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Gauhati University Fundamentals of Financial Management Question Paper Solution 2022
2022
COMMERCE
(Honours)
Paper COM-HC-5026
(Fundamentals of Financial Management Solved Paper)
Full Marks: 70
Time: Three hours
The figures in the margin indicate full marks for the questions.
(A) Choose the correct option of the following (any five) 1x5=5
(a) Long term investment decision is also known as
(i) working capital
(ii) dividend decision
(iii) capital budgeting
(iv) None of the above
(b) The overall cost of capital is also known as
(i) marginal cost of capital
(ii) variable cost of capital
(iii) weighted average cost of capital
(iv) specific cost of capital
(c) Capital structure represents
(i) ratio between different forms of capital
(ii) all liabilities
(iii) all assets
(iv) assets and liabilities
(d) The capitalization of profit is termed as
(i) cash dividend
(ii) bond dividend
(iii) stock dividend
(iv) property dividend
(e) Key financial function of a firm includes the following, except
(i) investment decision
(ii) dividend decision.
(iii) financing decision
(iv) make or buy decision.
(f) According to which model dividend policy has no effect on the market price of the shares and value of the firm ?
(i) Walter's model
(ii) M M model
(iii) Gordon's model
(iv) None of the above
(g) Capital budgeting deals with
(i) cash Management
(ii) management of working capital
(iii) managing fixed assets
(iv) None of the above
(h) Which is not payback method?
(i) Pay-off method
(ii) Payout method
(iii) Recoupment period method
(iv) None of the above
(i) When should a project be accepted under profitability index (PI) ?
(i) When PI > 1.0
(ii) When Pl< 1.0
(iii) When PI-0
(iv) None of the above
(B) Write whether the following statements are True or False: (any five) 1×5=5
(a) Cost of retained earnings is less than cost of equity. (False)
(b) Stable dividend does not mean a fixed dividend payout ratio.(True)
(c) Every financial decision should be based on cost-benefit analysis.(True)
(d) Working capital is also known as excess of current assets over current liabilities. (True)
(e) Profitability index is the relationship between present value of cash inflows and the present value of cash outflows.(True)
(f) The cost of capital is the minimum rate of return expected by its investors. (True)
(g) Stock dividend affects liquidity position of the company.(False)
(h) Receivables constitute a significant portion of the fixed assets.(False)
(i) Capital structure is the mix of preference and equity share capital.(False)
2. Answer any five of the following questions in about 50 words each: 2×5-10
(a) What is financing decision ?
Ans:- Financing Decision: A financing decision is the process by which a company determines how to raise funds for its operations and investments. It involves choosing the right mix of debt and equity to finance projects while considering factors like cost, risk, and capital structure.
(b) What is permanent working capital ?
Ans:- Permanent Working Capital: Permanent working capital refers to the minimum level of current assets required by a business to maintain its day-to-day operations. It represents the ongoing, non-seasonal working capital needs of a company.
(c) What do you mean by a capital structure?
Ans:- Capital Structure: Capital structure refers to the composition of a company's long-term funding sources, including debt, equity, and preferred stock. It reflects how a firm balances its financial obligations and ownership interests to optimize its cost of capital.
(d) What is bond dividend ?
Ans:- Bond Dividend: Bond dividend is not a common financial term. It might be a reference to interest payments made to bondholders, which are usually called bond interest or coupon payments.
(e) Write two importances of capital budgeting.
Ans:- Importances of Capital Budgeting: Capital budgeting helps companies allocate resources efficiently and make informed investment decisions. Two important aspects are:
1) Maximizing profitability by selecting the most profitable projects, and
2) Mitigating risk by assessing the potential returns and risks associated with investments.
(f) What do you mean by cash management?
Ans:- Cash Management: Cash management involves monitoring, controlling, and optimizing a company's cash flows. It includes activities such as cash forecasting, liquidity management, and optimizing the timing of payments and receipts to ensure adequate funds for operations.
(g) What is payback period ?
Ans:- Payback Period: The payback period is the time it takes for an investment to generate cash flows equal to its initial cost. It's a simple measure to evaluate the time it will take to recover an investment.
(h) Define cost of capital.
Ans:- Cost of Capital: The cost of capital is the rate of return a company expects to generate from its investments to satisfy its investors (both debt and equity holders). It's a key factor in determining the hurdle rate for investment decisions.
(i) What do you mean by accounting rate of return?
Ans:- Accounting Rate of Return: The accounting rate of return (ARR) is a financial metric used to evaluate the profitability of an investment. It calculates the average annual accounting profit generated by an investment as a percentage of the initial investment cost.
(j) What are the objectives of receivable management ?
Ans:- Objectives of Receivable Management: Receivable management aims to optimize a company's accounts receivable. Key objectives include 1) reducing the risk of bad debts, 2) minimizing the collection period to improve cash flow, and 3) ensuring a balance between credit sales and cash sales to maintain profitability.
3. Answer any four of the following questions in about 150 words each: 5x4=20
(a) Briefly explain the sources of long-term financing.
Ans:- (a) Sources of Long-term Financing:
Long-term financing refers to the capital acquired by a company to support its operations and growth over an extended period, typically more than one year. The key sources of long-term financing include:
1. Equity Financing: This involves issuing shares of stock to raise capital. Common sources of equity financing include initial public offerings (IPOs), private placements, and retained earnings.
2. Debt Financing: Companies can raise funds through loans, bonds, or debentures. These obligations have fixed interest rates and maturity dates. Debt financing can come from banks, financial institutions, or the issuance of corporate bonds.
3. Preference Shares: Companies can issue preference shares that combine characteristics of both debt and equity. They pay fixed dividends, similar to debt, but also carry ownership rights.
4. Venture Capital and Private Equity: Startups and growth-stage companies often seek funding from venture capitalists and private equity firms in exchange for equity ownership.
5. Retained Earnings: Companies can reinvest their profits back into the business for growth and expansion, avoiding external financing.
(b) Write a brief note on valuation of securities.
Ans:- Valuation of Securities:
Valuation of securities refers to the process of determining the intrinsic or market value of financial assets such as stocks and bonds. It involves analyzing various factors, including financial statements, market conditions, and economic indicators, to estimate a security's worth. Common methods of valuation include:
1. Fundamental Analysis: This involves examining a company's financial statements, earnings, growth prospects, and industry trends to assess the intrinsic value of its securities.
2. Technical Analysis: This approach focuses on historical price and trading volume patterns to predict future price movements.
3. Comparable Company Analysis (CCA): CCA involves comparing the financial ratios and multiples of a target company to those of similar publicly traded companies to determine its value.
4. Discounted Cash Flow (DCF) Analysis: DCF calculates the present value of expected future cash flows generated by a security, using a discount rate that reflects the risk associated with the investment.
5. Market Capitalization: For stocks, market capitalization is calculated by multiplying the stock's current market price by the total number of outstanding shares.
(c) Discuss five factors determining working capital requirements.
Ans:- Factors Determining Working Capital Requirements:
Working capital is vital for a company's day-to-day operations. Five factors that influence a company's working capital requirements include:
1. Seasonality: Businesses with seasonal fluctuations in demand may need to maintain higher working capital during peak periods to meet increased expenses.
2. Growth Rate: Rapidly growing companies often require more working capital to support increased sales and production.
3. Credit Policy: A company's credit terms to customers and supplier credit terms affect the need for working capital. Tighter credit policies may reduce the requirement.
4. Inventory Management: Efficient inventory management can reduce working capital needs by minimizing carrying costs.
5. Economic Conditions: Economic downturns can lead to reduced sales, delayed payments, and increased working capital requirements.
(d) Write the different types of dividend policies.
Ans:- Types of Dividend Policies:
Dividend policies are strategies that companies use to distribute profits to shareholders. The main types of dividend policies include:
1. Stable Dividend Policy: Companies following this policy aim to pay a consistent dividend amount regardless of earnings fluctuations.
2. Residual Dividend Policy: Dividends are paid from the residual earnings left after covering all capital expenditures and financial requirements.
3. Constant Payout Ratio Policy: A fixed percentage of earnings is paid as dividends, resulting in varying dividend amounts with changing earnings.
4. Low Regular Dividend with Special Dividends: Companies maintain a low regular dividend and issue special dividends when they have excess cash.
5. No Dividend Policy: Some growth-oriented companies reinvest all earnings into the business and do not pay dividends.
(e) What is IRR method of capital budgeting? Mention two advantages and two limitations of this method.
Ans:- IRR Method of Capital Budgeting:
The Internal Rate of Return (IRR) is a capital budgeting method used to evaluate the profitability of investment projects. Two advantages of the IRR method are:
Advantages:
1. It considers the time value of money by discounting cash flows, providing a more accurate picture of project profitability.
2. IRR provides a single rate of return, making it easy to compare different investment opportunities.
Limitations:
1. Multiple IRRs: Some projects may have multiple IRRs, making interpretation difficult.
2. Reinvestment Assumption: IRR assumes that cash flows are reinvested at the project's IRR rate, which may not be realistic.
(f) Why is wealth maximization objective considered as superior to profit maximization objective? Write five reasons.
Ans:- Wealth Maximization vs. Profit Maximization:
Wealth maximization is considered superior to profit maximization for several reasons:
1. Long-Term Focus: Wealth maximization emphasizes maximizing the long-term value of the firm, aligning with the interests of shareholders over time.
2. Consideration of Risk: Wealth maximization accounts for risk by using discounted cash flows, ensuring that investments generate returns above the cost of capital.
3. Shareholder Wealth: It directly addresses the goal of shareholders, who benefit from increased stock prices and dividend payouts.
4. Sustainable Growth: Wealth maximization promotes sustainable growth and financial stability, reducing the risk of financial distress.
5. Adaptability: It allows for flexibility in decision-making, as it doesn't prioritize short-term gains at the expense of long-term value.
(g) State the limitation of financial management.
Ans:- Limitation of Financial Management:
The limitations of financial management include:
1. Subjectivity: Financial decisions are often influenced by subjective factors, making them susceptible to biases and errors.
2. Economic Uncertainty: Financial managers must contend with economic fluctuations and unpredictable events that can impact financial outcomes.
3. Ethical Concerns: Ethical dilemmas may arise when making financial decisions that balance profitability and social responsibility.
4. Information Asymmetry: Managers may have more information than shareholders, leading to information asymmetry issues and potential agency problems.
5. External Factors: Factors beyond a company's control, such as changes in government regulations or global economic conditions, can impact financial management decisions.
(h) Explain the significance of cost of capital.
Ans:- Significance of Cost of Capital:
The cost of capital is crucial in financial management because it represents the minimum return a company must earn on its investments to satisfy investors and maintain the market value of its stock. It serves several key purposes:
1. Investment Appraisal: It helps assess the feasibility of new projects by comparing their expected returns to the cost of capital.
2. Capital Budgeting: Companies use the cost of capital to determine which projects to undertake, prioritizing those with returns exceeding the cost of capital.
3. Financial Structure: It guides decisions about the optimal mix of debt and equity financing to minimize the overall cost of capital.
4. Performance Evaluation: Companies can evaluate their performance by comparing actual returns to the cost of capital.
5. Investor Attraction: A lower cost of capital makes a company more attractive to investors and lenders, potentially reducing the cost of financing.
4. Answer any three of the following questions in about 600 words each: 10×3=30
(a) What is capital asset pricing model? Discuss the various assumptions and elements of CAPM. 2+(4+4)=10
Ans:- The Capital Asset Pricing Model (CAPM) is a widely used financial theory that helps investors and financial professionals determine the expected return on an investment based on its risk and the overall market's risk. Developed by William Sharpe, John Lintner, and Jan Mossin in the early 1960s, CAPM has become a fundamental tool in the field of finance for evaluating the risk and return relationship of securities. It's essential for portfolio management, asset allocation, and investment decision-making.
Assumptions of CAPM:
1. Perfect Markets: CAPM assumes that financial markets are efficient, meaning that all available information is reflected in asset prices. This implies that investors have access to the same information and can make rational investment decisions.
2. Risk-Free Rate: The model assumes the existence of a risk-free rate, typically represented by the yield on a government bond, which is considered to have zero risk. Investors can lend or borrow money at this rate without any risk.
3. Single Time Period: CAPM assumes that the investment horizon is a single period, which simplifies calculations and analysis. In reality, investors often have multi-period investment horizons.
4. Homogeneous Expectations: All investors in the market have the same expectations about future returns, standard deviations, and correlations of assets. This simplifies the model but may not reflect the diversity of real-world investor beliefs.
5. No Taxes or Transaction Costs: CAPM assumes no taxes or transaction costs associated with buying or selling assets. In reality, these costs can significantly impact investment returns.
Elements of CAPM:
1. Risk-Free Rate (Rf): The risk-free rate is a foundational component of CAPM. It represents the return an investor can earn without taking on any risk. Typically, it's based on the yield of a government bond, such as the U.S. Treasury bond.
2. Expected Market Return (Rm): This represents the expected return of the overall market. It reflects the average return investors anticipate from a diversified portfolio of all available assets.
3. Beta (β): Beta measures the sensitivity of an asset's returns to changes in the overall market returns. A beta of 1 implies the asset moves in line with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 suggests lower volatility.
4. Expected Return (Re): The expected return of an asset is calculated using CAPM as follows:
\[Re = Rf + β(Rm - Rf)\]
where:
- \(Re\) = Expected return of the asset
- \(Rf\) = Risk-free rate
- \(β\) = Beta of the asset
- \(Rm\) = Expected market return
5. Security Market Line (SML): The SML is a graphical representation of the CAPM equation, showing the relationship between an asset's risk (measured by beta) and its expected return. Assets plotted above the SML are considered underpriced (good investments), while those below are overpriced (poor investments).
6. Capital Market Line (CML): The CML is an extension of the SML that introduces a risk-free asset. It shows the efficient portfolios that combine the risk-free asset and a risky portfolio to achieve different risk-return trade-offs.
CAPM's usefulness lies in its ability to provide a systematic framework for evaluating investments and building diversified portfolios. However, it has faced criticism for its assumptions, especially the perfect market assumption, which doesn't always hold in real-world conditions. Some argue that other factors, such as behavioral biases, can impact asset prices and returns.
(b) Discuss the role and responsibilities of a finance manager in modern business organization.
Ans:- The role of a finance manager in a modern business organization is critical to the financial health and success of the company. Finance managers are responsible for managing the company's financial resources, ensuring compliance with financial regulations, and providing strategic financial guidance to support the organization's goals. Here are some key responsibilities and roles of a finance manager:
1. Financial Planning and Analysis:
- Developing and implementing financial plans, budgets, and forecasts.
- Analyzing financial data to make informed decisions and recommendations.
- Identifying areas of improvement and opportunities for cost savings or revenue growth.
2. Financial Reporting:
- Preparing and presenting financial statements and reports to management and stakeholders.
- Ensuring compliance with accounting standards and regulatory requirements.
- Providing accurate and timely financial information for decision-making.
3. Cash Flow Management:
- Managing the organization's cash flow to ensure it has enough liquidity to meet its obligations.
- Monitoring and controlling cash flow through effective cash management techniques.
- Recommending strategies to optimize working capital.
4. Risk Management:
- Identifying and assessing financial risks, such as market risks, credit risks, and operational risks.
- Developing and implementing risk mitigation strategies and policies.
- Ensuring compliance with risk management regulations and best practices.
5. Investment Management:
- Evaluating investment opportunities, such as capital projects or acquisitions.
- Making recommendations on where to allocate financial resources for maximum returns.
- Managing investment portfolios to achieve the organization's financial goals.
6. Cost Control:
- Monitoring and controlling expenses to ensure efficient use of resources.
- Implementing cost reduction initiatives and cost control measures.
- Analyzing cost structures to identify areas for improvement.
7. Capital Structure:
- Determining the optimal capital structure, including debt and equity financing.
- Managing debt obligations, including interest payments and debt covenants.
- Balancing the cost of capital with the financial risks involved.
8. Financial Compliance:
- Ensuring compliance with financial regulations, tax laws, and reporting requirements.
- Coordinating with auditors and regulatory agencies during financial audits.
- Implementing internal controls to safeguard company assets and prevent fraud.
9. Strategic Financial Planning:
- Collaborating with senior management to develop financial strategies that align with the organization's overall goals and objectives.
- Providing financial insights and recommendations to support strategic decision-making.
10. Team Management:
- Leading and managing a team of finance professionals, including accountants, financial analysts, and budget analysts.
- Providing mentorship and guidance to team members.
(c) Sunrise Enterprise is considering two mutually exclusive projects with the following cash flow stream:
If the cost of capital to the firm is 12%, rank the two projects in terms of -
(i) payback period, and
(i) net present value
(At 12% the present value of Re. I received at the end of the 1st, 2nd, 3rd, and 4th years are 0.892, 0.797, 0.711, and 0.635 respectively) 5+5= 10
Solution:
(i) Payback Period:
The payback period is the time it takes for a project to recover its initial investment. It is calculated by subtracting the cumulative cash flows from the initial investment until the cumulative cash flows become positive.
For Project A:
For Project B:
Ranking by Payback Period:
Project A: 3 years
Project B: 3 years
(ii) Net Present Value (NPV):
NPV is calculated by discounting each cash flow to present value and then summing them up.
For Project A:
For Project B:
Ranking by NPV:
Project B: +591,040
Project A: +314,790
So, when considering payback period, both projects have the same payback period of 3 years. However, when considering NPV, Project B has a higher NPV and should be preferred over Project A.
(d) Radha & Company issues 10,000 preference shares at 10% and face value of the share is Rs. 100 each. The cost of issue is Rs. 2 per share. Calculate the cost of preference share capital if issued -
(i) at a premium of 10%, and
(ii) at a discount of 5%. 5+5=10
Ans:- To calculate the cost of preference share capital, you need to consider whether the shares are issued at a premium or a discount.
(i) When preference shares are issued at a premium of 10%:
- Face value of each share = Rs. 100
- Premium per share = 10% of face value = 0.10 * 100 = Rs. 10
- Cost of issue per share = Rs. 2
The total cost of preference share capital is the sum of the face value, premium, and cost of issue per share:
Total Cost per Share = Face Value + Premium + Cost of Issue
Total Cost per Share = Rs. 100 + Rs. 10 + Rs. 2 = Rs. 112
Since there are 10,000 preference shares issued, the total cost of preference share capital at a premium of 10% is:
Total Cost of Preference Share Capital = Total Cost per Share * Number of Shares
Total Cost of Preference Share Capital = Rs. 112 * 10,000 = Rs. 1,120,000
(ii) When preference shares are issued at a discount of 5%:
- Face value of each share = Rs. 100
- Discount per share = 5% of face value = 0.05 * 100 = Rs. 5
- Cost of issue per share = Rs. 2
The total cost of preference share capital is the face value minus the discount plus the cost of issue per share:
Total Cost per Share = Face Value - Discount + Cost of Issue
Total Cost per Share = Rs. 100 - Rs. 5 + Rs. 2 = Rs. 97
Since there are 10,000 preference shares issued, the total cost of preference share capital at a discount of 5% is:
Total Cost of Preference Share Capital = Total Cost per Share * Number of Shares
Total Cost of Preference Share Capital = Rs. 97 * 10,000 = Rs. 970,000
So, the cost of preference share capital for Radha & Company is Rs. 1,120,000 if issued at a premium of 10% and Rs. 970,000 if issued at a discount of 5%.
(e) What is dividend? Discuss the important factors which determine. dividend policy of a company. 2+8-10
Ans:- Dividend: A dividend is a payment made by a corporation to its shareholders, typically in the form of cash or additional shares of stock. It represents a distribution of a portion of the company's profits to its owners, the shareholders. Dividends are usually paid out regularly, often on a quarterly or annual basis, and are one of the ways in which shareholders receive a return on their investment in the company.
Factors Determining Dividend Policy:
The dividend policy of a company is influenced by various internal and external factors. Here are some important factors that determine a company's dividend policy:
1. Profitability: The company's current and anticipated profitability is a significant factor. If a company is consistently earning profits, it is more likely to pay dividends. However, the availability of profits also depends on other factors such as reinvestment needs and debt obligations.
2. Financial Needs: The company's financial requirements for growth and expansion play a crucial role. If a company has profitable investment opportunities that require capital, it may choose to retain earnings rather than paying them out as dividends.
3. Shareholder Expectations: The expectations and preferences of shareholders also matter. Some shareholders may prefer regular dividend income, while others may be more interested in capital appreciation. Companies often aim to strike a balance between these expectations.
4. Industry and Competitive Position: The industry in which the company operates can influence its dividend policy. Mature industries with stable cash flows are more likely to pay consistent dividends, while growth-oriented industries may reinvest profits for expansion.
5. Tax Considerations: Tax laws and regulations can impact dividend decisions. In some jurisdictions, dividends may be taxed differently for shareholders compared to capital gains. This can influence the attractiveness of dividends.
6. Legal and Regulatory Constraints: Companies must adhere to legal and regulatory requirements regarding dividend payments. These rules may impose restrictions on the amount and timing of dividends.
7. Access to Capital Markets: A company's ability to raise capital from external sources can affect its dividend policy. If a company can easily access capital markets for funding, it may be more inclined to pay higher dividends.
8. Economic Conditions: The overall economic environment, including interest rates and inflation, can influence dividend policy. Economic downturns may lead companies to conserve cash and reduce dividends.
9. Dividend Stability: Companies often aim for dividend stability, meaning they try to avoid frequent changes in dividend amounts. Consistency in dividend payments can enhance investor confidence.
10. Company's Life Cycle: A company's stage in its life cycle can impact its dividend policy. Newer companies may prioritize reinvestment for growth, while more mature companies may focus on distributing profits to shareholders.
(f) Discuss the disadvantages of excessive working capital and dangers of inadequate working capital encountered by a firm. 5+5=10
Ans:- Disadvantages of Excessive Working Capital:
1. Reduced Profitability: Excessive working capital ties up funds that could be used more productively elsewhere. This can lead to lower profitability as idle cash does not generate returns.
2. Opportunity Cost: The funds locked in excess working capital could have been invested in income-generating assets or used for expansion and growth opportunities. Missing out on such opportunities is an opportunity cost.
3. Inefficient Use of Resources: Maintaining excessive inventory and accounts receivable can result in higher storage costs, insurance expenses, and bad debts. These inefficiencies reduce overall resource utilization.
4. Risk of Obsolescence: Excessive inventory may become obsolete or deteriorate over time, resulting in losses. This risk is higher when inventory turnover is low.
Dangers of Inadequate Working Capital:
1. Financial Distress: Insufficient working capital can lead to financial distress, as the company may struggle to meet its short-term obligations, such as paying suppliers or employees.
2. Difficulty in Operations: Inadequate working capital can hinder daily operations and production. It may lead to disruptions in the supply chain and production process.
3. Lack of Flexibility: A lack of working capital limits a company's ability to respond to unexpected opportunities or emergencies. It reduces the company's financial flexibility.
4. Creditworthiness Issues: A company with inadequate working capital may find it challenging to obtain credit or loans, which can further worsen its financial situation.
5. Supplier Relations: Delayed payments to suppliers due to inadequate working capital can strain supplier relationships, potentially leading to supply disruptions or strained terms.
(g) Explain the relationship between operating leverage and financial leverage.
Ans:- Operating leverage and financial leverage are two different aspects of a company's capital structure and financial performance, but they are related in how they impact a company's risk and return profile.
1. Operating Leverage:
Operating leverage relates to a company's fixed and variable costs in its operations. It measures the sensitivity of a company's operating income (earnings before interest and taxes, EBIT) to changes in its sales or revenue. Companies with high operating leverage have a higher proportion of fixed costs relative to variable costs. This means that as sales increase, the percentage increase in EBIT is greater because the fixed costs remain constant. Conversely, when sales decrease, the percentage decrease in EBIT is also greater.
The formula for operating leverage is:
Operating Leverage = Contribution Margin / EBIT
2. Financial Leverage:
Financial leverage refers to a company's use of debt and other fixed-interest securities in its capital structure. It measures the impact of interest expenses and financial obligations on a company's earnings. Companies with high financial leverage have a significant amount of debt compared to equity, which means they have to pay interest on that debt, and it can magnify both profits and losses.
The formula for financial leverage is:
Financial Leverage = Earnings per Share (EPS) / Earnings before Interest and Taxes (EBIT)
Relationship:
- High operating leverage can lead to high financial leverage and vice versa. When a company has high fixed operating costs, it may need to borrow money (incur debt) to finance those costs. This increases its financial leverage.
- The combined effect of high operating and financial leverage can amplify a company's return on equity (ROE) when things are going well (increasing sales and profits). However, it can also amplify losses when the company faces a decline in sales or profitability.
- Companies need to strike a balance between operating and financial leverage to manage their risk. Too much leverage can make a company vulnerable in economic downturns, while too little leverage might limit growth potential.
(h) Discuss the modern method of capital budgeting.
Ans:- Modern Methods of Capital Budgeting: Capital budgeting involves evaluating and selecting investment projects that require significant capital expenditures. Modern methods of capital budgeting use sophisticated techniques to make investment decisions. Here are a few modern methods:
1. Net Present Value (NPV): NPV calculates the present value of expected cash flows generated by an investment, subtracting the initial investment cost. If the NPV is positive, the project is considered acceptable because it's expected to generate more value than it costs.
2. Internal Rate of Return (IRR): IRR is the discount rate that makes the NPV of a project equal to zero. If the IRR exceeds the company's required rate of return, the project is accepted.
3. Profitability Index (PI): PI is the ratio of the present value of cash inflows to the initial investment. A PI greater than 1 indicates a favorable investment.
4. Modified Internal Rate of Return (MIRR): MIRR addresses some of the issues with IRR by assuming reinvestment at a specified rate and financing at another. It's often preferred over IRR in certain situations.
5. Real Options Analysis: This method considers the option to make decisions during the life of a project, such as expansion, abandonment, or switching product lines. It uses option pricing models to assess the value of these choices.
6. Simulation and Sensitivity Analysis: These techniques involve running multiple scenarios to assess the impact of different variables and uncertainties on project outcomes. It helps in understanding the range of possible outcomes.
7. Monte Carlo Simulation: This involves using random sampling and statistical modeling to simulate various scenarios and estimate the probability distribution of project outcomes.
8. Capital Asset Pricing Model (CAPM): CAPM is used to calculate the required rate of return for an investment based on its risk relative to the overall market.
Modern capital budgeting methods aim to provide a more comprehensive and accurate assessment of investment opportunities, considering factors like risk, timing, and uncertainty to make informed decisions about allocating capital resources.
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