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TRIMESTER - 5
FINANCIAL MANAGEMENT
MID TERM PAPER
Maximum Marks : 70
Time allowed : 2 hours
(This is an open book examination)
Q-1 a) ‘A rupee of today is not equal to the rupee of tomorrow”. Do you agree? (10)
I agree that ‘A rupee of today is not equal to the rupee of tomorrow”, because, money has
time value.
Over the period of time, due to inflation in the economy, value of money decreases. A
unit purchase capacity of money today will be reduce due to inflation.
e.g. if inflation rises @ 7 %, the value of Rs. 1,000 will be Rs 935 at the end of the
year. Hence, what could be bough by Rs Rs 1,000 today will need Rs (1,000 / 0.935) after
one year.
On the other hand, if money is invested today, it can earn returns.
e.g. if Rs. 10,000 invested with expected rate of return of 5 % per annum, at the end of
one year, it will be Rs 10,000 + (10,000 X 0.05 ) = 10,000+500 = 10,500
which will go on increasing year after year.
Hence, a rupee of today will not be equal to the rupee of tomorrow.
b) A Company’s bond of Rs. 1,000 is currently selling at Rs. 900/- in the Stock
Exchange. The bond has coupon rate of interest of 9% and maturity period of 6 years. Is
it worthwhile to purchase if the investor expected rate of return is 12%.
(10)
Ans :
Cash inflows of investment of Rs. 900 with coupon rate of interest 9% and expected rate
of 12% will have following cash inflows:
STATEMENT OF CASH INFLOWS
Year end
Bond
Value
1
2
3
4
5
6
TOTAL
1000
1090
1188.1
1295.03
1411.58
1538.62
Earning at
Coupon rate
9%
90.00
98.10
106.93
116.55
127.04
138.48
677.10
Invested
value
900
1008
1128.96
1264.44
1416.17
1776.44
Earning @
expected
12 %
108
128.96
135.48
151.72
168.94
213.17
906.27
Now amount invested will be Rs 900.
Interest earned due to coupon interest will be Rs 677.10.
Interest of 12% for Rs 900 would be Rs 906.27.
Hence, it is clear that the if expected return is of 12%, than it is not worthwhile to
purchase the bond.
Q-2)
The Plant of a Company is doing poorly and is being considered for replacement.
Three mutually exclusive Plants A, B and C have been proposed. The Plants are expected
to cost Rs. 2,00,000/- each and have an estimated life of 5 years, 4 years and 3 years
respectively, and have no salvage value. The Company’s required rate of return is 10%.
The anticipated cash inflows after taxes for the three Plants are as follows :
YEAR
1
2
3
4
5
PLANT A
Rs. 50,000
Rs. 50,000
Rs. 50,000
Rs. 50,000
Rs. 1,00,000
PLANT B
Rs. 80,000
Rs. 80,000
Rs. 80,000
Rs. 30,000
-
PLANT C
Rs. 1,00,000
Rs. 1,00,000
Rs. 10,000
-
Find out the Payback Period and Net Present Value. Which machine should be selected?
(Use tables given at the end of your book if required).
(20)
Ans :
CALCULATION OF PAY BACK PERIOD
YEAR
1
2
3
4
5
CASH INFLOWS (Rs)
A
50,000
50,000
50,000
50,000
1,00,000
B
80,000
80,000
80,000
30,000
-
C
1,00,000
1,00,000
10,000
-
CUMULATIVE CASH INFLOWS
(Rs)
A
B
C
50,000
80,000
1,00,000
1,00,000
1,60,000
2,00,000
1,50,000
2,40,000
2,10,000
2,00,000
2,70,000
3,00,000
Pay back period for Plant A = 4 Year
Plant B = Nos of year completed + (remaining cost to be covered/ total
cash inflows of that year)
= 2 + (40,000 / 80,000)
= 2 + 0.5
= 2.5 years
Plant C = 2 years
CALCULATION OF NPV
YEAR
1
2
3
4
5
CASH INFLOWS (Rs)
A
50,000
50,000
50,000
50,000
1,00,000
TOTAL
B
80,000
80,000
80,000
30,000
C
1,00,000
1,00,000
10,000
-
PV
Factor
10%
0.909
0.826
0.751
0.683
0.621
PV of cash inflows (Rs)
A
45,450
41,300
37,550
34,150
62,100
2,20,550
B
72,720
66,080
60,080
20,490
C
90,900
82,600
7,510
2,19,370
1,81,010
For Machinery C , present worth of inflows is less than the present worth of outflows,
hence it shall not be accepted.
Hence, selection to be made between Plant A and Plant B.
Out of which, Plant B Shall be selected for the reason:
a) Plant B has positive NPV,
b) Plant B NPV is close to A.
c) Pay back period of Plant B is less as compared to Plant A.
d) Return of Plant B in the initial year is higher as compared to Plant A
Q-3) ‘S’ Ltd., has the following capital structure on 31st March, 2009.
Equity Share Capital
(60,000 shares of Rs. 10/- each)
12% Preference Shares
10% Debentures
Rs. 6,00,000
Rs. 6,00,000
Rs. 3,00,000
The equity shares of the Company are quoted at Rs. 102/- and the Company is expected
to declare a dividend of Rs. 9/- per share for the next y ear. The Company has registered
a dividend growth rate of 5% which is expected to be maintained. Assuming the tax rate
to be 50%, calculate the cost of equity, cost of preference shares, cost of debentures and
the weighted average cost of capital.
(20)
Ans :
(A) Cost of equity: (Ke)
Ke= (D1 / Po) + g
Do= current rate of dividend which is 8.82
D1= Do + 5% of 8.82 (incremental growth of dividend)
= 8.82 + 0.441
g= Growth rate of dividend
Po= Market price of share
Hence, Ke= [( 8.82 + 0.441) / 102] + 0.05
= [20 / 102] + 0.05
= 0.196+0.05
= 0.246 hence, 24.6 %
Cost of equity capital = 24.6 %.
(B) Cost of Debt.: Kd
Kd = l ( 1-t)
Where l = rate of debenture which is 10 and, t = tax rate, which is 50%
Kd
= 10 (1-0.5)
= 10 ( 0.5)
=5%
(C) Cost of preference share capital = 12%
(As there is no information of redeemable value)
CALCULATION OF WACC
Capital
Amount (Rs)
Weight
Equity
6,00,000
Preference
6,00,000
Shares
Debenture
3,00,000
TOTAL
15,00,000
Cost of Capital Weighted cost
0.4
0.246
0.0984
0.4
0.12
0.048
0.2
0.05
0.01
0.1564
Therefore WACC = 15.64 %.
Q-4 a) In case NPV method and IRR method of Capital Budgeting give conflicting
results, which method should be used for decision making and why?
(5)
In case NPV method and IRR method of capital budgeting give conflicting results,
NPV method should be used for decision making.
The basic objective of financial management is to maximize the wealth of the owner.
The NPV method considers Net Present Value, which is more meaningful for wealth
estimation. Where as, IRR method gives idea about rate of return on investment
rather than total return on investment.
b) Is cost of retained earnings same as cost of equity? How can cost of retained
earnings be obtained with the help of cost of equity ?
(5)
Yes, Cost of retained earnings is same as cost of equity.
While retaining the earning, do not involve cost of floatation & brokerage, hence it
cost of retained earning can be calculated by subtracting these cost from cost of
equity, which is denoted by following formula:
Kr = Ke (1-b) ( 1-f)
Where Kr = Cost of retained earnings
Ke = Cost of Equity
b= cost of brokerage
f=cost of floatation
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