2nd semester assignment - mb0029

8/9/2019 2nd Semester Assignment - MB0029

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Name Syed Khaleelullah

Roll No. 530910706

Program MBA 2 nd Semester Assignment

Subject Financial Management, Set2

Code MB 0029


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Q1. Is Equity Capital Free of cost? Substantiate your statement.

Ans. No. Equity Capital is not free of cost. Some people are of the opinionthat equity capital is free of cost for the reason that a company is not legallybound to pay dividends and also the rate of equity dividend is not fixed likepreference dividends. This is not a correct view as equity shareholders buyshares with the expectation of dividends and capital appreciation. Dividendsenhance the market value of shares and therefore equity capital is not freeof cost.Equity shareholders do not have a fixed rate of return on their investment.There is no legal requirement (unlike in the case of loans or debentureswhere the rates are governed by the deed) to pay regular dividends to them.Measuring the rate of return to equity holders is a difficult and complexexercise. There are many approaches for estimating return - the dividendforecast approach, capital asset pricing approach, realized yield approach,etc. According to dividend forecast approach, the intrinsic value of an equityshare is the sum of present values of dividends associated with it.

Q2.(a) What is the rate of return for a company if the is 1.25, riskfree rate of return is 8% and the market rate of return is 14%. UseCAPM model.

Ans.Ke = Rf + (RmRf)

= 0.08 + 1.25(0.14 - 0.08)= 0.08 + 0.075= 0.155 or 15.5%

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(b) Sundaram Transports has the following capital structure.

Equity capital Rs.10 par value 250 lakhs12% preference share capital Rs.100 each 100 lakhsRetained earnings 150 lakhs12% Debentures (Rs.100 each) 350 lakhs14% Term loan from SBI 150 lakhsTotal 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare adividend per share of Rs.2 per share and there will be a growth of 10% inthe dividends for the next 5 years. The preference shares are redeemableat a premium of Rs.5 per share after 8 years. The current market price of

preference share is Rs.92. Debenture redemption will take place after 7years at a discount of 2% and the current market price is Rs.91 perdebenture. The corporate tax rate is 40%. Calculate WACC.(7 Marks)

Ans.Ke is the cost of external equity,D1 is the dividend expected at the end of year 1 = 2P0 is the current market price per share = Rs. 92

g is the constant growth rate of dividends = 10%f is the floatation costs as % of current market price.

Step I is to determine the cost of each component.

Cost of external equity:Ke =( D1/P0) + g

= (2/54) + 0.1= 0.137 or 13.7%

Cost of preference capital:Kp = D + {(FP)/n} / (F+P)/2D is the preference dividend per share payable=11F is the redemption price=105P is the net proceeds per share = 92n is the maturity period =8

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Weighted Average of Cost of Capital:WACC = WeKe + WpKp +WrKr + WdKd + WtKt= (0.25*0.137) + (0.1*0.1281) + (0.15*0.137) + (0.35*0.0867) +(0.15*0.084)

= 0.03425+ 0.01281+ 0.02055+ 0.030345+ 0.0126= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004= 0.1105 or 11.05%

Q3. The effective cost of debt is less than the actual interestpayment made by the firm. Do you agree with this statement? If yes/no substantiate your views.

Ans. Yes. The debentures carry a fixed rate of interest. Interest qualifies fortax deduction in determining tax liability. Therefore the effective cost of debtis less than the actual interest payment made by the firm.The Net Cash Outflows in terms of Amount of Periodic interest Payment andRepayment of Principal in Installments or in lump-sum on Maturity.

The Interest Payment made by the firm on Debt Issues qualifies for taxdeduction in determining the net taxable income. Therefore, the effectivecash outflow is less than the actual payment of Interest made by the firm tothe debt holders by the amount of tax shield on Interest Payment. The debtcan either be Perpetual/Irredeemable or Redeemable.

Q4.Why capital budgeting decision very crucial for financemanagers?

Ans. There are many reasons that make the Capital budgeting decisionsthe most crucial for finance Managers:

1. These decisions involve large outlay of funds now in anticipation of cashflows in future. For example, investment in plant and machinery. Theeconomic life of such assets has long periods. The projections of cash flowsanticipated involve forecasts of many financial variables. The most crucialvariable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of itsproduction facilities based on its own sales forecast. During this period,huge investments in R & D in packaging industry brought about newpackaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself thatthe market for its metal boxes had declined drastically. The end result is

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that Metal Box became a sick company from the position it enjoyedearlier prior to the execution of expansion as a blue chip. Employees losttheir jobs. It affected the standard of lining and cash flow position of itsemployees. This highlights the element of risk involved in these type of decisions.

b. Equally we have empirical evidence of companies which took decisionson expansion through the addition of new products and adoption of thelatest technology creating wealth for shareholders. The best example isthe Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capitalexpenditure can significantly affect the firm. An upward bias may lead toa situation of the firm creating idle capacity, laying the path for thecancer of sickness.

d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its competitors. Both are risky fraught with graveconsequences.

2. A long term investment of funds some times may change the risk profileof the firm. A FMCG company with its core competencies in the businessdecided to enter into a new business of power generation. This decision willtotally alter the risk profile of the business of the company. Investorsperception of risk of the new business to be taken up by the company willchange his required rate of return to invest in the company. In thisconnection it is to be noted that the power pricing is a politically sensitivearea affecting the profitability of the organization. Therefore, Capitalbudgeting decisions change the risk dimensions of the company and hencethe required rate of return that the investors want.

3. Most of the Capital budgeting decisions involve huge outlay. The fundsrequirements during the phase of execution must be synchronized with theflow of funds. Failure to achieve the required coordination between theinflow and outflow may cause time over run and cost over run. These twoproblems of time over run and cost over run have to be prevented from

occurring in the beginning of execution of the project. Quite a lot empiricalexamples are there in public sector in India in support of this argumentthat cost over run and time over run can make a companys operationsunproductive. But the major challenge that the management of a firmfaces in managing the uncertain future cash inflows and out flowsassociated with the plan and execution of Capital budgeting decisions.

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4. Capital budgeting decisions involve assessment of market for companysproducts and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firmwere to realize after committing itself considerable sums of money in theprocess of implementing the Capital budgeting decisions taken that the

decision to diversify or expand would become a wealth destroyer to thecompany, then the firm would have experienced a situation of inability tosell the equipments bought. Loss incurred by the firm on account of thiswould be heavy if the firm were to scrap the equipments bought specificallyfor implementing the decision taken. Sometimes these equipments will bespecialized costly equipments. Therefore, Capital budgeting decisions areirreversible.

5. The most difficult aspect of Capital budgeting decisions is the influenceof time. A firm incurs Capital expenditure to build up capacity inanticipation of the expected boom in the demand for its products. Thetiming of the Capital expenditure decision must match with the expectedboom in demand for companys products. If it plans in advance it mayeffectively manage the timing and the quality of asset acquisition. Butmany firms suffer from its inability to forecast the future operations andformulate strategic decision to acquire the required assets in advance atthe competitive rates.

6. All Capital budgeting decisions have three strategic elements. Thesethree elements are cost, quality and timing. Decisions must be taken at theright time which would enable the firm to procure the assets at the leastcost for producing the products of required quality for customer. Any lapseon the part of the firm in understanding the effect of these elements onimplementation of Capital expenditure decision taken will strategicallyaffect the firms profitability.

7. Liberalization and globalization gave birth to economic institutions likeWorld Trade organization. General Electrical can expand its market intoIndia snatching the share already enjoyed by firms like Bajaj Electricals orKirloskar Electric Company. Ability of G E to sell its products in India at arate less than the rate at which Indian Companies sell cannot be ignored.

Therefore, the growth and survival of any firm in todays businessenvironment demands a firm to be proactive. Proactive firms cannot avoidthe risk of taking challenging Capital budgeting decisions for growth.Therefore, Capital budgeting decisions for growth have become anessential characteristics of successful firms today.

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8. The social, political, economic and technological forces generate highlevel of uncertainty in future cash flows streams associated with Capitalbudgeting decisions. These factors make these decisions highly complex.

9. Capital expenditure decisions are very expensive. To implement these

decisions firms will have to tap the Capital market for funds. Thecomposition of debt and equity must be optimal keeping in view theexpectation of investors and risk profile of the selected project.

Q5.A road project require an initial investment of Rs.10,00,000. It isexpected to generate the following cash flow in the form of toll taxrecovery.

Year Cash Inflows1 4,50,0002 4,25,0003 3,00,0004 3,50,000

What is the IRR of the project?Ans.To calculate Internal Rate of Return (IRR):Step I : Compute the average of annual cash inflows

Year Cash Inflow inRs.

1 4,50,0002 4,25,0003 3,00,0004 3,50,000Total 15,25,000

Average = 15,00,000 / 4 = Rs. 3,81,250

Step II : Divide the initial investment by the average of annual cash inflows:=10,00,000 / 3,81,250=2.622

Step III : From the PVIFA table for 4 years, the annuity factor very near to2.622 is 20%. Thereforethe first initial rate is 20%Year Cash flows PV factor at 20% PV of Cash1 4,50,000 0.833 3,74,8508 Roll No: 530910706


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2 4,25,000 0.694 2,94,9503 3,00,000 0.579 1,73,7004 3,50,000 0.482 1,68,700

Total 10,12,200

Since the initial investment of Rs.10,00,000 is less than the computed valueat 20% of Rs. 10,12,200 then next trial rate is 22%.

Year Cash flows PV factor at 22% PV of Cash1 4,50,000 0.82 3,69,0002 4,25,000 0.672 2,85,6003 3,00,000 0.551 1,65,3004 3,50,000 0.451 1,57,850

Total 9,77,750

Since initial investment of Rs.10,00,000 lies between 9,77,750 (22%) and10,12,200 (20%), the IRR by interpolation is,

IRR = 20 + ((10,12,200-10,00,000) / (10,12,200-9,77,750))*2= 20 + 0.3541 *2= 20.70%

Q6.What is sensitivity analysis? Mention the steps involved in it.

Ans. Sensitivity Analysis:There are many variables like sales, cost of sales, investments, tax rates etcwhich affect the NPV and IRR of a project. Analysing the change in theprojects NPV or IRR on account of a given change in one of the variables iscalled Sensitivity Analysis. It is a technique that shows the change in NPVgiven a change in one of the variables that determine cash flows of aproject. It measures the sensitivity of NPV of a project in respect to achange in one of the input variables of NPV.

The reliability of the NPV depends on the reliability of cash flows. If forecasts go wrong on account of changes in assumed economic environments,reliability of NPV & IRR is lost. Therefore, forecasts are made under differenteconomic conditions viz pessimistic, expected and optimistic. NPV is arrivedat for all the three assumptions.

Steps involved in Sensitivity analysis:

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1. Identification of variables that influence the NPV & IRR of the project.2. Examining and defining the mathematical relationship between thevariables.3. Analysis of the effect of the change in each of the variables on the NPV of the project.

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2nd semester assignment - mb0029

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