NAME KOTHAKAPU MEGHANA REDDY

ROLL NUMBER 2314510855

PROGRAM BACHELOR OF BUSINESS ADMINISTRATION (BBA)
SEMESTER III
COURSE NAME FINANCIAL MANAGEMENT
COURSE CODE DBB2104
 Assignment Set – 1

Answer 1:

a) The present value of an annuity represents the current value of a series of future
payments, adjusted for the impact of time and discounting. In this case, the company
anticipates receiving Rs 120,000 annually for the next 10 years, with a discount rate
of 15%.

The present value can be calculated using the following formula:

𝟏
𝟏−
(𝟏 + ⅈ)𝐧
𝐏𝐕 = 𝐀 [ ]
ⅈ

Where:

𝐏𝐕 represents the current worth of the annuity

𝐀 = Annual payment (Rs 120,000)

i = Discount rate (0.15)

n = Number of periods (10 years)

Substituting the given values:

𝟏
𝟏−
(𝟏 ⋅ 𝟏𝟓)𝟏𝟎
𝐏𝐕 = 𝟏𝟐𝟎𝟎𝟎𝟎 × [ ]
𝟎 ⋅ 𝟏𝟓

Calculating the present value:

1
1−
(1 ⋅ 15)10
PV = 120000 × [ ]
0 ⋅ 15

(1 − 0.2472)
PV = 120000 × [ ]
0.15
0.7528
PV = 120000 × [ ]
0.15
PV = 120000 × 5.0187
PV = 602,244
Therefore, the present value of this annuity is approximately Rs 602,244. This means that
receiving Rs 120,000 annually for the next 10 years is equivalent to receiving Rs 602,244
today, Taking into account the time value of money and a 15% discount rate.
b) Sources of Long-Term Financing
Long-term financing forms the backbone of a company’s financial stability, enabling
investment in fixed assets and core working capital. It typically spans five years or more and
includes the following sources:

1. Equity Shares: Equity shares are a popular source of permanent capital with no
maturity period. Shareholders hold ownership rights and share in the company’s
risks and rewards. Dividends are variable and non-compulsory, and shareholders
have voting rights in company decisions.
2. Preference Shares: These shares carry preferential rights over equity shares for
fixed dividends and capital repayment during liquidation. They are a hybrid of debt
and equity, often non-voting and convertible into equity.
3. Retained Earnings: Also known as ploughing back profits, retained earnings are
internal funds derived from undistributed profits. They are cost-effective, tax-
saving, and provide financial stability by acting as a reserve for economic
uncertainties.
4. Debentures/Bonds: Debentures are fixed-income securities issued for a specific
term with fixed interest. They are secured against company assets and can be
convertible into equity or preference shares.
5. Term Loans: Term loans are negotiated debts from banks or financial institutions
for projects like expansion or modernization. They are secured by company assets
and involve repayment over a fixed term.
6. Special Financial Institutions (SFIs): SFIs, such as IDBI and NABARD,
provide medium and long-term loans, foreign currency funding, and advisory
services to industries, promoting economic growth.
Each source has unique features and is selected based on the company’s financial strategy and
requirements.
Answer 2:
a) To determine the value of ABC Corporation, we can use the Modigliani-Miller
Approach under tax considerations. The formula for the value of a levered firm
is:
𝐕𝐋 = 𝐕𝐔 + 𝐓𝐚𝐱 𝐬𝐡ⅈ𝐞𝐥𝐝

Where:

𝐕𝐋 = Value of the levered firm

𝐕𝐔= Value of the unlevered firm
Tax Shield = Debt × Tax Rate
Step 1: Calculating the value of the unlevered firm (VU):
𝐄𝐁𝐈𝐓 × (𝟏 − 𝐓𝐚𝐱 𝐑𝐚𝐭𝐞)
𝐕𝐔 =
𝐜𝐨𝐬 𝐭 𝐨𝐟 𝐞𝐪𝐮ⅈ𝐭𝐲

Substitute the given values:

EBIT = $300,000
Tax Rate = 25% = 0.25
Cost of Equity = 10% = 0.10
300,000 × (1 − 0 ⋅ 25)
VU =
0 ⋅ 10
300,000 × 0.75
VU =
0.10
225,000
VU =
0.10
VU = 2,250,000

Step 2: Calculate the Tax Shield

Tax Shield = Debt × Tax Rate
Tax Shield = $800,000 × 0.25
Tax Shield = $200,000
Step 3: Calculate the value of the levered firm (VL):
VL = VU + Tax Shield
VL = $2,250,000 + $200,000
VL = $2,450,000
Therefore, the value of ABC Corporation is $2,450,000.
 a) Wealth maximization, as the modern approach to financial management, offers
several advantages over profit maximization, making it a more comprehensive
and long-term objective for firms.
1. Focus on Cash Flows: Wealth maximization emphasizes cash inflows and
outflows over reported accounting profits. rather than accounting profits. Cash
flows are more reliable, tangible, and less susceptible to manipulation, providing a
clearer picture of a firm's financial health. Profit, on the other hand, can be
influenced by accounting policies and non-cash items, leading to misleading
conclusions about a company's actual performance.
2. Long-Term Orientation: Wealth maximization takes a long-term perspective,
aligning with the sustainable growth of the company. While profit maximization may
encourage short-term gains, wealth maximization focuses on creating value for
shareholders over time. It discourages managers from pursuing actions that generate
quick profits but may harm the company's long-term viability.
3. Consideration of Risk: Unlike profit maximization, wealth maximization
incorporates the concept of risk and uncertainty. By considering the time value of
money and discounting future cash flows, it evaluates for both the magnitude
and timing of returns. This approach ensures that high-risk investments are
carefully evaluated, providing a more balanced decision-making process.

4. Maximizing Shareholder Value: Wealth maximization directly aligns with the

goal of maximizing shareholder value, which is the ultimate objective of most
firms. By increasing the market value of shares, wealth maximization reflects the
economic welfare of shareholders, ensuring that the firm’s decisions contribute to
their long- term financial well-being.

In conclusion, wealth maximization is a more comprehensive, realistic, and sustainable

objective compared to profit maximization, as it considers long-term growth, risk, and
shareholder value.

Answer 3:

PQR Ltd is evaluating an investment project that requires an initial outlay of $250,000 and is
projected to generate annual cash flows of $60,000 for the next four years. The company
uses a discount rate of 18% to determine the project's financial viability. The goal is to
compute the Net Present Value (NPV) and assess whether it is a good investment.

To analyze the financial viability of the investment project, we calculate the Net Present
Value (NPV), which is a method used to evaluates the profitability of an investment. The
NPV formula is:
cn
NPV = ∑ − I0
(1 + r)t

Where:

Cn is the cash flow at time

r is the discount rate

t is the year of the cash flow

I0 is the initial investment

Given Information:

Initial Investment: $250,000

Annual Cash Inflows: $60,000 per year for 4 years

Discount Rate: 18% (0.18)

Project Duration: 4 years

Step-by-Step Calculation:
Step 1: Compute the Present Value (PV) of Cash Flows for Each Year

60,000
PVt =
(1 ⋅ 18)t
Year 1: The first year's cash flow of $60,000 is discounted at the rate of 18%. The present
value (PV1 ) is:
60,000 60,000
PV1 = 1
= = 50,847.46
(1 ⋅ 18) 1 ⋅ 18
Year 2: The second year's cash flow is also discounted:
60,000 60,000
PV2 = 2
= = 43,091.06
(1 ⋅ 18) 1.3924
Year 3: Similarly, for the third year:

60,000 60,000
PV3 = = = 36,517.85
(1 ⋅ 18)3 1.6430
Year 4: For the fourth year:

60,000 60,000
PV4 = = = 30,947.33
(1 ⋅ 18)4 1.9387

Step 2: Calculate the Total Present Value of Cash Inflows:

To find the total present value of cash inflows, we sum up the present values calculated for
each year:
𝐏𝐕𝐓𝐨𝐭𝐚𝐥 = 𝐏𝐕𝟏 + 𝐏𝐕𝟐 + 𝐏𝐕𝟑 + 𝐏𝐕𝟒

Total Present Value (𝐏𝐕𝐓𝐨𝐭𝐚𝐥 ) = $50,847.46 + $43,091.06 + $36,517.85 + $30,947.33

𝐏𝐕𝐓𝐨𝐭𝐚𝐥 = $161,403.70
Step 3: NPV Calculation:
The last step involves deducting the initial investment from the total present value of the cash
inflows:
𝐍𝐏𝐕 = 𝐏𝐕𝐓𝐨𝐭𝐚𝐥 − 𝐈𝐧ⅈ𝐭ⅈ𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

𝐍𝐏𝐕 = 161,403.70 − 250,000 = −88,596.30

Step 4: Interpretation and Recommendation

The NPV of the project is -$88,596.30, which means that The initial investment required for
the project exceeds the present value of the expected cash flows. A negative NPV indicates
that the project will result in a net loss for the company, considering the time value of
money and the cost of capital (18%)
In financial management, a project is considered viable if the NPV is positive, as This
suggests that the project is projected to create more value than its implementation cost..
Since the NPV is negative in this case, it suggests that the project will not generate
sufficient returns to justify the investment. Therefore, PQR Ltd should not proceed with this
investment unless there are significant changes in the cash flows, discount rate, or project
structure.
Based on the NPV calculation, the project is not financially viable. The company should
explore alternative investment opportunities or reconsider the assumptions behind the
project’s cash flows and discount rate to improve the potential for positive returns.
 Assignment Set – 2

Answer 4:

Calculation of Cost of Equity for X Ltd

The cost of equity represents the return that investors expect from their investment in a
company’s equity. For X Ltd, the cost of equity can be calculated using the Dividend
Discount Model (DDM), which is a commonly used approach. The model is based on the
present value of the expected dividends and the expected price appreciation of the stock.
There are two scenarios to consider in this case: when the dividends are expected to grow and
when the dividends do not grow.

1. Cost of Equity with Growing Dividends

The Dividend Discount Model (DDM) for growing dividends is given by the formula:
𝐃
𝐊𝐞 = +𝐠
𝐏𝟎

Where:

D is the expected dividend at the end of the first year,

P0 is the stock's current market price,

g denotes the dividend growth rate.

Step 1: Calculate the Expected Dividend (D)

The expected dividend is given as 15% of the face value of the equity share, which is Rs 100.
Therefore, the expected dividend at the end of the first year is:

D = 15% × 100 = Rs15

Step 2: Determine the Current Market Price of the Stock (P0)

The stock was issued at a 10% premium. This means the issue price of each share is

P0 = Rs 100 + 10% of Rs 100 = Rs 110.

Therefore, the current price of the stock (P0) is Rs 110.

Step 3: Use the Growth Rate

The dividends are expected to grow annually at a rate of 8%, so:

g = 8% = 0.08 , The growth rate (g) is 0.08.

Step 4: Calculate the Cost of Equity

Substitute the values into the formula:

15
Ke = + 0.08
110
K e = 0.13636 + 0.08 = 0.21636 = 21.64%

Thus, the cost of equity for X Ltd, assuming dividends grow at 8%, is 21.64%.

2. Cost of Equity with No Dividend Growth.

Calculate the Cost of Equity with No Growth

Since the dividends are not growing, we use the same expected dividend of Rs 15 and the
current price of Rs 110. Therefore, the cost of equity is:
15
Ke =
110
K e = 0.13636 = 13.63%
Thus, the cost of equity for X Ltd, assuming no dividend growth, is 13.63%.

• With growing dividends, the cost of equity for X Ltd is 21.64%.

• Without dividend growth, the cost of equity is 13.63%.
The difference in the cost of equity in these two scenarios highlights the impact of dividend
growth on the required return for investors. When dividends grow, investors expect higher
returns, thus increasing the cost of equity. Conversely, without growth, the cost of equity is
lower as the expected future cash flows are more stable.

Answer 5:
Walter’s Model and Share Price Calculation for X Company
Walter’s model is a well-known approach for valuing a company's shares based on its
dividend policy. The model assumes that the value of a share depends on the relationship
between the company’s return on investment (ROI) and its cost of equity capital. The formula
For calculating the share price under Walter’s model is:
𝐃 𝐫(𝐄 − 𝐃)⁄𝐊 𝐞
𝐩= +
𝐊𝐞 𝐊𝐞

Where:

p= Market price per share

D = Dividend per share
K e = Cost of equity capital
r = Internal rate of return (ROI)
E = Earnings per share
Given Data:
Earnings per share (E) = Rs. 5
Cost of equity capital (K e ) =10% or 0.10
Internal rate of return (r) = 18% or 0.18
Dividend payout ratio = 25%, so the dividend per share (D) = 25% of Rs. 5

D = 0.25 × 5 = Rs. 1.25

a) Share Price Calculation:

To calculate the share price using Walter’s formula, we need to substitute the given values
into the equation.
Dividend per share (D)=1.25
Cost of equity capital K e =0.10
Internal rate of return (r) =0.18
Earnings per share (E)=5

Substituting these values into the formula:

1.25 0 ⋅ 18(5 − 1 ⋅ 25)⁄0.10
p= +
0 ⋅ 10 0 ⋅ 10

Now, let’s calculate each term:

First term:
1.25
= 12.5
0.10

Second term:

0.18 × (5 − 1 ⋅ 25)⁄0.10 = 0 ⋅ 18 × 3 ⋅ 75/ 0.10 = 6.75

Then,
6.75
= 67.50
0.10

Adding these two terms together:

p = 12.5 + 67.5 = 80

Thus, the share price at a 25% dividend payout ratio is Rs. 80.
b) According to Walter’s theory, the optimal dividend payout ratio is determined by
 comparing the company's return on investment (r) with its cost of equity capital
(Ke).
• If r > Ke , the company should retain earnings to maximize shareholder wealth, as
reinvesting the earnings will generate a higher return.
• If r<Ke , the company should pay out dividends to maximize shareholder value, as the
return on reinvested earnings would be lower than the cost of equity.
In this case, r=18% and K e =10%, so r>K e . This means that the company can earn a higher
return on its investments than the cost of equity capital, and therefore, Walter’s model
suggests that the optimal payout ratio is 0%. This would imply that the company should
retain all its earnings rather than paying dividends to maximize the value of its shares.
The share price at a 25% dividend payout ratio is calculated to be Rs. 80. However, according
to Walter’s theory, the optimal payout ratio is 0% (no dividends paid), as retaining earnings
would yield a higher return and increase the share price further. Therefore, the 25% dividend
payout ratio is not optimal for maximizing shareholder wealth in this case.

Answer 6:
a) Gross Working Capital vs. Net Working Capital
Gross Working Capital (GWC) and Net Working Capital (NWC) are two important
concepts in working capital management, but they differ in their scope and purpose.
Gross Working Capital (GWC) represents a company’s total investment in current assets,
which are expected to be converted into cash within a year. These assets include cash,
accounts receivable, inventory, and prepaid expenses, all essential for daily business
operations. GWC measures the financial resources tied up in short-term assets, ensuring
smooth operational activities. However, it does not account for short-term liabilities, focusing
solely on the company’s ability to finance immediate needs without considering outstanding
obligations.
Formula: 𝐆𝐫𝐨𝐬𝐬 𝐖𝐨𝐫𝐤ⅈ𝐧𝐠 𝐂𝐚𝐩ⅈ𝐭𝐚𝐥 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
On the other hand, Net Working Capital is the difference between a company’s short-term
assets and its short-term liabilities. It represents the liquidity available to a company to meet
its short-term obligations and fund its day-to-day operations. NWC is a key indicator of a
company’s financial health, as it shows whether a company has enough assets to cover its
short-term liabilities. A positive NWC indicates that the company can easily meet its short-
term obligations, while a negative NWC could signal potential liquidity problems.
Formula: 𝐍𝐞𝐭 𝐖𝐨𝐫𝐤ⅈ𝐧𝐠 𝐂𝐚𝐩ⅈ𝐭𝐚𝐥 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋ⅈ𝐚𝐛ⅈ𝐥ⅈ𝐭ⅈ𝐞𝐬
In summary, while GWC focuses solely on the company’s current assets, NWC considers
both current assets and liabilities, offering a more accurate view of a company's capacity to
fulfill its short-term financial commitments.

b) Permanent Working Capital vs. Temporary Working Capital

Permanent Working Capital and Temporary Working Capital are two distinct types of
working capital that a company needs to manage its operations.
Permanent Working Capital refers to the minimum level of current assets that a company
must maintain to support its ongoing operations throughout the year. This capital remains
relatively constant and is required to ensure that the company can continue its daily
activities without disruption. It includes funds needed to cover the basic operational
expenses, such as raw materials, finished goods, and accounts receivable, and is typically
financed through long-term sources like equity or long-term debt. Permanent working
capital is not subject to fluctuations in business cycles and remains stable over time.

In contrast, Temporary Working Capital is the additional working capital required to

support seasonal or cyclical fluctuations in business operations. This type of capital is
needed during peak periods, such as during high sales seasons, and decreases during off-
peak times. Temporary working capital fluctuates based on the business's sales volume,
production schedules, or market conditions. It is generally financed through short-term
sources, such as short-term loans or overdrafts, as it is not a permanent requirement for the
business. In summary, while permanent working capital is necessary for regular business
operations and remains stable, temporary working capital is needed to manage short-term
variations in business activity and is more variable in nature.