a) 360/ Receivables Turnover Ratio (b) Average Creditors / Sales per day (c) Sales / Debtors (d) Purchases / Debtors Answer – (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
  28. 28. 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 costs Answer – (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 Capital requirements (a) Nature of the business (b) seasonality of operations (c) availability of raw materials (d) amount of fixed assets Answer – (d) 40. The capital structure ratio measure the (a) Financial Risk (b) Business Risk (c) Market Risk (d) operating risks Answer – (a)

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