NAME – FARIHA NAAZ

ROLL NO. – 2414505457

PROGRAM – BBA

SEMESTER – 2nd

COURSE NAME – FINANCIAL MANAGEMENT

COURSE CODE – DBB1208

SET-1

Question 1- A company issued bonds with a face value of $100, sold at a 10% discount, and
are redeemable at a 10% premium. Calculate the effective cost of these bonds for the
company considering:

a) A 5-year maturity period.

b) Perpetual bonds (no maturity).

The company's tax rate is 40%.

Answer- Given Data:

Parameter Value

Face Value (F) $100

Issue Price (P) $90 (10% discount)

Redemption Value (R) $110 (10% premium)

Tax Rate (T) 40%

Maturity Period (n) 5 years (for part a)

Part (a): Effective Cost of Debt for 5-Year Bonds

The effective cost of debt is the yield to maturity (YTM), i.e., the rate rrr that satisfies:
P=R(1+r)nP = \frac{R}{(1 + r)^n}P=(1+r)nR

Substituting values:

90=110(1+r)590 = \frac{110}{(1 + r)^5}90=(1+r)5110

Rearranged as:

(1+r)5=11090=1.2222(1 + r)^5 = \frac{110}{90} = 1.2222(1+r)5=90110=1.2222

Taking the fifth root:

1+r=(1.2222)15=1.0411 + r = (1.2222)^{\frac{1}{5}} = 1.0411+r=(1.2222)51=1.041

r=1.041−1=0.041=4.1%r = 1.041 - 1 = 0.041 = 4.1\%r=1.041−1=0.041=4.1%

Thus, the before-tax cost of debt is 4.1%.

Adjusting for Tax:

Interest expense is tax-deductible, so the after-tax cost of debt is:

rafter-tax=r×(1−T)=4.1%×(1−0.40)=4.1%×0.60=2.46%r_{\text{after-tax}} = r \times (1 - T)
= 4.1\% \times (1 - 0.40) = 4.1\% \times 0.60 = 2.46\%rafter-tax
=r×(1−T)=4.1%×(1−0.40)=4.1%×0.60=2.46%
Part (b): Effective Cost of Debt for Perpetual Bonds

For perpetual bonds, the cost of debt is calculated as:

Cost of Debt=Annual Coupon PaymentNet Proceeds×(1−T)\text{Cost of Debt} =

\frac{\text{Annual Coupon Payment}}{\text{Net Proceeds}} \times (1 -
T)Cost of Debt=Net ProceedsAnnual Coupon Payment×(1−T)

Note: The coupon rate is not explicitly given. Assuming the coupon rate equals the
redemption premium of 10% of face value, i.e.,

Coupon=10%×100=$10\text{Coupon} = 10\% \times 100 = \$10Coupon=10%×100=$10

Thus,

Cost of Debt=1090×(1−0.40)=0.1111×0.60=6.67%\text{Cost of Debt} = \frac{10}{90}

\times (1 - 0.40) = 0.1111 \times 0.60 = 6.67\%Cost of Debt=9010
×(1−0.40)=0.1111×0.60=6.67%

Scenario Cost of Debt (After Tax)

5-Year Maturity 2.46%

Perpetual Bonds (assumed 10% coupon) 6.67%

• The cost of debt for bonds with a 5-year maturity is 2.46% after tax considering issue
discount and redemption premium.

• For perpetual bonds (assuming 10% coupon), the after-tax cost of debt is higher at
6.67%, reflecting ongoing coupon payments relative to the discounted issue price.

Question 2- a) If an amount of ₹50,000 is invested at an annual interest rate of 12%, calculate

the future value of the investment after 3 years.

b) Determine the present value of ₹50,000 to be received in the future, assuming a suitable
discount rate and considering the concept of time value of money.

Answer- Given:

• Principal (P) = ₹50,000

• Interest rate (r) = 12% per annum

• Time (t) = 3 years

• Future value (FV) and Present value (PV) to be calculated

• For part (b), assume discount rate = 12% (same as interest rate for consistency)

Part (a): Calculation of Future Value (FV)

The formula to calculate Future Value with compound interest is:

FV=P×(1+r)tFV = P \times (1 + r)^tFV=P×(1+r)t
Substituting values:

FV=50,000×(1+0.12)3=50,000×(1.12)3FV = 50,000 \times (1 + 0.12)^3 = 50,000 \times

(1.12)^3FV=50,000×(1+0.12)3=50,000×(1.12)3 FV=50,000×1.404928=₹70,246.40FV =
50,000 \times 1.404928 = ₹70,246.40FV=50,000×1.404928=₹70,246.40

Therefore, the future value of the investment after 3 years is ₹70,246.40.

Part (b): Calculation of Present Value (PV)

The formula to calculate Present Value is:

PV=FV(1+r)tPV = \frac{FV}{(1 + r)^t}PV=(1+r)tFV

Assuming ₹50,000 is to be received 3 years later and discount rate r=12%r = 12\%r=12%,

PV=50,000(1+0.12)3=50,0001.404928=₹35,594.72PV = \frac{50,000}{(1 + 0.12)^3} =

\frac{50,000}{1.404928} = ₹35,594.72PV=(1+0.12)350,000=1.40492850,000=₹35,594.72

Therefore, the present value of ₹50,000 to be received after 3 years is ₹35,594.72.

Explanation:

• Future Value (FV) represents the amount the investment will grow to after a period,
considering compound interest.

• Present Value (PV) represents how much a future sum of money is worth today,
reflecting the concept of the time value of money — money available now is worth
more than the same amount in the future due to its earning potential.

Calculation Type Amount (₹)

Future Value (after 3 years) 70,246.40

Present Value (of ₹50,000 after 3 years) 35,594.72

Question 3- a) What is leverage in financial management? Explain how it contributes to

maximizing shareholders' wealth

b) Explain the concept of wealth maximization and distinguish it from profit maximization,
highlighting their key differences and implications for financial decision-making.

Answer- a) Leverage in Financial Management

Leverage refers to the use of fixed-cost resources, such as debt or fixed operating costs, to
increase the potential return to shareholders. It allows a company to amplify its earnings by
using borrowed funds or fixed assets.
There are two main types of leverage:

• Operating Leverage: Use of fixed operating costs to magnify profits from sales.
 • Financial Leverage: Use of debt to finance assets, which increases potential returns
but also risk.

How Leverage Maximizes Shareholders' Wealth:

• Enhances Returns: By using debt (financial leverage), a company can increase the
return on equity when the return on investment exceeds the cost of debt.

• Tax Benefits: Interest payments on debt are tax-deductible, reducing taxable income
and increasing after-tax profits.

• Growth Opportunity: Leverage provides additional capital to invest in projects that

can generate higher profits.

However, excessive leverage increases risk, including the risk of bankruptcy, so it must be
managed carefully.

b) Wealth Maximization vs. Profit Maximization

Aspect Wealth Maximization Profit Maximization

Maximizing the market value of Maximizing short-term earnings or

Definition
shareholders’ wealth or share price. net profit.

Time Frame Long-term focus. Short-term focus.

Increase the overall value of the firm Increase accounting profits

Objective
and shareholders’ wealth. regardless of timing or risk.

Risk Takes into account risk and Ignores risk and focuses only on
Consideration uncertainties. profit figures.

Uses discounted cash flows, share Uses accounting profits, revenues,

Decision Criteria
price, and market value. and costs.

Promotes sustainable growth, better May lead to decisions that boost

Implications for
investment decisions, and short-term profits but harm long-
Decisions
shareholder satisfaction. term firm value.

Implications for Financial Decision-Making:

• Wealth maximization encourages managers to consider the risk-return trade-off and

focus on creating value over time, leading to better capital budgeting, financing, and
dividend decisions.
• Profit maximization may ignore timing and risk, potentially leading to decisions that
boost immediate profits but hurt the firm’s reputation or sustainability.

Leverage, when used judiciously, can amplify shareholder wealth by increasing returns and
providing tax advantages. Meanwhile, wealth maximization is a superior objective over profit
maximization, as it ensures long-term value creation and considers risk, timing, and
shareholder interests.

SET-2
Question 4- Briefly explain and compare the following financial instruments, highlighting
their key features and differences:
a) Financial Lease
b) Hire-Purchase Financing

Answer- a) Financial Lease

A financial lease is a long-term rental agreement where the lessee (user) leases an asset from
the lessor (owner) for most of the asset’s useful life. The lessee is responsible for
maintenance, insurance, and other costs. At the end of the lease term, the lessee usually has
the option to purchase the asset at a nominal price.
Key Features:
• Long-term contract, usually non-cancellable.
• Lessee bears most risks and rewards of ownership.
• Asset appears on lessee’s balance sheet as a fixed asset and liability.
• Payments include interest and principal recovery by lessor.
• Used to finance high-cost assets like machinery, vehicles, etc.
b) Hire-Purchase Financing
Hire-purchase financing is an agreement where the buyer hires an asset and pays in
instalments. Ownership of the asset transfers only after the full payment is made. Until then,
the seller retains ownership.
Key Features:
• Ownership transfers after the last instalment is paid.
• Buyer has use of the asset during the payment period.
• Typically involves down payment and periodic instalments.
• Buyer is responsible for maintenance and risks during the hire period.
• Commonly used for consumer goods, vehicles, and equipment.
Comparison:
Aspect Financial Lease Hire-Purchase Financing
Ownership remains with lessor; Ownership transfers after all payments
Ownership
option to buy later are completed
Aspect Financial Lease Hire-Purchase Financing
Balance Sheet Lessee recognizes asset and Asset and liability recognized by buyer
Impact liability after ownership transfer
Usually covers most of asset’s
Duration Fixed period until full payment
life
Risk & Lessee bears risk and
Buyer bears risk and maintenance
Maintenance maintenance
Less flexible; contract often non- More flexible with installment
Flexibility
cancellable payments
Used for both consumer and business
Purpose Used mainly for business assets
assets
Both financial lease and hire-purchase are financing methods to acquire assets without paying
the full amount upfront. However, they differ primarily in ownership transfer timing,
accounting treatment, and contractual obligations. Financial lease suits businesses seeking
long-term use without immediate ownership, while hire-purchase benefits those who plan
eventual ownership after instalments.
Question 5- Critically analyse the major theories of capital structure, highlighting their key
assumptions, implications, and relevance with appropriate examples.
Answer- Capital structure refers to the mix of debt and equity used by a firm to finance its
operations and growth. Several theories explain how firms choose their optimal capital
structure. The major theories include:
1. Net Income (NI) Approach
Key Assumptions:
• Cost of debt is constant and cheaper than equity due to tax benefits.
• No risk of bankruptcy.
• No change in cost of equity with leverage.
• Firms can increase value by increasing debt.
Implications:
• Increasing debt lowers overall cost of capital and increases firm value.
• Leverage is always beneficial.
Relevance:
• Simplistic and unrealistic, ignores financial distress costs.
• Applicable in stable, low-risk environments.
Example:
A utility company with stable cash flows might benefit from NI approach by using debt to
reduce taxes.
2. Net Operating Income (NOI) Approach
Key Assumptions:
• Total cost of capital remains constant regardless of debt-equity mix.
• Increase in debt raises the cost of equity proportionally.
• Value of firm is unaffected by leverage (capital structure irrelevant).
Implications:
• Capital structure does not affect firm value or overall cost of capital.
Relevance:
• Reflects Modigliani and Miller’s early theory without taxes.
• Highlights that investors can create leverage themselves.
Example:
For a firm in perfect capital markets with no taxes or bankruptcy costs, capital structure is
irrelevant.
3. Modigliani-Miller (MM) Theorem (Without Taxes)
Key Assumptions:
• No taxes, bankruptcy costs, or transaction costs.
• Perfect capital markets.
• Investors and firms borrow at the same rate.
Implications:
• Value of the firm is independent of capital structure.
• Cost of equity increases with leverage but overall WACC remains constant.
Relevance:
• Fundamental theory forming the base for other capital structure theories.
• Demonstrates the irrelevance of capital structure under ideal conditions.
4. Modigliani-Miller Theorem (With Taxes)
Key Assumptions:
• Corporate taxes exist, and interest on debt is tax-deductible.
• No bankruptcy or transaction costs.
Implications:
• Value of firm increases with leverage due to tax shield.
• Optimal capital structure is 100% debt theoretically.
Relevance:
• Shows tax advantages of debt but ignores bankruptcy risk.
• Practical firms balance tax benefits with bankruptcy risk.
Example:
Firms with stable earnings and low bankruptcy risk, like large corporations, use debt to gain
tax advantages.
5. Trade-Off Theory
Key Assumptions:
• Firms balance tax benefits of debt against bankruptcy costs.
• Bankruptcy and financial distress costs increase with debt.
• Agency costs and asymmetric information affect capital structure.
Implications:
• There is an optimal debt level that maximizes firm value.
• Beyond a certain point, bankruptcy costs outweigh tax benefits.
Relevance:
• More realistic; explains moderate debt usage in practice.
• Helps firms find a balanced capital structure.
Example:
Automobile companies with cyclical earnings avoid excessive debt to minimize bankruptcy
risk.
6. Pecking Order Theory
Key Assumptions:
• Firms prefer internal financing first.
• If external funds needed, debt is preferred over equity to avoid dilution and
asymmetric information costs.
• No target debt-equity ratio.
Implications:
• Capital structure is a result of financing needs, not an objective.
• Firms issue equity only as a last resort.
Relevance:
• Explains observed financing behaviour in many firms.
• Relevant in markets with asymmetric information.
Example:
Tech startups typically use retained earnings and debt before issuing equity to avoid
undervaluation.
7. Market Timing Theory
Key Assumptions:
• Firms time equity and debt issuance based on market conditions.
• Equity issued when stock prices are high; debt issued when interest rates are low.
Implications:
• Capital structure is a consequence of past market timing decisions.
• No stable optimal capital structure.
Relevance:
• Explains fluctuating capital structures and financing patterns.
Summary Table:
Theory Assumptions Key Implications Practical Relevance
Constant cost of debt, no More debt → higher
Net Income (NI) Overly simplistic
risk value
Net Operating Capital structure Useful in perfect
Cost of capital constant
Income (NOI) irrelevant markets
MM Without Capital structure
No taxes, perfect markets Theoretical base
Taxes irrelevant
More debt → more Highlights tax benefits,
MM With Taxes Corporate taxes exist
value ignores distress
Taxes and bankruptcy Optimal debt balances Explains real-world
Trade-Off Theory
costs benefits leverage levels
Pecking Order Information asymmetry, Financing depends on Matches observed
Theory financing preference internal funds financing behaviour
Market Timing Market conditions Capital structure Explains capital
Theory influence varies structure fluctuations
Each capital structure theory offers valuable insights, from idealized conditions (MM) to
more practical considerations (Trade-Off, Pecking Order). Firms must balance tax benefits,
bankruptcy risk, and market conditions to optimize their capital mix and maximize
shareholder value.
Question 6- ABC Corp is evaluating a potential investment project involving an initial outlay
of $200,000. The expected annual cash inflows are $50,000 for the next 3 years. Given a
discount rate of 15%, calculate the Net Present Value (NPV) of the project and provide an
assessment of its financial viability.
Answer- Given Data:
Parameter Value
Initial Investment (C₀) $200,000
Annual Cash Inflows (C₁, C₂, C₃) $50,000 each year for 3 years
Discount Rate (r) 15%
Project Life 3 years
Step 1: Calculate Present Value of Cash Inflows
The Present Value (PV) of each year's cash inflow is calculated using the formula:
PV=Cash Inflow(1+r)tPV = \frac{\text{Cash Inflow}}{(1 + r)^t}PV=(1+r)tCash Inflow
Calculate PV for each year:
PV1=50,000(1+0.15)1=50,0001.15=43,478.26PV_1 = \frac{50,000}{(1 + 0.15)^1} =
\frac{50,000}{1.15} = 43,478.26PV1=(1+0.15)150,000=1.1550,000=43,478.26
PV2=50,000(1+0.15)2=50,0001.3225=37,797.54PV_2 = \frac{50,000}{(1 + 0.15)^2} =
\frac{50,000}{1.3225} = 37,797.54PV2=(1+0.15)250,000=1.322550,000=37,797.54
PV3=50,000(1+0.15)3=50,0001.5209=32,864.86PV_3 = \frac{50,000}{(1 + 0.15)^3} =
\frac{50,000}{1.5209} = 32,864.86PV3=(1+0.15)350,000=1.520950,000=32,864.86

Step 2: Calculate Total Present Value of Cash Inflows

PVtotal=PV1+PV2+PV3=43,478.26+37,797.54+32,864.86=114,140.66PV_{\text{total}} =
PV_1 + PV_2 + PV_3 = 43,478.26 + 37,797.54 + 32,864.86 = 114,140.66PVtotal=PV1+PV2
+PV3=43,478.26+37,797.54+32,864.86=114,140.66

Step 3: Calculate Net Present Value (NPV)

NPV=PVtotal−Initial InvestmentNPV = PV_{\text{total}} - \text{Initial
Investment}NPV=PVtotal−Initial Investment NPV=114,140.66−200,000=−85,859.34NPV =
114,140.66 - 200,000 = -85,859.34NPV=114,140.66−200,000=−85,859.34
Step 4: Financial Viability Assessment
• Since NPV is negative (-$85,859.34), the project is expected to reduce the company’s
value and is financially unviable at a 15% discount rate.
 • A negative NPV indicates that the project's returns do not cover the cost of capital.
• ABC Corp should reject this investment if the discount rate and cash flow estimates
are accurate.
Summary:
Calculation Amount ($)
Present Value of Inflows 114,140.66
Initial Investment 200,000
Net Present Value (NPV) -85,859.34
Project Decision Reject (Not viable)
The project’s negative NPV suggests it does not generate sufficient returns to justify the
initial outlay at the required rate of 15%. ABC Corp should consider alternative projects or
renegotiate costs and cash flow estimates.