Financial Management Assignment Set

There are two versions of the goals of financial management of the firm – Profit Maximisation and Wealth Maximisation. Profit Maximisation Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns with the best output and price levels. A firm’s performance is evaluated in terms of profitability.

Profit maximisation is the traditional and narrow approach, which aims at maximising the profit of the concern. Allocation of resources and investor’s perception of the company’s performance can be traced to the goal of profit maximisation.Wealth Maximisation The term wealth means shareholder’s wealth or the wealth of the persons those who are involved in the business concern. Wealth maximisation is also known as value maximisation or net present worth maximisation. This objective is an universally accepted concept in the field of business. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company.

It has been accepted by the finance managers as it overcomes the limitations of profit maximisation. Q2.Calculate the PV of an annuity of Rs. 500 received annually for four years when discounting factor is 10%. ? Answer: The calculation of Present Value (PV) of the annuity of Rs. 500 can be depicted as follows: End of the year| Cash Inflows| PV factor| PV in Rs.

| 1| Rs. 500| 0. 909| 454. 5| 2| Rs. 500| 0.

827| 413. 5| 3| Rs. 500| 0. 751| 375.

5| 4| Rs. 500| 0. 683| 341. 5| Total| Rs. 2000| 3.

170| 1585. 0| Hence the PV of the annuity of Rs. 500 received annually for 4 years is Rs. 1585. 00 Q3. Suraj Metals are expected to declare a dividend of Rs.

per share and the growth rate in dividends is expected to grow @ 10% p. a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company? Answer: Cost of equity capital = (D1/Pe) + G {where D1=Dividend, Pe=Price of Share, G=Growth Rate) = (5/110) + 0.

10 = 0. 1454 = 14. 54 % Hence the cost of equity capital is 14. 54% Q4. What are the assumptions of MM approach? Answer: The MM approach to irrelevance of dividend is based on the following assumptions: * The capital markets are perfect and the investors behave rationally.

All information is freely available to all the investors. * There is no transaction cost. * Securities are divisible and can be split into any fraction. No investor can affect the market price. * There are no taxes and no flotation cost.

* The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted. Q5. An investment will have an initial outlay of Rs 100,000.

It is expected to generate cash inflows. Table 1. 2 highlights the cash inflow for four years. Table 1.

2: Cash inflow Year | Cash inflow | 1 | 40000 | 2 | 50000 | 3 | 15000 | 4 | 30000 | If the risk free rate and the risk premium is 10%, a) Compute the NPV using the risk free rate b) Compute NPV using risk-adjusted discount rate Answer: a) NPV can be calculated using risk free rate : YEAR| CASH INFLOWS| PV FACTOR@10%| PV OF CASH INFLOWS| 1| 40000| . 909| 36360| 2| 50000| . 826| 41300| 3| 15000| . 751| 11265| 4| 30000| .

683| 20490| | PV of cash inflows| | 109415| PV of cash outflows| (100000)| | | NPV| | 9415| b) NPV can be computed using Risk Adjusted discount : YEAR| CASH INFLOWS| PV FACTOR@20%| PV OF CASH INFLOWS| 1| 40000| . 833| 33320| 2| 50000| . 694| 34700| 3| 15000| . 579| 8685| 4| 30000| . 482| 14460| | PV of cash inflows| | 91165| | PV of cash outflows| (100000)| | | NPV| | (8835)| The project will be acceptable when no allowance is made for risk. However if the firm where to use the IRR, then the project would be acceptable when IRR is greater than the risk adjusted discount rate.

Q6.What are the features of optimum credit policy? Answer: The firm’s operating profit is maximized when total cost is minimised for a given level of revenue. Credit policy at point an in represents the maximum operating profit (since total cost is minimum). But it is not necessarily the optimum credit policy. Optimum credit policy is one which maximizes the firm’s value. The value of the firm is maximized when the incremental or marginal rate of return of an investment is equal to the incremental or marginal cost of funds used to finance the investment.

The incremental rate of return can be calculated as incremental operating profit divided by the incremental investment in receivable. The incremental cost of funds is the rate of return required by the suppliers of funds, given the risk of investment in accounts receivable. Note that the required rate of return in not equal to the borrowing rate. Higher the risk of investment, higher the required rate of return. As the firm loosens its credit policy, its investment in accounts receivable becomes more risky because of increase in slow-paying and defaulting accounts.

Thus the required rate of return is an upward sloping curve. In sum, we may state that the goal of the firm’s credit policy is to maximize the value of the firm. To achieve this goal, the evaluation of investment in accounts receivable should involve the following four steps: 1) Estimation of incremental operating profit. 2)Estimation of incremental investment in account receivable 3)Estimation to the incremental rate of return of investment  4)Comparison of the incremental rate of return with the required rate of return.