MBA SEMESTER-3

MB0045

FINANCIAL MANAGEMENT-MB0045
ASSIGNMENT SET
Q1. Explain the differences between wealth
maximization and profit maximization. Explain relation
between finance and accounting
A. Differences between wealth maximization and profit maximization
Profit maximization is based on the cardinal rule of efficiency. Its goal is to maximize the
returns with the best output and price levels. Profit maximization is the traditional and narrow
approach, which aims at maximizing the profit of the concern. Profit maximization has been
criticized on many accounts: Allocation of resources and investors perception of the
companys performance can be traced to the goal of profit maximization. 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.
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. 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.
Explanation of relation between finance and accounting
In the hierarchy of the finance function of an organization, the controller reports to the CFO,
Accounting is one of the functions that a controller discharges. Accounting is a part of
Finance. For computation of return on investment, earnings per share and for various ratios of
financial analysis, the data base will be accounting information. Without a proper accounting
system, an organization cannot administer the effective function of financial management.
The purpose of accounting is to report the financial performance of the business for the
period under consideration. All the financial decisions are futuristic based on cash flow
analysis. All the financial decisions consider quality of cash flow as an important element of
decisions. Since financial decisions are futuristic, they are taken and put into effect under
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conditions of uncertainty. Assuming the condition of uncertainty and incorporating the effect
on decision making results in use of various statistical models. In the selection of the
statistical models, element of subjectivity creeps in.
The relationship between finance and accounting has two dimensions:
(a) They are closely associated to the extent that accounting is an important input in financial
decision making
(b) There are definite differences between them
Accounting is a necessary input for the finance function as it generates information through
the financial statements. The data contained in these financial statements assists the financial
managers in assessing the past performance and providing future directions to the firm and in
meeting certain legal obligations. Thus accounting and finance are functionally inseparable.

Q2 Explain about the doubling period and future value.

Solve the below given problem:
Under the ABC Banks Cash Multiplier Scheme, deposits
can be made for periods ranging from 3 months to 5
years and for every quarter, interest is added to the
principal. The applicable rate of interest is 9% for
deposits less than 23 months and 10% for periods more
than 24 months. What will be the amount of Rs. 1000
after 2 years?
A. Explanation of doubling period
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.
For example, 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)}.
Solving the problem :
i mXn
Vn
(1+
)
F
=PV
m
M = 12/3 = 4 (quarterly compounding)
(42)
= 1000(1+0.10 /4)
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= 1000(1+0.10 /4)

=Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.
Explanation of future value
The process of calculating future value will become very cumbersome if it has to be
calculated over long maturity periods of 10 or 20 years. A generalized procedure of
calculating the future value of a single cash flow compounded annually is as follows:
n
V
F n = PV (i+1)
Where, F

Vn

= future value of the initial flow in n years hence,

PV = initial cash flow

i = annual rate of interest
n = life of investment
n
The expression (i+ 1) represents the future value of the initial investment of Re. 1 at
the end of n number of years at a rate of interest i referred to as the Future Value Interest
Factor (FVIF)

Q3 Write short notes on: a) Irredeemable bonds b) Zero

coupon bonds c) Valuation of Shares
A. Explanation of irredeemable bonds
Bonds are long-term debt instruments/fixed income (debt) instruments issued by government
agencies or big corporate houses to raise large sums of money. Bonds which will never
mature are known as irredeemable or perpetual bonds. Indian Companies Act restricts the
issue of such bonds and therefore, these are very rarely issued by corporates these days. In
case of these bonds, the terminal value or maturity value does not exist because they are not
redeemable. The face value is known, and the interest received on such bonds is constant and
received at regular intervals and hence, the interest receipt resembles perpetuity. The present
value is calculated as:
V0
=

I
id

Where Vo is the present value; I is the annual interest payable on the bond and id is the
required rate of interest.
If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 per value and the current
yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875.
Explanation of zero coupon bonds
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In India, zero coupon bonds are alternatively known as Deep Discount Bonds (DDBs). These
bonds became very popular in India for over a decade because of issuance of such bonds at
regular intervals by IDBI and ICICI.
Zero coupon bonds have no coupon rate, that is, there is no interest to be paid out. Instead,
these bonds are issued at a discount to their face value, and the face value is the amount
payable to the holder of the instrument on maturity. Thus, no interest or any other type of
payment is available to the holder before maturity. Since there is no intermediate payment
between the date of issue and the maturity date, these DDBs are also called zero coupon
bonds. The valuation of DDBs is similar to the ordinary bonds valuation. Since DDB at the
time of maturity generates only one future cash flow, the value of this may be taken as equal
to the present value of this future cash flow discounted at the required rate of return of the
investor for the number of years of the life of DDBs. The value of DDB is calculated as:
FV
B0
(DDB)= (1+r )n , where
B0

(DDB)=Value of the DDB

FV= Face value of DDB payable at maturity

r= The required rate of return
n= Life of the DDB

Effective interest earned = Discounted issue price Face value

They are called deep discount bonds because these bonds are long-term bonds whose
maturity some time extends up to 25 to 30 years. Reading the compound value (FVIF) table,
horizontally along the 25-year line, we find r equals 8%. Therefore, the bond gives an
effective return of 8% per annum.
Explanation on valuation of shares
A companys shares can be categorised into:
Ordinary or equity shares
Preference shares
The returns the shareholders receive in return are called dividends. Preference shareholders
get a preferential treatment as to the payment of dividend and repayment of capital in the
event of winding up. Such holders are eligible for a fixed rate of dividends.
The following are some important features of preference and equity shares:
Dividends Rate is fixed for preference shareholders. They can be given cumulative
rights, that is, the dividend can be paid off after accumulation. The dividend rate is not
fixed for equity shareholders. They change with an increase or decrease in profits. During
the years of big profits, the management may declare a high dividend. The dividends are
not cumulative for equity shareholders, that is, they cannot be accumulated and
distributed in the later years. Dividends are not taxable.
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Claims In the event of the business closing down, the preference shareholders have a
prior claim on the assets of the company. Their claims shall be settled first and the
balance, if any, will be paid off to equity shareholders. Equity shareholders are residual
claimants to the companys income and assets.
Redemption Preference shares have a maturity date on which the company pays off the
face value of the shares to the holders. Preference shares can be of two types
redeemable and irredeemable. Irredeemable preference shares are perpetual. Equity
shareholders have no maturity date.
Conversion A company can issue convertible preference shares. After a particular
period, as mentioned in the share certificate, the preference shares can be converted into
ordinary shares.
Preference shares like bonds carry a fixed rate of dividend or return. Symbolically, this can be
expressed as: P0= Dp/{1+Kp)n } + Pn/{(1+Kp)n} or
P0 = Dp*PVIFA (Kp, n) + Pn *PVIF (Kp, n)
Where P0= Price of the share
Dp= Dividend on preference share
Kp= Required rate of return on preference share
n= Number of years to maturity
Ordinary shares- People hold common stocks:
to obtain dividends in a timely manner
to get a higher amount when sold
Generally, shares are not held in perpetuity. An investor buys the shares, holds them for some
time during which he gets dividends, and finally sells it off to get capital gains. The value of a
share which an investor is willing to pay is linked with the cash inflows expected and risks
associated with these inflows.
Intrinsic value can be referred to as the value of a stock which is justified by assets, earnings,
dividends, definite prospects, and the factor of the management of the issuing company.

Q4 Explain the factors affecting Capital Structure. Solve

the below given problem:
A. Explanation of factors affecting capital structure
Capital structure should be planned at the time a company is promoted. The initial capital
structure should be designed very carefully. The management of the company should set a
target capital structure, and the subsequent financing decisions should be made with a view to
achieve the target capital structure. The major factor affecting the capital structure is
leverage.
Leverage - The use of sources of funds that have a fixed cost attached to them, such as
preference shares, loans from banks and financial institutions, and debentures in the capital
structure, is known as trading on equity or financial leverage.
If the assets financed by debt yield a return greater than the cost of the debt, the EPS will
increase without an increase in the owners investment. Similarly, the EPS will also increase
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if preference share capital is used to acquire assets. But the leverage impact is felt more in
case of debt because of the following reasons:
The cost of debt is usually lower than the cost of preference share capital
The interest paid on debt is a deductible charge from profits for calculating the taxable
income while dividend on preference shares is not.
The companies with high level of Earnings Before Interest and Taxes (EBIT) can make
profitable use of the high degree of leverage to increase return on the shareholders equity.
The other factors to be considered before deciding on an ideal capital structure are:

Cost of capital High cost funds should be avoided. However attractive an investment
proposition may look like, the profits earned may be eaten away by interest repayments.
Cash flow projections of the company Decisions should be taken in the light of cash
flow projected for the next 3-5 years. The company officials should not get carried away
at the immediate results expected. Consistent lesser profits are any way preferable than
high profits in the beginning and not being able to get any profits after 2 years.

Dilution of control The top management should have the flexibility to take appropriate
decisions at the right time. Fear of having to share control and thus being interfered by
others often delays the decision of the closely held companies to go public. To avoid the
risk of loss of control, the companies may issue preference shares or raise debt capital. An
excessive amount of debt may also cause bankruptcy, which means a complete loss of
control. The capital structure planned should be one in this direction.

Floatation costs Floatation costs are incurred when the funds are raised. Generally, the
cost of floating a debt is less than the cost of floating an equity issue. A company desiring
to increase its capital by way of debt or equity will definitely incur floatation costs.
Effectively, the amount of money raised by any issue will be lower than the amount
expected because of the presence of floatation costs. Such costs should be compared with
the profits and right decisions should be taken.

Solution for the problem

Average cost of capital of firm A is: =10% * 0/Rs. 666667 + 15% * 666667/666667
= 0 + 15 = 15%
Average cost of capital of firm B is: =10% * 25000/750000 + 15% * 533333/750000
= 3.34 + 10 = 13.4%
Interpretation:
The use of debt has caused the total value of the firm to increase and the overall cost of
capital to decrease.

Q5. Explain the capital Budgeting process and its

appraisals. Solve the given problem:
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A. Explanation of capital budgeting process and its appraisals.

After the screening of proposals for potential involvement is over, the company should take
up the following aspects of capital budgeting process:
A proposal should be commercially viable. The following aspects are examined to
ascertain the commercial viability of any investment proposal:
Market for the product
Availability of raw materials
Sources of raw materials
The elements that influence the location of a plant, i.e., the factors to be considered in the
site selection
Infrastructural facilities such as roads, communication facilities, financial services such as
banking and public transport services
Ascertaining the demand for the product or services is crucial. It is done by market
appraisal. In appraisal of market for the new product, the following details are
compiled and analysed:
Consumption trends
Competition and players in the market
Availability of substitutes
Purchasing power of consumers
Regulations stipulated by government on pricing the proposed products or services
Production constraints
Relevant forecasting technologies are employed to get a realistic picture of the potential
demand for the proposed product or service. Many projects fail to achieve the planned targets
on profitability and cash flows, if the firm could not succeed in forecasting the demand for
the product on a realistic basis.
Capital budgeting process involves three steps Financial appraisal, Technical appraisal and
Economic appraisal.
Technical appraisal- The technical appraisal deals with the technical aspects of the project.
The technical aspects of a project are:
Selection of process know-how
Decision on determination of plant capacity
Selection of plant, equipment and scale of operation
Plant design and layout
General layout and material flow
Construction schedule
Technical appraisal ensures implementation of all the technical aspects of the project.
Economic appraisal- The economic appraisal deals with economic and social impacts of a
project. It examines the impact of the project on the following:
Environment
Income distribution in the society
Fulfilment of certain social objective like generation of employment and attainment of
self sufficiency
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Materially altering the level of savings and investment in the society. Economic appraisal
examines the project from the social point of view. Hence, is referred to as social cost
benefit analysis.

Financial appraisal- Financial appraisal is to examine the financial viability of the project.
Financial appraisal technique examines:
Cost of the project
Investment outlay
Means of financing and the cost of capital
Expected profitability
Expected incremental cash flows from the project
Break-even point
Cash break-even point
Risk dimensions of the project
Project potential to materially alter the risk profile of the company
If the project is financed by debt, expected Debt Service Coverage Ratio
Tax holiday benefits, if any
Under this appraisal, the risk and returns at various stages of project execution are assessed.
Besides, it examines whether the risk adjusted return from the project exceeds the cost of
financing the project.
Solution for the problem
Table shows the cash flows and the cumulative cash flows of the projects A and B.
Year
1
2
3
4
5

Project A
Cash
Cumulative cash
flows(Rs.)
flows
2,00,000
2,00,000
1,75,000
3,75,000
25,000
4,00,000
2,00,000
6,00,000
1,50,000
7,50,000

Cash
flows(Rs.)
1,00,000
2,00,000
3,00,000
4,00,000
2,00,000

Project B
Cumulative cash
flows
1,00,000
3,00,000
6,00,000
10,00,000
12,00,000

From the cumulative cash flows column, project A recovers the initial cash outlay of Rs
4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years.
From the cumulative cash flow column the initial cash outlay of Rs. 5,00,000 lies between
2nd year and 3rd year in case of project B.
5,00,0003,00,000
Therefore, payback period for project B is =2 +
3,00,000
= 2.67 years
Pay-back period for project B is 2.67 years

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Q6 Explain the concepts of working capital. Explain the

determinants of working capital.
A. Explanation of concepts of working capital
The four most important concepts of working capital include gross working capital, net
working capital, temporary working capital and permanent working capital.
Figure depicts the concepts of working capital.

Gross working capital - Gross working capital refers to the amounts invested in various
components of current assets. It basically refers to the current assets. This concept has the
following practical relevance:
Management of current assets is the crucial aspect of working capital management
Gross working capital helps in the fixation of various areas of financial
responsibility
Gross working capital is an important component of operating capital. Therefore,
for improving the profitability on its investment, the finance manager of a
company must give top priority to efficient management of current assets.
Gross working capital is often termed as the quantitative aspect of working
capital.

Net working capital - Net working capital is the excess of current assets over current
liabilities and provisions. Net working capital is positive when current assets exceed
current liabilities and negative when current liabilities exceed current assets. Net
working capital is a qualitative concept, which indicates the liquidity position of the firm
and the extent to which working capital needs may be financed by permanent sources of
funds.

Permanent working capital- Permanent working capital is the minimum amount of

investment required to be made in current assets at all times to carry on the day-to-day
operation of firms business. This minimum level of current assets has been given the
name of core current assets by the Tandon committee. Permanent working capital is also
known as fixed working capital.

Temporary working capital -Temporary working capital is also known as variable

working capital or fluctuating working capital. The firms working capital requirements
vary depending upon the seasonal and cyclical changes in demand for a firms products.

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The extra working capital required as per the changing production and sales levels of a
firm is known as temporary working capital. It is the amount of investment required to
take care of variations/fluctuations in the business activity.

Explanation of determinants of working capital

The following factors determine a firms working capital requirements
Nature of business Working capital requirements are basically influenced by the
nature of business of the firm. Trading organisations are forced to carry large stocks of
finished goods, accounts receivables and accounts payables. Public utilities require
lesser investment in working capital.
Size of business operation Size is measured in terms of the scales of operations.
Normally, a firm with large scale of operation requires more working capital than a
firm with a low scale of operation.
Manufacturing cycle Capital intensive industries with longer manufacturing
process will have higher requirements of working capital, because of the need of
running their sophisticated and long production process.
Products policy Production schedule of a firm influences the investments in
inventories. A firm, exposed to seasonal changes in demand that follows a steady
production policy, will have to face the costs and risks associated with inventory
accumulation during the offseason periods..
Volume of sales There is a positive direct correlation between the volume of sales
and the size of working capital of a firm.
Term of purchase and sales A firm that allows liberal credit to its customers will
need more working capital than a firm with strict credit policy. A firm, which enjoys
liberal credit facilities from its suppliers requires lower amount of working capital
when compared to a firm, which does not have such a facility.
Operating efficiency The firm with high efficiency in operation can bring down the
total investment in working capital to lower levels. Here, effective utilisation of
resources helps the firm in bringing down the investment in working capital.
Price level changes Inflation affects the working capital levels in a firm. To
maintain the operating efficiency under an inflationary set up, a firm should examine
the maintenance of working capital position under constant price level. The ability of
a firm to revise its products price with rising price levels will decide the additional
investment to be made to maintain the working capital intact.
Business cycle During boom, sales rise as business expands. Depression is marked
by a decline in sale. During boom, expansion of business can be achieved only by
augmenting investment in various assets that constitute working capital of a firm.
When there is a decline in business on account of depression in economy, the
inventory glut forces a firm to maintain the working capital at a level far in excess of
the requirements under normal conditions.
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Processing technology Longer the manufacturing cycle, larger is the investment in

working capital. When raw material passes through several stages in the production,
process work in process inventory will increase correspondingly.
Fluctuations in the supply of raw materials Companies which use raw materials
available only from one or two sources are forced to maintain buffer stock of raw
materials to meet the requirements of uncertainty in lead time. Such firms normally
carry more inventory than it would have done, had the materials been available in
normal market conditions.

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