Chapter 3: Time Value of Money
Basically TVM covers the concept of how to determine Present Value (PV) of Future Cash Flow and how to determine Future Value (FV) of Present Cash Flows. The process of determining Future value is a compounding concept and the process of determining Present value is called discounting concept.
* Present Value
(1) Present Value of Single Cash Flows
(2) Present Value of Multiple Cash Flows: In the case of multiple cash flows, sometimes CF are equal in all the years. It is called Even Cash Flow. In some case CFs are not equal in all the years, which is called Uneven Cash Flow
(a) Even Cash Flows: It uses PVIFA factors at k% and n years.
PV0 = CFn x PVIFA k% n years
(b) Uneven Cash Flows: It uses PVIF factors of individual years one by one
* Future Value
FVn = CF0 x FVIF k% n years
and also
FVn = CFn x FVIF k% n-1 years
(2) Future Value for Multiple Cash Flows: In the case of multiple cash flows, sometimes CFs are equal in all the years. It is called Even Cash Flow. In some case, CFs are not equal in all the years, which is called Uneven Cash Flow
(a) Even Cash Flow: It uses FVIFA at k% and n years
FVn = CFn x FVIFA k% n years (for CF at 0 time or as on today)
(b) Uneven Cash Flows: It uses FVIF at k% and n years (or 2-1 years)
Solutions to few Practical Problems
Types of Bonds
Following are some of the major types of bonds
1. Government Bonds: Union Government issue bonds through the central bank of the country, which are called Government bond. There is very rate default in payment back of such bonds. Therefore Government bonds are considered safe and secured investment. Examples are Treasury Bills, Treasury Notes, etc
2. Municipal Bonds: Local Government like Municipalities or State Government issue bonds to finance the local development projects for school, water system etc, which are called Municipal Bonds. Municipal bonds are also safe and secured but less than government bonds
3. Corporate Bonds: Corporate bonds are bonds issued by Companies. Companies issue corporate bonds to raise money for a variety of purposes such as purchase of Machinery & Equipment, start up a new line of business, for growing in business etc. There are different kinds of Corporate bonds also, some of the major kinds are given as below
Kinds of Corporate Bonds
(a) Mortgage Bonds: The bonds which are supported by pledging some kind of specific assets as collateral behind the bonds are called Mortgage bonds. This kind of bonds are safe to some extent as there is some specific assets bind as collateral, which try to ensure that in case of any default, the mortgaged assets shall be sold and fund generated so shall be used to pay back to the investors.
(b) Debentures: A debenture is a type of long term business debt, which is not secured by any collateral. It is a funding option for companies with solid financial position.
(c) Income Bonds: An income bond is a type of debt security in which only the face value (principal amount of debt) of the bond is promised to be paid. Interest is not sure to be paid. Interest is generally paid if the issuing company has enough earning to pay for coupon (interest) payment
(d) Convertible Bonds: When a Corporate bond is issued with the benefit that it can be converted into Common Share or Equity Shares at a predetermined numbers, this type of bond is called Convertible bond. Convertible bonds offer a lower rate of coupon interest than comparable conventional bonds
(e) Zero Coupon Bond: Zero coupon bonds are bonds that do not pay any interest during the life of the bonds. Instead, the investors get a discount in it.
(f) Callable and Putable Bonds: Callable bonds are the bonds that can be paid off or redeemed by the issuing company before or prior to the bond maturity date.
On the other hand, putable bonds are the bonds which give right to the bondholders (investors) to demand an early repayment of the the principal amount from the issuer prior to the bond maturity date.
Valuation of Bonds
Valuation of Bonds is a technique for determining the theoretical fair value of a particular bond. Valuation of bond is denoted by V0. Bond valuation includes the following two components.
1. Present Value of streams of future coupon interest (I) using PVIFA kd% n years.
2. Present Value of Maturity Value (M) using PVIF kd% n years.
Hence standard formula for valuation of bond appears as below
V0 = I x PVIFA kd% n years + M x PVIF kd% n years
Where I = annual Coupon interest amount
M = Maturity value or Face value or Termination value
kd = Cost of Debt or Required Rate of Return or Cost of Money or market rate of Return
n = Life of bond in years
If the bond has no definite life, then such bond is called perpetual bond. Following is the formula for Valuation of perpetual bond
I
V0 = -------------- = Rs ....
Kd
Case: Coupon interest payable: semi annual (m = 2)
new Coupon interest (I) = I / 2
new kd = kd / 2
new no of period (n) = n x 2
Further in the case of Coupon payment quarterly, m becomes 4 and corresponding changes take place with I, kd and n
Current Yield
Current yield is the ratio `of the coupon interest rate payable on a bond to the actual market price of the bond (V0) which is presented in the form of percentage. Following is the formula for Current Yield
I Coupon Interest
Current Yield = ------------- = ---------------------------
V0 Price of Bond
Current Yield (CY), Yield to Maturity (YTM) and Effective Annual Yield (EAR)
CY, YTM and EAR all are return or earning from bond measured in terms of one year. There are following differences between them
a. Current yield is a spot rate of return and does not consider PV
b. YTM is also rate of return considering PV
c. EAR is a compounding rate of return of YTM (EAR is always greater than YTM with semiannual coupon payment)
Steps to find YTM
Step 1: Find out Approximate YTM
Step 2: Trial at LR and HR
Step 3: Interpolation
Current Yield and Capital Gain Yield
As stated earlier, there are two types of earning in bonds. These earnings are called yield. One is current yield, i.e. Coupon Interest and another is Capital gain Yield, i.e. rise in the price of an Investment amount over a given period of time. Adding both Current yield and Capital gain yield becomes Total Yield or YTM
Total Yield = Current Yield + Capital Gain yield
Capital Gain Yield = Total Yield - Current Yield
Capital Gain Yield = YTM - Capital Gain Yield
Nominal Interest Rate, Real Interest Rate and Inflation Rates
The interest rate that a person earn by investment in security is called Nominal interest rate. Nominal interest rate is quoted on the investment security. On the other hand, when the nominal interest rate is adjusted with the inflation rate, then it is called real interest rate.
For example, suppose the nominal interest rate offered on a two year deposit is 5 percent and the inflation rate over the period is 3%, then the investor's real rate of return is 2 percent. Another example, suppose, nominal interest rate is 5 percent, but the inflation rate over the period is 7%, then the real interest rate of the investor becomes negative. The investor is loosing
The real rate of interest is always smaller than the nominal rate of return. It is because of the inflation effect. The inflation decrease the purchasing power of money.
Nominal interest rate is denoted by r and real interest rate is denoted by rr and inflation is denoted by i. Then the real interest rate is expressed as below
rr = r - i
The above expression shows only the approximate relationship between nominal interest rate and real interest rate, it ignores the compounding effect of interest. The actual relationship between nominal interest rate and real interest rate is expressed as below, which also consider the compounding effect.
1 + r
1 + rr = ------------
1 + i
Stock Valuation is a process of making theoretical valuation of Share (stock) and comparing the theoretical value with the current market price and see whether the stock is overvalued or undervalued.
Common stock is a source of long term capital. One who posses the common share own ownership in the company and they are the real owner of the company. Common shares are also called Equity Shares or Ordinary Shares. Common share holders has voting right which the holders can use in the election of BOD (Board of directors)
Issued Shares, Treasury Stock & Outstanding Shares
The numbers of shares that a company issue for sale is called issued shares. Suppose a company sells 10,000 common shares in the market. Then these 10000 shares are called Issued Shares. Sometimes the company buy back its own share from the open market for any specific purpose, then the shares that have been bought back from the market then, it is called Treasury Stock or Treasury shares. Suppose the company make a plan to distribute 500 shares to its best employees on the occasion of its anniversary, For the purpose, the company shall buy back 500 shares from the open secondary market. These 500 shares bought back is called Treasury stock. Now there is 9500 shares remaining in the hands of the investors in the market. These 9500 shares (10000 shares - 500 shares) is called Outstanding shares.
Basic Stock Valuation Models
The fundamental of valuation of share is like the "valuation of bond" Like bond, the value of a common share or stock is equal to the present value (PV) of all future benefits it is expected to provide. However, valuation of share is difficult than valuation of bond because of the following reasons.
a. Expected Cash flow of Common share (dividend) is more uncertain than the expected cash flow of bond (interest)
b. Changes in the market price of Common shares is more uncertain than the price of bond
c. Interest rate of bond is comparatively less likely to increase (grow), whereas dividend is generally expected to grow and growth rate may vary over the period of time
d. Bond has maturity period, but common share has no maturity period
Dividend Discount Model (DDM)of Stock Valuation
There are 3 different approach under DDM.
(i) Zero Growth: As the name suggests, Zero growth indicates that there is no growth in the percentage of dividend. In other words, dividend is constant in all the years. If company is expected to distribute Rs 20 every year as dividend, then it is called Zero Growth. Symbolically
D0 = D1 = D2 = D3 = D4 = Dn (where D = dividend and 1,2 .... n = 1st year, 2nd years, n years etc)
Formula to determine Stock value under Zero Growth is as follows.
D Where P0 = Intrinsic value per share of common stock
P0 = ----------------- D = Dividend per share
Ks Ks = Cost of capital
(ii) Constant Growth or Normal Growth: It assumes that dividend will grow at a constant rate and the growth rate is less than Required Rate of Return (RRR) or Cost of capital. Suppose a company distribute dividend Rs 20 in a year and it is expected to grow by 10% every year at a constant rate, then it is a constant growth. Formula to determine Stock value under Constant Growth is as under.
D1
P0 = -------------- Where D1 = D0 (1+g)
Ks - g Where g = growth rate
It is worth to note that P0 is the value of bond today (at 0 time). For P0 we take D1. If we determine Value of bond at year 1 (P1) , then we use D2. Accordingly for value of bond at year 3 (P3), we use D4 and so on, i.e. one year forward dividend (D)
The requirement of capital for a daily or regular activities in a business is called working capital. Symbolically, Working Capital is as below
Working Capital = Current Assets - Current Liabilities
Under Working Capital, the following are the major components that comes in the area of study
(a) Cash Management (Cash Budget)
(b) Receivable Management
(c) Inventory Management (EOQ, Stock Levels etc)
Chapter 7: Capital Budgeting Analysis
Capital Budgeting Analysis is technique of a long term financial planning. Capital Budgeting Technique helps in decision making whether investment in a certain projects or investment opportunities is beneficial or not for the company. Capital Budgeting decision is based on the expected future cash flows. There are various methods of Capital Budgeting Analysis. Following are some of the major methods
1. Pay Back Period Method
2. Discounted Pay Back Period Method
3. Accounting Rate of Return (ARR) Method
4. Present Value (PV) Method
5. Internal Rate of Return (IRR) Method
6. Modified Internal Rate of Return (MIRR) Method
7. Profitability Index (PI)
Most of the techniques use expected future Cash-flows for decision. Some methods use (a) Discounted Cash-flows and some methods use un-discounted Cash Flows for the calculations.
Discounted cash flows are cash flows adjusted to incorporate the time value of money. Un-discounted cash flows are not adjusted to incorporate the time value of money. The time value of money is considered in discounted cash flows and thus Discounted cash-flows is highly accurate and reliable. Present Value (PV) Table is used to convert the normal cash-flows into Discounted cash-flows.
Pay Back Period (PBP) Method
Pay back Period tells us that how many years it takes to recover the initial investment in a certain projects. Following is the formula. Initial investment amount and annual cash-flows are considered to calculate PBP. There are two kinds of annual cash-flows
1. Even Cash flows or Equal Cash flows: If cash flows amount is equal in all the years then, it is called Even Cash flows. For example, suppose cash flows are Rs 100,000 equal in all the years, then it is a case of even cash flows. Following is the formula to calculate PBP (in case of Even Cash Flows)
Initial Investment
PBP = -----------------------------
Annual Cash Flows
2. Uneven Cash flows or Unequal Cash flows or Odd Cash Flows: If cash flows are different or not equal, then it is called Uneven cash flows. For example, suppose cash flows are Rs 100,000 in first year, Rs 80,000 in second year, Rs 95,000 in the third year and this way different cash flows in different years, then it is a case of uneven cash flows. Since there are uneven cash flows, so it does not become possible to find out PBP by using above formula. Therefore, PBP is determined by following the following steps
Step 1: Determine Cumulative Cash Flows
(Suppose cost of project is Rs 300000 and cash flows are Rs 100,000 in first year, Rs 80,000 in the second year, Rs 95,000 in the third year, Rs 70,000 in the fourth year)
Year Cash Flows Cumulative CF
0 (300,000) (300,000)
1 100,000 (200,000)
2 80,000 (120,000)
3 95,000 ( 25,000)
4 70,000
Step 2: As the above table shows that the initial investment (Rs 300,000) shall be recovered in minimum 3 years and a maximum of 4 years. In other words, the initial investment amount Rs 300,000 shall be recovered in between 3 and 4 yea. Hence PBP is determined as follows
un-recovered amount
PBP = Min year + -----------------------------------------
Full cash flows of next period
25000
PBP = 3 years + -----------
70000
PBP = 3.36 years
Discounted Pay Back Period (DPBP) Method
The PBP Method and DPBP Method, under both methods it is determined that in how many years the investment money in the project is recovered. As the name indicates, the annual future cash flows are discounted using the factors of Present Value Table. Suppose cost of capital is 10%, then we loom into the present value table at 10% (PVIF 10%). Let us take one example: Suppose investment or initial cash outlay is Rs 300,000 and Cash flows are Rs 100,000 each year for next 5 years
Year Cash Flow PVIF 10% PV amount Cumulative CF
0 (300,000) 1.00 (300,000) (300,000)
1 100,000 0.9091 90910 (209,090)
2 100,000 0.8264 82640 (126,450)
3 100,000 0.7513 75130 (51,320)
4 100,000 0.6830 68300
The above table shows that the initial investment amount Rs 300,000 is recovered in between 3rd and 4th year. Hence DPBP is determined as follows.
unrecovered amt
DPBP = Min year + ----------------------------
Full CF of next period
51320
= 3 + ----------- = 3.75 years
68300
Accounting Rate of Return (ARR) Method
All other techniques consider the future annual cash flows, whereas ARR method does not consider cash flows. It consider Net Income for decision making. Following is the steps to determine ARR
Sum of Net Income of N years
(a) Find Out average Net Income = -------------------------------------------------
N or Numbers of year
Initial Investment
(b) Find Average Investment = -----------------------------
Avg Net Income 2
(c) ARR = ---------------------------
Avg Investment
Net Present Value (NPV) Method
NPV Method considers the present value of future cash flows. Following are the steps to determine NPV
(a) Find Out PV using PVIFA (for even CF) or PVIF (for uneven CF)
(b) NPV = TPV - Initial Investment (TVP = Total Present Value or sum of PV of all the future CF)
Decision Rule: If NPV is positive, accept the project or vv
Internal Rate of Return (IRR) Method
IRR method shows that what is the rate of return from the given project in the given situations. Following are the steps to find out IRR
(a) Find Out PBP
(b) Locate the PBP in the PVIFA Table at the given no of year and find out the exact value where does it lies
(c) It the PBP value is not exact matching in the PVIFA Table, then find out the range the value lies in between this and this percentage
(d) Find out the IRR using interpolation
PVIFALR - PBP
IRR = LR + ---------------------------- X (HR - LR)
PVIFALR - PVIFAHR
Decision rule: If IRR is more than RRR, accept the project or vv
Profitability Index (PI)
Profitability Index is a ratio (times) of present value of Cash In Flow on Initial Investment or Initial Cash Outlay. It shows the Present Value per Re of initial investment in the project. PI is measured with the help of the following formula
PV of future cash flows
PI = ------------------------------------------
Initial Investment
Decision Rule: PI greater than 1 is accepted and vv
Mutually Exclusive Projects
Sometimes the situation is like that there are two projects and one need to select any one among both. Such a case is called mutually exclusive projects. Under mutually exclusive projects, any one of the projects are selected and following is the decision rule
1. Pay Back Period: Project having smaller PBP is selected
2. Discounted PBP: Project having smaller PBP is selected
3. ARR: Project having a higher rate of return is selected
4. Internal Rate of Return: Project having higher rate is selected
5. MIRR: Project having higher rate is selected
6. Net Present value: Project having higher NPV is selected
7. Profitability Index: Project having higher PI is selected
Key Point: Conflict between NPV and IRR
Single project: In case of a single conventional project, both NPV and IRR gives the same result about whether accept or reject the project.
Mutually Exclusive project: In the case of two or more exclusive projects, the NPV and IRR may not provide the same indicator. For example, as per NPV, it may be that project A is to be selected, but as per IRR, it may be that project B is to be selected. In other words, NPV and IRR may provide conflicting results. Following are some of the major reason behind "why a conflicting result comes?"
(a) A significant difference in the amount of Initial investment or Initial Cash Outlay among the projects under consideration
(b) A significant difference in the cash inflows pattern or timing of the various proposals under consideration
(c) A significant difference in the service life of the projects under consideration
What to do, if there is conflict in the results (indicator)
In such a case, one should always decide on the basis of NVP, not the IRR. One should select the projects giving the largest positive NPV using the appropriate cost of capital or a predetermined cut-off rate. The reason for preferring NPV to IRR lies in the fact that the objective of the firm is to maximize shareholders wealth. The project with the largest NPV has most beneficial effect on share prices and shareholders wealth. Thus the NPV method is more reliable as compared to the IRR method in ranking the mutually exclusive projects. In fact, NPV is the best operational criterion for ranking mutually exclusive investment proposals.
MACRS method of Depreciation
Depreciation helps business organizations to allocate the costs of assets over the life the assets will be used. The most common methods of depreciation are Fixed Installment method and Diminishing balance methodThere is another method which is used in USA. This method of depreciation is called Modified Accelerated Cost Recovery System (MACRS). MACRS depreciation method was introduced in 1986 to encourage businesses to invest in depreciable assets by allowing larger amount of depreciation deductions in the earlier years of the asset’s useful life. This system contrasts with Fixed Installment method and Diminishing balance method, where the businesses get the same amount (or percentage) of deductions each year until the assets are fully depreciated
Under the MACRS system, the capitalized cost of tangible property is recovered over a specified life by annual deductions for depreciation. It helps to motivate the businesses to invest in depreciable assets as they will be allowed to deduct a larger amount of depreciation as expenses in the early years of an asset’s life, and lower deductions in later years. This will allow a tax benefit to the organizations
Under the MACRS system, all the assets are divided into different property class like 3 year property class, 5 year property class, 7 years property class, 10 year property class, 15 year property class and son on. Rate of depreciation is pre determined for each class of assets. There is a separate chart developed for the assets class and their rate of depreciation
Book Salvage Value vs Cash Salvage Value
The term "Salvage Value" means the value of the Assets at the end of its useful life. Salvage value is also called "Scrap value or residual value or terminal value" also. Suppose life of the FA (say machine) is 5 years. Then the value of the FA at the end of 5th year is called "Salvage Value" Further, there are two kinds of salvage value as mentioned below
(a) Book Salvage Value: Book salvage value means the value of the FA shown in the book at the end of its service life. Book salvage value (BSV) can be determined as below
BSV = Cost - accumulated Depreciation
BSV of a FA at the end of its service life is generally Zero. Let us take one example. Suppose a company buy a Machine for Rs 500,000. It service life is 5 years. Now annual depreciation becomes Rs 100000 (Rs 500000/5). Now BSV of the Machine shall be
BSV = 500000 - (100000 x 5 years) = 0
(b) Cash Salvage Value: Cash Salvage value is the market value or market price of the FA at which it was actually sold. There can not be or there is not any formula to determine Cash salvage value (CSV). It is given in the question. If there is not given cash salvage value, it means CSV is zero.
The difference between BSV and CSV becomes Gain or Loss on Sale. If CSV > BSV. It is a case of Gain. On the Gain, Tax is payable, i.e. minus in the calculation. If BSV > CSV. It is a case of Loss. On the Loss, Tax is saved and called Tax saving, i.e. plus in the calculation
Replacement Proposal
All the details prescribed above are in respect for proposal of new project. When a company is already running a project and using a machine for production. The company wants to replace the existing machine with a new one with higher technology. For the purpose, the company wants to evaluate whether replacing the old machine with a newer one is beneficial or not. Such evaluation is called "Replacement proposal"
The process of evaluating a replacement proposal is similar to the evaluation process of a new proposal (single machine) with few additions.
Process followed in the case of new proposal
Step 1: Calculation of Net Cash Outlay
Cost of Machine (xxxx)
Installation charge (xxxx)
Working Capital (xxxx)
Total Initial Cash Outlay (xxxx)
Step 2: Annual Cash Inflows after Tax
Sales xxxx
Less: Operating Costs (xxxx)
Operating Saving xxxx
Less: Depreciation (xxxx)
EBT xxxx
Less: Tax (xxxx)
EAT xxxx
Add back: Depreciation xxxx
CFAT (Cash Flow after Tax) xxxx
Step 3: Terminal Cash Flow
Cash Salvage Value (CSV) xxxx
Working Capital Release xxxx
Tax Adjustment
CSV xxxx
BSV xxxx
Gain or Loss xxxx (xxxx)
Tax payable on gain or (xxxx)
Tax saving on loss xxxx
xxxx
Process to be followed in the case of replacement proposal
Step 1: Calculation of Net Cash Outlay
Cost of new machine (xxxx)
Installation charge (xxxx)
Working Capital (xxxx)
CSV of Old Machine xxxx
W C release of Old machine xxxx
Tax adjustment - old machine
CSV xxxx
BSV xxxx
Gain or Loss xxxx (xxxx)
Tax Payable on Gain or (xxxx)
Tax Saving on Loss xxxx
Step 2: Differential annual Cash inflows after Tax
Differential Sales (new - old) xxxx
Less: Differential Cost (xxxx)
Differential Saving xxxx
Less: Differential Depn (xxxx)
Differential EBT xxxx
Less: Tax (xxxx)
Differential EAT xxxx
Add back: Differential Depn xxxx
Differential CFAT xxxx
Step 3: Differential Terminal Cash Flows
Differential CSV xxxx
Differential WC xxxx
Differential Tax Adjustment
New Old Diff
CSV xxxx xxxx xxxx
BSV xxxx xxxx xxxx
Gain or (Loss) xxxx
Tax payable on gain (xxxx)
Tax saving for loss xxxx
xxxx
Chapter 4: Risk & Return
Risk and return are associated with all investment opportunity. Usually high risk investments yield higher financial returns and low risk investments yield a lower return. In other words, generally the risk of a particular investment is directly related to the returns being earned from the same. Risk is a chance that the investor is going to lose money and return is a chance of a gain made by the investor. When it comes to investing money, risk and return come hand-in-hand. Investors cannot have one without the other.
Generally, higher is the risk and higher is the potential return of an investment.But the rule is not true all the times. There is no guarantee that you will actually get a higher return by accepting more risk. Now how to minimize the risks for a higher return. There is one technique which is called Diversification. Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns.
Explanation of Risk
Risk can be defined in many ways. However, in the context of financial management and investing, Risk can be defined:
(a) As the probability of losing ‘X’ amount of an investment over a given time period or
(b) As the return volatility of an investment over a given time period, i.e. instability in the possible returns in future
Formula to determine Expected Return, Variance and Standard deviation are as follows.
Sum of Return
Expected Return (Er) = ----------------------------
N
(R- EṜ)2
Variance = ---------------- =
N - 1
Standard Deviation = Square Root of variance
For sample standard deviation, why divide by (N - 1)?
It is most common that we estimate s.d. with the sample average, the population average is generally unknown.The N - 1 is used in the general situation where we are analyzing a sample data and wants to generalize the conclusions. The standard deviation computed with N - 1 in the denominator is the best guess for the value of the standard deviation for the overall population.
In other words, dividing by N - 1 corrects the bios or error while calculating the variance. Since the sample mean is based on the sample data, it will drawn towards the center of mass, more near to the population. Go through the following attachment for more insight.
Explanation of Return
Return is usually presented as a percentage relative to the original investment over a given time period. There are two rates of return which are often used in financial management.
(a) Nominal rates of return that include inflation
(b) Real rates of return that exclude inflation
Investment return can come in a wide range of forms like capital gains, interest gain, dividends gain are the different major gain or yield or return.
TU Exam Theory & Short Questions answers
Exam Question: August 2021: Group A: True or False: for 1 mark each
The following statements are true or false? Support your answer with reason
1. Wealth maximization goal of firm is superior goal to profit maximization: Ans: True (Reason: Organizations must maximize its wealth for survival and growth)
2. Net cash-flow usually differ from firm's net income: Ans: True (Reason: Calculation of Net income considers all cash and non cash items while Cash-flows includes only cash items for calculation)
3. If we deposit Rs 1000 today at an annual interest of 10%. It is compounded to Rs 1464 at the end of year 4: Ans: False (Reason: Compounding amount shall be Rs 1464.10)
4. When required rate of return is greater than the coupon rate, the bond will sell at premium: Ans: False (Reason:
If the prevailing interest rate or required rate of return is greater, then people shall earn a lower fixed rate of return i.e. interest than prevailing market interest rate.5. The risk free rate and expected market return are 8% and 14% respectively. If Mega's company stock has a beta of 2, required rate of return should be 16%: Ans: False (Reason: Rf + (Mr - Rf) x beta = 20%)
6. Stock beta measures total risk associated with the security: Ans: True (Reason: Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall stock market)
7. Increase in working capital is considered as cash inflow at the beginning of the long-term investment: Ans: False (Reason: Working capital refers to short term investments)
8. Management attempts to increase total assets turnover: Ans: True (Reason: Because Assets turnover indicates the times increase in the Sales for one unit of investment in assets)
9. Effective annual rate is always higher than nominal rate when compounding period is less than one year: Ans: True (Reason: Compounding period less than one year means reinvestment of multiple time within one year, so compounding effect always increase the effective annual rate than the normal interest rate)
10. Higher cash conversion cycle increases the profitability of the firm: Ans: False (Reason: High cash conversion cycle means delay in conversion into cash. It increase the interest expense)
Exam Question: September 2019: Group A: True or False: for 1 mark each
1. The investment decision of a firm is concerned with deciding on which financing sources are to be used to finance an investment: Ans: False (Reason: Investment decision is concerned with deciding which investment proposal is profifitable)
2. A steam of equal payments occur at equal interval of time to infinity is called annuity: Ans: True (Reason: Annuity means an equal amount of cashflows in an equal intervals.
3.The risk-free rate is 6%, the expected market return is 10. If stock's beta is 1.5, required rate of return on the stock should be 12%: Ans: True (Reason: as above)
4. Higher liquidity ratio is desirable: Ans: True (Reason: A higher liquidity ratio shows a sufficient amount of liquid assets to pay its short term obligations)
5. Value of zero-coupon bond can be calculated by dividing coupon interest by discount rate: Ans: False (Reason: Because there is no coupon interest)
6. Preferred stock is often called hybrid security: Ans: True (Reason: Preferred stock has the features of Owners Equity or Share capital as well as the feature of debt capital_
7. Internal rate of return method considers entire stream of cash-flow: Ans: True (Reason: IRR is the intrinsic rate of return considering entire cashflows
8. A firm purchases 25,000 units annually. Its ordering cost is Rs 100 per order and carrying cost is Rs 5 per unit. Firm EOQ should be 1000 units: Ans: True (Reason: Using EOQ formula, EOQ is 1000 units)
9. Net working capital can be defined as the difference between total assets and current liability: Ans: False (Reason: It is difference between CA and CL)
Exam Question: August 2021: Group B: Short answers questions : for 5 mark each
Q No 16: What do you mean by agency problem between shareholders and management? How do you resolve the agency problem between shareholders and management?
Answer: Shareholders are the real owners of the company, but they cannot actively manage the company themselves as they are in large numbers and dispersed in various geographical locations. The shareholders also may not have necessary skills, expertise and experiences to manage a company. Therefore, they elect a BOD from among themselves for managing the firm. BOD delegates its authority to CEO who is responsible for the management of a company
The agency problem between the owners and managers occur because the management may tend to act for achieving his/her own goals at the expense of other owners. Since, Managers have much more information about the company they can manipulate the company’s information for their own benefit. Managers may not work hard for maximizing shareholder’s wealth because only less of the wealth will be given to them. This kind of problems is called agency problem
Following could be the ways to resolve the agency problems between shareholder and management
1. Offering incentives to management for strong performance and ethical behavior
Q No 17: What do you mean by working capital? Describe the objectives of working capital management.
Answer: Working capital management is a business process that helps in how to make effective use of their current assets and optimize its cash flow. Working Capital is mainly oriented around ensuring to meet short-term financial obligations and expenses in time
(a) Optimization of Working Capital Operating Cycle
(b) Minimize cost of capital
(c) Helps the business to avoid over borrowing
(d) Expansion of company's business
(e) Healthy relations with suppliers
Exam Question: August 2021: Group B: Short answers questions: for 5 marks each
Q No 11: Compare between wealth maximization and profit maximization goals. Which goal would you like to recommend and why?
Answer: The major difference between the profit maximization and the wealth maximization is that the profits maximization focus on short-term earnings, while the wealth maximization focus on increasing the overall value of the business entity over a long period of time. Hence, profit maximization is a wholly short-term strategy for business management and wealth maximization places more emphasis on the long term. In other words, profit maximization aims at increasing the profit of a firm, wealth maximization has a larger role to play and it deals with the overall well-being of the stakeholders as a whole.
Exam Questions: Oct 2018: Group A: True or False: for 1 mark each
1. The investment decision of a firm is concerned with deciding on which financial sources are to be used to finance an investment: Ans: False (Reason: Similar question above)
2. If we deposit Rs 1000 today at an annual interest rate of 10%, it is compounded to Rs 1331 at the end of year 3: Ans: True (Reason: Rs1000 x 1.1 x 1.1 x 1.1 = Rs 1331)
3. The risk free rate is 6%, the expected market return is 10%. If Omega's stock has a beta of 1.5, the required rate of return should be 12%: Ans: True Reason: refer above)
4. When required rate of return is greater than the coupon rate, the bond will sell at premium: Ans: False (Reason:
If the prevailing interest rate or required rate of return is greater, then people shall earn a lower fixed rate of return i.e. interest than prevailing market interest rate.5. Preferred stock is hybrid security: Ans: True (Reason: Because preferred stock carries the characteristics of both stocks as well as debt)
6. Payback period does not consider entire streams of cash-flows: Ans: True (Reason: Pay back period considers the cash flows of the earlier years till the Net investment is collected or paid back)
7. A firm purchases 10000 units annually. Its ordering cost is Rs 100 per order and carrying cost is Rs 2 per unit. Firm's EOQ should be 1000 units: Ans: True
8. Net working capital can be defined as the difference between total assets and current liabilities: Ans: False (Reason: Net working capital = CA - CL)
9. Presently a firm is selling at the term 2/10, net 30. Its sales will increase if it sells at term 3/10. net 50: Ans: True (Reason: If discount offer is increased from 2% to 3% as well as if total credit days is increased from 30 days to 50 days then definitely Sales will increase)
10. Depreciation is not shown in cash budget: Ans: True (Reason: Because depreciation is a non cash item)
Exam Questions: Oct 2018: Group B: Short answers questions: for 5 marks each
Q No 11: Compare between wealth maximization and profit maximization goals. Which goal would you like to recommend and why?
Answer: same answer as Q No 11
Q No 16: What do you mean by working capital management? Briefly explain the importance of working capital management
Answer: same answer as above Q No 17
Exam Questions: Oct 2017: Group A: True or False: for 1 mark each
1. The financing decision of a firm is concerned with utilizing funds in Fixed Assets: Ans: True
2. Balance Sheet shows financial positions of a firm: Ans: True (Reason: BS shows assets and liabilities. It is financial position of a firm)
3. The risk free rate and expected market return are 5% and 9% respectively. If firm's stock has beta of 1.5, required rate of return should be 11%: Ans: True (Reason: Formula is Rf + (Rm - Rf) x beta )
4. Present value of cash-flow decreases when higher discounting rate is used: Ans: True
5. If we combine perfectly positively correlated assets, we can completely eliminate the risk using minimum variance weight: Ans: False (Reason: Perfectly positively correlated assets or investments mean stocks of the same industry. It increases the portfolio risk)
6. Depreciation is non-cash operating expenses which is deducted only for tax reporting purpose, but it is added back to the net income of the project to determine net cash-flow: Ans: True (Reason: For tax purpose Depreciation is deducted and then added back)
7. If projects are mutually exclusive, we can choose all projects which have positive NPV: Ans: False (Reason: Bucause exclusive means any one could be selected)
8. If city bank offers 10% interest and applies semiannually compounding, the effective interest rate is 10.25%: Ans: True
9. Non cash income and non cash expenditure are not included in cash budget: Ans: True (Reason: Because cash budget considers only cash items)
10. A firm's current assets and fixed assets are Rs 90,000 and Rs 180,000 respectively. If firm's long-term financing is Rs 200,000, amount of net working capital will be Rs 20000: Ans: True (Reason: Long term financing means long term Liabilities. Total Assets is Rs 270000, total long-term liability is Rs 200,000. It means short term or current liability is Rs 70000)
Exam Questions: Oct 2016: Group A: True or False: for 1 mark each
1. Executive finance functions are handled by the persons with the basic knowledge of accounting: Ans: False (Reason: There is required person with financial knowledge)
2. Preference shareholders have prior claim to debt holders: Ans: False (Reason: First of all creditors are paid then share holders are paid at the time of liquidation of company)
3. If we identify perfectly positively correlated assets, we can completely eliminate risk: Ans: False (reason: refer above)
4. If Equity Multiplier (EM) is 2, Debt ratio must be 0.50: Ans: True (Reason EM = TA/Equity)
5. There is inverse relationship between market interest rate and value of bond: Ans: True
6. A rupee in hand today is worth more than a rupee to be received next year: Ans: True (Reason: interest factor)
7. Increase in Net Working Capital (NWC) is considered as the cash outflow while determining the Net Cash Outlay (NCO) of the project: Ans: True (Reason: Increase in WC means increase in the investment in WC)
8. If a firm places 25 times order in a year with Rs 400 costs per order placed, the total costs associated to the ordering of inventory is Rs 7200: Ans: False (Reason: Ordering costs shall be 25 x 400 = Rs 10000)
9. Par value and intrinsic value of bond becomes equal when market interest rate is more than coupon rate: Ans: False
10. Effective annual interest rate (EAIR) is always less than or equal to simple interest rate because of compounding effect: Ans: False
Exam Questions: Oct 2015: Group A: True or False: for 1 mark each
1. Business finance deals with raising funds only: Ans: False (Reason: It also deals with a better investment opportunities)
2. A rupee in hand today is worth more than a rupee to be received next year: Ans: True (Reason: Because of compinding effect of interest)
3. Yield curve is a graph that shows the relationship between interest rate and maturity period: Ans: True
4. If two investments offer the same expected return, most investors would prefer the one with higher standard deviation: Ans: False (Reason: standard deviation is the measurement of risk. Higher standard deviation means a higher risk)
5. Common stock is also called hybrid security: Ans: False ( Reason: Preferred stock is called a hybrid security)
6. The current market price of XYZ Co's stock is Rs 100, expected year end dividend is Rs 5 per share and constant growth rate is 7%, an investor's required rate of return is 13%: Ans:
7. A firm has an average inventory of 90 days, an average collection period of 40 days, and an average payment period of 30 days. The firm operating cycle is 160 days: Ans: False (Reason: Operating cycle = inventory conversion cycle and receivable conversion cycle or average collection period)
8. Short term sources of financing consist of all the liabilities or obligations that are originally scheduled for repayment of one year or less: Ans: True
9. If the coupon rate of bond is higher than market interest rate, the value of bond will be higher than its par value: Ans: True (Reason: Refer above)
10. Compensating balance increase its effective cost of bank loan: Ans: True (Reason: Because compensating balance means a minimum amount to be left in the account without any interest)