POST GRADUATION DIPLOMA IN BUSINESS ADMINISTRATION Semester 2

MB 0045 Financial Management

ASSIGNMENT- Set 1
Q1: What are the goals of financial management? Answer: Financial Management means maximisation of economic welfare of its shareholders. Maximisation of economic welfare means maximisation of wealth of its shareholders. Shareholders wealth maximisation is reflected in the market value of the firms shares. Experts believe that, the goal of the financial management is attained when it maximises its value. There are two versions of the goals of financial management of the firm Profit Maximisation and Wealth Maximisation. Profit Maximisation:

Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns, with the best output and price levels. A firms performance is evaluated in terms of profitability. Allocation of resources and investors perception of the companys performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts: 1. The concept of profit lacks clarity. What does profit mean? o Is it profit after tax or before tax? o Is it operating profit or net profit available to share holders? Differences in interpretation on the concept of profit expose the weakness of profit maximisation. 2. Profit maximisation ignores time value of money. It does not differentiate between profits of current year with the profit to be earned in later years. 3. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to thebusiness risk of the firm. 4. The concept of profit maximisation apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximisation fails to meet the standards stipulated in an operational and a feasible criterion for maximising shareholders wealth, because of the deficiencies explained above.

Wealth Maximisation

Wealth maximisation means maximising the net wealth of a companys shareholders. Wealth maximisation 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 maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.

Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.

Q 2: Calculate the PV of annuity of Rs. 500 received annually for four years when discounting factor is 10% Solution : The present value of annuity can be calculated from the table 3.6 as shown under: Year 1 2 3 4 Cash flows 500 500 500 500 Present value factor at 10% 0.909 0.827 0.751 0.683 3.170 Present value (2 x 3) 454.50 413.50 375.50 341.50

Present value of an annuity is Rs. 1585.

OR By directly looking at the table we can calculate:

= 500*PVIFA (10%, 4y) = 500*3.170 = Rs. 1585 The present value of annuity is Rs. 1585. Q 3: Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10 % p.a. The price of one share is currently Rs.110 in the market. What is the cost of equity capital to the company? Answer: K = (DI/P) + G = (5/110) + 0.10 = 0.1454 OR 14.54% So, the cost of equity capital to the company is 14.54% K: Cost of capital DI : Divided Share

P : Current price of share G: Growth Rate Q 4: What are the assumptions of MM approach? Answer:

The MM approach to irrelevance of dividend is based on the following assumptions: The capital markets are perfect and the investors behave rationally. All information is freely available to all the investors. There is no transaction cost. Securities are divisible and can be split into any fraction. No investor can affect the market price. There are no taxes and no flotation cost. The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted. The model Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividends. They have used the arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. They have shown that given the investment opportunities, a firm will finance these either by ploughing back profits of if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. In order to satisfy their model, MM has started with the following valuation model. P0= 1* (D1+P1)/ (1+ke)

Where, P0 = Present market price of the share Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P1 = Expected market price of the share at the end of year 1 With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are: Payment of dividend by the firm Rising of fresh capital. With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.

Q 5: An investment will have an initial outlay of 100,000. It is expected to generate cash flows. Table 1.2 highlights the cash flow for four years.

Year 1 2 3 4 If the risk free rate and risk premium is 10%, a) Compute the NPV using the risk free rate?

Cash flow 40000 50000 15000 30000