Master of Business Administration- MBA Semester 2

MB0045 –Financial Management

(Book ID: B1134)

Assignment Set- 1

Q.1 . Show the relationship between required rate of return and coupon

rate on the value of a bond.

Ans: It is important for prospective bond buyers to know how to determine the

price of a bond because it will indicate the yield received should the bond be

purchased. In this section, we will run through some bond price calculations for

various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bond’s price is

higher than its par value, it will sell at a premium because its interest rate is

higher than current prevailing rates. If the bond’s price is lower than its par value,

the bond will sell at a discount because its interest rate is lower than current

prevailing interest rates. When you calculate the price of a bond, you are

calculating the maximum price you would want to pay for the bond, given the

bond’s coupon rate in comparison to the average rate most investors are

currently receiving in the bond market. Required yield or required rate of return is

the interest rate that a security needs to offer in order to encourage investors to

purchase it. Usually the required 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 coupon payments plus the present value of the par value at maturity.

Calculating bond price is simple: all we are doing is discounting the known future

cash flows. Remember that to calculate present value (PV) – which is based on

the assumption that each payment is re-invested at some interest rate once it is

received–we have to know the interest rate that would earn us a known future

value. For bond pricing, this interest rate is the required yield. (If the concepts of

present and future value are new to you or you are unfamiliar with the

calculations, refer to Understanding the Time Value of Money.)

Here is the formula for calculating a bond’s price, which uses the basic present

value (PV) formula:

C = coupon payment

n = number of payments

i = interest rate, or required yield

M = value at maturity, or par valueThe 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 straight bond are paid at ordinary annuity.)

The first payment of an ordinary annuity occurs one interval from the time at

which the debt security is acquired. The calculation assumes this time is the

present.

You may have guessed that the bond pricing formula shown above may be

tedious to calculate, as it requires adding the present value of each future

coupon payment. Because these payments are paid at an ordinary annuity,

however, we can use the shorter PV-of-ordinary-annuity formula that is

mathematically 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.

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 are further into the future the

present value of the second coupon payment is worth less than the first coupon

and 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 fundamental

concept for which the PV-of-ordinary-annuity formula accounts. It calculates the

sum of the present values of all future cash flows, but unlike the bond-pricing

formula we saw earlier, it doesn’t require that we add the value of each coupon

payment. (For more on calculating the time value of annuities, see Anything but

Ordinary: Calculating the Present and Future Value of Annuities and

Understanding the Time Value of Money.)

Accounting for Different Payment Frequencies

In the example above coupons were paid semi-annually, so we divided the

interest rate and coupon payments in half to represent the two payments per

year. You may be now wondering whether there is a formula that does not

require steps two and three outlined above, which are required if the coupon

payments occur more than once a year. A simple modification of the above

formula will allow you to adjust 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 the frequency of coupon payments, or the number of times a

year the coupon is paid. Therefore, for bonds paying annual coupons, F would

have a value of one. Should a bond pay quarterly payments, F would equal four,

and if the bond paid semi-annual coupons, F would be two.

Q. 2. 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 that inventory and subsequent generation of a profit.

The shorter the operating cycle, the faster a business gets a return on investment

(ROI) for the inventory it stocks. As a general rule, companies want to keep their

operating cycles short for a number of reasons, but in certain industries, a long

operating cycle is actually the norm. Operating cycles are not tied to accounting

periods, but are rather calculated in terms of 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 may be borrowed or paid up front, but in either case, once the

business has purchased inventory, those funds are not available for other uses.

The business views this as an acceptable tradeoff because the inventory is an

investment that will hopefully generate returns, but keeping the operating cycle

short is still a goal for 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 and this can become costly, especially with items that

require special handling, such as humidity controls or security. Furthermore,

inventory can depreciate if it is kept in a store too long. In the case of perishable

goods, it can even be rendered unsalable. Inventory must also be insured and

managed by staff members 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 example, keep inventory on hand for years before it is sold,

because of the nature of the business. In these industries, the return on

investment happens in the long term, rather than the short term. Such companies

are usually structured in a way that allows them to borrow against existing

inventory or land if funds are needed to finance short-term operations.

Operating cycles can fluctuate. During periods of economic stagnation, inventory

tends to sit around longer, while periods of growth may be marked by more rapid

turnover. Certain products can be consistent sellers that move in and out of

inventory quickly. Others, like big ticket items, may be purchased less frequently.

All of these issues must be accounted for when making decisions about ordering

and pricing items for inventory.

Q.3 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 producing its goods or offering its services. Fixed costs include

advertising expenses, administrative costs, equipment and technology,

depreciation, and taxes, but not interest on debt, which is part of financial

leverage. By using fixed production costs, a company can increase its profits. If a

company has a large percentage of fixed costs, it has a high degree of operating

leverage. Automated and high-tech companies, utility companies, 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. Firm A uses a highly automated production process with robotic

machines, whereas firm B assembles the widgets using primarily semiskilled

labor. Table 1 shows both firm’s operating cost structures.

Highly automated firm A has fixed costs of $35,000 per year and variable costs of

only $1.00 per unit, whereas labor-intensive firm B has fixed costs of only

$15,000 per year, but its variable cost per unit is much higher at $3.00 per unit.

Both firms produce and sell 10,000 widgets per year at a price of $5.00 per

widget.

Firm A has a higher amount of operating leverage because of its higher fixed

costs, but firm A also has a higher breakeven point—the point at which total

costs equal total sales. Nevertheless, a change of I percent in sales causes more

than a I percent change in operating profits for firm A, but not for firm B. The

“degree of operating leverage” measures this effect. The following simplified

equation demonstrates the type of equation used to compute the degree of

operating leverage, although to calculate this figure the equation would require

several additional factors such as the quantity produced, variable cost per 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 A’s sales decrease

by I percent, its profits will decrease by more than I percent, too. Hence, the

degree of operating leverage shows the responsiveness of profits to a given

change in sales.

Implications: Total risk can be divided into two parts: business risk and financial

risk. Business risk refers to the stability of a company’s assets if it uses no debt

or preferred stock financing. Business risk stems from the unpredictable nature of

doing business, i.e., the unpredictability of consumer demand for products and

services. As a result, it also involves the uncertainty of long-term profitability.

When a company uses debt or preferred stock financing, additional risk—

financial risk—is placed on the company’s common shareholders. They demand

a higher expected return for assuming this additional risk, which in turn, raises a

company’s costs. Consequently, companies with high degrees of business risk

tend to be financed with relatively low amounts of debt. The opposite also holds:

companies with low amounts of business risk can afford to use more debt

financing while keeping total risk at tolerable levels. Moreover, using debt as

leverage is a successful tool during periods of inflation. Debt fails, however, to

provide leverage during periods of deflation, such as the period during the late

1990s brought on by the Asian financial crisis.

Q.4 Explain the factors affecting Financial Plan

Ans: To help your organization succeed, you should develop a plan that needs to

be followed. This applies to starting the company, developing new product,

creating a new department or any undertaking that affects the company’s future.

There are several factors that affect planning in an organization. To create 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 the planning process of any project. For

example, if you are in the process of planning a large expansion project and your

largest customer suddenly threatens to take their business to your competitor,

then you might have to shelve the expansion planning until the customer issue is

resolved. When you start the planning process for any project, you need to

assign each of the issues facing the company a priority rating. That priority rating

will determine what issues will sidetrack you from the planning of your project,

and 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 succeed, but 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 to complete the project, compared to the resources the company has

available. Some of the resources to consider 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. Forecasting sales revenues, materials costs,

personnel costs and overhead costs can help a company plan for upcoming

projects. Without accurate forecasting, it can be difficult to tell if the plan has any

chance of success, if the company has the capabilities to pull off the plan and if

the plan will help to strengthen the company’s standing within the industry. For

example, if your forecasting for the cost of goods has changed due to a sudden

increase in material costs, then that can affect elements of your product roll-out

plan, including projected profit and the long-term commitment you might need to

make to a supplier to 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 has decided to pursue a new product

line, there needs to be a part of the plan that addresses the possibility that the

product line will fail. The reallocation of company resources, the acceptable

financial losses and the potential public relations problems that a failed product

can cause all need to be part of the organizational planning process from the

beginning.

Q.5 An employee of a bank deposits Rs. 30000 into his PF A/c at the end of

each year for 20 years. What is the amount he will accumulate in his PF at

the end of 20 years, if the rate of interest given by PF authorities is 9%?

Year Amount Interest Total

1 30000 9% 300002 30000 9% 327003 30000 9% 356434 30000 9% 388515 30000 9% 423476 30000 9% 461597 30000 9% 503138 30000 9% 548419 30000 9% 59777

10 30000 9% 65157

11 30000 9% 7102112 30000 9% 7741313 30000 9% 8438014 30000 9% 91974

15 30000 9%

10025

2

16 30000 9%

10927

4

17 30000 9%

11910

9

18 30000 9%

12982

9

19 30000 9%

14151

4

20 30000 9%

15425

0

Q.6 Mr. Anant purchases a bond whose face value is Rs.1000, and which

has a nominal interest rate of 8%. The maturity period is 5 years. The

required rate of return is 10%. What is the price he should be willing to pay

now to purchase the bond?

Ans: Solution:

Interest payable=1000*8%=Rs. 80, Principal repayment is Rs. 1000

Required rate of return is 10% V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Value of the bond=80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y)

= 80*3.791 + 1000*0.621 = 303.28 + 621 =Rs. 924.28

This implies that the company is offering the bond at Rs. 1000 but is worth Rs.

924.28 at the required rate of return of 10%. The investor may not be willing to

pay more than Rs. 924.28 for the bond today.