Question 1

The three financial decisions; deferred loan instalments

18.75 marks

Time to write
About 38 minutes

From an older CBCS paper

Question

Question 1 · 18.75 marks

Q1. "Financial Management is concerned with the solution of three major decisions- the investment, the financing and the dividend decision". Explain this statement, and highlight how these decisions are inter-related.

Also advise Mr. Y: if he borrows an amount of Rs. 14,40,000 from a Bank @ 10% p.a. on 1-4-2023, with repayment to be made in 6 equal annual installment starting three years from now, what would each installment amount to?

Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

38 minfor 18.8 marks

Read from the question

  • Explain…Advise…What…?3 questions in all: answer every one.
  • ExplainTie the answer to the quoted statement: say what it means first, and come back to it at the end.
  • adviseEnd with a one-line decision that follows from your figures.

What the paper leaves open

  1. "Starting from three years from now" is read as: the first of the six equal instalments is paid at the end of the third year after borrowing (two years of deferment), interest accruing in the meantime.
  2. No mark is printed for the question; the paper asks for any four of six, equal marks.

Write it in this order

  1. Read the data; note exactly what is asked 2 min
  2. 1 The three decisions explained 6 marks 11 min
  3. 2 How they are inter-related 4.8 marks 9 min
  4. 3 Loan compounded for the deferral 3 marks 5 min
  5. 4 Annuity factor and instalment, with check 5 marks 9 min
  6. Check: arithmetic, units (₹, %), final answer underlined 2 min

Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Part 1: the three decisions and how they are related. The modern approach sees financial management as concerned with three major problems, corresponding to the investment, financing and dividend decisions: procuring funds at the lowest cost, investing them profitably, and distributing returns to satisfy the shareholders; all are taken to maximise shareholders' wealth, that is, the market value of the share. They are the three important functions of financial management.

  1. Investment decision: the asset composition of the firm: long-term assets (capital budgeting) and current assets (working capital management).
  2. Financing decision: when, where from and how to raise the funds: the mix of debt and equity (capital structure).
  3. Dividend decision: how much of the profit to distribute and how much to retain.

How they are inter-related.

  • The investment decision fixes the amount and timing of the funds needed; the financing decision fixes the cost of capital, which is the discount rate that decides which investments are acceptable.
  • Retained earnings are a source of finance, so the dividend decision is also a financing decision: a high payout means more external finance.
  • The dividend a firm can pay depends on its investment opportunities, and the share price reflects all three together. So the three must be decided jointly to maximise the value of the firm.

Part 2: advice to Mr. Y. The first of six equal instalments is paid at the end of the third year (paper note), so the loan earns interest for two years and the instalments then form an ordinary annuity. The present value of an annuity is the instalment multiplied by the annuity factor (the sum of the yearly present value factors).

  • Loan with interest at the end of year 2: 14,40,000 × (1.10)² = 14,40,000 × 1.210 = ₹17,42,400.
  • Annuity factor, 6 years at 10% = 4.355.
  • Each instalment = 17,42,400 ÷ 4.355 = ₹4,00,091.85, paid at the end of years 3 to 8 (from 1-4-2023).

Check: 4,00,091.85 × 4.355 = 17,42,400, and 17,42,400 ÷ 1.210 = 14,40,000.

Where the 18.75 marks sit

#ComponentMarks
1The three decisions explained6
2How they are inter-related4.75
3Loan compounded for the deferral3
4Annuity factor and instalment, with check5
Total18.75
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