Set-2 Finan Thag

DINA BUSINESS SCHOOL DINA INSTITUTE OF HOTEL AND BUSINESS MANAGEMENT PUNE – 411 028 CENTRE CODE – 02758

ASSIGNMENT – SET 1 / SET 2

NAME

: TAHA MOHAMMED DHILAWALA

ROLL.NO.

: 520850852

PAPER / SUBJECT CODE

: Financial Management : MB0029

SEMESTER

:

I / II / III / IV

SIKKIM MANIPAL UNIVERSITY

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1. Compare and contrast NPV with IRR . ANS. Net present value method The cash inflow in different years are discounted (reduced) to their present value by applying the appropriate discount factor or rate and the gross or total present value of cash flows of different years are ascertained. The total present value of cash inflows are compared with present value of cash outflows (cost of project) and the net present value or the excess present value of the project and the difference between total present value of cash inflow and present value of cash outflow is ascertained and on this basis, the various investments proposals are ranked. Cash inflow = earnings / profits of an investment after taxes but before depreciation The present value of cash outflows = initial cost of investment and the comment of project at various points of time ^ Decision rule After ranking various investments proposals on basis on net present value, projects with negative net present value (net present value of cash inflows less than their original costs) are rejected and projects with positive NPV are considered acceptable. In case of mutually exclusive alternative projects, projects with higher net present value are selected. Net present value method is suitable for evaluating projects where cash flows are uneven. Merits 1. The most significant advantage is that it explicitly recognizes the time value of money, e.g., total cash flows pertaining to two machines are equal but the net present value are different because of differences of pattern of cash streams. The need for recognizing the total value of money is thus satisfied. 2. It also fulfills the second attribute of a sound method of appraisal. In that it considers the total benefits arising out of proposal over its life time. 3. It is particularly useful for selection of mutually exclusive projects. 4. This method of asset selection is instrumental for achieving the objective of financial management, which is the maximization of the shareholder's wealth. In brief the present value method is a theoretically correct technique in the selection of investment proposals.

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Demerits 1. It is difficult to calculate as well as to understand and use, in comparison with payback method or average return method. 2. The second and more serious problem associated with present value method is that it involves calculations of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present value because different discount rates will give different present values. The relative desirability of a proposal will change with the change of discount rate. The importance of the discount rate is thus obvious. But the calculation of required rate of return pursuits serious problem. The cost of capital is generally the basis of the firm's discount rate. The calculation of cost of capital is very complicated. In fact there is a difference of opinion even regarding the exact method of calculating it. 3. Another shortcoming is that it is an absolute measure. This method will accept the project which has higher present value. But it is likely that this project may also involve a larger initial outlay. Thus, in case of projects involving different outlays, the present value may not give dependable results. 4. The present value method may also give satisfactory results in case of two projects having different effective lives. The project with a shorter economic life is preferable, other things being equal. It may be that, a project which has a higher present value may also have a larger economic life, so that the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situations the present value method may not reflect the true worth of alternative proposals. This method is suitable for evaluating projects whose capital outlays or costs differ significantly. Internal rate of return method The technique is also known as yield on investment, marginal efficiency value of capital, marginal productivity of capital, rate of return, time adjusted rate of return and so on. Like net present value, internal rate of return method also considers the time value of money for discounting the cash streams. The basis of the discount factor however, is difficult in both SET 2 MB0029

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cases. In the net present value method, the discount rate is the required rate of return and being a predetermined rate, usually cost of capital and its determinants are external to the proposal under consideration. The internal rate of return on the other hand is based on facts which are internal to the proposal. In other words, while arriving at the required rate of return for finding out the present value of cash flows, inflows and outflows are not considered. But the IRR depends entirely on the initial outlay and cash proceeds of project which is being evaluated for acceptance or rejection. It is therefore appropriately referred to as internal rate of return. The IRR is usually, the rate of return that a project earns. It is defined as the discount rate which equates the aggregate present value of net cash inflows (CFAT) with the aggregate present value of cash outflows of a project. In other words it is that rate which gives the net present value zero. IRR is the rate at which the total of discounted cash inflows equals the total of discounted cash outflows (the initial cost of investment). It is used where the cost of investment and its annual cash inflows are known but the rate of return or discounted rate is not known and is required to be calculated. Accept / Reject decision The use of IRR as a criterion to accept capital investment decision involves a comparison of actual IRR with required rate of return, also known as cut off rate or hurdle rate. The project should qualify to be accepted if the internal rate of return exceeds the cut off rate. If the internal rate of return and the required rate of return be equal, the firm is indifferent as to accept or reject the project. In case of mutually exclusive or alternative projects, the project which has the highest IRR will be selected provided its IRR is more than the cut off rate. In case there are budget constraints, the projects are ranked in descending order of their IRR and are selected subject to provisions. Evaluation of IRR 1. Is a theoretically correct technique to evaluate capital expenditure decision. It possesses the advantages which are offered by the NPV criterion such as, it considers the time value of money and takes into account the total cash inflows and outflows. 2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. For instance, Business X will SET 2 MB0029

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understand the investment proposal in a better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10% instead of saying that NPV of Machine B is Rs. 15,396. 3. It itself provides a rate of return which is indicative of profitability of proposal. The cost of capital enters the calculation later on. 4. It is consistent with overall objective of maximizing shareholders wealth. According to IRR, the acceptance / rejection of a project is based on a comparison of IRR with required rate of return. The required rate of return is the minimum rate which investors expect on their investment. In other words, if the actual IRR of an investment proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR, only such projects are accepted which have IRR of the required rate, therefore, the share prices will tend to rise. This will naturally lead of maximization of shareholders wealth. ^ The IRR suffers from serious limitations: 1. It involves tedious calculations. It involves complicated computation problems. 2. It produces multiple rates which can be confusing. This situation arises in the case of non-conventional projects. 3. In evaluating mutually exclusive proposals, the project with highest IRR would be picked up in exclusion of all others. However in practice it may not turn out to be the most profitable and consistent with the objective of the firm i.e., maximization of shareholders wealth. 4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates. The reinvestment rate assumption under the IRR is therefore very unrealistic. Moreover it is not safe to assume always that intermediate cash flows from the project may be reinvested at all. A portion of cash inflows may be paid out as dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the project if it assumes that it invests the entire intermediate cash proceeds. SET 2 MB0029

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Further it is not safe to assume that they will be reinvested at the same rate of return as the company is currently earning on its capital (IRR) or at the current cost of capital (k). NPV versus IRR NPV indicates the excess of the total present value of future returns over the present value of investments. IRR (or DFC rate) indicates on the other hand the rate at which the cash flows (at present values) are generated in the business by a particular project. Both NPV and IRR iron out the difference due to interest factor or say higher returns in earlier years and higher returns in later years (though the total returns in absolute terms may be around the same for several projects). Between the two, IRR or DFC rate is the more sophisticated method a popular as well, since: (a) IRR method - mostly subjective decision regarding discounting rate. ^ (b) Whilst under NPV the main basis of comparison is between different NPV's of different projects, under IRR or DFC rate approach a number of basis is available. For example DFC rate Vs Discount rate of return (on normal operations) ^ DFC rate Vs Cut off rate of the company DFC rate Vs Borrowing rate (on cost of capital) DFC rates between different projects (c) The results under DFC rate approach are simpler for the management to understand and appreciate. We should however be very careful in applying the decision rules properly when NPV and IRR calculation shows divergent results. The rules are (i) the projects be the basis of decision when mutually exclusive in character; (ii) there is capital rationing situation (d) IRR should be a better guide when there are plenty of project situations (as it is there in a long enterprise) and no major constraints (for example, in respect of macro projects).

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2. Zodiac Ltd is considering purchase of investment worth Rs. 40 lakhs. The estimated life and the new cash flow fir 3 years are as under. Machines A B C 3 Years 3years Estimated life 3 Years Cash inflows(in lakhs) 1 Year 27 06 12 2 Year 18 21 80 3 Year 55 33 30 Which machine should be selected on the basis of payback period? Calculate discounted payback period if the cost of capital is 12%

ANS:A) Payback period Project A year Cash Cumulative flows cash flows 1 27 27 2 18 45 3 55 100

Project B Cash Cumulative flows cash flows 06 6 21 27 33 60

Project C Cash Cumulative flows cash flows 12 12 80 92 30 122

Machine A. Rs.27 lakhs will be recovered in 1st year & the balance 13 lakhs (40 – 27) will be recovered in 2nd year of 18 lakhs Payback period = 1year +(13/18*12month) or 1year 8.6 month st

=1year +13/18 = 1year + 0.72

1.72year

machine B. Rs.06 lakhs will be recovered in 1 year & the balance 34 lakhs (40 – 6) will be recovered in 2nd year of 21 lakhs payback period = 1year +(35/21*12month) or =1year + 35/21 = 1year 20 month = 1year +1.66 st

2.66year

machine c. Rs.12 lakhs will be recovered in 1 year & the balance 28 lakhs (40 – 12) will be recovered in 2nd year of 80 lakhs payback period = 1year + (28/80*12month) or =1year + 28/80 = 1year + 4.2 month = 1year + 0.35 = 1.35year SET 2 MB0029

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B)Discount payback period Machine year p/v factor c.v @12% 0.8928 27 1 18 0.7972 2 0.7118 15 3

Project A

A p.v

machine c.f

21.1056 06 14.349 21 39.149 33

Project B

B p.v

Machine C c.v p.v

5.3568 16.74 23.489

12 80 30

10.713 63.78 21.35

Project C

Year

Cash Cumulative Cash Cumulative Cash Cumulative flows cash flows flows cash flows flows cash flows 1 21.1056 21.1056 5.3568 5.3568 10.7136 10.7136 2 14.349 35.4546 16.74 22.0968 63.78 74.4936 3 39.149 74.6036 23.489 45.5858 21.35 95.8436 nd machine A. Rs. 35.4546 will be recovered in 2 year & balance 4.5454(4035.4546) will be recovered in 3rd year out of 39.149 =2year + (4.5454/39.149) =2year + 0.1161 =2.11year machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(4022.0968) will be recovered in 3rd year out of 23.489 =2year + (17.9032/23.489) =2year +0.7621 =2.76year machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936 (40- 74.4936) will be recovered in 3rd year out of 95.8436 =2year + (-34.4936/95.8436) =2year + -0.3598 = 1.64year

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3A.The cash flow stream of Nanotech Ltd, is as follows: Year 0 1 2 3 4 5 40 60 80 100 Cash flows 120 100 In million The cost of capital is 13% find MIRR.

6 130

ANS. Present value of cost = 120 * 100/1.13 = 194.69 Terminal value of cash flow 4 3 2 = 40(1.13) + 60(1.13) +80(1.13)+100(1.13)+130 = 40*1.6305 + 60*1.4429 + 80*1.2769 + 113 + 130 =496.95 MIRR is obtain on solving the following equation. 6 194.69 = 496.95/(1+mirr) 6 (1+mirr) = 496.95/194.69 6 (1+mirr) = 2.5525

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3. Elaborate different sources of risk in a project ANS. Risk in the project are many. It is possible to identify three separate and distinct type of risk in any project. 1. Stand – alone risk : it is measured by the variability of expected returns of the project 2. portfolio risk : a firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on the existing portfolio of the projects. If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified away. 3. market or beta risk: it is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate. Stand alone risk of a project when the project is considered in isolation. Corporate risk is the projects risks of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence it has on stock prices. Source of risk: the source of risk are 1. project – specific risk 2. competitive or competition risk 3. industry - specific risk 4. international risk 5. market risk 1. project – specific risk: the source of this risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flow or discount rate may lead to a situation of actual cash flow relised being less than that projected. 2. competitive risk or competition risk: unanticipated of a firm’s competitors will materially affect the cash flows expected from a project. Because of this the actual cash flow from a project will be less than that of the forecast. 3. industry- specific : industry – specific risks are those that affect all the firms in the industry. It could be again grouped in to technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. The changes in technology SET 2 MB0029

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affect all the firms not capable of adapting themselves to emerging new technology. The best example is the case of firm manufacturing motors cycles with two stroke engines. When technological innovation replaced the two stroke engines by the four stroke engines those firms which could not adapt to new technology had to shut down their operations. Commodity risk is the arising from the affect of price – changes on goods produced and marketed. Legal risk arise from changes in laws and regulations application to the industry to which the firm belongs. The best example is the imposition of service tax on apartments by the government of India when the total number of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in import – export policy of the government of India have led to the closure of some firms or sickness of some firms. 4. international risk : these types of risk are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets. For example, rupee –dollar crisis affected the software and BPOs because it drastically reduce their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produces. Rupee gaining and dollar weakening reduced their competitiveness in the global markets. The surging crude oil price coupled with the

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4. The expected cash flow of Tejaswini Ltd, are an follow. Year Cash flow 0 50000 1 9000 2 8000 3 7000 4 12000 5 21000 The certainty equivalent factor balance as per the following equation αt =1-05.05t calculate the NPV of the project if the risk free rate of return is 9%. ANS:Year 1 2 3 4 5

Cash flows (inflows) Rs. PV Factor at 9% PV of Cash flows (in flows) 9,000 0.9174 8,257 8,000 0.8417 6,734 7,000 0.7722 4,959 12,000 0.7084 8,501 21,000 0.6499 13,649 PV of Cash in flows 42,100 PV of Cash outflows 50,000 NPV Negative (7,900)

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5. From the following information prepare cash budgets for VSI Co. Ltd.: PARTICULARS Opening cash balance Collection from customer Payments: Raw materials purchase Salary and Wages Other expenses Income Tax Machinery

JAN 20,000 1,30,000

FEB 25,000 1,60,000

MARCH 25,000 1,65,000

APRIL 25,000 2,30,000

1,50,000

1,85,000

1,90,000

2,55,000

25,000 1,00,000 15,000 6,000 ---

45,000 1,05,000 10,000 -----

40,000 1,00,000 15,000 --20,000

63,200 1,14,200 12,000 -----

The firm wants to maintain a minimum cash balance of Rs.25000 for each month. Creditors are allowed one-month credit. There is no lag in payment of salary, other expenses. ANS:PARTICULARS Opening cash balance Collection from customer Payments: Raw materials purchase Salary and Wages Other expenses Income Tax Machinery Closing balance

JAN 20,000 1,30,000 1,50,000

FEB 25,000 1,60,000 1,85,000

MARCH 25,000 1,65,000 1,90,000

APRIL 25,000 2,30,000 2,55,000

25,000 1,00,000 15,000 6,000 --1,46,000 4,000

45,000 1,05,000 10,000 ----1,60,000 5,000

40,000 1,00,000 15,000 --20,000 1,75,000 15,000

63,200 1,14,200 12,000 ----1,89,400 65,600

For JAN: Bank over Draft 21,000 for maintain minimum cash balance for month of February 21000+4000=25000. For FEB: No need to take bank over Draft because closing balance 25,000. For MARCH: Bank over Draft 10,000 for maintain minimum cash balance for month of April 15,000+10,000=25000. At last closing balance month of April 65,600 so return to bank 31,000 form month of april , 65,600 – 31,000= 34,400 SET 2 MB0029

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Case Study Assume you are an external financial consultant. You have been approached by a client M/s Technotron Ltd to give a presentation on Credit Policy adopted by Information technology companies. You are specifically asked to deal with credit standards, credit period, cash discounts and collection programme. For the sake of simplicity take any two information technology companies and analyze the credit policy followed by them. ANS:- Credit policy Variables 1. Credit standards. 2. Credit period. 3. Credit discount and 4. Collection programme. 1. Credit standards : The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are. a. Credit rating b. References c. Average payment period d. Ratio analysis There is always a benefit to the company with the extension of credit to its customers but with the associated risks of delayed payment or non payment, funds blocked in receivables etc. The firm may have light credit standards. It may sell on cash basis and extend credit only to financially strong customers. Such strict credit standards will bring down bad – debt losses and reduce the cost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more the costs saved by the firm. The firm should evaluate the trade – off between cost and benefit of any credit standards. 2. Credit period: Credit period refer to the length of time allowed to its customers by a firm to make payment for the purchase made by customers of the firm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payment are made within the specified period. If a firm follows a credit period of ‘net 20’ it means that it allows to its customers 20 days of credit with no inducement for early payments. Increasing the credit period will bring in additional sales from existing customers and new sales from new customers. Reducing the credit period SET 2 MB0029

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will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases the incidence of bad debt loss. The effect of increasing the credit period on profits of the firm are similar to that of relaxing the credit standards. 3. Cash discount: Firms offer cash discount to induce their customer to make prompt payments. Cash discount have implications on sales volume, average collection period, investment in receivables, incidence of bad debt and profits. A cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the payment is made by the tenth day; other wise full payment will have to be made by 20th day. 4. Collection programme : The success of a collection programme depends on the collection policy pursued by the firm. The objective of a collection policy is to achieve. Timely collection of receivable, there by releasing funds locked in receivables and minimize the incidence of bad debts. The collection programmes consists of the following. 1. Monitoring the receivables 2. Reminding customers about due date of payment 3. On line interaction through electronic media to customers about the payments due around the due date. 4. Initiating legal action to recover the amount from overdue customer as the last resort the dues from defaulted customers. Collection policy formulated shall not lead to bad relationship with customers.

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