Fundamentals of Financial Management Solved Question Paper 2023
COMMERCE (Honours Core)
Paper: COM-HC-5026
(Fundamental of Financial
Management)
Full Marks: 70
Time: 3 hours
The figures in the margin
indicate full marks for the questions.
1. Choose the right answers: 1x10=10
(1) Which of the following is a part of financial decision making?
(a) Financing decisions.
(b) Dividend decision.
(c) Investment decision.
(d) All of the above.
Ans: (d) All of the above.
(2) Which of the following represents the capital structure of a
company?
(a) Debt and equities.
(b) Equities and preference share capital.
(c) All assets.
(d) All liabilities.
Ans: (a) Debt and equities.
(3) Which of the following is also known as long-term investment
decision?
(a) Dividend decision.
(b) Working capital.
(c) Capital budgeting decision.
(d) All of the above.
Ans: (c) Capital budgeting decision.
(4) Current assets are twice the current liabilities If the working
capital is Rs. 2,00,000, current assets would be:
(a) Rs. 2,00,000.
(b) Rs. 4,00,000.
(c) Rs. 3,00,000.
(d) Rs. 1,00,000.
Ans: (b) Rs. 4,00,000.
(5) The capitalisation of profit is termed as:
(a) Stock dividend.
(b) Cash dividend.
(c) Property dividend.
(d) Bond dividend.
Ans: (a) Stock dividend.
(6) Investment decisions are outside the purview of financial
decisions.
(a) True.
(b) False.
Ans: (b) False.
(7) Increased use of debt increases the financial risk of equity
shareholders.
(a) True.
(b) False.
Ans: (a) True.
(8) Capital budgeting decisions are generally of irreversible
nature.
(a) True.
(b) False.
Ans: (a) True.
(9) The rate of return on investment falls with the shortage of
working capital.
(a) True.
(b) False.
Ans: (a) True.
(10) Profitability index is also known as benefit/cost ratio.
(a) True.
(b) False.
Ans: (a) True.
2.
Answer the following questions in about 50 words each: 2x5=10
(a)
What is financial management?
Ans:
Financial management is management principles and practices
applied to finance. General management functions include planning, execution
and control. Financial decision making includes decisions as to size of
investment, sources of capital, extent of use of different sources of capital
and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of
money resources, raising of such resources and retention of profit/payment of
dividend.
(b)
What is leverage?
Ans:
The term leverage refers to an increased means of accomplishing
some purpose. Leverage is used to lifting heavy objects, which may not be
otherwise possible. In the financial point of view, leverage refers to furnish
the ability to use fixed cost assets or funds to increase the return to its
shareholders.
(c)
What are the various methods of capital budgeting decisions?
Ans:
Payback period method, Net present value method, profitability index, average
rate of return.
(d)
What is dividend?
Ans:
Meaning of Dividend: A dividend is that portion of profits and
surplus funds of a company which has actually set aside by a valid act of the
company for distribution among its shareholders.
According to ICAI, “Dividend is the distribution to the
shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part of divisible
profits of a business company which is distributed to the shareholders.”
(e)
What is permanent working capital?
Ans:
The fund, which is required to produce a certain amount of goods
or services at a certain period of time, is called fixed working capital. The
minimum amount of cash money, A/R, which is kept to operate the business is
called fixed working capital.
3.
Answer the following questions within 150-200 words each: (any four) 5x4=20
(a)
State the nature of financial management.
Ans:
Nature or Features or Characteristics of Financial Management
Nature of financial management is concerned with its functions,
its goals, trade-off with conflicting goals, its indispensability, its systems,
its relation with other subsystems in the firm, its environment, its
relationship with other disciplines, the procedural aspects and its equation
with other divisions within the organisation.
1)
Financial Management is an integral
part of overall management. Financial considerations are involved in all
business decisions. So financial management is pervasive throughout the
organisation.
2)
The central focus of financial management
is valuation of the firm. That is financial decisions are directed at
increasing/maximization/ optimizing the value of the firm.
3)
Financial management essentially
involves risk-return trade-off Decisions on investment involve choosing of
types of assets which generate returns accompanied by risks. Generally, higher
the risk, returns might be higher and vice versa. So, the financial manager has
to decide the level of risk the firm can assume and satisfy with the
accompanying return.
4)
Financial management affects the
survival, growth and vitality of the firm. Finance is said to be the life blood
of business. It is to business; what blood is to us. The amount, type, sources,
conditions and cost of finance squarely influence the functioning of the unit.
5)
Finance functions, i.e., investment,
rising of capital, distribution of profit, are performed in all firms -
business or non-business, big or small, proprietary or corporate undertakings.
Yes, financial management is a concern of every concern.
(b)
Explain the significance of cost of capital.
Ans: Significance of Cost of Capital
Computation
of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
a)
Importance to Capital Budgeting
Decision: Capital budget decision largely depends on the cost of capital of
each source. According to net present value method, present value of cash
inflow must be more than the present value of cash outflow. Hence, cost of
capital is used to capital budgeting decision.
b)
Importance to Structure Decision:
Capital structure is the mix or proportion of the different kinds of long term
securities. A firm uses particular type of sources if the cost of capital is
suitable. Hence, cost of capital helps to take decision regarding structure.
c)
Importance to Evolution of Financial
Performance: Cost of capital is one of the important determine which affects
the capital budgeting, capital structure and value of the firm. Hence, it helps
to evaluate the financial performance of the firm.
d)
Importance to Other Financial
Decisions: Apart from the above points, cost of capital is also used in some
other areas such as, market value of share, earning capacity of securities etc.
hence, it plays a major part in the financial management.
(c)
Explain the significance and limitations of financial leverage.
Ans: Uses of Financial Leverage
a)
Financial leverage helps to examine
the relationship between EBIT and EPS.
b)
Financial leverage measures the
percentage of change in taxable income to the percentage change in EBIT.
c)
Financial leverage locates the correct
profitable financial decision regarding capital structure of the company.
d)
Financial leverage is one of the
important devices which are used to measure the fixed cost proportion with the
total capital of the company.
e)
If the firm acquires fixed cost funds
at a higher cost, then the earnings from those assets, the earning per share
and return on equity capital will decrease.
(d)
Explain the capital budgeting process.
Ans: Capital Budgeting Process
The important steps involved in the capital budgeting process are:
(1) Project generation,
(2) Project evaluation,
(3) project selection and
(4) project execution.
1. Project Generation. Investment proposals of various types may
originate at different levels within a firm. Investment proposals may be either
proposals to add new product to the product line or proposals to expand
capacity in existing product lines. Secondly, proposals designed to reduce
costs in the output of existing products without changing the scale of
operations. The investment proposals of any type can originate at any level. In
a dynamic and progressive firm there is a continuous flow of profitable
investment proposals.
2. Project evaluation. Project evaluation involves two steps: i)
estimation of benefits and costs and ii) selection of an appropriate criterion
to judge the desirability of the projects. The evaluation of projects should be
done by an impartial group. The criterion selected must be consistent with the
firm’s objective of maximizing its market value.
3. Project Selection. There is no uniform selection procedure for
investment proposals. Since capital budgeting decisions are of crucial
importance, the final approval of the projects should rest on top management.
4. Project Execution. After the final selection of investment
proposals, funds are earmarked for capital expenditures. Funds for the purpose
of project execution should be spent in accordance with appropriations made in
the capital budget.
(e)
Distinguish between gross working capital and net working capital.
Ans:
Gross
working capital refers to investment in all
current assets -raw materials, work-in-progress, finished goods, book debts,
bank balance and cash balance. The gross concept of working capital is significant
in the context of measuring working capital needed, measuring the size of the
business, continued and smooth flow of operations of the business and the like.
Net
working capital refers to the excess of current assets over
current liabilities. That is, value of current assets minus value of current
liabilities (current liabilities include trade creditors, bills payable,
outstanding expenses such as wages, salaries, dividend payable and tax payable,
bank overdraft, etc.) The net concept of working capital is significant in the
context of financing of working capital, the short term liquidity aspects of
the business, and the like.
(f)
Explain the various forms of dividend.
Ans:
Dividend may be divided into following categories:
1.
Cash Dividend.
2.
Stock Dividend or Bonus Dividend.
3.
Bond Dividend.
4.
Property Dividend.
5.
Composite Dividend.
6.
Interim Dividend.
7.
Special or Extra Dividend.
8.
Optional Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most
common form of the dividend. The shareholders are paid in cash per share. The
board of directors announces the dividend payment on the date of declaration.
The dividends are assigned to the shareholders on the date of record. The
dividends are issued on the date of payment. But for distributing cash
dividend, the company needs to have positive retained earnings and enough cash
for the payment of dividends.
BONUS SHARE: Bonus share is also called as the
stock dividend. Bonus shares are issued by the
company when they have low operating cash, but still want to keep the investors
happy. Each equity shareholder receives a certain number of additional shares
depending on the number of shares originally owned by the shareholder. For
example, if a person possesses 10 shares of Company A, and the company declares
bonus share issue of 1 for every 2 shares, the person will get 5 additional
shares in his account. From company’s angle, the no. of shares and issued
capital in the company will increase by 50% (1/2 shares). The market price,
EPS, DPS etc. will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued between two accounting
year on the basis of expected profit. This dividend is declared before the
preparation of final accounts.
PROPERTY DIVIDEND: The company makes the payment in the
form of assets in the property dividend. The asset could be any of this
equipment, inventory, vehicle or any other asset. The value of the
asset has to be restated at the fair value while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note
to pay the shareholders later. This type of dividend is used when the company
does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the company returns the
original capital contributed by the equity shareholders as a dividend, it is
termed as liquidating dividend. It is often seen as a sign of closing down the
company.
Also Read: Fundamentals of Financial Management Question Paper and Solutions
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Also Read: Fundamentals of Financial Management Important Questions (GU)
4.
Answer the following questions within 500-600 words each:
(a)
Discuss the scope and objectives of financial management. 10
Ans: Scope of Financial Management
Financial management is one of the important parts of overall
management, which is directly related with various functional departments like
personnel, marketing and production. Financial management covers wide area with
multidimensional approaches. The following are the important scope of financial
management:
1. Financial Management and Economics: Economic concepts like
micro and macroeconomics are directly applied with the financial management
approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial
management also uses the economic equations like money value discount factor,
economic order quantity etc. Financial economics is one of the emerging area,
which provides immense opportunities to finance, and economical areas.
2. Financial Management and Accounting: Accounting records
includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and
accounting. In the olden periods, both financial management and accounting are
treated as a same discipline and then it has been merged as Management
Accounting because this part is very much helpful to finance manager to take
decisions. But now a day’s financial management and accounting discipline are
separate and interrelated.
3. Financial Management or Mathematics: Modern approaches of the
financial management applied large number of mathematical and statistical tools
and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital,
capital structure theories, dividend theories, ratio analysis and working
capital analysis are used as mathematical and statistical tools and techniques
in the field of financial management.
4. Financial Management and Production Management: Production
management is the operational part of the business concern, which helps to
multiple the money into profit. Profit of the concern depends upon the
production performance. Production performance needs finance, because
production department requires raw material, machinery, wages, operating
expenses etc. These expenditures are decided and estimated by the financial
department and the finance manager allocates the appropriate finance to
production department. The financial manager must be aware of the operational
process and finance required for each process of production activities.
5. Financial Management and Marketing: Produced goods are sold in
the market with innovative and modern approaches. For this, the marketing
department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial management are
interrelated and depends on each other.
Objectives of Financial Management
The firm’s investment and financing decision are
unavoidable and continuous. In order to make them rational, the firm must have
a goal. Two financial objectives predominate amongst many objectives. These
are:
1. Profit maximization
2. Shareholders’ Wealth Maximization (SWM)
Profit maximization refers to the rupee income
while wealth maximization refers to the maximization of the market value of the
firm’s shares. Although profit
maximization has been traditionally considered as the main objective of the
firm, it has faced criticism. Wealth maximization is regarded as operationally
and managerially the better objective.
1. Profit maximization: Profit maximization
implies that either a firm produces maximum output for a given input or uses
minimum input for a given level of output. Profit maximization causes the
efficient allocation of resources in competitive market condition and profit is
considered as the most important measure of firm performance. The underlying
logic of profit maximization is efficiency.
In a market economy, prices are driven by
competitive forces and firms are expected to produce goods and services desired
by society as efficiently as possible. Demand for goods and services leads
price. Goods and services which are in great demand can command higher prices.
This leads to higher profits for the firm. This in turn attracts other firms to
produce such goods and services. Competition grows and intensifies leading to a
match in demand and supply. Thus, an equilibrium price is reached. On the other
hand, goods and services not in demand fetches low price which forces producers
to stop producing such goods and services and go for goods and services in
demand. This shows that the price system directs the managerial effort towards
more profitable goods and services. Competitive forces direct price movement
and guides the allocation of resources for various productive activities.
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present
value of a course of action to shareholders. Net Present Value (NPV) of a
course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization
(SWM) considers timing and risk of expected benefits. Benefits are measured in
terms of cash flows. One should understand that in investment and financing
decisions, it is the flow of cash that is important, not the accounting
profits. SWM as an objective of financial management is appropriate and
operationally feasible criterion to choose among the alternative financial
actions.
Or
Describe
the determinants of capital structure of a firm.
Ans: Factors Determining the Capital
Structure of a Company
The following factors are considered while deciding the capital
structure of the firm.
a)
Leverage: It is the basic and
important factor, which affect the capital structure. It uses the fixed cost
financing such as debt, equity and preference share capital. It is closely
related to the overall cost of capital.
b)
Cost of Capital: Cost of capital
constitutes the major part for deciding the capital structure of a firm.
Normally long- term finance such as equity and debt consist of fixed cost while
mobilization. When the cost of capital increases, value of the firm will also
decrease. Hence the firm must take careful steps to reduce the cost of capital.
c)
Nature of the business: Use of fixed
interest/dividend bearing finance depends upon the nature of the business. If
the business consists of long period of operation, it will apply for equity
than debt, and it will reduce the cost of capital.
d)
Size of the company: It also affects
the capital structure of a firm. If the firm belongs to large scale, it can
manage the financial requirements with the help of internal sources. But if it
is small size, they will go for external finance. It consists of high cost of
capital.
e)
Legal requirements: Legal requirements
are also one of the considerations while dividing the capital structure of a
firm. For example, banking companies are restricted to raise funds from some
sources.
f)
Requirement of investors: In order to
collect funds from different type of investors, it will be appropriate for the
companies to issue different sources of securities.
g)
Flexibility: The capital structure must have flexibility as
to increase or decrease the funds as per requirements of the enterprise.
Excessive dependence on fixed cost securities make the capital structure rigid
due to fixed payment of interest or dividend.
h)
Regularity of Income: Capital structure is affected by the
regularity of income. If a company expects regular income in future, debenture
and bonds should be issued. Preference shares may be issued if a company does
not expect regular income.
i)
Certainty of Income: If a company is not certain about any
regular income in future, it should never issue any type of securities other
than equity shares.
j)
Government policy Promoter
contribution is fixed by the company Act. It restricts to mobilize large, long
term funds from external sources. Hence the company must consider government
policy regarding the capital structure.
(b)
State the various factors determining the dividend policy of a company. 10
Ans: Factors Influencing Dividend
Decision: There are various factors which affect
dividend decision. These are enumerated below with brief explanation.
a)
Legal position: Section 205 of the
Companies Act, 2013 which lays down the sources from which dividend can be
paid, provides for payment of dividend (i) out of past profits and (ii) out of
moneys provided by the Central/State Government, apart from current profits.
Thus, by law itself, a company may be allowed to declare a dividend even in a
year when the profits are inadequate or when there is absence of profit.
b)
Magnitude and Trend in EPS: EPS is the
basis for dividend. The size of the EPS and the trend in EPS in recent years
set how much can be paid as dividend a high and steadily increasing EPS enables
a high and steadily increasing DPS. When EPS fluctuates a different dividend
policy has to be adopted.
c)
Taxability: According to Section
205(3) of the Companies Act, 1956 'no dividend shall be payable except in
cash'. However, the Income-Tax Act defines the term dividend so as to include
any distribution of property or rights having monetary value. Therefore,
liberal dividend policy becomes unattractive from the point of view of the
shareholders/investors in high income brackets. Thus a company which considers
the taxability of its shareholders, may not declare liberal dividend though
there may be huge profit, but may alternatively go for issuing bonus shares
later.
d)
Liquidity and Working Capital
Position: Apparently, distribution of dividend results in outflow of cash and
as such a reduction in working capital position. Even in a year when a company
has earned adequate profit to warrant a dividend declaration, it may confront
with a week liquidity position. Under the circumstance, while one company may
prefer not to pay dividend since the payment may impair liquidity, another
company following a stable dividend policy, may wish to declare dividends even
by resorting to borrowings for dividend payment in cash.
e)
Impact on share price: The impact of
dividends on market price of shares, though cannot be precisely measured, still
one could consider the influence of dividend on the market price of shares. The
dividend policy pursued by a company naturally depends on how far the
management is concerned about the market price of shares. Generally, an
increase in dividend payout results in a hike in the market price of shares.
This is significant as it has a bearing on new issues.
f)
Control consideration: Where the
directors wish to retain control, they may desire to finance growth programmes
by retained earnings, since issue of fresh equity shares for financing growth
plan may lead to dilution of control of the dominating group. So, low dividend
payout is favoured by Board.
g)
Type of Shareholders: When the
shareholders of the company prefer current dividend rather man capital gain a
high payment is desirable. This happens so, when the shareholders are in low
tax brackets, they are less moneyed and require periodical income or they have
better investment avenues than the company. Retired persons, economically
weaker sections and similarly placed investors prefer current income i.e.
dividend. If, on the other hand, majority of the shareholders are moneyed
people, and want capital gain, then low payout ratio is desirable. This is
known as clientele effect on dividend decision.
h)
Industry Norms: The industry norms
have to be adhered to the extent possible. It most firms in me industry adopt a
high payout policy, perhaps others also have to adopt such a policy.
i)
Age of the company: Newly formed
companies adopt a conservative dividend policy so that they can get stabilized
and think of growth and expansion.
j)
Investment opportunities for the
company: If the company has better investment opportunities, and it is
difficult to raise fresh capital quickly and at cheap costs, it is better to
adopt a conservative dividend policy. By better investment opportunities we
mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is
good. And vice versa.
k)
Restrictive covenants imposed by debt
financiers: Debt financiers, especially term lending financial institutions,
may impose restrictive conditions on the rate, timing and form of dividends
declared. So, that consideration is also significant.
Or
State
the various factors determining the working capital requirements of a firm.
Ans:
Factors Affecting Working Capital Requirement: The level
of working capital is influenced by several factors which are given below:
a)
Nature of Business: Nature of business is one of
the factors. Usually in trading businesses the working capital needs are higher
as most of their investment is found concentrated in stock. On the other hand,
manufacturing/processing business needs a relatively lower level of working
capital.
b)
Size of Business: Size of business is also an
influencing factor. As size increases, an absolute increase in working capital
is imminent and vice versa.
c)
Production Policies: Production
policies of a business organisation exert considerable influence on the requirement
of Working Capital. But production policies depend on the nature of product.
The level of production, decides the investment in current assets which in turn
decides the quantum of working capital required.
d)
Terms of Purchase and Sale: A
business organisation making purchases of goods on credit and selling the goods
on cash terms would require less Working Capital whereas an organisation
selling the goods on credit basis would require more Working Capital. If the
payment is to be made in advance to suppliers, then large amount of Working
Capital would be required. 286
e)
Production Process: If
the production process requires a long period of time, greater amount of
Working Capital will be required. But, simple and short production process
requires less amount of Working Capital. If production process in an industry
entails high cost because of its complex nature, more Working Capital will be
required to finance that process and also for other expenses which vary with
the cost of production whereas if production process is simple requiring less
cost, less Working Capital will be required.
f)
Turnover of Circulating Capital: Turnover
of circulating capital plays an important and decisive role in judging the
adequacy of Working Capital. The speed with which circulating capital completes
its cycle i.e. conversion of cash into inventory of raw materials, raw
materials into finished goods, finished goods into debts and debts into cash
decides the Working Capital requirements of an organization. Slow movement of
Working Capital cycle requires large provision of Working Capital.
g)
Dividend Policies: Dividend
policies of a business organisation also influence the requirement of Working
Capital. If a business is following a liberal dividend policy, it requires high
Working Capital to pay cash dividends where as a firm following a conservative
dividend policy will require less amount of Working Capital.
h)
Seasonal Variations: In
case of seasonal industries like Sugar, Oil mills etc. More Working Capital is
required during peak seasons as compared to slack seasons.
i)
Business Cycle: Business
expands during the period of prosperity and declines during the period of
depression. More Working Capital is required during the period of prosperity
and less Working Capital is required during the period of depression.
j)
Change in Technology: Changes
in Technology as regards production have impact on the need of Working Capital.
A firm using labour oriented technology will require more Working Capital to
pay labour wages regularly.
k)
Inflation: During
inflation a business concern requires more Working Capital to pay for raw
materials, labour and other expenses. This may be compensated to some extent
later due to possible rise in the selling price.
(c)
Discuss the traditional methods of capital budgeting decision. 10
Ans: Methods
used in Investment decision making: Most
commonly used technique in investment decision making are given below:
1) Payback
period Method: It is one of the simplest methods to
calculate period within which entire cost of project would be completely
recovered. It is the period within which total cash inflows from project would
be equal to total cash outflow of project. It is calculated by dividing initial
investments in project by annual cash inflows. Here, cash inflow means profit
after tax but before depreciation.
Merits of
Payback Period Method
a) This method of evaluating proposals for capital budgeting is
simple and easy to understand, it has an advantage of making clear that it has
no profit on any project until the payback period is over i.e. until capital
invested is recovered. This method is particularly suitable in the case of
industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method
favours projects that generates cash inflows in earlier years, thereby
eliminating projects bringing cash inflows in later years that generally are
conceived to be risky as this tends to increase with futurity.
Limitations
of payback period
a) It stresses capital recovery rather than profitability. It does
not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2
projects where the cash inflows are uneven.
2)
Accounting rate of return (Average rate of return – ARR): ARR
is a financial ratio used in capital budgeting. The ratio does not take into
account the concept of time value of money. ARR calculates the return,
generated from net income of the proposed capital investment. The ARR is a
percentage return. Say, if ARR = 7%, then it means that the project is expected
to earn seven cents out of each dollar invested. If the ARR is equal to or
greater than the required rate of return, the project is acceptable. If it is
less than the desired rate, it should be rejected. When comparing investments,
the higher the ARR, the more attractive the investment. Over one-half of large
firms calculate ARR when appraising projects. It is calculated with the help of
the following formula:
ARR=Average Profit / Investment
3) Net
present value (NPV) method: The best method for evaluation of
investment proposal is net present value method or discounted cash flow
technique. This method takes into account the time value of money. The net
present value of investment proposal may be defined as sum of the present
values of all cash inflows as reduced by the present values of all cash
outflows associated with the proposal. Each project involves certain
investments and commitment of cash at certain point of time. This is known as
cash outflows. Cash inflows can be calculated by adding depreciation to profit
after tax arising out of that particular project.
Merits of
NPV method:
1) NPV method takes into account the time value of money.
2) The whole stream of cash flows is considered.
Limitations
of NPV method:
1) It involves different calculations.
2) The ranking of projects depends on the discount rate.
4)
Internal rate of return (IRR): The internal rate of return method is
also a modern technique of capital budgeting that takes into account the time
value of money. It is also known as ‘time adjusted rate of return’ discounted
cash flow’ ‘discounted rate of return,’ ‘yield method,’ and ‘trial and error
yield method’. In the net present value method, the net present value is
determined by discounting the future cash flows of a project at a predetermined
or specified rate called the cut-off rate. But under the internal rate of
return method, the cash flows of a project are discounted at a suitable rate by
hit and trial method, which equates the net present value so calculated to the
amount of the investment. Under this method, since the discount rate is
determined internally, this method is called as the internal rate of return
method. The internal rate of return can be defined as that rate of discount at
which the present value of cash-inflows is equal to the present value of cash
outflows.
Merits of
IRR
1.
It considers the time value of money.
2.
It considers entire cash flows over
entire life of the project.
Demerits of IRR
1.
It requires the estimation of cash
inflows and cash outflows, which is a difficult task.
2.
It assumes that intermediate cash
inflows are reinvested at IRR.
5)
Profitability Index (PI): It is also a time-adjusted method of
evaluating the investment proposals. Profitability index also called as
Benefit-Cost Ratio (B/C) or ‘Desirability factor’ is the relationship between
present value of cash inflows and the present value of cash outflows.
Merits of
PI
1.
It considers the time value of money.
2.
It considers entire cash flows over
entire life of the project.
Demerits of PI
1.
It requires the estimation of cash
inflows and cash outflows, which is a difficult task.
2.
It requires the computation of the
cost of capital to be used as discount rate.
Or
ABC Company is considering to purchase one of the following two
machines, the details of which are given below:
|
Year |
Cash inflow (Rs.) |
Discount factor @ 10% |
|
|
Machine X |
Machine Y |
||
|
1st 2nd 3rd 4th 5th |
3,00,000 4,00,000 5,00,000 3,00,000 2,00,000 |
1,00,000 3,00,000 4,00,000 6,00,000 4,00,000 |
0.909 0.826 0.751 0.683 0.621 |
Cost of Machine X and Machine Y is Rs. 10,00,000 each. Calculate Net
Present Value and Profitability Index. 7+3=10
Ans: I have not solved this practical question yet, but from my past video you can learn how to solve this questions
***
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