MBA 2nd Semester (DDE) Examination
FINANCIAL MANAGEMENT
Ques.1 “The profit maximization objective does not provide us write an
Operationally useful criterion.” Explain.
Ans. Certain objections have been raised against the goal of profit maximization
which strengthen the case for wealth maximization as the goal of business
enterprise. The objections are :- (a) Profit cannot be ascertained well in
advance to express the probability of return as future is uncertain. It is not at
all possible to maximize what cannot be known. Moreover, the return profit
vague and has not been explained clearly what it means. It may be total profit
before tax and after tax of profitability tax. Profitability rate, again is
ambiguous as it may be in relation to capital employed, share capital, owner’s
fund or sales. This vagueness is not present in wealth maximisation goal as the
concept of wealth is very clear. It represents value of benefits minus the cost
of investment.
(b)The executive or the decision maker may not have enough confidence in
the estimates or future returns so that he does not attempt further 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 ‘maximise’.
(c)There must be a balance between expected return and risk. The possibility of higher expected yields are associated with greater risk to recognize such a balance and wealth maximisation is brought in to the analysis. In such cases, higher capitalization rate involves. Such combination of expected returns with risk variations and related capitalization rate cannot be considered in the concept of profit maximisation.
(d)The goal of maximisation of profits is considered to be a narrow outlook. Evidently when profit maximisation becomes the basis of financial decision 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.
(e) The criterion of profit maximisation ignores time value factor. It considers the
total benefits or profits in to account while considering a project where as the
length of time in earning that profit is not considered at all. Whereas the
wealth maximization concept fully endorses the time value factor in evaluating cash flows. Keeping the above objection in view, most of the thinkers on the subject have come to the conclusion that the aim of an enterprise should be wealth maximisation and not the profit maximisation.
To make a distinction between profits and profitability. Maximisation of profits with a view to maximizing the wealth of share holders is clearly an unreal motive. On the other hand, profitability maximisation with a view 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 maximisation.
Ques. 2 Explain the mechanics of calculating the present value of cash flows.
Ans.PRESENT VALUE METHOD
It is one of the Discounted Cash Flow (DCF) or time adjusted methods. It is also
Known as ‘Discounted Benefit – cost ratio method’. This method takes into account the time value of money and all cash flows are expressed in terms of their present value. It also takes into account all the benefits and costs occurring throughout the useful life time of a project. This method is used on the assumption that the value of present investments cannot be equal to future amounts of cash inflows from this investment. This problem can be solved by converting the future amounts of earnings to their present values. The steps involved in computing the present values of investment outlays and cash inflows are recapitulated as follows :
(a)Determination of the rate of discount, i.e., cut-off rate. This discount rate is the cost of capital of the firm or the rate of return desired by the firm on its investment.
(b)Determination of cash outlays, both initial and subsequent , and cash inflows for different years.
(c)Computation of the present value of cash outlays of the project by discounting future cash outlays at the pre – determined discount rate. In case, the capital asset has any salvage value, it present value of the cash outlays. For computing the present value of cash flows at different periods, present value factor may be calculated by the following formula :
Present value factor (PVF) = 1/(1+r)n
Where, r = Rate of interest or desired Rate of Return
N = Number of years.
(d)Determination of the present value of the cash inflows expected to be
generated by the investment outlays. In determining the cash inflows after tax(CFAT), all direct and indirect costs including operational and maintenance
costs are deducted from the total cash receipts. Depreciation is disregarded
as a cost under this method. With the help of the pre-determined discount rate, present values of cash inflows after tax at different periods may be computed either by calculating the present factor as mentioned above or by taking the present value factor (PVF) from the annuity tables.
(e)The present values of all cash inflows and outflows for different periods are determined as under :
PV = Actual cash flow X PVF
Present values of all cash inflows and cash outflows for different periods are added together respectively which serve as an accept – reject criterion. In case the present value of cash outflows, the project will be accepted otherwise rejected.
PV > C accepted the proposal
PV > C reject the proposal
Where PV is the present value cash inflows and C is the present value of cash outflows or outlays.
Ques.3 Explain the merits and Demerits of the time. adjusted methods of evaluating the investment projects.
Ans. MERITS OF TIME ADJUSTED METHOD
- This method takes into account the entire economic life of an investment and income therefrom . It gives the true rate of return effected by a new project.
- It gives due weight to time factor of financing. In the words of Charles Horn green : “ Because the discounted returns on method explicitly and routinely weights the time value of money, it is the best method to use for long-range decisions.”
- It permits direct comparison of the projected returns on investment with the cost of borrowing money which is not possible in other methods.
- It makes allowance for difference in the time at which investment generate their income.
- This approach by recognizing the time factor makes sufficient provision for uncertainty and risk. It offers a good measure or relative profitability of capital expenditure by reducing the earnings to the present value.
DEMERITS
- It involves a good amount of calculations. Hence it is difficult and complicated one . But this criticism has no force.
- It is very difficult to forecast the economic life of any investment exactly.
- The selection or cash – inflow is based on sales forecasts which is in itself an interminable element.
- The selection of an appropriate rate of interest is also difficult.
But despite these defects, this approach afford an opportunity for making valid comparisons between several long term competing capital projects.
Ques. 5Does financial leverage always increase the earnings per share ? Support your ans. With suitable example.
Ans.Earnings per share (EPS) is simply a measure of profits reported available for equity shareholders during a period divided by the total number of equity shares outstanding at the end of that period.
Financial leverage indicates the effects of debt component in capital structure on earnings of equity shareholders under various conditions. It can be measured, by the ratio of
- The rate of growth in earnings available to the shareholders ot
- The rate of growth of EBIT. This can be illustrated by the following formula :
EBIT or EBT
EBIT – Interest
The financial leverage in our hypothetical company can be analyzed, by using the following formula :
EBIT150 1.5
EBIT – Interest 150 – 50
This formula requires modification to consider implications of financial leverage caused by preference shares where an adjustment for tax factor is also essential.
Table 1
Original / After an increase of 10% in salesSales
Variable cost
EBIT
Interest (assumed)
PBT
Taxes @ 55%
PAT / 1500
900
450
150
50
100
55
45 / 1650
990
450
210
50
160
88
72
Percentage increase in EBIT1
Operating leverage =
Percentage increase in sales
40
==4
10
EBIT
Financial leverage =
EBIT – Interest
150
= = 1.5
100
Combined effect of operating and financial leverage : 4 * 1.5 = 6 times
Thus, an increase in sales @ 10% will cause an increase in EBIT of 6 times or 60%. By combining, the operating leverage and financial leverage, we get 4 * 1.5 = 6. It means that an increase in sales of 10% brings an increase in EBIT of 40% and an increase in profits of 60%. Similarly a decrease of 10% in sales will mean a full in EBIT of 20% and a decline in PBT of 60%.
FAVOURABLE AND UNFAVOURABLE LEVERAGE
From the shareholders point of view, the value of leverage depends upon whether it is helping or hurting them. So long as shareholders find rising sales and EBIT levels, leverage is advantages or favorable to them, because it tends to maximize the related increase in EPS, DPS and possible market price. On the other hand , when sales and EBIT levels are falling leverage tends to be disadvantageous since it maximizes the related decline in EPS1.
Thus, leverage is a double edged sword. It has got tremendous acceleration of deceleration effect on EBIT as well as on EPS. It may prove a blessing for companies which are suitable place for making an optimum use of financial resources in terms of growing earnings. However, it may prove a blessing for cause for companies with high debt financing but loan and uncertain cash inflows to meet the debt obligations.
Ques.6Write notes on the following.
Ans.NET OPERATING INCOME APPROACH
According to the net operating income (NOI) approach the market value of the firm is not affected by the capital structure changes. The market value of the firm is found out by capitalizing the net operating income at the over all or the weighted average cost of capital, which is constant.
The overall capitalization rate depends on the business risk of the firm. It is independent of financial mix. If NOI and average cost of capital are independent of financial mix, market value of firm will be a constant and independent of capital structure changes. The critical assumptions of the NOI approach are :
a)The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important.
b)The market uses an overall capitalization rate, to capitalize the net operating income. Overall cost of capital depends on the business risk. If the business risk is assumed to remain unchanged, overall cost of capital is a constant.
c)The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalization rate to increase. Thus, the advantage of debt is offset exactly by the increase in the equity – capitalisation rate.
(d)The debt capitalisation rate is constant.
(e)The corporate income taxes do not exist.
Thus, we find that the weighted cost of capital is constant and the cost of equity increase as debt is substituted for equity capital.
Ques.7Explain the concept of working capital. Discuss the working capital need of a manufacturing firm.
Ans.Money required by the company to meet out day – today expenses to finance production and stocks to pay wages and other production etc. is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more round about and complicated the production to fixed working capital increase correspondingly.
Therefore, working capital management refers to the management of current assets and current liabilities. Working capital, however, represents investment in current assets, such as cash, marketable securities, inventories and bills receivables. Current liabilities mainly include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year.
What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. If the firm has business which deals with public utility services, obviously the requirement will be low. It is primarily because the amount becomes available as soon as services are sold and also the services arranged by the firm and immediately sold, without much difficulty and complication. On the other hand trading concerns need heavy amounts because these require funds for carrying goods traded. Similarly many industrial units will also need heavy amounts for carrying on their business. Many manufacturing concerns will also need sufficiently heavy amounts, that of course depends on the nature of commodities which are being manufactured.
MANUFACTURING FIRM
We now come to manufacturing firm. If it is complex and complicate, it will be another determinant. In this complex process obviously more capital will be needed and goods will be produced after considerable delays. Longer it takes to produce a good , more will be its cost and more working capital will become unavoidable. When the companies are engaged in the production of heavy machinery and equipment, a way out is found out by demanding some advance money from the party or parties which plea orders or which usually take away the goods.
Ques.8Define EOQ. How is it computed ? Give an example.
Ans.Economic order quantity refers to the size of the order which gives maximum economy is purchasing any item of raw materials or finished product. It is fixed mainly after talking into account the following costs :
- INVENTORY CARRYING COST
It is the cost of keeping items in stock. It includes interest on investment. Obsolescence losses, store – keeping cost, insurance premium, etc. The larger the volume of inventory, the higher will be the inventory carrying cost and vice versa.
IIORDERING COST
It is the cost of placing an order and securing the supplies. It various from time to time depending upon the number of orders placed and the number of times ordered. The more frequently the orders are placed and fewer the quantities purchased an each order, the greater will be the ordering cost and vice versa.
The economic ordering quantity can be determined by any of the following two methods :
1)FORMULA METHOD
In this case the EOQ can be determined as per the following for formula :
Where :
E = Economic ordering quantity
U = Quantity purchased in a year
P = Cost of placing an order
S = Annual cost of storage of one unit
A refrigeration manufacture, purchases 1600 units of a certain component from 13. His annual usage is 1600 units. The order placing cost is Rs. 100 and the cost of carrying one unit for a year is Rs. 8.
Calculate the economic ordering qty by formula method :
E = Sqrt. (2u * p)/s
= Sqrt. (2*1.600*100)/8
= Sqrt. (40,000) = 200 units
EOQ model is based on the following assumptions :
- The firm knows with certainly the annual usage or demand of the particular item of inventories.
- The rate at which the firm uses the inventories or makes sales is constant through out a year.
- The order the replenishment of inventory are placed exactly when inventories reach the zero level.
The above assumption may also be called as limitation of EOQ modes. There is every likelihood of a discrepancy between actual and estimated demand for a particular items of inventory. Similarly, the assumptions as to constant usage or sale of inventories and instantaneous replenishment of inventories are also of doubtful validity. On account of these reasons, EOQ model may sometimes give wrong estimate about economic order quantity.
2 .TABULAR METHOD
This method is to be used in those circumstances where the inventory carrying cost per units is not constant. This will be clear with the following :
Calculating the Economic Ordering Quantity using Tabular Method on the basis of data given.
Annual Requirement / Orders per year / Units per order / Order placing costs / Avg. stock in units (50% of order placed) / Carrying costs / Total amount cost1600 / 1 / 1600 / 100 / 800 / 6400 / 6500
2 / 800 / 200 / 400 / 3200 / 3400
3 / 533 / 300 / 267 / 2136 / 2436
4 / 400 / 400 / 200 / 1600 / 2000
5 / 320 / 500 / 160 / 1280 / 1780
6 / 267 / 600 / 134 / 1072 / 1672
7 / 229 / 700 / 115 / 920 / 1620
8 / 200 / 800 / 100 / 800 / 1600
9 / 178 / 900 / 89 / 712 / 1612
10 / 160 / 1000 / 80 / 640 / 1640
The above table shows that total cost is the minimum when each is of 200 units. Therefore, economics ordering quantity is 200 units only.
A graphic presentation of the economic ordering quantity on the basis of figures given in the above table will be as follows :
Total cost on inventory management