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Master of Business Administration-MBA Semester 2

Financial Management MB0045

(Book ID: B1134)

Assignment Set- 1

Q1. What are the 4 finance decisions taken by a finance manager?

Answer: A firm performs finance functions simultaneously and continuously in the normal course of thbusiness. They do not necessarily occur in a sequence. Finance functions call for skilful planning, conand execution of a firms activities.

Let us note at the outset hat shareholders are made better off by a financial decision that increases thvalue of their shares, Thus while performing the finance function, the financial manager should strive tmaximize the market value of shares. Whatever decision does a manger takes need to result in wealthmaximization of a shareholder.

Investment Decision

Investment decision or capital budgeting involves the decision of allocation of capital or commitment ofunds to long-term assets that would yield benefits in the future. Two important aspects of the investmdecision are:(a) the evaluation of the prospective profitability of new investments, and

(b) the measurement of a cut-off rate against that the prospective return of new investments could becompared.

Future benefits of investments are difficult to measure and cannot be predicted with certainty. Becausthe uncertain future,investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of boexpected return and risk. Besides the decision for investment managers do see where to commit fundwhen an asset becomes less productive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunitycost of capital. However, there are problems in computing the opportunity cost of capital in practice fro

the available data andinformation. A decision maker should be aware of capital in practice from the available data andinformation. A decision maker should be aware of these problems.

Financing Decision

Financing decision is the second important function to be performed by the financial manager. Broadlyher or she must decide when, where and how to acquire funds to meet the firms investment needs.

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The central issue before him or her is to determine the proportion of equity and debt. The mix of debt aequity is known as the firms capital structure. The financial manager must strive to obtain the bestfinancing mix or the optimum capital structure for his or her firm. The firms capital structure is consideto be optimum when the market value of shares is maximized. The use of debt affects the return and rof shareholders; it may increase the return on equity funds but it always increases risk. A proper balanwill have to be struck between return and risk. When the shareholders return is maximized with minimrisk, the market value per sharewill be maximized and the firms capital structure would be considered optimum. Once the financialmanager is able to determine the best combination of debt and equity, he or she must raise theappropriate amount through the best availablesources. In practice, a firm considers many other factors such as control, flexibility loan convenience,legal aspects etc. in deciding its capital structure.

Dividend Decision

Dividend decision is the third major financial decision. The financial manager must decide whether thefirm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like thedebt policy, the dividend policy shouldbe determined in terms of its impact on the shareholders value. The optimum dividend policy is one thmaximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firmsdividend policy, the financial manager must determine the optimum dividend payout ratio. The payouratio is equal to the percentage of dividends to earnings available to shareholders. The financial manashould also consider the questions of dividend stability, bonus shares and cash dividends in practice.Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonusshare (or stock dividend), are also issued to the existing shareholders in addition to the cash dividend.

Liquidity Decision

Current assets management that affects a firms liquidity is yet another important finances function, inaddition to the management of long-term assets. Current assets should be managed efficiently forsafeguarding the firm against the dangers of liquidity and insolvency. Investment in current assets affethe firms profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managcurrent assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But would lose profitability, as idle current assets would not earn anything.

Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that

neither insufficient nor unnecessary funds are invested in current assets, the financial manager shoulddevelop sound techniques of managing current assets. He or she should estimate firms needs forcurrent assets and make sure that funds would be made available when needed. It would thus be cleathat financial decisions directly concern the firms decision to acquire or dispose off assets and requirecommitment or recommitment of funds on a continuous basis. It is in this context that finance functionare said to influence production, marketing and other functions of the firm. This, in consequence, finanfunctions may affect the size, growth, profitability and risk of the firm, and ultimately, the value of the fi

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The function of financial management is to review and control decisions to commit or recommit funds tnew or ongoing uses. Thus, in addition to raising funds, financial management is directly concerned wproduction, marketing and other functions, within an enterprise whenever decisions are about theacquisition or distribution of assets. Various financial functions are intimately connected with each othe

For instance, decision pertaining to the proportion in which fixed assets and current assets are mixeddetermines the risk complexion of the firm. Costs of various methods of financing are affected by thisrisk. Likewise, dividend decisions influence financing decisions and are themselves influenced byinvestment decisions.

In view of this, finance manager is expected to call upon the expertise of other functional managers ofthe firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to beacquired for the firm, level of inventories to be kept in hand, type of customers to be granted creditfacilities, terms of credit should be made after consulting production and marketing executives.However, in the management of income finance manager has to act on his own. The determination ofdividend policies is almost exclusively a finance function. A finance manager has a final say in decisioon dividends than in asset management decisions.

Financial management is looked on as cutting across functional even disciplinary boundaries. It is insuch an environment that finances manager works as a part of total management. In principle, a finanmanager is held responsible to handle all such problem: that involve money matters. But in actualpractice, as noted above, he has to call on the expertise of those in other functional areas to dischargehis responsibilities effectively.

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Q.2 What are the factors that affect the financial plan of a company?

Answer: To help your organization succeed, you should develop a plan that needs to be followed. Thiapplies to starting the company, developing new product, creating a new department or any undertakinthat affects the companys future. There are several factors that affect planning in an organization. Tocreate an efficient plan, you need to understand the factors involved in the planning process.Organizational planning is affected by many factors:

Priorities

In most companies, the priority is generating revenue, and this priority can sometimes interfere with thplanning process of any project. For example, if you are in the process of planning a large expansionproject and your largest customer suddenly threatens to take their business to your competitor, then yomight have to shelve the expansion planning until the customer issue is resolved. When you start theplanning process for any project, you need to assign each of the issues facing the company a priorityrating. That priority rating will determine what issues will sidetrack you from the planning of your projecand which issues can wait until the process is complete.

Company Resources

Having an idea and developing a plan for your company can help your company to grow and succeedbut if the company does not have the resources to make the plan come together, it can stall progress.One of the first steps to any planning process should be an evaluation of the resources necessary tocomplete the project, compared to the resources the company has available. Some of the resources toconsider are finances, personnel, space requirements, access to materials and vendor relationships.

Forecasting

A company constantly should be forecasting to help prepare for changes in the marketplace. Forecastsales revenues, materials costs, personnel costs and overhead costs can help a company plan forupcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance ofsuccess, if the company has the capabilities to pull off the plan and if the plan will help to strengthen thcompanys standing within the industry. For example, if your forecasting for the cost of goods haschanged due to a sudden increase in material costs, then that can affect elements of your product rollout plan, including projected profit and the long-term commitment you might need to make to a supplieto try to get the lowest price possible.

Contingency Planning

To successfully plan, an organization needs to have a contingency plan in place. If the company hasdecided to pursue a new product line, there needs to be a part of the plan that addresses the possibilitthat the product line will fail. The reallocation of company resources, the acceptable financial losses anthe potential public relations problems that a failed product can cause all need to be part of theorganizational planning process from the beginning.

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Q.3 Show the relationship between required rate of return and coupon rate on the value of abond.

Answer: It is important for prospective bond buyers to know how to determine the price of a bondbecause it will indicate the yield received should the bond be purchased. In this section, we will runthrough some bond price calculations for various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bonds price is higher than its par value, will sell at a premium because its interest rate is higher than current prevailing rates. If the bonds pricelower than its par value, the bond will sell at a discount because its interest rate is lower than currentprevailing interest rates. When you calculate the price of a bond, you are calculating the maximum pricyou would want to pay for the bond, given the bonds coupon rate in comparison to the average ratemost investors are currently receiving in the bond market. Required yield or required rate of return is thinterest rate that a security needs to offer in order to encourage investors to purchase it. Usually therequired yield on a bond is equal to or greater than the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected couponpayments plus the present value of the par value at maturity. Calculating bond price is simple: all we adoing is discounting the known future cash flows. Remember that to calculate present value (PV) whis based on the assumption that each payment is re-invested at some interest rate once it is receivedhave to know the interest rate that would earn us a known future value. For bond pricing, this interestrate is the required yield. (If the concepts of present and future value are new to you or you are unfamwith the calculations, refer to Understanding the Time Value of Money.)

Here is the formula for calculating a bonds price, which uses the basic present value (PV) formula:

C = coupon paymentn = number of paymentsi = interest rate, or required yield

M = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to as an ordinary annuity,which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straightbond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from thtime at which the debt security is acquired. The calculation assumes this time is the present.

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You may have guessed that the bond pricing formula shown above may be tedious to calculate, as itrequires adding the present value of each future coupon payment. Because these payments are paid an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula that ismathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The followingdiagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value) received in

periods one, two and three. Notice how the present value decreases for those coupon payments that afurther into the future the present value of the second coupon payment is worth less than the first coupand the third coupon is worth the lowest amount today.

The farther into the future a payment is to be received, the less it is worth today is the fundamentalconcept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the presentvalues of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesnt require thawe add the value of each coupon payment

By incorporating the annuity model into the bond pricing formula, which requires us to also include thepresent value of the par value received at maturity, we arrive at the following formula:

Lets go through a basic example to find the price of a plain vanilla bond.

Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a couponrate of 10%, and a required yield of 12%. In our example well assume that coupon payments are madsemi-annually to bond holders and that the next coupon payment is expected in six months. Here are steps we have to take to calculate the price:

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1. Determine the Number of Coupon Payments: Because two coupon payments will be made eachyear for ten years, we will have a total of 20 coupon payments.

2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annuadivide the coupon rate in half. The coupon rate is the percentage off the bonds par value. As a result,each semi-annual coupon payment will be $50 ($1,000 X 0.05).

3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divideby two because the number of periods used in the calculation has doubled. If we left the required yield12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6%(0.12/2).

4. Plug the Amounts Into the Formula: From the above calculation, we have determined that the bois selling at a discount; the bond price is less than its par value because the required yield of the bondgreater than the coupon rate. The bond must sell at a discount to attract investors, who could find highinterest elsewhere in the prevailing rates. In other words, because investors can make a larger return the market, they need an extra incentive to invest in the bonds

Accounting for Different Payment FrequenciesIn the example above coupons were paid semi-annually, so we divided the interest rate and couponpayments in half to represent the two payments per year. You may be now wondering whether there iformula that does not require steps two and three outlined above, which are required if the couponpayments occur more than once a year. A simple modification of the above formula will allow you toadjust interest rates and coupon payments to calculate a bond price for any payment frequency:

Notice that the only modification to the original formula is the addition of F, which represents thefrequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bondspaying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F wouldequal four, and if the bond paid semi-annual coupons, F would be two.

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Q.4 Discuss the implication of financial leverage for a firm.

Answer: The financial leverage implies the employment of source of funds, involving fixed return so ato cause more than a proportionate change in earnings per share (EPS) due to change in operatingprofits. Like the operating leverage, financial leverage can be positive when operating profits areincreasing and can be negative in the situation of decrease in such profits. In view of these, financialleverage will affect the financial risk of the firm. An important analytical tool for financial leverage is theindifference point at which the EPS/market price is the same for different financial plans underconsideration.

The objective of this study was to provide additional evidence on the relationship between financialleverage and the market value of common stock. Numerous empirical studies have been done in thisarea, and, concurrently, many theories have been developed to explain the relationship betweenfinancial leverage and the market value of common stock. Because of the methodological weaknessespast studies, however, no conclusions can be drawn as to the validity of the theories. Theories onfinancial leverage may be classified into three categories: irrelevance theorem, rising from valueindefinitely with increase in financial leverage, and optimal financial leverage. Empirical implications ofthese categories along with the consequences of serious confounding effects are analyzed.

The implications are then compared with evidence from actual events involving financial leveragechanges, and distinguished from each other as finely as possible, using simple and multiple regressioanalyses, normal Z-test, and a simulation technique. The evidence shows that changes in the marketvalue of common stock are positively related to changes in financial leverage for some firms andnegatively related for other firms.

This evidence is consistent with the existence of an optimal financial leverage for each firm, assumingthat financial leverages of firms with a positive relationship are below the optimum and those of firms wa negative relationship are above the optimum. The results of the study do not depend upon thedefinition of the market portfolio, the definition of the event period, or the choice of financial leveragemeasure. Betas estimated from equally weighted market portfolios were generally higher than thoseestimated from value weighted market portfolios during 1981-1982. However, the results of the studywere the same for both portfolios.

Abnormal returns were computed for seven and two day event periods, and the results were the samefor both periods. Seven different definitions of financial leverage were tested, and the results were thesame for all measures.

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Q.5 The cash flows associated with a project are given below:Year Cash flow0 (100,000)1 250002 400003 500004 400005 30000

Calculate the a) payback period.b) Benefit cost ratio for 10% cost of capital.

Answer:

a) Payback period:

The cash flows and the cumulative cash flows of the projects is shown under in table

Table Cash flows and cumulative cash flows

Year Project

Cash flows (Rs.) Cumulative Cash flows

1 25,000 25,0002 40,000 65,0003 50,000 115,0004 40,000 155,0005 30,000 185,000

From the cumulative cash flow column the initial cash outlay of Rs. 1, 00,000 lies between 2nd year

3rd year in respect of project.

Therefore, payback period for project is:

=000,65

000,65000,1002

+

= 2.54 years

Pay-back period for project B is 2.54 years.

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b) Benefit cost ratio for 10% cost of capital

Table: Present Value (PV) of Cash inflows

YearCash inflows PV factor at 10% PV of Cash in flows

1 25,000 0.909 22,7252 40,000 0.826 33,0403 50,000 0.751 37,5504 40,000 0.683 27,3205 30,000 0.621 18,630

PV of Cashinflow

139,265

Initial Cash out lay 1,00,000NPV 39,265

Benefit cost ratio =

PV of Cash

inflow

Initial Cash

outlay

=139,265

1,00,000

= 1.39

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Q6. A companys earnings and dividends are growing at the rate of 18% pa. The growth rate isexpected to continue for 4 years. After 4 years, from year 5 onwards, the growth rate will be 6%forever. If the dividend per share last year was Rs. 2 and the investors required rate of return is10% pa, what is the intrinsic price per share or the worth of one share.

Answer : P = Intrinsic price per shareE = Earnings per share = 18%,

D = Dividend per share = 2

r = Rate of return = 10%

P = [2(1.18)/(1.10)1] + [2(1.18)2/(1.10)2] + [2(1.18)3/(1.10)3]

+ [2(1.18)4/(1.10)4] + [2(1.18)4 (1.06)/(1.10)5] + [2(1.18)4 (1.06)2/(1.10)6]

+ .

= 2.15 + 2.30 + 2.47 + 2.65 + 2.55 + 2.46

Intrinsic price per share = 14.58

Master of Business Administration-MBA Semester 2

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Financial Management MB0045

(Book ID: B1134)

Assignment Set- 2

Q.1 Discuss the objective of profit maximization vs wealth maximization .

The financial management come a long way by shifting its focus from traditional approacmodern approach. The modern approach focuses on wealth maximization rather than profit This givelonger term horizon for assessment, making way for sustainable performance by businesses. A myoperson or business is mostly concerned about short term benefits. A short term horizon can fuobjective of earning profit but may not help in creating wealth. It is because wealth creation needs lonterm horizon Therefore, Finance Management or Financial Management emphasizes on wemaximization rather thanmaximization.

For a business, it is not necessary that profit should be the only objective; it may concentrate on variother aspects like increasing sales, capturing more market share etc, which will take care of profitabiSo, we can say thatmaximizations a subset of wealth and being a subset, it will facilitate wealth creagiving priority to value creation; managers have now shifted from traditional approach to modapproach of financial management that focuses on wealth maximization. This leads to better and tevaluation of business. For e.g., under wealth maximization, more importance is given to cash florather than profitability. As it is said that profit is a relative term, it can be a figure in some currency, it cbe in percentage etc.

For e.g. a profit of say $10,000 cannot be judged as good or bad for a business, till it is compared winvestment, sales etc. Similarly, duration of earning the profit is also important. Whether it is earnedshort term or long term. In wealth maximization, major emphasizes is on cash flows rather than profit. to evaluate various alternatives for decision making, cash flows are taken under consideration. For to measure the worth of a project, criteria like:

Present valueof its cash inflow present value of cash outflows (net present value) is taken. Tapproach considers cash flows rather than profits into consideration and also use discounting technito find out worth of a project. Thus, maximization of wealth approach believes that money has time va

An obvious question that arises now is that how can we measure wealth. Well, a basic principle is

ultimately wealth maximization should be discovered in increased net worth or value of business. Someasure the same, value of business is said to be a function of two factors - earnings per share capitalization rate. And it can be measured by adopting following relation: Value of business = EPCapitalization rate

http://efinancemanagement.com/finance-financial-management/87-profit-maximization-or-maximization-of-profitshttp://efinancemanagement.com/finance-financial-management/87-profit-maximization-or-maximization-of-profitshttp://www.efinancemanagement.com/component/glossary/Glossary-1/P/Present-Value-2/http://www.efinancemanagement.com/component/glossary/Glossary-1/P/Present-Value-2/http://efinancemanagement.com/finance-financial-management/87-profit-maximization-or-maximization-of-profitshttp://efinancemanagement.com/finance-financial-management/87-profit-maximization-or-maximization-of-profitshttp://www.efinancemanagement.com/component/glossary/Glossary-1/P/Present-Value-2/http://www.efinancemanagement.com/component/glossary/Glossary-1/P/Present-Value-2/

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At times, wealth maximization may create conflict, known as agency problem. This describes conbetween the owners and managers of firm. As, managers are the agents appointed by ownersstrategic investor or the owner of the firm would be major concerned about the longer term performaof the business that can lead to maximization of shareholders wealth. Whereas, a manager might foon taking such decisions that can bring quick result, so that he/she can get credit for good performancHowever, in course of fulfilling the same, a manager might opt for risky decisions which can piton stthe owners objectives.

Hence, a manager should align his/her objective to broad objective of organization and achieve tradebetween risk and return while making decision; keeping in mind the ultimate goal of finanmanagement i.e. to maximize the wealth of its current shareholder she objections are:-(i) Profit cannoascertained well in advance to express the probability of return as future is uncertain. It is not at possto maximize what cannot be known.(ii) The executive or the decision maker may not have enouconfidence in the estimates of future returns so that he does not attempt future to maximize. It is arguthat firm's goal cannot be to maximize profits but to attain a certain level or rate of profit holding cershare of the market or certain level of sales.

Firms should try to 'satisfy' rather than to 'maximize'(iii) There must be a balance between expecreturn and risk. The possibility of higher expectedyields is associated with greater risk to recognize sa balance and wealth Maximization is brought in to the analysis. In such cases, higher capitalization involves. Such combination of expected returns with risk variations and related capitalization rate canbe considered in the concept of profit maximization.(iv) The goal of Maximization of profits is consideto be a narrow outlook.

Evidently when profit maximization becomes the basis of financial decisions of the concern, it ignoresinterests of the community on the one hand and that of the government, workers other concerpersons in the enterprise on the other hand. Keeping the above objections in view, most of the thinkon the subject have come to the conclusion that the aim of an enterprise should be wealth Maximizat

and not the profit Maximization. Prof. Solomon of Stanford University has handled the issued vlogically. He argues that it is useful to make a distinction between profit and 'profitability'. Maximizaof profits with a vie to maximizing the wealth of shareholders is clearly an unreal motive. On the othand, profitability Maximization with a view to using resources to yield economic values higher than

joint values of inputs required is a useful goal. Thus the proper goal of financial management is wemaximization.

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Q2. Explain the Net operating approach to capital structure.

Ans. net operating income approach examines the effects of changes in capital structure in terms ofoperating income. In the net income approach discussed above net income available to shareholderobtained by deducting interest on debentures form net operating income. Then overall value of the firmcalculated through capitalization rate of equities obtained on the basis of net operating income, called net income approach. In the second approach, on the other hand overall value of the firmassessed on the basis of net operating income not on the basis of net income. Hence this secoapproach is known as net operating income approach.

The NOI approach implies that (i) whatever may be the change in capital structure the overall valuethe firm is not affected. Thus the overall value of the firm is independent of the degree of leveragecapital structure. (ii) Similarly the overall cost of capital is not affected by any change in the degreeleverage in capital structure. The overall cost of capital is independent of leverage.

If the cost of debt is less than that of equity capital the overall cost of capital must decrease with increase in debts whereas it is assumed under this method that overall cost of capital is unaffected hence it remains constant irrespective of the change in the ratio of debts to equity capital. How can assumption be justified? The advocates of this method are of the opinion that the degree of risbusiness increases with the increase in the amount of debts. Consequently the rate of equity oinvestment in equity shares thus on the one hand cost of capital decreases with the increase in volume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benof leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustthispoint.If follows that with the increase in debts rate of equity capitalization also increases and consequently overall cost of capital remains constant; it does not decline.

To put the same in other words there are two parts of the cost of capital. One is the explicit cost whicexpressed in terms of interest charges on debentures. The other is implicit cost which refers to

increase in the rate of equity capitalization resulting from the increase in risk of business due to higlevel of debts.

Optimum capital structure

This approach suggests that whatever may be the degree of leverage the market value of the fremains constant. In spite of the change in the ratio of debts to equity the market value of its eqshares remains constant. This means there does not exist a optimum capital structure. Every capstructure is optimum according to net operating income approach.

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Q.3 what do you understand by operating cycle.

Ans. An operating cycle is the length of time between the acquisition of inventory and the sale of inventory and subsequent generation of a profit. The shorter the operating cycle, the faster a busingets a return on investment (ROI) for the inventory it stocks. As a general rule, companies want to ketheir operating cycles short for a number of reasons, but in certain industries, a long operating cyclactually the norm. Operating cycles are not tied to accounting periods, but are rather calculated in teof how long goods sit in inventory before sale.

When a business buys inventory, it ties up money in the inventory until it can be sold. This money mbe borrowed or paid up front, but in either case, once the business has purchased inventory, those fuare not available for other uses. The business views this as an acceptable tradeoff because the invenis an investment that will hopefully generate returns, but keeping the operating cycle short is still a gfor most businesses so they can keep their liquidity high.

Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be stored this can become costly, especially with items that require special handling, such as humidity controlsecurity. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishagoods, it can even be rendered unsalable. Inventory must also be insured and managed by smembers who need to be paid, and this adds to overall operating expenses.

There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for examkeep inventory on hand for years before it is sold, because of the nature of the business. In thindustries, the return on investment happens in the long term, rather than the short term. Scompanies are usually structured in a way that allows them to borrow against existing inventory or lanfunds are needed to finance short-term operations.

Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit arolonger, while periods of growth may be marked by more rapid turnover. Certain products can

consistent sellers that move in and out of inventory quickly. Others, like big ticket items, maypurchased less frequently. All of these issues must be accounted for when making decisions abordering and pricing items for inventory.

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Q.4 What is the implication of operating leverage for a firm.

Ans.

Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producinggoods or offering its services. Fixed costs include advertising expenses, administrative costs, equipmand technology, depreciation, and taxes, but not interest on debt, which is part of financial leverageusing fixed production costs, a company can increase its profits. If a company has a large percentagefixed costs, it has a high degree of operating leverage. Automated and high-tech companies, utcompanies, and airlines generally have high degrees of operating leverage.

As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets. Firmuses a highly automated production process with robotic machines, whereas firm B assembles widgets using primarily semiskilled labor. Table 1 shows both firms operating cost structures.

Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 per uwhereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variable cost per unmuch higher at $3.00 per unit. Both firms produce and sell 10,000 widgets per year at a price of $5per widget.

Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm A also hahigher breakeven pointthe point at which total costs equal total sales. Nevertheless, a change percent in sales causes more than a I percent change in operating profits for firm A, but not for firmThe degree of operating leverage measures this effect. The following simplified equation demonstrathe type of equation used to compute the degree of operating leverage, although to calculate this figthe equation would require several additional factors such as the quantity produced, variable cost unit, and the price per unit, which are used to determine changes in profits and sales:

Operating leverage is a double-edged sword, however. If firm As sales decrease by I percent, its pro

will decrease by more than I percent, too. Hence, the degree of operating leverage shows responsiveness of profits to a given change in sales.

Implications: Total risk can be divided into two parts: business risk and financial risk. Business refers to the stability of a companys assets if it uses no debt or preferred stock financing. Business stems from the unpredictable nature of doing business, i.e., the unpredictability of consumer demandproducts and services. As a result, it also involves the uncertainty of long-term profitability. Whecompany uses debt or preferred stock financing, additional riskfinancial riskis placed on companys common shareholders. They demand a higher expected return for assuming this additiorisk, which in turn, raises a companys costs. Consequently, companies with high degrees of businrisk tend to be financed with relatively low amounts of debt. The opposite also holds: companies with

amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levMoreover, using debt as leverage is a successful tool during periods of inflation. Debt fails, howeveprovide leverage during periods of deflation, such as the period during the late 1990s brought on by

Asian financial crisis.

Q.5

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A company is considering a capital project with the following information:

The cost of the project is Rs.200 million, which consists of Rs. 150 million in plant a machinery and Rs

million on net working capital. The entire outlay will be incurred in the beginning. The life of the projec

expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs

million ad the net working capital will be liquidated at par. The project will increase revenues of the by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation

applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capita

10% what is the net present value of the project.

ANS.

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Q.6 Given the following information, what will be the price per share using the Walter model.Earnings per share Rs. 40Rate of return on investments 18%Rate of return required by shareholders 12%Payout ratio being 40%, 50%, or 60%.

ANS.

Given

Ke = required by shareholder = 12%

R = return on investment = 18%

E = Earnings = Rs. 40

Price by walter model = [D + (E D)r/Ke] / Ke

If Dividend payout

40% 50% 60%

[16 + (40 16)0.18/0.12]

/ 0.12

= Rs. 433.33

[20 + (40 20)0.18/0.12]

/ 0.12

= Rs. 416.67

[24 + (40 24)0.18/0.12]

/ 0.12

= Rs. 400