IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 6. What is a payback and what is its importance?

Ans. PAYBACK PERIOD

The Payback- period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR. Ordinary people not well versed in appraisal techniques, often use very simple technique to judge the profitability of any investment proposal. They think in terms of initial expenditure (outflow) and the time duration in which this amount can be recovered. Suppose somebody spent Rs.50,000 on any project and expects that within 3 year he can get back this amount, then the payback period is 3 years. Payback period of any proposal can be calculated as follows;

 If the cash inflows are uniform then

Payback period = Initial cash outflow / Annual cash inflows

If the cash inflows are not uniform then

Payback period = time period in which the cumulative cash flows are equal to initial inflows.

Acceptance Rule and Ranking Rule : - If the calculated payback is less than any predicted value then an investment proposal is acceptable, otherwise it will be rejected. So far as ranking is concerned, the lower the value of the payback the higher will be the ranking of any investment proposal.

Evaluation of payback method :- It is a simple method in concept and understanding. That is why even lay men can understand and use it with ease. Moreover, since its emphasis is on early recovery of investment, it automatically takes care of risk. Projects with smaller payback are considered safer and secure as compared to the projects with longer payback.

The payback method, however, suffers from serious drawbacks. Firstly it takes into account only early cash flows which determine the payback and ignores those which come later. This may be often leading to wrong conclusions.

 

IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 5. What is an ARR and how is this to be calculated?

Ans. ACCOUNTING RATE OF RETURN

The Accounting Rate of Return also called the Average Rate of Return (ARR) is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the Net Profit After Tax and the amount of initial investment made in the project.

ARR= Average PAT / Initial Investment

Another view about ARR is that since we take average of the PAT for calculating ARR we should also use average level of investment for the project. In such a situation the equation for calculating ARR should be modified as follows.

ARR= Average Profit After Tax / Average Investment

Acceptance & Ranking Rule :- When we adopt ARR as the decision criteria, then the acceptance rule is that the calculated ARR should be greater than some specified rate. We will reject those proposals which have an ARR lower than this specified rate. So far as ranking of projects is concerned, the project with a higher ARR should be ranked higher than other project which has a lower ARR.

Evaluation of ARR Method :- The ARR method is a relatively simple method involving the calculation of averages. It is also based on easily understood accounting information like EBIT/PAT, depreciation, investment etc. However, when it is evaluated for its suitability as a investment criteria for making long term investment decisions, we find it deficient in several respects. Firstly, it is ill defined; we do not know whether to use EBIT or PAT; Initial Investment or Average Investment. Each variable will give different values of ARR. Moreover, accounting information itself is not very certain and subject to great manipulation; Thirdly the average of income, whether EBIT or PAT ignores time value of money and hence not suitable for scientific decision making, and lastly the bench mark rate, against which the calculated ARR will be compared is arbitrary and there is no scientific basis for deciding it.

IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 4. Why do we use a cash flow analysis instead of a profit analysis in a capital budgeting decision? What are the general principles of cash flow estimation?

Ans. Principles of cash flow estimation

In this part we are going to see, how a capital budgeting decision is to be made and what are the principles that must be observed in order to make an estimation of cash flows in a scientific manner. As pointed out in previous section all estimates of receipts and payments should be based on cash flow rather than on revenue and expenditure or profit and loss. The reason is that cash flows are very certain amounts and are not subject to different interpretation by different people. Accrual principle is considered better for the purpose of accounting, (probably because it calculates profit or loss for a given year), but for a long term investment decision making cash principle will be better. Every payment of cash, for whatever purpose, is an outflow, while every receipt of cash, for whatever reason is an inflow. Any non cash expenditure (like depreciation) will not be accounted for because it does not involve any cash outflow. The following principle should be adhered to in estimating cashflows in respect of a project.

1. All calculation of cash flows should be done on incremental basis rather than on aggregate basis. If any inflow is in addition to the exiting inflows, it should be accounted for otherwise not. If a machine costs Rs. 1,00,000 and it replaces an old machine which has fetched Rs. 20,000, then the cash outflow should be taken as only Rs. 80,000, even if the cost of machine is Rs. 1,00,000.

2. Cash flow should be taken on ‘After-tax’ basis. Each income of a company is subject to corporate income tax. So the amount of tax is cash outflow even if we may not consider it as expenditure. Hence, if we have to find out net cash inflow the amount of tax paid should be subtracted and ‘cash flow after tax ‘(CFATs) should be calculated.

3. Sunk- costs should be ignored. The costs which have already been incurred and which are non recoverable should not be taken into account while calculating cash outflows for a period. This is because no net cash flows are taking place on account of a particular decision (since they have already been incurred and can’t be recouped).

 4. Calculation of cash flows should also take into account the opportunity cost even if no actual cash inflow or outflow takes place. For example, if we are using our own premises for a particular project, then possible rental should be taken as the cash outflow while making our calculations. This is because in making our decision we are foregoing this income and this should be regarded as a cost.

5. A very important aspect of cash flow calculation is that cash flows on account of interest payments are not to be considered while making the calculation of cash flows. This may look odd, because the interest payment is an actual outflow and ignoring it may appear to be incorrect. However, it must be understood that the discounting of cash flows for their time value automatically takes into account the interest cost of any investment. Therefore, subtracting interest payment and then discounting it for time value will lead to double counting. Rate of interest is a compensation for time value of money and when we discount some cash flows for their time value at the given rate of interest, there is no need to subtract interest payments separately.

6. Cash needs for working capital should be treated as a cash outflow at the time of commencement of a project and should be treated as inflows when that cash is released at the time of closure or termination of project. Increases or decreases of working capital should be treated as outflows and inflows respectively as and when they take place.

IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 3. What are the requirements of a good method of capital budgeting decision making? Give an overview of different methods.

Ans. Requirements of a good method

The previous section has shown us various methods, which may be used for investment decision making. In fact, each method has its own advantages as well as shortcomings. Given below are the requirements of a good method of investment decision making.

1. It should be based on cash-flows rather than on profits or expenditure.

2. Cash flows to be covered over the entire expected life of the asset rather than few years only.

3. It should give the absolute value of gain or loss.

4. It should consider time value of money.

5. It should indicate relative profitability between different alternatives so that a ranking can be made between different proposals.

6. It should indicate the degree of risk and the chances of getting profit or loss in a given situation.

There is probably no method which will posses all the above attributes but different methods do posses some of them. As we get introduced to different methods in this and the next unit, we will be able to assess the suitability of a method /methods for different situations.

 

METHODS OF CAPITAL BUDGETING

ACCOUNTING RATE OF RETURN

The Accounting Rate of Return also called the Average Rate of Return (ARR) is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the Net Profit After Tax and the amount of initial investment made in the project.

ARR= Average PAT / Initial Investment

Another view about ARR is that since we take average of the PAT for calculating ARR we should also use average level of investment for the project. In such a situation the equation for calculating ARR should be modified as follows.

ARR= Average Profit After Tax / Average Investment

 

PAYBACK PERIOD

The Payback- period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR. Ordinary people not well versed in appraisal techniques, often use very simple technique to judge the profitability of any investment proposal. They think in terms of initial expenditure (outflow) and the time duration in which this amount can be recovered. Suppose somebody spent Rs.50,000 on any project and expects that within 3 year he can get back this amount, then the payback period is 3 years. Payback period of any proposal can be calculated as follows;

 If the cash inflows are uniform then

Payback period = Initial cash outflow / Annual cash inflows

If the cash inflows are not uniform then

Payback period = time period in which the cumulative cash flows are equal to initial inflows.

IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 2. What are the different types of projects ? And what is the distinguishing feature of each type of project? Which project do you think involves highest risk and why?

 Ans. Types Of Capital Budgeting Decision

1. New Projects - The new projects mean expenditure on creation of new assets. For example, setting up an entirely new factory, a new building, a new plant, a new bridge etc. these projects are generally of a big size and take a relatively longer time for its completion and for the returns to flow in.

2. Expansion Projects - Wherever an existing capital asset needs expansion of capacities like setting up more machines in an existing factory or expanding the building of a factory or constructing a new facility etc., this will be called an ‘expansion project’. This type of project is relatively of a smaller size and gives the returns faster.

3. Renewal / Renovation Projects - Whenever a new factory has been set up, after some years some machines or part of it become technically obsolete and need replacement in order to remain competitive. In such a situation the old machinery is disposed off and new machinery is installed in its place. Fundamentally it is also a project like the above ones, with the only difference that the disposal of old machines will fetch some price which must be accounted for, when we take the cost of the new machine.

 4. Exploration Projects - Exploration projects are those projects when some new resources are to be discovered. The expenditure incurred on e.g. oil exploration may be called a project of this kind. This expenditure is also a capital budgeting expenditure, where we spend money now to reap benefits in future, with the only difference that there is far greater uncertainty about finding the resource for which the expenditure is to be incurred.

5. Research and Development (R & D) Projects - R & D projects are those projects in which present expenditure is being incurred in the hope of getting a new product, a new raw material, a new design or an improvement in the exiting ones. These projects are typically of a higher uncertainty than the above ones, because when we are undertaking a research project, we are neither sure of the time duration, nor of the expenditure, nor of the end result. Many R & D projects take a pretty long time in its completion with a high degree of uncertainty of end result.

6. Projects for the Compliance of Certain Statutory Requirements - There are some projects which are not undertaken explicitly for business prospects, but are nevertheless undertaken in compliance of legal requirements. These projects may be for ensuring certain safety requirements, e.g. installing fire fighting equipment or modification in existing structures for the safety of workers, or may be for controlling pollution from the factory e.g. an effluent treatment plant. Although no direct business profit seems to be coming but still no responsible company can ignore these projects. Sometimes or the other the law will take its course with immense cost to the company in terms of penalties and even closures. The case of Supreme Court ordering the closure the closure of all polluting factories around Taj Mahal is not a very old one.

 

Research and Development (R & D) involves highest risk

R & D projects are those projects in which present expenditure is being incurred in the hope of getting a new product, a new raw material, a new design or an improvement in the exiting ones. These projects are typically of a higher uncertainty than the above ones, because when we are undertaking a research project, we are neither sure of the time duration, nor of the expenditure, nor of the end result. Many R & D projects take a pretty long time in its completion with a high degree of uncertainty of end result.

 

IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 1. What is a Capital Budgeting Decision ? What is its Importance ?

Ans. The capital budgeting decision is a decision on an expenditure of capital nature (as against revenue expenditure) which is intended to create physical assets. The assets are is turn expected to reap benefits to the company for years to come. The expenditure on monetary assets (like purchase of Bonds, Shares, Treasury bills, Debentures etc.) is not to be treated as a capital budgeting expenditure. Only investment in physical assets is appraised in capital budgeting while investment in monetary and financial assets is appraised under portfolio analysis.

Importance 

Spending money on capital assets is a very important decision that a finance manager is required to make. Capital investment expenditure may be on Plant, Machinery Equipment, Land, Buildings, Roads, and Bridges etc. Although spending money on anything is important and prudence must be exercised in all such matters, but spending money on capital assets is especially more important and the finance manager is, therefore, required to be much more cautious in making such a decision, for the following reasons;

(i) It involves substantially higher amounts than for other routine expenses.

(ii) The decision is irreversible, i.e. it is not possible to withdraw your steps easily, once you have taken few steps in this regard.

(iii) It has long term impact on the affairs of a company and it, infact, determines the future of a company.

IGNOU : M.COM : MCO 7 : UNIT 5 : Q - 3. What are the importance of Cost of Capital ?

Ans. Importance of Cost of Capital

The determination of the firm's cost of capital is important from the point of view of the following :

i) It is the basis of appraising new capital expenditure proposals. This gives the acceptance / rejection criterion for capital expenditure projects.

ii) The finance manager must raise capital from different sources in a way that it optimizes the risk and cost factors. The source of funds which have less cost involve high risk. Cost of capital helps the managers in determining the optimal capital structure.

iii) It is the basis for evaluating the financial performance of top management.

iv) It helps in formulating appropriate dividend policy.

v) It also helps the organization in developing an appropriate working capital policy.

 

IGNOU : M.COM : MCO 7 : UNIT 5 : Q - 2. How will you calculate the Cost of Preferences Share Capital ?

Ans. Cost of Preference Capital

The preference share represents a special type of ownership interest in the firm. Preference shareholders must receive their stated dividends prior to the distribution of any earnings to the equity shareholders. In this respect preference shares are very much like bonds or debentures with fixed interest payment. The cost of preference shares can be estimated by dividing the preference dividend per share by the current price per share, as the dividend can be considered a continuous  level payment.                                                                  

Cost of Preference Capital        =      Dividend/   Market Price – Issue Cost

For example, A company is planning to issue 9% preference shares expected to sell at Rs. 85 per share. The costs of issuing and selling the shares are expected to be Rs. 3 per share.

The first step in finding out the cost of the preference capital is to determine the rupee amount of preference dividends, which are stated as 9% of the share of Rs. 85 per share. Thus 9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs, the net proceeds are Rs. 82 per share.

Thus the cost of preference capital :

=  Dividend per share/ Net proceeds after selling

=   Rs. 7.65 /Rs. 82 = 9.33 %

Now, the companies can issue only redeemable preference shares. Cost of capital for such shares is that discount rate which equates the funds available from the issue of preference shares with the present values of all dividends and repayment of preference share capital. This present value method for cost of preference share capital is similar to that used for cost of debt capital, the only difference is that in place of `interest’ stated dividend on preference share is used.

IGNOU : M.COM : MCO 7 : UNIT 5 : Q - 1. How is the Cost of Debt Capital ascertained ? Give examples.

Ans. Cost of Long Term Debt

Debt may be issued at par, or at premium or at of discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained in the following paragraphs.

(a) The formula for computing the Cost of Long Term debt at par is

                   Kd = (1 – T) R

Where

                   Kd = Cost pf long term debt

                    T = Marginal Tax Rate

                    R = Debenture Interest Rate

 For example, if a company has issued 10% debentures and the tax rate is 50%, the cost of debt will be

           (1 - .5) 10 = 5%

(b) In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realised. The formula will be as follows :

                                                         I

                                           Kd   = ------   (1 – T)

                                                 Np

    Where

                          Kd = Cost of debt after tax

                          I = Annual Interest Payment

                         NP = Net Proceeds of Loans

                          T = Tax Rate

 Illustrations on Page No.-  [ 7-13 ] of    Unit - 5

IGNOU : M.COM : MCO 7 : UNIT 4 : Q - 4. Explain in brief the ideas of Arbitrage Pricing Theory.

Ans. Arbitrage Pricing Theory

Arbitrage pricing theory is one of the tools used by the investors and portfolio managers. The capital asset pricing theory explains the returns of the securities on the basis of their respective betas. According to the previous models, the investor chooses the investment on the basis of expected return and variance. The alternative model developed in asset pricing by Stephen Ross is known as Arbitrage Pricing Theory. The APT theory explains the nature of equilibrium in the asset pricing in a less complicated manner with fewer assumptions compared to CAPM.

Arbitrage : Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. The process generates riskless profit. In the security market, it is of selling security at a high price and the simultaneous purchase of the same security at a relatively lower price. Since the profit earned through arbitrage is riskless, the investors have the incentive to undertake this whenever an opportunity arises. In general, some investors indulge more in this type of activities than others. However, the buying and selling activities of the arbitrager reduces and eliminates the profit margin, bringing the market price to the equilibrium level. The assumptions:

1. The investors have homogenous expectations.

2. The investors are risk averse and utility maximisers.

3. Perfect competition prevails in the market and there is no transaction cost.

The APT theory does not assume (1) single period investment horizon, (2) no taxes, (3) investors can borrow and lend at risk free rate of interest, and (4) the selection of the portfolio is based on the mean and variance analysis. These assumptions are present in the CAPM theory.

The APT Model : According to Stephen Ross, returns of the securities are influenced by a number of macro economic factors. They are: growth rate of industrial production, rate of inflation, spread between long term and short term interest rates and spread between low-grade and high grade bonds. The arbitrage theory is represented by the equation:

Ri = λo + λ1 bi1 + λ2 bi2 ….. + λj bii

Ri = average expected return

λ1 = sensitivity expected return to bi1

bi1 = the beta co-efficient relevant to the particular factor

Whatever be the number of factors built into the model, two securities with the same factor betas, should provide the same expected return. If not, arbitrage (i.e., the process of buying the cheaper and selling the expensive) will take place and security prices adjust themselves. The investors will try to realize arbitrage profits, if there is disequilibrium and adjust their portfolios and the security prices are driven to equilibrium.

Carrying further their piece of research work, Richard Roll and Stephen Ross believed that there are five specific factors that capture systematic risk of a portfolio of securities. They are:

i) Changes in the expected inflation

ii) Unanticipated changes in inflation

iii) unanticipated changes in industrial production

iv) unanticipated changes in the yield differential between low and high grad securities (known to be default risk premium).

v) unanticipated changes in the yield differential between long term and short term bonds (known to be the term structure of interest rates).

IGNOU : M.COM : MCO 7 : UNIT 4 : Q - 3. Explain with suitable illustrations the contribution of CAPM.

 

Ans. According to CAPM, there is an implied equilibrium relationship between risk and return for each security. Under the conditions of market equilibrium, a security is expected to provide a return commensurate with its unavoidable risk. The greater the unavoidable risk of a security, the greater the return that investors will expect from the security. The relationship between the expected return and unavoidable risk and the valuation of securities is the essence of CAPM. Stated in other words, “the risk averse investors will not hold risky assets, unless they are adequately compensated for the risks, they bear”. Assumptions of the Model: The following are the important assumptions of the model.

1. Investors make their decisions only on the basis of the expected return, risk associated with the security.

2. An individual investor cannot influence the price of a stock in the market.

3. Investors can lend or borrow funds at the riskless rate of interest.

4. Assets are infinitely divisible.

5. There are no transaction costs involved on buying and selling of stocks.

 6. There is no personal income Tax.

It implies that the investor is indifferent between capital gain and dividend.

IGNOU : M.COM : MCO 7 : UNIT 4 : Q - 2. Define the concept of Risk.

Ans. CONCEPT OF RISK

Risk may be understood as the possibility of adverse happening. We consider those situations as risky, if they involve larger deviations from the expectations. Whether a particular situation involves risk or not depends on with what precision we can estimate the possibility of occurrence of a particular event. This gives raise to the following three states of possibilities:

A. Certainty

B. Uncertainty

C. Risk

Certainty is a situation reflecting the happening of a particular event as expected with zero deviation. In case of certain ‘All Truths’, there will be no deviation. Like the sun rising in the east and inevitability of death. Similarly, there may be some business situations involving near certainty. Expecting to sell a certain number of bags of rice in a locality, when you are a monopolistic and rice is the staple food of the people of the locality.

Uncertainty is a situation that makes prediction difficult. One may not be sure of the occurrence of a particular event with any degree of precision. People find it often difficult to make predictions pertaining to weather. So also, the meteorological department , sometimes. To attempt to define uncertainty with any rigor presents extremely  complex and hazardous conceptual and mathematical problems. In practice also, it is difficult to deal with the situations of uncertainty, since nothing stands to prediction.

                             Continuum Reflecting the possibility of occurrence of an Event

              Certainty (100%)                                      Risk                                 Uncertainty (0%)

The third state of possibility, i.e., risk, is said to be a situation lying in between the above two states, viz., certainty and uncertainty. This can be best understood in the form of a continuum with certainty and uncertainty on the two ends and risk covering the middle ground.

In statistical terminology, Risk is referred to be a situation in which future outcomes, together with their associated probabilities are known. In other words, it is said to be as dispersion in a subjective probability distribution.

As a matter of fact, a businessman can face confidently, the situation of risk only. There will be no difficulty in making decisions under the situation of certainty; and he will not be precise with any amount of sophistication of tools under uncertainty. Therefore, what can a manager reasonably perform are the situations of risk only. The theory of finance, therefore, realizes the significance of risk in final decision-making.

Ex-ante and Ex-Post Risk :  Risk, as a concept, has both ex-ante and ex-post meaning. Ex-ante risk refers to a decision variable reflecting the probability of realizing unfavourable outcomes in the future as a result of a decision made currently. Ex post risk refers to observed variation in outcomes during prior periods. This risk is historical. The estimation and evaluation of future outcomes, based on current information, is the most difficult exercise involved in financial decision making. Finance literature considers the ex ante concept of risk as having greater value than the ex-post concept of risk, since it is the former that a finance manager confronts.

IGNOU : M.COM : MCO 7 : UNIT 4 : Q - 1. Define the concept of Return.

Ans. CONCEPT OF RETURN

Return is something received back. In the field of financial decision making the manager invests the company’s money on diverse fixed and current assets and hopes to receive something back on his investment. This can be said to be the meaning of return. Nevertheless, the term ‘return’ has several dimensions, as of the following:

(i) Book Vs. Market Return

(ii) Single period Vs. Multi period Return

(iii) Ex-ante (expected) Vs. Ex post (Realized) Return

(iv) Security Vs. Portfolio Return

Book Vs. Market Return :  Book return is the return calculated from the books of the company using profits and assets. Normally, the return on assets (ROA) is taken as the indicator of book return. Several other return calculations can also be made using other variables like capital employed, net worth, capital invested, earnings per share and dividends per share. In all these cases, these returns reflect historical performance. Whereas , market return is based on the market values of the assets. Suppose, X buys the stock of ABC company for Rs.100, whose face value is Rs.10/- and the company earning Rs.1 per share, his book return is 10% ; while his market return is 1 per cent.

Single period Vs. Multi period Return : Return is always computed with reference to a particular period. If an investment of Rs.100 earns an income of Rs.3 over a three month period, the rate of return is 3 per cent. If another investment earns an income of Rs.3 over a 12-month period, then also the return is 3 per cent. But the measures appear to be illogical, unless they are related to a specific time period. Normally, rates of return are computed on an annual basis. As such, the rates of return of the above two investments would be 12 per cent and 3 per cent respectively.

Ex-ante Vs. Export Return  : Ex-ante means before the fact, whereas ex-post means after the fact. There is significant difference in these two, as far as security returns are concerned. An ex-ante return is the one that an investor hopes to get from his investment. There is no guarantee that what the investor has hoped for would come true. Whereas, the ex post return is the actual or realized return. In the event of bullish or bearish conditions prevailing in the markets, the gap between the expected return and actual return may be very wide. The following are the simple formulae for computing both the returns.

Security Vs. Portfolio : return This is with reference to the investment in a single asset/security against a group of assets/securities. Whatever be the security, whether it is debentures, preference shares or equities, the procedure for valuation can be common. Nevertheless, in case of the valuation of equities, authors in finance have proposed certain valuation models based on dividends or earnings.

IGNOU : M.COM : MCO 7 : UNIT 3 : Q - 2. Discuss the limitations of liquidation value and book value approaches.

 Ans. Book Value

The book value per share means the net worth of the company i.e., paid equity share capital plus free reserves and surpluses divided by the number of equity shares outstanding. For example, if the paid LIP capital of a company is Rs. 50,00,000 and reserves Rs. 30,00,000 i.e., net worth Rs. 80,00,000. If the equity shares are 20,00,000, then the book value per share is Rs. 80,00,000+20,00,000 = Rs. 4. Those who favour this approach say it is an objective measure of value. But it suffers from a serious drawback. It is based on historical balance sheet figures that are arrived at according to accounting conventions and estimates of accountants are so not reliable.

Liquidation Value

Under this approach, it is assumed that if the company goes into liquidation how much amount its assets would realize on sale. The following formula is used to find the liquidation value per share

 

Please SEE Page No. – 41 OF UNIT 3 

IGNOU : M.COM : MCO 7 : UNIT 3 : Q - 1. Explain the various appraoches used to value equity shares?

 

Ans. VALUATION OF EQUITY SHARES

Equity shares or common stock is not so easy to value. The cash flows are not stable and not easily identiable. The Future stream of earnings poses two problems. First, it is neither specified nor perfectly known in advance. Second, dividends and earnings are two alternatives to be chosen from, thus, there are two approaches used to value equity shares based on dividend and earnings.

1) Dividend Capitalization Approach

2) Earnings Capitalization Approach

Dividend Capitalization Approach

A problem in using the dividend valuation model is the timing of cash flows, we shall examine it in two situations.

1) Single period valuation

2) Multiple period valuation

This will be further examined assuming

a) Dividends do not grow in future i.e., zero growth. they are constant

b) Dividends grow at a constant rate in future

c) Dividends grow at a varying rate in future

Please SEE Page No. – 35 TO 40 OF UNIT 3

IGNOU : M.COM : MCO 7 : UNIT 2 : Q - 1. Explain "Time Value of Money". What is the role of interest rate in it ?

 

Ans. You must have heard that a rupee today is worth more than a rupee tomorrow. Did you imagine, why is it so? Let me tell you by an example. Anil's grandfather decided to gift him rupee one lakh (1,00,000) at the end of five years; and gave him a choice of having Rs. 75,000 today. Had you been in Anil's place what choice would you have made? Would you have accepted Rs. 1,00,000 after five years or Rs.75,000 today ? What do you say ? Apparently, Rs.75,000 today is much more attractive than Rs.1,00,000 after five years because present is certain than future. You could invest Rs.75,000 in the market and earn return on this amount. Rs.1,00,000 at the end of five years would have less purchasing power due to inflation, We hope you have got the message that a rupee today is worth more than a rupee tomorrow. But the matters money are not so simple. The time value of money concepts will unravel the mystery of such choices which all of us could face in our daily life. We may say a good understanding of time value of money constitute 90% of finance sense. Investment decisions involve cash flow occurring at different points of time. Therefore, recognition of time value of money is very important. In this unit, you will learn about compound interest aid discount concepts and how future value of a single mount and an annuity and present value of a single amount and an annuity is calculated

FUTURE VALUE OF A SINGLE CASH FLOW

First of all let us explain the meaning of future value. By future value (FV) we mean the amount of money an investment will grow to over some period of time at some given interest rate. In other words, future value is the cash value of an investment at sometime in future.

Future Value of a Single Amount for single period

If you deposit Rs. 1000 in a fixed account of your bank at 10% interest per year, how much you will get after one year ? You will get Rs. 1100. This is equal to your principal amount Rs. 1000 and Rs. 100 interest which you have earned on it in a year. Hence, Rs. 1100 is the future value of Rs. 1000 deposited (investment) for one year at 10 per cent. It means that Rs. 1000 today is worth Rs. 1100 in one year given that 10 per cent is the interest rate.

Thus, if you invest for one period at all interest rate of i, Your investment will grow to (1+i) per rupee invested. In the above example, I is 10 per cent.

 Future Value of a Single Amount fir more than One Period

Taking the various example, if you invest the same amount for two years what will you have after two years, assuming that interest rate remain the same '? You will earn Rs. 1100 + 10 + Rs. 100 interest during the second year so you will have total of Rs. 1210 (1100+ 110). This is the future value of 1000 for two years at 10 per cent.

You can notice here that this Rs. 1210 has four parts. First part is Ks. 1000 which is the principal amount, second part is Its. 100 as interest earned in first year and third part is another Rs. 100 earned as interest in second year. The fourth and last is Rs. 10 which is the interest earned in second year on interest paid in first year Rs. 100 x 10 = Rs. 10. So the total interest earned is Its 210. Hence, the future value is Rs. 1210 (1000+100+100+10).

The process of putting your money and any accumulated interest on an investment for more than a period, thereby reinvesting the interest is called compounding. Compounding the interest means earning interest on interest. We can call the result compound interest. The interest earned each period only on the original principal is called simple interest.

 

IGNOU : M.COM : MCO 7 : UNIT 1 : Q - 2. Discuss the challenges faced by the financial managers in India.

Ans.  CHALLENGES FOR FINANCIAL MANAGER

While mobilization of funds and investments of funds have been the prime responsibility of financial manager/CFO owing to momentous changes in the business environment particularly economic and financial, the nature of challenges faced by financial manager have undergone immense shifts. The first and the foremost challenge is shareholders value creation. The shareholders, even the minority, have become demanding and vocal. They are no more satisfied with increasing sales, or decreasing costs; they want growing total shareholders return. As a consequence, the financial manager has to concentrate not only on earning per share but also on market capitalization.

IGNOU : M.COM : MCO 7 : UNIT 1 : Q - 1. Critically evaluate the goals of financial management.

Ans. GOALS OF FINANCIAL MANAGEMENT

 A good goal must be clear, timely measurable and consistent. So must be the goal of financial management. A firm  may have different goals e.g., production goals, sales goal, and financial management goal.

But what is the main goal of financial management ? The main goal of financial management should be such that is directed to achieve the ultimate goal of a firm. The ultimate goal, as a good consensus, of a film is to maximize the shareholders' wealth. This in operational terms means:

a) Maximization of profit

b) Maximization of Return on capital employed

c) Growth in earning per share or market value of a share or dividends

d) Optimum  level of leverage

e) Minimization of costs of capital.

Let us examine in detail maximization of shareholders wealth as an ultimate goal of financial management.

 Maximization of Shareholders Wealth

The separation of ownership from management and the increase in intensity of competition has lead to the redefinition of profit maximization objective of a firm. Financial theory, in general rests upon the promise that the objective of the firm should be maximization of the value of the firm to the equity shareholders. It means maximizing the market value of its equity shares. the justification of this objective is that it provides a rational guide for business decision making and helps in efficient allocation of resources. A second reason in favour of this objective is that equity shareholders provide risk (venture) capital for starting a company. They appoint the board of management. So this objective brings a responsibility on management to promote the welfare of equity shareholders.

The shareholders wealth can be maximized by maximizing value of shares of a firm. The economic value of the shareholders' wealth is the market price of the share which is the present value of all future dividends and benefits expected from the firm. The underlying assumption in this approach is that shares arc traded in efficient capital  market where the effect of a decision is reflected in market price of a share. With this objective is view the management will allocate the available economic resources in the best possible way keeping in view the risk involved. This objective timely guides three functions of financial management (investment, financing and dividend decision). The main problem of this objective is that an efficient capital market must exist which can really discover and reflect time market price. Thus, wealth maximization of shareholders is the main objective, though profit maximization can be considered as a part of wealth maximization objective.