87167133 Financial Management 2nd Sem

8/2/2019 87167133 Financial Management 2nd Sem

1/23

ASSIGNMENT -01

NAME : SAHITHI GOWDA S

REGISTRATION NO : 571124176

LEARNING CENTER : SYSTEM DOMAIN

LEARNING CENTER CODE : 03337

COURSE : MBA

SUBJECT : FINANCIAL MANAGEMENT

SEMESTER : 2nd SEM

DATE OF SUBMISSION : 30/03/2012

DIRECTORATE of DISTANCE EDUCATION

SIKKIM MANIPAL UNIVERSITY

2ND

FLOOR, SYNDICATE HOUSE

MANIPAL -576104

SIGNATURE OF CO-ORDINATOR SIGNATURE OF CENTER SIGNATURE OF EVALUATOR


2/23

MB0045Financial Management

(Book ID: B1134)

Set- 1

Q1. Explain the steps involved in Financial Planning.

Answer:

Financial PlanningThe Finance Manager has to estimate the financial requirements of the company. He should

determine the sources from which capital can be raised and determine how effectively and

judiciously these funds are put into use so that repayments can be done in time. Financial

planning is deciding in advance the course of action for future. Financial planning includes:

Estimation of the amount of funds to be raised, finding out the various sources of capital and the

securities offered against the money so received and laying down policies to administer the usageof funds in the most appropriate way.

Estimate capital requirements: This is the first step in financial planning. The followingfactors may be used to determine the capital:

Requirement of fixed assets.

Investment intangible assets like patents, copyrights, etc.

Amount required for current assets like stocks, cash, bank balances, etc.

Cost of set-up and likely expenses to be incurred on the new issue of shares and

debentures.

Determine the type of sources to be acquired and their proportion: The Finance Manager

has to decide on the form in which the money is to be sourced, that is, debt, equity, preference

shares, loans from banks and the proportion in which these are to be procured.

Steps in Financial Planning:

The financial planning process involves the following steps:

Projection of financial statements:

Financial statements are the company's profit and loss account and the balance sheet. These twostatements can be prepared for a certain period of future time and they help the manager to

determine the amount of fund requirements.

Determination of funds needed:Once the projections are drawn in terms of sales of products, the cost of production, marketing

1


3/23

activities, etc., the Finance Manager can draw up a plan as to the fund requirement based on the

time factor. He can know whether the funds are to be procured on a short term basis or on a longterm basis.

Forecast the availability of funds:

A company will have a steady flow of funds. If the manager is able to forecast these amountsproperly, then the moneys to be borrowed can be reduced, thus saving on the interest payments.

Establish and maintain control system:Control system is ineffective without adequate planning and the adequacy of planning can be

gauged only through proper control measures. Both these activities are essential for effective

utilization of funds.

Develop procedures:

Procedures should be developed for basic plans how they should be achieved.

Q2. 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 in plant a

machinery and Rs.50 million on net working capital. The entire outlay will be incurred in

the beginning. The life of the project is expected to be 5 years. At the end of 5 years, the

fixed assets will fetch a net salvage value of Rs. 48 million ad the net working capital will be

liquidated at par. The project will increase revenues of the firm by Rs. 250 million per

year. The increase in costs will be Rs.100 million per year. The depreciation rate applicable

will be 25% 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.

Solution:

Cost of Project Pv factorPv of Cash

inflow

200 Million

150Million50 Million

.909

.826

.751

181.8

123.937.55

Q3. Discuss the relevance and factors that influence the determination of stock level.

Answer:

2


4/23

Most of the industries are subject to seasonal fluctuations and sales during different months of

the year are usually different. If, however, production during every month is geared to salesdemand of the month, facilities have to installed to cater to for the production required to meet

the maximum demand. During the slack season, a large portion of the installed facilities will

remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt

has to be made to obtain a stabilized production programme throughout the year. During theslack season, there will be accumulation of finished products which will be gradually cleared as

sales progressively increase. Depending upon various factors of production, storing and cost, a

normal capacity will be determined. To meet the pressure of sales during the peak season,however, higher capacity may have to be sued for temporary periods. Similarly, during the slack

season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down.

Accordingly, there will be a maximum capacity and minimum capacity, only consumption ofraw material will accordingly vary depending upon the capacity usage. Again, the delivery

period or lead time for procuring the materials may fluctuate. Accordingly, there will be

maximum and minimum delivery period and the average of these two is taken as the

normal delivery period.

Maximum Level:

Maximum level is that level above which stock of inventory should never rise. Maximum level is

fixed after taking in to account the following factors:

1. Requirement and availability of capital

2. Availability of storage space and cost of storing.

3. Keeping the quality of inventory intact

4. Price fluctuations5. Risk of obsolescence, and

6. Restrictions, if any, imposed by the government.

Maximum Level = Ordering level(MRC x MDP) + standard ordering quantity.Where, MRC = minimum rate of consumption

MDP= minimum lead time.

Minimum Level:Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL(NRC x NLT)

Where,

OL = ordering level

NRC = Normal rate of consumptionNLT = Normal Lead Time.

Ordering Level:Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X MLT

3


5/23

Where,

MRC = Maximum rate of consumption

MLT = Maximum lead time.

3. Average stock levelAverage stock level can be computed in two ways

1. Minimum level + maximum level/22. Minimum level + 1 /2 of reorder

quantity.

Average stock level indicates the average investment in that item of inventory. It in of quiterelevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level :

1. It ensure the smooth productions of the finished goods by making available the raw materialof right quality in right quantity at the right time.

2. It optimizes the investment in inventories. In this process, management can avoid bothoverstocking and shortage of each and every essential and vital item of inventory.

3. It can help the management in identifying the dormant and slow moving items of inventory.

This brings about better coordination between materials management and productionmanagement on the one hand and between stores manager and marketing manager on the

other.

Reorder Point:When to order is another aspect of inventory management. This is answered by re order

point. The reorder point is that inventory level at which an order should be placed to replenish

the inventory.

To arrive at the reorder point under certainty the two key required details are:

1. Lead time

2. Average usagelead time refers to the average time required to replenish the inventory after placing orders

for inventory

Reorder point = lead time x Average usageUnder certainty, reorder point refers to that inventory level which will meet the consumption

needs during the lead time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately, provision

is made for handling the uncertainty in consumption due to changes in usage rate and lead time.

The firm maintains a safety stock to manage the stockout arising out of this uncertainty.When safety stock is maintained, (When Variation is only in usage rate)

Reorder point = lead time x Average usage + Safety stock

4


6/23

Safety stock = [(maximum usage rate)(Average usage rate)] x lead time.

OrSafety stock when the variation in both lead time and usage rate are to be incorporated.

Safety stock = (Maximum possible usage)(Normal usage)

Maximum possible usage = Maximum daily usage x Maximum lead time

Normal usage = Average daily usage x Average lead timeExample: A manufacturing company has an expected usage of 50,000 units of certain product

during the next year. Re cost of processing an order is Rs 20 and the carrying cost per unit per

annum is Rs 0.50. Lead time for an order is five days and the company will keep a reserve of twodays usage. Calculate 1. EOQ 2. Reorder point. Assume 250 days in a year

Solution:

EOQ = 2DK/Kc

= 2 x 50000 x 20/0.50

= 2000 units

Re order point

Daily usage = 50000/250

= 200 units

Safety stock = 2 x 200 400 units.

Reorder point (lead time x Average usage) + safety stock

(5 x 200) + 400 = 1,400 units

Q4.There was a replacement of its existing machine by a new machine. The new machinewill cost Rs 2, 00,000 and have a life of five years. The new machine will yield annual cash

revenue of Rs 2, 50,000 and incur annual cash expenses of Rs 1, 30,000. The estimated

salvage of the new machine at the end of its economic life is Rs 8,000. The existing machine

has a book value of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used

for the next five years is expected to generate annual cash revenue of Rs 2, 00,000 and to

involve annual cash expenses of Rs 1, 40,000. If sold after five years, the salvage value of

the existing machine will be negligible.

The company pays tax at 40%. It writes off depreciation at 30% on the written down value.

The companys cost of capital is 20%

Compute the incremental cash flows of replacement decisions.

Solution:

5


7/23

Initial investment and annual cash flow

Initial investment

Gross investment for new machine (2,00,000)

Less: Cash received from the sale of existing machine 20,000

Net cash outlay (1,80,000)Annual cash flow from operations

Incremental cash flow from revenue 50,000

Incremental decrease in expenditure 10,000

Incremental depreciation schedule

YearDepreciation

(new machine)

Depreciation

(old machine)

Incremental

Depreciation (Rs)

1 66,000 10,000 (35,000)

2 46,200 7,500 (26,250)3 32,340 5,625 (19,687)

4 22,638 4,219 (14,765)

5 15,847 3,164 (11,074)

Calculation of depreciation

Book value 40,000

Add: cost of new machine 2,00,000

2,40,000

Less: sale proceeds of old machine 20,0002,20,000

Depreciation for 1 year 30% 66,000

1,54,000


1,07,800


75,460


52,822


Book value after 5 years 36,975

6


8/23

Statement of incremental cash flow

Particulars Years

0 1 2 3 4 5

1.Investment in new

machine

(2,00,000)

2.After tax salvage value

of old machine20,000

3.Net Cash Out lay (1,80,000)

4.Increase in revenue 50,000 50,000 50,000 50,000 50,000

5.Decrease in expenses 10,000 10,000 10,000 10,000 10,000

6.Increase in

depreciation(35,000) (26,250) (19,687) (14,765) (11,074)

7.Increase in EBIT(4+5-6)

25,000 33,750 40,313 45,235 48,926

8.EBIT (1-T)

(1-.30)

17,500 23,625 28,219 31,665 34,248

9.Incremental Cash flow

from operation

(8+6)

EAT+ Depreciation

52,500 49,875 47,906 46,430 45,322

10.Salvage value of newmachine

8,000

11.Incremental Cashflows

(1,40,000)negative

52,500 49,875 47,906 46,430 53,322

Q5. Explicit cost and implicit cost are the two dimensions of cost. What role does cost play

in financial decisions.

Answer:

The cost of debt has two partsexplicit cost and implicit cost. Explicit cost is the given

rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can

mean that the increasing proportion of debt does not affect the financial risk of lenders and they

do not charge higher interest. Implicit cost is increase in Ke attributable to Kd.Thus the advantage of use of debt is completely neutralized by the implicit cos t

resulting in Ke and Kd being the same. Graphically this is represented as: Percentage cost

7


9/23

Q6. The following details have been extracted from the books of Ashraya Ltd Income

Statement (Rs. In millions)

2009 2010

Sales less returns 1200 1000

Gross Profit 300 520

Selling Expenses 100 120

Administration 40 45

Deprecation 60 75

Operating Profit 100 280

Non operating income 20 40

EBIT (Earnings before interest & Tax) 120 320

Interest 15 18

Profit before tax 105 302Tax 30 100

Profit after tax 75 202

Dividend 38 100

Retained earnings 37 102

8


10/23

Solution:

Balance Sheet

Liabilities 2009 2010 Assets 2009 2010

Shareholders fund Fixed assets 400 510

Share capital Less depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investment 50 50

Reserves and surplus 122 224

Secured loans 100 120Current assets, Loans andAdvances

Unsecured loans 50 60 Cash at bank 10 12

Receivables 80 128

Current liabilities Inventories 200 300

Trade creditors 210 250 Loans and Advances 50 80

Provision Miscellaneous expenditure 10 24Tax 10 60

Proposed dividend 38 100

700 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following

assumptions:

Sales for the year 2008 will increase by 30% over the sales value for 2007.

Use percent of sales method to forecast the values for various items of income statementusing the percentage for the year 2007.

Depreciation is charged at 25% of fixed assets. Fixed assets will increase by Rs.100 million

Investments will increase by Rs.100 million

Current assets and current liabilities are to be decided based on their relationship with thesales in the year 2007

Miscellaneous expenditure will increase by Rs.19 million

Secured loans in 2008 will be based on its relationship with the sales in the year2007

Additional funds required, if any, will be met by bank borrowings

Tax rates will be 30 %

Dividends will be 50 % of the profit after tax

Non- operating income will increase by 10%

There will be no change in the total amount of administration expenses to be spent in theyear 2008

There is no change in equity and preference capital in 2008

Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007

9


11/23

ASSIGNMENT -02

NAME : SAHITHI GOWDA S

REGISTRATION NO : 571124176

LEARNING CENTER : SYSTEM DOMAIN

LEARNING CENTER CODE : 03337

COURSE : MBA

SUBJECT : FINANCIAL MANAGEMENT

SEMESTER : 2nd SEM

DATE OF SUBMISSION : 30/03/2012

DIRECTORATE of DISTANCE EDUCATION

SIKKIM MANIPAL UNIVERSITY2

NDFLOOR, SYNDICATE HOUSE

MANIPAL -576104

SIGNATURE OF CO-ORDINATOR SIGNATURE OF CENTER SIGNATURE OF EVALUATOR


12/23

MB0045Financial Management

(Book ID: B1134)

Set- 2

Q1. Examine the importance of capital budgeting.

Answer:

Capital budgeting decisions are the most important decisions in corporate financial management.

These decisions make or mar a business organization. These decisions commit a firm to invest

its current funds in the operating assets (i,e long-term assets) with the hope of employing themmost efficiently to generate a series of cash flows in future.

These decisions could be grouped into

1. Replacement decisions: These decisions may be decision to replace the equipments formaintenance of current level of business or decisions aiming at cost reductions.

2. Decisions on expenditure for increasing the present operating level or expansion throughimproved network of distribution.

3. Decisions for products of new goods or rendering of new services.

4. Decisions on penetrating into new geographical area.

5. Decisions to comply with the regulatory structure affecting the operations of the company.

Investments in assets to comply with the conditions imposed by Environmental Protection Actcome under this category.

6. Decisions on investment to build township for providing residential accommodation to

employees working in a manufacturing plant.

There are many reasons that make the Capital budgeting decisions the most crucial for financeManagers

1. These decisions involve large outlay of funds now in anticipation of cash flows in future. For

example, investment in plant and machinery. The economic life of such assets has long

periods. The projections of cash flows anticipated involve forecasts of many financialvariables. The most crucial variable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of its production

facilities based on its own sales forecast. During this period, huge investments in R & D in

packaging industry brought about new packaging medium totally replacing metal as an

1


13/23

important component of packing boxes. At the end of the expansion Metal Box Ltd found

itself that the market for its metal boxes had declined drastically. The end result is thatMetal Box became a sick company from the position it enjoyed earlier prior to the

execution of expansion as a blue chip. Employees lost their jobs. It affected the standard

of lining and cash flow position of its employees.

This highlights the element of risk involved in these type of decisions.

b. Equally we have empirical evidence of companies which took decisions on expansion

through the addition of new products and adoption of the latest technology creating wealthfor shareholders. The best example is the Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capital expenditure cansignificantly affect the firm. An upward bias may lead to a situation of the firm creating idle

capacity, laying the path for the cancer of sickness.

d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its

competitors. Both are risky fraught with grave consequences.

2. A long term investment of funds sometimes may change the risk profile of the firm. A FMCGcompany with its core competencies in the business decided to enter into a new business of

power generation. This decision will totally alter the risk profile of the business of the

company. Investors perception of risk of the new business to be taken up by the companywill change his required rate of return to invest in the company. In this connection it is to be

noted that the power pricing is a politically sensitive area affecting the profitability of the

organization. Therefore, Capital budgeting decisions change the risk dimensions of the

company and hence the required rate of return that the investors want.

3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements during

the phase of execution must be synchronized with the flow of funds. Failure to achieve the

required coordination between the inflow and outflow may cause time over run and cost overrun. These two problems of time over run and cost overrun have to be prevented from

occurring in the beginning of execution of the project. Quite a lot empirical examples are

there in public sector in India in support of this argument that cost overrun and time over run

can make a companys operations unproductive. But the major challenge that the

management of a firm faces in managing the uncertain future cash inflows and out flows

associated with the plan and execution of Capital budgeting decisions.

4. Capital budgeting decisions involve assessment of market for companys products and

services, deciding on the scale of operations, selection of relevant technology and finally

procurement of costly equipment. If a firm were to realize after committing itself considerablesums of money in the process of implementing the Capital budgeting decisions taken that the

decision to diversify or expand would become a wealth destroyer to the company, then the

firm would have experienced a situation of inability to sell the equipments bought. Lossincurred by the firm on account of this would be heavy if the firm were to scrap the

2


14/23

equipments bought specifically for implementing the decision taken. Sometimes these

equipments will be specialized costly equipments. Therefore, Capital budgeting decisions areirreversible.

5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs

Capital expenditure to build up capacity in anticipation of the expected boom in the demandfor its products. The timing of the Capital expenditure decision must match with the expected

boom in demand for companys products. If it plans in advance it may effectively manage the

timing and the quality of asset acquisition. But many firms suffer from its inability to forecastthe future operations and formulate strategic decision to acquire the required assets in

advance at the competitive rates.

6. All Capital budgeting decisions have three strategic elements. These three elements are

cost, quality and timing. Decisions must be taken at the right time which would enable the

firm to procure the assets at the least cost for producing the products of required quality for

customer. Any lapse on the part of the firm in understanding the effect of these elements on

implementation of Capital expenditure decision taken will strategically affect the firmsprofitability.

7. Liberalization and globalization gave birth to economic institutions like World Trade

organization. General Electrical can expand its market into India snatching the share already

enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell itsproducts in India at a rate less than the rate at which Indian Companies sell cannot be

ignored. Therefore, the growth and survival of any firm in todays business environment

demands a firm to be proactive. Proactive firms cannot avoid the risk of taking challenging

Capital budgeting decisions for growth. Therefore, Capital budgeting decisions for growth havebecome an essential characteristics of successful firms today.

8. The social, political, economic and technological forces generate high level of uncertainty in

future cash flows streams associated with Capital budgeting decisions. These factors makethese decisions highly complex.

9. Capital expenditure decisions are very expensive. To implement these decisions firms willhave to tap the Capital market for funds. The composition of debt and equity must be optimal

keeping in view the expectation of investors and risk profile of the selected project.

Q2. Considering the following information, what is the price of the share as per Gordons

Model?

Net sales Rs. 120 lakhs

Net profit margin 12.5%

Outstanding preference shares Rs. 50 lakhs @ 12% dividend

No. of equity shares 250000

3


15/23

Cost of equity shares 12%

Retention ratio 40%

ROI 16%

Solution:

P= E (1-b)/Ke-br

Where P is the price of the share,

E is Earnings Per Share,

b is Retention ratio,(1b) is dividend payout ratio,

Ke is cost of equity capital,

br is growth rate in the rate of return on investment.

P= E (1-b)/Ke-br

P= 3.6(1-0.40)/0.12-(0.4x0.16)

P= 3.6(0.6)/0.12-0.064

P= 2.16/0.056

P= 38.57

Q3. Internal capital rationing is uses by firms for exercising financial control How does a

firm achieve this?

Answer:

Firms may have to make a choice from among profitable investment opportunities, because ofthe limited financial resources. Capital rationing refers to a situation in which the firm is under a

constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a

situation may be due to external factors or due to the need to impose internal constraints, keeping

in view of the need to exercise better financial control.

Internal capital rationing

Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal

capital rationing.

This decision may be the result of a conservative policy pursued by a firm. Restriction may be

4


16/23

imposed on divisional heads on the total amount that they can commit on new projects.

Another internal restriction for capital budgeting decision may be imposed by a firm based on

the need to generate a minimum rate of return. Under this criterion only projects capable of

generating the managements expectation on the rate of return will be cleared.

Generally internal capital rationing is used by a firm as a means of financial control.

The various factors relating to the internal constraints imposed by the management are (see

figure 10.2)Private owned company, Divisional constraints, Human resource limitations,

Dilution and Debt constraints.

Figure 10.2: Internal constraints

Private owned companyUnder internal constraint, the management of the firms might decide that expansion of the

company might be a problem and not worth taking. This kind of condition arises only when the

management of a firm fears losing the control in the company.

Divisional constraints

Another constraint might lead to the allocation of fixed amount for each division in a firm by theupper management. This procedure can also be considered as an overall corporate strategy.

These situations arise mainly from the point of view of a department. The cost of capital or the

cost structure of the management, the budget constraints imposed by the senior officials or

decisions coming from the head-office and wholly owned subsidiary decisions relate to theinternal constraints.

Human Resource limitationsThe management of the firm or the company should see that excessive labour is being used for

the project. Lack of proper man-power can become an internal constraint.

5


17/23

Dilution

Dilution refers to the dilution of the company. This constraint occurs mainly when a reluctancein the issuing of further equity takes place, due to the fear of management losing the control over

the company.

Debt constraintsDebt constraints also constitute to the internal constraints in capital rationing. This constraint

occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to

a certain level.

These are the methods by which various factors are effecting the capital rationing of a particular

firm or a management. Let us now look at the different types of capital rationing in the followingtopic.

Q4. A company has two mutually exclusive projects under consideration viz project A &

project B

Each project requires an initial cash outlay of Rs. 3, 00,000 and has an effective life of 10

years. The companys cost of capital is 12%. The following fore cast of cash flows are made

by the management.

Economic Project A Project B

Environment Annual cash inflows Annual cash inflows

Pessimistic 65, 000 25, 000

Expected 75, 000 75, 000

Optimistic 90, 000 1, 00, 000

What is the NPV of the project?

Which project should the management consider?

Given PVIFA = 5.650 Unit 9 worked example

Solution:

6


18/23

NPV of project A

Economic Project PVIFA PV of cash flow NPV

Environment Cash inflowAt 12% for 10

years

Pessimistic 65000 5.65 367250 67250Expected 75000 5.65 423750 123750

Optimistic 90000 5.65 508500 208500

NPV of project B

Economic Project PVIFA PV of cash flow NPV

Environment Cash inflowAt 12% for 10

years

Pessimistic 25000 5.65 141250 -158750

Expected 75000 5.65 423750 123750

Optimistic 100000 5.65 565000 265000

PROJECT A PROJECT B

NPVACCEPT /

REJECTNPV

ACCEPT /

REJECT

Pessimistic

(+)

Rs.67,250ACCEPT

(-)

Rs.158750REJECT

Expected(+)

Rs.1,23,750ACCEPT (A)

OR (B)

(+)

Rs.1,23,750

ACCEPT (A)

OR (B)

Optimistic(+)

Rs.2,08,500REJECT

(+)

Rs.2,65,000

ACCEPT

(HIGHER

NPV)

Project B is risky compared to Project A because the NPV range is large.

Difference between Optimistic and Pessimistic NPV

Project A = 1, 14,250

Project B = 4, 23,750

7


19/23

Q5. Explain various types of bonds.

Answer:

Types of Bonds

Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b) Redeemable

Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon Bonds.

(a)Irredeemable Bonds or Perpetual Bonds

Bonds which will never mature are known as irredeemable or perpetual bonds. Indian

Companies Acts restricts the issue of such bonds and therefore these are very rarely issued by

corporates these days. In case of these bonds the terminal value or maturity value does not exist

because they are not redeemable. The face value is known the interest received on such bonds isconstant and received at regular intervals and hence the interest receipts resemble a perpetuity.

The present value (the intrinsic value) is calculated as:

V0=I/idIf a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 par value, and the current

yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875

(b)Redeemable Bonds:

There are two types viz., bonds with annual interest payments and bonds with semiannual

interest payments.

Bonds with annual interest payments

Basic Bond Valuation Model:The holder of a bond receives a fixed annual interest for a specified number of years and a fixed

principal repayment at the time of maturity. The intrinsic value or the present value of bond can

be expressed as:

V0 or P0=n t=1 I/ (I+kd) n +F/ (I+kd) nWhich can also be stated as follows

V0=I*PVIFA (kd, n) + F*PVIF (kd, n)

Where V0= Intrinsic value of the bond

P0= Present Value of the bond

I= Annual Interest payable on the bond

F= Principal amount (par value) repayable at the maturity timen= Maturity period of the bond

Kd= Required rate of return

Example: A bond whose face value is Rs. 100 has a coupon rate of 12% and a maturity of 5

years. The required rate of interest is 10%. What is the value of the bond?

8


20/23

Solution:

Interest payable=100*12%=Rs. 12Principal repayment is Rs. 100

Required rate of return is 10%


Value of the bond=12*PVIFA (10%, 5y) + 100*PVIF (10%, 5y)

= 12*3.791 + 100*0.621= 45.49+62.1

= Rs. 107.59

Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years

coupled with a nominal interest rate of 8%. The required rate of return is 10%. What is the price

he should be willing to pay now to purchase the bond?

Solution:Interest payable=1000*8%=Rs. 80

Principal repayment is Rs. 1000Required rate of return is 10%


Value of the bond=80*PVIFA (10%, 5y) + 1000*PVIF (10%, 5y)

= 80*3.791 + 1000*0.621

= 303.28 + 621

=Rs. 924.28

This implies that the company is offering the bond at Rs. 1000 but is worth Rs. 924.28 at therequired rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for

the bond today.

Bond Values with Semi-Annual Interest payment:

In reality, it is quite common to pay interest on bonds semiannually. With the effect ofcompounding, the value of bonds with semiannual interest is much more than the ones with

annual interest payments. Hence, the bond valuation equation can be modified as:

V0 or P0= n t=1 I/2/ (I+id/2) n +F/ (I+id/2) 2n

Where V0=Intrinsic value of the bond

P0=Present Value of the bondI/2=Semiannual

9


21/23

Interest payable on the bond

F=Principal amount (par value) repayable at the maturity time2n=Maturity period of the bond expressed in half-yearly periods

Kd/2=required rate of return semi-annually.

Example: A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period of 6 years.Interest is payable semiannually. If the required rate of return is 12%, calculate the value of the

bond.

Solution:

V0 or P0= n t=1 (I/2)/ (I+kd/2) n +F/ (I+kd/2) 2n

= (100/2)/ (1+0.12/2) 6 + 1000/ (1+0.12/2) 6=50*PVIFA (6%, 12y) + 1000*PVIF (6%, 12y)

=50*8.384 + 1000*0.497

=419.2 + 497

=Rs. 916.20

It is to be kept in mind that the required rate of return is halved (12%/2) and the period doubled

(6y*2) as the interest is paid semiannually.

(c)Zero Coupon Bonds:

In India Zero coupon bonds are alternatively known as Deep Discount Bonds. For close to a

decade, these bonds became very popular in India because of issuance of such bonds at regular

intervals by IDBI and ICICI. Zero-coupon bonds have no coupon rate, i.e. there is no interest tobe paid out. Instead, these bonds are issued at a discount to their face value, and the face value is

the amount payable to the holder of the instrument on maturity. The difference between the

discounted issue price and face value is effective interest earned by the investor. They are called

deep discount bonds because these bonds are long term bonds whose maturity some time extendsup to 25 to 30 years.

Example:River Valley Authority issued Deep Discount Bond of the face value of Rs.1, 00,000 payable 25

years later, at an issue price of Rs.14, 600. What is the effective interest rate earned by an

investor from this bond?

Solution:The bond in question is a zero coupon or deep discount bond. It does not carry any coupon rate.

Therefore, the implied interest rate could be computed as follows:Step 1. Principal invested today is Rs.14600 at a rate of interest of r% over 25 years to amounttoRs.1, 00,000.

Step 2. It can be stated as A = P0 (1+r) n

10


22/23

1, 00,000 = 14,600 (1+r) 25

Solving for r, we get 1, 00,000/14600 = (1+r) 25

6.849 = (1+r) 25

Reading the compound value (FVIF) table, horizontally along the 25 year line, we find r equals8%. Therefore, bond gives an effective return of 8% per annum.

Q6. 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%.

Solution:

Walter Mode Formula

P=D/Ke + [r (E-D)/Ke]/Ke

P is the market price per share, D is the dividend per Share, Ke is the cost of capital

g is the growth rate of earnings, E is earning of share = 40, r is IRR = 18 %Dp ratio = 40 %, 50%, 60%

P=D/Ke + [r (E-D)/Ke]/Ke

40% =0.4/Ke + [0.18(40-0.4)/0.12]/0.12

=0.4 + [0.18(40-0.4)/0.12]/0.12

P =Rs.498.33

50%=0.5/0.12 + [0.18(40-0.5)/0.12]/0.12

=0.5 + [0.18(40-0.5)/0.12]/0.12

P =Rs.497.91

11


23/23

60%=0.6/0.12 + [0.18(40-0.6)/0.12]/0.12

=0.6 + [0.18(40-0.6)/0.12]/0.12

P =Rs.497.91

12

Documents

87167133 Financial Management 2nd Sem