FM-Set2

8/3/2019 FM-Set2

http://slidepdf.com/reader/full/fm-set2 1/7

Name: Prema N

Enrollment No. 511124286

Course: MBA

Subject: Financial Management

LearningCentre:

Sampoorna Academy of Management & Science

Date: 07-Jan-2012

No of Pages: 9

MBA ² Semester 2

Subject Code ² MB0045

Assignment Set -2

8/3/2019 FM-Set2


Assignment SET-2 MB0045- Financial Management

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

The financial management comes a long way by shifting its focus from traditional approach to modernapproach. The modern approach focuses on wealth maximization rather than profit maximization. Thisgives 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 canfulfillobjective of earning profit but may not help in creating wealth. It is because wealth creation needs alonger term horizon Therefore, Finance Management or Financial Management emphasizes on wealthmaximization rather than profit maximization. For a business, it is not necessary that profit should be theonly objective; it may concentrate on various other aspects like increasing sales, capturing more marketshare etc, which will take care of profitability. So, we can say that profit maximization is a subset of wealth and being a subset, it will facilitate wealth creation Giving priority to value creation, managers havenow shifted from traditional approach to modern approach of financial management that focuses onwealth maximization. This leads to better and true valuation of business. For e.g., under wealthmaximization, more importance is given to cash flows rather than profitability. As it is said that profit is arelative 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 evaluatevarious alternatives for decision making, cash flows are taken under consideration. For e.g. to measurethe worth of a project, criteria like:

Present value of its cash inflow ± present value of cash outflows (net present value) is taken. Thisapproach considers cash flows rather than profits into consideration and also use discounting techniqueto 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 thatultimately wealth maximization should be discovered in increased net worth or value of business. So, tomeasure the same, value of business is said to be a function of two factors - earnings per share andcapitalization 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 conflictbetween the owners and managers of firm. As, managers are the agents appointed by owners, a strategicinvestor or the owner of the firm would be majorly concerned about the longer term performance of thebusiness that can lead to maximization of shareholderµs wealth. Whereas, a manager might focus ontaking 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 ownerµs objectives. Hence, a manager should align his/her objective to broad objective of organizationand achieve a tradeoff between risk and return while making decision; keeping in mind the ultimate goalof financial management i.e. to maximize the wealth of its current share holder she objections are:-(i)Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It isnot at possible to maximize what cannot be known.(ii) The executive or the decision maker may not haveenough confidence in the estimates of future returns so that he does not attempt future to maximize. It isargued that firm's goal cannot be to maximize profits but to attain a certain level or rate of profit holdingcertain 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 isbrought in to the analysis. In such cases, higher capitalisation rate involves. Such combinationof expected returns with risk variations and related capitalisation rate cannot be considered in the conceptof 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 theinterests of the community on the one hand and that of the government, workers and other concernedpersons in the enterprise on the other hand. Keeping the above objections in view, most of the thinkerson the subject have come to the conclusion that the aim of an enterprise should be wealth Maximization

8/3/2019 FM-Set2



and not the profit Maximization. Prof. Soloman of Stanford University has handled the issued verylogically. Heargues that it is useful to make a distinction between profit and 'profitability'. Maximizationof profits with a via to maximising the wealth of shareholders is clearly an unreal motive. On the other hand, profitability Maximization 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 wealthmaximization.

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

Net operating income approach examines the effects of changes in capital structure in terms of netoperating income. In the net income approach discussed above net income available to shareholders isobtained by deducting interest on debentures form net operating income. Then overall value of the firm iscalculated through capitalization rate of equities obtained on the basis of net operating income, it is callednet income approach. In the second approach, on the other hand overall value of the firm is assessed onthe basis of net operating income not on the basis of net income. Hence this second approach is knownas 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 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 theincrease in debts whereas it is assumed under this method that overall cost of capital is unaffected andhence it remains constant irrespective of the change in the ratio of debts to equity capital. How can thisassumption 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 thevolume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benefitof leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustratethis point.

If follows that with the increase in debts rate of equity capitalization also increases and consequently theoverall 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 isexpressed in terms of interest charges on debentures. The other is implicit cost which refers to theincrease 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 firmremains 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 capitalstructure is optimum according to net operating income approach.

Q.3 What do you understand by operating cycle.

An operating cycle is the length of time between the acquisition of inventory and the sale of thatinventory and subsequent generation of a profit. The shorter the operating cycle, the faster a businessgets a return on investment (ROI) for the inventory it stocks.

8/3/2019 FM-Set2



As a general rule, companies want to keep their operating cycles short for a number of reasons, but incertain industries, a long operating cycle is actually the norm. Operating cycles are not tied to accountingperiods, 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 beborrowed or paid up front, but in either case, once the business has purchased inventory, those funds arenot available for other uses. The business views this as an acceptable tradeoff because the inventory isan 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 andthis 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 perishablegoods, 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, keepinventory 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 areusually 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 aroundlonger, while periods of growth may be marked by more rapid turnover. Certain products can beconsistent sellers that move in and out of inventory quickly. Others, like big ticket items, may bepurchased less frequently. All of these issues must be accounted for when making decisions aboutordering and pricing items for inventory.

Q.4 What is the implication of operating leverage for a firm. Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing itsgoods or offering its services. Fixed costs include advertising expenses, administrative costs, equipmentand technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage. Byusing 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, utilitycompanies, 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 Auses a highly automated production process with robotic machines, whereas firm B assembles thewidgets 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 ismuch 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 ahigher breakeven point²the point at which total costs equal total sales. Nevertheless, a change of Ipercent in sales causes more than a I percent change in operating profits for firm A, but not for firm B.The ³degree of operating leverage´ measures this effect. The following simplified equation demonstratesthe type of equation used to compute the degree of operating leverage, although to calculate this figurethe 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:

8/3/2019 FM-Set2



Operating leverage is a double-edged sword, however. If firm A¶s sales decrease by I percent, its profitswill decrease by more than I percent, too. Hence, the degree of operating leverage shows theresponsiveness of profits to a given change in sales.

Implications: Total risk can be divided into two parts: business risk and financial risk. Business risk refersto the stability of a company¶s assets if it uses no debt or preferred stock financing. Business risk stemsfrom 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 acompany uses debt or preferred stock financing, additional risk²financial risk²is placed on thecompany¶s common shareholders. They demand a higher expected return for assuming this additionalrisk, which in turn, raises a company¶s costs. Consequently, companies with high degrees of business risktend to be financed with relatively low amounts of debt. The opposite also holds: companies with lowamounts 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, toprovide leverage during periods of deflation, such as the period during the late 1990s brought on by the

Asian financial crisis.

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 inplant a machinery and Rs.50 million on net working capital. The entire outlaywill be incurred in the beginning. The life of the project is expected to be 5years. At the end of 5 years, the fixed assets will fetch a net salvage value ofRs. 48 million ad the net working capital will be liquidated at par. The projectwill increase revenues of the firm by Rs. 250 million per year. The increase incosts will be Rs.100 million per year. The depreciation rate applicable will be25% 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.

Total outflow Rs. 150 Million + Rs. 50 Million = Rs. 200 Million

Incremental approachRevenue ± CostRs. 250 Million ± Rs. 100 Million = 150 Million

Pr factor @10% for 5 years = 3.790

@ 150 X 3.790 = Rs. 568.62

Calculation of depreciation:

15025%

Year Depreciation Tax saving PV@10% Tax saving

1 37.5 11.25 0.909 10.226

8/3/2019 FM-Set2



2 28.125 8.4375 0.826 6.969

3 21.09 6.327 0.751 4.751

4 15.82 4.746 0.683 3.241

5 11.87 3.561 0.621 2.211

27.398

Total inflow: 568.62 + 27.398 = 596.018

+ Inflow in 5th year 50+48 = 98 60.858

X 0.621 656.876

Q.6 Given the following information, what will be the price per share using the

Walter model.

Earnings per share Rs. 40

Rate of return on investments 18%

Rate of return required by shareholders 12%

Payout ratio being 40%, 50%, or 60%.

1. D=40 %EPS = 40Kc = 12%ROI =18%

E = dividend/payout ratio (40/0.4 = 16%)

According to Walter Model,

P = [D + (E - D) x ROI / Kc] / Kc

P = [40 + (16-40) x 0.18/0.12] / 0.12

= 200

NPV = 656.876 -200 = 456.876

8/3/2019 FM-Set2



2. D=50 %EPS = 40Kc = 12%ROI =18%E = dividend/payout ratio (50/0.4 = 20%)

According to Walter Model,P = [D + (E - D) x ROI / Kc] / Kc

P = [50 + (20-50) x 0.18/0.12] / 0.12

= 250

3. D=60 %EPS = 40Kc = 12%ROI =18%

E = dividend/payout ratio (60/0.4 = 24%)

According to Walter Model,P = [D + (E - D) x ROI / Kc] / Kc

P = [60 + (24-60) x 0.18/0.12] / 0.12

= 300

********************************

FM-Set2

Documents

Transcript of FM-Set2