FIN 611 Financial Management

Assignment 2
Weight 10%
Submit by 5 August 2021
Question 1 [ Capital Budgeting] [ Textbook P 388 Question 10 ]
a)
Payback Method
Payback for Project A : 10,000/12,000 = 0.83 Years
Payback for Project B : 10,000/10,000 = 1 Years
Under the Payback Method, you should select Project A because of the shorter payback period

b)
Net Present Value Method Project A
Year Cash Flow PVIF at 10% Present Value

1 $12,000 0.909 $10,908

2 $ 8,000 0.826 $ 6,608

3 $ 6,000 0.751 $ 4,506

Present Value of Inflows     : $22,022
Present Value of Outflows : 10,000
Net Present Value             : $12,022
Net Present Value Method Project B
Year Cash Flow PVIF at 10% Present Value

1 $10,000 0.909 $ 9,090

2 $ 6,000 0.826 $ 4,956

 3 $16,000 0.751 $12,016
Present Value of Inflows     : $26,062
Present Value of Outflows : 10,000
Net Present Value             : $16,062
Under the net present value method, you should select Project B because of the higher net present
value.
c)
A company should normally have more confidence in answer b because the net present value
considers all inflows as well as the time value of money. The heavy late inflow for Project B was
partially ignored under the payback method.

Question 2
[ Text book , Question 18 P. 390]
1. Calculation of NPV:
Present Value =
Cash flow *
Present value Present value
Cash discounting discounting
Year Particulars flow factor @ 13% factor

-
Initial investment 60,00
0 (Cost of machine) 0 1 -60,000.00

Incremental 23,00
1 saving 0 0.8850 20,355.00

Incremental 26,00
2 saving 0 0.7831 20,360.60

Incremental 29,00
3 saving 0 0.6931 20,099.90

Incremental 15,00
4 saving 0 0.6133 9,199.50

Incremental
5 saving 8,000 0.5428 4,342.40
 Present Value =
Cash flow *
Present value Present value
Cash discounting discounting
Year Particulars flow factor @ 13% factor

Net Present Value

(NPV) 14,357.40
By excel

Net present value of selecting a new machine = $14,357.40

2. Calculation of IRR:
Since the NPV @ 13% cost of capital is positive, IRR is greater than 13%.
Let's calculate NPV @ 25% and then use interpolation to calculate IRR.
Present value Present Value = Cash
Cash discounting flow * Present value
Year Particulars flow factor @ 25% discounting factor

Initial -
0 investment 60,000 1 -60,000.00
 Present value Present Value = Cash
Cash discounting flow * Present value
Year Particulars flow factor @ 25% discounting factor

(Cost of
machine)

Incremental
1 saving 23,000 0.8000 18,400.00

Incremental
2 saving 26,000 0.6400 16,640.00

Incremental
3 saving 29,000 0.5120 14,848.00

Incremental
4 saving 15,000 0.4096 6,144.00

Incremental
5 saving 8,000 0.3277 2,621.60

Net
Present
Value
(NPV) -1,346.40

NPV @ 13% = $14,357.40

NPV @ 25% = -$1,346.40
Using interpolation,
= 13 + [(25-13) / (14357.40 - (-1346.40))] * 14357.40
= 13 + 10.9712
= 23.9712% (Approximately, difference is due to rounding off)

By excel
3. The said project should be accepted because the Net present value at the given cost of capital is
positive which means that the project is earning more than the cost of capital.
As we can see, IRR of the project is 23.9712% whereas the cost of capital is just 13%. Therefore,
the project is beneficial and profitable.

Question 3
Explain briefly demerits of Pay Back Period.
One of the demerits of the pay back period method is that it does not consider time value money.
Explain with example how discounted pay back period method could sort this shortcoming?

Pay back period is calculated to know the period within which the company expect to generate
returns.

Demerits of payback period:

1. As the company can't plan the project budget for the long-term when it takes up a new one, it
can't focus on the budgets for this kind of plan.
2. They also fail to consider the time value of money as this is not included in their calculation.
3. It's not suitable for complex projects.

The discounted payback period (DPP) method is based on the discounted cash flows technique and is used in
project valuation as a supplemental screening criterion. In simple words, it is the number of years needed to
recover initial cost (cash outflows) of a project from its future cash inflows. To calculate it, we need
consequentially add the discounted value of each future cash inflow as long as the initial cost will be recovered.

Advantages and Disadvantages

The main disadvantage of the discounted payback period method is that it does not take into account cash flows
coming in after break-even. Furthermore, it shows only the time needed to recover the initial cost of a project and
is some break-even analysis technique. For this reason, this method can conflict with NPV and therefore can be
wrong. Also, there isn’t any way to determine how short the payback period should be to accept the project. In
academic studies, using this method is not recommended for mutually exclusive projects.

The main advantage of the discounted payback period method is that it can give some clue about liquidity and
uncertainly risk. Other things being equal, the shorter the payback period, the greater the liquidity of the project.
Also, the longer the project, the greater the uncertainty risk of future cash flows. Therefore, the shorter the
payback period, the lower the overall risk of a project. However, the choice of a project solely on the basis of the
payback criterion is purely an arbitrary decision.An example of the shortcoming of discounted payback
period is as the present value of money is worth than the future amount, the calculation of payback
period doesn't take this into account.
Question 4
[ Textbook P. 390 Question 19]

In this we have to calculate present value of cash flow and from that we can get net present
value and profitability index.

PROJECT 1
Interest rate =14%
Initial investment =$20000
Present value =Future cash flow/(1+r)^n
Present value of cash flow =10000/(1.14)+8000/(1.14)^2 +9000/(1.14)^3 + 8000/(1.14)^4
Present value of cash flow =$25739.06
Initial investment =$20000
Net present value =Present value of cash flow- initial investment 
Net present value =25739.06 - 20000
Net present value =$5739.06
Profitability index =Present value of cash flow/Initial investment 
Profitability index =25739.06/20000
Profitability index =1.30

Project X(20000 investment)

Project NPV= C0+ CF1/(1+r)^1 + CF2/(1+r)^2 …………CFn/(1+r)^n
= -20000+10000/1.14^1+8000/1.14^2+9000/1.14^3+8600/1.14^4
= -20000+8771.9298+6155.7402+6074.7436+5091.8904
= 6094.3040
Profitability Index= PV of inflows/ Initial cost
=( 10000/1.14^1+8000/1.14^2+9000/1.14^3+8600/1.14^4 )/20000
=(8771.9298+6155.7402+6074.7436+5091.8904)/20000
= 26094.304/20000
= 1.30

PROJECT 2
Initial investment =$40000
Present value of cash flow =20000/(1.14)+13000/(1.14)^2 +14000/(1.14)^3 +16000/(1.14)^4
 IRR is that discount
rate for which NPV is
0. It has to be found
out by trial and error,
1 by varying
Present value of cash flow =$46469.82
Netthe
present value
discount =46469.82 - 40000
rate
Netsuitably,
present value =$6469.82
till NPV
Profitability
becomes 0. index =46469.82/40000
Profitability index =1.17
P P
Project X(40000 investment) V V
Project NPV= C0+ CF1/(1+r)^1 Ca + IFCF2/(1+r)^2
P IF …………CFn/(1+r)^n
= -40000+20000/1.14^1+13000/1.14^2+14000/1.14^3+16600/1.14^4
sh at V at PV
= -40000+17543.8596+10003.0779+9449.6012+9828.5326
Fl 1 at 1 at
=6825.07 o 1 11 2 12
Profitability
Year Index= PV of inflows/
w %Initial % cost
% %
=(1.14^1+13000/1.14^2+14000/1.14^3+16600/1.14^4)/40000
$    
=(17543.8596+10003.0779+9449.6012+9828.5326)/40000
= 46825.0714/ 40000        $   
= 1.17     $    
(2 (2      
6,0 6, (26
00 00 ,00
PROJECT
0 X first PROJECT ) 1 0) 1 0)
Profitability index =1.30
NPV=$5739.06 $     $    $    
PROJECT second                     
NPV=$6469.82    0. 0.   
Profitability index =1.17  12, 90 10 89 10,
So based on NPV second PROJECT00 09is better 
,8 28 71
1 0 0 11 6
But based on profitability index first X PROJECT 4is better.
So select First X PROJECT which have initial investment of $20000
$     $   
Even though Profitability Index of the first project is higher, select the second project (40000
             $    
investment) since it has higher
   NPV 0.     0.       
11, 81 8, 79     
Question 5 00 16 92 71 8,7
2 0 2 8 9 69

$   
$           $    
       0.     0.       
      73 6, 71     
9,0 11 58 17 6,4
3 00 9 1 8 06
Calculate internal Rate of Return of the project. Should the project be accepted?
If reinvestment rate assumption of IRR $   
is changed to cost of capital 11% , what should the
modified rate of return ( MIRR)?       $    
            
The MIRR modifies the situation by  considering
     
31 at the (11
reinvestment of intervening cash flows
NPV 9 1)

As 0 NPV is got
between 11% and 12%,
the IRR also lies
between them.

By simple
2
]

cost of capital of 11%.

Cash FVIF at PV at
Year Flow 11% 11%

$             $        
1 12,000 1.23210 14,785

$             $        
2 11,000 1.11000 12,210

3 $ 9,000 1.00000 $ 9,000

$        
Cumulative FV 35,995

Now there are only two cash flows. A total cash inflow of
$35,995 at t3 and a cash outflow of

$26,000 at t0. MIRR is that discount rate which equates

the PV of $35,995 with the initial

investment of $26,000.

That is, 26000 = 35995/(1+MIRR)^3

MIRR = (35995/26000)^(1/3)-1 = 11.45%

Question 6 [Estimating Working Capital Requirement Using Operating Cycle Method]

X Ltd Co. wants to know working capital by operating cycle methods when : Estimated Sales
20,000 units @ $5 P.U.
Production and Sales will remain similar throughout the year. Production costs: M – 2.5 P.U.,
Labour 1.00 P.U. Overheads $17.500.
Customers are given 60 days credit and 50 days credit from suppliers. 40 days supply of raw
materials and 15 days supply of finished goods are kept in store.
Production cycle is 15 days. All materials are issued at the commencement of each production
cycle. 1/4 on an Average of working capital is kept as cash balance for contingencies.

Total Operating Expenditure for the

year
R.M.
$50,000
(20,000×2.520,000×2.5)
Labor
$20,000
(20,000×120,000×1)
Overheads $17,500
  87,500

Period of the Production cycle Days

Material storage days period  40
Finished goods storage period 15
Production cycle period 15
Average collection period 60
  130
Less: Average payment period  50
  80

No. of operating cycle in the year = 365 / 80=4.5625

Working Capital = 87,500 / 4.5625=$19,178
Reserve for contingencies = 1 / 4×$19,178=$4,794
Estimated Total Working Capital Requirement = $19,178+$4,794=$23,972

Question 7 Capital structure theory :

Explain with example traditional capital structure theory. How is it different from the capital
structure theory of Modigliani & Miller. Which of the two theories would you prefer – give
reasons.

Traditional Theory of Capital Structure

The traditional theory of capital structure states that once the weighted cost of capital (WACC)
is reduced, and also the market price of assets is maximized, Associate in
Nursing optimum structure of capital exists. this can be achieved by utilizing a
mixture of each equity and debt capital.
Understanding the Traditional Theory of Capital Structure
The traditional theory of capital structure says that a firm's price will increase to a particular level
of debt capital, when that it tends to stay constant and eventually begins to decrease if there's an
excessive amount of borrowing. This decrease in price when the debt
tipping purpose happens attributable to overleveraging. On the opposite hand, an organization with
zero leverage can have a WACC adequate its price of equity finance and might cut back its WACC
by adding debt up to the purpose wherever the price of debt equals the price of equity finance. In
essence, the firm faces a trade-off between {the price the worth} of augmented leverage against the
increasing prices of debt as borrowing prices rise to offset the rise value. on the far side this time,
any further debt can cause the value and to extend the price of capital. a mix of equity and
debt finance will cause a firm's optimal capital structure.
The traditional theory are often contrasted with the Modigliani and Miller (MM) theory, that argues
that if monetary markets area unit economical, then debt and equity finance are going to
be basically interchangeable which different forces can indicate the best capital structure of a
firm, like company tax rates and tax deductibility of interest payments.

For example, the capital structure of an organization may be 40% long-run debt (bonds), 100

percent stock, and five hundredth stock. The capital structure of a firm is actually the
proper facet of its record.

Understanding the Modigliani-Miller theory

Companies have solely 3 ways to boost cash to finance their operations and fuel their growth
and enlargement. they will borrow cash by provision bonds or getting loans; they will re-invest
their profits in their operations, or they will issue new stock shares to investors.

different from the capital structure theory of Amedeo Modigliano & Miller. 

The fundamentals of the Amedeo Modigliano and Miller Approach fit that of net in

operation financial gain Approach. Amedeo Modigliano and Miller advocate capital
structure unconnectedness theory, that suggests that the valuation of a firm is inapplicable to the
capital structure of a corporation. 

The Amedeo Modigliano and Miller Approach any states that the value of a firm is stricken

by its in operation financial gain, excluding the danger concerned within the investment. the
speculation expressed that the worth of the firm isn't addicted to the selection of capital structure
or funding choices of the firm.

The Modigliani-Miller theory of capital structure was criticized because the assumption that capital
markets area unit good is totally unreal. Therefore, the value of a levered firm are more
than AN unlevered one, presumptuous that each of them area unit at intervals constant category of
business risk.

The optimum capital structure of a firm is that the best mixture of debt and equity financing that

maximizes a company's value whereas minimizing its price of capital. In theory,
debt funding offers very cheap price of capital thanks to its tax deductibility
Question 8
Briefly discuss the following approaches of working capital financing :
Conservative approach
Moderate approach
Aggressive approach

Working Capital Financing:

Working capital finance is finance intended to increase the working capital ready for a business.
It is usually employed for particular growth projects, such as accepting a larger contract or
financing in a new market.
Several businesses utilize working capital financing for various purposes, although the overall
idea is that utilizing working capital finance saves up cash for developing the business which
will be recovered in the short to medium time.
1. Conservative Approach:
A conservative approach has the least risk and profitability when compared with other working
capital financing approaches.
Companies use long-term financing to finance not just non-current assets and continual working
capital but additionally some part of temporary working capital.
This strategy is also integrated into lower liquidity risk due to excessive cash.

2. Moderate Approach:
The moderate approach, also known as the hedging strategy, follows the matching principle.
As per this strategy, non-current assets should be funded by long-term financing and current
assets with short-term funding.
Hence, companies should apply long-term funding to finance non-current assets and continual
working capital.
The requirement for temporary working capital should be satisfied by short-term funding.

3. Aggressive Approach:
This approach is the riskiest among working capital financing approaches.
It does not assume to maintain any reserves to satisfy spontaneous requirements in working
capital.
It indicates that only some part of permanent or continual working capital is funded by long-
term financing.
The rest and the temporary working capital, which also includes seasonal variations, are
satisfied by short-term borrowing.
Choosing this approach makes it probable to decrease interest costs and improve the profitability
of a company, however, it also brings the highest risk.
Question 9
Explain dividend policy of Emirates Integrated Telecommunications Company (EITC)
EITC Dividend Policy

Background
The Emirates Integrated Telecommunications Company (EITC or the Company) dividend
policy provides guidance on the company’s dividend distribution philosophy and principles.
It provides a clear policy statement on the determination of how much dividend to pay, the
frequency of payments and the approval model.
The dividend policy has been prepared in accordance with the regulations of the Securities
and Commodities Authority (SCA) and the EITC’s Articles of Association.
Policy statements
The dividends shall be paid to shareholders pursuant to the regulations, decrees and
circulars issued by the SCA in this regard.
As a responsible organization, dividend will be paid only out of the current year net income
or operating profits. The dividend payout ratio shall not exceed 100% of the company’s net
income after royalties, after withholding the statutory reserves.
EITC will strive to maintain a constant annual Dividends per Share (DPS) of AED
0.35. The Board of Directors may increase or decrease the DPS depending on a number of
factors including, but not limited to the following:
Profit for the year, after withholding the statutory reserves and settling the Royalty fees.
Cash flow requirements (short and long term) and availability.
Business need(s) that might require retention of cash/profit.
Investment (e.g. acquisition) opportunities.
Capital structure
Funding and/or loan covenant requirements.
Market or economic conditions
Other financial and non-financial conditions that may be impacted by such dividend
distribution.
The Board will endeavour to distribute dividends when possible. However, as not all of the
above factors are within the Company’s control, there can be no guarantee that in any given
year a dividend will be proposed or declared.
Dividends can be paid twice a year (interim and final); interim dividend can be determined
and approved for payment by EITC’s Board of Directors (BoD) while the Company’s General
Assembly ratifies and approves the interim and final/full year dividend respectively, at the
Annual General Meeting. The life of the EITC dividend policy shall be three (3) years, after
which the may propose changes for the AGM’s approval for another three (3) years.
Policy approval and date(s)
This Policy shall be reviewed and endorsed by the EITC’s Board for the Company’s
shareholders consideration and approval at the AGM. The Policy will be effective from 1
January 2019.

All amendments will be done in compliance with all applicable laws, articles and any other such
document as indicated above.

Explain dividend policy followed by google.

Google (Alphabet) has never paid out any cash dividend to shareholders. However, it still managed
to return $9.1 bn to investors in 2018, which was 30% of its net profits. It did use cash buybacks
instead of dividends, which is just another way how a company can return money to its
shareholders The table below shows how much precisely each year Google/Alphabet paid out to its
shareholders and how much from it were cash dividends, and how much were cash buybacks
Google’s) Cash Payouts to Shareholders by Year
Year Cash Dividends Cash Buybacks

2014 $0 bn $0 bn

2015 $0 bn $1.8 bn

2016 $0 bn $3.7 bn

2017 $0 bn $4.8 bn

2018 $0 bn $9.1 b
Yet Google clearly states on its investor website that it does not "expect to pay any cash dividends
in the foreseeable future." The argument is simple -- it needs ample free cash to make big
acquisitions, invest in new in-house technologies, and pursue "moonshots" like driverless cars,
robots, and genetic databases. Moreover, offering a dividend and buying back stock is generally
considered an admission that a tech companies' high growth days are over. Therefore, let's take a
look at why Google doesn't pay a dividend, and why it doesn't care if investors want one or not.
Why Google should pay a dividend
The key to paying out a dividend is a healthy cash flow. Google's free cash flow has been rising
over the past decade, but it's certainly been a bumpy ride due to the company's series of hit and
miss acquisitions.Smart acquisitions include Android ($50 million, 2005), which is now the world's
largest mobile OS, YouTube ($1.65 billion, 2006), now the world's top video sharing site, and
DoubleClick ($3.1 billion, 2007), which is the foundation of Google's display advertising business.
Why Google doesn't care if you want a dividend
Google can certainly afford to pay a dividend, but that doesn't mean it wants to. Google prevents
activist investors from pressuring the company to do anything via its share class system.
There are currently three classes of Google stock -- A, B, and C shares. Everyday investors can
only buy A or C shares on the open market. A shares (GOOGL) are entitled to one vote, while C
shares (GOOG) are entitled to zero votes. The C shares split off the original class A shares last year
during its 2 for 1 split. Google uses A shares to pay its employees and fund acquisitions.
Meanwhile, B shares, which are entitled to ten votes each, are only owned by Google's founders
and their inner circle.
Simply put, B shares give Google's top brass the power to defend against any shareholder revolt.
Shareholders united against that plan at a previous meeting, casting 180 million votes in favor of
the elimination of share classes. Larry Page, Sergey Brin, Eric Schmidt and others crushed the
proposal with 551 million vote

Question 10
Briefly discuss pecking order theory of capital structure.

The pecking order theory of capital indicates that a firm must prefer to finance itself first internally
with the use of retained earnings.
If retained earnings are not available for the firm , the the firm must finance itself via debt.
Finally, and as a last resort, the firm can finance itself via issuing of new equity.
Hence, as per the pecking order theory of capital, the highest priority for financing must be via
retained earnings, then debt and finally equity.
It also indicates that firms which finance itself via retained earnings and do not rely on debt or
equity are performing very strongly in the industry.

Briefly discuss clientele theory and signaling theory of dividend policy.

Dividend policy  of a company is the policy to either retain or distribute the profit of a company.
Depending on the dividend policy of a company, dividend payout ratio and the frequency with
which dividends are to be distributed are decided.
Clientele theory of dividend policy.
Clientele theory  of dividend policy-The clientele effect  is the theory  which explains the  impact
on price of a company's share due to factors like change in tax, dividend or any other policy
changes.
Shareholders who prefer stable dividend policy  or prefer a particular dividend payout  ratio, will
feel depressed if the company declares a reduction in dividend payout. 
On the other hand, growth investors  prefer high growth companies. Growth investors do not
expect companies to distribute the profit . Such investors would prefer reinvestment of profits  into
the company and want capital appreciation. If the company stops reinvestment  of profit and starts
distribution in the form of dividend, growth investors would fell depressed. 
Any change in company's policies  that is  unfavorable to the shareholders, will  cause such
shareholders to sell a part  or their entire holdings , thereby putting pressure on the share price of
the company. The share price will fall substantially.
Signaling theory of dividend policy.
Signaling theory emphasizes  that when a company announces an increase in dividend payout,
investors as well as analyst  termed this increase as a positive future outlook of the company. The
general perception is that the future growth of the company is  certain and the management is
confident of  continuing with the growth in future as well. For example,  FedEx have increased
their divided payout on a sustained basis.
On the other, decrease in dividend payout is seen as negative for the company, It is assumed that 
the future of the company is bleak.