Assignment Code: MCO-07/TMA/2022-23

Course Code: MCO-07

Assignment Name: Financial Management

Year: 2022-2023

Verification Status: Verified by Professor

Maximum Marks: 100

Attempt all the questions:

a) “Investment, financing and dividend decisions are all interrelated” comment. (10 + 10)

Ans) People say that money is what keeps a business going. "Money brings more money" and "money makes the horse go" are famous sayings that show how important money is to everyone. It's hard to tell the finance function from the production, marketing, and other functions, but it's easy to figure out what each function is.

Financing decisions, investment decisions, and dividend decisions are the decisions about how to get money, invest it in assets, and give the profits back to shareholders. So, it's clear that the finance functions of a business need to be planned, controlled, and carried out with skill.

Investment Decision

When a company decides where to invest, it spends capital, which can be used for any project. The financial management gives you a plan for making smart investments. It had to do with

1. Management of working capital

2. Capital budgeting decision

3. Management of mergers, reorganisation, and disinvestment

4. Buy or lease decisions

5. Securities analysis and portfolio management

When making an investment decision, most of the choices have to do with the mix of fixed and current assets.

Financing Decisions

The second most important job of a financial manager is to make decisions about financing. To meet the firm's investment needs, one must decide when, where, and how to get funds. The most important thing is to figure out the right mix of equity and debt, which will lead to the best capital structure. When the market value of each share is at its highest, the firm's capital structure is said to be at its best. Once the financial manager has figured out the best mix of debt and equity, he or she must find the best way to raise the right amount of money. This can come from both internal and external sources. "Financial leverage" refers to the use of these sources in different ways. For this decision, you need to do different kinds of analysis, such as a leverage analysis or an EBIT-EPS analysis.

Dividend Decision

The decision about the dividend is the third big financial decision. The financial manager has to decide if the company should give away all of its profits, keep them all, give away some and keep the rest. The dividend pay-out ratio measures how much of a company's profit is given out as dividends. The retention ratio measures how much of a company's profits are kept for itself. Like the debt policy, a good retention ratio maximises the market value of a company's shares. The decision to keep earnings depends on the opportunities to reinvest and the chance to make more money. Dividends can be paid out in cash or extra shares.

b) What is time value of money? Discuss its relevance in financial decision making.

Ans) Time Value of Money, also called present discounted value, is the idea that money you have now is worth more than the same amount of money you will have in the future because it can grow. The phrase is similar to the idea that "time is money," but it refers to the money itself instead of the person's time. Money is worth more the sooner you get it, as long as it can earn interest, which it can.

The time value of money is one of the things that is taken into account when figuring out how much it costs to spend money instead of saving or investing it. As a result, this is one of the reasons why people pay or get interest: whether it's on a bank deposit or a loan, interest compensates the depositor or lender for not being able to use their money. Investors are only willing to put off spending their money now if they think they will get a good net return on their investment in the future. This means that the value of their investment will go up enough in the future to make up for the fact that they would rather spend their money now and for inflation, if there is any. See required rate of return.

We all know that if we put money in a savings account, it will earn interest. Because of this, we would rather get money now than the same amount in the future. When making financial decisions, it is very important to know how money changes over time and how much risk there is. One rupee is worth more today than it is tomorrow. Having Rs. 75,000 now is a much better choice than having Rs. 1,00,000 in five years, because the present is more certain. You could make money on Rs. 75,000 that you put into the market. On the other hand, because of inflation, Rs. 1,00,000 would be worth less after five years. The ideas behind the time value of money will explain these choices, which we all have to make every day. Most financial decisions, like buying assets or getting money, change the cash flow of a business at different times. For example, if a fixed asset is bought, cash will have to be spent right away, but it will also bring in cash flows when the owner has to pay cash for interest and pay back the principal in the future. So, knowing the value of money over time is very important, and a good understanding of it makes up 90% of good financial sense.

If the timing and risk of cash flows aren't taken into account, the company may make decisions that don't help the owner as much as it could. A rupee is worth more today than it is tomorrow. Most people would rather get money right now than have to wait for one or more times to get the same amount. Time preference for money means that a person would rather get a certain amount of money now than the same amount in the future. The person's time preference for none could be due to three things 

1. Risk

2. Preference for consumption

3. Investment opportunities

Most of the time, an interest rate shows how much money is worth over time. Even if there were no risk, this rate would still be good. So, you might call it the risk-free rate. In the real world, an investor will always face some risk. So, he would need a rate of return from the investment, called a "risk premium," to make up for both the time and the risk. So, the rate of return needed will be,

Required rate of return = Risk free rate + Risk premium

You can also call the required rate of return the opportunity cost of capital of similar risk. No matter what a person likes or how they feel, the interest rates take time and the value of money into account.

2) Discuss the different approaches for valuation of equity shares. (20)

Ans) Ordinary shares, also called equity shares, are harder to put a value on. There are two things that cause the problem. First of all, the rate of dividends on equity shares is not known and paying equity dividends is up to the company. So, it is harder to predict the amount and timing of the cash flows that equity shareholders expect. When it comes to debentures and preference shares, the interest rate and dividend are both known for sure. So, it is easy to make predictions about the cash flows that go with them. Second, earnings and dividends from equity shares tend to go up over time, while interest on bonds and preference dividends tend to go down. Variable dividends on equity shares make it hard to figure out how much each share is worth. So, there are two ways to figure out the value of stock based on dividends and profits.

1. Dividend capitalisation Approach.

2. Earnings capitalisation Approach

Dividend Capitalisation Approach

The expected cash flows from an equity share are the dividends the owner expects to get while he holds on to the share and the price he expects to get when he sells the share. When the owner sells the share, the price he gets will include his original investment and a capital gain (or minus capital loss). The final conclusion is that, for most shareholders, the only expected cash flows are future dividends. This means that the value of an ordinary share is calculated by capitalising the expected stream of future dividends at the opportunity cost of capital. The opportunity cost of capital is the return an investor could get from a market investment with the same level of risk. A share's value is the present value of the dividends it will get in the future. The timing of cash flows is a problem with the dividend valuation model. We will look at this in two situations:

1. Single period valuation

2. Multiple period valuations.

This will be further examined assuming

1. Dividends do not grow in future i.e., zero growth. They are constant.

2. Dividends grow at a constant rate in future.

3. Dividends grow at a varying rate in future.

Single Period Valuation

In a single period of one year the price of equity will be calculated as given below:

P0 = D1 / (1+r) + P1 /(1+r)

Or

= D1 + P1 / (1 + r)

Where, 

P0 =current price of equity shares.

D1  = dividend expected at year-end.

P1 = price of the equity share expected at year-end.

r = rate of return required

Multiple Period Valuations

The value of an equity can be put in a formula as follows:

P0  = D1 / (1 + r )1 + D2 / (1 + r )2 + D3/ (1 + r )3 + ……………. + / (1 + r )t

P0  =  

As equity shares have no maturity time period. They are likely to bring a nonstop dividend for endless period.

Earnings Capitalisation Approach

The dividend capitalization models we've talked about so far are the most basic way to value a share. But in two situations, the expected earnings can be used to figure out how much the share is worth. When a company pays out 100% of its profits as dividends, it doesn't keep any of its own money.

When a company's return on equity (ROE) is the same as its opportunity cost of capital at the rate of return needed, this is called a "breakeven point" (r). Under this method, the expected price is estimated in three steps:

1. Estimate future earnings per share,

2. Estimate growth rate, and

3. Find normal price earnings ratio.

For one year holding period with D1 as expected dividends in the next year, the expected return can be found as follows:

Expected Return D1 + (I - P) / P

where, P = Actual pay-out ratio.

P1 = Expected pay-out ratio

The most important part of this method is figuring out the normal price earnings ratio. Earnings per share and the pay-out ratio are used to figure out the dividend.

Hence, Dt = Pt Et

Or  Pt = Dt / Et

Pt = Pay-out ratio

Et = earnings per share in time “t”.

Dt = dividend in time “t”

Forecasting earning per share and pay-out ratio, then will mean forecasting dividends. It can be expressed as:

 =

If earnings grow at a rate ‘g’ in future period, then

Et = Et – 1 ( 1+ft) P.

The normal price is calculated as:

Vi / E0 = P (1+ gt) / (r-gt)

Vi= Intrinsic value or the price

E0 = Actual level of earnings.

This shows that the expected pay-out ratio will be higher if the normal earnings ratio is higher. The price earnings ratio goes up as the expected rates go up.

Other Approaches

Other ways to figure out how much a share of stock is worth are based on its book value or its liquidation value per share value earnings. Not many people use these methods.

Book Value

When we say, "book value per share," we mean the company's net worth, which is the paid equity share capital surpluses divided by the number of outstanding equity shares.

For example, if a company has Rs. 50,000 in paid-up capital and Rs. 30,000 in reserves, it has a net worth of Rs. If there are 200,000 equity shares, then the book value of each share is Rs. 8,000,000 divided by 200,000, which is Rs. 4. This method is an objective way to measure value, but it also has a very big problem. It is based on historical balance sheet numbers that are found by following accounting rules. Estimates from accountants are not reliable, so this method is used.

Liquidation Value

The following formula is used to find the liquidation value per share.

Amount realised on liquidation from sale of assets – Amount to paid to all creditors and preferences shares / Number of equities shares outstanding

3)  A company is considering the following investment projects. (20)

Projects Initial Investment (₹) Cash Flow (₹) A 10,00,000 12,00,000 8,00,000 Nil B 10,00,000 8,00,000 10,00,000 12,00,000 C 10,00,000 3,00,000 5,00,000 5,00,000 D 10,00,000 10,00,000 6,00,000 3,00,000

Find out payback period, and net present value and rank the projects according to them. Assume discount rate 10% and 20%.

Ans)

4) a) What is operating leverage and financial leverage? What is their significance? (10 + 10)

Ans) Operating leverage happens when a company has fixed operating costs and a steady stream of income. There are three types of costs that a business has to pay to run.:

1. Fixed costs are those that don't change with the number of sales, are based on time, and are usually contractual. They have to be paid no matter how much money is coming in.

2. Variable costs are those that change directly with the number of sales, and semi-variable or semi-fixed costs are those that are partly fixed and partly variable. They stay the same over a certain range of sales volume and go up when sales volume goes up. Since the last group of costs can be broken down into fixed and variable parts, a firm's costs can be broken down into (a) fixed and (b) variable.

Operating leverage is a company's ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage happens when a business has fixed costs that must be paid no matter how much it sells. We use fixed-cost assets in the hopes that sales will bring in more than enough money to cover both fixed and variable costs. In other words, when you have fixed costs, a change in volume causes a bigger change in profits than the change in volume. The term for this is operating leverage.

The presence of fixed financial costs in the firm's income stream leads to financial leverage. These fixed costs don't change based on the operating profits or earnings before interest and taxes (EBIT). They must be paid no matter how much EBIT is available to pay them. After paying them, the operating profits (EBIT) go to the ordinary shareholders. Financial leverage looks at how changes in EBIT affect the amount of money that equity holders can earn. It is the ability of a company to use fixed financial costs to make changes in EBIT have a bigger effect on earnings per share. In other words, financial leverage is using funds that were bought for a fixed price in order to increase the return to shareholders.

When figuring out how much money to spend on capital, operating leverage is a key factor. It shows how a change in sales affects operating income or EBIT. A firm's risk goes up when it has a lot of operating leverage. The effect of a further rise in risk will play a role in deciding whether or not to use debt in the capital structure. Leverage helps finance managers come up with the best capital structure and plan for making money. If you have a lot of debt, you have a lot of fixed costs and a lot of financial risk. When a company uses financial leverage, the shareholders will benefit from higher Earnings Per Share (EPS) and Return on Equity (ROE) only if the return on investment (assets) is higher than the cost of interest.

b) Firm “A” has an annual sale of  Rs. 80,00,000 and variable cost is Rs. 50,00,000. Fixed cost is Rs 5,00,000 per year. Company has 11% debentures of Rs 30,00,000. Find out operating leverage and financial leverage of the firm.

Ans)

 Sales Rs.                                                                            80,00,000

Variable Costs Rs.                                                                50,00,000

Fixed Costs Rs.                                                                    5,00,000

Debt Rs.                                                                             30,00,000

Financial Costs @ 11%, Rs.                                                    3,30,000

Contribution= Sales- Variable costs                                       30,00,000

EBIT= Contribution -fixed costs                                             25,00,000

EBT= EBIT- Interest                                                              21,70,000

Operating Leverage                                                            

Contribution / EBIT                                                              120

Financial Leverage                                                              

EBIT/EBT                                                                             1.15

5) a) Discuss M & M preposition I of capital structure. (10 + 10)

Ans)

Modigliani and Miller

The traditional view is not shared by Modigliani and Miller. They say that a firm's market value and the cost of capital stay the same even if its capital structure changes in a perfect capital market with no taxes or transaction costs. The firm's value is based on how much it makes and how risky its assets are, not on how the assets were paid for. The best way to explain the MM hypotheses is to look at their two propositions.

Proposition I

It's important to keep in mind that the MM Propositions only work in the MM world, which is a perfect, ideal place. MM assumed, either explicitly or not, that:

1. Capital markets are frictionless.

2. Firms can lend at the risk-free rate (riskless debt)

3. Individuals can also borrow and lend at the risk-free rate

4. There are no costs to bankruptcy

5. Firms only issue two types of claims: risk-free debt and (risky) equity

6. All firms are assumed to be in the same risk class

7. There are no taxes

8. All cash flow streams are perpetuities (i.e., no growth)

9. Corporate insiders and outsiders have the same information (i.e., no signalling opportunities)

10. Managers always maximise shareholders' wealth and do not expropriate in anyway other stakeholders of the company (i.e., no agency costs)

11. Contracts are complete and can always be enforced.

MM Proposition I say that the value of a firm with debt is equal to the value of a firm without debt plus the present value of an infinite stream of tax benefits from interest on debt. The required rate of return to lenders is used to discount the future, infinite stream of tax breaks from interest on debt. The present value of an infinite stream of operating cash flows is the value of a company that has no debt. In an all-equity company, the future operating cash flows are discounted at the required rate of return to shareholders.

VL = Vu + Tc *  rd * D / rd

Vo = EMT /ro

where:

VL = Value of levered firm

VU = Value of unlevered firm

Tc= Corporate income tax rate

rd = required rate of return to lenders

D = Amount of debt in capital structure

EBIT = Earnings before interest and taxes

ro = required rate of return to equity shareholders of an all-equity firm

The graphic presentation of MM proposals I is as under:

Relationship between Debt and Firm Value

The obvious explanation for MM Proposition I is that companies can deduct interest on loan funds as a tax-deductible expense, but they can't deduct dividend payments. This means that financial leverage lowers tax payments and raises the value of a company. MIA uses a net operating income approach because the value of a company is equal to its net operating income multiplied by its capitalization. Both the firm's net operating cost and its opportunity cost of capital are thought to stay the same no matter how much financial leverage it has. For a leveraged company, the expected net operating income is the sum of the income of shareholders and the income of debtholders. Interest is what debt holders get paid and expected net operating income minus interest is what shareholders get paid, which is called net income. The value of the levered firm is the sum of the value of its equity and the value of its debt. The expected rate of return for a leveraged company is the ratio of its expected operating income to the total value of all its securities. This is the average expected rate of return on investments that all of the firm's security holders would want the firm to make.

b) What is credit policy? Explain its variables.

Ans) "Credit Policy" refers to the factors that affect the amount of trade credit, i.e., the amount of money invested in receivables. The amount of risk a company is willing to take in its sales activities is set by its credit policy. If the credit policy is flexible and easy going, receivables will be higher than if the policy was strict. The goal of credit policy, also known as receivables management, is to include the following types of people.

1. Increase sales and profit through a better understanding and skillful handling of all credit functions.

2. Match risk and reward through customer and financial analysis.

3. Monitor, protect and manage the company's investment in accounts receivables.

4. Communicate the condition, cost, and trend of the company's investment in receivables to management.

5. Convert accounts receivable to cash in a timely manner.

6. Increase cooperation between sales and credit.

7. Maintain and increase goodwill in customer relations.

8. Coordinate credit activities with all departments.

9. Train and supervise credit department personnel.

10. Educate other departments about credit and the credit function.

11. Control operating costs and expenses.

12. Reduce collections and debt.

The important variables of credit policy are:

Credit Standard

Credit standards are the criteria that a company uses to decide which customers to give credit to. The company may have strict credit standards, which means it may sell mostly for cash and give credit to only the most trustworthy and financially stable customers. With these standards, there will be no bad debt losses and the cost of managing credit will go down. But the company might not be able to sell more. The company may lose more money on lost sales than it saves on costs. On the other hand, if there are fewer restrictions on credit, the company may make more money. But the company will have to keep a bigger number of receivables. The costs of managing credit and losing money on bad debt will also go up. So, choosing the best credit standards requires making a trade-off between incremental return and incremental cost. You can also expect that changing credit standards will change the number of sales. As standards are relaxed. Sales are expected to go up, but they are expected to go down if things get tighter.

Credit Period

The amount of time that a customer has to pay back a loan is called the credit period. Most of the time, it is written as a net date. For example, if a company's credit terms are "net 35," customers are expected to pay their debts within 35 days. The industry standards may determine how long a company has to pay back debts. But depending on what it wants to do, the company can make the credit period longer. On the other hand, the company may shorten its credit period if too many customers stop paying and bad-debt losses start to mount.

A company lengthens its credit period to increase its operating profit by selling more. But there will only be a net increase in operating profit if the cost of extending the credit period is less than the operating profit increase. When sales go up and credit terms get longer, investments in receivables go up. This rise is caused by two things: (a) more sales mean more receivables, and (b) existing customers will take longer to pay back their credit obligations (i.e., the average collection period will go up), which makes the amount of receivables go up.

Cash Discount

A cash discount is a payment discount given to customers to get them to pay off their credit obligations in a shorter amount of time than the normal credit period. Most of the time, it is shown as a percentage of sales. Cash discount terms tell you how much of a discount you can get and for how long. If the customer doesn't take advantage of the offer, he has to pay within the normal amount of time. Cash discount is a way for a business to boost sales and get paid faster from customers. So, the number of unpaid bills and the costs that come with them may go down. The discounts that customers take are what pay for it.

Collection Efforts

To get customers to pay what they owe, the company should have a clear collection policy and set of steps to follow. When a customer's normal credit period is up and he hasn't paid, the company should send him a polite letter reminding him that the bill is due. If the customer doesn't answer, the company may send letters with increasingly harsh language. If the debt is still not paid, letters may be followed by a phone call, a telegram, or a personal visit from a representative of the company. If the customer still doesn't pay, the company may file a lawsuit against them. Before going to court, the company has to find out how much money the customer has. If it is weak, going to court against him will only speed up his bankruptcy. The customer will not give the company anything. In this situation, it's better to be patient and wait, or to settle the account for less money.