Master of Business Administration- MBA Semester 2 MB0045 Financial Management - 4 Credits (Book ID:B1134) Assignment Set- 2 (60 Marks)

Q1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt Answer:WACC = debt/TF(cost of debt) (1-tax) + equity/TF(cost of equity) Market value of Equity Market value of Debt Cost of Equity Cost of Debt Tax rate = 10,00,000 = 5,00,000 = 18% = 13 % = 40 %

TF means Total Financing WACC WACC = debt/TF(cost of debt) (1-tax) + equity/TF(cost of equity) = 5,00,000/15,00,000(13) (1-40) + 10,00,000/15,00,000(18) = 033 X 13 X 0.60 + 0.66 X 18 = 2.57 + 11.88 WACC= 14.45

1|Page

Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL. Details of ABC Ltd. 20,000 Output Fixed costs units Rs.3,500 Rs.0.05 per

Variable cost unit Interest on borrowed funds Selling price per unit Nil 0.2

Hint calculate DFL =

EBIT EBIT - I - {Dp /(1 T)}}

Answer:-

Quantity sold 200,00 units Variable cost per unit 0.05 V Var cost = cost * Qty 1000 Selling price S 0.2 Seles Revenue = 4000 selling price * Qty Fixed cost F EBIT = Q(S-V)-F 3,500 20000*(4000-1000)-3500 59996500
2|Page

DFL =

EBIT T)}}

EBIT I - {Dp /(1 -

EBIT = Earnings before interest & tax, I is Interest, Dp is dividend on preference shares, T is tax rate.

DFL =

59996500 59996500 - I - {Dp /(1 T)}}

DFL =

59996500 59996500

DFL = 0

Interest, dividend on preference shares and tax rate is not given

3|Page

Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

Answer:-

Net operating income( 20 % on 5000000 Less: Interest on debentures 14% Less: Tac 40% Earning availabe to ESH (NI) Cost of equity (Ke) S =Value of equity shares (NI/Ke) Value of debt (B) Total value of firm (S+B=V) Overall cost of capital (EBIT/V)

X 100000 0 350000

Y 100000 0 0

260000 400000 39000 0 600000 22% 22% 177272 272727 7 2 250000 0 0 42727 272727 27 2 23.40 36.67

4|Page

Q4. Explain the Importance of Capital Budgeting? Answer: Importance of capital budgeting: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or a business organization. These decisions commit a firm to invest its current funds in the operating assets with the hope of employing those most 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 for maintained of current level of business or decision aiming of cost reductions. 2. Decisions on expenditure for increasing the present operating level or expansion through improved 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 effecting the operations of the company. Investment in assets to comply with the conditions imposed by environmental protection act comes under this category. 6. Decisions an investment to build township for providing residential accommodation to employees working in a manufacturing plant. 7. Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in production of goods are rendering of services. 8. Capital budget is a blue print of planned investments in operating assets
5|Page

9. It helps in evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation.

Q5.Briefly explain the process of Capital Rationing? Answer: Capital rationing is the process by which management allocates available investment funds among competing capital investment proposals. Normally, management uses various combinations of the valuation methods in developing an effective approach to capital rationing. In capital rationing, an initial screening of alternative proposals is usually performed by establishing minimum standards for the cash payback and the average rate of return methods. The proposals that survive this initial screening are further analyzed using the net present value and internal rate of return methods. Throughout the capital rationing process, qualitative factors related to each proposal should also be considered. For example the acquisition of new, more efficient equipment that eliminates several jobs could lower employee morale to a level that could decrease over all plant productivity. alternatively, new equipment might improve the quality of the product and thus increase consumer satisfaction and sales. The final step in the capital rationing process is to rank the proposals according to management's criteria, compare the proposals with the funds available, and select the proposals to be funded. The unfunded proposals may be considered if funds later become available. The following flowchart portrays the capital rationing decision process:

6|Page

Q6. Explain the Concept of Working Capital? Answer: Working capital is classified as (i) Gross Working Capital. (ii) Net Working Capital. (iii) Permanent Working Capital (i) Gross Working Capital: Gross Working Capital refers to the amounts invested in the various Components of current assets. This concept has the following practical relevance. a. Management of current assets is the crucial aspect of Working Capital Management. b. It is an important component of operating capital. Therefore, for improving the profitability on tis investment a finance manager of a company must give top priority to efficient management of current assets. c. The need to plan and monitor the utilization of funds of a firm demands working capital Management as applied to current assets. d. It helps in the fixation of various areas of financial responsibility.
7|Page

(ii) Net Working Capital Net Working Capital is the excess of current assets over current liabilities and provisions. Net Working Capital is positive. When current assets exceed current liabilities and negative when Current liabilities exceed current assets. This concept has the following practical relevance. 1. It indicates the ability of the firm to effectively use the spontaneous finance in managing the Firms Working Capital requirements. 2. A firms short term solvency is measured through the net Working Capital position it Commands. (iii) Permanent Working Capital Permanent Working Capital is the minimum amount of investment required to be made in current Assets at all times to carry on the day to day operation of firms business. This minimum level of current asset has been given the name of core current assets by the Tandon Committee. It is also known as fixed Working Capital. Temporary Working Capital It is also known as Variable Working Capital or fluctuating Working Capital. The firms working Capital requirements vary depending upon the seasonal and cyclical changes in demands for a Firms products. The extra Working Capital required as per the changing production and sales levels of a firm is known as Temporary Working Capital.

8|Page