MB0045 Naser Shoukat Firfire

Master of Business Administration - MBA Semester 2MB0045 – Financial Management - 4 Credits

(Book ID: B1134)Assignment Set- 1 (60 Marks)

Note: Each question carries 10 marks. Answer all the questions.

Q.1 What are the 4 finance decisions taken by a finance manager.

Modern approach of financial management provides a conceptual and analytical framework for financial decision making. According to this approach there are 4 major decision areas that confront the Finance Manager these are:-

1. Investment Decisions2. Financing Decisions3. Dividend Decisions4. Financial Analysis, Planning and Control Decisions

a) Investment Decisions;

Investment decisions are made by i n v e st o r s a nd i n ve s t m ent m ana g e rs . Investors commonly perform i n v e s t m ent an a l y s i s by making use of f u n da m en t a l ana l y s i s , t ech n i c a l ana l y s i s , s c r e ene r s a nd g ut f e e l . Investment decisions are often supported by dec i s i o n t oo ls . The p o r t f o l i o t he o r y i s often applied to helpthe investor achieve a s a ti sf ac t o r y r e t u r n compared to the r i sk t aken.

b) Financing Decisions;

What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.· There are three types of financial management decisions: Capital budgeting, Capital structure, andWorking capital management.· Capital budgeting is the process of planning and managing a firm's long-term investments. The key to capital budgeting is size, timing, and risk of future cash flows is the essence of capital budgeting. Forexample, yesterday I received a call from our manager over our Sand & Gravel Operations. He islooking into buying a new crusher (to crush stone into gravel and sand). I helped him today evaluate the return on investment for this opportunity. It quite a lot of work, but we determined that buying the new crusher would bring in 60,000 more tons of production/sales within the 1st year of owning the machine.· Capital Structure refers to the

c) Dividend Decisions

The Dividend Decision is a decision made by the d ir e c t o r s o f a company. It relates to the amount and

timing of any cash payments made to the company's stockholders. The decision is an important one for

MB0045 Naser Shoukat Firfire

the firm as it may influence its capital structure and stock price. In addition, the decision may determine

the amount of t ax a ti o n t hat stockholders pay.

There are three main factors that may influence a firm's dividend decision:

Free-cash flow

Dividend clienteles

Information signalling

Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash

that is surplus after it invests in all available positive n e t p r e s e n t v a l ue p rojects.

A key criticism of this theory is that it does not explain the observed dividend policies of real-world

companies. Most companies pay relatively consistent dividends from one year to the next and managers

tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates

dramatically from one year to the next. These criticisms have led to the development of other models that

seek to explain the dividend decision.

Dividend clienteles

A particular pattern of dividend payments may suit one type of stock holder more than another. A retiree

may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a

high income from employment may prefer to avoid dividends due to their high m a r g i n a l t a x r a t e on

income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximise its

stock price and minimise its cost of capital by catering to a particular clientele. This model may help to

explain the relatively consistent dividend policies followed by most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to

provide the pattern of cash flows that they desire. An investor who would like to receive some cash from

their investment always has the option of selling a portion of their holding. This argument is even more

cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that

there are taxation-based clienteles for certain types of dividend policies.

Information signalling

A model developed by M er t on M i l l e r a nd K e v i n R ock i n 1985 suggests that dividend announcements

convey information to investors regarding the firm's future prospects. Many earlier studies had shown that

stock prices tend to increase when an increase in dividends is announced and tend to decrease when a

decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information

content of dividends.

MB0045 Naser Shoukat Firfire

When investors have incomplete information about the firm (perhaps due to opaque accounting practices)

they will look for other information that may provide a clue as to the firm's future prospects. Managers

have more information than investors about the firm, and such information may inform their dividend

decisions. When managers lack confidence in the firm's ability to generate cash flows in the future they

may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely,

managers that have access to information that indicates very good future prospects for the firm (e.g. a full

order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell the

firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when

dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know

that stock holders closely watch dividend announcements looking for good or bad news. As managers

tend to avoid sending a negative signal to the market about the future prospects of their firm, this also

tends to lead to a dividend policy of a steady, gradually increasing payment

d) Financial Analysis, Planning and Control Decisions

Introduction

Management has been defined as ―the art of asking significant questions.‖ The same applies to financial analysis, planning and control, which should be targeted toward finding meaningful answers to these significant questions—whether or not the results are fully quantifiable.

This seminar not only presents the key financial tools generally used, but also explains the broader context of how and where they are applied to obtain meaningful answers. It provides a conceptual backdrop both for the financial/economic dimensions of systematic business management and for understanding the nature of financial statements, analyzing data, planning and controlling.

Seminar Objectives

The seminar provides delegates with the tools required to find better answers to questions such as:

What is the exact nature and scope of the issue to be analyzed? Which specific variables, relationships, and trends are likely to be helpful in analyzing the issue? Are there possible ways to obtain a quick ―ballpark‖ estimate of the likely result? How precise an answer is necessary in relation to the importance of the issue itself? How reliable are the available data, and how is this uncertainty likely to affect the range of

results? Are the input data to be used expressed in cash flow terms—essential for economic analysis—or

are they to be applied within an accounting framework to test only the financial implications of adecision?

What limitations are inherent in the tools to be applied, and how will these affect the range of results obtained?

MB0045 Naser Shoukat Firfire

How important are qualitative judgments in the context of the issue, and what is the ranking of their significance?

Who Should Attend?

This seminar is a ‗must‘ for Chief Financial Officers, Financial Controllers, Finance Executives, Accountants, Treasurers, Corporate Planning and Business Development Executives and Sales and Marketing Professionals.

Middle and junior personnel will also find this seminar highly useful in their career advancement. All participants will be able to offer their input, based on their individual experiences, and will find the seminar a forum for upgrading and enhancing their understanding of best corporate practices in the areas examined.

Competencies Emphasised

Obtaining the relevant information, given the context of the situation Choosing the most appropriate tools Knowing the strengths and limitations of the available tools Viewing all analysis, planning and control decisions in the context of their impact on shareholder

value

Personal Impact

Delegates will acquire the ability, when involved in decisions about business investment, operations, or financing, to choose the most appropriate tools from the wide variety of analytical techniques available to generate quantitative answers. Selecting the appropriate tools from these choices is clearly an important part of the analytical task. Yet, experience has shown again and again that first developing a proper perspective for the problem or issue is just as important as the choice of the tools themselves.

Organisational Impact

This seminar provides an integrated conceptual backdrop both for the financial/economic dimensions of systematic business management and for understanding the nature of financial statements.

All the topics on the seminar are viewed in the context of creating shareholder value—a fundamental concept that is consolidated on the final day of the seminar.

Training Methodology

The training methodology combines lectures, discussions, group exercises and individual exercises. Delegates will gain both a theoretical and a practical knowledge of the topics covered. The emphasis is on the practical application of the topics and as a result delegates will return to the workplace with both the ability and the confidence to apply the techniques learned, in carrying out their duties.

All delegates will receive a comprehensive set of notes to take back to the workplace, which will serve as a useful source of reference in the future. In addition, all delegates will receive a CD-ROM disk containing additional reference material and Excel templates, related to the seminar.

MB0045 Naser Shoukat Firfire

Seminar Outline

Day 1 – The Challenge of Financial/Economic Decision-making

The practice of financial/economic analysis The value-creating company A dynamic perspective of business What information and data to use The nature of financial statements The context of financial analysis

Day 2 – Assessment of Business Performance

Ratio analysis and performance Management‘s point of view Owners‘ point of view Lenders‘ point of view Ratios as a system Integration of financial performance analysis Some special issues

Day 3 – Projection of Financial Requirements

Interrelationship of financial projections Operating budgets Standard costing and variance analysis Cash forecasts/budgets Sensitivity analysis Dynamics and growth of the business system Operating leverage Financial growth plans Financial modelling

Day 4 – Analysis of Investment Decisions

Applying time-adjusted measures Strategic perspective Economic value added (EVA) and net present value (NPV) Refinements of investment analysis Equivalent annual cost (EAC) Modified internal rate of return (MIRR) Dealing with risk and changing circumstances

Day 5 – Valuation and Business Performance

Managing for shareholder value Shareholder value creation in perspective Evolution of value-based methodologies

MB0045 Naser Shoukat Firfire

Creating value in restructuring and combinations Financial strategy in acquisitions Business valuation Business restructuring and reorganisations Management buy-outs and management buy-ins

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

The various other factors affecting financial plan are listed down in figure 2.2

Nature of the industryThe very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns.

Size of the company

The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long term sources at competitive terms.On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates

Status of the company in the industry

MB0045 Naser Shoukat Firfire

A well established company enjoys a good market share, for its products normally commands investors‟ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging fromchanging business environment

Nature of the industryThe very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns.

Size of the company

The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long term sources at competitive terms.On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates

Status of the company in the industry

A well established company enjoys a good market share, for its products normally commands investors‟ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging fromchanging business environment

Sources of finance availableSources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firm‟s capability to manage the risk exposure.

The capital structure of a company

The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders.

Matching the sources with utilisation

The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset – investments are to be financed by long term sources, which is a cardinal principle of financial planning.

Flexibility

MB0045 Naser Shoukat Firfire

The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market.

Government policy

SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt. of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint

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

The fair price of a straight bond (a bond with no e m bedded o p ti o n; see E m bedded O p ti o n ) is usually

determined by discounting its expected cash flows at the appropriate d i s cou n t r a t e . The formula

commonly applied is discussed initially. Although this present value relationship reflects the theoretical

approach to determining the value of a bond, in practice its price is (usually) determined with reference to

other, more l i qu i d instruments. The two main approaches, Relative pricing and Arbitrage-free pricing, are

discussed next. Finally, where it is important to recognise that future interest rates are uncertain and that

the discount rate is not adequately represented by a single fixed number - for example w hen an o p ti o n i s

w ri t t en on t he bo n d i n que s ti on - stochastic calculus may be employed.

Present value approach

Below is the formula for calculating a bond's price, which uses the basic present value (PV) formula for a

given discount rate:[ 1] ( This formula assumes that a coupon payment has just been made; see b e l ow f or

adjustments on other dates.)

F = face value

iF = contractual interest rate

C = F * iF = coupon payment (periodic interest payment)

N = number of payments

i = market interest rate, or required yield, or y i e l d t o m a t u r i t y ( see b e l o w )

M = value at maturity, usually equals face value

P = market price of bond

MB0045 Naser Shoukat Firfire

If the market price of bond is less than its face value (par value), the bond is selling at a discount.

Conversely, if the market price of bond is greater than its face value, the bond is selling at a premium. [ 2]

Relative price approach

Under this approach, the bond will be priced relative to a benchmark, usually a g o v e r n m ent s e cu ri t y ; see

R e l a ti v e v a l u a ti o n . Here, the yield to maturity on the bond is determined based on the bond's C r e d i t r a t i ng

r elative to a government security with similar maturity or d u r a t i on; seeC r e d i t sp r e ad ( bon d ) . T he better

the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark.

This required return, i in the formula, is then used to discount the bond cash flows as above to obtain the

price.

Arbitrage-free pricing approach

Under this approach, the bond price will reflect its a r b i t r a g e - free price. Here, each cash flow (coupon or

face) is separately discounted at the same rate as a z e r o - coupon bond c orresponding to the coupon date,

and of equivalent credit worthiness (if possible, from the same issuer as the bond being valued, or if not,

with the appropriate c r e d i t sp r e a d ) . Here, in general, we apply the r a t i on a l p ri c i ng l ogic relating to " A s s e t s

w it h i de n t i cal c a sh f l o w s " . I n detail: (1) the bond's coupon dates and coupon amounts are known with

certainty. Therefore (2) some multiple (or fraction) of zero-coupon bonds, each corresponding to the

bond's coupon dates, can be specified so as to produce identical cash flows to the bond. Thus (3) the bond

price today must be equal to the sum of each of its cash flows discounted at the d i s c ou n t r a t e i mplied by

the value of the corresponding ZCB. Were this not the case, (4) the abitrageur could finance his purchase

of whichever of the bond or the sum of the various ZCBs was cheaper, by sh o r t se l l i ng t he other, and

meeting his cash flow commitments using the coupons or maturing zeroes as appropriate. Then (5) his

"risk free", arbitrage profit would be the difference between the two values. See R a t i on a l p r i c i n g : Fi x ed

i nco m e s ec u r i t i e s .

Stochastic calculus approach

The following is a pa r t i al d i ff e r e n t i al e qu a ti o n ( PDE) in s t o cha s t i c c a l c u l us which is satisfied by any zero-

coupon bond. This methodology recognises that since future interest rates are uncertain, the discount rate

referred to above is not adequately represented by a single fixed number.

MB0045 Naser Shoukat Firfire

The solution to the PDE is given in [3]

where is the expectation with respect to r i s k - neu tr al pr obab i l i t i e s , and R(t,T) is a random variable

representing the discount rate; see also M a r ti n g a l e p r i c i n g .

Practically, to determine the bond price, specific s ho r t r a t e m ode l s a re employed here. However, when

using these models, it is often the case that no c l o s ed f o r m so lution exists, and a l a t t i c e - or s i m u l a t i o n -

ba s ed i mplementation of the model in question is employed. The approaches commonly used are:

the C I R m odel

the Bl ac k - D e r m a n - T oy m o del

the H u ll - Wh i t e m odel

the H JM f r a m ework

the C h e n m ode l .

Clean and dirty price

When the bond is not valued precisely on a coupon date, the calculated price, using the methods above,

will incorporate a c c r ued i n t e re s t : i.e. any interest due to the owner of the bond since the previous coupon

date; see day cou n t c on v en t i o n . T he price of a bond which includes this accrued interest is known as the

"d i rt y p r i c e " (or "full price" or "all in price" or "Cash price"). The "c l e a n p r i c e " is the price excluding any

interest that has accrued. Clean prices are generally more stable over time than dirty prices. This is

because the dirty price will drop suddenly when the bond goes "ex interest" and the purchaser is no longer

entitled to receive the next coupon payment. In many markets, it is market practice to quote bonds on a

clean-price basis. When a purchase is settled, the accrued interest is added to the quoted clean price to

arrive at the actual amount to be paid.

Yield and price relationships

Once the price or value has been calculated, various y i e l ds - which relate the price of the bond to its

coupons - can then be determined.

Yield to Maturity

The y i e l d t o m at u r it y i s the discount rate which returns the m a r k et p r i ce of the bond; it is identical

to r (required return) in the above equation. YTM is thus the i n t e r n a l r a t e of r e t u r n of an investment in the

bond made at the observed price. Since YTM can be used to price a bond, bond prices are often quoted in

terms of YTM.

To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond owner must:

MB0045 Naser Shoukat Firfire

buy the bond at price P0,

hold the bond until maturity, and

redeem the bond at par.

Coupon yield

The cou p on y i e l d i s simply the coupon payment (C) as a percentage of the face value (F).

Coupon yield = C / F

Coupon yield is also called no m i nal y i e ld .

Current yield

The c u rr e n t y i e l d i s simply the coupon payment (C) as a percentage of the (current) bond price (P).

Current yield = C / P0.Relationship

The concept of current yield is closely related to other bond concepts, including yield to

maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is

as follows:

When a bond sells at a discount, YTM > current yield > coupon yield.

When a bond sells at a premium, coupon yield > current yield > YTM.

When a bond sells at par, YTM = current yield = coupon yield amt

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

In fi nanc e , l everage is a general term for any technique to multiply gains and losses. [ 1] C ommon ways to

attain leverage are borrowing money, buying fi xed a s s e t s and using de r i v a ti v e s . [ 2] I mportant examples

are:

A pub l i c c o r p o r a t i on m ay leverage its eq u it y by borrowing money. The more it borrows, the less

equity cap i t a l i t needs, so any profits or losses are shared among a smaller base and are

proportionately larger as a result. [ 3]

A business entity can leverage its revenue by buying fixed assets. This will increase the

proportion of f i xe d , as opposed to v a r i ab l e , costs, meaning that a change in r e v e n ue w ill result in a

larger change in op e r a ti ng i nco m e . [ 4][5]

MB0045 Naser Shoukat Firfire

H ed g e f unds o ften leverage their assets by using derivatives. A fund might get any gains or losses

on $20 million worth of crude oil by posting $1 million of cash as m a r g i n

Measuring leverage

A good deal of confusion arises in discussions among people who use different definitions of leverage.

The term is used differently ini n v e s t m en t s a nd c o r po r a t e f i nan c e , and has multiple definitions in each

field.[7]

[ed i t ] Investments

Accounting leverage is total assets divided by total assets minus total l i ab i l it i e s . [ 8] N otional leverage is

total notional amount of assets plus total notional amount of liabilities divided by equity. [ 1] Econo mic

leverage is v o l a t i l it y of equity divided by volatility of an unlevered investment in the same assets. To

understand the differences, consider the following positions, all funded with $100 of cash equity. [ 9]

Buy $100 of crude oil. Assets are $100 ($100 of oil), there are no liabilities. Accounting leverage

is 1 to 1. Notional amount is $100 ($100 of oil), there are no liabilities and there is $100 of equity.

Notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is the

only asset and you own the same amount as your equity, so economic leverage is 1 to 1.

Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so accounting

leverage is 2 to 1. Notional amount is $200, equity is $100 so notional leverage is 2 to 1. The

volatility of the position is twice the volatility of an unlevered position in the same assets, so

economic leverage is 2 to 1.

Buy $100 of crude oil, borrow $100 worth of gasoline and sell the gasoline for $100. You now

have $100 cash, $100 of crude oil and owe $100 worth of gasoline. Your assets are $200, liabilities

are $100 so accounting leverage is 2 to 1. You have $200 notional amount of assets plus $100

notional amount of liabilities, with $100 of equity, so your notional leverage is 3 to 1. The volatility

of your position might be half the volatility of an unlevered investment in the same assets, since the

price of oil and the price of gasoline are positively correlated, so your economic leverage might be 0.5

to 1.

Buy $100 of a 10-year fixed-rate t r eas u r y bon d , and enter into a fixed-for-floating 10-

year i n t e r e s t r a t e swap t o convert the payments to floating rate. The derivative is o ff - ba l an c e s h ee t , so

it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of

the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of

the economic risk of the treasury bond, so economic leverage is near zero.

MB0045 Naser Shoukat Firfire

Corporate finance

Degree of Operating Leverage (DOL)= (EBIT + Fixed costs) / EBIT; Degree of Financial Leverage

(DFL)= EBIT / ( EBIT - Total Interest expense ); Degree of Combined Leverage (DCL)= DOL * DFL

Accounting leverage has the same definition as in investments.[ 10] T here are several ways to define

operating leverage, the most common.[ 11 ] i s:

Financial leverage is usually defined[ 8] a s:

Operating leverage is an attempt to estimate the percentage change in op e r a ti ng i n co m e ( ea r n i n g s b e f o r e

i n t e r e st and t ax e s or EBIT) for a one percent change in revenue . [ 8]

Financial leverage tries to estimate the percentage change in net i n c o m e f or a one percent change in

operating income.[12][ 13]

The product of the two is called Total leverage,[ 14] and estimates the percentage change in net income for

a one percent change in revenue . [ 15]

There are several variants of each of these definitions,[ 1 6] and the financial statements are usually

adjusted before the values are computed.[ 8 ] Mo reover, there are industry-specific conventions that differ

somewhat from the treatment above.[1 7]

Leverage and ROE

If we have to check real effect of leverage on RO E, we have to study financial leverage. Financial

leverage refers to the use of debt to acquire additional assets. Financial leverage may decrease or increase

return on equity in different conditions. Financial over-leveraging means incurring a huge debt by

borrowing funds at a lower rate of interest and utilizing the excess funds in high risk investments in order

to maximize returns. [18]

Leverage and risk

The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money

might face ban k r u p t cy du ring a business downturn, while a less-levered corporation might survive. An

investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%. [ 9]

There is an important implicit assumption in that account, however, which is that the underlying levered

asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product

MB0045 Naser Shoukat Firfire

line, or expand internationally, the additional diversification might more than offset the additional risk

from leverage.[ 9] O r if an investor uses a fraction of his or her portfolio to margin stock index futures

and puts the rest in a money market fund, he or she might have the same volatility and expected return

as an investor in an unlevered equity index fund, with a limited downside.[ 6] So while adding leverage to

a

given asset always adds risk, it is not the case that a levered company or investment is always riskier than

an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered

bond funds,[ 6] and public utilities with lots of debt are usually less risky stocks than unlevered technology

companies. [ 9]

Popular risks

There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of

money often end up badly. But the issue here is those people are not leveraging anything, they're

borrowing money for consumption.[9]

In finance, the general practice is to borrow money to buy an asset with a higher return than the interest

on the debt. [ 7] T hat at least might work out. People who consistently spend more than they make have a

problem, but it's overspending (or underearning), not leverage. The same point is more controversial for

governments.

People sometimes borrow money out of desperation rather than calculation. That also is not leverage.[ 9] B ut it is true that leverage sometimes increases involuntarily. When L o ng - T e r m C ap it a l

M a na g e m ent c ollapsed with over 100 to 1 leverage, it wasn't that the principals tried to run the firm at

100 to 1 leverage, it was that as equity eroded and they were unable to liquidate positions, the leverage

level was beyond their control. One hundred to one leverage was a symptom of their problems, not the

cause (although, of course, part of the cause was the 27 to 1 leverage the firm was running before it got

into trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the real troubles

started). [ 9] B ut the point is the fact that collapsing entities often have a lot of leverage does not mean that

leverage causes collapses.

Involuntary leverage is a risk. [ 7 ] I t means that as things get bad, leverage goes up, multiplying losses as

things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild

or temporary. [ 9] T he risk can be mitigated by negotiating the terms of leverage, and by leveraging only

liquid assets.[6]

Forced position reductions

A common misconception is that levered entities are forced to reduce positions as they lose money. This

is only true if the entity is run at maximum leverage.[ 1 ] For example, if a person has $100, borrows

another $100 and buys $200 worth of oil, he has 2 to 1 accounting leverage. If the price of oil declines

25%, he has $50 of equity supporting $150 worth of oil, 3 to 1 accounting leverage. If 2 to 1 is the

MB0045 Naser Shoukat Firfire

maximum his counterparties will allow him, he has to sell one-third of his position to pay his debt down

to $50. Now if oil goes back up to the original price, he has only $83 of equity. He lost 17 percent of his

equity, even though the p (say) $10 of cash margin to enter into $200 of long oil futures contracts. Now if

the price of oil declines 25%, the investor has to put up an additional $50 of margin, but she still has $40

of unencumbered cash. She may or may not wish to reduce the position, but she is not forced to do so.

The point is that it is using maximum leverage that can force position reductions, not simply using

leverage.[ 6] I t often surprises people to learn that hedge funds running at 10 to 1 or higher notional

leverage ratios hold 80 percent or 90 percent cash.

[ed i t ] Model risk

Another risk of leverage is model risk. Many investors run high levels of notional leverage but low levels

of economic leverage (in fact, these are the type of strategies hedge funds are named for, although not all

hedge fund pursue them). Economic leverage depends on model assumptions.[ 6] For example, a fund with

$100 might feel comfortable holding $1,000 long positions in crude oil futures and $1,000 of short

positions in gasoline futures. The notional leverage is 20 to 1 (accounting leverage is zero) but the fund

might estimate economic leverage is only 1 to 1, that is the fund may assume a 10% fall in the price of oil

will cause a 9% fall in the price of gasoline, so the fund will lose only 10% net ($100 loss on the oil long

and $90 profit on the gasoline short). If that assumption is incorrect, the fund may have much more

economic leverage than it thinks. For example, if refinery capacity is shut down by a hurricane, the price

of oil may fall (less demand from refineries) while the price of gasoline might rise (less supply from

refineries). A 5% fall in the price of oil and a 5% rise in the price of gasoline could wipe out the fund.[9]

Counterparty risk

Leverage may involve a coun t e r p a rt y , either a c r e d i t or or a derivative counterparty. It doesn't always do

that, for example a company levering by acquiring a fixed asset has no further reliance on a

counterparty. [ 2] I n the case of a creditor, most of the risk is usually on the creditor's side, but there can

be risks to the borrower, such as demand repayment clauses or rights to seize collateral. [ 9] I f a derivative

counterparty fails, unrealized gains on the contract may be jeopardized. These risks can be mitigated by

negotiating terms, including mark-to-market collateral. [ 6]

Q.5 The cash flows associated with a project are given below:

Year Cash flow0 (100,000)1 250002 400003 500004 400005 30000

MB0045 Naser Shoukat Firfire

Calculate the

a) Payback period.

Payback Period (PB) calculation give us an idea on how long it will take for a project to recover the initial investment.If Y is the year before the full recovery of the investment I, U is the unrecovered cost at the start of last year and CFi is the CF of the year Y+1 then:

PB = Y + U/CFi

The initial investment is $100,000 and you will recover it during the fourth year, then:Y = 5 andU = 100,000- (25000 + 40000 + 50000+40000+30000) = 85,000

PB (Payback period) = 5 + 85,000/85,000 = 6 years

The Payback period is 6 complete years.

b) Benefit cost ratio for 10% cost of capital

- NPV:

Present Value (PV):CF1 CF2 CF5

PV = --------- + ---------- + ... + ---------- (1 + r)^1 (1 + r)^2 (1 + r)^5

Where r is the required return (13% or 0.13 in this case)

Net Present Value (NPV):

NPV = PV - I where I = Total Initial Investment

First calculate the PV of the cash flows:

PV = 25000/1.13 + 40000 /(1.13)^2 + 50000 /(1.13)^3 + 40000 /(1.13)^4 + 30000 /(1.13)^5= 22123.89 + 17699.11 + 14749 + 8849.55 + 5309.73 == 68731.28

NPV = PV - I = 68731.28- 100,000 = - 31268.72

(NEGATIVE!!) The net present value of this project is -

31268.72 . Since it isnegative, you will lose money with this project.

MB0045 Naser Shoukat Firfire

Q6. A company’s earnings and dividends are growing at the rate of 18% pa. The growth rate is expected 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

For 4 Years = 18 % Pa

Dividend Per Share = Rs 2

After 4 Year (Means 8 Years) = 6 %

Rate of Return = 10 % PA

D1 = Dividend for next period

r = Cost of Capital or the capitalization rate of the company

E = Earning on equity

g = The growth rate of the company.

E1 = 2

P0 / E1 = 1/r [ 1+ (PVGO/(E1/r))].

= 1 / 18 [ 1 + 18/2/18]

= 0.07 X 361

= 25.27

P0 / E1 = 1/r [ 1+ (PVGO/(E1/r))].

= 1 / 6 [ 1 + 6/2/6]

= 0.16 X 19

= 19.16

P0 / E1 = 1/r [ 1+ (PVGO/(E1/r))].

= 1 / 10 [ 1 + 10/2/10]

= .1 X 51

= 5.1

Intrinsic price per share = 3.75

MB0045 Naser Shoukat Firfire

Master of Business Administration - MBA Semester 2MB0045 – Financial Management - 4 Credits

(Book ID: B1134)Assignment Set- 2 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

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

The financial management come a long way by shifting its focus from traditional approach to modern approach. The modern approach focuses on wealth maximization rather than p r o f i t m ax i m i z a ti o n . T his gives a longer term horizon for assessment, making way for sustainable performance by businesses.

A myopic person or business is mostly concerned about short term benefits. A short term horizon can fulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer term horizon Therefore, Finance Management or Financial Management emphasizes on wealth maximization rather than p r o f i t m ax i m i z a ti o n . For a business, it is not necessary that profit should be the only objective; it may concentrate on various other aspects like increasing sales, capturing more market share etc, which will take care of profitability. So, we can say that p r o f i t m ax i m i za t i on i s a subset of wealth and being a subset, it will facilitate wealth creation

MB0045 Naser Shoukat Firfire

Giving priority to value creation, managers have now shifted from traditional approach to modern approach of financial management that focuses on wealth maximization. This leads to better and true evaluation of business. For e.g., under wealth maximization, more importance is given to cash flows rather than profitability. As it is said that profit is a relative term, it can be a figure in some currency, it can be 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 with investment, sales etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short term or long term.

In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate various alternatives for decision making, cash flows are taken under consideration. For e.g. to measure the worth

of a project, criteria like: ― p r e s ent v a l ue o f its cash inflow – present value of cash outflows‖ (net present value) is taken. This approach considers cash flows rather than profits into consideration and also use discounting technique to find out worth of a project. Thus, maximization of wealth approach believes that money has time value.

An obvious question that arises now is that how can we measure wealth. Well, a basic principle is that ultimately wealth maximization should be discovered in increased net worth or value of business. So, to measure the same, value of business is said to be a function of two factors - earnings per share and capitalization rate. And it can be measured by adopting following relation:

Value of business = EPS / Capitalization rate

At times, wealth maximization may create conflict, known as agency problem. This describes conflict between the owners and managers of firm. As, managers are the agents appointed by owners, a strategic investor or the owner of the firm would be majorly concerned about the longer term performance of the business that can lead to maximization of shareholder‘s wealth. Whereas, a manager might focus on taking such decisions that can bring quick result, so that he/she can get credit for good performance.However, in course of fulfilling the same, a manager might opt for risky decisions which can put on stakethe owner‘s objectives.

Hence, a manager should align his/her objective to broad objective of organization and achieve a tradeoff between risk and return while making decision; keeping in mind the ultimate goal of financial management i.e. to maximize the wealth of its current shareholdershe objections are:-

(i) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at possible to maximize what cannot be known.

(ii) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt future to maximize. It is argued that firm's goal cannot be to maximize profits but to attain a certain level or rate of profit holding certain share of the market or certain level of sales. Firms should try to 'satisfy' rather than to 'maximize'

(iii) There must be a balance between expected return and risk. The possibility of higher expected yields are associated with greater risk to recognise such a balance and wealth Maximization is brought in to the analysis. In such cases, higher capitalisation rate involves. Such combination of expected returns with risk variations and related capitalisation rate cannot be considered in the concept of profit maximization.

(iv) The goal of Maximization of profits is considered to be a narrow outlook. Evidently when profit maximization becomes the basis of financial decisions of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.

MB0045 Naser Shoukat Firfire

Keeping the above objections in view, most of the thinkers on the subject have come to the conclusion that the aim of an enterprise should be wealth Maximization and not the profit Maximization. Prof. Soloman of Stanford University has handled the issued very logically. He argues that it is useful to make a distinction between profit and 'profitability'. Maximization of profits with a vie to maximising the wealth of shareholders is clearly an unreal motive. On the other hand, profitability Maximization with aview to using resources to yield economic values higher than the joint values of inputs required is a useful goal. Thus the proper goal of financial management is wealth maximization.

The traditional approach of financial management was all about profit maximization.The main objective of companies was to make profits.The traditional approach of financial management had many limitations:1.Business may have several other objectives other than profit maximization.Companies may have goals like: a larger market share, high sales,greater stability and so on.The traditional approach did not take into account so many of these other aspects.2.Profit Maximization has to defined after taking into account many things like:

a.Short term,mid term,and long term profits b.Profits over period of time

The traditional approach ignored these important points.3.Social Responsibility is one of the most important objectives of many firms.Big corporates make an effort towards giving back something to the society.The big companies use a certain amount of the profits for social causes.It seems that the traditional approach did not consider this point.Modern Approach is about the idea of wealth maximization.This involves increasing the Earning per shareof the shareholders and to maximize the net present worth.Wealth is equal to the the difference between gross presentworth of some decision or course of actionand theinvestment required to achieve the expected benefits.Gross present worth involves the capitalised value of the expected benefits.This value is discounted a some rate,thisrate depends on the certainty or uncertainty factor of the expected benefits.The Wealth Maximization approach is concerned with theamount of cash flow generated by a course ofaction rather than the profits.Any course of action that has net present worth above zero or in other words,creates wealth should be selected.

Q.2 Explain the Net operating approach to capital structure.

The second approach as propounded by David Durand the net operating income approach examines the effects of changes in capital structure in terms of net operating income. In the net income approach discussed above net income available to shareholders is obtained by deducting interest on debentures form net operating income. Then overall value of the firm is calculated through capitalization rate of equities obtained on the basis of net operating income, it is called net income approach. In the second approach, on the other hand overall value of the firm is assessed on the basis of net operating income not on the basis of net income. Hence this second approach is known as net operating income approach.

The NOI approach implies that (i) whatever may be the change in capital structure the overall value of the firm is not affected. Thus the overall value of the firm is independent of the degree of leverage in

MB0045 Naser Shoukat Firfire

capital structure. (ii) Similarly the overall cost of capital is not affected by any change in the degree of leverage 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 the increase in debts whereas it is assumed under this method that overall cost of capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity capital. How can this assumption be justified? The advocates of this method are of the opinion that the degree of risk of business increases with the increase in the amount of debts. Consequently the rate of equity over investment in equity shares thus on the one hand cost of capital decreases with the increase in the volume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benefit of leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustrate this point.

If follows that with the increase in debts rate of equity capitalization also increases and consequently the 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 which is expressed in terms of interest charges on debentures. The other is implicit cost which refers to the increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts.

Optimum capital structure

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

Net operating Income (NOI) ApproachThis approach has been suggested by Durand. According to this approach, the market value fo the firm isnot affected by the capital structure changes. The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital which is constant. The market value of the firm isdetermined as follows:

Market value of the firm (V) = (Earnings before interest and tax)/(Overall cost of capital)

The value of equity can be determined by the following equation

Value of equity (S) = V (market value of firm) – D (Market value of

debt)

and the cost of equity = (Earnings after interest and before tax)/(market value of firm (V)- Market value of debt (D))

The Net Operating Income Approach is based on the following assumptions:

(i) The overall cost of capital remains constant for all degree of debt equity mix.

(ii) The market capitalizes the value of firm as a whole. Thus the split between debt and equity is not important.

MB0045 Naser Shoukat Firfire

(iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity capitalization rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalization rate.

(iv) There are no corporate taxes

(v) The cost of debt is constant.

Under NOI approach since overall cost of capital is constant, therefore there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal one.

Q.3 What do you understand by operating cycle.

Operating Cycle Definition

The Operating cycle definition, also known as cash operating cycle or cash conversion cycle or asset conversion cycle, establishes how many days it takes for a company to turn purchases of inventory into cash receipts from its eventual sale. Operating cycle has three components of payable turnover days, inventory turnover days and accounts receivable turnover days. These come together to form the complete measurement operating cycle days. The operating cycle formula and operating cycle analysis stems logically from these.

Operating Cycle Formula

Operating cycle calculations are completed simply with this formula:

Operating cycle = DIO + DSO - DPO

Where

DIO represents da y s i n v e n t o r y ou t s t an d i ng

DSO represents d ay s al e s o u t s t an d i ng

DPO represents d a y s p a y ab l e o u t s t an d i ng

Operating Cycle Calculation

Calculating operating cycle may seem daunting but results in extremely valuable information.

DIO = (Average inventories / cost of sales) * 365 DSO = (Average accounts receivables / net sales) * 365

MB0045 Naser Shoukat Firfire

DPO = (Average accounts payables / cost sales) * 365

Example: What is the operating cycle of a business? A company has 90 days in days inventory outstanding, 60 days in days sales outstanding and 70 in days payable outstanding.

Operating cycle = 90 + 60 - 70 = 80

This means that on average it takes 80 days for a company to turn purchasing inventories into cash sales. In regards to accounting, operating cycles are essential to maintaining levels of cash necessary to survive. Maintaining a beneficial net operating cycle ratio is a life or death matter.

Operating Cycle Applications

The operating cycle concept indicates a company‘s true liquidity. By tracking the historical record of the operating cycle of a company and comparing it to its peer groups in the same industry, it gives investors investment quality of a company. A short company operating cycle is preferable since a company realizes its profits quickly and allows a company to quickly acquire cash that can be used for reinvestment. A longbusiness operating cycle means it takes longer time for a company to turn purchases into cash through sales. In general, the shorter the cycle, the better a company is since less time capital is tied up in the business process.

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

physics, leverage denotes the use of a lever and a small amount of force to lift a heavy object. Likewise

in business, leverage refers to the use of a relatively small investment or a small amount of debt t o

achieve greater profits. That is, leverage is the use of assets and l i ab i l i t i es t o boost profits while balancing

the risks involved. There are two types of leverage, operating and financial. Operating leverage refers to

the use of fixed co s t s i n a company's earnings stream to magnify operating profits. Financial leverage, on

the other hand, results from the use of debt and pr e f e rr ed s t o ck t o increase stockholder earnings.

Although both types of leverage involve a certain amount of risk, they can bring about significant

benefits with little investment when successfully implemented.

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 adve r t i s i ng exp enses, administrative costs, equipment and

technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage. By

MB0045 Naser Shoukat Firfire

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.

FINANCIAL LEVERAGE

Financial leverage involves changes in shareholders' income in response to changes in operating profits,

resulting from financing a company's assets with debt or preferred stock. Similar to operating leverage,

financial leverage also can boost a company's returns, but it increases risk as well. Financial leverage is

concerned with the relationship between operating profits and earnings per share. If a company is

financed exclusively with common stock, a specific percentage change in operating profit will cause the

Q.5 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.50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the fixed assets will fetch a net salvage value of Rs. 48 million ad the net working capital will be liquidated at par. The project will increase

MB0045 Naser Shoukat Firfire

revenues of the firm by Rs. 250 million per year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable will be 25% as per written down value method. The tax rate is 30%. If the cost of capital is 10% what is the net present value of the project.

Answer

CP = 200 million

CP (machinery) = Rs 50

T = 5 Years

Value = 48 million.

Per Year = 250 million

Increase in cost = 100 million per Yr

Tax Rate = 30 %

Rate of cost of capital = 10 %

Year Cash flow Present value

T=0 2500000000/(1+0.10)

152,000000

T=1 2500000000/(1+0.10)1

52,72700000

T=2 2500000000/(1+0.10)2

20,6610000

T=3 2500000000/(1+0.10)3

18,7830000

T=4

T=5

2500000000/(1+0.10)1

2500000000/(1+0.10)1

17,0750000

15,52300000

NPV = 15,523000 X 30/ 100= 4569000000/100= 45690000

= 456900 X 10 /100= 456900.

Henc NPV = 15,523000 + 4569000= 20092000

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%.

P is the market price per share

M is a multiplier

D is the dividend per share

E is the earning per share = 40

Walter model: according to this model founded by James Walter, the dividend policy of a company has an impact on the share valuation.

Quantitatively P=(D+(E-D) r/k)/k

Where:

P, D, E have the same connotations as above and r is the internal rate of return on the investments and k is the cost of capital

D/P ratio = 50%

When EPS = 40 and D/P ratio is 40%, D = 10 x 40% = $4

4 + [0.08 / 0.10] [10 - 4] P =

0.10= 85

D/P ratio = 25%When EPS = $40 and D/P ratio is 50%, D = 10 x 50% = $2.5

2.5 + [0.08 / 0.10] [10 -

P =2.5]

0.10

= 75