ASSIGNMENTS- MBA Sem-II MB0029 – FINANCIAL MANAGEMENT

ASSIGNMENTS- MBA
SEM-II
Subject code: MB0029
Subject Name: FINANCIAL MANAGEMENT
Set 1& Set 2

Submitted By:
Mr. Mithesh Kumar
Reg. No. 520930668
948-000-9987
Kumar.mithesh@gmail.com

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 ASSIGNMENTS- MBA Sem-II MB0029 – FINANCIAL MANAGEMENT

Q.1:- Why wealth maximization is superior to profit maximization in today’s

context? Justify your answer

Profit maximization has been considered as the legitimate of a firm because

profit maximization is based on the cardinal rule of efficiency. Under perfect
competition allocation of resource shall be based on the goal of profit maximization.
A firm’s performance is evaluated in terms of profitability. Investor’s company’s
performance can be traced to the goal of profit maximization. But .the goal of profit
maximization has been criticized on many accounts.

Wealth maximization had been accepted by the finance mangers,

because it overcomes the limitations of profit maximization. Wealth maximization
means maximizing the net wealth of the Company’s share holders.wealth
maximization is possible only when the company pursue policies that would increase
the market value of shares of the company.

Superiority of Wealth Maximizations over Profit Maximizations 

 It is based on cash flow, not based on accounting profit. 
 Through  the  process  of  discounting  it  takes  care  of  the  quality  of  cash 
flows. Distant Cash flows are uncertain. Concerting uncertain cash flows into
comparable values at base period facilitates better comparison of projects.
There are various ways of dealing with risk associated with cash flows. These
risk are adequately considered when present values of cash flows are taken to
arrive at the net present value of any project
 In today’s competitive business scenario corporate play a key role. In
company form of organization, shareholders own the company but the
management of the company rests with the board of directors.
 Directors are elected by shareholders and hence agents of the shareholders.
Company management procures funds for expansion and diversification from
Capital Markets.  
  When a firm follows wealth maximization goal it achieve maximization, it
achieves maximization of market value of share.when a firm practices wealth

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maximization goal. It is possible only when it produces quality goods at low

cost. On this account society gains because of the societal welfare.
 Maximization of wealth demands on the part of corporate to develop new
products or render new service in the most effective manner. This helps the
consumer as it will bring to the market the products and service that
consumer’s need.
 Another notable feature of the firms committed to the maximization of wealth
is that to achieve this goal they are forced to render efficient to their customers
with courtesy. This enhance consumer welfare and hence the benefit to the
society.
 From  the  point  of  evaluation  of  performance  of  listed  firms, 
the most remarkable measure is that  of  performance  of  the  company  in 
the  share  market. Every corporate finds its reflection on the market value of
shares of the company. Therefore, shareholder wealth maximization could be
considered a superior goal compared to a superior goal compared to profit
maximization.
 Since listing ensures liquidity to the shares held by the investors, shareholder
can reap the benefits arising from the performance of company only when they
sell their shares. Therefore, it is clear that maximization of market value of
share will lead to maximization of the net wealth of shareholders.

Q.2:- Your grandfather is 75 years old. He has total savings of Rs.80,000. He

expects that he live for another 10 years and will like to spend his savings by
then. He places his savings into a bank account earning 10 per cent annually. He
will draw equal amount each year- the first withdrawal occurring one year from
now in such a way that his account balance becomes zero at the end of 10 years.
How much will be his annual withdrawal?

Present Value (PV) = 80000/-

Amount (A) = ?
Interest Rate (I) = 10%
No. of Year (N) = 10

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PVAn = A {1+i)n-1} /{ i(1+i)n}

80000 = A{1+.10)10 }/{.10(1+.10)10}
80000 = A{ 1.593742/0.259374}
A = 80000/ 6.144567

A = 13019.63 Yearly
The Annual withdrawal will be Rs. 13019.63

Q.3:- What factors affect financial plan?

Followings are the Factors Affecting Financial Plan:

1. Nature of the Industry: Here, we must consider whether it is a capital
intensive or labour intensive industry. This will have a major impact on the
total assets that the firm owns.
2. Size of the Company: The size of the company greatly influences the
availability of funds from different sources. A small company normally finds
it difficult to raise funds from long term sources at competitive terms. On the
other hand, large companies like Reliance enjoy the privilege of obtaining
funds both short term and long term at attractive rates.
3. Status of the Company in the Industry: A well established company
enjoying a good market share, for its products normally commands investors’
confidence. Such a company can tap the capital market for raising funds in
competitive terms for implementing new projects to exploit the new
opportunities emerging from changing business environment.
4. Sources of Finance Available: Sources of finance could be grouped into debt
and equity. Debt is cheap but risky whereas equity is costly. A firm should aim
at optimum capital structure that would achieve the least cost capital structure.
A large firm with a diversified product mix may manage higher quantum of
debt because the firm may manage higher financial risk with a lower business
risk. Selection of sources of finance is closely linked to the firm’s capacity to
manage the risk exposure.
5. The Capital Structure of a Company is influenced by the desire of the
existing management (promoters) of the company to retain control over the

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affairs of the company. The promoters who do not like to lose their grip over
the affairs of the company normally obtain extra funds for growth by issuing
preference shares and debentures to outsiders.
6. Matching the Sources with Utilization: The prudent policy of any good
financial plan is to match the term of the source with the term of investment.
To finance fluctuating working capital needs, the firm resorts to short terms
finance. All fixed asset – investments are to be financed by long term sources.
It is a cardinal principle of financial planning.
7. Flexibility: The financial plan of a company should possess flexibility so as to
effect changes in the composition of capital structure when ever need arises. If
the capital structure of a company is flexible, it will not face any difficulty in
changing the sources of funds. This factor has become a significant one today
because of the globalization of capital market.
8. Government Policy: SEBI guidelines, finance ministry circulars, various
clauses of Standard Listing Agreement and regulatory mechanism imposed by
FEMA and Department of corporate affairs (Govt. of India) influence the
financial plans of corporate today. Management of public issues of shares
demands the compliances with many statues in India. They are to be complied
with a time constraint.
9. Economic Factors: Many economic factors will significantly affect your
financial plan, i.e. supply and demand, various institutions, business, labor
force, and government. Supply and demand will form price. Price level will
change your consumption pattern, so do your investment and others. Labor
force will determine your income. When unemployment rate is high, it will be
more difficult to find job. When job is rare, people are willing to work for less
money, and vice versa. Financial institutions and others business are the user
of labors. Their activities will shape the economic and eventually affect your
financial. Government will influence economic by monetary and fiscal
policy. The steps government take will affect you financially. When
government raise the interest rate, economic will cool down. When economic
slowdown, government will lower the interest rate. When interest rate is low,
invest your money in bank will not give you decent return. It means take
longer time for your investment to reach your financial goals. Therefore, in
order to get higher return people invest in stock market or business.
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10. Global Influence: Since the advance of technology causes this globe to
become “smaller”, especially in the era of globalization. Now people do
business cross the country boundary, therefore what happen in other country
will have an effect on people in another country “Rain at Wall Street, drizzle
around the world”. The economic of particular country depend on foreign
investment. When many foreign investors come, they will create new
businesses. New business will absorb many labors, therefore lowering
unemployment rate and increasing wages. However higher wage does not
always guarantee the prosperity of workers in certain country. When you earn
high income but everything is so expensive there. It is identical with make
little, since your much money actually cannot buy many things. For instance,
average worker in Indonesia make approximately 1 million Rupiah monthly.
Can you imagine make 1 million dollars monthly here? Unfortunately, that 1
million Rupiah is only around $ 108, since the currency exchange of Rupiah is
around Rp. 9,200 to $ 1 USD. Currency exchange surely will impact your
purchasing power and your financial situation. Currency of a country is
usually base on its economic condition i.e. government’s budget, balance
trade, inflation level and growth. Foreign exchange is the biggest financial
market in the world, we definitely will learn about it in later articles.
11. Economic Condition: Consumer price, consumer spending, interest rate,
money supply, unemployment, house started, gross domestic product, trade
balance and market indication are among economic condition that affect your
decision in handling your money matters.
12. Consumer Price: Measure the value of your money through inflation rate. It
influences your personal financial planning because consumer price alter your
money purchasing power. When consumer price increase beyond your
income, you will unable to buy as much thing as you used to. Consumer
spending measures the demand of good and service by individuals and
household. When consumer spending is up, more jobs will be available and
wage will be higher. Increase in consumer spending will drive consumer price
to increase and inflation level as well.
13. Interest Rate: measure cost of money or credit and return of investment.
Increase in interest rate will make credit more expensive and discourage
borrowing. With high interest, people are more likely to invest their money to
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earn interest than take higher risk to do business. Excessive investment from
investor with inability of bank lending to third party will create over supply of
fund. In which will drive down the interest rate eventually
14. Money Supply: Measures money available for spending in an economic.
More money make people have more to save. Therefore, increases in money
supply tend to decrease interest rate as more people save. Moreover, higher
saving and lower spending will reduce job opportunity. Unemployment
measures number of people, who willing and able to work, out of work. High
unemployment rate reduce consumer spending and job opportunity. It is wiser
to setup higher emergency fund and reduce debt to cope with high
unemployment rate, since it is harder to get new job when unemployment rate
are high. House started measures the number of new house built. New house
build is sign of economic expansion. When new house build increase, it
creates more jobs, higher wage and higher consumer spending. Gross domestic
product measures the total value produce within a country’s border. GDP
indicate country prosperity. High GDP will increase employment opportunity
and opportunity for personal financial wealth.
15. Trade Balance: Measures different between export and import. Deficit
happen, when import exceed export. Large deficit over long run will hurt
employment and GDP. Surplus happen, when export exceed import. Large
surplus will raise the value of the currency, reducing the future opportunity of
export, since commodity become more expensive to foreigner. Market
indication (stock market index) measures the relative value of stocks. These
indexes provide indication of the price movement of stocks. Since you will
invest your money in the market to help you reach your financial goals,
understand how the market work will benefit you.

Q.4:- Suppose you buy a one-year government bond that has a maturity value
of Rs.1000. The market interest rate is 8 per cent. (a) How much will you pay for
the bond? (b) If you purchase the bond for Rs.904.98, what interest rate will you
earn from this investment?
a)
Principal Repayment is Rs. 1000/00
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Rate of interest is = 8%
Interest payable is = 1000*8%= Rs. 80
Value of bond = F*PVIF ( kd , n)
1000* PVIF (8% 1yr)
= 1000*0.926
= 926.00 RS.
Amount paid for bond is Rs 926.00

b)
Value of Bond is Rs.904.98
Rate of interest is = 8 %
Value of bond = F*PVIF ( kd , n)
904.98 = F * PVIF( 8, 1yr)
904.98 = F * 0.926
F = 977.30 Rs.
Face value of bond will be Rs.977.30
Interest Payable is = 977.30*8%
= Rs. 78.184

Case Study:
Deepak Hand tools Private Limited
DHPL is a small sized firm manufacturing hand tools. It manufacturing
plan is situated in Haryana. The company’s sales in the year ending on 31st
March 2007 were Rs.1000 million (Rs.100 crore) on an asset base of Rs.650
million. The net profit of the company was Rs.76 million. The management of the
company wants to improve profitability further. The required rate of return of
the company is 14 percent.
The company is currently considering an investment proposal. One is to expand
its manufacturing capacity. The estimated cost of the new equipment is Rs.250
million. It is expected to have an economic life of 10 years. The accountant
forecasts that net cash inflows would be Rs.45 million per annum for the first
three years, Rs.68 million per annum from year four to year eight and for the
remaining two years Rs.30million per annum. The plant can be sold for Rs.55
million at the end of its economic life.
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The company would need to raise debt to the extent of Rs.200 million. The
company has the following options of borrowing Rs.200 million:

a) The company can borrow funds from a nationalized bank at the interest
rate of 14 percent for 10 years. It will be required to pay equal annual
installment of interest and repayment of principal.

b) A financial institution has offered to lend money to DHPL at 13.5 per

annum but it needs to pay equated quarterly installment of interest and
repayment of principal.

Questions:
1. Should the company expand its capacity? Show the computation of
NPV
2. What is the annual installment of bank loan?
3. Calculate the quarterly installments of the Financial Institution
loan
4. Should the company borrow from the bank or from the financial
institution?

Given Details:
Sales Rs 1,000 million = Rs 100 crore
Asset base Rs 650 million = Rs 65 crore
Net Profit Rs 76 million = Rs 7.6 crore

1.
Calculation NPV

Rate of return is 14%

Compute value of NPV of the Project

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Year Cash Flow PV of Cash Flow

1 45000000.00 39473684.21
2 45000000.00 34626038.78
3 45000000.00 30373718.23
4 68000000.00 40261458.86
5 68000000.00 35317069.18
6 68000000.00 30979885.24
7 68000000.00 27175337.93
8 68000000.00 23838015.73
9 30000000.00 9225238.29
10 30000000.00 8092314.29
Total 279362760.7

Sum of the present value of cash inflow = 279362760.74

Less: Sum of the present value of cash out flow = 250000000.00
= Rs.29,362,760.74
The plant can be sold for Rs.55 million at the end of its economic life
So Total NPV = Rs.79, 362,760.74
The project generates a positive NPV of Rs.79, 362,760.74 therefore; project should
be accepted. That means company should expand its capacity.

2.
Loan Amount = Rs 200 million
Rate of interest = 14% Yearly
Duration = 10 years

Annual Installments = Rs 21,305,567.00

(This equal annual installment amount)

3.
Loan Amount = Rs 200 million
Rate of interest = 13.5 % Quarterly
Duration = 10 years

Quarterly Installments = Rs 6,236,698.00

According to this total amount paid in one year = Rs.24, 946,792.00

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4.
Annual Installments = Rs 21,305,567.00 (BANK)
Quarterly Installments = Rs 6,236,698.00 (Financial Institution)
So Annual amount paid in case of financial institution = Rs.24, 946,792.00

So, from the above statistics it’s clear that the company should borrow loan from
bank and they can save Rs.3, 641,225.00 annually

Q.1:- A. What is the cost of retained earnings?

B. A company issues new debentures of Rs.2 million, at par; the net
proceeds being Rs.1.8 million. It has a 13.5 per cent rate of interest and 7

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years maturity. The company’s tax rate is 52 per cent. What is the cost of
debenture issue? What will be the cost in 4 years if the market value of
debentures at that time is Rs.2.2 million?
A.

Cost of Retained Earnings: A company’s earnings can be reinvested in full

to fuel the ever-increasing demand of company’s fund requirements or they may be
paid off to equity holders in full or they may be partly held back and invested and
partly paid off. These decisions are taken keeping in mind the company’s growth
stages. High growth companies may reinvest the entire earnings to grow more,
companies with no growth opportunities return the funds earned to their owners and
companies with constant growth invest a little and return the rest. Shareholders of
companies with high growth prospects utilizing funds for reinvestment activities have
to be compensated for parting with their earnings. Therefore the cost of retained
earnings is the same as the cost of shareholder’s expected return from the firm’s
ordinary shares. That is, Kr=Ke

There are three methods one can use to derive the cost of retained
earnings:

a) Capital-Asset-Pricing-Model (CAPM) approach: To calculate the cost

of capital using the CAPM approach, you must first estimate the risk-free
rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the company’s beta (b i), which is an estimate of
the stock’s risk. Inputting these assumptions into the CAPM equation, you can then
calculate the cost of retained
earnings.

This model establishes a relationship between the required rate of

return of a security and its systematic risks expressed as β. According to this
model,
Ke= Rf +β ( Rm-Rf)
Where Ke is the rate of return on share,

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Rf is the risk free rate of return,

β is the beta of security,
Rm is return on market portfolio.

The CAPM model is based on some assumptions, some of which are:

 Investors are risk-averse.
 Investors make their investment decisions on a single-period horizon.
 Transaction costs are low and therefore can be ignored. This translates to
assets being bought and sold in any quantity desired. The only considerations
mattering are the price and amount of money at the investor’s disposal.
 All investors agree on the nature of return and risk associated with each
investment.

b) Earnings Price Ratio Approach

According to this approach, the cost of equity can be calculated as:
Ke =E1/P where E1 is expected EPS one year hence and P is the current
market price per share.
E1 is calculated by multiplying the present EPS with (1 + Growth
rate).

c) Cost of Retained Earnings and Cost of External Equity

As we have just learnt that if retained earnings are reinvested in
business for growth activities the shareholders expect the same amount
of returns and therefore Ke=Kr. But it should be borne in mind by the
policy makers that floating a new issue and people subscribing to it
will involve huge amounts of money towards floatation costs which
need not be incurred if retained earnings are utilized towards funding
activities. Using the dividend capitalization model, the following
model can be used for calculating cost of external equity.

Ke = { D1 / P0 ( 1-f)}+ g
Where Ke is the cost of external equity,
D1 is the dividend expected at the end of year 1,
P0 is the current market price per share,

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‘g’ is the constant growth rate of dividends,

‘f’ is the floatation costs as a % of current market price.

The following formula can be used as an approximation:

K’e = ke/(1—f)
Where K’e is the cost of external equity,
ke is the rate of return required by equity holders,
‘f’ is the floatation cost.

B)
WKT

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,
T is the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realized per debenture,
n is maturity period.

Cost of Debenture Issues

Where
I= 13.5% n= 7 T= 52%=0.52
F= 2 million P=1.8 million

I ( 1−T ) + [ ( F−P ) /n ]
Kd=
( F+ P ) /2

13.5 ( 1−0.52 ) + [ ( 2−1.8 ) /7 ]

Kd=
( 2+1.8 ) /2
= 3.42
The cost in 4 years if the market value of debentures at that time is Rs.2.2 million
Where

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I= 13.5% n= 4 T= 52%=0.52
F= 2 million P=2.2 million

I ( 1−T ) + [ ( F−P ) /n ]
Kd=
( F+ P ) /2

13.5 ( 1−0.52 ) + [ ( 2−2.2 ) /4 ]

Kd=
( 2+2.2 ) /2

= 3.06

Q.2:- Volga is a large manufacturing company in the private sector. In 2007 the
company had a gross sale of Rs.980.2 crore. The other financial data for the company
are given below:

Items Rs. In crore

Net worth 152.31
Borrowing 165.47
EBIT 43.17
Interest 34.39
Fixed cost (excluding interest) 118.23

You are required to calculate:

a. Debt equity ratio

b. Operating leverage
c. Financial leverage
d. Combined leverage. Interpret your results and comment on the Volga’s debt policy

a)
Total Liabilities
Debt equity ratio=
Shareholders equity

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b)
Degree of Operating Leverage (DOL)
% Change∈Operation Income
¿
% Change∈ Sales

% Change∈EBIT
DOL=
% Change∈output

¿
[ Q ( S−V ) ]
[Q ( S−V )−F ]

c)
Degree of Financial Leverage (DFL)

% Change∈ EPS
¿
% Change∈ EBIT

EBIT
DFL=
{ EBIT−1−{ D p / ( 1−T ) }}

d)
Combined leverage (DTL)

Q ( S−V )
DTL=
Q ( S−V )−F−1− {D p / (1−T ) }

3. Explain Miller and Modigliani Approach to capital structure theory.

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Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected by
leverage up to a reasonable limit and Ko being constant at all degrees of leverage.
They state that the relationship between leverage and cost of capital is elucidated as in
NOI approach. The assumptions for their analysis are:
 Perfect Capital Markets: Securities can be freely traded, that is, investors are
free to buy and sell securities (both shares and debt instruments), there are no
hindrances on the borrowings, no presence of transaction costs, securities
infinitely divisible, availability of all required information at all times.
 Investors Behave Rationally, that is, they choose that combination of risk
and return that is most advantageous to them.
 Homogeneity of investors risk perception, that is, all investors have the same
perception of business risk and returns.
 Taxes: There is no corporate or personal income tax.
 Dividend Pay-Out is 100%, that is, the firms do not retain earnings for future
activities.
Basic Propositions: The following three propositions can be derived based on the
above assumptions:
Proposition I: The market value of the firm is equal to the total market value of
equity and total market value of debt and is independent of the degree of leverage. It
can be expressed as:

Expected NOI
Expected Overall Capitalization Rate
V + (S+D) which is equal to O/Ko which is equal to NOI/Ko
V + (S+D) = O/Ko = NOI/Ko
Where V is the market value of the firm,
S is the market value of the firm’s equity,
D is the market value of the debt,
O is the net operating income,
Ko is the capitalization rate of the risk class of the firm.

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The basic argument for proposition I is that equilibrium is restored in the

market by the arbitrage mechanism. Arbitrage is the process of buying a security at
lower price in one market and selling it in another market at a higher price bringing
about equilibrium. This is a balancing act. Miller and Modigliani perceive that the
investors of a firm whose value is higher will sell their shares and in return buy shares
of the firm whose value is lower. They will earn the same return at lower outlay and
lower perceived risk. Such behaviors are expected to increase the share prices whose
shares are being purchased and lowering the share prices of those share which are
being sold. This switching operation will continue till the market prices of identical
firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization

rate) applicable plus a premium.
Ke = Ko +[(Ko—Kd)D/S]

Proposition III: The average cost of capital is not affected by the financing decisions
as investment and financing decisions are independent.

Criticisms of MM Proposition
 Risk Perception: The assumption that risks are similar is wrong and the risk
perceptions of investors are personal and corporate leverage is different. The
presence of limited liability of firms in contrast to unlimited liability of
individuals puts firms and investors on a different footing. All investors lose if
a levered firm becomes bankrupt but an investor loses not only his shares in a
company but would also be liable to repay the money he borrowed. Arbitrage
process is one way of reducing risks. It is more risky to create personal
leverage and invest in unlevered firm than investing in levered firms.
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 Convenience: Investors find personal leverage inconvenient. This is so

because it is the firm’s responsibility to observe corporate formalities and
procedures whereas it is the investor’s responsibility to take care of personal
leverage. Investors prefer the former rather than taking on the responsibility
and thus the perfect substitutability is subject to question.
 Transaction costs: Another cost that interferes in the system of balancing
with arbitrage process is the presence of transaction costs. Due to the presence
of such costs in buying and selling securities, it is necessary to invest a higher
amount to earn the same amount of return.
 Taxes: When personal taxes are considered along with corporate taxes, the
Miller and Modigliani approach fails to explain the financing decision and
firm’s value.
 Agency Costs: A firm requiring loan approach creditors and creditors may
sometimes impose protective covenants to protect their positions. Such
restriction may be in the nature of obtaining prior approval of creditors for
further loans, appointment of key persons, restriction on dividend pay-outs,
limiting further issue of capital, limiting new investments or expansion
schemes etc.

4. How to estimate cash flows? What are the components of incremental cash
flows?

Cash flow Estimation: is a must for assessing the investment decisions of any
kind. To evaluate these investment decisions there are some principles of cash flow
estimation. In any kind of project, planning the outputs properly is an important task.
At the same time, the profits from the project should also be very clear to arrange
finances in a proper way. These forecasting are some of the most difficult steps
involved in the capital budgeting. These are very important in the major projects
because any kind of fault in the calculations would result in huge problems. The
project cash flows consider almost every kind of inflows of cash. The capital
budgeting is done through the coordination of a wide range of professionals who are
going to be involved in the project. The engineering departments are responsible for

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the forecasting of the capital outlays. On the other hand, there are the people from the
production team who are responsible for calculating the operational cost. The
marketing team is also involved in the process and they are responsible for forecasting
the revenue.

Next comes the financial manager who is responsible to collect all the data
from the related departments. On the other hand, the finance manager has the
responsibility of using the set of norms for better estimation. One of these norms uses
the principles of cash flow estimation for the process.

There are a number of principles of cash flow estimation. These are the
consistency principle, separation principle, post-tax principle and incremental
principle. The separation principle holds that the project cash flows can be divided in
two types named as financing side and investment side. On the other hand, there is the
consistency principle. According to this principle, some kind consistency is necessary
to be maintained between the flow of cash in a project and the rates of discount that
are applicable on the cash flows. At the same time, there is the post-tax principle that
holds that the forecast of cash flows for any project should be done through the after-
tax method.

Incremental Principle: The incremental principle is used to measure the

profit potential of a project. According to this theory, a project is sound if it increases
total profit more than total cost. To have a proper estimation of profit potential by
application of the incremental principle, several guidelines should be maintained:

Incidental Effects: Any kind of project taken by a company remains related to the
other activities of the firm. Because of this, the particular project influences all the
other activities carried out, either negatively or positively. It can increase the profits
for the firm or it may cause losses. These incidental effects must be considered.

Sunk Cost: These costs should not be considered. Sunk costs represent an
expenditure done by the firm in the past. These expenditures are not related with any
particular project. These costs denote all those expenditures that are done for the
preliminary work related to the project, unrecoverable in any case.
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Overhead Cost: All the costs that are not related directly with a service but have
indirect influences are considered as overhead charges. There are the legal and
administrative expenses, rentals and many more. Whenever a company takes a new
project, these costs are assigned.

Working Capital: Proper estimation is essential and should be considered at the time
when the budget for the project's profit potential is prepared.

5. What are the steps involved in capital rationing?

Capital budgeting decisions involve huge outlay of funds. Funds available for
projects may be limited. Therefore, a firm has to prioritize the projects on the basis of
availability of funds and economic compulsion of the firm. It is not possible for a
company to take up all the projects at a time. There is the need to rank them on the
basis of strategic compulsion and funds availability. Since companies will have to
choose one from among many competing investment, proposal, the need to develop
criteria for Capital rationing cannot be ignored. The companies may have many
profitable and viable proposals but cannot execute because of shortage of funds.
Another constraint is that the firms may not be able to generate additional funds for
the execution of all the projects. When a firm imposes constraints on the total size of
firm’s capital budget, it requires Capital Rationing. When Capital is rationed there is a
need to develop a method of selecting the projects that could be executed with the
company’s resources yet giving the highest possible net present value.

Capital Rationing may be due to

1. External factors
2. Internal constraints imposed by management
1. External Capital Rationing: External Capital Rationing is due to the
imperfections of capital markets Imperfection may be caused by:-
a. Deficiencies in market information
b. Rigidities that hamper the force flow of Capital between firms.

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When capital markets are not favourable to the company the firm cannot tap
the capital market for executing new projects even though the projects have positive
net present values. The following reasons attribute to the external capital rationing:-
i. Inability of the firm to procure required funds from Capital market
because the firm does not command the required investor’s confidence.
ii. National and international economic factors may make the market highly
volatile and unstable.
iii. Inability of the firm to satisfy the regularity norms for issue of
instruments for tapping the market for funds.
iv. High Cost of issue of Securities I,e High floatation cost. Smaller firms
may have to incur high costs of issue of securities. This discourages small
firms from tapping the capital markets for funds.

2. Internal Capital Rationing: Impositions of restrictions by a firm on the

funds allocated for fresh investment is called internal capital rationing.
This decision may be the result of a conservative policy pursued by a firm.
Restriction may be imposed on divisional heads on the total amount that
they can commit on new projects.
Another internal restriction for Capital budgeting decision may be imposed
by a firm based on the need to generate a minimum rate of return. Under
this criterion only projects capable of generating the management’s
expectation on the rate of return will be cleared. Generally internal capital
rationing is used by a firm as a means of financial control.

Steps involved in Capital Rationing

Steps involved in Capital Rationing are:
1. Ranking of different investment proposals
2. Selection of the most profitable investment proposal

Ranking of different investment proposals

The various investment proposals should be ranked on the basis of their
profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the
descending order.
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If the firm has sufficient funds and no capital rationing restriction, then all the
projects can be accepted because all of them have positive NPVs.

The objective is to maximize NPV per rupee of Capital and projects should be ranked
on the basis of the profitability index. Funds should be allocated on the basis ranks
assigned by profitability index.
Evaluation:
1. PI rule of selecting projects under Capital rationing may not yield satisfactory
result because of project indivisibility. When projects involving high investment
is accepted many small projects will have to be excluded. But the sum of the
NPVs of small projects to be accepted may be higher than the NPV of single
large project.
2. It also suffers from the multi-period Capital constraints.
Programming approach: There are many programming techniques to Capital
rationing. Among them are:-
a. Linear Programming: LP approach to Capital rationing tries to
achieve maximum NPV subject to many constraints. Here the objective
function is maximization of sum of the NPVs of the projects. Here the
constraints matrix incorporates all the restrictions associated with
Capital rationing imposed by the firm.
b. Integer Programming: LP may give an optimal mix of projects in
which there may be need to accept fraction of a project. Accepting
fraction of a project is not feasible. Therefore, optimum may not be
attainable. The actual implementation of projects may be suboptimal.
When projects are not divisible, integer programming can be employed to
avoid the chances of accepting fraction of projects.

The advantage of programming approach is that it provides information on

dual variables. It also gives information on shadow prices of budget constraints. Dual
variables provide information for decision on transfer of funds from one year to
another year

The demerits of programming approach is that

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 Costly to use when large, indivisible projects are being

examined.
 They are deterministic models. But variables of Capital
budgeting are subject to change making the assumption of
deterministic highly invalid.

6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per year
for six years. A substitute equipment B would cost Rs.50,000 and generate net
cash flow of Rs.14,000 per year for six years. The required rate of return of both
equipments is 11 per cent. Calculate the IRR and NPV for the equipments.
Which equipment should be accepted and why?

Equipment A
IRR calculation
Given
Cost Rs 75,000.00
Net cash flow of Rs 20,000 per year for 6 years

Average annual cash flow = Rs 20,000.00

Initial Investmet 75,000

=
Avg . Annu al Cash flow 20,000

= 3.75

From the PVIFA table for 6 years, the annuity factor very near to 3.75 is 15%

Year Cash Flow PV of Cash Flow

1 20,000 17391.00
2 20,000 15122.87
3 20,000 13150.32
4 20,000 11435.06

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5 20,000 9943.53
6 20,000 8646.55
  Total 75689.33

Since the initial investment of Rs 75,000.00 is less than computed value at 15% of Rs
75,689.33 the next trial rate is 16 %
Year Cash Flow PV of Cash Flow
1 20,000 17241.38
2 20,000 14863.26
3 20,000 12813.52
4 20,000 11045.82
5 20,000 9522.26
6 20,000 8208.85
  Total 73695.09

Since initial investment of Rs. 75,000.00 lies between Rs. 73695.09 (16%) and Rs.
75,689.33(15%) the IRR by interpolation
75689.33−75000
IRR=15+
75689.33−73695.06
= 15+0.3456
= 15.3456%

Calculation NPV

Rate of return is 11%

Compute value of NPV of the Project

Year Cash Flow PV of Cash Flow

1 20,000 18018.02
2 20,000 16232.45
3 20,000 14623.83
4 20,000 13174.62
5 20,000 11869.03
6 20,000 10692.82
  Total 84610.77

Sum of the present value of cash inflow = 84,610.77

Less: Sum of the present value of cash out flow = 75,000.00

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= Rs.9,610.77

Equipment B
IRR calculation
Given
Cost Rs 50,000.00
Net cash flow of Rs 14,000 per year for 6 years

Average annual cash flow = Rs 14,000.00

Initial Investmet 50,000

=
Avg . Annual Cash flow 14,000
= 3.5714
From the PVIFA table for 6 years, the annuity factor very near to 3.5714 is 17%
Year Cash Flow PV of Cash Flow
1 14,000 11965.81
2 14,000 10227.19
3 14,000 8741.19
4 14,000 7471.10
5 14,000 6385.56
6 14,000 5457.74
  Total 50248.59
Since the initial investment of Rs 75,000.00 is less than computed value at 15% of Rs
50,248.59 the next trial rate is 18 %
Year Cash Flow PV of Cash Flow
1 14,000 11864.41
2 14,000 10054.58
3 14,000 8520.83
4 14,000 7221.04
5 14,000 6119.53
6 14,000 5186.04
  Total 48966.43

Since initial investment of Rs. 75,000.00 lies between Rs. 48,966.43 (18%) and Rs.
50,248.59 (17%) the IRR by interpolation
50248.59−50000.00
IRR=17+
50248.59−48966.43
= 17+0.193
= 17.193%
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Calculation NPV

Rate of return is 11%

Compute value of NPV of the Project

Year Cash Flow PV of Cash Flow

1 14,000 12612.61
2 14,000 11362.71
3 14,000 10236.28
4 14,000 9222.23
5 14,000 8308.32
6 14,000 7484397
  Total 59227.12

Sum of the present value of cash inflow = 59227.12

Less: Sum of the present value of cash out flow = 50,000.00
= Rs.9, 227.12

From the above calculation

Equipment ‘A’ can be selected according to NPV.
Equipment ‘B’ can be selected according to IRR.

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