Set-2 Finan Thag

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SET 2 MB0029 Page 1

DINA BUSINESS SCHOOL

DINA INSTITUTE OF HOTEL AND BUSINESS MANAGEMENT

PUNE 411 028

CENTRE CODE 02758

ASSIGNMENT SET 1 / SET 2

NAME : TAHA MOHAMMED DHILAWALA

ROLL.NO. : 520850852

PAPER / SUBJECT : Financial Management

CODE : MB0029

SEMESTER : I / II / III / IV

SIKKIM MANIPAL UNIVERSITY


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1. Compare and contrast NPV with IRR .

ANS. Net present value methodThe cash inflow in different years are discounted (reduced) to their

present value by applying the appropriate discount factor or rate and the

gross or total present value of cash flows of different years are ascertained.The total present value of cash inflows are compared with present value ofcash outflows (cost of project) and the net present value or the excess

present value of the project and the difference between total present value of

cash inflow and present value of cash outflow is ascertained and on this

basis, the various investments proposals are ranked.Cash inflow = earnings / profits of an investment after taxes but

before depreciationThe present value of cash outflows = initial cost of investment and the

comment of project at various points of time ^

Decision rule

After ranking various investments proposals on basis on net present value,

projects with negative net present value (net present value of cash inflowsless than their original costs) are rejected and projects with positive NPV are

considered acceptable. In case of mutually exclusive alternative projects,projects with higher net present value are selected. Net present value method

is suitable for evaluating projects where cash flows are uneven.

Merits

1. The most significant advantage is that it explicitly recognizes the

time value of money, e.g., total cash flows pertaining to two machines are

equal but the net present value are different because of differences of patternof cash streams. The need for recognizing the total value of money is thus

satisfied.2. It also fulfills the second attribute of a sound method of appraisal.

In that it considers the total benefits arising out of proposal over its life time.

3. It is particularly useful for selection of mutually exclusive projects.4. This method of asset selection is instrumental for achieving the

objective of financial management, which is the maximization of the

shareholder's wealth. In brief the present value method is a theoreticallycorrect technique in the selection of investment proposals.


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Demerits

1. It is difficult to calculate as well as to understand and use, incomparison with payback method or average return method.

2. The second and more serious problem associated with present value

method is that it involves calculations of the required rate of return todiscount the cash flows. The discount rate is the most important element

used in the calculation of the present value because different discount rateswill give different present values. The relative desirability of a proposal will

change with the change of discount rate. The importance of the discount rateis thus obvious. But the calculation of required rate of return pursuits serious

problem. The cost of capital is generally the basis of the firm's discount rate.The calculation of cost of capital is very complicated. In fact there is a

difference of opinion even regarding the exact method of calculating it.

3. Another shortcoming is that it is an absolute measure. This methodwill accept the project which has higher present value. But it is likely that

this project may also involve a larger initial outlay. Thus, in case of projectsinvolving different outlays, the present value may not give dependable

results.

4. The present value method may also give satisfactory results in caseof two projects having different effective lives. The project with a shorter

economic life is preferable, other things being equal. It may be that, a projectwhich has a higher present value may also have a larger economic life, so

that the funds will remain invested for longer period while the alternative

proposal may have shorter life but smaller present value. In such situationsthe present value method may not reflect the true worth of alternative

proposals. This method is suitable for evaluating projects whose capitaloutlays or costs differ significantly.

Internal rate of return method

The technique is also known as yield on investment, marginal efficiency

value of capital, marginal productivity of capital, rate of return, time

adjusted rate of return and so on. Like net present value, internal rate ofreturn method also considers the time value of money for discounting the

cash streams. The basis of the discount factor however, is difficult in both


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cases. In the net present value method, the discount rate is the required rateof return and being a predetermined rate, usually cost of capital and its

determinants are external to the proposal under consideration. The internalrate of return on the other hand is based on facts which are internal to the

proposal. In other words, while arriving at the required rate of return forfinding out the present value of cash flows, inflows and outflows are not

considered. But the IRR depends entirely on the initial outlay and cashproceeds of project which is being evaluated for acceptance or rejection. It is

therefore appropriately referred to as internal rate of return. The IRR isusually, the rate of return that a project earns. It is defined as the discount

rate which equates the aggregate present value of net cash inflows (CFAT)with the aggregate present value of cash outflows of a project. In other

words it is that rate which gives the net present value zero. IRR is the rate atwhich the total of discounted cash inflows equals the total of discounted

cash outflows (the initial cost of investment). It is used where the cost ofinvestment and its annual cash inflows are known but the rate of return or

discounted rate is not known and is required to be calculated.

Accept / Reject decision

The use of IRR as a criterion to accept capital investment decision

involves a comparison of actual IRR with required rate of return, also knownas cut off rate or hurdle rate. The project should qualify to be accepted if the

internal rate of return exceeds the cut off rate. If the internal rate of return

and the required rate of return be equal, the firm is indifferent as to accept orreject the project. In case of mutually exclusive or alternative projects, the

project which has the highest IRR will be selected provided its IRR is morethan the cut off rate. In case there are budget constraints, the projects are

ranked in descending order of their IRR and are selected subject toprovisions.

Evaluation of IRR

1. Is a theoretically correct technique to evaluate capital expenditure

decision. It possesses the advantages which are offered by the NPV criterionsuch as, it considers the time value of money and takes into account the total

cash inflows and outflows.

2. In addition, the IRR is easier to understand. Business executivesand non-technical people understand the concept of IRR much more readily

than they understand the concept of NPV. For instance, Business X will


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understand the investment proposal in a better way if it is said that the totalIRR of Machine B is 21% and cost of capital is 10% instead of saying that

NPV of Machine B is Rs. 15,396.

3. It itself provides a rate of return which is indicative of profitability

of proposal. The cost of capital enters the calculation later on.

4. It is consistent with overall objective of maximizing shareholderswealth. According to IRR, the acceptance / rejection of a project is based on

a comparison of IRR with required rate of return. The required rate of returnis the minimum rate which investors expect on their investment. In other

words, if the actual IRR of an investment proposal is equal to the rateexpected by the investors, the share prices will remain unchanged. Since,

with IRR, only such projects are accepted which have IRR of the requiredrate, therefore, the share prices will tend to rise. This will naturally lead of

maximization of shareholders wealth.

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicatedcomputation problems.

2. It produces multiple rates which can be confusing. This situationarises in the case of non-conventional projects.

3. In evaluating mutually exclusive proposals, the project with highest

IRR would be picked up in exclusion of all others. However in practice itmay not turn out to be the most profitable and consistent with the objective

of the firm i.e., maximization of shareholders wealth.

4. Under IRR, it is assumed that all intermediate cash flows arereinvested at the IRR. It is rather ridiculous to think that the same firm has

the ability to reinvest the cash flows at different rates. The reinvestment rateassumption under the IRR is therefore very unrealistic. Moreover it is not

safe to assume always that intermediate cash flows from the project may be

reinvested at all. A portion of cash inflows may be paid out as dividends, a

portion may be tied up with current assets such as stock, cash, etc. Clearly,the firm will get a wrong picture of the project if it assumes that it invests

the entire intermediate cash proceeds.


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Further it is not safe to assume that they will be reinvested at the same

rate of return as the company is currently earning on its capital (IRR) or atthe current cost of capital (k).

NPV versus IRR

NPV indicates the excess of the total present value of future returns over the

present value of investments. IRR (or DFC rate) indicates on the other handthe rate at which the cash flows (at present values) are generated in the

business by a particular project.Both NPV and IRR iron out the difference due to interest factor or say

higher returns in earlier years and higher returns in later years (though thetotal returns in absolute terms may be around the same for several projects).

Between the two, IRR or DFC rate is the more sophisticated method -a popular as well, since:

(a) IRR method - mostly subjective decision regarding discounting rate.

(b) Whilst under NPV the main basis of comparison is betweendifferent NPV's of different projects, under IRR or DFC rate approach a

number of basis is available. For example -DFC rate Vs Discount rate of return (on normal operations) ^

DFC rate Vs Cut off rate of the company

DFC rate Vs Borrowing rate (on cost of capital)

DFC rates between different projects

(c) The results under DFC rate approach are simpler for themanagement to understand and appreciate. We should however be very

careful in applying the decision rules properly when NPV and IRR

calculation shows divergent results. The rules are -(i) the projects be the basis of decision when mutually exclusive in

character;(ii) there is capital rationing situation

(d) IRR should be a better guide when there are plenty of project

situations (as it is there in a long enterprise) and no major constraints (for

example, in respect of macro projects).


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2. Zodiac Ltd is considering purchase of investment worth Rs. 40

lakhs.

The estimated life and the new cash flow fir 3 years are as

under. Machines

A B C

Estimated life 3 Years 3 Years 3years

Cash inflows(in lakhs)

1 Year 27 06 12

2 Year 18 21 80

3 Year 55 33 30

Which machine should be selected on the basis of payback period?

Calculate discounted payback period if the cost of capital is 12%

ANS:-A) Payback period

Project A Project B Project C

year Cash

flows

Cumulative

cash flows

Cash

flows

Cumulative

cash flows

Cash

flows

Cumulative

cash flows

1 27 27 06 6 12 12

2 18 45 21 27 80 92

3 55 100 33 60 30 122

Machine A. Rs.27 lakhs will be recovered in 1st

year & the balance 13 lakhs(40 27) will be recovered in 2nd year of 18 lakhs

Payback period = 1year +(13/18*12month) or =1year +13/18

1year 8.6 month = 1year + 0.72

1.72yearmachine B. Rs.06 lakhs will be recovered in 1st year & the balance 34 lakhs

(40 6) will be recovered in 2nd year of 21 lakhs payback period = 1year +(35/21*12month) or =1year + 35/21

= 1year 20 month = 1year +1.66

2.66yearmachine c. Rs.12 lakhs will be recovered in 1st year & the balance 28 lakhs

(40 12) will be recovered in 2nd year of 80 lakhs

payback period = 1year + (28/80*12month) or =1year + 28/80

= 1year + 4.2 month = 1year + 0.35

= 1.35year


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B)Discount payback period

Machine A machine B achine C

year p/v factor@12%

c.v p.v c.f p.v c.v p.v

1 0.8928 27 21.1056 06 5.3568 12 10.7132 0.7972 18 14.349 21 16.74 80 63.78

3 0.7118 15 39.149 33 23.489 30 21.35

Project A Project B Project

CYear Cash

flows

Cumulative

cash flows

Cash

flows

Cumulative

cash flows

Cash

flows

Cumulative

cash flows1 21.1056 21.1056 5.3568 5.3568 10.7136 10.7136

2 14.349 35.4546 16.74 22.0968 63.78 74.4936

3 39.149 74.6036 23.489 45.5858 21.35 95.8436

machine A. Rs. 35.4546 will be recovered in 2nd year & balance 4.5454(40-35.4546) will be recovered in 3rd year out of 39.149

=2year + (4.5454/39.149)=2year + 0.1161

=2.11year

machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(40-22.0968) will be recovered in 3rd year out of 23.489

=2year + (17.9032/23.489)=2year +0.7621

=2.76year

machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936

(40- 74.4936) will be recovered in 3rd year out of 95.8436

=2year + (-34.4936/95.8436)=2year + -0.3598

= 1.64year


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3A.The cash flow stream of Nanotech Ltd, is as follows:

Year 0 1 2 3 4 5 6

Cash flows

In million

120 100 40 60 80 100 130

The cost of capital is 13% find MIRR.

ANS. Present value of cost = 120 * 100/1.13

= 194.69Terminal value of cash flow

4 3 2

= 40(1.13) + 60(1.13) +80(1.13)+100(1.13)+130

= 40*1.6305 + 60*1.4429 + 80*1.2769 + 113 + 130

=496.95

MIRR is obtain on solving the following equation.6

194.69 = 496.95/(1+mirr)

6(1+mirr) = 496.95/194.69

6

(1+mirr) = 2.5525


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3. Elaborate different sources of risk in a project

ANS. Risk in the project are many. It is possible to identify threeseparate and distinct type of risk in any project.

1. Stand alone risk : it is measured by the variability of expectedreturns of the project

2. portfolio risk : a firm can be viewed as portfolio of projects having acertain degree of risk. When new project is added to the existing

portfolio of project, the risk profile of the firm will alter. The degree

of the change in the risk depends on the existing portfolio of the

projects. If the return from the new project is negatively correlated

with the return from portfolio, the risk of the firm will be furtherdiversified away.3. market or beta risk: it is measured by the effect of the project on the

beta of the firm. The market risk for a project is difficult to estimate.Stand alone risk of a project when the project is considered in

isolation. Corporate risk is the projects risks of the firm. Market risk issystematic risk. The market risk is the most important risk because of

the direct influence it has on stock prices.Source of risk: the source of risk are

1. project specific risk

2. competitive or competition risk3. industry - specific risk

4. international risk5. market risk

1. project specific risk: the source of this risk could be traced tosomething quite specific to the project. Managerial deficiencies or

error in estimation of cash flow or discount rate may lead to asituation of actual cash flow relised being less than that projected.

2. competitive risk or competition risk: unanticipated of a firms

competitors will materially affect the cash flows expected from aproject. Because of this the actual cash flow from a project will be lessthan that of the forecast.

3. industry- specific : industry specific risks are those that affect all thefirms in the industry. It could be again grouped in to technological

risk, commodity risk and legal risk. All these risks will affect theearnings and cash flows of the project. The changes in technology


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affect all the firms not capable of adapting themselves to emergingnew technology. The best example is the case of firm manufacturing

motors cycles with two stroke engines. When technologicalinnovation replaced the two stroke engines by the four stroke engines

those firms which could not adapt to new technology had to shutdown their operations. Commodity risk is the arising from the affect

of price changes on goods produced and marketed. Legal risk arisefrom changes in laws and regulations application to the industry to

which the firm belongs. The best example is the imposition of servicetax on apartments by the government of India when the total number

of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in import export policy of the

government of India have led to the closure of some firms or sicknessof some firms.

4. international risk : these types of risk are faced by firms whosebusiness consists mainly of exports or those who procure their main

raw material from international markets. For example, rupee dollar

crisis affected the software and BPOs because it drastically reduce

their profitability. Another best example is that of the textile units inTirupur in Tamilnadu, exporting their major part of the garments

produces. Rupee gaining and dollar weakening reduced theircompetitiveness in the global markets. The surging crude oil price

coupled with the


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4. The expected cash flow of Tejaswini Ltd, are an follow.

Year Cash flow

0 50000

1 90002 8000

3 7000

4 12000

5 21000

The certainty equivalent factor balance as per the following

equation t =1-05.05t calculate the NPV of the project if the risk

free rate of return is 9%.

ANS:-

Year Cash flows (inflows) Rs. PV Factor at 9% PV of Cash flows (in flows)

1 9,000 0.9174 8,257

2 8,000 0.8417 6,734

3 7,000 0.7722 4,959

4 12,000 0.7084 8,501

5 21,000 0.6499 13,649

PV of Cash in flows 42,100PV of Cash outflows 50,000

NPV Negative (7,


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5. From the following information prepare cash budgets for VSI Co. Ltd.:PARTICULARS JAN FEB MARCH APRIL

Opening cash balance 20,000 25,000 25,000 25,000

Collection from

customer

1,30,000 1,60,000 1,65,000 2,30,000

1,50,000 1,85,000 1,90,000 2,55,000

Payments:

Raw materials purchase 25,000 45,000 40,000 63,200

Salary and Wages 1,00,000 1,05,000 1,00,000 1,14,200

Other expenses 15,000 10,000 15,000 12,000

Income Tax 6,000 --- --- ---

Machinery --- --- 20,000 ---

The firm wants to maintain a minimum cash balance of Rs.25000 for each

month. Creditors are allowed one-month credit. There is no lag in payment

of salary, other expenses.

ANS:-PARTICULARS JAN FEB MARCH APRIL

Opening cash balance 20,000 25,000 25,000 25,000

Collection from customer 1,30,000 1,60,000 1,65,000 2,30,000

1,50,000 1,85,000 1,90,000 2,55,000

Payments:

Raw materials purchase 25,000 45,000 40,000 63,200

Salary and Wages 1,00,000 1,05,000 1,00,000 1,14,200

Other expenses 15,000 10,000 15,000 12,000Income Tax 6,000 --- --- ---

Machinery --- --- 20,000 ---

1,46,000 1,60,000 1,75,000 1,89,400

Closing balance 4,000 5,000 15,000 65,600

For JAN:

Bank over Draft 21,000 for maintain minimum cash balance for month of

February 21000+4000=25000.

For FEB:

No need to take bank over Draft because closing balance 25,000.

For MARCH:

Bank over Draft 10,000 for maintain minimum cash balance for month ofApril 15,000+10,000=25000.

At last closing balance month of April 65,600 so return to bank 31,000 form monthof april , 65,600 31,000= 34,400


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Case Study

Assume you are an external financial consultant. You have been

approached by a client M/s Technotron Ltd to give a presentation on

Credit Policy adopted by Information technology companies. You are

specifically asked to deal with credit standards, credit period, cash

discounts and collection programme. For the sake of simplicity take any

two information technology companies and analyze the credit policy

followed by them.

ANS:- Credit policy Variables

1. Credit standards.

2. Credit period.3. Credit discount and

4. Collection programme.1. Credit standards : The term credit standards refer to the criteria for

extending credit to customers. The bases for setting credit standardsare.

a. Credit ratingb. References

c. Average payment periodd. Ratio analysis

There is always a benefit to the company with the extension of credit to itscustomers but with the associated risks of delayed payment or non payment,

funds blocked in receivables etc. The firm may have light credit standards. Itmay sell on cash basis and extend credit only to financially strong

customers. Such strict credit standards will bring down bad debt losses andreduce the cost of credit administration. But the firm may not be able to

increase its sales. The profit on lost sales may be more the costs saved by thefirm. The firm should evaluate the trade off between cost and benefit of

any credit standards.

2. Credit period: Credit period refer to the length of time allowed to its

customers by a firm to make payment for the purchase made by

customers of the firm. It is generally expressed in days like 15 daysor 20 days. Generally, firms give cash discount if payment are madewithin the specified period.

If a firm follows a credit period of net 20 it means that it allows to its

customers 20 days of credit with no inducement for early payments.Increasing the credit period will bring in additional sales from existing

customers and new sales from new customers. Reducing the credit period


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will lower sales, decrease investments in receivables and reduce the baddebt loss. Increasing the credit period increases the incidence of bad debt

loss.The effect of increasing the credit period on profits of the firm are similar to

that of relaxing the credit standards.3. Cash discount: Firms offer cash discount to induce their customer to

make prompt payments. Cash discount have implications on salesvolume, average collection period, investment in receivables,

incidence of bad debt and profits. A cash discount of 2/10 net 20means that a cash discount of 2% is offered if the payment is made by

the tenth day; other wise full payment will have to be made by 20 th

day.

4. Collection programme : The success of a collection programmedepends on the collection policy pursued by the firm. The objective of

a collection policy is to achieve. Timely collection of receivable, thereby releasing funds locked in receivables and minimize the incidence

of bad debts. The collection programmes consists of the following.

1. Monitoring the receivables

2. Reminding customers about due date of payment3. On line interaction through electronic media to customers about the

payments due around the due date.4. Initiating legal action to recover the amount from overdue customer as

the last resort the dues from defaulted customers.

Collection policy formulated shall not lead to bad relationship with

customers.

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