Question 1
Profit maximisation as a criterion; choosing between two loan repayment options
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 1 · 15 marks"The profit maximization is not a criterion that is operationally feasible." Do you agree ? Give reasons. 8
Mr. Ajay is borrowing ₹12 lakhs from a bank to renovate his house, and the bank offers him two options. Under option one, he is to return the money in six equal annual installments, at a rate of 7% p.a. Under option two, he repays it in equal half installments over six years, at an annual interest rate of 6.5%p.a. Which of the options should he select, and why ? 7
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
Read from the question
- Is…?Give…Two asks in one question: answer both. Where it asks why, give reasons, not a description.
- agreeA statement to judge: take a stand on it in your first line, and come back to it at the end.
- Which of the options should he…End with a one-line decision that follows from your figures.
What the paper leaves open
"Equal half installments" is read as equal half-yearly installments (twelve over the six years). The two loans are compared on a common basis, the present value of their repayments at a common rate.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 (a) Agreement, with reasons 8 marks 14 min
- 2 (b) Instalment under each option 4 marks 7 min
- 3 (b) Comparison on a common basis and choice 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 3's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 30 minutes for 15 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.
(a) Is profit maximisation operationally feasible?
Yes, the statement is correct. Profit maximisation, though simple, cannot serve as an operational criterion for financial decisions, for these reasons:
1Quick cash today: the deal is struck even as the godown behind them crumbles.
Weaknesses of profit maximisationIt ignores the risk of the profits; it ignores the timing of costs and returns.
2Asha weighs time against risk on the scale—and the share price curve climbs behind her.
Strengths of wealth maximisationIts result is visible in the market price of the share.
- Vagueness. "Profit" is not defined: short-term or long-term, total profit or rate of profit, before or after tax, profit on capital employed or on equity. A criterion that can mean so many things cannot guide a decision.
- It ignores the timing of benefits. Two projects with equal total profits are treated alike even if one returns its profits much earlier; the time value of money is ignored.
- It ignores risk. A project with higher but very uncertain profit is preferred to a safer one with slightly lower profit, although shareholders are risk-averse.
- It ignores social responsibility and the interests of employees, customers and society.
Wealth (value) maximisation, which uses the present value of cash flows discounted at a risk-adjusted rate, removes these defects and is the accepted operational criterion.
(b) Choice between the two loan options
Option 1: six equal annual instalments at 7%. Annuity factor (6 years, 7%) = 4.767. Instalment = 12,00,000 ÷ 4.767 = ₹2,51,730.65 a year.
Option 2: twelve equal half-yearly instalments at 6.5% a year, i.e. 3.25% a half-year: when interest is compounded semi-annually the rate is halved and the number of periods doubled. Annuity factor (12 periods, 3.25%) = 9.8071. Instalment = ₹1,22,360.63 each half-year.
Comparison on a common basis (paper note). Interest compounded half-yearly at 6.5% is an effective annual rate of (1.0325)² − 1 = 6.61%, below option 1's 7%. Equivalently, the twelve half-yearly payments of option 2, discounted at option 1's 7% a year, have a present value of ₹11,86,542, less than the ₹12,00,000 borrowed: option 2 costs less in present-value terms. (Total cash repaid: option 1, 6 × 2,51,730.65 = ₹15,10,383.90; option 2, 12 × 1,22,360.63 = ₹14,68,327.56.)
Ajay should select option two: its effective cost is lower (6.61% against 7%), and repaying half-yearly matches the outflow more closely to a salary income, though it requires a payment every six months.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | (a) Agreement, with reasons | 8 |
| 2 | (b) Instalment under each option | 4 |
| 3 | (b) Comparison on a common basis and choice | 3 |
| Total | 15 |
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