BBA/B.Com Financial Management DEC 2024

Description

Financial Management

December 2024 Examination

 

 

1. In the context of financial management, discuss the concepts of wealth maximization and profit maximization. What are the key differences between the two? Which concept is more appropriate for guiding the financial decisions of a corporation? (Student can make any assumptions to further explanation of their view point) (10 Marks)

Ans 1.

Introduction

Financial management is the backbone of corporate decision-making, ensuring the optimal allocation of resources to achieve organizational goals. Two fundamental concepts—wealth maximization and profit maximization—play a pivotal role in shaping a firm’s financial strategies. Profit maximization focuses on generating immediate earnings, often associated with short-term goals, while wealth maximization emphasizes the creation of long-term value for shareholders. These approaches guide investment, financing, and dividend decisions within a business. However, in

 

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2. RK Ltd has a stock with a beta of 1.3 and an expected return of 16.7%. The current risk-free rate is 7.6%. Explain how CAPM determines the expected return of a stock based on its risk relative to the market and calculate the risk premium on the market. Show the step-by-step calculation. (10 Marks)

Ans 2.

Introduction
The Capital Asset Pricing Model (CAPM) is a cornerstone in financial theory, designed to evaluate the expected return of an investment based on its risk relative to the overall market. It establishes a relationship between systematic risk (non-diversifiable risk) and expected return, helping investors and analysts determine whether a stock is fairly valued given its inherent risk. RK Ltd., with a beta of 1.3 and an expected return of 16.7%, presents an ideal scenario to explore CAPM’s practical application. Beta measures a stock’s sensitivity to market movements, while the risk-free rate represents a theoretical return on a zero-risk investment, such as government bonds. CAPM uses these inputs, along with the market risk premium, to assess expected returns. Calculating the risk premium on the market offers further insights into the market’s

 

3. A company is considering its capital structure to minimize its overall cost of capital. The company’s current capital structure consists of 40% debt and 60% equity. The cost of debt is

6%, and the cost of equity is 12%. The company is evaluating a new capital structure with 50% debt and 50% equity, where the cost of debt will increase to 7% due to higher financial risk, while the cost of equity will rise to 14%. (Assume corporate tax rate 30%)

1. Calculate the weighted average cost of capital (WACC) for the company’s current and proposed capital structures. (5 Marks)

Ans 3a.

Introduction

The Weighted Average Cost of Capital (WACC) is a critical financial metric used to determine a company’s overall cost of raising capital from various sources. It is calculated by weighting the costs of equity and debt proportionally to their use in the capital structure, accounting for the tax shield provided by debt. A lower WACC indicates that the company can fund its operations and growth at a lower cost, thereby maximizing value. This section evaluates the WACC for the company’s current and proposed capital structures, considering changes in the cost of debt and equity

 

 

1. Based on the WACC calculated in part (a), determine the optimal capital structure for the company. Discuss the trade-offs involved in choosing between a lower cost of debt and a potentially higher financial risk. (5 Marks)

Ans 3b.

Introduction

Determining the optimal capital structure involves balancing the trade-offs between debt and equity to minimize WACC. While debt is cheaper due to tax benefits, excessive reliance on it increases financial risk, raising both the cost of debt and equity. This section discusses the implications of the WACC analysis and evaluates the trade-offs in deciding the optimal capital structure for the company.

Concept and Application

The optimal capital structure