Archive for the ‘MB0045Financial Management Assignments’ Category
MB0045 : a) Discuss the advantages of ordering Economic order quantity of inventory. b) Discuss the Dividend discount model of measuring cost of equity.
Posted October 18, 2011
on:MB0045 : a) Discuss the advantages of ordering Economic order quantity of inventory.
b) Discuss the Dividend discount model of measuring cost of equity.
Advantages of ordering Economic order quantity of inventory.
 Constant or uniform demand: The demand or usage is even throughout the period
 Known demand or usage: Demand or usage for a given period is known i.e. deterministic
 Constant unit price: Per unit price of material does not change and is constant irrespective of the order size
 Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory
 Constant ordering cost: Cost per order is constant whatever be the size of the order
Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.
Dividend discount model of measuring cost of equity
The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.In other words, it is used to evaluate stocks based on the net present value of the future dividends.
Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as
whereP_{0} is the current stock price, D_{1} is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.
This equation is also used to estimate cost of capital by solving for r
From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; r − g cannot be negative, i.e., r>g. In the short run if g>r, then usually a two stage DDM is used:
Therefore,
whereg denotes the shortrun expected growth rate, denotes the longrun growth rate, and N is the period (number of years), over which the shortrun growth rate is applied.
MB0045 : Calculate the present value of the following options:
a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa
b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually
c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa
d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years
Solution:
a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa.
Present valve = 10, 000*PVIF (10%, 5y)
= 10,000*0.621
= 6210
The PV of Rs. 10,000 after 5years is Rs. 6210.
b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually
Present valve = 10, 000*PVIF (5%, 10y)
= 10,000*0.614
= 6140
The PV of Rs. 10,000 after 5years is Rs. 6140.
c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa
Present valve = 5, 000*PVIF (10%, 5y)
= 5,000*0.621
= 3105
The PV of Rs. 5,000 after 5years is Rs. 3105.
d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years
Present valve of annuity = 5, 000*PVIF (10%, 5y)
= 5,000*0.621
= 3105
Present valve of annuity = 10, 000*PVIF (10%, 10y)
= 10,000*0.386
= 3860
The PV of Rs. 5,000 after 5years is Rs. 3105 and PV of Rs. 10,000 after 10years is Rs.3860.
MB0045 : Given the following information, calculate the weighted average cost of capital.
Posted October 18, 2011
on:MB0045 : Given the following information, calculate the weighted average cost of capital.
Capital structure in millions
Equity capital ( Rs.10 par value) 2
14% preference share capital Rs.100 each 1.5
Retained earnings 2
12% Debentures Rs.100 each 4
8% term loan 0.5
Total 10
The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital.
Solution:
Step I is to determine the cost of each component.
K_{e} = (D1/P0) + g
= (5/45) + 0.15
= 0.2611 or 26.11%
K_{p} = [D + {(FP/n}] / [{F+P/2]
= [14+ (21590)/5] / (21590)/2
= 14+25/62.5 = 0.624 or 62.4%
K_{r} = K_{e} which is 26.11%
K_{d} = [1(1T) + (FP) /n}] / {F+P)/2]
= [12(10.3) + (21090)/5] / (21090)/2
= 8.4+24/60 = 0.54 or 54%
K_{t} = 1(1T)
= 0.8(10.3) = 0.56 or 56%
Step II is to calculate the weight of each source.
W_{e} = 2/10 = 0.2
W_{p} = 15/10 = 0.15
W_{r} = 2/10 = 0.2
W_{d} = 4/10 = 0.4
W_{t} = 0.510 = 0.05
Step III
WACC = W_{e}k_{e }+ W_{p}k_{p }+ W_{r}k _{r}+ W_{d}K_{d }+ W_{t}K_{t}
= (0.2*0.2611) + (0.15*0.624) + (0.2*0.2611) + (0.4*0.54) + (0.05*0.56)
= 0.052 + 0.0936 + 0.052 + 0.216 + 0.028
= 0.4416 or 44.16%
MB0045 : Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement.
Posted October 18, 2011
on:MB0045: Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement.
Raw material 60
Direct labour 22
Overheads 44
Total cost 126
Profit 18
Selling price 140
The following additional information is available:
Average raw material in stock one month
Average materials in process 15 days
Credit allowed by suppliers one month
Credit allowed to debtors two months
Time lag in payment of wages 15 days
Time lag in payment of overheads one month
Sales on cash basis 20%
Cash balance to be maintained 80,000
You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.
Solution:
Estimation of Working Capital
a) Investment in inventory
1. Raw material = RMC x RMCP
360
= 100,000 x 60 x 30
360
= 500,000
2. Work in process inventory = COP x WIPCP
360
= 100,000 x 126 x 15
360
= 525,000
3. Finished goods inventory = COS x FGCP
360
= 100000 x 126 x 60
360
= 2,100,000
b) Investment in debtors = Cost of credit sales x DCP
360
= 80,000 x 126 x 60
360
= 1,680,000
c) Cash Balance = 80,000
d) Total Current Asset (A+B+C) = 4,885,000
e) Current Liabilities
1. Creditors = Purchase of raw materials x PDP
360
= 100,000 x 60 x 30 / 360 = 500,000
Wages = 100,000 x 22 x 15 / 360 =91,667
3. Overheads = 100000 x 44 x 30/360 = 366,667
f) Total Current Liabilities = 958334
Net Working Capital (D – F) = 3,926,666
MB0045 : Given the following information, prepare a cash budget:
Month  Sales  Purchases  Wages  Production overheads  Selling overheads 
Jan  100000  40000  10000  6000  6000 
Feb  120000  45000  15000  6500  6500 
March  150000  35000  18000  7000  6600 
April  160000  30000  20000  7700  6800 
May  175000  25000  22000  8000  6200 
June  200000  20000  24000  8500  6300 
The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000.
The company has a opening balance of cash of Rs. 40,000 on 1st Jan 2010. Prepare a cash budget for Jan to June.
Solution:
Cash Budget
Jan 
Feb 
March 
April 
May 
June 

Opening Cash Balance 
40000 
90000 
113000 
170000 
225900 
326400 
Cash Receipts:  
Cash Sales 
50000 
60000 
75000 
80000 
87500 
100000 
Credit Sales 
25000 
30000 
37500 
40000 
43750 

25000 
30000 
37500 
40000 

Total Cash available 
90000 
175000 
243000 
317500 
390900 
510150 
Cash Payments:  
Materials 
40000 
45000 
35000 
30000 
25000 

Wages 
10000 
15000 
18000 
20000 
22000 

Production overheads 
6000 
6500 
7000 
7700 
8000 

Selling overheads 
6000 
6500 
6600 
6800 
6200 

Capital Expenditure 
25000 

Total cash payments 
0 
62000 
73000 
91600 
64500 
61200 
Closing cash balances 
90000 
113000 
170000 
225900 
326400 
448950 
MB0045 : Explain the Net operating income approach to capital structure theories.
Posted September 22, 2011
on:MB0045 : Explain the Net operating income approach to capital structure theories.
Answer : The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mixany mix is as good as any other.
Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.
Features of NOI approach:
 At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.
 The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm – Value of debt
 Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.