MMPC-014 Solved Question Paper

Question 1

Time value of money and how managers actually use it

The time value of money (TVM) is the idea that a rupee in your hand today is worth more than a rupee you will receive in the future, because today’s rupee can be invested and start earning returns immediately.

Why the time value of money really matters

• Investment decisions: When a firm considers buying a new machine, opening a branch, or launching a product, all cash flows occur at different points in time. TVM lets us compare them on a common “today” basis.
• Financing decisions: Loans, debentures and leases involve fixed future payments. TVM helps managers judge whether a borrowing cost is acceptable.
• Personal finance: Individuals use TVM (even informally) when comparing fixed deposits, EMIs, SIPs, or deciding whether to prepay a loan.
• Performance evaluation: Many project evaluations, incentive schemes and valuation models are built on discounting future cash flows.

Key tools to calculate the time value of money

In practice, finance managers mainly use the following TVM tools:

• Future value (FV): How much an amount today will grow to in the future at a given interest rate.
• Present value (PV): What a future amount is worth today after discounting it at an appropriate rate.
• Annuities: Equal cash flows at regular intervals (for example, EMIs, rent, SIPs).
• Perpetuities: Equal cash flows that conceptually go on forever (for example, some preference shares).

A common formula used in day-to-day work is the present value of a single future sum:

$$ PV = \frac{FV}{(1 + r)^n} $$

Here, FV is the future amount, r is the discount rate per period, and n is the number of periods.

Practical illustration: Suppose a supplier offers a client two options – pay ₹90,000 today or ₹1,00,000 after one year. If the client can earn 12% elsewhere, the present value of ₹1,00,000 after a year is:

$$ PV = \frac{100000}{(1 + 0.12)^1} \approx 89{,}286 $$

Since ₹90,000 today > ₹89,286, paying now is slightly costlier in PV terms. Many managers intuitively feel this trade-off, but formal TVM tools make such choices transparent and defensible.

Question 2

Why we value securities and main business valuation approaches

Valuation of securities means estimating the fair worth of financial instruments like shares, debentures or entire businesses. It is fundamental for investment decisions, mergers and acquisitions, IPO pricing, and even internal restructuring. 

Why do managers need valuation?

• Investment choice: Portfolio managers compare intrinsic value with market price to decide whether to buy, hold, or sell.
• Mergers and acquisitions: When one firm acquires another, valuation helps in negotiating a fair deal and deciding the mix of cash, shares or debt.
• Raising capital: When issuing new equity or debt, firms need a view of what investors are likely to pay.
• Strategic decisions: Divestment of a division, spin-offs, or buy-backs all rely on understanding value.

Major business valuation approaches

The course material highlights several broad approaches; in practice, analysts often use more than one and then reconcile the results. 

• 1. Asset-based (balance sheet) approach:
  • Starts from the fair value of assets minus liabilities.
  • Useful for asset-heavy firms (real estate, manufacturing with tangible plant) or liquidation scenarios.
  • Limitation: ignores future earning power and intangible assets like brand and customer relationships.
• 2. Earnings / income-based approaches:
  • Capitalisation of earnings: Normalised sustainable earnings are capitalised by an appropriate rate to get firm value.
  • Discounted cash flow (DCF): Project free cash flows and discount them using the cost of capital. Widely used for project appraisals and firm valuation.
  • Strength: explicitly links value to expected future cash flows and risk.
• 3. Market-based (relative) valuation:
  • Uses multiples such as P/E, EV/EBITDA or P/BV of comparable companies.
  • Popular in investment banking and equity research because it is quick and easy to explain.
  • Limitation: depends heavily on the choice of peers and market moods.

Example from practice: When a mid-sized logistics company plans to sell a 30% stake to a private equity fund, the deal team typically prepares a DCF model, an asset-based valuation (especially if there is valuable fleet and warehouses), and a peer multiple table. Negotiations revolve around these numbers, adjusted for qualitative factors like management quality and future contracts.

Question 3

Importance of working capital and key factors that decide its level

Working capital is the capital locked in day-to-day operations — mainly inventories, receivables and cash, minus short-term payables. 

Why working capital is crucial

• Ensures smooth operations: Adequate inventory and cash prevent production stoppages and payment delays.
• Protects business reputation: Timely payment to suppliers and employees builds trust and bargaining power.
• Reduces risk of insolvency: Even profitable firms can fail if they cannot meet short-term commitments.
• Improves profitability: Efficient working capital reduces interest costs and frees funds for higher-return projects.

In real companies, CFOs spend a lot of time on working capital reviews — aging of debtors, inventory days, and payables terms — because even small improvements can release significant cash.

Main determinants of working capital needs

• Nature of business: Trading firms need more working capital relative to fixed assets than software or consulting firms.
• Operating cycle length: The longer it takes to convert raw material into cash (through production and credit sales), the higher the working capital requirement. 
• Credit policy to customers: Liberal credit terms increase receivables and therefore working capital.
• Credit from suppliers: Longer credit periods from suppliers reduce the net working capital needed.
• Production policy: Level production (steady output) vs seasonal production affects inventory build-up.
• Growth and expansion: Fast-growing firms usually need more working capital to support higher sales.
• Operating efficiency: Better inventory control, faster billing and collection, and just-in-time practices reduce working capital.
• Market and economic conditions: Inflation, interest rates and supply chain disruptions can change working capital levels significantly.

Practical view: Many Indian SMEs struggle not because their products are bad, but because working capital is locked in slow-moving stock and overdue receivables. Simple changes like stricter credit checks, early-payment discounts, and better production planning often improve their cash position dramatically.

Question 4

Equity shares and debentures – meaning, pros and cons

What are equity shares?

Equity shares represent ownership in a company. Equity shareholders are residual claimants – they receive dividends only after all other obligations are met, and they have voting rights in general meetings. 

Advantages of equity from the company’s angle

• No compulsory fixed payment; dividends can be adjusted depending on profits.
• No maturity; equity is a permanent source of capital.
• Improves the firm’s debt-equity position, making it easier to borrow later.

Limitations of equity for the company

• Generally more expensive than debt because investors demand higher returns for higher risk.
• Excessive equity can dilute control of existing owners.
• Dividends are not tax-deductible, so there is no tax shield.

From investor’s perspective

• Pros: Potential for high returns via dividends and capital gains; voting rights; hedge against inflation.
• Cons: Higher risk, variable dividends, and last priority in liquidation.

What are debentures?

Debentures are long-term debt instruments through which a company borrows money at a fixed rate of interest. Debenture-holders are creditors, not owners. 

Advantages of debentures for the company

• Interest is tax-deductible, reducing effective cost of capital.
• Debt does not dilute ownership or voting control.
• Can enhance EPS through financial leverage if the company earns more than the cost of debt.

Limitations of debentures

• Interest must be paid irrespective of profits, increasing financial risk.
• Principal has to be repaid at maturity, creating refinancing pressure.
• Too much debt can lead to downgrades and higher borrowing costs.

From investor’s perspective

• Pros: Fixed, regular income with higher priority in liquidation; generally lower risk.
• Cons: Limited upside; no voting rights; exposed to default and interest-rate risk.

Real-world trade-off: A growing company with volatile earnings may initially rely more on equity to avoid rigid interest commitments. Once cash flows stabilise, it often adds debt (debentures, term loans) to benefit from the tax shield and boost shareholder returns, keeping an eye on rating and leverage ratios.

Question 5

Why dividend decisions matter and “relevance” theories of dividend

Why is the dividend decision important?

The dividend decision is about how much of the firm’s earnings should be distributed to shareholders now and how much should be retained for reinvestment. It is closely linked to financing because retained earnings are an internal source of equity. 

• Impacts shareholder wealth: Many investors, especially small shareholders and retirees, value stable cash dividends.
• Affects growth: Retained earnings finance future projects; too high a payout may starve good projects of funds.
• Signals information: Changes in dividend often signal management’s confidence (or concern) about future earnings.
• Influences cost of capital: Perceived risk and investor clientele may change with dividend policy.

Relevance theories of dividend

“Relevance” theories argue that dividend policy does affect the value of the firm, contrary to the Modigliani–Miller irrelevance view. Key models are:

1. Traditional (or empirical) view

• Investors generally prefer steady, reasonable dividends.
• Very high payouts may hurt growth; very low payouts may make the share unattractive.
• A balanced policy – moderate, stable dividends with adequate retention – is thought to maximise value.

2. Walter’s model

• Links dividend policy directly to the firm’s internal rate of return (r) and its cost of equity (k_e).
• If r > k_e, the firm should retain earnings (low or zero dividend), because reinvestment creates more value than shareholders could generate elsewhere.
• If r < k_e, the firm should distribute most earnings; shareholders can invest better outside.
• If r = k_e, dividend policy does not affect value.

3. Gordon’s model (“bird-in-the-hand”)

• Assumes investors are risk-averse and prefer certain dividends today over uncertain capital gains later.
• The share price is expressed as the present value of an infinite stream of growing dividends.
• Higher payout and stable growth can increase value when investors strongly value current income.

Practical angle: Many listed Indian companies follow a target payout range, such as 30–40% of profits, adjusting slowly over time. Even when theory suggests retaining more earnings for positive-NPV projects, boards often hesitate to cut dividends sharply because markets react negatively and long-term investors may lose confidence.

Question 6

What makes a good investment appraisal method? Discounted cash flow techniques managers actually use

Characteristics of a sound appraisal method

A good capital budgeting technique should: 

• Consider all cash flows over the project’s life, not just early years.
• Incorporate time value of money, giving more weight to earlier cash flows.
• Reflect risk through the discount rate or explicit risk adjustments.
• Be consistent with the objective of maximising shareholder wealth.
• Be understandable and usable by practising managers who must explain and defend their proposals.

Major discounted cash flow (DCF) methods

1. Net Present Value (NPV)

• NPV is the present value of future net cash inflows minus the initial investment.

$$ NPV = \sum_{t=1}^{n} \frac{CF_t}{(1 + k)^t} – I_0 $$

• If NPV > 0, the project adds value; if NPV < 0, it destroys value.
• Real-world use: Many large firms use NPV as the primary criterion for plant expansions, IT systems, and infrastructure projects.

2. Internal Rate of Return (IRR)

• IRR is the discount rate that makes NPV = 0.
• Decision rule: Accept the project if IRR > required rate of return (cost of capital).
• Managers like IRR because it is expressed as a percentage and is easy to compare with hurdle rates.
• However, for non-conventional cash flows or mutually exclusive projects, IRR can be misleading; NPV then gets priority.

3. Profitability Index (PI)

• PI = Present value of future cash inflows / Initial investment.
• Projects with PI > 1 are acceptable.
• Helpful when capital is rationed and projects must be ranked.

4. Discounted Payback Period

• Measures how long it takes to recover the investment in present value terms.
• Shows liquidity and risk exposure period, but ignores cash flows after payback.

In practice: A typical capital expenditure proposal in a manufacturing company includes NPV, IRR, payback and sometimes scenario analysis (best case, base case, worst case). Senior management often insists on a minimum IRR and a maximum payback period, but final approval is usually framed around NPV and strategic fit.

Question 7

Behavioural finance – meaning, scope, characteristics and how it differs from traditional finance

What is behavioural finance?

Behavioural finance studies how psychological factors and cognitive biases influence the financial decisions of investors, managers and markets, often leading to outcomes that differ from those predicted by strictly rational models. 

Scope of behavioural finance

• Individual investor behaviour: How retail and institutional investors form expectations, overreact, or follow the herd.
• Corporate decisions: How CEO overconfidence, attachment to legacy projects, and fear of admitting mistakes affect investment and financing choices.
• Market anomalies: Explaining bubbles, crashes, momentum and value effects that traditional models struggle with.
• Product design and advice: Designing mutual funds, retirement plans and financial education based on real human behaviour, not ideal rationality.

Key characteristics of behavioural finance

• Uses insights from psychology and sociology to explain financial decisions.
• Recognises systematic biases such as overconfidence, loss aversion, mental accounting, and anchoring.
• Accepts markets as “boundedly rational” – sometimes efficient, sometimes distorted by human behaviour.
• Emphasises real-world evidence from experiments, surveys and market data.

Behavioural vs traditional finance

• Assumptions about investors: Traditional finance assumes fully rational, utility-maximising investors; behavioural finance assumes people have limited information, limited processing power and emotions that affect choices.
• View of markets: Traditional theory (like EMH) sees markets as largely efficient; behavioural finance accepts that mispricing and bubbles can persist.
• Decision process: Traditional models focus on optimisation; behavioural finance focuses on heuristics (“rules of thumb”) and biases.
• Methods: Traditional finance is heavily mathematical; behavioural finance uses experiments, surveys and interdisciplinary research.

Real-life illustration: During strong bull markets, many investors keep buying simply because “everyone else is making money,” ignoring fundamentals. Later, when prices fall sharply, the same investors panic and sell at the bottom. Behavioural finance labels these patterns as herding and loss aversion, and encourages strategies like pre-decided asset allocation and systematic investing to counter them.

Question 8

EPS under alternative financing plans – choosing the better capital structure

A company needs ₹5,00,000 to buy a new plant. It is considering three financing plans based on the same expected earnings before interest and tax (EBIT) of ₹1,00,000 and a tax rate of 50%:

1. Plan A – All equity: Issue 50,000 equity shares of ₹10 each.
2. Plan B – Equity plus debt: Issue 25,000 equity shares of ₹10 each and 2,500 debentures of ₹100 each at 8% interest.
3. Plan C – Equity plus preference shares: Issue 25,000 equity shares of ₹10 each and 2,500 preference shares of ₹100 each at 8% dividend.

We will compute earnings per share (EPS) for each plan and recommend the most favourable one. 

Plan A – All equity

• EBIT = ₹1,00,000
• No interest → Profit before tax (PBT) = ₹1,00,000
• Tax @ 50% = ₹50,000
• Profit after tax (Earnings for equity) = ₹50,000
• Number of equity shares = 50,000

$$ EPS_A = \frac{50{,}000}{50{,}000} = ₹1.00 \text{ per share} $$

Plan B – Equity plus debentures

• EBIT = ₹1,00,000
• Interest on debentures = 8% of (2,500 × 100) = 0.08 × 2,50,000 = ₹20,000
• PBT = 1,00,000 − 20,000 = ₹80,000
• Tax @ 50% = ₹40,000
• Profit after tax (Earnings for equity) = ₹40,000
• Number of equity shares = 25,000

$$ EPS_B = \frac{40{,}000}{25{,}000} = ₹1.60 \text{ per share} $$

Plan C – Equity plus preference shares

• EBIT = ₹1,00,000
• No interest → PBT = ₹1,00,000
• Tax @ 50% = ₹50,000
• Profit after tax (Earnings available to equity and preference) = ₹50,000
• Preference dividend = 8% of 2,50,000 = ₹20,000 (not tax-deductible)
• Earnings available for equity = 50,000 − 20,000 = ₹30,000
• Number of equity shares = 25,000

$$ EPS_C = \frac{30{,}000}{25{,}000} = ₹1.20 \text{ per share} $$

Comparison and recommendation

• Plan A: EPS = ₹1.00
• Plan B: EPS = ₹1.60
• Plan C: EPS = ₹1.20

Plan B (mix of equity and debentures) gives the highest EPS because the company is using cheaper, tax-deductible debt and benefiting from financial leverage. As long as the firm is comfortable with the additional interest obligation and financial risk, Plan B is financially preferable.

Managerial insight: In real board meetings, such an analysis is usually accompanied by sensitivity tests – “What if EBIT falls to ₹80,000?” – and ratios like interest coverage. A plan with the highest EPS is attractive, but prudent managers also check whether the firm can service debt comfortably even in weaker years.