FINANCIAL MGT...... SMU ASSIGNMENT.. SEM --2 ... BY ROHIT MISHRA

1. Master of Business Administration
Semester II
MB0045 – Financial Management
Assignment
Set- 1
Q. Explain the steps involved in Financial Planning?
Ans.
Financial Planning
The 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 usage
of funds in the most appropriate way.
Estimate capital requirements: This is the first step in financial planning. The following factors
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.

2. 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 two statements 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 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 long term basis.
Forecast the availability of funds
A company will have a steady flow of funds. If the manager is able to forecast these
amounts properly, 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.

3. Q. Discuss the relevance and factors that influence the determination of stock level.
Ans.
Safety stock
Safety stock (also called buffer stock) is a term used by logisticians to describe a level of extra
stock that is maintained to mitigate risk of stock outs (shortfall in raw material or packaging) due
to uncertainties in supply and demand. Adequate safety stock levels permit business operations
to proceed according to their plans. Safety stock is held when there is uncertainty in the demand
level or lead time for the product; it serves as an insurance against stock outs.
With a new product, safety stock can be utilized as a strategic tool until the company can judge
how accurate their forecast is after the first few years, especially when used with a material
requirements planning worksheet. The less accurate the forecast, the more safety stock is
required. With a material requirements planning (MRP) worksheet a company can judge how
much they will need to produce to meet their forecasted sales demand without relying on safety
stock. However, a common strategy is to try and reduce the level of safety stock to help keep
inventory costs low once the product demand becomes more predictable. This can be extremely
important for companies with a smaller financial cushion or those trying to run on lean
manufacturing, which is aimed towards eliminating waste throughout the production process.
The amount of safety stock an organization chooses to keep on hand can dramatically affect their
business. Too much safety stock can result in high holding costs of inventory. In addition,
products which are stored for too long a time can spoil, expire, or break during the warehousing
process. Too little safety stock can result in lost sales and, thus, a higher rate of customer
turnover. As a result, finding the right balance between too much and too little safety stock is
essential.
Reasons for safety stock
Safety stocks are mainly used in a "Make To Stock" manufacturing strategy. This strategy is
employed when the lead time of manufacturing is too long to satisfy the customer demand at the
right cost/quality/waiting time.
The main goal of safety stocks is to absorb the variability of the customer demand. Indeed, the
Production Planning is based on a forecast, which is (by definition) different form the real
demand. By absorbing these variations, safety stock improves the customer service level.
By creating a safety stock, you will also prevent stock-outs from other variations :
an upward trend in the demand
a problem in the incoming product flow (machinery breakdown, supplies delayed, strike.

4. Reducing safety stock
Safety stock is used as a buffer to protect organizations from stock outs caused by inaccurate
planning or poor schedule adherence by suppliers. As such, its cost (in both material and
management) is often seen as a drain on financial resources that results in reduction initiatives. In
addition, time sensitive goods such as food, drink, and other perishable items could spoil and go
to waste if held as safety stock for too long. Various methods exist to reduce safety stock, these
include better use of technology, increased collaboration with suppliers, and more accurate
forecasting In a lean supply environment, lead times are reduced, which can help minimize
safety stock levels thus reducing the likelihood and impact of stockouts.[ Due to the cost of
safety stock, many organizations opt for a service level led safety stock calculation; for example,
a 95% service level could result in stockouts, but is at a level that is satisfactory to the company.
The lower the service level, the lower the requirement for safety stock.
An Enterprise Resource Planning system (ERP system) can also help an organization reduce its
level of safety stock. Most ERP systems provide a type of Production Planning module. An ERP
module such as this can help a company develop highly accurate and dynamic sales forecasts and
sales and operations plans. By creating more accurate and dynamic forecasts, a company reduces
their chance of producing insufficient inventory for a given period and, thus, should be able to
reduce the amount of safety stock that they require. In addition, ERP systems use established
formulas to help calculate appropriate levels of safety stock based on the previously developed
production plans. While an ERP system aids an organization in estimating a reasonable amount
of safety stock, the ERP module must be set up to plan requirements effectively.
Inventory policy
The size of the safety stock depends on the type of inventory policy that is in effect. An
inventory node is supplied from a "source" which fulfills orders for the considered product after
a certain replenishment lead time. In a "periodic review" inventory policy the inventory level is
checked periodically (such as once a month) and an order is placed at that time if necessary; in
this case the risk period is equal to the time until the next review plus the replenishment lead
time. On the other hand, if the inventory policy is a "continuous review" policy (such as an Order
point-Order Quantity policy or an Order Point-Order Up To policy) the inventory level is being
check continuously and orders can be placed immediately, so the risk period is just the
replenishment lead time. Therefore "continuous review" inventory policies can make do with a
smaller safety stock.

5. Example calculation
A commonly used approach calculates the safety stock based on the following factors:
Demand rate: the amount of items consumed by customers, on average, per unit time.
Lead time: the delay between the time the reorder point (inventory level which initiates an
order is reached and renewed availability.
Service level: the desired probability that a chosen level of safety stock will not lead to a stock
out. Naturally, when the desired service level is increased, the required safety stock increases as
well.
Forecast error: an estimate of how far actual demand may be from forecasted demand.
Expressed as the standard deviation of demand.

6. Q. There was a replacement of its existing machine by a new machine. The new machine
will 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 company’s cost of capital is 20%
Compute the incremental cash flows of replacement decisions.
Ans.
Calculation of Annual Incremental After Tax Cash Flows
First, realize different texts use different notation:
• After-tax Net (Operating) Cash flows (NCF),
• After-tax Net Operating Cash flows (NOCF),
• After Tax Cash Flows (ATCF) (ACF),
• Incremental After Tax Cash Flows (ΔACF) (Δ ATCF),
But all of the above represent the same concept.
Next, review some basic accounting:
A simplified Income Statement
Revenues (R)
- Operating Expenses (O)
- Depreciation (D)

7. - Interest and Financing Expenses (F)
= Earnings Before Taxes (EBT)
- Taxes ($T)
= Earnings After Taxes (EAT)
But in our cash flow calculation we do not include interest expenses or other financing costs so
we can focus on operating Earnings Before Taxes (OEBT) rather than EBT.
Revenues (R)
- Operating Expenses (O)
- Depreciation (D)
= Operating Earnings Before Taxes (OEBT)
- Taxes ($T)
= Operating Earnings After Taxes (EAT)
And if we add back non-cash charges such as Depreciation, we get;
Revenues (R)
- Operating Expenses (O)
- Depreciation (D)
= Operating Earnings Before Taxes (OEBT)
- Taxes ($TAX)
= Operating Earnings After Taxes (OEAT)
+ Depreciation (D)
= Net Cash Flows (after tax net cash flows) (NCF)
Or, simply,
R
-O
-D

8. = OEBT
- $TAX
= OEAT
+D
= NCF
Now think about this…
= OEBT
- $TAX
= OEAT
So…
OEBT - $TAX = OEAT
We get $TAX by multiplying OEBT by the tax rate (T)
Or…
OEBT - (OEBT*T) = OEAT
Or…
OEBT * (1-T) = OEAT
So we end up with …
R
-O
-D
= OEBT
* (1-T)
= OEAT
+D
= NCF

9. The above represents an easy calculation for
Net (after tax) Cash Flow in any year.
And lay this calculation down on its side to get:
R - O - D = OEBT * (1-T) = OEAT + D = NCF
Note that this version does NOT reflect any changes in working capital investment. The textbook
includes changes in net working capital in this annual calculation.
Other texts include the changes in net working capital in the Net Investment (NINV) calculation
and in the Terminal Cash Flows (or “Salvage Value”) calculation because there is usually an
increase at the start of a project in WC investment and a recapture of WC investment when a
project is shut down. These authors have chosen to include the changes in the annual cash flows.
Now our focus is on Incremental After Tax Cash Flows and the above equation gives us single
year cash flows - they are not incremental.
To calculate Incremental NCF’s we must identify our two possible investment choices. In the
simple case, we either accept the project or we reject the project.
If we reject, nothing changes but we still have a set of possible CF’s generated by current
operations. Let (wo) represent the values without the project.
Rwo
- Owo
- Dwo
= OEBTwo
- $TAXwo
= OEATwo
+ Dwo
= NCFwo
If we accept, there may be changes in any of the components of the operating cash flow
calculation so we have another possible set of CF’s generated by current operations plus the new
project. Let (w) represent the values with the project.

10. Rw
- Ow
- Dw
= OEBTw
- $TAXw
= OEATw
+ Dw
= NCFw
To get the Incremental Net cash Flows, we subtract the calculation without the project from the
calculation with the project…
[ Rw - Rwo ]
- [ Ow - Owo ]
- [ Dw - Dwo ]
= [ OEBTw - OEBTwo ]
- [ $TAXw - $TAXwo ]
= [ OEATw - OEATwo ]
+ [ Dw - Dwo ]
= [ NCFw - NCFwo ]
ΔR
- ΔO
- ΔD
= ΔOEBT
* Δ$TAX
= ΔOEAT
+ ΔD

11. = ΔNCF ]
ΔR
- ΔO
- ΔD
= ΔOEBT
* (1-T)
= ΔOEAT
+ ΔD
= ΔNCF ]
or…
Incremental Revenues
- Incremental Operating Expenses
- Incremental Depreciation
= Incremental Operating Earnings Before Tax
* tax rate (to get incremental after tax operating earnings)
= Incremental Operating Earnings After Tax
+ Incremental Depreciation
= Incremental After Tax Cash Flows
(remember, incremental working capital investment, ΔNWC, is included in the calculation
elsewhere)

12. Q. Explicit cost and implicit cost are the two dimensions of cost. What role does cost play in
financial decisions?
Ans.
Implicit cost
In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must give up in order using factors which it neither
purchases nor hires. It is the opposite of an explicit cost, which is borne directly. In other words,
an implicit cost is any cost that results from using an asset instead of renting, selling, or lending
it. The term also applies to forgone income from choosing not to work.
Implicit costs also represent the divergence between economic profit (total revenues minus total
costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total
revenues minus only explicit costs). Since economic profit includes these extra opportunity costs,
it will always be less than or equal to accounting profit.
Lipsey (1975) uses the example of a firm sitting on an expensive plot worth £10,000 a month in
rent which it bought for a mere £50 a hundred years before. If the firm cannot obtain a profit
after deducting £10,000 a month for this implicit cost, it ought to move premises (or close down
completely) and take the rent instead. In calculating this figure, the firm ought to ignore the
figure of £50, and remember instead to look at the land's current value.
Explicit cost
An explicit cost is a direct payment made to others in the course of running a business, such as
wage, rent and materials, as opposed to implicit costs, which are those where no actual payment
is made. It is possible still to underestimate these costs, however: for example, pension
contributions and other "perks" must be taken into account when considering the cost of labour.
Explicit costs are taken into account along with implicit ones when considering economic profit.
Accounting profit only takes explicit costs into account.

13. What Are Explicit Cost And Implicit Cost?
Explicit cost
An Explicit cost is a business expense accounted cost that can be easily identified such as wage,
rent and materials. Explicit costs gives clear and evident cash outflows from business that
decreases its end result profitability. This cost directly effect the revenue. Intangible expenses
such as goodwill and amortization are not explicit expense because these expenses don't show
clear effects on a business's revenue and expenses.
Implicit cost
An implicit cost results if the person who at first foregoes the satisfaction in the search of an
activity and is not rewarded by money or another form of payment. The implicit cost begins and
ends with foregoing the benefits and satisfaction. When an organization or owner uses its own
equity for company's well-air then that cost is considered as implicit cost. Goodwill is a good
example of implicit cost.
Explicit Cost vs. Implicit Cost
Explicit cost can be counted in terms of money whereas implicit cost cannot be traded and
therefore cannot be counted in terms of money.
Explicit cost is a direct tangible cost whereas implicit cost is indirect intangible cost. Anonymous

14. ASSIGNMENT
Set 2
Q. Examine the importance of capital budgeting?
Ans.
Capital budgeting (or investment appraisal) is the planning process used to determine whether
an organization's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth pursuing. It is budget for
major capital, or investment, expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
Accounting rate of return
Net present value
Profitability index
Internal rate of return
Modified internal rate of return
Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.
Net present value
Each potential project's value should be estimated using a discounted cash flow (DCF) valuation,
to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see
also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating
the size and timing of all the incremental cash flows from the project. (These future cash highest
NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate -
sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the
Minimum acceptable rate of return on an investment. This should reflect the riskiness of the
investment, typically measured by the volatility of cash flows, and must take into account the
financing mix. Managers may use models such as the CAPM or the APT to estimate a discount
rate appropriate for each particular project, and use the weighted average cost of capital (WACC)
to reflect the financing mix selected. A common practice in choosing a discount rate for a project
is to apply a WACC that applies to the entire firm, but a higher discount rate may be more
appropriate when a project's risk is higher than the risk of the firm as a whole.

15. Internal rate of return
The internal rate of return (IRR) is defined as the discount rate that gives a net present value
(NPV) of zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for (non-mutually
exclusive) projects in an unconstrained environment, in the usual cases where a negative cash
flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases,
all independent projects that have an IRR higher than the hurdle rate should be accepted.
Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the
highest IRR - which is often used - may select a project with a lower NPV.
In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR
exists and is unique if one or more years of net investment (negative cash flow) are followed by
years of net revenues. But if the signs of the cash flows change more than once, there may be
several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual
annual profitability of an investment. However, this is not the case because intermediate cash
flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is
almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of
Return (MIRR) is often used.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over
NPV although they should be used in concert. In a budget-constrained environment, efficiency
measures should be used to maximize the overall NPV of the firm. Some managers find it
intuitively more appealing to evaluate investments in terms of percentage rates of return than
dollars of NPV.
Equivalent annuity method
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by
the present value of the annuity factor. It is often used when assessing only the costs of specific
projects that have the same cash inflows. In this form it is known as the equivalent annual cost
(EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.
It is often used when comparing investment projects of unequal life spans. For example if project
A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would
be improper to simply compare the net present values (NPVs) of the two projects, unless the
projects could not be repeated.
The use of the EAC method implies that the project will be replaced by an identical project.

16. Alternatively the chain method can be used with the NPV method under the assumption that the
projects will be replaced with the same cash flows each time. To compare projects of unequal
length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3
year project are compare to three repetitions of the 4 year project. The chain method and the
EAC method give mathematically equivalent answers.
The assumption of the same cash flows for each link in the chain is essentially an assumption of
zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the
calculations.
Real options
Real options analysis has become important since the 1970s as option pricing models have gotten
more sophisticated. The discounted cash flow methods essentially value projects as if they were
risky bonds, with the promised cash flows known. But managers will have many choices of how
to increase future cash inflows, or to decrease future cash outflows. In other words, managers get
to manage the projects - not simply accept or reject them. Real options analysis try to value the
choices - the option value - that the managers will have in the future and adds these values to the
NPV.
Ranked Projects
The real value of capital budgeting is to rank projects. Most organizations have many projects
that could potentially be financially rewarding. Once it has been determined that a particular
project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest
Profitability index to lowest Profitability index). The highest ranking projects should be
implemented until the budgeted capital has been expended.
Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are
generally available to publicly traded corporations: corporate bonds, preferred stock, and
common stock. The ideal mix of those funding sources is determined by the financial managers
of the firm and is related to the amount of financial risk that corporation is willing to undertake.
Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest
rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to
the preferred stockholders before any cash disbursements can be made to common stockholders;
they generally have interest rates higher than those of corporate bonds. Finally, common stocks
entail no financial risk but are the most expensive way to finance capital projects. The Internal
Rate of Return is very important.

17. IMPORTANCE OF CAPITAL BUDGETING
1. Long-term Implications: A capital budgeting decision has its effect over a long time span
and inevitably affects the company’s future cost structure and growth. A wrong decision can
prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset
would influence the competitive position of the firm. So the capital budgeting decisions
determine the future destiny of the company.
2. Involvement of large amount of funds: Capital budgeting decisions need substantial amount
of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an
incorrect decision would not only result in losses but also prevent the firm from earning profit
from other investments which could not be undertaken.
3. Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible
because it is difficult to find a market for such assets. The only way out will be scrap the capital
assets so acquired and incur heavy losses.
4. Risk and uncertainty: Capital budgeting decision is surrounded by great number of
uncertainties. Investment is present and investment is future. The future is uncertain and full of
risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about
cost, revenues and profits may not come true.
5. Difficult to make: Capital budgeting decision making is a difficult and complicated exercise
for the management. These decisions require an overall assessment of future events which are
uncertain. It is really a marathon job to estimate the future benefits and cost correctly in
quantitative terms subject to the uncertainties caused by economic-political social and
technological factors.
Kinds of capital budgeting decisions:
Generally the business firms are confronted with three types of capital budgeting decisions.
(i) The accept-reject decisions;
(ii) Mutually exclusive decisions;
(iii) Capital rationing decisions.
1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. If
the proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those
investment proposals which yield a rate of return greater than cost of capital are accepted and the
others are rejected. Under this criterion, all the independent proposals are accepted.

18. 2. Mutually exclusive decisions: It includes all those projects which compete with each other in
a way that acceptance of one precludes the acceptance of other or others. Thus, some technique
has to be used for selecting the best among all and eliminates other alternatives.
3. Capital rationing decisions: Capital budgeting decision is a simple process in those firms
where fund is not the constraint, but in majority of the cases, firms have fixed capital budget. So
large amount of projects compete for these limited budgets. So the firm rations them in a manner
so as to maximize the long run returns. Thus, capital rationing refers to the situations where the
firm has more acceptable investment requiring greater amount of finance than is available with
the firm. It is concerned with the selection of a group of investment out of many investment
proposals ranked in the descending order of the rate or return.

19. Q. Considering the following information, what is the price of the share as per Gordon’s
Model?
Net sales Rs. 120 lakhs
Net profit margin 12.5%
Outstanding preference shares Rs. 50 lakhs @ 12% dividend
No. of equity shares 250000
Cost of equity shares 12%
Retention ratio 40%
ROI 16%
Hint: Apply the Gordon formula.
Ans.
Share price
In economics and financial theory, analysts use random walk techniques to model behavior of
asset prices, in particular share prices on stock markets, currency exchange rates and commodity
prices. This practice has its basis in the presumption that investors act rationally and without
bias, and that at any moment they estimate the value of an asset based on future expectations.
Under these conditions, all existing information affects the price, which changes only when new
information comes out. By definition, new information appears randomly and influences the
asset price randomly.
Empirical studies have demonstrated that prices do not completely follow random walks. Low
serial correlations (around 0.05) exist in the short term, and slightly stronger correlations over the
longer term. Their sign and the strength depend on a variety of factors.
Researchers have found that some of the biggest price deviations from random walks result from
seasonal and temporal patterns. In particular, returns in January significantly exceed those in
other months (January effect) and on Monday’s stock prices go down more than on any other
day. Observers have noted these effects in many different markets for more than half a century,
but without succeeding in giving a completely satisfactory explanation for their persistence.

20. Technical analysis uses most of the anomalies to extract information on future price movements
from historical data. But some economists, for example Eugene Fama, argue that most of these
patterns occur accidentally, rather than as a result of irrational or inefficient behavior of
investors: the huge amount of data available to researchers for analysis allegedly causes the
fluctuations.
Another school of thought, behavioral finance, attributes non-randomness to investors' cognitive
and emotional biases. This can be contrasted with Fundamental analysis.
When viewed over long periods, the share price is directly related to the earnings and dividends
of the firm. Over short periods, especially for younger or smaller firms, the relationship between
share price and dividends can be quite unmatched.
Many U.S.-based companies seek to keep their share price (also called stock price) low, partly
based on "round lot" trading (multiples of 100 shares). A corporation can adjust its stock price by
a stock split, substituting a quantity of shares at one price for a different number of shares at an
adjusted price where the value of shares x price remains equivalent. (For example 500 shares at
$32 may become 1000 shares at $16.) Many major firms like to keep their price in the $25 to $75
price range.
A US share must be priced at $1 or more to be covered by NASDAQ. If the share price falls
below that level the stock is "delisted", and becomes an OTC (over the counter stock). A stock
must have a price of $1 or more for 10 consecutive trading days during each month to remain
listed.
Robert D. Coleman's Evolution of Stock Pricing notes that the invention of double-entry
bookkeeping in the fourteenth century led to company valuations being based upon ratios such as
price per unit of earnings (from the income statement), price per unit of net worth (from the
balance sheet) and price per unit of cash flow (from the funds statement). The next advance was
to price individual shares rather than whole companies. A price/dividends ratio began to be used.
Following this, the next stage was the use of discounted cash flows, based on the time value of
money, to estimate the intrinsic value of stock.

21. Q. Internal capital rationing is uses by firms for exercising financial control” How does a
firm achieve this?
Ans.
Internal capital rationing
Capital rationing is a business decision to limit the amount available to spend on new
investments or projects. The practice describes restricting channels of outflow of funds by
placing a cap on the number of new projects. Capital rationing may be employed by different
kinds of companies to achieve desired financial targets. The theory behind capital rationing
practices is that, when fewer new projects are undertaken, the company is better able to manage
them through more time and resources dedicated to existing projects and each new project.
Factors
o Factors influencing capital rationing decisions include both financial situations
and management philosophy. Companies may wish to limit capital spending when
the NPV (net present value) or IRR (internal rate of return) has a pronounced
effect on the overall budget amount, or when potential investment opportunities
are unfeasible, if current commitments are extensively pursued. Other factors that
influence capital rationing decisions include the amount of funds that come from
current operations and the feasibility of acquiring capital, either by borrowing or
issuing additional stock. In addition, rationing may be implemented in different
ways by growth-minded management and management with a more conservative
approach.
Artificial Constraint
o Capital rationing decisions are implemented only in certain scenarios, such as
when a company does not have enough funds to invest in projects that have
promise. When there are more projects than funds available, only the most
lucrative ones are considered, and other projects, even if they are profitable, are
excluded. This is known as artificial constraint, because the amount to be spent on
projects is specified by management. Capital rationing occurs due to management
fears of sudden growth bursts or when management is reluctant to use external
financing.

22. Types
o Capital rationing can be classified into hard and soft, based on whether the factors
are external or internal. Hard capital rationing is when constraints that may affect
business decisions are externally determined; hard capital rationing does not occur
under perfect market conditions. Soft capital rationing occurs when investment
expenditure is controlled and limited internally, by restrictions imposed by
management.
External Reasons
o There are two kinds of reasons for capital rationing--external and internal. When a
business is unable to borrow funds from outside sources, it is an external reason
for capital rationing. A firm may be unable to borrow funds because of internal
financial shortages, substandard operating performance, unfavorable credit
conditions or when it introduces a new, untested product. Banks are particularly
reluctant to lend to small businesses and individuals with a less-than-satisfactory
performance.
Internal Reasons
o Internal reasons for capital rationing include management apprehension that
expansion would lead to a dilution of control. In a privately-owned company,
management may want to limit growth of business to have a stronger hold on the
business. In larger companies, upper management may specify spending limits for
each department, following a comprehensive corporate strategy. Internal reasons
also include human resource constraints, in which the company may not have
adequate middle management personnel to cover expansion. Debt constraints are
also part of internal reasons for capital rationing; it might be that debt issued
earlier prohibits the company from pursuing more debt, because of impositions
placed by the earlier debt.

23. Q. 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 company’s cost of capital is 12%. The following forecast of cash flows is made
by the management.
Economic Project A Project B
Environment Annual cash Annual cash in
inflows flows
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.
Ans.
Net present value
In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash
flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the
individual cash flows of the same entity.
In the case when all future cash flows are incoming (such as coupons and principal of a bond)
and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows
minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow

24. (DCF) analysis, and is a standard method for using the time value of money to appraise long-
term projects. Used for capital budgeting, and widely throughout economics, finance, and
accounting, it measures the excess or shortfall of cash flows, in present value terms, once
financing charges are met.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or
discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of
cash flows and a price as input and inferring as output a discount rate (the discount rate which
would yield the given price as NPV) - is called the yield, and is more widely used in bond
trading.
Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed.
Therefore NPV is the sum of all terms,
where
t - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an investment in the
financial markets with similar risk.); the opportunity cost of capital
- the net cash flow (the amount of cash, inflow minus outflow) at time t. For
educational purposes, is commonly placed to the left of the sum to emphasize its role
as (minus) the investment.
The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial
Cash outlay the present value but in case where the cash flows are not equal in amount then the
previous formula will be used to determine the present value of each cash flow separately. Any
cash flow within 12 months will not be discounted for NPV purpose.[2]
The discount rate
The rate used to discount future cash flows to the present value is a key variable of this process.
A firm's weighted average cost of capital (after tax) is often used, but many people believe that it
is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount

25. rate with higher rates applied to cash flows occurring further along the time span might be used
to reflect the yield curve premium for long-term debt.
Another approach to choosing the discount rate factor is to decide the rate which the capital
needed for the project could return if invested in an alternative venture. If, for example, the
capital required for Project A can earn five percent elsewhere, use this discount rate in the NPV
calculation to allow a direct comparison to be made between Project A and the alternative.
Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate can be defined
as the rate of return for the firm's investments on average. When analyzing projects in a capital
constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's
weighted average cost of capital as the discount factor. It reflects opportunity cost of investment,
rather than the possibly lower cost of capital.
An NPV calculated using variable discount rates (if they are known for the duration of the
investment) better reflects the real situation than one calculated from a constant discount rate for
the entire investment duration. Refer to the tutorial article written by Samuel Baker[3] for more
detailed relationship between the NPV value and the discount rate.
For some professional investors, their investment funds are committed to target a specified rate
of return. In such cases, that rate of return should be selected as the discount rate for the NPV
calculation. In this way, a direct comparison can be made between the profitability of the project
and the desired rate of return.
To some extent, the selection of the discount rate is dependent on the use to which it will be put.
If the intent is simply to determine whether a project will add value to the company, using the
firm's weighted average cost of capital may be appropriate. If trying to decide between
alternative investments in order to maximize the value of the firm, the corporate reinvestment
rate would probably be a better choice.
Using variable rates over time, or discounting "guaranteed" cash flows differently from "at risk"
cash flows may be a superior methodology, but is seldom used in practice. Using the discount
rate to adjust for risk is often difficult to do in practice (especially internationally), and is
difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly
correct the cash flows for the risk elements using rNPV or a similar method, then discount at the
firm's rate.
NPV in decision making
NPV is an indicator of how much value an investment or project adds to the firm. With a
particular project, if is a positive value, the project is in the status of positive cash inflow in
the time of t. If is a negative value, the project is in the status of discounted cash outflow in
the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not
necessarily mean that they should be undertaken since NPV at the cost of capital may not
account for opportunity cost, i.e. comparison with other available investments. In financial
theory, if there is a choice between two mutually exclusive alternatives, the one yielding the
higher NPV should be selected.

26. If... It means... Then...
NPV the investment would
the project may be accepted
> 0 add value to the firm
the investment would
NPV
subtract value from the project should be rejected
<0
the firm
We should be indifferent in the decision whether to accept or
the investment would
NPV reject the project. This project adds no monetary value. Decision
neither gain nor lose
=0 should be based on other criteria, e.g. strategic positioning or other
value for the firm
factors not explicitly included in the calculation.
Example
A corporation must decide whether to introduce a new product line. The new product will have
startup costs, operational costs, and incoming cash flows over six years. This project will have an
immediate (t=0) cash outflow of 100,000 (which might include machinery, and employee
training costs). Other cash outflows for years 1–6 are expected to be 5,000 per year. Cash
inflows are expected to be 30,000 each for years 1–6. All cash flows are after-tax, and there are
no cash flows expected after year 6. The required rate of return is 10%. The present value (PV)
can be calculated for each year:
Year Cash flow Present value
T=0 -100,000
T=1 22,727
T=2 20,661
T=3 18,783
T=4 17,075

27. T=5 15,523
T=6 14,112
The sum of all these present values is the net present value, which equals 8,881.52. Since the
NPV is greater than zero, it would be better to invest in the project than to do nothing, and the
corporation should invest in this project if there is no mutually exclusive alternative with a
higher NPV.
The same example in Excel formulae:
NPV(rate,net_inflow)+initial_investmen
PV(rate,year_number,yearly_net_inflow)

28. More realistic problems would need to consider other factors, generally including the calculation
of taxes, uneven cash flows, and salvage value as well as the availability of alternate investment
opportunities.

29. Q. Explain various types of bonds?
Ans.
Different Types Of Bonds
Government Bonds
In general, fixed-income securities are classified according to the length of time before maturity.
These are the three main categories:
Bills - debt securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.
Marketable securities from the U.S. government - known collectively as Treasuries - follow this
guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills).
Technically speaking, T-bills aren't bonds because of their short maturity. (You can read more
about T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as
extremely safe, as is the debt of any stable country. The debt of many developing countries,
however, does carry substantial risk. Like companies, countries can default on payments.
Municipal Bonds
Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go
bankrupt that often, but it can happen. The major advantage to munis is that the returns are free
from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for
residents, thus making some municipal bonds completely tax free. Because of these tax savings,
the yield on a muni is usually lower than that of a taxable bond. Depending on your personal
situation, a muni can be a great investment on an after-tax basis.
Advertisement - Tutorial continues below.
Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility
as to how much debt they can issue: the limit is whatever the market will bear. Generally, a
short-term corporate bond is less than five years; intermediate is five to 12 years, and long term
is over 12 years.

30. Corporate bonds are characterized by higher yields because there is a higher risk of a company
defaulting than a government. The upside is that they can also be the most rewarding fixed-
income investments because of the risk the investor must take on. The company's credit quality
is very important: the higher the quality, the lower the interest rate the investor receives.
Other variations on corporate bonds include convertible bonds, which the holder can convert into
stock, and callable bonds, which allow the company to redeem an issue prior to maturity.
Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable
discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10
years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth
$1,000 in 10 years.
Terminology
Used in Bond Market Meaning in General Terms
Bonds Loans (in the form of a security)
Issuer of Bonds Borrower
Bond Holder Lender
Amount at which issuer pays interest and which is repaid on the
Principal Amount
maturity date
Issue Price Price at which bonds are offered to investors
Maturity Date Length of time (More than one year)
Rate of interest paid by the issuer on the par/face value of the
Coupon
bond
Coupon Date The date on which interest is paid to investorstd-txt
Types of Bonds
1. Classification on the basis of Variability of Coupon
I. Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their face value and at the time of
maturity, the principal/face value is repaid to the holders. No interest (coupon) is
paid to the holders and hence, there are no cash inflows in zero coupon bonds.
The difference between issue price (discounted price) and redeemable price (face

31. value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is
inversely related to their maturity period, i.e. longer the maturity period lesser
would be the issue price and vice-versa. These types of bonds are also known as
Deep Discount Bonds.
II. Treasury Strips
Treasury strips are more popular in the United States and not yet available in
India. Also known as Separate Trading of Registered Interest and Principal
Securities, government dealer firms in the United States buy coupon paying
treasury bonds and use these cash flows to further create zero coupon bonds.
Dealer firms then sell these zero coupon bonds, each one having a different
maturity period, in the secondary market.
III. Floating Rate Bonds
In some bonds, fixed coupon rate to be provided to the holders is not specified.
Instead, the coupon rate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
For better understanding let us consider an example of one such bond from IDBI
in 1997. The maturity period of this floating rate bond from IDBI was 5 years.
The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up,
with reference to the 10 year yield on Central Government securities (as the
benchmark). This means that if the benchmark rate was set at �X� %, then
coupon for IDBI�s floating rate bond was set at �(X + 0.50)� %.
Coupon rate in some of these bonds also have floors and caps. For example, this
feature was present in the same case of IDBI�s floating rate bond wherein there
was a floor of 13.50% (which ensured that bond holders received a minimum of
13.50% irrespective of the benchmark rate). On the other hand, a cap (or a
ceiling) feature signifies the maximum coupon that the bonds issuer will pay
(irrespective of the benchmark rate). These bonds are also known as Range Notes.
More frequently used in the housing loan markets where coupon rates are reset at
longer time intervals (after one year or more), these are well known as Variable
Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even
move in an opposite direction to benchmark rates. These bonds are known as
Inverse Floaters and are common in developed markets.
2. Classification on the Basis of Variability of Maturity
I. Callable Bonds
The issuer of a callable bond has the right (but not the obligation) to change the
tenor of a bond (call option). The issuer may redeem a bond fully or partly before
the actual maturity date. These options are present in the bond from the time of
original bond issue and are known as embedded options. A call option is either a
European option or an American option. Under an European option, the issuer can
exercise the call option on a bond only on the specified date, whereas under an
American option, option can be exercised anytime before the specified date.

32. This embedded option helps issuer to reduce the costs when interest rates are
falling, and when the interest rates are rising it is helpful for the holders.
II. Puttable Bonds
The holder of a puttable bond has the right (but not an obligation) to seek
redemption (sell) from the issuer at any time before the maturity date. The holder
may exercise put option in part or in full. In riding interest rate scenario, the bond
holder may sell a bond with low coupon rate and switch over to a bond that offers
higher coupon rate. Consequently, the issuer will have to resell these bonds at
lower prices to investors. Therefore, an increase in the interest rates poses
additional risk to the issuer of bonds with put option (which are redeemed at par)
as he will have to lower the re-issue price of the bond to attract investors.
III. Convertible Bonds
The holder of a convertible bond has the option to convert the bond into equity (in
the same value as of the bond) of the issuing firm (borrowing firm) on pre-
specified terms. This results in an automatic redemption of the bond before the
maturity date. The conversion ratio (number of equity of shares in lieu of a
convertible bond) and the conversion price (determined at the time of conversion)
are pre-specified at the time of bonds issue. Convertible bonds may be fully or
partly convertible. For the part of the convertible bond which is redeemed, the
investor receives equity shares and the non-converted part remains as a bond.
3. Classification on the basis of Principal Repayment
I. Amortising Bonds
Amortising Bonds are those types of bonds in which the borrower (issuer) repays
the principal along with the coupon over the life of the bond. The amortising
schedule (repayment of principal) is prepared in such a manner that whole of the
principle is repaid by the maturity date of the bond and the last payment is done
on the maturity date. For example - auto loans, home loans, consumer loans, etc.
II. Bonds with Sinking Fund Provisions
Bonds with Sinking Fund Provisions have a provision as per which the issuer is
required to retire some amount of outstanding bonds every year. The issuer has
following options for doing so:
i. By buying from the market
ii. By creating a separate fund which calls the bonds on behalf of the issuer
Since the outstanding bonds in the market are continuously retired by the issuer
every year by creating a separate fund (more commonly used option), these types
of bonds are named as bonds with sinking fund provisions. These bonds also
allow the borrowers to repay the principal over the bond�s life.
Investing in Bonds
Many people invest in bonds with an objective of earning certain amount of interest on their
deposits and/or to save tax. Bonds are considered to be a less risky investment option and are
generally preferred by risk-averse investors. Though investors should not get overtly confident of

33. investing in bonds as bond prices are also subject to market risk. For example, bond prices have
a negative correlation with interest rates due to which any increase in interest rates can lead to a
fall in bond prices and vice-versa. Thus, it is recommended that investors should consider the
risk-return factor (i.e. the expected return for the given level of risk) before investing.
Investments Eligible for Deductions
Holders of certain bonds are eligible to claim deduction from their taxable income. A list of such
deposits is mentioned hereunder:
1. Interest on Government Securities, National Savings Certificate (issues VI, VII and VIII),
Development Bonds, Development Bonds and 7 year National Rural Development Bonds
2. Interest on Post Office Term Deposits, Recurring Deposits Accounts and National
Savings Schemes (as referred to in National Savings Scheme Rules, 1992)
3. Dividends received from a co-operative society
4. Income from investments in UTI (up to assessment year 1999-2000)
5. Interest on deposits with a banking company or a co-operative bank
6. Interest on deposits with a co-operative society made by a member of the society
7. Interest on deposits with housing boards
8. Interest from deposits made under A.E. (C, D.) Act & C.D.S. (I.T.P.) Act.
9. Interest on notified debentures of any co-operative society, any institution or any public
sector company.
10. Interest on deposits with a financial corporation which is engaged in providing long-term
finance for industrial development in India and which is eligible for deduction under
Section 36(l)(viii) [up to assessment year 1999-2000, the corporation is approved by
Central Government].
11. Interest on deposits with a public company formed and registered in India with the main
object of carrying on the business of providing long-term finance for construction or
purchase of houses in India for residential purposes and which is eligible for deduction
under Section 36(l)(viii) [up to assessment year 1999-2000, the company is approved by
the Central Government under Section 36(l)(viii)].
12. Interest on deposits with Industrial Development Bank of India.
13. Interest on deposits under National Deposit Scheme. Income in respect of units of mutual
fund specified under Section 10(23D) [up to assess. year 1999-00].
14. Interest on deposits under Post Office (Monthly Income Account) Rules.

34. Q. 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%.
Ans.
Walter's Dividend Model
Walter's model supports the principle that dividends are relevant. The investment policy of a firm
cannot be separated from its dividend policy and both are inter-related. The choice of an
appropriate dividend policy affects the value of an enterprise.
Assumptions of this model:
1. Retained earnings are the only source of finance. This means that the company does not
rely upon external funds like debt or new equity capital.
2. The firm's business risk does not change with additional investments undertaken. It
implies that r(internal rate of return) and k(cost of capital) are constant.
3. There is no change in the key variables, namely, beginning earnings per share(E), and
dividends per share(D). The values of D and E may be changed in the model to determine
results, but any given value of E and D are assumed to remain constant in determining a
given value.
4. The firm has an indefinite life.
Formula: Walter's model
P = D
Ke – g
Where: P = Price of equity
shares
D = Initial dividend
Ke = Cost of equity
capital
g = Growth rate

35. expected
After accounting for retained earnings, the model would be:
P = D
Ke – rb
Where: r = Expected rate of return on firm’s
investments
b = Retention rate (E - D)/E
Equation showing the value of a share (as present value of all dividends plus the present value of
all capital gains) – Walter's model:
P = D + r/ke (E
- D)
ke
Where: D = Dividend per share and
E = Earnings per share
Example:
A company has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = $10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.
Solution:
Case A:
D/P ratio = 50%
When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5
5 + [0.08 / 0.10] [10 -
5]
P = => $90
0.10
Case B:
D/P ratio = 25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5
P = 2.5 + [0.08 / 0.10] [10 - => $85

36. 2.5]
0.10
Conclusions of Walter's model:
1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio
increases, the market value of shares decline. It’s value is the highest when D/P ratio is 0.
So, if the firm retains its earnings entirely, it will maximize the market value of the
shares. The optimum payout ratio is zero.
2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P
ratio increases, the market price of the shares also increases. The optimum payout ratio is
100%.
3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this
case, there is no optimum D/P ratio.
Limitations of this model:
1. Walter's model assumes that the firm's investments are purely financed by retained
earnings. So this model would be applicable only to all-equity firms.
2. The assumption of r as constant is not realistic.
3. The assumption of a constant ke ignores the effect of risk on the value of the firm.
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37. THANK YOU