IMT – 59: FINANCIAL MANAGEMENT

PART – A

Q1. What are the arguments in favour of wealth maximization as the objective of a firm? Why is profit maximization an inferior objective? Give a numerical illustration.

Q2. Four common stocks, Wipro, TCS, Infosys and Rediff have the following expected return and standard

deviation of return over the next year:

 Expected return          Standard deviation

Wipro                                12%                          6%

TCS                           20%                          15%

Infosys                      15%                          10%

Rediff                                10%                          5%

Additionally assume that the correlation coefficient of returns on the two securities is:

Wipro                  TCS            Infosys               Rediff

Wipro                1.0                    0.5            0.6                    0.7

TCS           0.5                    1.0            0.8                    0.4

Infosys      0.6                    0.8            1.0                    0.9

Rediff                0.7                    0.4            0.9                    1.0

For a portfolio consisting of 25% of the funds invested in each of the companies, determine the 

(i)        Expected return on the portfolio.

(ii)       Standard deviation of return.

Q3. Explain the need for financial analysis. How does the use of ratios help in financial analysis?

Q4. How long will it take to double your money if it grows at 12% annually?

Q5. A bond is available for Rs 1400. It offer includes one immediate payment and 10 annual payments of Rs 210 each. Compute the rate of return.

PART – B 

Q1. Under what conditions do the NPV and IRR methods lead to the same investment decisions? Discuss with examples. 

Q2. A company expects to pay a dividend of Rs 7/-, next year that is expected to grow at 6%. It retains 30% of earnings. Assume a capitalization rate of 10%. You are required to:

(a) Calculate the expected earnings per share.

(b) Return on equity.

(c) The value of growth opportunities.

Q3. What issues arise when the firm is deciding how to partition profits between dividends and retained earnings? Give examples to support your answer.

Q4. What do you mean by the term Beta in investments? How do you calculate it for a stock?

Q5. AB Ltd created a sinking fund to redeem its preference capital of Rs 5 lakh issued on 6 April 2004 and will mature on 5 April 2015. The first annual payment was made on 6 April 1994. The company will make equal annual payments and expects that the fund will earn 12% per year, how much will be the amount of sinking fund payments?

PART – C

Q1. Sun Ltd has current sales of Rs 6 crore. Sales are expected to grow to Rs 8 crore next year. Sun currently has accounts receivables of Rs 90 lakh, inventories of Rs 1.5 crore and net fixed assets of Rs 2.1crore. These assets are expected to grow at the same rate as sales over the next year. The accounts payable is expected to increase from its current level of Rs 1.5 crore to Rs 1.9 crore next year. Sun wants to increase its cash balance at the end of next year by Rs 30 lakh over its current cash balance.Earnings after taxes next year are forecasted to be Rs 1.2 crore. Sun plans to pay Rs 20 lakh in dividend. Its marginal tax rate is 40 %. How much external financing is required by the firm next year?

Q2. As the difference between the costs of short-term and long-term debt becomes smaller, which financing plan, aggressive or conservative, becomes more attractive?

Q3. Two mutually exclusive projects have the following expected cash flows:

  Year                    G                                    H

0                      -10,000              -10,000

1                      5,000                        0

2                      5,000                        0

3                      5,000                17,000

        (a)        Calculate the IRR for each project.

        (b)        Calculate the NPV for each project, assuming the firm's WACC is 12%.

         (c)        Which project should be adopted? Why?

 Q4. How would you determine the optimum level of current assets? Illustrate your answer.

Q5. A company is considering an investment proposal, involving an initial cash outlay of Rs 45 lakh. The proposal has an expected life of 7 years and zero salvage value. At a required rate of return of 12%, the proposal has a profitability index of 1.182. Calculate the annual cash inflows.

CASE STUDY – 1

An oil company proposes to install a pipeline to transport crude oil from the wells to the refinery. Investment and operating costs of the pipeline vary for different sizes (diameter) of pipes. The following details have been

collected:

Estimated life of the installation is 10 years. Tax rate is 50%.

Questions

1. Calculate the net saving after paying tax and generating the cash flow. Recommend the largest pipeline to be installed if the company desires 15 per cent profit after tax return. Also indicate the proposal that has the shortest payback. Assume the company follows the straight-line method of depreciation, and there is no salvage value of pipeline after ten years.

2. Why is the Net Present Value method of evaluation superior in evaluating capital expenditure decisions?

CASE STUDY – 2

The senior executives of Laxmi Rice Mills Ltd have decided to replace the existing coal-fired furnace in the paddy boiling section with a new furnace. The capital cost of the new furnace is Rs 1 lakh. It would serve for ten years, at the end of which its residual value would be negligible. The book value of the present furnace is Rs 15,000, and it could be used for another ten years with only minor repairs. If scrapped now, it would fetch Rs 10,000. However, after ten more years of use, it would not fetch any amount if scrapped.

The main advantage of the new furnace is that it does not depend on coal, as the supplies of coal are becoming increasingly erratic in recent years. On a conservative estimate, the new furnace would result in a saving of Rs 25,000 per annum on account of eliminated coal cost. However, the cost of electricity and other operating expenses are likely to go up by Rs 8000 and Rs 4000 per annum respectively. The husk, (a by-product during the normal milling operations) at 3000 metric tonne of paddy milled per year, is adequate for operating the new furnace. On an average, for every metric tonne of paddy milled, the husk content is 20 per cent. At present, the husk is sold at a price of Rs 50 per metric tonne. Once the new furnace is installed, the husk would be diverted for own use. 'White Ash', which constitutes about 5 per cent of the husk burnt in the new furnace, would be collected in a separate ash pit, as it has a considerable demand in the refractory industry. It could be easily sold at a price of Rs 1500 per metric tonne.

The new furnace requires a motor of 15 HP, which costs Rs 1 lakh—excluding the capital cost of the furnace. A 15 HP motor is lying idle with the polishing section of the mill that could fetch Rs 3000 on sale; it has a net book value of Rs 5000. The motor could be used for the furnace. At the end of ten years, it would be scrapped at zero residual value.

All the assets of the company are in the same block. Depreciation will be calculated on the straight-line method, and the same is assumed to be acceptable for tax purposes as well. The applicable tax rate is 35 per cent and the cost of capital is 12 per cent.

You are required to:

        (a)        Formulate the incremental net profit after tax cash flows associated with the replacement project.

        (b)        Calculate the project's Net Present Value.

         (c)        Give your recommendations.