Finance and economics:

UNIT I FOUNDATIONS OF FINANCE: Financial management An overview- Time value of money- Introduction to the concept of risk and return of a single asset and of a portfolio- Valuation of bonds and shares-Option valuation.UNIT II INVESTMENT DECISIONS: Capital Budgeting: Principles and techniques - Nature of capital budgeting- Identifying relevantcash flows - Evaluation Techniques: Payback, Accounting rate of return, Net Present Value, Internal Rate of Return, Profitability Index - Comparison of DCF techniques - Project selection under capital rationing - Inflation and capital budgeting - Concept and measurement of cost of capital - Specific cost and overall cost of capital.UNIT III FINANCING AND DIVIDEND DECISION: Financial and operating leverage - capital structure - Cost of capital and valuation - designing capital structure. Dividend policy - Aspects of dividend policy - practical consideration - forms of dividend policy - forms of dividends - share splits.UNIT IV WORKING CAPITAL MANAGEMENT: Principles of working capital: Concepts, Needs, Determinants, issues and estimation of working capital - Accounts Receivables Management and factoring - Inventory management Cash management - Working capital finance : Trade credit, Bank finance and Commercial paper.UNIT V LONG TERM SOURCES OF FINANCE: Indian capital and stock market, New issues market Long term finance: Shares, debentures and term loans, lease, hire purchase, venture capital financing, Private Equity.

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UNIT I FOUNDATIONS OF FINANCE 1. Financial management An overview-2. Time value of money3. Introduction to the concept of risk and return of a single asset and4. Concept of risk and return of a portfolio.5. Valuation of bonds and shares6. Option valuation.1. Financial An overview -Meaning Finance is regarded as the life blood of a business enterprise. This is because in the modern money oriented economy, finance is one of the basic foundations of all kinds of economic activities.2. Definition of business financeAccording to the Wheeler, Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise.3. Types of financeFinance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names.Finance can be classified into two major parts:

1. Private Finance, which includes the Individual, Firms, Business or Corporate Financial activities to meet the requirements.2. Public Finance which concerns with revenue and disbursement of Government such as Central Government, State Government and Semi-Government Financial matters.3. Finance and other related disciplines:Explain the relationship between financial management and other disciplinesFinance and economics:The relevance of economics to financial management can be described in the light of the two broad areas of economics: macroeconomics and microeconomics.Macroeconomics is concerned with the overall institutional environment in which the firm operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary and fiscal policies. Since business firms operate in the macroeconomic environment, it is important for financial managers to understand the broad economic environment. They should recognize and understand how monetary policy affects the cost and the availability of funds; they should be versed in fiscal policy and its effects on the economy; they should be aware of the various financial institutions; they should understand the consequences of various levels of economic activity and changes in economic policy for their decision environment and so on.Microeconomics deals with the economic decisions of individuals and organizations. It concerns itself with the determination of optimal operating strategies. In other words, the theories of microeconomics provide for effective operations of business firms. The concepts and theories of microeconomics relevant to financial management are those involving supply and demand relationships and profit maximization strategies, issues related to the mix of productive factors, optimal sales level and product pricing strategies, measurement of utility preference, risk and value and rationale of depreciating assets. 1. Finance and accounting:Accounting function is a necessary input into the finance function. That is, accounting is a sub function of finance. Accounting generates information or data relating to operations of the firm. The end product of accounting constitutes financial statements. The information contained in these statements assists financial managers in assessing the past performance and future directions of the firm and in meeting legal obligations. Thus finance and accounting are functionally closely related.But there are two key differences between finance and accounting. 1. Treatment of funds: the measurement of funds in accounting is based on the accrual principle. For example, revenue is recognized at the point of sale and not when collected. Similarly, expenses are recognized when they are incurred rather than when actually paid. The view point of finance relating to the treatment of funds is based on cash flows. The revenues are recognized only when actually received in cash and expenses are recognized on actual payment. Financial manager is concerned with maintaining solvency of the firm and acquiring and financing the assets needed to achieve the goals of the firm.2. Decision making: finance and accounting also differ in respect of their purpose. The purpose of accounting is collection and presentation of financial data. It provides consistently developed and easily interpreted data. The financial manager uses such data for financial decision making. It does not mean that accounts never make decisions or financial managers never collect data. Generally finance begins where accounting ends.3. Financial managers should consider the impact of new product development and promotion plans made in marketing area since their plans will require capital outlays and have an impact on the projected cash flows.4. Changes in the production process may necessitate capital expenditures which the financial managers must evaluate and finance.5. The recruitment, training and placement of staff is the responsibility of the personnel department. However, all this requires finance and therefore, the decisions regarding these aspects cannot be taken by the personnel department in isolation of the finance department.6. The tools of analysis developed in the quantitative methods area are helpful in analyzing complex financial management problems.

4. Finance includes three areas..(1) Financial management: corporate finance, which deals with decisions related to how many and what types of assets a firm needs to acquire (investmentdecisions), how a firm should raise capital to purchase assets (financingdecisions), and how a firm should do to maximize its shareholders wealth (goal of a firm) - the focus of this class(2) Capital markets: study of financial markets and institutions, which deals with interest rates, stocks, bonds, government securities, and other marketable securities. It also covers Federal Reserve System and its policies.(3) Investments: study of security analysis, portfolio theory, market analysis, andbehavioral finance.5. Definition of financial managementFinancial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm.The term financial management has been defined by Solomon, It is concerned with the efficient use of an important economic resource namely, capital funds.It refers to Managerial activity which is concerned with the planning and controlling of the firms financial resources.5. Define financial assetIt is also called securities that are financial papers or instruments such as shares, bonds, debentures etc.6. Scope of financial managementFinancial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production.Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management.1. Financial Management and EconomicsEconomic concepts like micro and macroeconomics are directly applied with the financial management approaches.2. Financial Management and AccountingAccounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting.3. Financial Management or MathematicsModern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics.4. Financial Management and Production ManagementProduction management is the operational part of the business concern, which helps to multiple the money into profit. Profit of the concern depends upon the production performance.5. Financial Management and MarketingProduced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements.6. Financial Management and Human ResourceFinancial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department.7. Objectives of financial management[2 Marks]Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as:A. Profit maximizationB. Wealth maximization

1. Profit maximisation approach.According to this approach, actions that increase profits should be undertaken and that decrease profits should be avoided. Profits maximization approach implies that the functions of financial management/ Decisions taken by financial mangers (i.e. the investment, financing, and dividend policy decisions) should be oriented towards maximization of profits or Rupee income of the firm. Or the Company should select those assets, projects, and decisions which are profitable and reject those which are not. The profit maximization criterion has however been criticized on several grounds. The main technical flaws are ambiguity, timing of benefits and quality of benefits.1. AMBIGUITY.One practical difficulty with profit maximization criterion for financial decision making is that, the term profit is a vague and ambiguous concept. It is amenable to different interpretations by different people. It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. 2. TIMING OF BENEFITA more important technical objection to profit maximization is that it ignores the differences in the time pattern of the benefits received. The profit maximization criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timings, as equally valuable. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. The assumption of equal value is in consistent with the real world situation.3. QUALITY OF BENEFITSProfit maximization ignores the quality aspect of benefits associated with a financial course of action. The term quality refers to the degree of certainty with which benefits can be expected. As a rule, the more certain the expected return, the higher is the quality of the benefits. An uncertain and fluctuating return implies risk to the investors.B. Wealth maximization approach.This is also known as value maximization or Net Present Worth maximization. It removes the technical limitations of profit maximization criterion.(i.e. ambiguity, timing of benefit and quality of benefit.) Wealth maximization means maximizing the Net Present Value (or wealth) of a course of action. The Net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive Net Present Value creates wealth and therefore it is desirable. A financial action resulting in negative NPV should be rejected. The objective of wealth maximisation takes care of the questions of the timing and risk of expected benefits. These problems are handled by selecting an appropriate rate for discounting the expected flow of future benefits. It should be remembered that the benefits are measured in terms of cash flows. In investment and financing decisions it is flow of cash which is important, not the accounting profits. The Wealth created by a Company through its actions is reflected in the market value of companies' shares. The value of the companies share is represented by the market price, which in turn, is a reflection of the firm's financial decisions. The market price of the share serves as the performance indicator.Profit Maximization Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise.Profits also serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to face risks like fall in prices, competition from other units, advertise government policies etc. thus, profit maximization is considered as the main objective of business.

Limitations of profit maximizationThe profit maximization criterion is criticized on the following grounds:1) Quality of benefits: profit maximization approach ignores the quality aspects of benefits associated with a financial course of action. The quality means the degree of certainty with which benefits are expected.2) Ambiguity-vague: the term profit is vague and has different interpretations. It means different people. It can be pre-tax or post-tax profit or long term profit. Does it mean operating profit or profit available for shareholders? The other equivalent term, often used, is Return. Return can be on total capital employed or total capital employed or total assets or shareholders equity and so on.3) Timing and value of money-Ignored: The concept of profit maximization does not help in making a choice between projects, giving different benefits, spread over a period of time. It ignores the difference in time in respect of benefits arising from the similar amount of investment. The fact that a rupee received today is more valuable than the rupee received later is ignored in this concept.4) Change in Organization Structure: Principle of Profit maximization was, earlier, accepted when the structure of the business was sole proprietorship. In this type of structure, sole proprietor managed the business, individually, and was the recipient of total profits. As total profit belonged to him, his wealth maximized. This was the picture in 19th century, when the business was, totally, self-managed.5) Social Welfare may be Ignored: Due to Profit maximization objective, business may produce goods and service, which may not be necessary and beneficial to the society. So, it is, indeed, doubtful how far the Profit maximization objective serves or promotes social welfare, let alone optimizes social welfare.6) Ignores Financing and Dividend Aspects: The profit maximization concept concentrates on profitability aspect alone and impact of financing and dividend decisions on the market value of shares are, totally ignored.Thus, it is concluded that Profit maximization should be the basic criteria for decision-making. The primary responsibility of financial manager is to strike judicious balance between return and risk in order to maximize the profits.Wealth Maximization:This is also known as net present worth maximization approach, it takes into consideration the time value of money. Its operational features satisfy all the three requirements of a suitable operational objective of financial courses of action i.e. quality of benefits, timing of benefits and exactness.Limitations of Wealth Maximization:The Wealth maximization criterion is criticized on the following grounds:1) The objective of wealth maximization is not, necessarily, socially desirable.2) There is some controversy whether the objective of maximization of wealth is of the firm or stockholders. If wealth of firm were maximized, it would be benefiting the interests of debenture holders and preferences shareholders too. 3) In corporate sector, ownership and management are separate unlike in a sole proprietorship. Management acts as the agents of real owners i.e. shareholders. However, there is always a possibility of conflict of interest between the shareholders interests and managerial interests. The managers may act to maximize their managerial utility but not the wealth of stockholders of the firm. A particular decision may be taken to exhibit their managerial utility and that decision may not be in the exclusive interests of the firm. Many a time, individuals place their personal preferences and selfish interest, ahead of the institutional interests. The difference between Profit maximization and Wealth maximizationBasis of DistinctionProfit MaximizationWealth Maximization

1) Definition or NatureThe concept of profit maximization implies that a firm either produces maximum output for a given input, or uses minimum inputs for producing a given output. Thus, it relates to optimizing the input-output relationship of resources to minimize the wasteful costs.The concept of shareholders wealth maximization means maximizing the wealth in the hands of shareholders by way of dividends and value-creation or Net Present Value (NPV) of a course of action such that future inflows value is maximized and determined precisely.

2) Purpose or Concept The main purpose of profit maximization is to maximize the profitability derived out of economic activity of the business.The main purpose of this concept is to enhance the value of the firm and the market value of the shares of the shareholders.

3) FormulaeProfit maximization concept is based on the determination of maximization of profits. In a simple way:Profit = Total Revenue Receipts Total CostsThe stockholders current status of wealth in the firm is based on the share price and the number of shares held. It can be depicted as:Wealth= No. of Shares Owned x Current Stock.Price Per Share.

4) RationaleThe rationale behind this concept is the need for maximum profits and accumulated profits for growth in future and shelter against contingencies like economic recession, natural calamity, unforeseen losses in future, severe competition, etc.The rationale behind this concept is maximization of value of the firm and enhancing shareholder wealth as a gratitude for their commitment of funds and continued investor relationship with the company.

5) Time SpanThis concept relates to relatively shorter time period, say a financial year. Thus, a short-term myopic vision.This concept relates to long-term value building and augmenting individual shareholders utility. Thus, a long-term vision.

6) Time Value of Money (i.e., the Recognition that Value in Money Decreases Over Time)This concept does not give due consideration to the issues of time value of money. It determines profits for the financial year and ignores discounting factor of earnings.This concept gives due consideration to the time value of money and its implications. It calculates the future earning, at their exact value by applying Net Present Value (NPV) approach and discounting factor, etc.

7) Immediate Beneficiaries Management versus OwnersThe immediate benefit of this concept is derived by management and later by the shareholders, especially when there is separation of management from ownership.The immediate benefits are availed by shareholders and later by the organization as a whole. This can potentially cause conflicts when there is separation of management from ownership.

8) Limitation and ConstraintsThe profit maximization concept has the following constraints:i) It ignores the time value of money concept.ii) Short-term vision based.iii) Exploitative tendency towards resources, employees, customers if this concept is pursued beyond viable limits.iv) Gives lower priority to shareholders interest.The wealth maximization concept has the following constraints:i) It suffers from drastic changes and fluctuations in financial markets.ii) Tendency to overlook short-term economic objectives of the business.iii) Very long span of time, so increased efforts on value building.iv) Conflicts arises when there is separations of management from ownership.

Explain various setbacks of profit maximization and how that can be overcome through wealth maximization? Critically evaluate different objectives of financial management.1. Profit maximization:Maximizing the Rupee Income of Firm 7. Resources are efficiently utilized7. Appropriate measure of firm performance7. Serves interest of society also

Limitations: It is Vague It Ignores the Timing of Returns It Ignores Risk Assumes Perfect Competition In new business environment profit maximization is regarded as : Unrealistic Difficult Inappropriate Immoral.2. Wealth maximization:a. Maximizes the net present value of a course of action to shareholders.b. Accounts for the timing and risk of the expected benefits.c. Benefits are measured in terms of cash flows.d. Fundamental objectivemaximize the market value of the firms shares.8. What is the role of financial management/ Manager :a) Determining financial needs b) Choosing the sources of funds c) Financial analysis and interpretation d) Cost volume profit analysise) Capital budgetingf) Working capital managementg) Profit planning and control h) Dividend Policy.

9. What objectives of financial management?

1. Profit maximization : The main objective of financial management is profit maximization. The finance manager tries to earn maximum profits for the company in the short-term and the long-term. He cannot guarantee profits in the long term because of business uncertainties. However, a company can earn maximum profits even in the long-term, if:-i. The Finance manager takes proper financial decisions.ii. He uses the finance of the company properly.2. Wealth maximization : Wealth maximization (shareholders' value maximization) is also a main objective of financial management. Wealth maximization means to earn maximum wealth for the shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He also tries to increase the market value of the shares. The market value of the shares is directly related to the performance of the company. Better the performance, higher is the market value of shares and vice-versa. So, the finance manager must try to maximise shareholder's value.3. Proper estimation of total financial requirements : Proper estimation of total financial requirements is a very important objective of financial management. The finance manager must estimate the total financial requirements of the company. He must find out how much finance is required to start and run the company. He must find out the fixed capital and working capital requirements of the company. His estimation must be correct. If not, there will be shortage or surplus of finance. Estimating the financial requirements is a very difficult job. The finance manager must consider many factors, such as the type of technology used by company, number of employees employed, scale of operations, legal requirements.4. Proper mobilization: Mobilisation (collection) of finance is an important objective of financial management. After estimating the financial requirements, the finance manager must decide about the sources of finance. He can collect finance from many sources such as shares, debentures, bank loans, etc. There must be a proper balance between owned finance and borrowed finance. The company must borrow money at a low rate of interest.5. Proper utilisation of finance: Proper utilisation of finance is an important objective of financial management. The finance manager must make optimum utilisation of finance. He must use the finance profitable. He must not waste the finance of the company. He must not invest the company's finance in unprofitable projects. He must not block the company's finance in inventories. He must have a short credit period.6. Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of financial management. The company must have a proper cash flow to pay the day-to-day expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a good cash flow, it can take advantage of many opportunities such as getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and success of the company.7. Survival of company : Survival is the most important objective of financial management. The company must survive in this competitive business world. The finance manager must be very careful while making financial decisions. One wrong decision can make the company sick, and it will close down.8. Creating reserves : One of the objectives of financial management is to create reserves. The company must not distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as reserves. Reserves can be used for future growth and expansion. It can also be used to face contingencies in the future.9. Proper coordination : Financial management must try to have proper coordination between the finance department and other department of the company. 10. Create goodwill : Financial management must try to create goodwill for the company. It must improve the image and reputation of the company. Goodwill helps the company to survive in the short-term and succeed in the long-term. It also helps the company during bad times.11. Increase efficiency : Financial management also tries to increase the efficiency of all the departments of the company. Proper distribution of finance to all the departments will increase the efficiency of the entire company.12. Financial discipline : Financial management also tries to create a financial discipline. Financial discipline means:-1. To invest finance only in productive areas. This will bring high returns (profits) to the company.2. To avoid wastage and misuse of finance.13. Reduce cost of capital : Financial management tries to reduce the cost of capital. That is, it tries to borrow money at a low rate of interest. The finance manager must plan the capital structure in such a way that the cost of capital it minimised.14. Reduce operating risks : Financial management also tries to reduce the operating risks. There are many risks and uncertainties in a business. The finance manager must take steps to reduce these risks. He must avoid high-risk projects. He must also take proper insurance.10. Prepare capital structure : Financial management also prepares the capital structure. It decides the ratio between owned finance and borrowed finance. It brings a proper balance between the different sources of. capital. This balance is necessary for liquidity, economy, flexibility and stability. 11. Explain the functions of financial decisions management: [ 2 Marks ]The modern approach to the financial management is concerned with the solution of major problems like investment financing and dividend decisions of the financial operations of a business enterprise. Thus, the functions of financial management can be broadly classified into three major decisions, namely:(a) Investment decisions,(b) Financing decisions,(c) Dividend decisions.

i) Explain major decisions of financial management. [16 Marks ]a) Investment decision:The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad groups: (i) long term assets which yield a return over a period of time in future, (ii) current assets which in the normal course of business are convertible into cash without diminution in the value usually within a year.Capital budgeting is probably the most crucial financial decision of a firm. It relates to the selection of an asset or investment proposal whose benefits are likely to be available in future over the lifetime of the project. The first aspect of the capital budgeting decision relates to the choice of the new asset out of the alternatives available. Working capital management is concerned with the management of current assets. It is important as short term survival is a prerequisite for long term success. It is the trade off between profitability and liquidity. If a firm does not have adequate working capital, it may not have the ability to meet its current obligations and thus, invite the risk of bankruptcy. If the current assets are too large, profitability is adversely affected. In addition, the individual current assets should be efficiently managed so that neither inadequate nor unnecessary funds are locked up.b) Financing decision:The concern of the financing decision is with the financing mix or capital structure or leverage. The term capital structure refers to the proportion of debt and equity capital. The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. There are two aspects of the financing decision. First, the theory of capital structure which shows the theoretical relationship between the employment of debt and the return to the shareholders. The use of debt implies a higher return and also higher risk. Therefore, it is necessary to have balance between risk and return. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure.c) Dividend policy decision:The dividend decision should be analyzed in relation to the financing decision of a firm. Two alternatives are available in dealing with the profits of a firm: (i) they can be distributed to the shareholders in the form of dividends or (ii) they can be retained in the business itself. The proportion of profits distributed as dividends is called the dividend payout ratio and the retained portion of profits is known as the retention ratio.

12. What are the functions of Financial Manager /Management? Finance manager performs the following major functions:1. Forecasting Financial RequirementsIt is the primary function of the Finance Manager. He is responsible to estimate the financial requirement of the business concern. He should estimate, how much finances required to acquire fixed assets and forecast the amount needed to meet the working capital requirements in future.2. Acquiring Necessary CapitalAfter deciding the financial requirement, the finance manager should concentrate how the finance is mobilized and where it will be available. It is also highly critical in nature.3. Investment / Policy DecisionThe finance manager must carefully select best investment alternatives and consider the reasonable and stable return from the investment. He must be well versed in the field of capital budgeting techniques to determine the effective utilization of investment. The finance manager must concentrate to principles of safety, liquidity and profitability while investing capital.4. Cash ManagementPresent days cash management plays a major role in the area of finance because proper cash management is not only essential for effective utilization of cash but it also helps to meet the short-term liquidity position of the concern.5. Interrelation with Other DepartmentsFinance manager deals with various functional departments such as marketing, production, personnel, system, research, development, etc. Finance manager should have sound knowledge not only in finance related area but also well versed in other areas. He must maintain a good relationship with all the functional departments of the business organization.1. Funds raising2. Funds allocation3. Dividend distribution4. Profit planning5. Understanding capital markets13. How do you measure Time value of money? Illustrate Future value or compound valueCompounding is the Process of finding the future values of cash flows by applying the concept of compound interest.1. Compound value of lump sumF=P(1+i)nF- future value at the nth periodi- interest raten- number of yearsSuppose that Rs.1000 is placed in the savings account of a bank at 5 percent interest rate. How much shall it grow at the end of three years?F = 1000(1+0.05)F = 1157.60Compound value of an annuityAnnuity is the fixed payment or receipt for specified number of years. Suppose Rs.100 is deposited at the end of each of the next three years at 10 percent interest rate. What will be the value at the end of third year? For which, the following formula can be used for calculation

F=AA-annuity=331Present value:Present value is also called discount value that is the future cash flow is discounted to present worth.Present value of lump sumThe present values can be worked out for any combination of number of years and interest rate. The following general formula can be employed to calculate the present value of single cash flow to be received after some periods.

P=FSuppose that an investor wants to find out the present value of Rs.50000 to be received after 15 years. The interest rate is 9 percent.P=50000[1/(1+0.09)15=13750Present value of an annuityAn investor may have an investment opportunity of receiving a constant period amount for certain specific period. The present value of this amount can be estimated with following equation.

P=ATo illustrate, let us suppose that a person receives an annuity of Rs.5000 for four years. If the rate of interest is 10 percent, the present value is

Present value of perpetuityPerpetuity is an annuity that occurs indefinitely. Its present value is arrived at using following equation.

P=To take an example, let us assume that an investor expects a perpetual sum of Rs.500 annually from his investment. The present value if interest rate is 10 percent isP = 500/0.1=5000.Present value of growing annuityIn financial decision making there are number of situations where cash flows may grow at a constant rate. In this case the present value is

A company paid a dividend of Rs.60 last year. This dividend stream is expected to grow at 10 percent per annum for 15 years and then ends. If the discount rate is 21 percent, what is the present value?=456.36Present value of growing perpetuityConstantly growing perpetuities are annuities growing indefinitely. Suppose dividends of Rs.66 after one year are expected to grow at 10 percent indefinitely and discount rate is 21 percent. The present value calculation uses following equation.

P =66/ (0.21-0.1)=Rs.60012. Explain the methods of measuring the changes in the value of money?Compound value of lump sumF=P(1+i)nCompound value of an annuity

F=PPresent value of lump sum

P=FPresent value of an annuity

P=APresent value of perpetuity

P=12. What is time value of money? Value of money at different point of times or period is called as time value of money. Present value of money is more value than future value of money.13. Why time value of money is important?There are several reasons. Individuals in general prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. An investment of one rupee today would grow to (1+r) a year hence. in an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.13. What is meant by yield to maturity?It is the measure of a bonds return that considers both the interest income and capital gain.14. What do you mean by the term required rate of return?It is minimum return expected by investors. In other words it is known as cost of capital or discount rate.15. What is EPS?Earning per share is net profit per share or ratio of net profit to number of shares outstanding.16. What do you mean by risk return trade off?It explains the direct relationship between return and risk. That means if you want more return you have to bear more risk and vice versa.17. Differentiate between put option and call optionPut option is the contract by which the holder of option has right to sell underlying asset at specified price on or before particular period where as call option gives right to the holder to buy.18. Explain Meaning and features of OptionsAn option is a claim without liability. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. The option to buy an asset is known as a call option. The option to sell an asset is called a put option. The price at which option can be exercised is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset.European option is an option that is allowed to be exercised only on the maturity date. American option is an option that can be exercised any time before its maturity. An option holder will exercise his option when it provides him a benefit over buying or selling a underlying asset from the market at the prevailing price.There are three possibilitiesIn the money: a call or put option is said to be in the money when it is advantages for the investor to exercise it.Out of the money: a call or put option is out of the money if it is not advantageous for the investor to exercise it.At the money: when the holder of a call or a put option does not lose or gain whether or not he exercise.19. Explain Meaning and features of Options?An option is a claim without liability. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. The option to buy an asset is known as a call option. The option to sell an asset is called a put option. The price at which option can be exercised is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset.European option is an option that is allowed to be exercised only on the maturity date.American option is an option that can be exercised any time before its maturity. An option holder will exercise his option when it provides him a benefit over buying or selling a underlying asset from the market at the prevailing price.There are three possibilitiesIn the money: a call or put option is said to be in the money when it is advantages for the investor to exercise it.Out of the money: a call or put option is out of the money if it is not advantageous for the investor to exercise it.At the money: when the holder of a call or a put option does not lose or gain whether or not he exercise his option, it is called as at the money.The option premium is the price that the holder of an option has to pay for obtaining a call or put option.Call optionA call option on a share is a right to buy the share at an agreed exercise price. The call option holder exercises his option, when he benefits from it.Exercise call option whenShare price at expiration>exercise price = St>EDo not exercise call option whenShare price at exirationexercise price = StEThe value of call option at expiration is:Value of call option at expiration = Maximum[share price-Exercise price,0]Ct = Max[St-E,0]Call premium:A call buyer exercises his right only when the outcomes are favourable to him. The seller of a call option being the owner of the asset gives away the good outcomes in favour of the option buyer. The buyer, therefore, pay up front a price called call premium to the call seller to buy the option. The call premium is a cost to the option buyer and a gain to the call seller. The net pay off is value of call option minus call premium.Put option:A put option is a contract that gives the holder a right to sell a specified share at an agreed exercise price on or before a given maturity period. A put buyer gains when the share price falls below the exercise price. He will forgo his put option if the share price rises above the exercise price.Exercise put option whenExercise price>Share price at expiration = E>StDo not exercise put option whenExercise price Share price at expiration = EStThe value of a put option = Maximum [Exercise price Share price at expiration, 0]Pt = Max [E-St,0]Put option pay off is put option value minus put option premium.4. Explain Meaning and features of OptionsAn option is a claim without liability. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. The option to buy an asset is known as a call option. The option to sell an asset is called a put option. The price at which option can be exercised is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset.European option is an option that is allowed to be exercised only on the maturity date.American option is an option that can be exercised any time before its maturity. An option holder will exercise his option when it provides him a benefit over buying or selling a underlying asset from the market at the prevailing price.There are three possibilitiesIn the money: a call or put option is said to be in the money when it is advantages for the investor to exercise it.Out of the money: a call or put option is out of the money if it is not advantageous for the investor to exercise it.At the money: when the holder of a call or a put option does not lose or gain whether or not he exercise his option, it is called as at the money.The option premium is the price that the holder of an option has to pay for obtaining a call or put option.Call optionA call option on a share is a right to buy the share at an agreed exercise price. The call option holder exercises his option, when he benefits from it.Exercise call option whenShare price at expiration>exercise price = St>EDo not exercise call option whenShare price at exirationexercise price = StEThe value of call option at expiration is:Value of call option at expiration = Maximum[share price-Exercise price,0]Ct = Max[St-E,0]Call premium:A call buyer exercises his right only when the outcomes are favourable to him. The seller of a call option being the owner of the asset gives away the good outcomes in favour of the option buyer. The buyer, therefore, pay up front a price called call premium to the call seller to buy the option. The call premium is a cost to the option buyer and a gain to the call seller. The net pay off is value of call option minus call premium.Put option:A put option is a contract that gives the holder a right to sell a specified share at an agreed exercise price on or before a given maturity period. A put buyer gains when the share price falls below the exercise price. He will forgo his put option if the share price rises above the exercise price.Exercise put option whenExercise price>Share price at expiration = E>StDo not exercise put option whenExercise price Share price at expiration = EStThe value of a put option = Maximum [Exercise price Share price at expiration, 0]Pt = Max [E-St,0]Put option pay off is put option value minus put option premium.20. Explain the Options? Options are derivative instruments that provide the opportunity to buy or sell an underlying asset on a future date. An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the premium or price of the option. The right to buy or sell is held by the option buyer (also called the option holder); the party granting the right is the option seller or option writer. Unlike forwards and futures contracts, options require a cash payment (called the premium) upfront from the option buyer to the option seller. This payment is called option premium or option price. Options can be traded either on the stock exchange or in over the counter (OTC) markets. Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved. Options traded in the OTC market however are not backed by the Clearing Corporation. There are two types of optionscall options and put optionswhich are explained below.Call option A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. It may be noted that the person who has the right to buy the underlying asset is known as the buyer of the call option. The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (call option strike price in this case). Since the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. The buyer of the call option does not have an obligation to buy if he does not want to. Put option A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. The person who has the right to sell the underlying asset is known as the buyer of the put option. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (put option strike price in this case). Since the buyer of the put option has the right (but not the obligation) to sell the underlying asset, he will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry date of the contract. The buyer of the put option does not have the obligation to sell if he does not want to. Illustration Suppose A has bought a call option of 2000 shares of Hindustan Unilever Limited (HLL) at a strike price of Rs 260 per share at a premium of Rs 10. This option gives A, the buyer of the option, the right to buy 2000 shares of HLL from the seller of the option, on or before August 27, 2009 (expiry date of the option). The seller of the option has the obligation to sell 2000 shares of HLL at Rs 260 per share on or before August 27, 2009 (i.e. whenever asked by the buyer of the option). Suppose instead of buying a call, A has sold a put option on 100 Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium of Rs 8. This option is an obligation to A to buy 100 shares of Reliance Industries (RIL) at a price of Rs 2000 per share on or before August 27 (expiry date of the option) i.e., as and when asked by the buyer of the put option. It depends on the option buyer as to when he exercises the option. As stated earlier, the buyer does not have the obligation to exercise the option. Terminology of Derivatives In this section we explain the general terms and concepts related to derivatives.

Types of options Options can be divided into two different categories depending upon the primary exercise styles associated with options. These categories are: European Options: European options are options that can be exercised only on the expiration date. American options: American options are options that can be exercised on any day on or before the expiry date. They can be exercised by the buyer on any day on or before the final settlement date or the expiry date. Contract size As futures and options are standardized contracts traded on an exchange, they have a fixed contract size. One contract of a derivatives instrument represents a certain number of shares of the underlying asset. For example, if one contract of BHEL consists of 300 shares of BHEL, then if one buys one futures contract of BHEL, then for every Re 1 increase in BHELs futures price, the buyer will make a profit of 300 X 1 = Rs 300 and for every Re 1 fall in BHELs futures price, he will lose Rs 300. ContractContract value is notional value of the transaction in case one contract is bought or sold. It is the contract size multiplied but the price of the futures. Contract value is used to calculate margins etc. for contracts. In the example above if BHEL futures are trading at Rs. 2000 the contract value would be Rs. 2000 x 300 = Rs. 6 lacs.Margins In the spot market, the buyer of a stock has to pay the entire transaction amount (for purchasing the stoc k) to the seller. For example, if Infosys is trading at Rs. 2000 a share and an investor wants to buy 100 Infosys shares, then he has to pay Rs. 2000 X 100 = Rs. 2,00,000 to the seller. The settlement will take place on T+2 basis; that is, two days after the transaction date. In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement happens on a future date. Because of this, there is a high possibility of default by any of the parties. Futures and option contracts are traded through exchanges and the counter party risk is taken care of by the clearing corporation. In order to prevent any of the parties from defaulting on his trade commitment, the clearing corporation levies a margin on the buyer as well as seller of the futures and option contracts. This margin is a percentage (approximately 20%) of the total contract value. Thus, for the aforementioned example, if a person wants to buy 100 Infosys futures, then he will have to pay 20% of the contract value of Rs 2,00,000 = Rs 40,000 as a margin to the clearing corporation. This margin is applicable to both, the buyer and the seller of a futures contract. Moneyness of an Option Moneyness of an option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not. Moneyness of an option at any given time depends on where the spot price of the underlying is at that point of time relative to the strike price. The premium paid is not taken into consideration while calculating moneyness of an Option, since the premium once paid is a sunk cost and the profitability from exercising the option does not depend on the size of the premium. Therefore, the decision (of the buyer of the option) whether to exercise the option or not is not affected by the size of the premium. The following three terms are used to define the moneyness of an option. In-the-money option An option is said to be in-the-money if on exercising the option, it would produce a cash inflow for the buyer. Thus, Call Options are in-the-money when the value of spot price of the underlying exceeds the strike price. On the other hand, Put Options are in-the-money when the spot price of the underlying is lower than the strike price. Moneyness of an option should not be confused with the profit and loss arising from holding an option contract. It should be noted that while moneyness of an option does not depend on the premium paid, profit/loss do. Thus a holder of an in-the-money option need not always make profit as the profitability also depends on the premium paid.Participants in the Derivatives Market As equity markets developed, different categories of investors started participating in the market. In India, equity market participants currently include retail investors, corporate investors, mutual funds, banks, foreign institutional investors etc. Each of these investor categories uses the derivatives market to as a part of risk management, investment strategy or speculation. Based on the applications that derivatives are put to, these investors can be broadly classified into three groups: Hedgers Speculators, and Arbitrageurs We shall now look at each of these categories in detail. Hedgers These investors have a position (i.e., have bought stocks) in the underlying market but are worried about a potential loss arising out of a change in the asset price in the future. Hedgers participate in the derivatives market to lock the prices at which they will be able to transact in the future. Thus, they try to avoid price risk through holding a position in the derivatives market. Different hedgers take different positions in the derivatives market based on their exposure in the underlying market. A hedger normally takes an opposite position in the derivatives market to what he has in the underlying market. Hedging in futures market can be done through two positions, viz. short hedge and long hedge. Short Hedge A short hedge involves taking a short position in the futures market. Short hedge position is taken by someone who already owns the underlying asset or is expecting a future receipt of the underlying asset. or example, an investor holding Reliance shares may be worried about adverse future price movements and may want to hedge the price risk. He can do so by holding a short position in the derivatives market. The investor can go short in Reliance futures at the NSE. This protects him from price movements in Reliance stock. In case the price of Reliance shares falls, the investor will lose money in the shares but will make up for this loss by the gain made in Reliance Futures. Note that a short position holder in a futures contract makes a profit if the price of the underlying asset falls in the future. In this way, futures contract allows an investor to manage his price risk. Similarly, a sugar manufacturing company could hedge against any probable loss in the future due to a fall in the prices of sugar by holding a short position in the futures/ forwards market. If the prices of sugar fall, the company may lose on the sugar sale but the loss will be offset by profit made in the futures contract. Long Hedge A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward price. This strategy is used by those who will need to acquire the underlying asset in the future. For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried about any loss that may arise if the price of sugar increases in the future. To hedge against this risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal market, but he will be compensated against this loss through a profit that will arise in the futures market. Note that a long position holder in a futures contract makes a profit if the price of the underlying asset increases in the future. Long hedge strategy can also be used by those investors who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to lock the prevailing price in the market. This may be because he thinks that the prevailing price is very low. For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per stock. An investor is expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is at a very attractive level and he may miss the opportunity to buy the stock if he waits till the end of the month. In such a case, he can buy Wipro Ltd. in the futures market. By doing so, he can lock in the price of the stock. Basic terms in financial Management1. Money markets vs. capital marketsa. Money markets are markets for short-term and highly liquid debt securities (less than one year)b. Capital markets are markets for intermediate and long-term debts and stocks (one year or longer)2. Primary markets vs. secondary marketsa. Primary markets are markets for issuing new securitiesb. Secondary markets are markets for trading existing securitiesUNIT I FOUNDATIONS OF FINANCE 1. Financial management An overview-2. Time value of money3. Introduction to the concept of risk and return of a single asset4. Concept of risk and return of a portfolio.5. Valuation of bonds and shares6. Option valuation.PART A1. What is finance and financial assets?2. Define financial management?3. How is the term finance more comprehensive than money management?4. What is scope of financial management?5. What are the objectives of financial management?6. What is modern & traditional view on financial management?7. What is the emerging role of the financial management?8. Briefly explain any two setbacks of Profit maximization. 9. What is time value of money?10. Explain compound value concept.11. What is the concept of risk and return of portfolio?12. What is systematic risk & unsystematic risk?13. What are the types of return?14. What is effective rate of interest?15. What do you mean by portfolio?16. What is the formula of valuation of bond?17. Distinguish between call option and put option?18. What is present value?PART B1. Explain major decisions of financial management.2. What are the functional areas of financial management?3. What are the functions/ role of financial manager/Management? 4. What are the difference between profit maximization and wealth maximization and its limitations?5. In what ways is the wealth maximization objective superior to the profit maximization objective? Explain.6. Explain the changing scenario of financial management in India.[Ans 4]7. Discuss fully the organization of the finance functions in a business?8. List out and explain the method of measuring the changes in the value of money?9. What is risk? How can risk of a security be calculated? Explain your answer with an example.10. What are the basic financial decisions? How do they involve risk- return trade off?11. Explain how do you concept / measure Time value of money? Illustrate 12. Distinguish between the risk and return of a single asset and that of a portion?13. Define an option and explain briefly the Black Scholes option model?

UNIT 2 INVESTMENT DECISIONS:1. Capital Budgeting: Principles and techniques,2. Nature of capital budgeting, 3. Identifying relevant cash flows, 4. Evaluation Techniques,a. Payback, b. Accounting rate of return, c. Net Present Value, d. Internal Rate of Return, e. Profitability Index,5. Comparison of DCF techniques 6. Project selection under capital rationing, 7. Inflation and capital budgeting. 8. Concept and measurement of cost of capital, 9. Specific costs and overall cost of capital.1. Capital Budgeting: Principles and techniques. What is capital budgeting? (May 2013) It refers to planning the deployment of available capital for the purpose of maximizing the long-term profitability of a firm. It is the decision-making process by which the firm evaluates the purchases of fixed assets.2. Explain the importance and types of capital budgetinga) The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.b) The firms investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.c) Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firms expenditures and benefits, and therefore, they should also be evaluated as investment decisions.Features: The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. Importance Growth Risk Funding Irreversibility ComplexityTypes: One classification is as follows: Expansion of existing business Expansion of new business Replacement and modernisation Yet another useful way to classify investments is as follows: Mutually exclusive investments Independent investments Contingent investments

List out Factors affecting capital budgeting:Capital budgeting or capital expenditure decision depends on many factors such as1. Opportunities: The first and foremost factor which decides the capital budgeting decision is investment opportunities available for the firm. Without investment opportunity, there is no need of considering capital expenditure. When firm has more opportunities, the capital budgeting becomes significant and complex.2. Certainty:Every project has its own risk. The cash flow variation differs from project to project. Greater the risk the firm has, more the profitability it earns and vice versa. Though aim of the finance manager is to maximise wealth, he has to look in to quality of cash flow.3. Urgency:Sometimes an investment may require immediate attention in view of survival of business. Owing to urgency of investment, the firm may not follow stringent evaluation procedure.4. Availability of funds:It is another important factor that decides capital budgeting decision. Some due to lack of funds, even highly profitable project may not be in a position to undertake. When a firm posses abundant resources, even low profitable project may undertaken.5. Future earnings: A project may not be profitable today or in short term but it may be more profitable in long term or in future. When projects are evaluated this case may be short listed for investment.6. Obsolescence: There are certain projects which have greater risk of obsolescence than others. In case of projects with high rate of obsolescence, the project with lesser payback period may be preferred than one which may have higher profitability but still longer pay back period.7. cost considerations:Cost of capital, cost of production, opportunity cost of capital etc., are other consideration involved in the capital budgeting decisions.8. Intangible factors: Sometimes a capital expenditure has to be made due to certain emotional and intangible factors such as safety and welfare of workers, prestigious project, social welfare, goodwill etc.9. Legal factors:An investment which is required by the provisions of law is solely influenced by this factor. Though projects may not be profitable, investment should be made.3. What is capital rationing? (Nov 2013)Capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of investment proposals out of many investment proposals a acceptable under the accept reject decision. It employs ranking of the acceptable investment projects. The projects can be ranked on the basis of a predetermined criterion such as the rate of return.4. What is capital expenditure? Give examplesA capital expenditure is an expenditure intended to benefit future periods. Other words, any investment involves the commitment of funds now with the expectations of earning a satisfactory return on these funds over a period of time in future.Example: a) amount incurred on acquisition of fixed assets b) Amount incurred on making additions to the existing machinery etc c) Amount spent on replacing existing machinery etc d) Amount spent on research and development1. List out the various assumptions of capital structure theories5. What is discounted pay back period? One of the serious limitations of the payback method is that it does not discount the cash flows for calculating the pay back period. Some people, therefore, discount cash flows and calculate the discounted payback period. The number of periods taken in recovering the investment outlay on the present value basis is called the discounted payback period.6. What is time value of money in capital budgeting decisions? Money has time value. A rupee today is more valuable than a rupee a year hence. 7. What is pay back period? How do you calculate it? (Nov 2013)The term payback period refers to the period in which the project will generate the necessary cash to recover the investment. If cash flows are conventional:Pay back period = initial investment/annual cash inflowIn cash flows are unconventional:Calculation of period will take cumulative form. In such a case the pay back period can be found by adding up the amount of net cash inflows until the total is equal to the Initial investment.8. How PI is superior to NPV?The serious drawback of NPV method is that, being an absolute measure, it is not a reliable method to evaluate projects requiring different initial investments. The PI or Benefit-Cost method provides a solution to this kind of problem. It is, in other words, a relative measure. The PI approach measures the present value of returns per rupee invested, while the NPV is based on the difference between the present value of future cash inflows and present value of cash outlays.9. What is IRR?The internal rate of return of a project is the discount rate which makes its NPV equal to zero. Put differently, it is the discount rate which equates the present value of future cash flows with the initial investment.10. What do you mean by mutually exclusive and independent projects? Mutually exclusive projects: If the firm accepts one project, it may rule out the need for another. These are called mutual exclusive projects. They do not depend upon each other. Independent projects: These are projects that do not complete with one another in such a way that the acceptance of one precludes the possibility of acceptance of another.11. Make a comparison between NPV and IRRThough both are discounted cash flows methods, there are certain fundamental differences:The IRR and NPV methods can give different results in the ranking of proposals. IRR method assumes that future cash receipts are invested at the rate of return forecasted for the project. The NPV method assumes that proceeds are invested at the required return. If the forecasted return on the project exceeds the required rate as an unknown factor. The basic presumption of the NPV method is that intermediate cash inflows are reinvested at the cut off rate, whereas, in the case of the IRR method, intermediate cash flows are presumed to be reinvested at the IRR.12. What are the limitations of pay back method?a) It ignores the time value of money. It treats all the cash flows generated at different periods of time are equal.b) It does not take consider the interest factor.c) It does not consider income beyond the pay-back period and looks upon it a windfall.14. What is cash flow?Net profit + Non operating and non cash expenses15. What is salvage value?The value of asset at the end of useful life of the asset.17. What are thee financial problems involve cash flows occurring at different points of time?These cash flows have to be brought to the same point of time for the purposes of comparison and aggregation. Hence in capital budgeting decisions cash flows are to be discounted at the firms cost of capital to know the present value of cash flows18. What is cost of capital?Minimum expected rate of return by the investors.19. What is opportunity cost of capital?The return foregone by not choosing the next best alternative investment.20. What is average cost of capital?It is overall cost of capital assigning weight to various specific cost of capital respectively.21. What are the various methods of evaluating capital budgeting proposals?(May 2014)The various tools and techniques of capital budgeting are payback period method, discounted payback period method, accounting rate of return method, net present value method and internal rate of return method. 22. What is cut- off point?The cut-off point refers to the point below which a project would not be accepted. For example, if 10% is the desired rate of return, the cut-off rate is 10%. The cut-off point may also be in terms of period. Ex: If the management desires that the investment in the Project should be recovered in three years, the period of three years would be taken as the cut-off period. A project, incapable of generating necessary cash to pay for the initial investment in the project within three years, will not be accepted. 23. ABC Ltd pays no dividends anticipate in a long run level of future earnings of Rs.7 per share. The current price ABC Ltds share is Rs.55.45, floatation cost for the sale of new equity shares would average about 10% of the price of the share. What is the cost of new equity capital to ABC Ltd?(May 2014)Cost of new equity = 7/(55.45-5.545)=14.014%1. A firm is considering the following two mutually exclusive investments Cash flows

projectsC0C1C2C3

A-250005000500025640

B-28000126721267212672

The cost of capital is 12 %. Compute the NPV and IRR for each project. Which project should be undertaken? Why?. Suppose cost of capital declines to 10%, what would be the change in NPV of projects?Project A NPV @10% =Rs 2674 NPV @ 12%=Rs 1518.13 Difference = Rs 1155.87 IRR=15%Project B NPV @10%=Rs 3193.99 NPV @ 12%=Rs 2175.01 Difference =Rs1018.98 IRR=17%24. Explain various capital budgeting techniques with merits and demerits.Discounted cash flow methods: Net Present Value

NPV=Accept if NPV is positive and reject if NPV is negativeMeritsDemerits

Considers all cash flows

True measure of profitability

Based on the concept of the time

Satisfies the value additive principle

Consistent with the shareholders wealth maximizationRequires estimates of cash flows which is a tedious task

Requires computation of the opportunity cost of capital which poses practical difficulties

Sensitive to discount rates value of money

Internal rate of returnThe discount rate which equates the present value of an investments cash inflows and outflows is its internal rate of return.

where K is IRRAccept if IRR is more than cost of capital and reject if IRR is less than cost of capital.MeritsDemerits

Considers all cash flowsTrue measure of profitability

Based on the concept of the time value of money

Generally consistent with wealth maximization principleRequires estimates of cash flows which is a tedious work

Does not hold the value of additive principle

At times, fails to indicate correct choice between mutually exclusive projects

At times yields multiple rates

Relatively difficult to compute

Profitability indexThe ratio of the present value of the cash flows to the initial outlay is profitability indexAccept if profitability index is more than one and reject if PI is less than one.MeritsDemerits

Considers all cash flowsRecognizes the time value of moneyRelative measure of profitabilityGenerally consistent with wealth maximization principleRequires estimates of the cash flows which is tedious taskAt times fails to indicate correct choice between mutually exclusive projects

Non-discounted cash flow criteriaPay backThe number of years required to recover the initial outlay of the investment is called pay back.MeritsDemerits

Easy to understand and compute and inexpensive to useEmphasizes liquidityEasy and crude way to cope with riskUses cash flows informationIgnores time value of moneyIgnores cash flows occurring after the pay back periodNot a measure of profitabilityNo objective way to determine the standard paybackNo relation with the wealth maximization principle

Accounting rate of returnAn average rate of return found by dividing the average net operating profit by the average investmentMeritsDemerits

Uses accounting data with which executives are familiarEasy to understand and calculateGives more weightage to future receiptsIgnores the time value of moneyDoes not use cash flowsNo objective way to determine the minimum acceptable rate of return

25. Explain the various factors influencing capital expenditure decisions? Capital investment decisions are not governed by one or two factors because the investment problem is not simply one of replacing old equipment by a new one but is concerned with replacing an existing process in a system with another process which makes the entire system more effective. Management outlook(a) Competitors strategy(b) Opportunities created by technological changes(c) Market forecast(d) Fiscal incentives(e) Cash flow budget(f) Non economic factors11. Explain components of cash flow?1. Initial Investment2. Net Cash Flowsa) Revenues and Expenses b) Depreciation and Taxesc) Change in Net Working Capital Change in accounts receivable Change in inventory Change in accounts payabled) Change in Capital Expenditure e) Free Cash Flows3. Terminal Cash Flows a) Salvage Value Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage valueb) Release of Net Working Capital 14. What is capital expenditure? Give examplesA capital expenditure is an expenditure intended to benefit future periods. Other words, any investment involves the commitment of funds now with the expectations of earning a satisfactory return on these funds over a period of time in future.Exampl: a) amount incurred on acquisition of fixed assets b) Amount incurred on making additions to the existing machinery etc c) Amount spent on replacing existing machinery etc d) Amount spent on research and development15. What is time value of money in capital budgeting decisions?Money has time value. A rupee today is more valuable than a rupee a year hence. 9. Explain Return and risk of single security and portfolio?Return is the excess earnings over investment. Return consists of regular income and capital gain or loss. For shares, the regular income is dividend and capital appreciation is price changes between two periods.

P1- current price, P0- last year price and DIV1-current dividend, and R- returnRisk is variation in return or volatility in return. It can be calculated using range, variance and standard deviation.Range is the difference between highest return and lowest return. Suppose a share earns returns of 5%, 4%, 7% and 8% for 1 through 4 years respectively.The range is 4% (8-4).Variance Standard deviation of single portfolio

yearReturnDifference square

151

244

371

484

Mean return =6Variance = 10/3 = 3.33Standard deviation = 1,825Return with probability:Expected return is the sum of the product of each outcome or return and its associated probability.E(R) =

The share of hypothetical company limited has the following anticipated returns with associated probabilities.Return-20-101015202530

Probability0.050.100.200.250.200.150.05

Using formula the expected return and standard deviation are calculated.E(R) = 13%Standard deviation = 12.49%Risk and return of two assets portfolio:The return of the portfolio is equal to the weighted average of the returns of individual assets in the portfolio with the weights being equal to the proportion of investment value in each assetThere is a direct and simple method of calculating the expected rate of return on a portfolio if we know the expected rates of return on individual assets and their weights.

We can use variance or standard deviation to measure the risk of the portfolio of assets. The portfolio variance or standard deviation depends on the co movements of returns on two assets. Covariance of returns on two assets measures their comovement. Three steps are involved in the calculation of covariance between two assets:1. Determine the expected returns on assets2. Determine the deviation of possible returns from the expected return for each asset.3. Determine the sum of the product of each deviation of returns of two assets and respective probability.

The variance of two asset portfolio is not the weighted average of assets since they covary as well. The standard deviation of two security portfolio is given by the following equation.

It is noted from equation that the variance of a portfolio includes the proportion of variances of the individual securities. The covariance depends on the correlation between the securities in the portfolio.15. Explain the calculation of specific cost of capital and weighted average cost of capital.Computation of cost of capital consists of two important parts:1. Measurement of specific costs2. Measurement of overall cost of capital1. Measurement of Cost of CapitalIt refers to the cost of each specific sources of finance like:a) Cost of equityb) Cost of debtc) Cost of preference shared) Cost of retained earningsa) Cost of EquityCost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Conceptually the cost of equity capital (Ke) defined as the Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares. Cost of equity can be calculated from the following approach:A. Dividend price (D/P) approachB. Dividend price plus growth (D/P + g) approachC. Earning price (E/P) approachD. Realized yield approach.

A. Dividend Price ApproachThe cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares. Dividend price approach can be measured with the help of the following formula:

Where,Ke= Cost of equity capitalD = Dividend per equity shareNP = Net proceeds of an equity shareB. Dividend Price Plus Growth ApproachThe cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:

g = growth of dividendC. Earning Price ApproachCost of equity determines the market price of the shares. It is based on the future earnings prospects of the equity. The formula for calculating the cost of equity according to this approach is as follows.

E=earnings per share

b. Cost of DebtCost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable.Debt Issued at ParDebt issued at par means, debt is issued at the face value of the debt. It may be calculated with the help of the following formula.

I=interest ratet=tax rateDebt Issued at Premium or DiscountIf the debt is issued at premium or discount, the cost of debt is calculated with the help of the following formula.

Cost of Perpetual Debt and Redeemable DebtIt is the rate of return which the lenders expect. The debt carries a certain rate of interest.

c) Cost of Preference Share CapitalCost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share. There are two types of preference shares irredeemable and redeemable. Cost of redeemable preference share capital is calculated with the help of the following formula:

d) Cost of Retained EarningsRetained earnings are one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital. The opportunity cost of its retained earnings is the rate of return foregone by equity shareholders. The shareholders generally expect dividend and capital gain from their investment.2.Measurement of Overall Cost of CapitalIt is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.The overall cost of capital can be calculated with the help of the following formula;Ko= KdWd + KpWp + Ke We + KrWrWhere,Ko = Overall cost of capitalKd = Cost of debtKp = Cost of preference shareKe = Cost of equityKr = Cost of retained earningsWd= Percentage of debt of total capital.

UNIT -2 PART B1) What is equity? What is its yield to maturity?2) What is DCF of capital budgeting techniques?3) Calculate 1. Payback period method 2. NPV3. IRR4. Profitability Index 5. How will you calculate cost of capital? Explain with an illusteration? 4) Discuss objectives and functions of financial management. Explain Meaning and features of Options? 5) Discuss objectives and functions of financial management. 6) Explain Meaning and features of Options

UNIT III UNIT III FINANCING AND DIVIDEND DECISION: Financial and operating leverage - capital structure - Cost of capital and valuation - designing capital structure. Dividend policy - Aspects of dividend policy - practical consideration - forms of dividend policy - forms of dividends - share splits.

1.The current market price of a companys share is Rs.90 and the expected dividend per share next year is Rs.4.50. If the dividends are expected to grow at a constant rate of 8%, what is the shareholders required rate of return? Ke = D + g PoWhere D = dividend = Rs.4.50g = growth rate = 8%Po = present market value = Rs.90 Ke = Rs 4.50 + 8% or 0.08 = 0.05 + 0.08 = 0.13Rs.90Ke = 13%2. Define the degree of operating and degree of financial leverageThe degree of operating leverage (DOL) may be defined as the percentage change in operating profits (earnings before interest and taxes) resulting from a percentage change in sales. Thus, DOL = % change in operating profit % change in salesThe degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT. Thus,DFL = % change in EPS% change in EBIT 3.What is the effect of leverage on the cost of capital under the Net operating income approach (NOI)?The NOI approach states that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the real value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.4. If debt is cheaper than equity why do companies not finance their assets with 80% or 90% debt?Even though debt is cheaper than equity, companies will not finance their assets with 80% or 90% debt because, debt implies compulsory payment of interest, which the company is legally bound to pay. In case the company is unable to meet its interest obligations, it has to resort to external borrowing to meet it. In which case, ultimately debt works out to be operationally costlier than equity.5. What is Walters formula to determine the market price per share?Walters formula to determine the market price per share is as follows P = D/(Ke g)Where P = price of equity shares, D = initial dividend, Ke = cost of equity capital g = expected growth rate of earnings6. What is stable dividend policy? Stable or regular dividend policy is considered a desirable policy by the management of most companies in practice. This implies regularity in paying some dividend annually, even though the amount of dividend may fluctuate over years, and may not be related with earnings. Some of the most distinct forms of stable dividends are : i) constant dividend per share or dividend rate ii) constant payout iii) constant dividend per share plus extra dividend.7. A companys current price of share is Rs.60 and dividend per share is Rs.4. If its capitalization rate is 12%, what is the dividend growth rate? Po = D = D (1+ g) ke - g ke g60 = 4 ( 1 1 g) 0.12 - g7.2 60g = 4+4g- 64g = - 3.2g = 3.2 = 0.05 or 5%. 648. What are the steps involved in calculating a firms WACC? The various steps involved in calculating a firms WACC are as follows:i) Estimate the cost of each source of financing for various levels of its use through an analysis of current market conditions and an assessment of the expectations of investors and lendersii) Identify the levels of total new financing at which the cost of the new components would change, given the capital structure policy of the firm.iii) Calculate the WACC for various ranges of total financing between the breaking points.iv) Prepare the weighted marginal cost of capital schedule which reflects the WACC for each level of total new financing.9. Define financial leverage (May 2013). Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.10. Define operating leverageThe operating leverage may be defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage results from the existence of fixed operating expenses in the firms income stream.11. What is debt-service-coverage ratio? State the formula and name the variablesDebt-service coverage ratio indicates the capacity of the company to meet fixed financial charges. It shows the number of times the interest charges are covered by funds that are ordinarily available for their payment. Interest coverage ratio = EBDIT InterestWhere EBDIT = earnings before depreciation, interest and taxesToo high a ratio indicates that the firm is very conservative in using debt, and that it is not using credit to the best advantage of shareholders. A lower ratio indicates excessive use of debt, or inefficient operations. The firm should make efforts to improve the operating efficiency, or to retire debt to have a comfortable coverage ratio.12.What is EBIT EPS analysis?The EBIT EPS analysis, as a method to study the effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. The choice of the combination of the various sources would be one which, given the level of earnings before interest and taxes, would ensure the largest EPS.13. Compare bonus issue and stock split A stock dividend or bonus issue represents a distribution of shares in lieu of or in addition to the cash dividend to the existing shareholders. The declaration of stock dividend will increase the equity share capital and reduces the reserves and surpluses (retained earnings) of the company. A stock split is a method to increase the no. of outstanding shares through a proportional reduction in the par value of the share. With stock split, the total net worth does not change and the no. of outstanding shares increases with dilution in EPS and a proportionate fall in the market price of a share.14. Write the formula of Walter share valuation model. State the variables Walters share valuation model formula is as followsP = D where Ke g P = price of equity sharesD = initial dividendKe = cost of equity capitalG = expected growth rate of earnings 15. Who presented dividend irrelevance theorem? state any three criticisms of this theoremThe dividend irrelevance theorem was associated with Soloman, Modigliani and Miller. According to them, d