Financial Management: Concepts and Techniques

This article covers various financial concepts and techniques such as payback period, net present value, internal rate of return, and M&M propositions. It also includes solved examples and graphs to explain the concepts better.

Running Head: Financial Concepts
Financial Management

Financial Concepts 1
Question 1
Part a
Year Opening Balance Interest @ 8% Yearly Deposits Closing Balance
1 $
7,000.00
$
560.00 $ 4,000.00
$
11,560.00
2 $
11,560.00
$
924.80 $ 4,000.00
$
16,484.80
3 $
16,484.80
$
1,318.78 $ 4,000.00
$
21,803.58
4 $
21,803.58
$
1,744.29 $ -
$
23,547.87
Answer:
In three years, total sum of $ 21803.58 will be available and in four years a total sum of $
23547.87 will be available.
Part b
Year Annual Cash Inflow
DCF @
15% PV of payments
1 $ 12,000.00 0.870 $ 10,434.78
2 $ 12,000.00 0.756 $ 9,073.72
3 $ 12,000.00 0.658 $ 7,890.19
4 $ 12,000.00 0.572 $ 6,861.04
5 $ 12,000.00 0.497 $ 5,966.12

Financial Concepts 2
6 $ 12,000.00 0.432 $ 5,187.93
7 $ 12,000.00 0.376 $ 4,511.24
8 $ 12,000.00 0.327 $ 3,922.82
9 $ 12,000.00 0.284 $ 3,411.15
10 $ 12,000.00 0.247 $ 2,966.22
11 $ 12,000.00 0.215 $ 2,579.32
12 $ 12,000.00 0.187 $ 2,242.89
Total NPV $ 65,047.43
The maximum amount that the investor will be willing to pay will be $ 65047.43
Part c
Yield to
Maturity= Coupon Payment + Face Value - Market Price
Terms to Maturity
(Face Value + Market Price)*0.50
= 4+(( 100-91.137)/12)
(100+91.137)*0.50
=4.74
95.57
=4.96%

Financial Concepts 3
Bond Equivalent Yield= YTM * Number of Compounding
=4.96 * 2
=9.92%
Effective Annual
Yield= =(1+ (r/n))^n)-1 (
=(1+ (0.0992/2))^2-1
=10.17%
Question 2
Part a
Project A
Year Cash Flows
DCF @
15% PV of Cash Flows Cumulative Cash Flows
0 -250 1.000 -250.00 -250.00
1 100 0.870 86.96 -163.04
2 100 0.756 75.61 -87.43
3 100 0.658 65.75 -21.68
4 100 0.572 57.18 35.50
Payback
years 3.38 years
Project B
Year Cash Flows
DCF @
15% PV of Cash Flows Cumulative Cash Flows
0
-$
250.00 1.000 -$ 250.00
-$
250.00
1
$
100.00 0.870 $ 86.96
-$
163.04
2
$
200.00 0.756 $ 151.23
-$
11.81
3
$
- 0.658 $ -
-$
11.81
4
$
- 0.572 $ -
-$
11.81

Financial Concepts 4
No Payback
Period
Payback technique is a key technique of capital budgeting which is used to determine the
length of time within which the project will recover its initial cost of investment. Lower the
payback period, higher the chances of acceptance of project and when the project has
prolonged payback period, it loses its opportunity of acceptance. In the present case, Project
A has more chances of acceptance than Project B because the former has a payback period of
3.38 years however, Project B is found to be unable to recover the initial investment within
its economic life as it does not has sufficient amount of cash inflows to cover up the initial
outlay.
Part b
Project A
Year Cash Flows
DCF @
15% PV of Cash Flows
0 -$ 250.00 1.000 -$ 250.00
1 $ 100.00 0.870 $ 86.96
2 $ 100.00 0.756 $ 75.61
3 $ 100.00 0.658 $ 65.75
4 $ 100.00 0.572 $ 57.18
NPV $ 35.50
Project B
Year Cash Flows
DCF @
15% PV of Cash Flows
0 -$ 250.00 1.000 -$ 250.00
1 $ 100.00 0.870 $ 86.96
2 $ 200.00 0.756 $ 151.23
3 $ - 0.658 $ -
4 $ - 0.572 $ -
NPV -$ 11.81

Financial Concepts 5
Net present value is the most common technique of capita budgeting. It determines the
profitability of the project by taking into account the present values of the all the all the cash
flows of the project (Finance Management, 2018). Higher the NPV, higher is the potential of
the project of generating returns for its stakeholders (Bennouna, Meredith & Marchant,
2010). If the project has negative NPV, it must not be accepted as negative NPV has no
return potential. In the present case, the Project A has a NPV of $ 35.50 and Project B has a
negative NPV of $ 11.38. This is clearly indicated from the cash flows of the project A since
it is expected to generate cash inflows in all the four years while project B is expected to
generate cash inflows for the 2 years. Therefore, it can be said that from NPV point of view,
project A is better than project B. Hence, project A must be accepted.
Part c
Yes the conclusion of part ‘a’ and ‘b’ of the question is same. Both the above discussed parts
suggest that project A must be selected over project B as the former project has the capacity
to generate more cash inflows to offer returns to the project stakeholders. More amounts of
cash inflows of project A will allow it to recover its cash outflows. Project B, which has an
identical project life as that of project A, is not capable of earning any cash inflows in year 3
and 4 and due to this it will not allow it to recover even the initial project cost.
`Part d
There are various capital budgeting techniques that can be used to evaluate the worthiness of
both the proposed projects and to select one out of two proposals, in the present case. Those
techniques are internal rate of return, profitability index and so on (Management Study
Guide, 2018). The internal rate of return is the rate at which project remains at its breakeven
i.e. it neither incurs any losses nor generates any profit. The NPV at this point is zero. If the
IRR of the project is higher than the required rate of return of the project i.e. the desired rate

Financial Concepts 6
of return, the project shall be accepted. In the present case, the required rate return of both the
projects is 15%.
Internal Rate of Return
Project A
Year Cash Flows
0 -$ 250.00
1 $ 100.00
2 $ 100.00
3 $ 100.00
4 $ 100.00
IRR 22%
Project B
Year Cash Flows
0 -$ 250.00
1 $ 100.00
2 $ 200.00
3 $ -
4 $ -
IRR 12%
The IRR of project A is 22% which is higher than the project’s expected return and IRR of
project B is 12% which is less than the expected return of the project, hence Project A must
be accepted and Project B must be rejected as it does not have the potential to offer the
stakeholders their desired level of return.
Profitability Index:
Profitability Index= NPV + Initial Investment
Initial Investment
Project A 35.50+250
250
1.14

Financial Concepts 7
Project B 238.19
250
238.19
250
0.95
Profitability index is also an important capital budgeting technique that is used to rank the
proposed projects on the basis of the present values of their respective cash flows. The project
that has profitability index of more than 1 must be accepted and the project that has
profitability index of less than 1 must be rejected (Damodaran, 2012). The profitability index
of more than 1 for any project indicates that the present value of future cash flows is more
than its initial investment. In the present case Project A has PI of 1.14 and Project B has PI of
0.95 and hence the Project A must be accepted and Project B must not be accepted.
Question 3
Part a
M&M Proposition 1:
It contends that firm’s value is independent of its capital structure. For instance, there are two
firms operating the business with same operation and also have the similar kind of assets.
Due to this, the asset side of both the firms looks alike. The only difference in the balance
sheet of both the firms is of liabilities which show how such assets have been financed.

Financial Concepts 8
Figure 1: Capital Structure of Firm 1
Figure 2: Capital Structure of Firm 2
Figure 1 depicts that the firm has the equity stock which comprises of 70% of the total capital
structure and the debt (bonds) comprises 30% of its total capital structure. The Figure 2,
depicts the totally opposite position due to the reason that both the firms have same assets in
both the capital structures.
Therefore, M& M proposition suggests that it is totally irrelevant that how debt and equity
components of a firm are structured. The true value of a firm is determined by its real assets
and not by its capital structure (Fabozzi, 2005).
M&M Proposition II:

Financial Concepts 9
According to this proposition the value of the firm is majorly dependent on three factors that
are discussed below:
 The required rate of return on the assets of the firm
 Firm’s Cost of Debt and
 Firm’s Debt Equity Ratio
Figure 3: Graphical Presentation of M&M Proposition II
The above figure shows a graph that depicts that the firm’s required rate of return is a straight
line with the slope of (Ra – Rd)
The Re line is sloping upwards because the company’s risk of bankruptcy increases with the
increase in the quantum of debt it borrows from the market. As debt increases the financial
leverage of the company, the stockholders demand more return from the business. The rise in
debt equity ratio will increase the Re. Both M&M proposition I and II states the same thing
that the firm’s capital structure does not define its total value. Therefore, WACC remains
constant even when debt equity ratio changes (Pratheepkanth, 2011).

Financial Concepts 10
Part b
Firm’s beta will remain same as equity beta.

Financial Concepts 11
References:
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making: evidence from Canada. Management decision, 48(2), 225-247.
Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value
of any asset (Vol. 666). John Wiley & Sons.
Fabozzi, F.J., 2005. Bond Markets, Analysis and Strategies”(Int’l Edition)–5th Edition.
Prentice Hall.
Finance Management, 2018. Why Net Present Value is the Best Measure for Investment
Appraisal? Available at: https://efinancemanagement.com/investment-decisions/why-net-
present-value-is-the-best-measure-for-investment-appraisal
Gotze, U., Northcott, D., and Schuster, P. (2016). INVESTMENT APPRAISAL. (2nd ed.). New
York: Springer.
Higgins, R. C. (2012). Analysis for financial management. New York: McGraw-Hill/Irwin.
Management Study Guide, 2018. Problems With Using Internal Rate of Return (IRR) for
Investment Decision Making. Available at:
https://www.managementstudyguide.com/problems-with-using-internal-rate-of-return.htm
Pratheepkanth, P., 2011. Capital structure and financial performance: evidence from selected
business companies in Colombo stock exchange Sri Lanka. Researchers World, 2(2), p.171.
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