Financial Management 29

MB 0029
FINANCIAL MANAGEMENT
ASSIGNMENT – 1
Q.1. Explicit cost and implicit cost are the two dimensions of
cost. What role does cost play in financial decisions.
Ans.1. The cost of debt has two parts – explicit cost and
implicit cost. Explicit cost is the given rate of interest.
The firm is assumed to borrow irrespective of the degree
of leverage. This can mean that the increasing proportion
of debt does not affect the financial risk of lenders and
they do not charge higher interest. Implicit cost is
increase in Ke attributable to Kd. Thus the advantage of
use of debt is completely neutralized by the implicit cost
resulting in Ke and Kd being the same.
Graphically this is represented as:-

Percentage cost
Q.2. Assume you are newly appointed as Finance Executive in
a Manufacturing firm. What guidelines you need to follow
in financial planning?
Ans.2. Guidelines for financial planning that I would

follow:-
1. Never ignore the coordinal principle that fixed asset req
uirements be met from the long term sources.
2. Make maximum use of spontaneous source of
finance to achieve highest productivity of resources.
3. Maintain the operating capital intact by providing
adequately out of the current periods earnings. Due
attention to be given to physical capital maintenance or
operating capability.
4. Never ignore the need for financial capital maintenance
in units of constant purchasing power.
5. Employ current cost principle wherever required.
6. Give due weightage to cost and risk in using debt and
equity.
7. Keeping the need for finance for expansion of
business, formulate plough back policy of earnings.
8. Exercise thorough control over overheads.
9. Seasonal peak requirements to be met from short term
borrowings from banks.
Q.3. Due to over capitalization the company may collapse

which would certainly affect its employees, society,
consumers and its shareholders. What remedies you
would suggest? Give suitable example?
Ans.3. I would suggest following

Remedies for Overcapitalization:-
1. Reduction of debt burden.
2. Negotiation with term lending institutions for
reduction in interest obligation.
3. Redemption of preference shares through a scheme
of capital reduction.
4. Reducing the face value and paidup value of equity
shares.
5. Initiating merger with well managed profit making
companies interested in taking over ailing company.
A company is said to be overcapitalized, when its total

capital (both equity and debt) true value of its assets. It
is wrong to identify overcapitalization with excess of
capital because most of the overcapitalized firms suffer
from the problems of liquidity. The correct indicator of
overcapitalization is the earnings capacity of the firm. If
the earnings of the firm are less then that of the market
expectation, it will not be in a position to pay dividends
to its shareholders as per their expectations. It is a sign
of overcapitalization. It is also possible that a company
has more funds than its requirements based on current
operation levels, and yet have low earnings.
ASSIGNMENT – 2
Q.1. Equity Capital Free of cost? Substantiate your statement?
Ans.1. No, equity capital is not free of cost.

Some people are of the opinion that equity capital is free
of cost for the reason that a company is not legally bound
to pay dividends and also the rate of equity dividend is
not fixed like preference dividends. This is not a correct
view as equity shareholders buy shares with the
expectation of dividends and capital appreciation.
Dividends enhance the market value of shares and
therefore equity capital is not free of cost.
Equity shareholders do not have a fixed rate of return on

their investment. There is no legal requirement (unlike in
the case of loans or debentures where the rates are
governed by the deed) to pay regular dividends to them.
Measuring the rate of return to equity holders is a
difficult and complex exercise. There are many
approaches for estimating return - the dividend forecast
approach, capital asset pricing approach, realized yield
approach, etc. According to dividend forecast approach,
the intrinsic value of an equity share is the sum of
present values of dividends associated with it.
Q.2.(a) What is the rate of return for a company if the β is
1.25, risk free rate of return is 8% and the market rate of
return is 14%. Use CAPM model.
Ans.2.(a) Ke = Rf + β (Rm—Rf)
= 0.08 + 1.25(0.14 - 0.08)
= 0.08 + 0.075
= 0.155 or 15.5%
Q.2.(b) Sundaram Transports has the following capital

structure.
Equity capital Rs.10 par value 250 lakhs

12% preference share capital Rs.100 100 lakhs
each
Retained earnings 150 lakhs
12% Debentures (Rs.100 each) 350 lakhs
14% Term loan from SBI 150 lakhs
Total 1000
lakhs
The market price per equity is Rs 54. The company is

expected to declare a dividend per share of Rs.2 per
share and there will be a growth of 10% in the dividends
for the next 5 years. The preference shares are
redeemable at a premium of Rs.5 per share after 8 years.
The current market price of preference share is Rs.92.
Debenture redemption will take place after 7 years at a
discount of 2% and the current market price is Rs.91 per
debenture. The corporate tax rate is 40%. Calculate
WACC.
Ans.2.(b) Ke is the cost of external equity,
D1 is the dividend expected at the end of year 1 = 2
P0 is the current market price per share = Rs. 92
g is the constant growth rate of dividends = 10%
f is the floatation costs as % of current market price.
Step I is to determine the cost of each component.
Cost of external equity:-

Ke =( D1/P0) + g
= (2/54) + 0.1
= 0.137 or 13.7%
Cost of preference capital:-

Kp = D + {(F—P)/n} / (F+P)/2
D is the preference dividend per share payable=11
F is the redemption price=105
P is the net proceeds per share = 92
n is the maturity period =8
Kp = D + {(F—P)/n} / (F+P)/2
= 11 + (105—92)/8] / (105+92)/2
=12.625/98.5
= 0.1281 or 12.81%
Cost of Retained Earnings:-

Kr=Ke which is 13.7%
Cost of debentures:-
Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}
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 = 40%
F is the redemption price per debenture = Rs. 98
P is the net amount realized per debenture = Rs. 91
n is maturity period = 7 years
Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}

= [12(1—0.4) + (98—91)/7] / (98+91)/2
= [7.2 + 1] / 94.5
= 0.0867 or 8.67%
Cost of Term Loans:-

Kt = I(1—T)
=0.14(1—0.4)
= 0.084 or 8.4%
Step II is to calculate the weights of each source:-
We = 250/1000 = 0.25
Wp = 100/1000 = 0.1
Wr = 150/1000 = 0.15
Wd = 350/1000 = 0.35
Wt = 150/1000 = 0.15
Step III Multiply the costs of various sources of

finance with corresponding weights and WACC
calculated by adding all these components.
Weighted Average of Cost of Capital:-
WACC = WeKe + WpKp +WrKr + WdKd + WtKt
= (0.25*0.137) + (0.1*0.1281) + (0.15*0.137) +
(0.35*0.0867) + (0.15*0.084)
= 0.03425+ 0.01281+ 0.02055+ 0.030345+ 0.0126
= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004
= 0.1105 or 11.05%
Q.3. The effective cost of debt is less than the actual interest
payment made by the firm. Do you agree with this
statement? If yes/no substantiate your views?
Ans.5. Yes, the debentures carry a fixed rate

of interest. Interest qualifies for tax deduction in
determining tax liability. Therefore the effective cost of
debt is less than the actual interest payment made by the
firm.
The Net Cash Outflows in terms of Amount of Periodic
interest Payment and Repayment of Principal in
Installments or in lump-sum on Maturity.
The Interest Payment made by the firm on Debt Issues
qualifies for tax deduction in determining the net taxable
income. Therefore, the effective cash outflow is less than
the actual payment of Interest made by the firm to the
debt holders by the amount of tax shield on Interest
Payment. The debt can either be Perpetual/Irredeemable
or Redeemable.

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MB 0029

Graphically this is represented as:-

Ans.2. Guidelines for financial planning that I would

Q.3. Due to over capitalization the company may collapse

Ans.3. I would suggest following

A company is said to be overcapitalized, when its total

Q.1. Equity Capital Free of cost? Substantiate your statement?

Ans.1. No, equity capital is not free of cost.

Equity shareholders do not have a fixed rate of return on

Q.2.(b) Sundaram Transports has the following capital

Equity capital Rs.10 par value 250 lakhs

The market price per equity is Rs 54. The company is

Step I is to determine the cost of each component.

Cost of external equity:-

Cost of preference capital:-

Cost of Retained Earnings:-

Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}

Cost of Term Loans:-

Step II is to calculate the weights of each source:-

Step III Multiply the costs of various sources of

Ans.5. Yes, the debentures carry a fixed rate

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