MCO – 07
MCO 07 Solved Free Assignment 2023
MCO 07 Solved Free Assignment January 2023
Q 1) (a) “Investment, financing and dividend decisions are all interrelated” comment.
Ans. Investment, financing, and dividend decisions are all important components of financial decision-making for any business. These decisions are interrelated because they affect each other in various ways.
Understanding the relationship between these decisions is critical to the success of any business.
Investment decisions involve allocating resources to different projects, which can range from acquiring new assets to expanding into new markets.
This decision involves evaluating potential investments and selecting the ones that are most likely to generate returns for the business.
The investment decision also includes determining the appropriate level of risk that the business is willing to undertake.MCO 07 Solved Free Assignment 2023
Financing decisions, on the other hand, involve determining how to fund investments or the business operations. This decision can range from deciding to use internal funds such as retained earnings or issuing new debt or equity.
The financing decision also includes determining the optimal mix of debt and equity and the appropriate level of leverage.
Dividend decisions involve determining how to distribute profits to shareholders. The decision can range from retaining earnings to finance future growth or distributing profits to shareholders through dividends.
This decision is critical as it can have an impact on the stock price and shareholder value.
The interrelationship between these decisions can be seen in various ways. For example, investment decisions can impact financing decisions.
If a business decides to undertake a new investment, it may need to raise funds to finance it. MCO 07 Solved Free Assignment 2023
This may require the business to issue new debt or equity. Alternatively, financing decisions can impact investment decisions.
The cost and availability of capital can influence investment decisions. If the cost of capital is high, the business may decide to postpone investments.
Similarly, dividend decisions can impact investment decisions. If a business decides to distribute profits to shareholders through dividends, it may have less cash available for investments.
Alternatively, if a business retains earnings, it may have more resources available for investments. Investment decisions can also impact dividend decisions.
If a business invests in projects with high returns, it may generate more profits, which can then be distributed to shareholders through dividends.
The trade-offs between these decisions can be complex, and businesses need to consider various factors when making decisions.
For example, businesses need to consider the cost of capital, the expected return on investment, and the potential impact on the business’s financial position.
They also need to consider the impact on shareholder value and the expectations of stakeholders.MCO 07 Solved Free Assignment 2023
Overall, investment, financing, and dividend decisions are interrelated, and businesses need to carefully consider the trade-offs between these decisions to maximize shareholder value.
Effective financial decision-making requires a deep understanding of the relationship between these decisions and the ability to balance competing objectives.
Successful businesses are those that can make informed decisions that balance risk and return, while creating long-term value for shareholders.
(b) What is time value of money? Discuss its relevance in financial decision making
Ans. The time value of money is a fundamental concept in finance that refers to the idea that money available at different points in time is not worth the same amount. In other words, a dollar today is worth more than a dollar in the future.
This is because money available today can be invested and earn a return, while money in the future does not have the same earning potential.
The time value of money has important implications for financial decision-making.
One of the primary applications of the time value of money is in determining the present value of future cash flows. MCO 07 Solved Free Assignment 2023
For example, if a business is considering investing in a new project, it will need to estimate the future cash flows that the project will generate.
However, these future cash flows are not worth the same amount as cash flows that are available today.
To compare the value of future cash flows to present cash flows, the business needs to discount the future cash flows back to their present value using an appropriate discount rate.
The discount rate used to calculate the present value of future cash flows is based on the opportunity cost of capital. The opportunity cost of capital is the return that investors could earn by investing their money elsewhere.
If a business can earn a higher rate of return by investing in an alternative project or security, then the discount rate used to calculate the present value of future cash flows should reflect that higher rate of return.
The time value of money also has important implications for financing decisions. For example, if a business is considering taking out a loan to finance a project, it will need to pay interest on the loan. MCO 07 Solved Free Assignment 2023
The interest payments represent a cost to the business, and the cost of borrowing should be considered when evaluating the potential returns of the project.
If the project cannot generate returns that exceed the cost of borrowing, then it may not be a viable investment.
Another important application of the time value of money is in evaluating investment opportunities.
When evaluating different investment opportunities, businesses need to consider the expected return on investment and the risk associated with the investment.
However, businesses also need to consider the time horizon of the investment. Investments with longer time horizons typically have a higher degree of uncertainty, and the risk associated with these investments may be higher.
The time value of money can help businesses evaluate the potential returns of an investment over time, and how those returns compare to alternative investments.
Overall, the time value of money is a critical concept in finance that has important implications for financial decision-making.
By understanding the time value of money, businesses can make more informed decisions about investment opportunities, financing decisions, and other financial decisions. MCO 07 Solved Free Assignment 2023
The time value of money can help businesses evaluate the potential returns and risks associated with different options, and make decisions that create long-term value for stakeholders.
Q 2. Discuss the different approaches for valuation of equity shares.
Ans. There are several approaches that can be used to value equity shares, each with its own strengths and weaknesses. The three primary approaches for valuation of equity shares are:
Discounted Cash Flow (DCF) Method: The DCF method is based on the principle that the value of an investment is equal to the present value of the expected future cash flows that it generates.
In the case of equity shares, this involves estimating the expected future cash flows of the business, discounting them back to their present value using an appropriate discount rate, and then dividing that value by the number of outstanding shares to determine the per-share value. MCO 07 Solved Free Assignment 2023
The DCF method is considered to be a comprehensive approach to valuation as it takes into account the time value of money and the expected cash flows generated by the business.
However, it can be challenging to estimate the future cash flows accurately, and selecting an appropriate discount rate can be subjective.
Price-to-Earnings (P/E) Ratio Method: The P/E ratio is a widely used method for valuing equity shares. It involves dividing the current market price per share by the earnings per share (EPS) of the business.
The resulting ratio represents the multiple that investors are willing to pay for each dollar of earnings.
The P/E ratio is based on the assumption that investors are willing to pay a certain multiple of earnings for a share of stock, based on factors such as the growth prospects of the business and the overall risk of the investment.
The P/E ratio method is simple to use and widely understood, but it does not take into account the future growth potential of the business or the time value of money.
Asset-based Valuation Method: The asset-based valuation method involves valuing the equity shares based on the net value of the company’s assets after deducting liabilities. MCO 07 Solved Free Assignment 2023
This approach assumes that the value of the company’s assets represents the value of the business.
The asset-based valuation method is particularly useful for companies with significant tangible assets, such as real estate or manufacturing equipment.
However, it does not take into account the future earnings potential of the business or intangible assets such as intellectual property.
In addition to these primary approaches, there are other valuation methods that can be used to supplement or refine these approaches. These include:
Dividend Discount Model (DDM): The DDM method involves estimating the future dividends that the business is expected to pay and discounting them back to their present value. MCO 07 Solved Free Assignment 2023
The resulting value represents the total value of the business, which can then be divided by the number of outstanding shares to determine the per-share value.
Price-to-Book (P/B) Ratio Method: The P/B ratio is a valuation method that compares the market price per share of a company to its book value per share. The book value is the net value of the company’s assets after deducting liabilities.
The P/B ratio method is particularly useful for companies with significant tangible assets, but it does not take into account the future earnings potential of the business.
Comparable Company Analysis (CCA): The CCA method involves comparing the financial performance and valuation metrics of the target company to those of similar companies in the same industry. MCO 07 Solved Free Assignment 2023
This approach is useful for companies that are difficult to value using other methods or for which there are few comparable companies.
Q 3. A company is considering the following investment projects.
Find out payback period, and net present value and rank the projects according to
them. Assume discount rate 10% and 20%.
Ans. To determine the payback period of each project, we calculate the cumulative cash flows until the initial investment is recovered.
Projects Initial Investment Cash Flows ( ) Cumulative Cash Flows ( ) Payback Period
A 10,00,000 12,00,000 20,00,000 2 years
B 10,00,000 8,00,000 18,00,000 2 years
C 10,00,000 3,00,000 8,00,000 2 years and 6 months
D 10,00,000 10,00,000 16,00,000 1 year and 8 months
To calculate the net present value (NPV) of each project, we discount the cash flows at the given discount rates and subtract the initial investment.
Projects Discount rate 10% Discount rate 20%
Initial Investment Cash Flows ( ) NPV ( ) Cash Flows ( ) NPV ( )
A 10,00,000 12,00,000 90,909 (2,55,046)
B 10,00,000 8,00,000 58,824 1,23,967
10,00,000 73,529 96,694
12,00,000 88,235 70,171
C 10,00,000 3,00,000 (2,44,670) (6,27,886)
5,00,000 (90,909) (3,71,901)
5,00,000 (16,942) (1,60,079)
D 10,00,000 10,00,000 1,17,355 4,22,052
Finally, we can rank the projects based on their NPV at each discount rate.
Ranking at 10% discount rate: MCO 07 Solved Free Assignment 2023
Project B: NPV = ₹ 1,23,967
Project D: NPV = ₹ 1,17,355
Project A: NPV = ₹ 90,909
Project C: NPV = -₹ 2,44,670
Ranking at 20% discount rate:
Project D: NPV = ₹ 4,22,052
Project B: NPV = ₹ 96,694
Project A: NPV = -₹ 2,55,046
Project C: NPV = -₹ 6,27,886
Therefore, based on these calculations, we can conclude that Project B and D are the most favorable investment opportunities, with Project B having the highest NPV at a 10% discount rate, and Project D having the highest NPV at a 20% discount rate.
Project A is also a viable option, while Project C appears to be the least attractive of the four projects.
Q 4) (a) What is operating leverage and financial leverage? What is their significance?
Ans. Operating leverage and financial leverage are two important concepts in financial management. MCO 07 Solved Free Assignment 2023
Both of these concepts are used to measure the extent to which a company’s profitability is affected by changes in its revenue and costs structure.
Operating leverage refers to the degree to which fixed costs are used in a company’s operations. It is the ratio of fixed costs to total costs, and it measures the sensitivity of a company’s operating income to changes in sales volume.
A high degree of operating leverage means that a company has a large proportion of fixed costs in its operations, while a low degree of operating leverage means that a company has a larger proportion of variable costs.
Operating leverage is important because it can magnify the impact of changes in revenue on a company’s profits.
When a company has a high degree of operating leverage, a small change in revenue can have a significant impact on its operating income, which can result in a large change in its net income. MCO 07 Solved Free Assignment 2023
Therefore, companies with a high degree of operating leverage can experience large swings in profitability based on small changes in sales volume.
Financial leverage, on the other hand, refers to the extent to which a company uses debt financing in its capital structure.
It is the ratio of debt to equity, and it measures the degree to which a company’s earnings per share are affected by changes in interest rates and other costs associated with debt financing.
A high degree of financial leverage means that a company has a high level of debt relative to equity, while a low degree of financial leverage means that a company has a low level of debt relative to equity.
Financial leverage is significant because it can magnify the impact of changes in interest rates and other financing costs on a company’s profits.
When a company has a high degree of financial leverage, a small change in interest rates can have a significant impact on its earnings per share, which can result in a large change in its net income. MCO 07 Solved Free Assignment 2023
Therefore, companies with a high degree of financial leverage can be more vulnerable to changes in interest rates and other financing costs.
In general, both operating leverage and financial leverage can have significant implications for a company’s financial performance.
A company with a high degree of operating leverage can benefit from economies of scale and increased efficiency, but it can also be vulnerable to changes in sales volume.
Similarly, a company with a high degree of financial leverage can benefit from lower financing costs and increased returns on equity, but it can also be vulnerable to changes in interest rates and other financing costs.
Therefore, it is important for companies to carefully consider the extent to which they use operating leverage and financial leverage in their operations.
By balancing these two concepts and managing their costs and capital structure effectively, companies can achieve optimal financial performance and reduce their overall risk profile.MCO 07 Solved Free Assignment 2023
(b) Firm ‘A’ has a annual sale of Rs 80,00,000 and variable cost is Rs 50,00,000. Fixed cost is Rs 5,00,000 per year. Company has 11% debentures of Rs 30,00,000. Find out operating leverage and financial leverage of the firm.
Ans. To calculate the operating leverage of Firm A, we need to use the formula:
Operating Leverage = Contribution Margin / Operating Income
Where Contribution Margin is the difference between the total revenue and the variable costs, and Operating Income is the difference between the total revenue and the total costs (fixed costs plus variable costs).
Contribution Margin = Total Revenue – Variable Costs
= Rs 80,00,000 – Rs 50,00,000
= Rs 30,00,000
Operating Income = Total Revenue – Total Costs
= Rs 80,00,000 – (Rs 50,00,000 + Rs 5,00,000)
= Rs 25,00,000
Therefore, Operating Leverage of Firm A = Rs 30,00,000 / Rs 25,00,000
To calculate the financial leverage of Firm A, we need to use the formula:
Financial Leverage = Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT) MCO 07 Solved Free Assignment 2023
Where EBIT is the Operating Income minus the Interest Expense, and EBT is the Operating Income minus the Interest Expense and Taxes.
Interest Expense = 11% of Rs 30,00,000
= Rs 3,30,000
EBIT = Operating Income – Interest Expense
= Rs 25,00,000 – Rs 3,30,000
= Rs 21,70,000
EBT = EBIT – Taxes
Assuming the tax rate is 30%, we get
= Rs 21,70,000 – (0.30 x Rs 21,70,000)
= Rs 15,19,000
Therefore, Financial Leverage of Firm A = Rs 21,70,000 / Rs 15,19,000
In summary, the operating leverage of Firm A is 1.2, which means that a 1% change in sales volume would result in a 1.2% change in operating income.
The financial leverage of Firm A is 1.43, which means that a 1% change in operating income would result in a 1.43% change in earnings per share (EPS).
It is important to note that a high degree of leverage can increase the potential for high returns but also increases the risk of losses.
Therefore, companies must carefully manage their leverage levels to achieve a balance between risk and reward. MCO 07 Solved Free Assignment 2023
Q 5) (a) Discuss M & M preposition I of capital structure.
Ans. M&M proposition I (Modigliani-Miller proposition I), also known as the “irrelevance proposition,” is a theory in corporate finance that suggests that the value of a firm is independent of its capital structure.
In other words, the proposition asserts that a company’s total value is determined by its earning power and the risk of its underlying assets, and not by the way it is financed.
According to the M&M proposition I, in a perfect capital market, the cost of capital of a firm is not affected by its capital structure, which means that the cost of equity is the same whether the company uses only equity or a mix of debt and equity.
The rationale behind this theory is that investors can always replicate the returns of a levered company by borrowing and investing in an unleveled company or vice versa.
Therefore, there is no benefit or disadvantage to using debt or equity to finance a company’s operations. MCO 07 Solved Free Assignment 2023
The M&M proposition I has some important implications for corporate finance. Firstly, it suggests that companies cannot increase their value by changing their capital structure.
This is because the cost of capital remains the same regardless of whether the company uses only equity or a mix of debt and equity.
Secondly, it implies that there is no optimal capital structure that maximizes the value of a firm.
Since the cost of capital is constant, companies can use any combination of debt and equity to finance their operations.
However, the M&M proposition I assumes certain ideal conditions that are not present in the real world. Some of the assumptions include:
Perfect capital markets: M&M proposition I assumes that capital markets are perfect, which means that there are no taxes, transaction costs, or other frictions that affect the cost of capital. MCO 07 Solved Free Assignment 2023
In reality, capital markets are not perfect, and various costs and frictions can affect the cost of capital.
Homogeneous expectations: The proposition assumes that all investors have the same expectations about the future cash flows of the company.
However, in reality, investors may have different expectations, and this can affect the cost of capital.
No bankruptcy costs: The proposition assumes that there are no costs associated with bankruptcy. In reality, bankruptcy can be costly, and this can affect the cost of capital.
Despite these limitations, the M&M proposition I provides valuable insights into the relationship between capital structure and the value of a firm.
It suggests that companies should focus on maximizing their earning power and minimizing the risk of their underlying assets, rather than trying to optimize their capital structure.
Companies should also consider the tax implications of their financing decisions, as taxes can affect the cost of capital.
(b) What is credit policy? Explain its variables.
Ans. Credit policy refers to the guidelines and principles that a company follows when extending credit to its customers.
A company’s credit policy outlines the terms and conditions of credit sales, including credit limits, payment terms, credit checks, and collection procedures.
The variables of credit policy are the different components that make up a company’s credit policy. The main variables of credit policy are as follows:
Credit terms: Credit terms refer to the payment terms that a company offers to its customers. These terms can include the payment period, interest rates, and penalties for late payments. MCO 07 Solved Free Assignment 2023
Credit terms also specify the credit limit, which is the maximum amount of credit that a customer can use at any given time.
Credit evaluation: Credit evaluation involves assessing a customer’s creditworthiness to determine whether they are likely to repay their debts on time.
Credit evaluation includes reviewing the customer’s credit history, financial statements, and payment history.
The company may also request references and conduct a credit check to determine the customer’s creditworthiness.
Credit approval: Credit approval refers to the process of approving or denying a customer’s credit application.
This involves reviewing the customer’s credit history, financial statements, and payment history to determine whether they are eligible for credit.
Collection policy: Collection policy outlines the procedures that a company follows when collecting overdue debts. The policy includes procedures for sending payment reminders, contacting customers, and pursuing legal action.
Credit period: The credit period refers to the time period that a company offers its customers to pay their outstanding debt.
The credit period is usually measured in days and can vary depending on the industry, customer type, and creditworthiness of the customer.
Discount policy: A discount policy is a strategy that a company may use to encourage customers to pay their debts earlier. MCO 07 Solved Free Assignment 2023
This policy offers discounts for early payments, which can help to reduce the company’s outstanding debt and improve cash flow.
Credit risk: Credit risk refers to the risk that a company will incur losses due to customers defaulting on their debts.
Credit risk can be minimized by implementing a sound credit policy that includes credit evaluation, credit limits, and collection procedures.
At Last, credit policy is an important component of a company’s overall financial strategy.
It outlines the terms and conditions of credit sales, including credit terms, credit evaluation, credit approval, collection policy, credit period, discount policy, and credit risk. MCO 07 Solved Free Assignment 2023
By implementing a sound credit policy, companies can improve their cash flow, minimize credit risk, and improve their overall financial health.