ASSIGNMENT

DRIVE

SPRING 2014

PROGRAM

MBADS/ MBAFLEX/ MBAHCSN3/ MBAN2/ PGDBAN2

SEMESTER

II

SUBJECT CODE &

NAME

MB0045
FINANCIAL MANAGEMENT

BK ID

B1628

QUESTION NO.1
Explain Wealth maximization =

The term wealth means

shareholders wealth or the wealth of the persons those who are involved in
the business concern. Wealth maximization is also known as value
maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business. Wealth maximization
is possible only when the company pursues policies that would increase the
market value of shares of the company. It has been accepted by the finance
managers as it overcomes the limitations of profit maximization.
The following arguments are in support of the superiority of wealth
maximization over profit maximization:
Wealth maximization is based on the concept of cash flows. Cash flows are
a reality and not based on any subjective interpretation. On the other hand,
profit maximization is based on accounting profit and it also contains many
subjective elements.
Wealth maximization considers time value of money. Time value of money
translates cash flow occurring at different periods into a comparable value
at zero period. In this process, the quality of cash flow is considered critical
in all decisions as it incorporates the risk associated
with the cash flow stream. It finally crystallizes into the rate of return that
will motivate investors to part with their hard earned savings. Maximizing
the wealth of the shareholders means positive net present value of the
decisions implemented.
Let us now look at some of the key definitions.
Positive net present value can be defined as the excess of present value of
cash inflows of any decision implemented over the present value of cash
out flow.
Time value factor is known as the time preference rate; that is, the sum of
risk free rate and risk premium.

Risk free rate is the rate that an investor can earn on any government
security for the duration under consideration. Risk premium is the
consideration for the risk perceived by the investor in investing in that
asset or security.
Required rate of return is the return that the investors want for making
investment in that sector.
Wealth maximization vs. profit maximization
Let us now see how wealth maximization is superior to profit maximization.
Wealth maximization is based on cash flow. It is not based on the
accounting profit as in the case of profit maximization.
Through the process of discounting, wealth maximization takes care of the
quality of cash flow. Converting uncertain distant cash flow into comparable
values at base period facilitates better comparison of projects. The risks
that are associated with cash flow are adequately
reflected when present values are taken to arrive at the net present value
of any project.
Corporate play a key role in todays competitive business scenario. In an
organization, shareholders typically own the company, but the
management of the company rests with the board of directors. Directors
are elected by shareholders. Company management procures funds for
expansion and diversification of capital markets. markets effectively for
their capital requirements. Therefore, to keep the investors happy
throughout the performance of value of shares in the market, management
of the company must meet the wealth maximization
criterion.
When a firm follows wealth maximization goal, it achieves maximization of
market value of share. A firm can practice wealth maximization goal only
when it produces quality goods at low cost. On this account, society gains
because of the societal welfare. Maximization of wealth demands on the
part of corporate to develop new products or render new
services in the most effective and efficient manner. This helps the
consumers, as it brings to the market the products and services that a
consumer needs.

Another notable feature of the firms that are committed to the

maximization of wealth is that, to achieve this goal they are forced to
render efficient service to their customers with courtesy. This enhances
consumer welfare and benefit to the society.
From the point of evaluation of performance of listed firms, the most
remarkable measure is that of performance of the company in the share
market. Every corporate action finds its reflection on the market value of
shares of the company. Therefore, shareholders wealth maximization could
be considered as a superior goal compared to profit maximization.
Since listing ensures liquidity to the shares held by the investors,
shareholders can reap the benefits arising from the performance of
company only when they sell their shares. Therefore, it is clear that
maximization of market value of shares will lead to maximization of the net
wealth of shareholders.
Therefore, we can conclude that maximization of wealth is probably the
more appropriate goal of financial management in todays context. Though
this cannot be a goal in isolation, it is important to understand that profit
maximization as a goal, in a way, leads to wealth maximization.

QUESTION NO.2
A)If you deposit Rs 10000 today in a bank that offers 8%
interest, how many years will the amount take to double?
=
Rule of 72: The period within which the amount doubles is obtained by
dividing 72 by the rate of interest.
Doubling period
A very common question arising in the minds of an
investor is how long will it take for the amount invested to double for a
given rate of interest. There are 2 ways of answering this question:
1. One way is to answer it by a rule known as rule of 72. This rule
states that the period within which the amount doubles is obtained by
dividing 72 by the rate of interest. Though it is a crude way of
calculating, this rule is followed by most. For instance, if the given rate
of interest is 10%, the doubling period is 72/10, that is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the
rule known as rule of 69. By this method, Doubling Period =
0.35+69/Interest rate Going by the same example given above, we get
the number of years as 7.25 years {(0.35 + 69/10) or (0.35 +6.9)}. How
is the compound rate of growth for the above series determined? This
can be done in two steps:
1. The ratio of profits for year 6 to year 1 is to be determined, i.e.,
180/75 = 2.4.

2. The FVIF table is to be looked at. Look at the value that is close to 2.4
for the row of 5 years. The value close to 2.4 is 2.386, and the interest
rate corresponding to this is 19%. Therefore, the compound rate of
growth is 19%.

B) What is the future value of a regular annuity of Re 1.00

earning a rate of 12% interest p.a. for 5 years? =
Solution:

Fan = A * FVIFA (12%,5yrs)

= 1*FVIFA (12%, 5y) = 1*6.353
= Rs. 6.353

QUESTION NO.3
Relation between Financial leverage and the capital structure
=
Financial leverage relates to the financing activities of a firm and
measures the effect of EBIT on Earnings Per Share (EPS) of the company.
A companys sources of funds fall under two categories:
Those which carry fixed financial charges like debentures, bonds, and
preference shares
Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid
off irrespective of the firms revenues. The dividends are not contractual
obligations, but the dividend on preference shares is a fixed charge and
should be paid off before equity shareholders. The equity holders are
entitled to only the residual income of the firm after all prior obligations
are met.
Financial leverage refers to a firm's use of fixed-charge securities like
debentures and preference shares (though the latter is not always
included in debt) in its plan of financing the assets. The concept of
financial leverage is a significant one because it has direct relation with
capital structure management. It determines the relationship that could
exist between the debt and equity securities. A firm which does not

issue fixed-charge securities has an equity capital structure and does

not have any financial leverage. However, it is common for firms to
issue some debt securities, in which case, the leverage is either
favorable or unfavorable. Financial leverage is a process of using debt
capital to increase the rate of return on equity. For this reason, it is also
referred to as trading on equity. Borrowing is done by a company
because of the financial advantage that is expected from it. The use of
borrowings for the purpose of such advantage for residual shareholders
is also called trading on equity or leverage.
Thus, financial leverage refers to the mix of debt and equity in the
capital structure of the firm. This results from the presence of fixed
financial charges in the companys income stream. Such expenses have
nothing to do with the firms performance and earnings and should be
paid off regardless of the amount of EBIT.
It is the firms ability to use fixed financial charges to increase the
effects of changes in EBIT on the EPS. It is the use of funds obtained at
fixed costs which increase the returns on shareholders. A company
earning more by the use of assets funded by fixed sources is
said to be having a favorable or positive leverage. Unfavorable leverage
occurs when the firm is not earning sufficiently to cover the cost of
funds. Financial leverage is also referred to as trading on equity.
Thus, the effect of financial leverage is also measured through another
variable, via, EPS. This is done in the case of joint stock companies
which have raised their proprietary capital by selling units of such
capital known as equity shares.
EPS is obtained by dividing earnings (after interest and taxes) by total
equity. If a company has preference shares also on its capital structure,
net equity earnings will be arrived at after deducting interest, taxes, and
preference dividends.
Capital structure refers to the permanent long-term financing of a
company represented by a mix of long-term debt, preference shares,
and net worth (which included paid-up capital, reserves, and surplus).
Financial leverage and its effects are a crucial consideration in planning
and designing capital structures.

Capital Structure
As we are aware, equity and debt are the two
important sources of long-term sources of finance of a firm. The
proportion of debt and equity in a firms capital structure has to be
independently decided case to case. A proposal, though not being
favorable to lenders, may be taken up if they are convinced with the
earning potential and long-term benefits. What proportion of equity and
debt should be taken up in the capital structure of a firm? The answer is
tricky and is based on the understanding
and interpretation of the relationship between the financial leverage and
firm valuation or financial leverage and cost of capital. Many theories
have been propounded to understand the relationship between financial
leverage and firm value.
Assumptions
The following are some common assumptions made: The firm has
only two sources of funds, debt and ordinary shares
There are no taxes, both corporate and personal
The firms dividend payout ratio is 100%, that is, the firm pays off the
entire earnings to its equity holders and retained earnings are zero
The investment decisions of a company are constant, that is, the firm
does not invest any further in its assets
The operating profits/EBIT are not expected to increase or decrease
All investors shall have identical subjective probability distribution of the
future expected EBIT
A firm can change its capital structure at a short notice without the
incurrence of transaction costs
The life of the firm is indefinite

QUESTION NO.4
What is the IRR of the project?
Compute IRR =
Solution
Step 1
The average of annual cash inflows is computed
Average of Cash Inflows
Year
1
2
3

Cash inflows
50,000
50,000
30,000

4
Total

40,000
1,70,000

Average =1,70,000/4
=Rs.42,500

Step 2
Divide the initial investment by the average of annual cash inflows
= 1,00,000/42,500
= 2.35
Step 3
From the PVIFA table for 4 years, the annuity factor very near 2.35 is
25%. Therefore, the first initial rate is 25%
Trial Rate at 25%
Year

Cash flows

50,000

PV factor at
25%
0.800

PV of Cash flows
40,000

2
3
4

50,000
30,000
40,000

0.640
0.512
0.410
Total

32,000
15,360
16,400
1,03,760

As the initial investment of Rs.1,00,000 is less than the computed value

at 25% of Rs.1,03,760, the next trial rate is 26%.
Hence the changes in the calculations are

Trial Rate at 26%

Year

Cash flows

1
2
3
4

50,000
50,000
30,000
40,000

PV factor at
26%
0.7937
0.6299
0.4999
0.3968
Total

PV of Cash flows
39,685
31,495
14,997
15,872
1,02,049

The next trial rate is 27%, the changes are

Trial Rate at 27%

YEAR

Cash flows

50,000

PV factor at
27%
0.7874

PV of Cash
flows
39,370

2
3
4

50,000
30,000
40,000

0.6200
0.4882
0.3844
Total

31,000
14,646
15,376
1,00,392

The next trial rate is 28%, the changes are

Trial Rate at 28%

Year

Cash flows

1
2
3
4

50,000
50,000
30,000
40,000

PV factor at
26%
0.7813
0.6104
0.4768
0.3725
Total

PV of Cash
flows
39,065
30,520
14,304
14,900
98,789

Because, initial investment of Rs.1,00,000 lies between 98789 (28

%) and 1,00,392 (27%), the IRR by interpolation is equal to:
27+ 1,00,392-1,00,000/1,00,392-98,789*1
27+ 392/1603*1

= 27+0.2445
= 27.2445
= 27.24%

QUESTION NO.5
a) length of the operating cycle =
b) cash cycle =
Solution
Operating Cycle = Inventory Conversion Period +
Accounts Receivables
Conversion Period
From the above formula we need to first calculate the individual
conversion periods.
Inventory conversion period
Average Inventory/ Annual Cost of goods sold *
365

(( 9000+ 12000) / 2)*365 / 56000

10500*365/56000
= 68.4 days
Receivables Conversion Period
= Average Accounts Receivables / Annual Sales *365
(12000+16000) /2*365 /80000
= 63.9 days
Payables Conversion Period
Average Accounts Payables / Annual Cost of
Goods Sold *365
(7000+10000) /2 *365 / 56000
8500 * 365 / 56000
= 55.4 days
Operating Cycle = ICP + RCP
= 68.4 + 63.9
= 132.3 days
Cash Conversion Cycle= OC PDP
= 132.3 55.4
= 76.9 days

QUESTION NO.6
Walters model assumptions =
Prof. James E. Walter
considers that dividend pay-outs are relevant and have a bearing
on the share prices of the firm. He further states that investment
policies of a firm cannot be separated from its dividend policy and
both are inter-linked. The choice of an appropriate dividend policy
affects the value of the firm.
Walter model clearly establishes a relationship between the firms
rate of return r and its cost of capital k to give a dividend
policy that maximizes shareholders wealth. The firm would have
the optimum dividend policy that enhances the value of the firm.
Walter model can be studied with the relationship between r and
k.
If r>k, the firms earnings can be retained, as the firm has
better and profitable investment opportunities and the firm
can earn more than what

the shareholders could earn by re-investing, if earnings are

distributed. Firms which have r>k are called growth firms and
such firms should have a zero pay-out ratio.
If r<k, the firm should have a 100% pay-out ratio as the
investors have better investment opportunities than the
firm. Such a policy will maximize the firm value.

If r = k, the firms dividend policy will have no impact on

the firms value. The dividend pay-outs can range between
zero and 100% and the firm value will remain constant in all
cases. Such firms are called normal firms.

The following are the assumptions on which the Walters model is

based:
Financing All financing is done through retained earnings.
Retained earning is the only source of finance, available and
the firm does not use any external source of funds like debt
or equity.
Constant rate of return and cost of capital The firms
r and k remain constant and any additional investment
made by the firm will not change the risk and return profile.

 100% pay-out or retention All earnings are either

completely distributed or immediately re-invested.
Constant EPS and DPS The earnings and dividends do
not change and are assumed to be constant forever.
Life The firm has a perpetual life.
According to this approach, the market price of the share is taken
as the sum of the present value of the future cash dividends and
capital gains. Walters formula to determine the market price is as
follows:

Market price per share of the firm

P = D / (Ke g)
Implies, Ke = D/P + g , where g = P / P
Thus, Ke = D/P + P / P
But since, P = [r /Ke(E -D)], we get
P = D / Ke + [r /Ke(E - D)] / Ke
Where P is the market price per share
D is the dividend per share
Ke is the cost of capital
g is the growth rate of earnings
E is Earnings per share
r is IRR

P is change in price
Limitations of Walters Model
Walter has assumed that investments are exclusively
financed by retained earnings and no external financing is
used.
Walters model is applicable only to all-equity firms. Also, r
is assumed to be constant, which again is not a realistic
assumption.
Finally, Ke is also assumed to be constant and this ignores
the business risk of the firm which has a direct impact on the
firm value.
Other than in hypothetical cases of r = k, in other cases where
r>k and r<k, according to the Walter model, the dividend policy of
a firm is relevant for maximizing the share price of the firm.

NAME

ROLL NO. =

CHANDRAKESH YADAV
1308001976